The BDC Activist (a publication of the BDC Reporter) had a quick first look at the latest struggle between a business development company's external manager and a would-be change maker back in late January 2016. Then, we reviewed the initial arguments made by investment group Ironsides Partners against the incumbency of an affiliate of Fifth Street Asset Management (NASDAQ:FSAM), which serves as the investment advisor to Fifth Street Senior Floating Rate Corp. (NASDAQ:FSFR). Since then, there has been much back and forth between the two parties, as Ironsides seeks to convince shareholders in advance of the annual conclave to vote in two of its representatives as Directors, and drop FSAM as external manager.
(For readers with plenty of time on their hands, we refer you to the SEC filings at FSFR's website which show over 20 different Proxy related materials filed since late December of last year. The latest - dated March 28th - is an "infographic" by Ironsides that spells out its arguments, complete with diagrams, pictures and colors. That was followed up by a more conventional "Letter to Stockholders" from the current Powers-That-Be). The mission of the two Ironsides nominees - should they be accepted by FSFR's shareholders - would be to lay the groundwork for a sale of the company to a third party or its liquidation. As you can imagine, FSAM and the current Board of FSFR are making every argument possible against any disturbance in the current Board, investment advisory, strategy or fee arrangement.
Now, with the shareholder meeting not far off (April 7), we thought it would be a good time to have a second look at what's happening. Our interest is not only about what has and might happen at Fifth Street Senior Floating Corp., but how this episode fits into the bigger theme of the re-writing of the relationship between the managers of BDCs and the investors who entrust their capital to the vehicles they manage.
BRAVE NEW WORLD. OR NOT.
Since BDC "activism" became a theme running through the industry last year, there have been a number of false starts. The struggle we've written most about at the BDC Reporter - the three-way tussle to manage TICC Capital (NASDAQ:TICC) - continues to simmer, but with no clear outcome yet. NexPoint appears to have withdrawn from the fight to become a low-cost external manager to the BDC, rebuffed on corporate governance terms by a federal judge. TPG Specialty (NYSE:TSLX) continues to complain loudly from the sidelines, but has not been able to engage the company's Board in any meaningful negotiation, or even get shareholders' attention. It too is trying to get voices on the Board. The current external manager has reduced its fees, and appears to want to hold on to its role and its diminished but not unsubstantial stream of fee income for managing a much decreased asset base.
TURNCOAT OR SHREWD BUSINESSMAN
Elsewhere and even closer to home, a supposed "activist" (RiverNorth) shook the tree at Fifth Street Finance (NASDAQ:FSC), but was bought off with a combination of financial incentives and an inside look at the books. We do not know which of the two was the most compelling in getting a settlement between FSC, FSAM and its challenger. Certainly no huge financial gain appears to have been achieved by RiverNorth. The shareholders of FSC are left with a mountain of legal bills, several still ongoing shareholder lawsuits, and the ironic prospect that FSAM will soon be sending its own professional fees over for reimbursement. Look out in the next quarterly statement. (RiverNorth also agreed - for its pound of flesh and in an arrangement which we would have thought would have attracted greater attention from the regulators and the myriad law firms fishing in these waters - to not only vote with the incumbents at FSC but at FSFR as well. In a sense, the shareholders of FSAM, FSC and Mr. Tannenbaum (the CEO of the external manager) are paying RiverNorth to affect important issues at FSFR, which was not technically even involved in the activist's initial campaign against FSC). Here is what Antoine Gara at Forbes wrote:
But Friday's deal [between RiverNorth, FSC and FSAM] may play into Tannenbaum's hands by making it harder for frustrated investors to challenge the BDC's management agreement or its governance. RiverNorth agreed in the settlement to vote its 5.7% activist stake in Fifth Street Senior Floating Rate, another public BDC created by Tannenbaum, on behalf of management, potentially countering a separate activist campaign run by Ironsides Partners. (RiverNorth and Ironsides declined to comment.)
If there were not very real issues and money at stake, this would be amusing. We now have a once-fervent activist (RiverNorth) not only making peace with his prior target (FSC + FSAM), but actually joining forces to stymie the efforts of another "activist" with the same stated goals of unlocking shareholder value. BDC maneuverings have nothing on the ever changing alliances in the Middle East or any telenovela.
TRUST NO ONE
Our principal take-away from what we've witnessed on many fronts in the last year (and we were skeptical from the outset - as is our nature) is that investors should take with many grains of salt both the siren calls of the would-be "activists" and the self-serving arguments of the incumbents. The standard we are using in analyzing the current stand-off between Ironsides and Fifth Street Asset Management (who may not pay the bills but calls the shots) is whether i) the desired outcome by the challenger has a good probability of happening, ii) if so, will "regular" shareholders be better off in the long run?
To its credit, Ironsides has put its money where its mouth is, and has acquired a major stake in FSFR in preparation for their challenge, a whopping 6.4%. That's more than RiverNorth's stake, but less than owned by Mr. Tannenbaum. Unfortunately, the nature of corporate governance at this BDC - and essentially all the others - makes head on changes very difficult. FSFR has a "staggered Board", with only 2 directorships coming up for a vote in any year. Ironsides has its two nominees prepped and ready to go, but even if they are approved by shareholders, they will still be in a minority on the 7 person Board. We have no illusion that any of the other Directors - even those nominally "independent" would ever vote the same way as the Ironsides appointees. Shareholders hoping that the company might be sold or the Investment Advisory contract revised to be more favorable (Ironsides makes that compelling argument against the imposition of incentive fees when a BDC is losing money to the bottom line that the BDC Activist has been making for years) will, probably, be sorely disappointed.
Tactically, Ironsides is asking shareholders to allow its appointees to be the thin edge of a wedge, with no clear outcome to follow. Most likely, the two new Board members would be outvoted all year until the next election rolls around in 2017. Is Ironsides committed for the long term (this is a very long time in activist time) or will it fold and sell its shares at a premium - like RiverNorth did - after a few weeks or months?
If we give Ironsides the benefit of the doubt, and assume it might eventually get to elect a majority of like minded directors, how realistic is its plan to either bring in a new Investment Advisor and narrow the gap between the market value of the stock and actual value? There certainly is a huge gap between the year-end 2015 GAAP net asset value per share of $11.36, and a stock price currently mired under $8.0 a share. Even at 90% of NAV, the stock would be worth $10.2, a 33% premium over today's price of $7.65. The Ironsides argument is that the huge discount to NV is a reflection of the market's lack of trust in the external manager. Remove FSAM, bring in a new external manager, trust is restored and the stock price rises and everybody who bought shares in FSFR after June 2015 (when the $10 level was breached from the $15 IPO level) makes a profit.
STAND UP AND BE COUNTED
This is where the Ironsides plan gets fuzzy. No new Investment Advisor awaits in the wings. We have no idea if an Ironsides-controlled Board could bring on a new external manager on terms that would materially improve shareholder economics. Unlike at TICC where the base management was huge (2% of total assets), the compensation here is only 1%. We doubt anyone will be offering a much lower fee than that. Yes, the incentive fee (called a Part I fee by management) is unfair and irrational. Waiving of the near $7 million a year in incentive fees would benefit shareholders by $0.24 a year in additional net investment income per year, a 25% boost. Which asset manager, though, would agree to those terms? Even when TPG Specialty was lobbying TICC shareholders to bring them into its BDC, it was still pegging a base management fee of 1.5% and a 17.5% incentive fee. NexPoint, which had nothing to lose by promising the moon to TICC shareholders, was still intent on charging an incentive fee. Even if we look further afield to shareholder friendlier newer BDCs like Goldman Sachs BDC (which has an incentive fee which melts away if NAV drops), their base fee is 1.5% of assets. Existing BDC managers have too much to lose with their own shareholder base to take on FSFR with cut rate fees (even if they would still be highly profitable as we have no doubt they would). A new outside manager might be enticed, but not at 1% a year on total assets. The BDC Activist asks the question: who is willing to step into FSAM's managerial shoes, and on what terms? Without a good answer, this is not only a long shot, but into the dark besides.
If we're doubtful about the merits of changing external managers so late in the game, the BDC Activist is more sanguine about the relative benefits of a liquidation of the company, which Ironsides has also proposed. We'd guess virtually all the assets on both FSFR's own books and the JV could be readily sold off into the market, or $750 million. A rump $50 million of Watch List assets identified by the BDC Credit Reporter (look for our portfolio analysis coming soon) might be harder to sell and would have to be discounted or worked out. Selling off the "good" assets would generate - in a very short period - $250 million for shareholders, after all liabilities and debts were covered. Let's add $25 million of cash from the "Bad Assets" and shareholders could get paid $275 million from a pretty fast liquidation process. That's over $9.0 a share. Shareholders who bought into the original FSFR game plan a few years ago at $15.0 or in the teens when the secondary was offered up would not be happy. However, the $9.0 in the hand would probably be a better deal for most investors than the currently heavily discounted price, which shows no evidence of reversing itself despite a very sharp rally in the BDC sector.
However, we return again to the practical aspects of such an outcome. Clearly, FSAM would be vociferously opposed and throw up every roadblock possible if it does not get rejected in the coming vote. On the other hand, we're sure Ironsides would be delighted with such an outcome, but it does just not have the levers to effect such a transaction given the advantages of the incumbent and the time frame involved. There is no shareholder vote on liquidating the company. Even if Ironsides eventually gets control of the Board over two voting periods, there is no assurance shareholders would approve the sale of the business. Even if they did do so in 2017, conditions for asset sales could be very different, as could the performance of the portfolio.
IF NOT NOW, WHEN?
On the other hand, if shareholders ever wanted to effect a change at FSFR, this is probably the best chance they're going to have. If Ironsides' Directors get nominated (they only need a majority of the vote which in the weird world of corporate "democracy" is about as easy as it gets to make a change), there will - at least - be some scrutiny brought to a Board which has been very passive in the past. If shareholders are really mad and won't take it anymore, and also throw out FSAM as the external manager, there's a chance the Ironsides agenda might get implemented, and the stock price pumped up by a sale or the transfer to a new external manager.
We don't disagree with Ironsides that FSAM has been a poor external manager for FSFR over its recent history (notwithstanding the vigorous defense in the company's Letter To Stockholders). The sudden change in strategy and sale of a huge amount of equity at a discount to NAV just after reporting good quarterly results; the subsequent radio silence by management; the reduction in the distribution (in just 2.5 years as a public company, shareholders had their dividend cut 25% while fees have only grown); the big drop in the BDC's net asset value in the midst of an economic expansion and the deteriorating state of the loan portfolio, are all testaments to a job not well done. (That FSFR is not alone in the BDC universe in this regard is cold comfort to shareholders presumably).
However, Ironsides has not fully made a compelling case as to how it can realistically hope to make things any better for the company's shareholders who have already seen the stock price drop by 50% since the IPO, and 25% since last year if FSAM remains the external manager. Good intentions and a thundering critique of the incumbent are not enough by themselves to make a difference in the cold, hard world of the bottom line. The BDC Activist - at least - would like to see a more convincing and pragmatic game plan than what is currently on offer from Ironsides. However, we have to applaud that the would-be interloper is spending time and money "actively" seeking to change FSFR. We will see soon enough if FSFR's shareholders are in a "throw the rascals out" mode, even in the absence of a fully spelled out exit plan or are ready to stay with the "devil they know".
We have no position in FSFR, but one of our self-directed clients is Long the stock.
Disclosure: I am/we are long FSIC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: One of our self directed clients whom we advise has a Long position in FSFR common stock.