In July, Fifth Street Finance Corp. (NASDAQ: FSC) issued new shares to grow its balance sheet. This isn't necessarily a newsworthy thing to do. What was, though, was the price-tag -- shares were issued at a price that, after fees, diluted the wealth of existing shareholders.
Then, in August, Fifth Street Floating Rate Corp (NASDAQ: FSFR) -- a business development company, or BDC, managed by the same external manager as Fifth Street Finance Corp. -- inexplicably issued millions of new shares at a price of $12.14, a 20% discount to the previously reported net asset value per share of $15.13.
Shareholders were effectively robbed of millions of dollars due to this dilutive offering. I estimate that new shares sent the company's NAV per share to $12.80, a 15% haircut in a single day. Shares cratered.
To make matters worse, after diluting shareholders substantially, the company then rescheduled its post-earnings conference call, avoiding any interaction with its investors who watched their investment dwindle in value.
What's the deal with Fifth Street?
Fifth Street Finance and Fifth Street Floating Rate are externally managed BDCs. They pay management and incentive fees to an external manager for taking care of the day-to-day operations.
And, in a recent filing, we learn that the BDCs' external manager has plans to go public.
Aha!
Suddenly, it all makes sense.
Fifth Street needed to raise new capital to inflate its assets under management, or AUM, prior to filing for its own IPO. Thus, it arranged for a marginally dilutive offering at Fifth Street Finance, followed up with a massively dilutive offering for Fifth Street Floating Rate.
The net effect is more AUM for the asset manager, which only results in more management fees, and a higher price for its shares at IPO. (Interestingly, upon going public, Fifth Street Asset Management will retain nothing from the proceeds -- it's a cash-out IPO for the current owners.)
A wildly profitable asset manager
Fifth Street Asset Management is a cash cow. In an S-1 filed with the SEC, the company notes that it generated roughly $39.7 million in net income in 2013 from $73.6 million in revenue in 2013.
It's also making its managers rich. Leonard Tannenbaum received $633,530 in compensation plus dividends of more than $22.4 million just last year.
Unfortunately, these big paydays aren't coming as a result of outsized performance from Fifth Street's managed funds. No, they're coming from the ever-growing fees of the public BDCs, which have grown and grown, despite the fact that this growth has been nothing but bad news for existing owners. The S-1 proudly states that Fifth Street Asset Management has grown management fee revenue at a compounded rate of 40.2% in the past three years.
Source: S-1 filing
The funds' growth won't stop here. In August, after a substantial equity raise in July, Fifth Street Finance Corp. filed for its first-ever material at-the-market equity raise of $100 million to quietly sell more and more shares into the open market. An ATM program will allow the company to grow its balance sheet -- and fees for its manager -- every single time the stock trades only slightly higher than its previously reported net asset value.
The Foolish final word
Investors should carefully watch how managers behave with other people's money. The massively dilutive equity raise at Fifth Street Floating Rate is an appalling sign that management is more important than public shareholders. Buyer beware.
