Fifth Street Finance Corp. Is Making Use of the 30% Bucket

Fifth Street Finance  (NASDAQ: FSC  ) has joined a number of peers in making better use of its 30% "bucket."

High-yield business development companies such as Fifth Street can dedicate up to 30% of their balance sheet to assets that are considered "nonqualified" for a business development company structure.

What's it doing?
press release issued today stated that Fifth Street Finance is halfway to fully investing inside its Senior Loan Fund. The fund allows the asset manager to add additional leverage to senior loans, in a partnership with Kemper  (NYSE: KMPR  ) .

According to the press release, the partnership should generate "mid-teens" returns. This is consistent with other BDCs such as Ares Capital  (NASDAQ: ARCC  ) , which has consistently earned returns in the neighborhood of 15% per year.

Total Capacity
How big could this program be? Quite large.

You see, Fifth Street Finance hasn't been using its 30% bucket to the extent of its peers. On the last conference call, CEO Leonard Tannenbaum said, "We have plenty of capacity to grow the Senior Loan Fund, and other similar joint ventures, because less than 10% of our assets are nonqualifying versus a regulatory cap of 30% of assets."

One asset today dominates Fifth Street Finance's nonqualified assets: its wholly owned Healthcare Finance Group, which writes asset-backed loans to companies in the health-care sector. HFG is a true gem on the balance sheet, given its lower risk profile than middle-market loans that dominate the Fifth Street Finance platform. Other than that asset, the 30% bucket has largely been underutilized. Until now.

The Fifth Street Finance press release also noted that the company plans additional Senior Loan Funds in the future: "FSC has ample capacity to grow SLV JV 1 and is in active discussions with several other third parties about additional senior loan fund partnerships."

Fifth Street Finance desperately needs it. The company has slashed dividends repeatedly, and as its business is almost entirely dependent on the winds of private equity sponsors, it has suffered notable yield compression as middle-market borrowers refinance for lower yields.

A comment on the industry
Fifth Street Finance prides itself as being a "low beta" name in the private finance space. Whether that's true is for the shareholders to decide. But one thing is certain: Fifth Street Finance's eagerness to follow other BDCs and make use of its 30% bucket is telling. Yield compression hurts. 

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