Fifth Street Finance's (FSC) CEO Todd Owens on Q3 2016 Results - Earnings Call Transcript

| About: Fifth Street (FSC)

Fifth Street Finance Corp. (NYSE:FSC)

Q3 2016 Earnings Conference Call

August 9, 2016 10:00 AM ET

Executives

Robyn Friedman - Head of Investor Relations

Todd Owens - Chief Executive Officer

Steven Noreika - Chief Financial Officer

Analysts

Terry Ma - Barclays

Operator

Good day, ladies and gentlemen, and welcome to the Fifth Street Finance Corp. Q3 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference is being recorded.

I would like to introduce your host for today's conference, Robyn Friedman. You may begin.

Robyn Friedman

Thank you, Sierra. Good morning and welcome to Fifth Street Finance Corp's third quarter 2016 earnings call. I am joined this morning by Todd Owens, Chief Executive Officer; and Steven Noreika, Chief Financial Officer.

Before we begin, I would like to note that this call is being recorded. Replay information is included in our August 9, 2016, press release and is posted on the Investor Relations section of Fifth Street Finance Corp's website, which can be found at fsc.fifthstreetfinance.com. Please note that this call is the property of Fifth Street Finance Corp. 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.

Forward-looking statements may include statements as to the future operating results, dividends, and business prospects of Fifth Street Finance Corp. Words such as believes, expects, seeks, plans, should, will, estimates, projects, anticipates, intend, and future or similar expressions are intended to identify forward-looking statements, although not all forward-looking statements include these words. These forward-looking statements are subject to the inherent risks and uncertainties in predicting future results and conditions.

Certain factors could cause actual results to differ materially from those projected or implied 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. FSC undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise except as required by law.

The format for today's call is as follows. Todd will provide an overview of our results and outlook, and Steve will summarize the financials. Then we will open the line for Q&A.

I will now turn the call over to our CEO, Todd Owens.

Todd Owens

Thank you, Robyn. Good morning, everybody. For the quarter ended June 30, 2016, FSC generated $0.20 as net investment income per share, which exceeded our quarterly dividend of $0.18 per share. When we reset the dividend last year, the goal was to meet or exceed the dividend each quarter. We are pleased that excluding incremental professional fees, our net investment income has more than covered our dividend for six consecutive quarters.

The June quarter was characterized by an increase in middle-market leveraged loan activity and overall stability within our portfolio despite further deterioration and slight credits on our watch list. We continue to execute on share repurchases acquiring $10 million of shares in the open market, which added $0.04 per share to our entity this quarter and brought our total repurchases since September 2015 to $45 million.

Our leverage levers were elevated this quarter with debt to equity of 0.84 times at the end of the quarter above our targeted leverage range of 0.6 to 0.8 times. Going forward, intend to bring our leverage levels back within our targeted range.

Subsequent to quarter end, we announced that FSC reached a global settlement of the class action and related lawsuits. We're pleased to have reached a resolution that removes the burden and distractions of continued litigation. This will allow our team to turn its full attention back to executing on our business strategy. We continue to believe that the claims brought forth by the plaintiffs were without merit. However, we felt that expense drawn-out legal fight was not in the best interest of our shareholders. 99% of the settlement is covered by our insurance and the settlement also provides for additional shareholder friendly actions around our fee structure.

Turning to the middle market environment, the June quarter was marked by an increase in leverage loan volumes and lower spreads relative to the sluggish start to the calendar year. Despite this rally, the market remained challenging with a lack of M&A deals executed by middle-market private equity firms coupled with global growth concerns highlighted by Brexit, which tempered activity.

Despite this backdrop, I'm pleased to report that during the June quarter, FSC closed $277 million of investments in 11 new and 5 assisted portfolio companies. We believe that our ability to source deals with strong risk-adjusted returns facility add-on transactions with existing borrowers is a testament to the strength of our platform.

Our portfolio remains well-positioned with 79% of the portfolio consisting of senior secured loans through 133 portfolio companies. Over 99% of the loans in our portfolio at fair value are performing and our energy exposure continues to remain low at only 1.2% of the portfolio at fair value. Additionally, we have no CLO equity or debt exposure.

As I stated earlier, we feel good about the overall credit quality of our loans despite experience in further credit deterioration in the small number of portfolio companies. During the June quarter, we removed Ameritox from nonaccrual, but continue to suffer markdowns in the investment. In April, our portfolio management team worked closely with the company and its sponsor owners to restructure the investment and we exchanged our debt investment for debt and equity securities in the restructured entity. As equity holders in Ameritox, we may experience more volatility around the mark to market of this investment.

Another investment that had seen challenges over the course of the year is answers.com. Recent financial results have continued to risen, which has caused further price declines in the trading prices of both the first and second lien loans leading the mark to market write-downs. The company remains current on its interest and its cash interest payments, but given the mark on the answers.com second lien position, it remains on nonaccrual in respect of its OID.

On a positive note, I wanted to highlight our successful investment in Yeti, the outdoor-lifestyle brand. During the June quarter, the company refinanced the entire credit facility and as part of the transaction, we received $6.6 million cash dividend for our equity co-investment. We’ve been investors in the company through multiple transactions and retained a 1.5% equity interest in the company providing the opportunity for future upside. While the explosive growth witness that Yeti is an extraordinary event, this transaction emphasizes the value of an origination platform such as fixed rates and uncovering unique investment in the middle market lending space.

Despite the recent challenges we have faced, we are optimist about FSC’s future prospects and are pleased with our repositioning over the past year. We continue to monitor our watch list investments to preserve value for all stockholders and we will employ a high degree selectivity around future capital allocation decisions.

Over the course of 2015 and 2016, we've taken a number of actions to maximize shareholder value. As a reminder, in January, we permanently reduced FSC’s base management fee on total gross assets from 2% to 1.75%. Additionally, at that time, we committed to looking for additional ways to enhance shareholder value. We have decided to take a fresh look at ways to enhance the alignment of interest between our external advisor and our shareholders including potential changes to our fee structure. We have more to say about this topic on our next earnings call.

I would now like to turn the call over to our Chief Financial Officer, Steven Noreika, to discuss our financials in more detail.

Steven Noreika

Thank you, Todd. We ended the third quarter of 2016 with total assets of $2.5 billion as compared to $2.6 billion at September 30, 2015. Portfolio investments totaled $2.2 billion at fair value, which were spread across 133 companies at June 30, 2016. At the end of the June quarter we had $158.1 million of cash and cash equivalents on our balance sheet. Net asset value per share was $8.15 as of June 30, as compared to the net asset value per share of $8.33 in the prior quarter.

NAV was impacted this quarter by a few factors, including credit related losses of $0.32 share, which were offset by $0.04 of accretion due to our share repurchases and $0.08 of market-driven write-ups. We ended the quarter at a 0.84 times regulatory debt to equity ratio slightly above the upper end of our target range of 0.6 to 0.8 times. As Todd stated earlier, going forward we plan to bring our leverage levels back within our targeted range.

For the three-month ended June 30, 2016 we generated total investment income of $64 million. The quality of the income continue to be high as net PIK, which is PIK accruals recorded in excess of PIK payments received represented only 4.8% of total investment income. Net investment income was $29.1 million for the quarter ended June 30, 2016.

During the quarter, we closed $276.6 million of investments in 11 new and five existing portfolio customer companies and we received $63.2 million in connection with the full repayment of three of our debt investments, all of which were exited at or above par. We also received an additional $183.8 million in connection with paydowns, syndications, and sales of debt investment. The credit profiles of the investment portfolio continues to be solid as over 98% of the portfolio at fair value was ranked in the highest one and two rating categories.

We believe we are conservatively positioned relative to our peers with 92% of the portfolio at fair value consisting of debt investments, 79% of the portfolio invested in senior secured loans, 82% of the debt portfolio consisting of floating rate securities with no CLO investments, and limited energy exposure at quarter-end.

FSC’s joint venture with an affiliate of Kemper Corporation continues to perform well generating an 11.6% weighted average annualized return on FSC’s investment during the June quarter. As of June 30, 2016 the joint venture had $399 million of assets, including investments in a range of one-stop and senior secured loans to 37 portfolio companies. For the June quarter, the weighted average yield on FSC’s debt investments including the joint-venture return was 10.6% with the cash component of the yield making up 9.9%.

At June 30, 2016 the average size of a portfolio debt investment was $19.1 million. The average portfolio company EBITDA was $39.9 million. And our top 10 portfolio company investments represented 27.5% of total assets. Last week, our Board of Directors declared monthly dividends of $0.06 per share for September, October, and November consistent with the last five quarterly dividends.

We expect our Board of Directors to continue declaring monthly dividends on a quarterly basis subject to various factors, including company performance, capital availability, level and timing of share buybacks, as well as general economic and market conditions.

And I will now turn it back over to Robyn.

Robyn Friedman

Thank you for joining us on today's call. Kiara, please open the line for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And our first question comes from the line of Terry Ma from Barclays. Your line is open.

Terry Ma

Hi, good morning. So, we’ve heard several BDCs just talk about a tougher lending environment right now, we’ve seen tighter pricing and looser structures, so have you guys actually seen that given all the investments you've closed this quarter. Can you just give us some color around that?

Todd Owens

Yes, good morning Terry and thanks for the question. The environment rebounded a fair bit from the March quarter and we saw good investment opportunities, I think over the course of the quarter we saw tightening in pricing, but we are still seeing good investment opportunities as evidenced by a reasonably strong origination quarter for us.

Terry Ma

Got it. So, you wouldn't say the structure there is looser or any risk here than you have seen in the past or relative to a year ago.

Todd Owens

No. I don’t think. I think spreads have as a general matter been guiding tighter. We saw some volatility at the end of June, but that had more of an impact frankly on our mark-to-market than on the originations in the quarter. And I think from a structure perspective, a leverage perspective, a covenant perspective the originations that we did this quarter were pretty consistent with what we've seen in past quarters.

Terry Ma

Okay. That is helpful. And then you mentioned you guys are considering some additional things to the fee structure, can you maybe just elaborate or give some idea of what you guys are tossing around?

Todd Owens

Yes, thanks Terry. We're not right now in a position to comment. I would observe as, as we’ve observed in the past that there continues to be a robust conversation with our shareholders and throughout the industry about what the right fee construct is. And we have been thinking about that over time and we're going to refocus on that in the coming quarter.

Terry Ma

So is it safe to say that if you guys were to do something it would be presumably beneficial to shareholders?

Todd Owens

Yes. If we were to take an action here, we would intend that that would be beneficial for shareholders.

Terry Ma

Okay. Great. That’s it for me thanks.

Todd Owens

Thanks Terry.

Operator

Thank you. [Operator Instructions] At this time, I'm showing no further questions, I would like to turn the call over to Todd Owens for closing remarks.

Todd Owens

I want to just thank everybody for your attention and thanks Terry for the questions this morning.

Operator

Ladies and gentlemen thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone have a great day.

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