Fifth Street Finance Corp.: Buy After a Dividend Increase?

Fifth Street Finance announces a 10% dividend increase, putting the dividend back on track to potentially hit its 2013 levels.

Jul 9, 2014 at 8:59AM

Fsc

Source: Investor Relations

Score one for Fifth Street Finance (NASDAQ:FSC) shareholders.

The company announced a 10% dividend increase, promising to pay out an annualized dividend of $1.10 per share.

Dividends in flux
Business development companies find it difficult to pay stable, recurring dividends. By law, virtually all of their earnings must be paid out to shareholders in any given year. Thus, it's much more difficult for a BDC to "smooth" its dividend like other companies.

Here is a brief history of Fifth Street Finance's recent dividend activity:

Payment dates

Dividend per share

January 2011 – November 2013

$0.0958 per month ($1.15 per year)

January 2014 – August 2014

$0.0833 per month ($1 per year)

September 2014 onward

$0.0917 per month ($1.10 per year)

After several dividend cuts, it's good to see the dividend is back on the mend. Notably, increased dividends won't start until September, giving the company time to deploy capital in higher-yielding investments.

Why the increase?
Fifth Street Finance suggested its senior loan fund was the reason for a dividend increase. It also pointed to additional senior loan funds, which would make greater use of its "30% bucket," or the 30% of the balance sheet that can be dedicated to nonqualifying assets.

I take this dividend increase as a very obvious sign that Fifth Street Finance has another (several?) senior loan fund(s) in the works. Ares Capital (NASDAQ:ARCC) has a similar initiative in which it dedicates 24% of the company's assets to generate higher returns than lower-leveraged, middle-market debt investments. Fifth Street Finance believes the senior loan fund should generate "mid-teens" returns on equity, consistent with Ares Capital Corporation's Senior Secured Loan Program.

More importantly ...
In premarket trading yesterday, Fifth Street Finance shares rallied to $10.19 per share. At that price, the company trades at a roughly 4% premium to its last reported net asset value of $9.81 per share. At prices above net asset value, Fifth Street Finance should have the capacity to begin expanding the balance sheet with new equity issuance. Investors will have to watch this carefully, as accretive offerings could allow for additional increases in the dividend. 

BDCs that trade above NAV consistently can more easily grow their dividends, since each new offering above NAV results in proportionally more cash to invest than new shares on which a BDC must pay dividends.

The only downside, of course, is that Fifth Street Finance isn't the bargain it used to be. Earlier in the year, following a dividend cut, Fifth Street Finance shares could be found below book value. In fact, its shares were so cheap through the winter months that Fifth Street Finance approved a repurchase program in November 2013, and in December 2013 it repurchased shares at an average price of $8.98.

FSC Chart

FSC data by YCharts

Unfortunately, the company only deployed roughly $400,000 of the $100 million it earmarked for a potential repurchase. Looking back, a more active repurchase program would have had an enormous impact on the company's current net asset value and earnings power today. Alas, as with many externally managed companies, repurchases are rare -- they hurt the management team as much as they help shareholders.

The last word
All in all, Fifth Street Finance remains one of the better-managed BDCs on the market today, but at a premium to book value, shares aren't the bargain they used to be. The senior loan fund helps dividend coverage, but it also increases risk as its senior loan fund assets use much higher leverage -- each credit loss will have a bigger impact on the company's net asset value than losses in its lower-leveraged middle market loan book.

Take a wait-and-see approach. The next earnings report and subsequent conference call should shed more light on its senior loan fund plans, and the company's intention to expand the balance sheet with new capital raises. I'll be watching with great interest. You should, too.

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Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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