The last year has been a difficult one for Fifth Street Finance (NASDAQ:FSC). FSC is a Business Development Corporation that is primarily focused on making secured loans to middle market companies. Net Asset Value fell 9% from $9.20 per share on 3/31/2015 to $8.33 per share on 3/31/2016. Over the last year, FSC shares have declined 17% as investors lost confidence. FSC now trades at an astounding 36% discount to NAV and yields 13.8%. Dividends are paid monthly.
What meant wrong? RiverNorth Capital Management LLC acquired an 8.7% FSC stake and challenged management for control. Many shareholders hoped that a change of control would bring improved results and lower fees. It didn't happen. Instead the 8.7% RiverNorth stake was sold to external manager Fifth Street Asset Management (NASDAQ:FSAM) and FSAM's Founder, Chairman and Chief Executive Officer, Leonard M. Tannenbaum who now controls a 14.6% stake (including shares owned by FSAM). FSC hit a 52 week low shortly after the 2/19/2016 announcement.
Why is FSC so hated?
This recent article by YoungerDGInvestor does a nice job of summarizing some of the reasons for negative investor sentiment. RiverNorth is only the latest chapter in a lengthy book. There have been concerns about excessive management fees and conflicts of interest. Loan losses have been higher than peers. Shareholder lawsuits detail many of these concerns.
1. Large Discount to NAV
At a recent price of $5.38, FSC trades at a massive 36% discount to net asset value. This discount is larger than all but 6 of the 52 Business Development Corporations listed in the Closed-End Fund Advisors BDC Universe. The 38% discount is especially notable given FSC's $757 million market capitalization, high yield and focus on secured debt holdings.
What about the 6 other BDC issues trading at even larger discounts? Firsthand Technology Value Fund (NASDAQ:SVVC), OHA Investment Corporation (NASDAQ:OHAI), Crossroads Capital (NASDAQ:XRDC), GSC Capital Corp (NASDAQ:GSVC), Harris & Harris Group (NASDAQ:TINY) and Equus Total Return (NYSE:EQS) all have small market capitalizations ranging from $20 million - $112 million. OHAI is the only one of that group that currently pays a dividend. The rest are of no interest to income investors. OHAI has a tiny market capitalization of only $39 million. FSC is the most deeply discounted BDC issue that is worthy of serious consideration by income investors.
2. Management is under intense pressure to perform
FSC is externally managed by Fifth Street Asset Management. FSAM also manages Fifth Street Floating Rate Corp. (NASDAQ:FSFR). FSFR is a BDC focused on holding secured floating rate debt of middle market client companies. FSFR is also out of favor with investors, as reflected by its 27% discount to net asset value.
While many FSC shareholders regard the RiverNorth activist effort as a failure, I believe it was actually a positive. The founder now controls a 14.6% ownership stake. That's plenty of incentive to look out for shareholder interests. Management is under intense scrutiny due to shareholder lawsuits. It would be impractical for FSC to raise equity capital if shares continue to sell at a huge discount to NAV indefinitely. FSAM can not grow revenues without showing better results at FSC.
3. Active share buyback program
FSC actively repurchased shares during the March quarter. As noted in the fiscal Q2 2016 earnings report:
" Repurchased 3.1 million shares of FSC's common stock in the open market during the quarter ended March 31, 2016, and subsequently repurchased 1.9 million shares, for an aggregate cost of $25.1 million."
4. No CLO Exposure
FSC no longer invests in the CLO sector. I have no problem with a moderate level of CLO exposure, but some conservative investors are concerned about the safety and volatility of these leveraged structured products. Many BDC issues have significant investments is this area. For example, Prospect Capital (NASDAQ:PSEC) has 17% of assets invested in structured credits.
5. Very low energy exposure
While energy prices are now rebounding, many BDC investors are still concerned about energy exposure. FSC is underweight in this area with Energy Services comprising just 2.2% of total portfolio assets.
6. Focus on variable rate debt reduces risk
Total client company debt accounts for 93% of portfolio holdings. Variable rate debt accounts for 79% of portfolio holdings. Some BDC peers have significant equity holdings that are riskier than debt. Variable rate debt holdings provide a hedge against a potential spike in interest rates.
7. Low balance sheet leverage
Business Development Corporations are legally prohibited from exceeding a debt to total equity ratio of 1:1. This low balance sheet leverage makes BDC issues a good choice for income investors. FSC provides a nice over-view of the BDC business model here. FSC targets balance sheet leverage of 0.6X - 0.8X. As of 3/31/2106, balance sheet leverage was 0.77X (excluding the debentures issued by SBIC subsidiaries). To put this in perspective, a typical bank has balance sheet leverage of 6X to 10X.
8. Nuisance lawsuits are not material to results
Some investors are concerned that the shareholder lawsuits will have a material negative effect on results. This is unlikely. Statistics show that the average shareholder lawsuit drags on for 3 years and is eventually settled for just 2.2% of the claimed damages. Some of this settlement is typically covered by insurance. On the positive side, the intense management scrutiny created by lawsuits can force improvements in governance.
9. Fiscal Q3 results should be stronger than Q2
Professional fees skyrocketed to $4.5 million in fiscal Q2 2016 from $1 million for the prior year. This was largely due to the battle with RiverNorth Capital. Fees are expected to decline now that the fight for control is over. Buying back shares (see item #3) at a large discount to NAV is accretive to earnings. Equity and debt markets have traded higher since March. Fiscal Q2 is typically a weak seasonal quarter with lower than average fees from loan originations.
10. The dividend is sustainable
While FSC is already priced for a dividend cut, Scott Kennedy projected in this recent article that the 6 cent monthly dividend would be maintained. The dividend is especially critical for management, given their increased ownership stake (see item #4 above). FSAM's own dividend would be at risk if the FSC dividend was reduced. Stronger fiscal Q3 results (see item #9 above) should provide improved dividend coverage.
What Are the Major Risks?
New credit problems
Past loan losses have already been written off and are reflected in the current NAV. The current credit environment for junk debt (a reasonable proxy for high yield loans to middle market clients) has become extremely positive. Junk debt issues such as SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) have traded higher since March. Additional write-offs are always possible, but the favorable credit environment should help reduce the risk.
Management conflicts of interest
Shareholders remain concerned about governance and management conflicts of interest. Ironically, management's interests are now far more aligned with shareholders. Management now has a much larger ownership stake in FSC.
Lack of near-term catalysts
Investors may also be concerned with a lack of near term catalysts now that the RiverNorth activist effort has been greenmailed. Management has a larger equity stake making further activist efforts more difficult. I believe that improved Q3 results and maintaining the current dividend payout (contrary to some expectations) will provide a near term catalyst.
Dividend coverage is stretched
While I believe that FSC will continue the current 6 cent per share monthly dividend, the high yield reflects skepticism that the dividend is sustainable. See my arguments above in item #10.
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Lately, I've been finding some excellent high yield values in the BDC sector. Although high yields are often associated with high risk, this is not the case here. FSC is actually less risky than most BDC peers due to its large size, discount to NAV, diversified portfolio and focus on secured debt holdings. FSC has exited the volatile CLO sector altogether and is underweight in energy. It's rare to find an issue that offers this combination of high yield, moderate risk and the potential for capital gains.
Disclosure: I am/we are long FSC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.