September 24, 2012: Eight times a year, mid-sized Business Development Company ("BDC") Fifth Street Finance publishes a newsletter that expounds on conditions in the middle buy-out industry and at the company. The BDC Reporter frequently reviews the contents of the FSC Newsletter because it provides a rare update in the intra-earnings period, both to trends at the company and for the sector in general. The September issue (click here for the press release) came out today and here are the highlights:
DEAL DOING IS BACK ON
Middle Market buy-out activity is building. Early in the year, FSC had boldly claimed buy-out activity, and the attendant debt financing which BDCs provide, would be above average in 2012. However, with the May 2012 swoon in the markets, buy-out activity dropped as many players battened down the hatches in preparation of another macro-storm out of Europe. As FSC tells it, with a touch of colorful language, that has now changed: "The cooler fall air is reinvigorating the M&A market".
There has been an increase in private companies going on the auction block, and that should translate into a busy fourth quarter of financings. FSC gives a number of reasons for the change, most of which you would expect (private equity firms need to monetize long standing investments to mollify investors). However, there was one technical factor we had not considered, and which bears highlighting. Apparently, there is "insufficient capacity from new CLOs, due to lower leverage levels, to refinance maturing loans from pre-credit crisis CLOs". This suggests-if we're reading this right- that the new breed of CLOs (the most successful leveraged debt asset class in 2012 in terms of asset growth) are seeking to remain conservative in their underwriting and won't underwrite deals that would have past muster in 2006-2007. That role falls-in part- to BDCs such as FSC, who are willing to provide the junior tranches of capital necessary to refinance transactions done in the good old days.
SUBORDINATED DEBT IS THE PLACE TO BE ?
Keeping with that theme, according to FSC, mezzanine debt is the most attractive part of the capital structure to invest in. The Newsletter is very clear: "Mezzanine still represents the best risk adjusted return as more capital is flowing to first lien than mezzanine. For example, mezzanine yields are about 800 basis points wider than first lien yields versus a historic average of 500-700 basis points." As we have seen across the BDC space, there's a bifurcation of returns going on. Although the buy-out market is awash with capital, thanks to the revival of the CLO market and for other reasons, buyers of debt still overwhelmingly prefer the most senior, most liquid transactions. That's putting pressure on yields on larger senior debt loans, and creating opportunities/traps in the subordinated/mezzanine market.
FSC'S LOAN PORTFOLIO HAS BEEN "CLEANED UP"
FSC is suggesting portfolio credit quality should look better on paper in the future. When the BDC was first launched a number of poorly underwritten loans were booked, and the company has been restructuring and working out of them ever since. NAV took a hit as did the stock price, but FSC appears to be putting that chapter of their history behind them. The Newsletter was both very specific about one credit: Traffic Solutions Corporation (see the Newsletter for all the color) and vaguely positive about the rest of the under-performing 2007-2008 loans. Here's a quote:
"The credit trends in Fifth Street's portfolio remain favorable largely due to a shift that began in late 2009 to higher credit quality loans that are more senior in the capital structure and are with larger borrowers. As a result, we expect a substantial reduction in non-accruing assets when we report our September quarter and fiscal 2012 results later this year after exiting several legacy loans from the 2007 vintage."
That may not result in an increase in NAV but does appear to signify that an unusual amount of house cleaning has been done.
FSC AIMING TO LEVERAGE THE BALANCE SHEET
FSC reiterated it's intention to leverage up closer to the BDC regulatory limit. One of the items that appears to have frustrated institutional investors (based on comments made on Conference Calls) is that FSC has failed to grow the size of it's investment portfolio as fast as expected. The result is that the Company's earnings growth has been stunted, and earnings continue to fall short of the dividend. Nevertheless, FSC raised yet more equity in September in a secondary offering worth $91mn. Management, though, appears to feel that the pipeline of new deals is great enough to expect that the portfolio will grow, and bring the BDC's debt to equity by year-end to its target of 0.6:1.0 (excluding SBIC debt). The Newsletter suggests $400mn in net new assets will be added from here on in. Here's the quote from the Newsletter:
"After the recent capital raise and $103 million of quarter-to-date originations ($92 million funded at close), Fifth Street has approximately $400 million of available investment capacity until it reaches its target leverage. We expect to increase leverage closer to our target of 0.6x debt/equity (excluding SBA debentures) heading into calendar year 2013".
We're skeptical of FSC's ability to meet this self-imposed target, given the competition for new deals in the market and the boom in refinancings that we expect is coming, but that may be a blessing in disguise. Big run-ups in loans booked often result in higher write-offs down the road.
WHAT THIS MEANS FOR THE BDC SECTOR
The take-aways for the BDC industry as a whole from the Newsletter-if we dare to generalize- are that deal activity might hit a fever pitch in the last months of the year; new loan pricing is under pressure due to a flood of risk capital for larger, senior deals but opportunities still exist at the mezzanine level, but risks will be greater too.
Disclosure: I am long FSC.