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Fifth Street Finance Diversifies Into Niche Sectors. Good News ?

|Includes: ACAS, AINV, ARCC, HRZN, HTGC, Oaktree Specialty Lending Corporation (OCSL), PSEC

BDC REPORTER: Mid-sized Business Development Company ("BDC") Fifth Street Finance (FSC) has a problem: finding appropriate assets to add to their investment portfolio. As a BDC, the Company's capacity to leverage itself up is limited, which means Fifth Street must book loans with sufficient yield to pay operating expenses, management fees and provide a return to shareholders sufficient to attract capital (currently a 9%-10% return).

To date, Fifth Street has typically focused lending on the traditional hunting ground of Business Development Companies: financing private-equity buy-outs and recapitalizations. This has been a successful endeavor, and the size of the Company's total portfolio has risen substantially over the years since FSC went public in 2008.

THE PERILS OF SUCCESS: However, that very success has created new challenges for the BDC. As portfolio size has increased, so has the size of average loans booked (currently $22mn) . As loan sizes have increased, so has competition on price and terms from the highly liquid, syndicated loan market. Fifth Street has booked a very large number of loans, but has also faced substantial repayments, making net portfolio growth difficult, despite the fact that the BDC has ample capital available. Furthermore, loan yields are under pressure in every category: first lien senior, second lien senior, mezzanine and one-stop. At June 30 2013, the reported average yield on the loan portfolio was 11.4%, and the cash component 10.2%. New loans are being booked at below 10.0% on a cash basis, and could head lower. Three years ago, the gross yield was 14.6% and the cash yield 12.6%.

FIFTH STREET'S RESPONSE: Thankfully, the Company has not responded by simply climbing up the risk ladder to maintain profitability. (In any case, it's unclear that there are loans to be made to any borrower at the yields achieved a few years ago, and with sufficient volume to make it worthwhile). Instead, Fifth Street has enlarged the scope of it's lending activities to include sectors not covered before. That involves not only entering specialized lending areas as we'll discuss, but also changing the typical maturity of the loans, and the type of collateral involved.

AIRCRAFT,VENTURE INVESTING AND HEALTHCARE: In a short period of time, Fifth Street has announced initiatives to enter three new specialty lending disciplines. The nominal subject of this post is aircraft leasing. Fifth Street has hired an industry veteran, provided capital for some starter deals and is building up a team of aircraft leasing specialists.

In addition, a few days ago, Fifth Streetannounced hiring another industry hotshot, and a full team of professionals, to get involved in the "venture lending" business. Venture lending consists of making debt and equity investments in venture-capital backed early stage or mid-stage technology companies. (There are already two BDCs which specialize in venture lending: Hercules Technology (NASDAQ:HTGC) and Horizon Technology Finance(NASDAQ:HRZN)).

Back in June, Fifth Street made anotherstrategic move by acquiring Healthcare Finance Group. Here is a quote from the press release:

An asset-based and cash flow term loan lending specialist, HFG has long-standing expertise in the healthcare industry. Since inception, HFG has financed in excess of $21 billion in receivables. HFG's sophisticated and highly scalable operating platform includes an internally-developed technology system that facilitates daily credit monitoring and insight into customer performance. The proprietary system is highly adaptable, with additional capabilities that can be leveraged as the platform continues to expand.

Fifth Street hit the ground running in this last case, investing $114mn in the healthcare company.

GOOD NEWS OR BAD NEWS: Are Fifth Street's diversification initiatives going to be good news for the Company's shareholders ? The jury is still out. We don't know much about the economics of these new sectors and their potential contribution to the bottom line. It's not even certain that the average yield in these specialized areas will be higher than the traditional buy-out lending. FSC would probably argue risk-adjusted returns will be superior. Both health care and aircraft leasing provide Fifth Street will substantial collateral, which should limit losses in a recession or downturn. Venture lending, despite the obvious risks, has been a relatively safe place to invest for Hercules Technology thanks to the large amounts of capital committed by the venture capital groups which own the underlying borrowers. Furthermore, there is the prospect of equity gains, which Fifth Street has had little to point to in the buy-out world, where it is almost exclusively a "lender only".

We are encouraged that Fifth Street has gone and bought outside talent, rather than enter these highly specialized niche sectors with their existing loan personnel. It's more expensive this way, but the prospects of making disastrous early loans (as occurred to Fifth Street itself when it first came public) is lower.

WAIT AND SEE: Nonetheless, we won't have a full sense of the risks and the opportunities involved for many quarters, even if these specialized segments begin to contribute to earnings. Sadly, the wisdom of Fifth Street's diversification will only be clear when the economy takes a leg down, and we see how the portfolio holds up.

TECHNICAL ISSUES: BDC regulatory limitations (only 30% of assets can be invested in these "outside the box" initiatives) may limit the amount of diversification Fifth Street can undertake. There may be ways around the rules, but we'd guess that no more than 1/3rd of assets will invested in the three areas discussed above and others that may follow (real estate ?).

BIGGER PICTURE: Fifth Street's moves are part of a larger migration by the upper middle market focused BDCs from their historic role as buy-out lenders. For example, months ago, Apollo Investment (NASDAQ:AINV) also announced it's entry into the aircraft leasing arena. Ares Capital (NASDAQ:ARCC) is venturing into Venture Lending, with yet another Silicon Valley focused team. American Capital (NASDAQ:ACAS) is getting into infrastructure lending.Prospect Capital (NASDAQ:PSEC) is getting into commercial real estate, and many other arenas besides.

GLASS HALF FULL: For investors, if the BDC parents can successfully navigate the credit environment of these new areas, the long term implications of this historic shift in business mix are positive. Diversification, whether by sector, borrower, type of collateral, length of loan life etc., is important, and allows a BDC to navigate over the long term. Furthermore, with more niche segments generating income, BDCs will be less affected by the pricing pressures in the highly liquid, syndicated loan market where the voracious appetite of Collateralized Loan vehicles has been driving loan spreads down to ridiculously low levels. We're encouraged that the BDC model remains flexible enough to allow BDCs to take these steps, without getting away too much from the low risk model (low leverage, diversification, U.S. focus) that Congress envisaged when the BDC format was launched in 1980.

Disclosure: I am long FSC, ACAS, AINV, HRZN.