Fifth Street Finance Corp. (NASDAQ:FSC)
UBS Global Financial Services Conference Call
May 9, 2012 2:20 am ET
Leonard M. Tannenbaum – Chairman and Chief Executive Officer
Alexander C. Frank – Chief Financial Officer
Abu Ramin – UBS Securities LLC
Abu Ramin – UBS Securities LLC
Good afternoon, everybody. Thank you for coming to our conference. My name is Abu Ramin, and I’m the Consumer and Specialty Finance team at UBS. I have the pleasure of introducing Fifth Street Finance Corp. Fifth Street Finance Corp. has been one of the fastest growing BDCs nearly doubling its investment portfolio in its fiscal 2011 year.
Here to present of behalf of Fifth Street is Len Tannenbaum, Chief Executive Officer and Chairman of the Board of Directors joined by Alex Frank, CFO.
Leonard M. Tannenbaum
Thank you, very much. I think – let me see if I can use those slides, roughly maybe that’s simple. Disclaimers, what a BDC is? For those of you who don’t know; quickly, a BDC is a vehicle where you can do passthrough without double taxation. And we can take 1:1 one leverage. We were created in 1980, allowing Small Business Act to invest in small businesses, and we are heavily regulated by the SEC. So we’re registered investment advisor.
I founded the firm in 1998, it’s just me, and we built the firm based upon a phenomenal track record. We had 30% compounded returns in the first fund, 20% compounded returns to the second fund. The first fund was to seven years before full realization, which allowed us to raise a third fund in 2007, eventually converting to the BDC going public in June of 2008.
Today, then we were a $200 million something market cap company with one credit line of $50 million. After numerous fund raises, almost all of them were accretive to book value, except for the one that generate our SBA license, which is a huge bearing for us. We’re sitting here today with $800 market cap, approximately $1.2 billion in assets with a right side of the balance sheet where the portfolio is diversified; we will talk about that later.
One thing that differentiates us against many of the other BDCs and companies that lend in our market, is we only work with private equity sponsored transactions. So private equity sponsors are clients, our shareholders of course are more important clients. And the private equity sponsors will come to us, and say we want to buy company x for $80 million, will you finance us for $40 million? We put in $30 million, and ask them to put in $10 million. That’s the typical transaction that we do.
So what does that lead us to? It leads us to a high quality portfolio, all private equity sponsored, that’s why it’s that important. When there’s a problem, you actually have a private equity sponsor with a committed fund to put more money in, to turn the company around, to manage the company. And that diversified portfolio, we received two BBB minus ratings; one recently from S&P, another fund rating a year old from Fitch. And our funding base is spread out over a syndicated facility with ING, a great $150 million line with Wells Fargo, $200 million LIBOR plus, 225 line with Sumitomo Bank. And most importantly, we’re an SBA lender.
If you’re only an SBA lender, your stock trades above 1.5 times book it seems. We are an SBA lender that trades at a discount to book for some reason. But the SBA is an amazing thing, it’s two times leverage that doesn’t count against the 1:1 ratio, because the government decides to exclude itself. The other really good thing about the SBA loan, it’s a ten-year non-recourse no covenants money with seven years cyclability. So this could be a very good revenue generator, it is okay revenue generator for us, the way we deployed it, we can talk about that a little bit later.
We pay monthly dividends, we pay dividends basically in line with earnings, our earnings projections, and we’ve just declared $0.0958 the next three months; or actually through July, August and September. To date we’ve declared almost $5 in dividends, since our IPO. I personally have bought all of my shares, I’m one of the largest shareholders, and I brought that all 2 million shares; there’s no such thing as a granted equity or options in a strongly managed BDC. There’s the right button.
So versus the SPY, versus the [Exelis] on a total return basis, we’ve done really well. But I will tell, we probably have underperformed our expectations. We’ve underperformed our expectations for a couple of reasons, one we haven’t efficiently used our capital structure, two our 2007 assets have been disastrous, and it took us a long time to clean that portfolio. And number three, we did do one equity raise below book value to fund the SBA because we were forced by them to put $75 million in bank to get our first license at a time where the market was in (inaudible) and that was a great way to destroy $1 of a NAV. So absent those three things, I think we would have done extremely well and probably had a much better return than you’re seeing on this chart.
However, we are one of the dominant lenders in our space. I would tell you we were top three in something called the one stop or unitranche transaction. This areas is there is ups in gallop, I think we’re ahead of gallop, gallop things are ahead of us. We see gallop down there but for not just from us though. They would like to show tranche towards ahead of us which is not really true.
But Aries is clearly the dominant leader in our space, they are the most credible leader in our space and lead by (inaudible) and that market presence allows us for premium pricing, the private equity sponsor wants something called the unittranche transaction or one stop transaction. They really have to come to the three of us. And that kind of transaction has a huge advantage over the typical senior mezz transaction with the exception when the bank is overly aggressive and leverage or pricing which does happen.
Sort of going to – this is the more detail which I am not coming us to the details you can find that in our financial deck over how each facility works, what our pricing is and how it works. You saw areas recently price a LIBOR 225 main facility, next year potentially we can start working towards that number. We’ve lowered our debt cost of capital dramatically. At the same facility two to three years ago was LIBOR 450, went down to LIBOR 350, went down to LIBOR 300. So as we get bigger, as we get more institutionalized, as we get better credit, constantly lower our debt cost of capital.
And the other amazing thing we did since 2008 is change the firm from second line and mezzanine which is were our roots work and we did generate very high returns doing that to a much safer product line which is first line loans. Well you don’t see on this chart which is potentially the next slide deck, is the fact that average EBITDA of a company in 2008 was 3.5 million, average EBITDA in our company today is 11 million, it is an enormous difference. When you’re a 11 million company and you hit a cycle and 11 goes to seven.
I am not saying 11 to 7 is really good I am telling $7 million EBITDA company can be sold as liquid that can grow, it is up to the things you can do. When a $3.5 million EBITDA company goes to $1.5 million you’re in big trouble and potentially it can lose all your money even in the first line.
Today, not only we’re so much safer and lean, so much safer in capital position, we’re so much safer in size of company and diversification. And so this portfolio on a risk adjusted return even though you watched away the average yield drop from 16.5% to 12.4. On a risk adjusted return basis I think we’ll fall better off today, than we’ve ever been.
The other thing we did is we’re focused a lot on raising interest rates and we have been very wrong about when the interest rates are going up along with quite a few other small people. Our firm will do very, very well if they ever go up. And they do have to go up at some point. This we’ve started detailing probably the first (inaudible) Alex that we have this level of detail, about how much we make if interest rates go up or should I say when interest rates arise.
We’ve also taken the floating part of the portfolio in late 2009, very little of our portfolio was floating less than 10%. Today about two-thirds of our portfolio has floating rate loans and I think towards the end of the year, we’ll try to push that as high as 75%.
And the other amazing thing here by the way is the right side of the balance sheet, is becoming very fixed, SBA debt is fixed for 10 years, our convertible note offering is fixed. So on the right side of the balance sheet about half or towards half of our debt is fixed. So floating rate loans and your assets, makes straight liabilities create a pretty good environment when interest rates increase.
Diversification is always been a big part except that we are experts in healthcare. I came out of healthcare, 1998 I was on the board of a company called Assisted Living Concepts, right around that time. And from that learning about the continuum of care, I’ve always felt very comfortable in healthcare. We spend a lot of money on healthcare consultants, we have a lot of great healthcare sponsors, we have a lot of great healthcare underwriters which are one of the top originators out of healthcare, out of capital source which was know for healthcare lending and we are therefore focused.
I will tell you that healthcare, we might announce on today’s call is down from 32% of the portfolio to 26% of the portfolio and that’s not because I wanted a 26% of portfolio. I think it’s too low. This is twice issued on the portfolio because we’ve done solo in healthcare, we got repaid on it, two largest healthcare loans at 102 or about that. So, we’ve had a lot of success, it’s earned us a lot of money, we will deploy more money, we have some good ideas, some good pipeline ideas so you can expect that to come back up to 30%.
Now, managing credit risk is what it’s all about, I will tell you, when I was a one man shop in 1998, I wasn’t a very good risk manager. It should come as a surprise to anybody, but that was a long time ago. Today, we have three, we just hired our fourth fully staffed deal team with industry specialization coming out of great shops like GE and BMO and ING and all sorts of credit shops.
We spend at least $0.5 million on consultants. We spend at least $0.25 million on the reference calls whether using GLG or otherwise. Our quality earnings reports are better, our industry focus is better, our industry information is better and we put a million dollar computer system, which is black, (Inaudible) uses, but Black Mountain in Wall Street Office, it took me two years to implement that.
We can split out and slice any result in any way and at any time. Having said all that, as an entrepreneur, our business is extremely boring. We watch credit spreads over b-spreads, everything is very automated. Our credit under rating is very standardized. Our pricing unfortunately doesn’t vary that much because we know our market pricing is when we do get 50 basis points to 100 basis points offer that we have to fight for, but that’s about it.
So, what you are getting now is a very diversified stable portfolio that’s also (varying) the box. So, it depends what kind of an investor you are, but it’s good and bad to (have). And if you looked at the slide not too long ago, you would have not seen this, you would have seen two larger companies, both were refinanced last quarter, so last quarter we had an unusually high fact by far the highest quarter of money coming back at us from great deals and including our two largest holdings.
Now that’s good and bad. They came back to us in average of 102, which is good. We marked our book appropriately, we made some more money, and we get to recycle that that’s all great stuff. The other really good thing is our largest portfolio holding went down from 5% of assets to 4% of assets, but we really don’t like taking risk with any one company.
So, I don’t think you’ll see any company over 5% of assets. Again, if you look two years ago, our largest company was 10% of assets. So, we’ve really limited our whole size currently versus the past. Everyone marks 1, 2, 3, 4, or 5, I consider 3, 4, and 5 rated securities are garbage bucket and in our garbage bucket it’s about 2% of assets.
There is 2% of assets that we really have to stress and we are working on and we are trying to turn around or trying to fix. And that’s being consistent for about three quarters. 98% of our assets are not only performing, but they are doing quite well and 7.8% of our assets do have risk of refinance, they are doing too well. A perfect thing for a lender is a two-rated security, not a one rated security because they are one rated securities, even though we have equity in a lot of them, we have 20, or 25 securities where we have equity in and we could have some equity realizations and since I lost so much money in 2007, we have $60 million of capital loss carry forwards.
So they are going to go without any fee to us and without any tax to our shareholders and we eventually get some gains. However, absent that you really don’t want the ones and sure enough one of the questions on the conference call today, which we reported earnings this morning was your ones went down from a $130 million to only $82 million, what happened to your portfolio?
I said what happened to portfolio is exactly what I told would happen to portfolio. The ones got paid back. As Alex said we made a profit. So that’s what happened and you can see the little orange bar right staying pretty small, that means the problems are staying pretty small, but sure enough in cycles, right, the orange bar does get bigger and you can see what happens in the stress scenario.
Balance sheet, they maybe relatively flat. We earned our dividend and were you are seeing a little bit of a debt multiple expansion and a little bit of depth in middle market deals closed, I will point out what I will tell you about this chart is, I’m telling all of you by the end of the year we will have the biggest fourth quarter ever, calendar fourth quarter.
Because the tax increases next year, everyone is pulling forward their (M&A activity) they are already seeing a pick-up, our pipeline is coming close to a new record, so – but the pipeline has a lot of deals that are not going to close for quite a while, remember we originate structure and win the deals with our sponsors.
Each quarter will successively be better than the other also on origination that’s my projection. Last quarter was $142 million gross, this quarter is already looking better than that. And I assume that’s going to continue throughout the year.
Key investment highlights; we sort of talked about. I promised my friend David Einhorn, we started this company three things, transparency, marking your book appropriately and discipline, I follow all three religiously. And the presentation, see 19 minutes, 21 seconds left. Questions, comments.
Abu Ramin – UBS Securities LLC
Yeah, I’ll repeat it, yeah ask.
Leon, I’m an investor, thinking about investing in BDC, what should I think or how should I think about earnings quality?
Leonard M. Tannenbaum
So I think that’s a big question is, how does earning quality really work? How do you compare the different BDCs, 35 of them. Six large ones, we’re the fifth largest. And how should you look at, I wonder this is basic questions, you need to ask any BDC investor. Number one, how much PIK, payment-in-kind income do you have in your earnings. Payment-in-kind, is a manipulated number, it can be a manipulated number by BDC managers.
The way the BDC rules works is, it goes into income and you pay it out to shareholders in dividends. So if I want to hide my losses or if want to manufacture earnings, the best way to do it is to have a 100% PIK security. Any 100% PIK security has no chance of default, because it’s all PIK, and earnings as I believe manipulated because of it. Do we have a few million dollars at a 1.3 billion, it’s all PIK security yes, $1 million or $2 million or $3 million, not a $100 million, not $50 million et cetera.
You have some BDCs that have this highest 30% PIK securities as part of their earnings. And there is two very low ones, us and my arch rival and competitor Golub, which I can’t say anything bad about, because they are very tough and honest competitor. So we’re at 7% PIK as a percentage of income, down from 9% PIK the quarter before I think.
Alexander C. Frank
Yeah, and in Page 11 in the presentation we have those key metrics.
Leonard M. Tannenbaum
Golub, I think is right around the same number. Besides that the other guys are much higher. The other I would say earnings quality issue is, do I want to get on the [goods] quality origination treadmill. Every time you originate a loan, you get two or three points upfront. What do you do with those points? Do you take them into income or do you amortize them over the life of the loan, conservative approach. Amortizing them other approach taking them into income, we do take some fees into income. We do amortize a lot of the fees, we don’t find that our peers really amortize it, another earnings quality issue I think going forward. So there’s a couple of things and it really (inaudible) to go into more detail. I think it separates us from the pack at least in earnings quality. Any other questions?
Thank you very much for having us and do you have any other questions, please feel free to visit us, sure obviously follow-up and talk to Alex.
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