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Why Shares of Fifth Street Finance Corp. Are Surging on Friday

By Jordan Wathen - Updated Jul 14, 2017 at 10:39AM

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Oaktree Capital Group will take over the management of Fifth Street Finance Corp. and Fifth Street Floating Rate from Fifth Street Asset Management.

What's happening?

Shares of Fifth Street Finance Corp. (NASDAQ: FSC) are up nearly 16% as of 10 a.m. EDT on news that Oaktree Capital Group (OAK) is taking over the poorly performing business development company.

So what?

Fifth Street Finance Corp. has struggled under the direction of Fifth Street Asset Management (NASDAQ: FSAM).

When Fifth Street Finance filed its first quarterly report as a public company in 2008, it reported having a book value of $13.20 per share. But after a long list of bad investments, dilutive equity issuance, and run-ins with the SEC about its financial reporting, the BDC last reported book value of $7.23 per share, roughly 45% less than where it began. While other BDCs capitalized on a lender-friendly credit market in 2009-2011, Fifth Street Finance reported large losses.

Photo of spilling coin jar

Fifth Street's BDCs have bled assets. Oaktree's involvement could put an end to their decline. Image source: Getty Images.

Oaktree Capital Group has agreed to take over the management contracts of Fifth Street Finance and its sister BDC, Fifth Street Floating Rate (NASDAQ: FSFR), for $320 million in cash, which will be paid to Fifth Street Asset Management. Based on the surge in early trading, shareholders of the two BDCs are happy to see one of the most-respected asset managers (Oaktree) take over duties for one of the market's least-respected managers (Fifth Street Asset Management).

Fifth Street Finance will be renamed Oaktree Specialty Lending Corp., and Fifth Street Floating Rate will be renamed Oaktree Strategic Income Corp. Both will maintain similar investment strategies as they have today. Fifth Street Finance will have latitude to invest in riskier credits, whereas Fifth Street Floating Rate will continue investing in higher-quality senior loans.

In addition to new management, Fifth Street Finance shareholders will be asked to approve a new fee structure for the BDC. Oaktree Capital Group has proposed cutting Fifth Street Finance's management fee to 1.5% of assets, down from 1.75%. Incentive fees for good performance will be reduced from 20% of income and gains, to 17.5% of income and capital gains, subject to a 6% hurdle rate. Fifth Street Floating Rate shareholders will see no reduction in its 1% management fee, but the incentive fee will similarly drop from 20% of income and gains to 17.5%.

The deal is currently expected to close in the fourth quarter of 2017.

Now what

It's clear from the terms of the deal that Oaktree wanted the contracts, and little more. In an announcement, Fifth Street Asset Management noted that, "at the closing of the transaction, all current FSC board members except Richard P. Dutkiewicz, and all current FSFR board members except Richard W. Cohen, will resign." Executives of both BDCs will resign.

A BDC's board of directors has the responsibility to appropriately value the BDC's portfolio each quarter. Fifth Street Finance last reported that its net asset value stood at $7.23 per share. The question for shareholders is whether its new Oaktree board of directors will ascribe a similar valuation to the portfolio, or if more markdowns are in the cards. 

Even after today's pop, Fifth Street Finance shares trade at a 24% discount to its last-reported net asset value, far greater than the 5% discount to NAV of the median company in its industry.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Oaktree Capital. The Motley Fool has a disclosure policy.

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