Fifth Street Finance CEO Discusses F1Q2011 Results - Earnings Call Transcript

| About: Fifth Street (FSC)

Fifth Street Finance Corporation (NYSE:FSC)

F1Q2011 Earnings Call

March 2, 2011 10:00 AM ET


Stacey Thorne – Head, IR

Leonard Tannenbaum – Chairman and CEO

Bernard Berman – President, Chief Compliance Officer and Secretary

William Craig – CFO


Casey Alexander – Gilford Securities

Dean Choksi – UBS

Ram Shankar – FBR Capital Markets

Bill [ph] – Morgan Keegan

Robert Dodd – Morgan Keegan


Please standby. Good day everyone, and welcome to the Fifth Street Finance Corp first quarter 2011 earnings conference call. Today’s conference is being recorded. At this time, I would now like to turn the conference over to Ms. Stacey Thorne. Please go ahead, ma’am.

Stacey Thorne

Good morning and welcome everyone. My name is Stacey Thorne, and I am the Head of Investor Relations for Fifth Street Finance Corp. This call is to discuss Fifth Street Finance Corp’s first fiscal quarter 2011 ending December 31, 2010. I have with me this morning Leonard Tannenbaum, CEO; Bernard Berman, President; and William Craig, Chief Financial Officer.

Before I begin, I would like to point out that this call is being recorded. Replay information is included in our February 2, 2011 press release and is posted on our website Please note that this call is the property of Fifth Street Finance Corp. Any unauthorized rebroadcast of this call of any form is strictly prohibited. Before we go into our call portion – before we go into our earnings portion of the call, I would like to call your attention to the customary Safe Harbor disclosure in our February 2, 2010 press release regarding forward-looking information.

Today’s conference call includes forward-looking statements and projections and 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. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website or call Investor Relations at 914-286-6811.

The format for today’s call is as follows. Len will provide an overview, Bernie will provide an update on each of our lending facilities, and Bill will summarize the financials, and then we will open the line for Q&A.

I will now turn the call over to our CEO, Len Tannenbaum.

Leonard Tannenbaum

Thank you Stacey. I appreciate all of your patience regarding this call which was somewhat delayed due to our very successful and oversubscribed equity offering. From an economic standpoint, we are witnessing a recovery. Although we have noticed that it’s not robust or rapid.

The growth in our earnings is due to both margin expansion and revenue growth. In addition, since September 30, 2010 we have additional refinancings totaling approximately $54 million. The refinancing of our second-lien position in (inaudible) retailer was with prepayment penalties and our first collection of a TICC [ph]. The transaction was executed apart. We also have continued to aggressively pursue remedies for our portfolio problem companies those rated three, four and five.

Turnover of investments is an important component of earnings for BDCs as refinancings typically raise short-term earnings for those companies like ours where amortize the origination points over the life of loan as we do. We expect this quarter to be another very strong quarter for originations. Quarter to-date, we’ve originated $123 million and expect more deals to close in the near future.

I believe we are seeing high growth in deal volume for several reasons. Private equity sponsor views as a top provider of one-stop middle market solutions. And we’ve gained significant momentum from our $273 million of investments during the first fiscal quarter of 2011. Our new Chicago office is starting to generate very positive results, and our relationships are spanned in the country. In addition, the ability to commit to an entire transaction and syndicate it down later provides us with some additional pricing power in this market.

We believe it is still the preference for private equity sponsors to partner with the trust of lender, rather than reliance on syndicate group complete transactions. I believe we have seen the turn in credit quality, as many of our problem assets have been restructured or sold. Category 3.5 securities now account for approximately 5% of the portfolio at fair value as of December 31, 2010. And with our proactive portfolio management approach, we expect that percentage to continue to decline over the next year.

Investing environment is changing as highlighted in our recent news letters. While our rates continued to get – while rates continue to get compressed with the $20 million plus EBITDA sponsor buyouts, premiums are still being paid for the one-stop approach in for our relationships. In addition, we primarily are still in the $10 million to $20 million EBITDA market, with an average deal size closer to the $10 million EBITDA number, allowing us premium in the mid to lower middle market versus the upper market.

We were fortunate that the vast majority of our portfolio took advantage of the high return environment, and we were one of the few BDCs that had ample capital to invest during the credit dislocation. We expect that our vintage 2008 and beyond credit portfolio will generate strong returns as the economy continues to recover, even though we’ve recognized ultimately that many of these investments which were generated at high premiums relative to today’s market may get refinanced over the coming years which will generate an income boost when that happens.

As you have heard from me on previous calls, we remain focused on a potential for inflation to increase, given the continued pro-liquidity stance of the Federal Reserve. Our continued increase in the percentage of floating rate loans should enhance our NII as interest rates increase over the coming years. The current percentage of our debt portfolio with floating rates is over 50% and approaching 60% with the vast majority of our pipeline consisting of first-lien floating rate securities.

We expect that number to increase to over 70% in the next 12-months, positioning us to take advantage of the dimensional increase in interest rates. Some of them are recent loans having a low or no LIBOR floors, as we seek to maintain our spread while capturing additional economics when interest rates rise. Our SBA leverage will also serve as a hedge against rising interest rates, as the interest rate on that piece of debt is fixed for 10 years. We plan on locking an additional SBA allocation of $65 million later this month at an attractive rate.

We believe that our strong brand and relationships allow us to capture premium pricing over the market. Our reputation in the middle market as a leader as well as our continued increasing market share should grow as we add to our platform and provide a high level of service to our private equity sponsors. We believe the opportunities in the middle market are large and growing as M&A to increase, even as lenders continue to return to the market.

We plan to take advantage of the current economic climate to gain market share with these top quartile private equity sponsors as well as to capture strong risk-adjusted returns. First-lien loans currently stand at an all-time high and represent over 85% of our portfolio at fair value. Over 90% of the pipeline contains first-lien one-stop opportunities, so we should maintain a vast majority of first-lien deals Our overall target of first-lien deals versus second-lien deals is 75% first-lien, 25% second-lien. And we recognized that we overshot the target in our request for first-lien paper. We – still we do seek to balance that out over time.

We believe this gives us one of the most secured portfolios however of any BDC with our strong first-lien position and further diversification and expansion of assets, will position Fifth Street favorably to reduce its cost of capital over time.

I will now hand the call over to our President, Bernie Berman.

Bernard Berman

Thanks Len. Last week we amended both our ING led credit facility and our Wells Fargo credit facility. The size of our ING led facility was increased from $90 million to $215 million, with an accordion feature which would allow for potential future expansion up to a total of $300 million.

We were pleased that Deutsche Bank, Key Equipment Finance and Patriot National Bank joined the facility, and that all of the existing lenders increased their commitments as part of the expansion. The maturity date of the facility was also extended to February 2014, and if we received a credit rating of BBB, the interest rate on the facility will automatically drop to LIBOR plus 3% with no LIBOR floor.

In addition, we also amended our $100 million Wells Fargo facility by lowering the interest rate to LIBOR plus 3% with no LIBOR floor, and extending the maturity date of facility to February 2014. We also continue to utilize SBA leverage. In addition to the $73 million of debentures which we locked in September at an interest rate of 3.215% an all-time low for the program, we have joined an additional $65.3 million in SBA leverage, the pricing of which should fixed in the next couple of weeks.

While the 10 year treasury rate is a little higher than it was in September, we still expect the $65.3 million to fix at a very attractive rate for the next 10 years. When it does, we will have fixed $138.3 million of the maximum $150 million in debentures available under our license.

We are commencing the process of applying for a second SBIC license, which we would hope to receive sometime this year. A second license if granted would allow us to access up to an additional $75 million in debentures. Finally, we are contemplating of forming an asset manager in order to increase the menu of products available to our clients and to take advantage of deal flow which is already in our pipeline. In this regard, we recently hired John Trentos as our Head of Capital Markets. John has more than 20 years of syndicated loan, capital markets and portfolio management experience, including as a Managing Director at Centerline Capital Group and at Sandelman Partners, LP, where he co-founded and led asset management platforms. John also worked at GE Capital where he structured, originated and placed middle market senior secured loans.

We’ve already begun identifying investments which would go into the Asset Manager and we plan to obtain a new non-recourse credit facility under the Asset Manager. We’ll have more to say about the Asset Manager in the coming months, as we source more investments for this product and formerly establish its legal and capital structure.

I’m now going to turn it over to our CFO, Bill Craig.

William Craig

Thanks, Bernie. With respect to our balance sheet as of December

31, 2010, total assets were $798.8 million, which included total investments of $742.4 million at fair value, and cash and cash equivalents of $43 million. Liabilities were $223.9 million, which included a $123.3 million of SBA debentures payable and $89 million of borrowings outstanding under our credit facilities. At December 31, 2010, net assets were $574.9 million, and our net asset value per share was $10.44.

With respect to our operations, total investment income for the three-months ended December 31, 2010 was $25.3 million. This was comprised of $20.8 million of interest income, including $3.1 million of fixed interest and $4.5 million of fee income. We ended with net investment income for common share of $0.26 and earnings per common share of $0.32. For the three-months ended December 31, 2010 we recorded net unrealized appreciation of $16.8 million. This consisted of $10.3 million of reclassifications to realized losses, $5.5 million of net unrealized appreciation on debt investments, $0.3 million of net unrealized depreciation on equity investments and $0.7 million of net unrealized depreciation on our interest rate swap.

Our weighted average yield on debt investments at December 31, 2010 was 13.2%, which included a cash component of 11.4%. Our average portfolio of company investment was $19.5 million. This compares to the previous quarter with a weighted average yield on debt investments at September 30, 2010 of 14%, which included a cash component of 11.8 % and our average portfolio of company investment of $16.6 million.

With respect to the portfolio, during the quarter ended December 31, 2010, we invested $238.6 million across six new and seven existing portfolio companies. At December 31, 2010, our portfolio consisted of investments in 45 companies. At fair value, 98.6% of our portfolio consisted of debt investments and 86.5% of the portfolio were first-lien loans. As of December 31, 2010, we have stopped accruing cash interest, PIK interest and OID on three investments, which had not paid all their scheduled monthly cash interest payments.

At December 31, 2010, approximately 50% of our debt investment portfolio at fair value bore interest at floating rates. With respect to our ratings at December 31, 2010, the distribution of our debt investments on the one-to-five rating scale at fair value was as follows. The percentage of one and two-rated securities was 94.5% in comparison to 91.1% as of September 30, 2010. We are closely monitoring all of our investments and continue to provide proactive managerial assistance.

Fifth Street continues to pay a monthly dividend, in that regard our Board of Directors declared the following monthly dividends for our third fiscal quarter of 2011. $10 I’m sorry – $0.1066 per share, payable on April 29, 2011 to stockholders of record on April 1, 2011; $0.1066 per share, payable on May 31, 2011 to stockholders of record on May 2, 2011; and $0.1066 per share, payable on June 30, 2011 to stockholders of record on June 1, 2011.

Now I will turn it back to Stacey.

Stacey Thorne

Thank you, Bill. As a reminder, for the months that Fifth Street does not report quarterly earnings, we generally release a newsletter. If you want to be added to our mailing list and receive these communications directly, you can add a call me directly at 914-286-6811 or send a request email to Alternatively, email letters can be set up through the shareholder tool link under the Investors Relations tab on our website,

Thank you for participating on the call. I will now turn it back over to Cynthia, to open the line for questions.

Question-and-Answer Session


Thank you, Ms. Thorne. (Operator Instructions) And we’ll take a question from Casey Alexander with Gilford Securities.

Casey Alexander – Gilford Securities

Hi good morning. Just kind of turning to read the future here a little bit, with the tremendous expansion of the floaters in the portfolio, if interest rates do start going up, obviously that’s going to provide a positive effect to your income stream, but for the purposes of kind of benchmarking your portfolio to your buckets, wouldn’t that cause it downward migration of your EBITDA coverage ratios at the same time, and therefore kind of affect the way that your investments fall in their buckets, all things being equal.

Leonard Tannenbaum

Well first of all, you know that EBITDA is before interest, taxes, depreciation and amortization.

Casey Alexander – Gilford Securities


Leonard Tannenbaum

So EBITDA does not change when interest expense rises. And you mean net – with the cash flow of the companies, the net free cash flow of the companies. We’re only part of the structure and we feel like we’re very covered by the cash flow for underlying portfolio, but debt-to-EBITDA is a measure…

Casey Alexander – Gilford Securities


Leonard Tannenbaum

That would not change.

Casey Alexander – Gilford Securities

You’re right. Okay, thanks.


And our next question will come from Dean Choksi with UBS.

Dean Choksi – UBS

Good morning. Len, you mentioned that one of the drivers of the increased deal flow or pipeline was the ability to commit syndicate deals later on down the line. Can you just expand a little bit further, kind of where you are in building out that syndication effort, the number of relationships kind of how much deal volume you’re doing through that and how that changes, the types of loans that you’re originating?

Leonard Tannenbaum

That’s a very good question. And we’re excited to start capturing an additional fee stream to the BDC which is of course syndication fees. It’s a fee stream that is captured by the two industry leaders’ areas, Ares and Apollo. And we contemplated doing it, we need first the balance sheet to be able to take the larger deal sizes, and commit to them. And then syndicate them down and we now are in the position given our market cap, given our balance sheet, given our multiple credit lines to be able to do that. And so hiring a head of syndication – actually this quarter, we’re going to have our first syndication, where we’ll syndicate a small piece, small $20 million piece, and we’ll skim some of it, and we’ll earn some income – additional income because of it.

In fact one of the better players in this space that does a great job of that is Goldman Sachs specialty land bank, in fact not the BDC. They feel quite a bit in syndication fees. So we know how to do that model. We are very pleased to be of the size, because we believe the only the larger players can really do that. And the reputation that we are being chosen to (inaudible) fields, and we’re talking about maybe a $70 million deals selling down 30, it could be a $100 million deal selling down 50, and we’re definitely in a position to be able to do that.

Dean Choksi – UBS

Okay, thank you. Good to hear.


And our next question comes from Ram Shankar with FBR.

Ram Shankar – FBR Capital Markets

Hi good morning Len, how are you? Thanks for taking my question. One of your peers, Ares, yesterday talked fairly cautiously about the environment mostly on the broader syndicated market, with some extent on the middle market segment as well, I mean are you seeing any similar impacts anything from the new capital in terms of pricing in your sweet spot?

Leonard Tannenbaum

That’s a great question. And one I’m definitely going to address later on today, but the pace that we’re on the market and as we follow the Ares model and we believe companies like Solar which are similar size follow the Apollo model, and there is nothing wrong with the either models, they are both good model, they’re just different. Ares is up now in – towards the broadly syndicated market. It is on fire, I mean the spreads there have compressed, and I think Mike is making a very smart move in being very cautious to originate into that market, continuing to maintain the risk-adjusted returns that Ares always does.

As Ares is a partner in a deal of JCC Education, and as we look at deals together, we’re relatively similar, I believe in our underwriting philosophy, in terms of having to capture risk-adjusted returns. In the middle market or lower middle market, both of which we play, we’re not seeing the ill [ph] compression, we are seeing ill compression, we are not seeing the ill compression that the broadly syndicated is seeing for two reasons. One, CLOs for middle market companies are still not available, while CLOs for broadly syndicated now are down at 4 and 5 times.

So we are not feeling any pressure from a CLOs as a competitors, in fact, it’s so is less pressure than the past when Churchill and others had CLOs to be filled up. There is no CLOs currently filling in middle market, that I am aware of, or that we feel pressure from. Number two is banks, and we had a couple of banks through the office today and which confirm this deal. Large banks are going to use BDCs as sort of a middleman to access the lower middle market in terms of equity sponsors. They rather lend to us as a towards investment grade, investment grade credit, we believe our investment grade credit. And then we lend to the non-investment grade credits and aggregate, and mange through that portfolio.

So I think for the last four weeks we have seen the banks being aggressive, but they are more aggressive to the bigger credits. They are not aggressive to the smaller ones, and we do not believe given Basel 3, and given what all the banks have told us that they will enter that market again aggressively.

Ram Shankar – FBR Capital Markets

Okay, thanks for the color. And one other question if I may, and congratulations of the extension of your credit facilities, but from a modeling perspective are there any ramifications for the March quarter, I mean are there any upfront fees that we need to consider? And is a structure for the non-usage fee similar to how structured previously?

Leonard Tannenbaum

So as we you saw last two announcements with ING and Wells, we’re continuing to push down our cost of capital, because the idea is to be a cost of capital leader, and which allows us to maintain spreads even as our spreads might decrease a little bit, I think we’re very confident that we’re going to maintain spreads through this environment which is great. Yes, there were some things not in the headlines that the unused fees came down a little bit, and we’re more flexible. And that was one of the things of course that we’re focused on as we continue to grow the company and continue to look at different capital solutions that use our credit lines and draw them and pay them back to an extent.

So it did get a little bit better from a modeling purpose, but I don’t know that it would be it’s not an enormous move.

Ram Shankar – FBR Capital Markets

Great, thanks for taking my question.


And Robert Dodd with Morgan Keegan has our next question.

Bill [ph] – Morgan Keegan

Hi guys this is Bill for Robert. Two questions, talking about the increase in floating rate investments, how much would interest rates need to rise beyond seeing a material benefit given (inaudible) and such?

Leonard Tannenbaum

It’s funny, I ran that analysis Bill, last week, I asked for that analysis last week. And interest rates, as soon as they start rising for the first quarter point has some impact. The really big impact for us is going to be between LIBOR 1 and LIBOR 2 and obviously LIBOR 2 higher has a very larger impact on our income, but we’ll start seeing some impact from earnings even as LIBOR goes from 0.3 or 0.25 or wherever it is today, up a quarter. So you’ll start seeing our earnings growth right away, and we position – look, we position the firm in the downturn as a 96% fixed, when the interest rates were declining.

And my goal in the upturn is to be at least 75% floating. But even beyond that, I just want everybody to pay attention of borrowings, of the SBA which will be fixed for 10 years are fixed. So if we get fixed borrowings and we want to expand our fixed borrowing of course, but if we have fixed borrowing and lend floating, you make a lot of money as interest rates increase.

Robert Dodd – Morgan Keegan

Got you, thank you. One more, looking at the yields from last quarter, they looked a little bit lower than the overall companies in general. Is that simply floating rate or is that something we can look to continue in the future? Can you give us any color on that?

Leonard Tannenbaum

I think weighted average deals was 13.2 in our last reported period, and we’re going to continue to see that to decrease to approximately 12%, that’s my guess, over the next I don’t know what period, 12 to 18 months. I think that’s – if interest rates do not increase. If interest rates increase I think you’re going to see a nice offset to that. So who knows whether interest rates are going to increase or not, if I took the floating curve, and I reverse swap for the three year note, we could add quite a bit of income to our balance sheet today. We just don’t – we don’t do things like that.

Robert Dodd – Morgan Keegan

Thank you guys.


And there are no further questions at this time. On behalf of Fifth Street Finance Corp, we’d like to thank you for your participation in our conference call today.

Leonard Tannenbaum

Thanks everyone.

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