3 Things Fifth Street Management Wants You to Know

Fifth Street Finance (NASDAQ: FSC) is feeling the pain of an unimpressed stock market. At $ 7 per share, the company trades at a 24% discount to its last-reported book value — one of the widest discounts in its industry. Shares currently yield an eye-popping 13.7%.

But there are plenty of reasons Fifth Street Finance’s share price is depressed. Investors aren’t happy with its recent performance or its dividend policy. Its dividend was most recently cut to $ 0.06 per share per month, down from $ 0.09 in December 2014.

With its stock price lagging, company management was sure to field some tough questions from analysts. Here are some of the most important developments from the company’s latest conference call.

1. The fee structure is under review
Fifth Street Finance is an externally managed company that pays fees to its outside manager. These fees amount to 2% of its assets, plus 20% of returns annually when returns top its 8% required return. With its dividend and income falling, investors are left to wonder why shareholders are bearing the brunt of the decline.

On the conference call, Fifth Street’s managers outlined a plan that would reduce management fees on incremental capital. In other words, its 2-and-20 fees would stay in place for existing assets, but Fifth Street would entertain the idea of lowering fees on any additional capital it raises.

CEO Todd Owens explained his stance on fees:

I actually do think that there is a benefit to the shareholders to have a fee structure that enables us to share the benefits of scale going forward by reducing the management fees on incremental capital raises, and that’s what we’re talking about.

… Although we are a long way away from trading above NAV, as you just pointed out, I think that this is the right thing to do, and it’s the right leverage to build into the model at this point in time.

This is one of the most contested topics among BDCs today. As companies grow, they typically enjoy economies of scale. For BDCs, the single biggest expense (fees) does not scale down with assets, and thus size provides little benefit to investors.

Of course, the challenge is getting Fifth Street back to a place where it can raise additional capital. To do that, it would need to trade at a premium to book value, or above $ 9.18 per share.

To get there, one might argue that it needs to generate about $ 0.92 in annual dividends to shareholders, up from the current level of $ 0.72 annually. (Fifth Street has historically traded so that it yields 10% per year.) There’s a lot of work to do, no doubt.

2. It’s slowing down its venture lending
Fifth Street Finance hired a team to get into the business of venture debt investing. It has closed on a handful of transactions and seen one of its portfolio companies — Five9 — go public.

Fifth Street president and CIO Ivelin Dimitrov suggested that the company is pulling back from venture deals, given signs of frothiness in the deal terms:

We’re looking at a deal recently that we liked, and other people are proposing on that deal just for the benefit of being able to buy equity in the next round.

And from our perspective, that’s pretty crazy. And so, we’ve been very selective. There’s a couple of deals we are looking at opportunistically. Usually, it has to deal with a story that we support somewhere else around the platform. So, for example, health care IT has been a sector that we supported on the middle market side and also on the venture side. We like some of the solutions that companies are putting together in that space. And so we’ve been very selective. I think things will turn and will get more active again, but for the time being, we’ve chosen to be a little bit more conservative there.

3. One of its troubled assets likely found its bottom
In the prior quarter, Fifth Street Finance shocked many investors by putting four investments on non-accrual in a single calendar quarter as a new management team took the helm. One of its largest investments to go on non-accrual was a $ 17 million loan to Edmentum, which is shared among a number of competing BDCs.

This quarter, the loan was marked up slightly to 42% of principal value from 40%. The company was restructured in April, and Fifth Street Finance may come out owning a portion of Edmentum’s equity in exchange for its debt investment.

Fifth Street CEO Todd Owens was quick to say, “We feel good about the carrying value of Edmentum” in response to an analyst’s question about whether Edmentum was marked to reflect the restructuring that took place. That would suggest that most of the bleeding in that asset is over — at least for now.

In all, about 4% of the company’s debt investments at cost are on non-accrual. And while it’s good to see that no new investments were put on non-accrual this quarter, investors will need to carefully watch its other underperformers — JTC Education, CCCG, and Phoenix Brands — for any additional signs of stress.

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Jordan Wathen has no position in any stocks mentioned.

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