I recently suggested that business development companies merit further investigation for income-oriented investors. Given the complexity of some of the management structures, as well as the risky nature of the underlying investments made, investors interested in this niche should pay careful attention to the alignment of interests between management and shareholders.
I had indicated that I would follow up with a review of this dynamic if readers were interested, and that was overwhelmingly the case. Therefore, I am reviewing each of the 14 dividend-paying BDCs I had highlighted in order to assess the amount of "skin in the game."
After recently reviewing Ares Capital (ARCC), the largest of the group, Apollo Investment (AINV), Prospect Capital (PSEC), and Solar Capital (SLRC) - which has been the one with the best alignment with outside shareholders - I am following with Fifth Street Finance (FSC), which has a market cap of about $700 million. FSC is one of the newer BDCs, trading publicly since 2008:
The company filed its annual proxy on January 28, 2011. Like its four larger peers, where management is provided by an affiliated company, FSC is managed by its investment adviser, Fifth Street Management. CEO Leonard Tannenbaum (39) founded his first private investment firm in 1998 after working as an equity analyst for Merrill Lynch. The company recently replaced its CFO, who had served from 2007, with Alex Frank, who joined from Chilton Investment Company previously after 22 years with Morgan Stanley in a variety of operational and financial roles.
Total insider ownership was listed as 2.9%, almost all of which was held by Tannenbaum (1.46mm shares valued currently at about $14.5mm). Like many other insiders in the industry, Tannenbaum purchased shares in August. In his case, though, it was a very large purchase: 226K shares near $8.50. He has actually been a steady buyer of the stock and owns approximately 1.82mm shares. The share count has increased significantly this year as well, so the percentage has actually declined a bit. Still, Tannenbaum's ownership seems to offer reasonable alignment. Unlike each of the four BDCs I have previously reviewed, FSC is not permitted to sell new stock below the NAV.
Due to the structure of outside management, investors are unable to clearly weigh the alignment of interests, as there is no disclosure regarding salary and incentive pay levels (or metrics) for the individuals involved in running the firm. As the 10-K describes in detail, there are many potential conflicts of interest. I would also point out that CEO Tannenbaum has several outside demands on his time beyond his duties at FSC, as he serves on several outside boards of companies affilliated with Greenlight Capital.
In reviewing FSC, one of the things I ran across that I think shareholders should appreciate is the consistent policy of monthly messages that are published 8 months a year. The other four months are when the company reports earnings. FSC will share results for the year ending 9/30 at the end of this month. I also want to thank "dividendinvestor123" for sharing a link to a Bloomberg interview with Tannenbaum from March. Not only does the CEO come across as thinking and acting like the shareholder he is, but he also does a good job of explaining the industry and its value proposition.
While there are several other BDCs to evaluate regarding management's alignment with shareholder's, FSC compares favorably to the previously reviewed ARCC, PSEC and, especially, AINV, while being almost in the same league as Solar Capital (SLRC). While SLRC has more insider ownership, I like that FSC prohibits sale of the stock below NAV. While many factors ultimately influence the level of future dividends, it is likely that Tannenbaum, who has substantial equity exposure, is incentivized to steer the firm in a direction that sustains or even grows the payment without taking excessive risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.