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In Search of Yield: Fifth Street Finance, a 10% Yielder

Investors who are looking for income or yield might want to consider investing in Fifth Street Finance (NASDAQ:FSC). Fifth Street Finance current dividend yield is approximately 10.08% paying a little more than a dollar a year in dividends or $0.096 per month, a very competitive yield in the low interest rate world we live.

Fifth Street Finance is a "Business Development Corporation" (or "BDC" hereafter) with a market capitalization of approximately $900 million. The company came public on June 17, 2008. They completed an initial public offering of 10,000,000 shares of common stock at the offering price of $14.12 per share. The stock was listed on the New York Stock Exchange until November 28, 2011 when the Company transferred the listing to the NASDAQ Global Select Market where it continues to trade under the symbol "FSC."

FSC is in essence an investment vehicle raising and loaning capital to small and middle-market companies that might otherwise find it difficult to attract capital. Because FSC is focusing on middle market companies it is able to negotiate significantly higher interest rates, and or more favorable terms, on that loan than typically what you find in the high yield or junk bond market. The weighted average yield of their debt investments as of September 30, 2011 was approximately 12.4%, which included a cash component of 11.1%. As of June 30, 2012, 147.5% of net assets or $1.20 billion was invested in 76 long-term portfolio investments and 13.0% of net assets or $105.7 million was invested in cash and cash equivalents.

What makes this attractive for investors is that most investors cannot gain access to these types of investments unless they meet certain sophistication and net worth requirements, so including BDCs as part of a larger portfolio is a way to further diversify or gain exposure to an asset class that is difficult to get.

I consider FSC to be one of the more attractive BDCs to invest in for the following reasons. The Chief Executive, Leonard M. Tannenbaum, has significant financial interest through stock ownership. Operating agreements provide for incentive bonuses based on performance, and therefore aligning financial interests with shareholders. The company has historically had a high return on equity relative to other BDCs. The company primarily invests in "First Lien Debt" which I believe potentially improves the recovery value in the case of default versus other BDCs that invest lower in the capital structure. At the end of fiscal 2011, FSC had 77% of their capital invested in first lien debt and 14% in second lien debt. The company has a stock buyback program in place and has had willingness to buy back stock when management has deemed it appropriate.

Fifth Street Finance Portfolio Allocation

Source: 10K Fiscal Year 2011September 30, 2011September 30, 2011
Cost:DollarsPercent
First lien debt890,72977.05
Second lien debt161,45513.97
Subordinated debt85,5717.40
Purchased equity11,2630.97
Equity grants6,1580.53
Limited partnership interests9060.08
Total1,156,082100.00

Risk Factors to Consider

Investing in FSC involves a number of significant risks which go beyond the scope of this article to mention them all. However, some of the larger risks are as follows. Many of FSC's portfolio companies are and may be susceptible to economic slowdowns or recessions and may be unable to repay their loans during such periods. Because FSC borrows money to fund their investments, a portion of their net investment income may be dependent upon the difference between the interest rate at which they borrow funds at and the interest rate at which they invest these funds. Changes in their cost of funding can and would influence their profitability or net interest margin. As a result of annual distribution requirements or dividends to qualify for tax free treatment at the corporate level on income and gains distributed to stockholders, FSC needs to periodically access the capital markets to raise cash to fund new investments. A financial crisis like we saw in 2008 would likely make it impossible for FSC to raise capital. The FSC loan portfolio does not have liquidity or can be readily sold. All the investments are characterized as Level 3 assets for accounting purposes.

In summary, FSC is attractive because (1) as a portfolio diversifier, (2) generating monthly dividend income with a 10% dividend yield and (3) where management has a strong incentive to succeed. From a valuation perspective, FSC currently trades at a modest premium to book value which is at the high end of its historical range, but remains attractive due to its high dividend yield and strong management.

Disclosure: I am 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.