A Hidden Gem in the Fifth Street Finance Corp. High-Yield Portfolio

As business development companies become a sizable asset class on Wall Street, they're expanding beyond simple debt funds.

Many of the largest BDCs now have operating companies under their umbrella, which help drive earnings and, in some cases, lower the impact of fees to investors.

Fifth Street's Gem
Fifth Street Finance
(NASDAQ: FSC  ) acquired Healthcare Finance Group, or HFG, in its 2013 fiscal second quarter. Fifth Street structured the transaction so that HFG pays it 10% interest on a first-lien loan, with additional upside tied to the 100% equity stake.

Healthcare Finance Group is a nonbank lender like BDCs, but it competes with the banks on smaller transactions. HFG's specialty is asset-based lending, providing capital against expensive health-care equipment, real estate, and other assets that act as collateral.

Traditionally, asset-based lending was a weak spot for BDCs. Because there is collateral in play, interest rates are significantly lower than the 10%-12% rates BDCs charge for cash-flow lending. And since BDCs can't leverage their portfolios greater than 1-to-1, asset-based loans couldn't generate the returns BDCs need to pay high dividends to their investors.

How that's changing
Purchasing operating companies completely changes the game for BDCs. Whereas Fifth Street could never hold asset-backed paper on its balance sheet and generate sufficient returns, it can do so by owning an operating company.

HFG is levered at greater than 1:1 on its separate balance sheet. Fifth Street Finance, if it put the assets on its balance sheet, couldn't go any higher than 1:1. Basically, HFG is levered highly, but it isn't levered in Fifth Street's financials.

Why it matters
Operating companies are excellent assets for BDCs like Fifth Street Finance. HFG writes significantly lower-risk, asset-backed loans, and with leverage, it can earn BDC-like returns.

Fifth Street's CEO, Len Tannenbaum, had this to say about HFG on the last earnings call:

[I]t's consisted of senior loans ... senior revolvers. And HFG in 15 years hasn't lost money on one of them.

HFG consists of senior loans and revolvers, and the company hasn't lost a dime on any of them in 15 years. It's a gem in the portfolio -- one Fifth Street investors would love to let grow to more than 4.8% of the portfolio over the next several years. 

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Comments from our Foolish Readers

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  • Report this Comment On February 23, 2014, at 3:12 PM, stockanal45 wrote:

    MAIN, PSEC and MCC are all better than FSC. Do your homework!!!

  • Report this Comment On February 24, 2014, at 12:46 PM, TMFValueMagnet wrote:

    Stockanal45, FSC is pretty different than MAIN or PSEC. I understand some don't like it due to the dividend cuts, but unlike many of the larger BDCs, it's almost a pure-play on debt investments. It doesn't have any exotic structures or CLO investments, and equity investments are limited to a very small part of the portfolio. That leads to a lower dividend, but also a safer dividend, in my view.

    I think investors will do well buying Fifth Street at prices under net asset value.

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