Fifth Street Asset Management's (FSAM) CEO Leonard Tannenbaum on Q1 2016 Results - Earnings Call Transcript

| About: Fifth Street (FSAM)

Fifth Street Asset Management, Inc. (NASDAQ:FSAM)

Q1 2016 Earnings Conference Call

May 17, 2016 10:00 AM ET

Executives

Robyn Friedman - SVP & IR

Leonard Tannenbaum - Chairman & CEO

Alexander Frank - COO & CFO

Analysts

Ken Worthington - JP Morgan

Operator

Good day ladies and gentlemen, and welcome to the Q1 2016 Fifth Street Asset Management Earnings Conference Call. [Operator Instructions]

I would now like to turn the conference over to Robyn Friedman, Head of Investor Relations. Please go ahead.

Robyn Friedman

Thank you, Candis. Good morning and welcome to Fifth Street Asset Management Inc.'s first quarter 2016 earnings conference call. I am joined this morning by Leonard Tannenbaum, Chief Executive Officer and Alexander Frank, Chief Operating Officer and Chief Financial Officer. Before we begin, I would like to note that this call is being recorded. Replay information is included in our May 16, 2016, press release and is posted on the Investor Relations section of Fifth Street Asset Management Inc's website which can be found at fsam.fifthstreetfinance.com. Please note that this call is the property of Fifth Street Asset Management Inc.

Any unauthorized rebroadcast of this call in any form is strictly prohibited. Today's conference call may include forward-looking statements and projections that reflect the Company's current views with respect to, among other things, future events and financial performance. Words such as believes, expects, will, estimates, plans, projects, anticipates and future or similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ materially from those projected in these forward-looking statements. New risks and uncertainties arise over time and it is not possible for the Company to predict those events or how they may affect it. Therefore you should not place undue reliance on these forward-looking statements. We ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections.

To obtain copies of our latest SEC filings please visit our website or call Investor Relations at 203-681-3720. We undertake no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise except as required by law. In addition, this conference call will include certain non-GAAP financial measures such as pro forma adjusted net income. A reconciliation of these measures to the most comparable GAAP measures can be found in our earnings release, which is available on the Investor Relations portion of our website and has been filed with the SEC.

Further, an investment in Fifth Street Asset Management is not an investment in any of our funds. Investors should note that the historical investment performance of our funds, including Fifth Street Finance Corp. and Fifth Street Senior Floating Rate Corp., are not indicative of future results. The format for today's call is as follows. Len will provide introductory remarks, an overview of our results and strategic commentary and Alex will summarize the financials. Then we will open the lines for Q&A.

I will now turn the call over to our Chief Executive Officer, Len Tannenbaum.

Leonard Tannenbaum

Thank you, Robyn and good morning everyone. As we discussed last quarter, profitability during the March quarter was impacted by [Indiscernible] at FSAM, FSC and FSFR related to activist investors and litigation. In part due to these costs, for the quarter ended March 31, 2016, FSAM generated pro forma adjusted net income of $0.12 a share. Without any litigation related costs at FSAM, FSC or FSFR earnings would have been substantially higher.

Despite the downward pressure on earnings during the past two quarters, looking ahead, we expect FSAM's profitability to improve, as the costs related to the activist investors roll off. Additionally, based upon our investment advisory agreements, we believe that we are entitled to indemnification by FSC for the related expenses not covered by FSAM’s insurance, and as a result of that we have notified FSC that we intend to make such claims.

Following the trend [Indiscernible] the middle-market experienced its weakest quarter for sponsored loan volume in six years. Even when viewed against the traditional seasonal patterns of lighter volume, this quarter was significantly slower. Sponsored loan volume totaled just $7.3 billion for the March quarter, down 45% from the December quarter and 31% on a year-over-year basis.

Several factors contributed to the slowdown in the March quarter, including volatility in the energy and commodities sectors, as well as in the credit markets generally, slowing global growth and an uncertain economic outlook and reduced liquidity on a global basis.

Many of our private equity sponsors took a wait and see approach in the quarter given the lack of quality deals and lost evaluations.

Deal volumes during the quarter was mainly driven by LBOs and other M&A transactions as [Indiscernible]. Consistent with the broader market, the Fifth Street platform experienced muted origination volumes during the March quarter. When viewed holistically, the quarter was a [Indiscernible], January and February experiencing significantly lower origination volumes as very few deals were completed, while March was marked by an increase in activity.

While overall volumes remain muted relative to historic levels, we are optimistic for an up tick in deal flow in the quarters ahead. Despite a slower quarter, as a leading direct, middle-market sponsored origination platform, Fifth Street remains well positioned on several fronts. In terms of market uncertainty, the value of long-standing relationships that we have and mutual trust comes to the forefront.

A key talent for the Fifth Street platform has been providing flexible and efficient solutions to the middle-market private equity sponsor community. We are going to continue to maintain long-standing relationships with many key private equity sponsors through [Indiscernible] experience we have and value added solutions we provide, including the ability to provide relatively quick feedback and find creative ways to ensure deals closed on a timely manner.

To that end I would like to highlight a recent transaction that closed during the March quarter that illustrates the strength and flexibility of the Fifth Street platform in its support of key private equity sponsors. Fifth Street Management LLC serves as Joint Lead Arranger and Joint Lead Bookrunner for a First Lien Credit Facility to Support GTCR's Acquisition of Lytx, Inc., which was the 10th financing that Fifth Street had completed in support of GTCR.

Lytx is the leading provider of video-based safety solutions for commercial and public sector fleets, helping to improve driver behavior and reduce collisions and collision-related expenses. We look forward to working both with GTCR and company management over the life of the investment as they continue to execute on strategic initiatives.

As a credit focused asset manager, we continually emphasize capital preservation and maintain strict underwriting standards when deploying capital-intensive loans, and looking across the platform we remain encouraged by and expect to benefit from the diversified positioning of the portfolios of our two BDCs, as well as our CLO and hedge fund portfolio.

We believe that as credit managers we have made and continue to make prudent investment decisions, which include defensively positioning our portfolios focusing on investment in senior secured instruments entering unique verticals to drive enhanced returns as well as making macroeconomic calls such as maintaining limited energy exposure across the platform and having no CLO equity or debt exposure at either of the two BDCs we manage.

One example that illustrates our team’s ability to prudently manage assets and realize gains when a market opportunity presents itself occurred subsequent to the quarter end at FSC.

First Star Aviation, a wholly owned portfolio company of FSC has a track record of opportunistically selling plans in its portfolio, and recently sold one of its plans. The sale price was higher than the original purchase price and when you factor in the lease payments made over the life of FSC’s hold period, FSC realized a gross IRR of 19.1% on its investment. This is just one example of the great work our team has done to deliver strong tangible results.

Now that both of our business development companies have had their [Indiscernible], I wanted to provide an update on the outcomes at both FSC and FSFR. As we announced last quarter, FSC and RiverNorth reached an amicable resolution whereby RiverNorth sold its holdings through a combination of FSAM and [Indiscernible]. In combination with FSAM, I am now the largest shareholder of FSC and FSFR with approximately 15% and 11% ownership respectively.

As a result of the agreement, RiverNorth did not contest FSC’s latest director nominee at the 2016 annual meeting of shareholders and withdrew its binding proposal to terminate the investment advisory contract.

Turning to FSFR, the company held its annual meeting of shareholders in early April. FSFR’s stockholders supported the continuation of the investment advisory agreement with Fifth Street Management and elected one director from the management side and one director from the activist side.

We are pleased that both of these events are behind us and we look forward to returning our undivided focus back to our top priorities of investing stockholder value and executing on our business strategy. Turning back to FSAM, last year we made a decision to right size our business and rationalize costs assuming a steady state environment.

We have experienced both voluntary and involuntary employee attrition over the past few months and as a result we have hired some individuals we think will be beneficial to the FSAM platform. Despite some departures, the core senior management team remains intact. We believe that we are well staffed to handle the increased deal flow we are seeing and provide the continued high level of service to our existing business clients.

Subsequent to the end of the quarter, FSAM added two new members to its board of directors, Michael Arthur and Nathaniel August. Michael brings a valuable perspective as he has considerable experience successfully guiding businesses across a broad range of industries.

Nathaniel August, President of Mangrove Partners, a hedge fund that is the largest outside shareholder of FSAM, with 12% of the Class A common stock, is also a significant stockholder of both FSC and FSFR. We believe that Nathaniel brings significant financial and operational expertise, while offering an important perspective in the interest of enhancing stockholder value across the Fifth Street platform.

We look forward to working together with our two newest members of the board to implement additional best practices to position our business for future success. Although we are disappointed with the results for the March quarter, we remain excited about FSAM’s position in the market, the scalability of our direct origination platform and the diversified credit portfolios at each of the entities we manage. Despite the many challenges that we have faced over the past few months, we are increasingly optimistic with the positive direction that FSAM is heading and we look forward to reporting on what we will expect to be an improved June quarter.

One of our key goals for 2016 is drive an increase in share price at all three of our publicly traded entities, something that we continue to work very hard to accomplish. I would now like to turn the call over to Alex Frank, our Chief Financial Officer, to discuss the financials in more detail.

Alexander Frank

Thank you, Len. Total revenues were $19 million for the quarter ended March 31, 2016, a $3.9 million decrease compared to the quarter ended December 31, 2015, primarily due to lower originations across the platform even when taking into account seasonality as Len discussed and higher levels of professional fee expenses at FSC and FSFR impacting our management fees. Management fees, which include base management fees and Part I fees, were $17.1 million for the quarter ended March 31, 2016 or 89.7% of total revenues.

Total expenses for the quarter ended March 31, 2016 were $16.5 million. After adjusting for nonrecurring and reimbursed items and MMKT, net expenses were $12.4 million, representing a $2.6 million increase year-over-year mainly due to litigation related costs in the current quarter. Total litigation-related costs at FSAM, which we expect to roll off over time, were $3.2 million for the quarter ended March 31, 2016, and we expect some costs already incurred to be reimbursed over time, as a result of indemnification by FSC as Len previously discussed.

Excluding these litigation related costs, net expenses decreased by 600,000 or 6% as compared to the prior year period. Fee-earning AUM at March 31, 2016, was $4.3 billion, which was relatively flat as compared to December 31, 2015.

Pro forma adjusted net income for the quarter ended March 31, 2016, was $6.1 million or $0.12 per share, which excludes litigation related costs at FSAM. Before adjustment for litigation-related costs at FSAM, pro forma adjusted net income was $0.08 per share. As calculated under GAAP, net loss for the quarter ended March 31, 2016 was $11.1 million or $0.22 per share. The GAAP net loss for the quarter was driven by $13.4 million of net unrealized and other charges in the current period primarily due to purchasing FSC shares at a premium to the market price.

Last week our Board of Directors declared a quarterly dividend of $0.10 per share consistent with last quarter’s dividend. The dividend will be payable on July 15, 2016, to stockholders of record on June 30, 2016. We expect our Board of Directors to continue declaring quarterly dividends subject to various factors, including company performance, capital availability, level and timing of share purchases as well as general, economic and market conditions.

Going forward, as some of the incremental professional expenses and other litigation-related costs roll off, we anticipate that the dividend will return to normalized levels.

I will now turn it back over to Robyn.

Robyn Friedman

Thank you for joining us on today's call. We will take questions during the Q&A session from analysts that cover FSAM. If any investor has questions, please call the investor relations line at 203-681-3720. Candis, please open the line for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And our first question comes from the line of Ken Worthington of JP Morgan. Your line is now open.

Ken Worthington

Hi, good morning. Sorry, I have got just a collection of really little questions, so maybe first on the credit facility, you continue to draw down on the credit facility, is that mainly to pay out the dividend, and can you just remind us what the major covenants are on the facility?

Leonard Tannenbaum

That is a question for Alex.

Alexander Frank

The major covenants – let me take that one first, on the facility are a debt-to-EBITDA covenant of 3 to 1, and by the way the credit facility itself has been filed. So it is a public document. So you can look at that. And there is also an interest coverage covenant. We are in compliance of all of the covenants. The draw downs under the facility have primarily been associated with making investments in the funds that we manage.

So, we have purchased FSC shares, we have purchased FSFR shares, we have repurchased some FSAM shares over time, and we have also made significant investments in the CLOs that we manage. So that has been the primary purpose. And I think what was the other – was there anything else.

Ken Worthington

Yes, that covered it. Okay. The gain on MMKT, what was the basis for the gain in this quarter?

Leonard Tannenbaum

Alex.

A – Alexander Frank

You want me to take that. So, MMKT is a subsidiary of FSAM, and FSAM owns 80% of it. The subsidiary has some convertible notes outstanding, which are non-recourse to FSAM, and under the accounting rules as we made a decision to begin winding down the business and think about some other alternatives, strategic alternatives for it, the accounting rules require that you fair value the notes based upon the expected pay-off on the notes and based upon the identifiable assets in the subsidiary, we wrote down the notes to what we expect to be the amount that will be repaid at this time.

Ken Worthington

Okay, great. And then on the $3.2 million of litigation, I believe you said that that would not recur in 2Q, do you have any estimate of litigation costs as we look out either to next quarter or for the rest of the year?

Leonard Tannenbaum

[Indiscernible], but yes Alex.

Alexander Frank

So, I think what I said or meant to say just to be clear is that we expect the litigation related costs to roll off over time. So, we don't have an estimate at this point of what we expect them to be going forward, but I wouldn’t at this point put out there that there wouldn’t be any litigation related costs in the future. But we do expect them to be lower in the future and eventually over time to decline to zero or be recovered through a

combination potentially of both insurance and indemnification.

Ken Worthington

Great. Thank you very much.

Operator

[Operator Instructions] And I am showing no further questions at this time. I would like to turn the conference back over to Mr. Tannenbaum for closing remarks.

Leonard Tannenbaum

Thank you everyone for attending and we look forward to reporting the June quarter to you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Have a great day everyone.

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