Scary Short Stories: Fifth Street Finance And Fifth Street Senior Floating Rate Corp.

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About: Oaktree Specialty Lending Corporation (OCSL), OCSI, Includes: FSAM, OAK, PSEC
by: Code Talker Market Analysis
Summary

Fifth Street Finance and Fifth Street Senior Floating Rate Corp. are trading at significant discounts to NAV.

This is even compared to poorly managed peers like Prospect Capital.

An impending buyout of the manager, Fifth Street Asset Management, could breathe new life into their share price multiples against NAV.

Good riddance to Fifth Street Asset Management, if it is inked!

Hello, and welcome to Scary Short Stories part 1: Fifth Street Finance Corp. (FSC) and Fifth Street Senior Floating Rate Corp. (FSFR).

On July 29, the Wall Street Journal broke the news that Oaktree Capital Group LLC (NYSE:OAK) was considering a buyout of debt investor Fifth Street Asset Management Inc. (OTCPK:FSAM). Fifth Street Asset Management manages beleaguered Fifth Street Finance Corp. and Fifth Street Senior Floating Rate Corp. Shareholders of both are aptly described as long-suffering.

On June 30, Fifth Street Asset Management confirmed it was involved in strategic discussions with a buyer.

As a long term shareholder, I've seen how Leonard Tannenbaum and company have driven the share price into the ground for equities related to Fifth Street companies. I should have known better than to commit capital to a BDC managed by a guy nudged into creating BDCs by a hedge fund manager notorious for shorting that space. A sustained history of NAV decreases and dividend cuts over my ownership time frame looked abysmal, especially when compared to management's maintenance salaries, fees, and bonuses.

It looked to some as though Fifth Street companies were managed in a way as to cycle through shareholders, transferring wealth from shareholders into the pockets of management. A successful lawsuit and poor handling of what looked like a greenmail attempt further confirmed to some this was not the management team to helm the assets they had acquired under the Fifth Street Finance Corp. and Fifth Street Senior Floating Rate Corp banners. Investors were advocating reasonably, therefore, for a change of management from Fifth Street Asset Management, Inc.

Folks paying attention to chaotic management changes and abrupt departures saw risky assets written down significantly, with impairments increasing. I was not alone in asking myself where the bottom for the stock prices associated with these companies might be.

Good news for shareholders of Fifth Street Finance?

Even at prices after a bump from the rumors, Fifth Street Finance's current price per share is $4.92. Its latest NAV is $7.23. That's almost a 29% discount to its net asset value. For comparison, I will use a similarly out-of-favor BDC, Prospect Capital Corporation (NASDAQ:PSEC). Its latest NAV was $9.43. It trades at $8.11. That's only a 14% discount. A well-managed BDC like Main Street Capital Corporation (NYSE:MAIN) trades above NAV. However, if a new manager just brings the NAV discount in line with that of the poorly managed Prospect Capital, Fifth Street Finance should trade at a 14% discount, or $6.22. That's almost a 20% increase from today's share price just on the news of an inked deal!

Good news for shareholders of Fifth Street Senior Floating Rate Corp.?

Fifth Street Senior Floating Rate Corp. got a similar benefit from talks of Fifth Street Asset Management being sold. Its current price per share is $8.11. Its latest NAV is $10.83. That's a 25% discount to NAV. I will use the same out-of-favor BDC, Prospect Capital Corporation, for comparison as a peer. This is, again, not a well-managed BDC like MAIN, which trades above NAV. If a new manager just brings the NAV discount in line with that of the poorly managed Prospect Capital, Fifth Street Senior Floating Rate Corp. should trade at a 14% discount, or $9.31. That's almost a 15% increase in share price just on an inked deal.

Surface value: This is bad for shorts

Ignore the price reaction in both Fifth Street Finance and Fifth Street Senior Floating Rate Corp. to the news.

Imagine you are holding short positions in the two names. You might believe, based on the above peer comparison with out-of-favor Prospect Capital, that you could wake up tomorrow and see the prices climb 40% and 15% respectively in a single morning based on an inked deal. Would you want to be short? Furthermore, any shorts caught on a day in which a deal is inked will be fighting with other buyers trying to acquire shares and other shorts exiting the stock to find shares to buy. Even the perception that a competent management team will work the assets should spike the price per share much closer to the NAV.

Another managing firm has many tools up its sleeve, including the unlikely fee reduction, reinflating the capital structure with new funds, and other tools - not just competent management of Fifth Street Finance's and Fifth Street Senior Floating Rate Corp.'s assets as they are. Some managers are better than others at working out low-quality debt and working with nonaccruals. Good managers could help Fifth Street Finance and Fifth Street Senior Floating Rate Corp. out of the debt-equity traps which are currently preventing them from taking on more debt to buy assets. This would allow Fifth Street Finance, in particular, not just to work bad assets but to acquire other, better assets, escaping the stalemate which traps the firm with a deteriorating asset portfolio.

Scary Short Story

In short - and this is what makes this story a scary short story - I would not want to be short Fifth Street Finance or Fifth Street Senior Floating Rate Corp. while it is possible a deal could be inked imminently.

In fact, given the potential medium-term upside on an inked deal, I would be long these stocks - and I am. However, even as a hopeful investor in Fifth Street Finance and Fifth Street Senior Floating Rate Corp., there are important forward-looking questions to ask.

What was the leaked deal?

According to the leaked deal, Oaktree Capital would acquire Fifth Street Asset Management in an acquisition valued at $350 million. If you take out Fifth Street Asset Management's last-reported credit facility of $102 million plus some extra, that leaves about $230 million for share purchase. FSAM has about 50 million shares outstanding. That values the buyout at about $4.6 per share. FSAM traded as high as $5.28 on the news, before settling down to around $5.10 a share. That seems high to me for a deal to go through.

What did the leak do to the deal?

At face value, it looks like this leak would reduce the chances of a deal being made. Fifth Street Asset Management shareholders would be taking a loss now to sell their shares to Oaktree Capital at $4.60 a share, since they're now holding $5.10 a share. This jeopardizes gains in Fifth Street Finance and Fifth Street Senior Floating Rate Corp., as without a deal shareholders are left with untrustworthy management and lower multiples against NAV for share prices.

Why would anyone leak it?

Just brainstorming based on what I've read:

Someone wanted to sell Fifth Street Finance or Fifth Street Senior Floating Rate Corp. shares? This would be a good opportunity to exit positions in either quickly.

Someone wanted to kill the deal? Perhaps someone close to the situation didn't want his goose laying golden eggs taken away from him. Departures in Fifth Street companies recently seemed to signal disappointment with the direction management was taking. Maybe there was resentment enough to throw a monkey wrench in the deal, too.

Someone wanted to fetch a better value for Fifth Street Asset Management? Leaking the deal would alert other potential buyers, raising the share price for Fifth Street Asset Management so that either Oaktree Capital or another suitor would have to put in a higher bid to close the acquisition. This puts the deal at risk, but it could be a risk someone with substantial holdings was willing to take.

The deal was breaking down between Oaktree Capital and Fifth Street Asset Management? By leaking the deal to the press, someone might have been adding fuel to the likelihood some kind of deal would be achieved. This would be achieved at the risk that share price increases in Fifth Street Asset Management would make the leaked offer of $350 million no longer appealing to FSAM holders. Contrary to that, the share price increase itself might be the factor the leaker was hoping would help motivate large shareholders of FSAM to get behind a deal at $350 million.

The simple matter of a leak. The simple matter of a leak means that there is gamesmanship of a high order afoot. Someone is risking leaking insider information (someone backed by a good legal team?) in order to leak this to the press. If a deal does not go through, the leaker could be addressed with a shareholder lawsuit, claiming the leak impaired the deal's completion. At this time, just based on official press releases, we don't even know if Oaktree Capital is truly a suitor or if Fifth Street Asset Management is simply in strategic discussions with one or more potential suitors.

Digging Deeper

Tannenbaum has a lot to gain with the sale of Fifth Street Asset Management. By clearing the management issue, he benefits from the increase in valuation of both Fifth Street Finance and Fifth Street Senior Floating Rate Corp. A surface examination says he wants a deal to go through. Still, there are no guarantees a deal will be inked, especially with all the considerations above concerning the leak. Every business day that goes by without a press release concerning an inked deal would have me lower my expectations and share price valuation of Fifth Street equities in proportion.

What would happen to Fifth Street Finance, Fifth Street Asset Management, and Fifth Street Senior Floating Rate Corp. shareholders if the deal does not go through? Immediately, I believe Fifth Street shareholders would see dramatic share price losses, as they would be stuck with a poorly performing management team which has been perceived as self-dealing. Since the risks are significant that gamesmanship concerning the leak means some bluffing is going on, suggesting the deal is nowhere near certain, I'm not sure I'd be a buyer here. The history of management here is so troubled that I would not invite others to join me at the sad party I hold every time I look at the Fifth Street portion of my portfolio. However, the rise in share price might attract serious buyers of Fifth Street Asset Management, as a suitor might also be found. So, I'd hope eventually for relief in an acquisition of FSAM.

What would happen to Fifth Street Finance, Fifth Street Asset Management, and Fifth Street Senior Floating Rate Corp. shareholders if the deal does go through? I assert, as do others, that Fifth Street Finance and Fifth Street Senior Floating Rate Corp. shareholders would see share prices climb steadily and rapidly to a price closer to their NAVs. Even valuing it according to Prospect Capital, as I have done above, puts some tasty gains on the table. However, if longer term the manager turns out to be high-quality like that of Main Street Capital or Ares Capital (NASDAQ:ARCC), the share prices might even exceed NAV. Simply by removing the uncertainty of Fifth Street Finance and Fifth Street Asset Management under currently underwhelming management, however, should quickly restore value to shareholders.

Longer term

Longer term, however, I'd want to see what Oaktree, or any buyer's, plans with Fifth Street Finance and Fifth Street Senior Floating Rate Corp. are:

  • Does it intend to acquire those companies as well?
  • Will the new manager take fee reductions as a measure of goodwill to shareholders?
  • Does the new manager have a way out of the debt-equity trap Fifth Street Finance has fallen into, in which it is difficult to improve its perch given that it doesn't have capital to navigate?
  • How committed to Fifth Street Finance and Fifth Street Senior Floating Rate Corp. is the new manager, or is it going to do a fire sale of assets, forming one company which is easier and more cost-effective to manage - a single company of assets with a single leadership structure?

These are all questions which would need to be answered before I formed a revised buy, hold, or sell leaning on Fifth Street Finance and Fifth Street Senior Floating Rate Corp.

Currently, I am holding more shares in both - tens of thousands - than I'd like to have on the line with a leaked deal and a history of feints from current management. I'm cautiously optimistic this time is not just all bluster, that there is actual substance which is being negotiated over in order to close a deal. Hopefully, a deal will end the sorrowful saga of my ownership of stocks under the Fifth Street banner.

Disclosure: I am/we are long FSC, FSFR, PSEC, MAIN, ARCC. 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.

Additional disclosure: I also hold other BDCs with out-of-favor management teams like CPTA. I have no positions in OAK, nor any intent to open a position over the next 72 hours.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.