Implications of Fifth Street Finance's Ultra Low SBIC Financing

by: Nicholas Marshi

On Monday, Fifth Street Finance (FSC), a Business Development Company (“BDC”) which focuses on lending in the lower middle market, announced super-low pricing on its Small Business Investment Company (“SBIC”) financing in a press release which we will quote in full:

Oct. 11, 2010 (GLOBE NEWSWIRE) -- Fifth Street Finance Corp. (NYSE:FSC - News) ("Fifth Street") today announced that its wholly-owned subsidiary, Fifth Street Mezzanine Partners IV, L.P. (the "SBIC Subsidiary"), has received a $75 million leverage commitment from the United States Small Business Administration ("SBA"), which brings the SBIC Subsidiary's maximum leverage to $150 million. In addition, the interest rate on the SBIC Subsidiary's $73 million of outstanding debentures was recently fixed at 3.215% per annum for 10 years, which Fifth Street believes is the lowest rate in the 52 year history of the SBIC program.

We agree that the rate at which the 10 year funding was fixed is quite remarkable. Typically, in the past, BDCs have reported rates of anywhere from 5.8% -6.5% or higher. Clearly the formula for setting the rates must be benefiting from the rock bottom rates for Treasuries.

For Fifth Street Finance the benefits of the cheap financing are material. With investments earning north of 14%, a 3.125% cost of capital is remarkable. After all, that’s cheaper even than borrowing on its unutilized Revolver with Wells Fargo at an all-in rate of about 3.75%, and that facility matures in two years not ten. Or put another way, if you assume FSC is paying 3% less than what it might have paid had it fixed its SBIC borrowing a few months ago, that’s 4 cents a year of higher profits for shareholders.

(The press release also suggests that FSC has been relatively active since June 30, 2010 when the SBIC balance was at $35mn. We’re guessing that with the loan balance at $73mn, the $36mn difference is comprised of new loans made in recent months. However, it’s possible that existing loans were transferred into the SBIC subsidiary to take advantage of these low rates).

The bigger implication oaf FSC’s news is that a number of other BDCs may be positioned to take fix in very low long term SBIC rates. As we’ve mentioned before, there’s been a stampede of BDCs applying for new or even multiple licenses with the SBIC, and most of them appear to have been granted and active borrowing is underway. What with quantitative easing continuing, we may see half a dozen or more BDCs in a position to take advantage of a similar opportunity. Potential beneficiaries includes Hercules Technology (NASDAQ:HTGC), Main Street Capital (NYSE:MAIN); Triangle Capital (NYSE:TCAP) Medallion Financial (ticker: TAXI) and PennantPark (NASDAQ:PNNT). Not to mention FSC itself which has another $77mn in SBIC funding to borrow and fix. It’s a big boost for the smaller BDCs which have relied heavily on the SBIC for their funding both during and after the Great Recession.

Disclosure: Author is long FSC, HTGC, MAIN, TCAP and PNNT. No position TAXI.