5 Reasons Fifth Street's Deal Talk Smells Fishy

Last week, The Wall Street Journal broke the news that Fifth Street Asset Management (NASDAQ: FSAM) was on the auction block, apparently for the second time. 

The whole deal smells fishy, and it's unlikely to create good outcomes for Fifth Street Finance (NASDAQ: FSC) or Fifth Street Floating Rate (NASDAQ: FSFR) shareholders.

Shares of the Fifth Street trio may have rallied on the news, but here are five reasons this deal doesn't change the case for investing in anything related to Fifth Street.

1. Fifth Street Finance's asset and liability problem

Fifth Street Asset Management's premier asset is its contract to manage Fifth Street Finance, a business development company with $1 billion of shareholders' equity. Fifth Street Asset Management collects a fee stream of about $50 million from the BDC each year. We'll primarily focus here on Fifth Street Finance, as it is by far the biggest piece of the Fifth Street puzzle.

Fifth Street Finance is in a world of hurt. Not only has it revealed that more loans are going sour -- more than 10% of its assets are underperforming, according to its internal investment ranking scale -- but it also has a real problem on the liability side of its balance sheet.

The fund uses leverage to amplify its returns, but leverage will almost certainly have to come down. The ratings agencies generally prefer a debt-to-equity ratio of 0.85-to-1 for BDCs, but Fifth Street Finance was last levered at about 1.1-to-1. Back out the cash it had on hand, and leverage was still much too high at 0.93-to-1. (This understates Fifth Street Finance's leverage, given that it uses off-balance-sheet leverage in its joint venture.)

Two key sources of financing -- a credit facility with a balance of $402.5 million and senior notes of $250 million -- mature in less than two years, which represents 61% of its total on-balance-sheet liabilities.

I can't overstate how much of a warning sign this really is. BDCs try to extend their liabilities for as long as possible, and none would choose to be in a position where a credit facility has just four months until it expires.

Data source: SEC filings.

Fifth Street Finance lost its investment-grade rating from Fitch in 2015. S&P followed with a rating cut in March 2017. The downgrades have a number of far-reaching implications, including higher rates to refinance existing liabilities, and forced deleveraging as cash is directed to paying down its balances. 

Fifth Street Finance's dividend cut is designed to preserve cash leading up to the end of the draw period on its ING credit facility. Dividends for the next few months are as follows:

• $0.02 per share paid on March 31.
• $0.02 per share paid on June 30.
• A $0.125-per-share quarterly dividend paid on Sept. 29.

2. Dalton's first (and only) 92 days

In November, Fifth Street Finance announced that Patrick Dalton would become CEO of the company, effective Jan. 2. Many believed he was the "turnaround guy," as his inaugural conference call -- on which the company took zero questions from analysts -- featured Dalton explaining his goal for Fifth Street, which included hiring new employees and generally investing in the company's lending platform.

On April 4, less than two months after that Dalton-led conference call, he departed as CEO and board member.

The official word was that his "resignation from the board was not a result of any disagreement with the company on any matter relating to the company's operations, policies, or practices." That's boilerplate language you'll find in any departure announcement.

Many are concerned about the quality of Fifth Street Finance's assets. Given troubles in the past, particularly as they relate to the overvaluation of Fifth Street Finance's struggling portfolio companies, it's interesting that Dalton left after the end of the first calendar quarter, but before his signature would have appeared on the company's financial statements for the period. (To be fair, Dalton signed off on the financial statements in its February 10-Q filing.)

File this under "things that make you worry."

3. Tannenbaum's about-face

In December, just after Dalton was named as the new Fifth Street Finance CEO, Fifth Street's founder, Leonard Tannenbaum, filed with the SEC his intention to sell up to 7 million shares of Fifth Street Finance stock. The document also revealed that Fifth Street Asset Management would also sell up to 2 million Fifth Street Finance shares.

As we later learned, Tannenbaum didn't cash out of Fifth Street Finance -- he bought more. His holdings grew to 17.6 million shares as of his most-recent amended 13D filed in March, up from 13.3 million shares when he filed his intention to start dumping Fifth Street Finance stock.

By increasing his stake, Tannenbaum further cements the shareholder vote in the event a suitor makes a bid. It's one of a few signs that, in retrospect, points to a potential sale of Fifth Street Asset Management. (Shareholders of the BDCs will have to vote to approve a new management contract, which I'll discuss in more detail in a moment.)

4. Blue-light special

Greenmail, the prying eyes of SEC Enforcement, and class action lawsuits aren't the kind of attributes many find desirable in an asset manager on the auction block, but there is precedent for struggling and controversial management companies to catch a bid.

Last year, the private BDC Business Development Corporation of America, transferred ownership of its management company to Benefit Street Partners after a series of high-profile flubs. The fact is that any BDC manager, no matter how hated, has intrinsic value due to the outsize fees it can collect from the BDC's permanent capital base.

Keep in mind that Fifth Street Asset Management went public at a price of $17 per share, only to rapidly decline in value as a public company. Now, the same ownership group that was happy to sell a bite-sized chunk of the company at $17 wants to dump the whole thing as shares trade for less than $5 each.

Given all this, particularly Fifth Street Finance's asset and liability problems, it feels like something of a last-ditch effort to get something for Fifth Street Asset Management.

5. The BDC shareholders have little recourse

If Fifth Street Asset Management gets a bid for its management contracts, shareholders of Fifth Street Finance and Fifth Street Floating Rate will have to vote to approve the management change. That's one of the few valuable shareholder protections the 1940 Act affords BDC investors.

The unfortunate reality is that shareholders will simply have to take what they can get. A vote for a change in management is a vote for new management. A vote against any new management is a vote to keep the Fifth Street Asset Management crew in place.

Remember what happened when the TICC Capital management contract was in play. The TICC-approved team couldn't get enough shareholder votes to become the new owners of the management company, and thus the same TICC team stayed in place.

Owners of Fifth Street's BDCs won't want to make the same mistake. By all appearances, Fifth Street is merely a shell of an asset manager. Besides Fifth Street, there are few places where billions of dollars of assets are managed by a group that lacks a named chief credit officer and chief investment officer.

If history is a guide

When Fifth Street Asset Management went public, the result was nothing good for shareholders of Fifth Street Finance or Fifth Street Floating Rate.

Because the company's owners are again looking to cash out of the company -- this time by selling all of it -- I'm left to believe that Fifth Street Finance and Fifth Street Floating Rate have many more problems than the public knows about.

Shares of both Fifth Street BDCs rallied on the news that Fifth Street Asset Management was up for sale, perhaps because shareholders feel any new management is better than existing management, but the rapid exit by a "turnaround" CEO hire and a growing liability problem for Fifth Street Finance stock give me pause.

The House of Tannenbaum remains untouchable.