Fifth Street Finance (NASDAQ:FSC) certainly hasn't been the best dividend stock in recent history. Since 2010, dividends have been cut twice, from $0.106 per month to $0.0833 per month at the current level.
Luckily, the current dividend seems sustainable. Dividend growth, however, will require a new strategy.
Leveraging new investments
By law, business development companies are limited to 1-to-1 leverage at the corporate level. That is, a BDC must have $2 in assets for each $1 it borrows.
There are, however, ways around this limit. Ares Capital (NASDAQ:ARCC) works with GE Capital on a program to create more leverage. Ares Capital contributes $2.3 billion to the program and GE Capital contributes $8.7 billion for a total of $11 billion.
The pool of cash is combined, invested in loans, and then the returns are distributed between GE Capital and Ares Capital. GE Capital primarily provides low-risk, low-cost capital, and gets paid first. Ares Capital is paid last, earning 8% over the floating benchmark rate plus any funds leftover after all claims are paid.
This partnership is a key earnings driver for Ares Capital, providing annual returns in excess of 15%, so it's no wonder other BDCs would love to replicate it.
How Fifth Street will use the model
On the latest conference call, Fifth Street Finance CEO Len Tannenbaum expressed interest in starting a similar program. He believes it would provide a way to invest in lower-risk, and higher-quality loans at lower interest rates, yet provide greater returns due to the leverage inherent in a loan program.
If Ares Capital's success with its SSLP is any indication, it can do just that. But creating a loan program requires a partner -- a partner willing to split investments with Fifth Street.
For now, Fifth Street Finance is busy working on "back levering" its new investments. Back levering allows Fifth Street to make a new investment, and essentially create a loan program on the fly for each individual investment.
CEO Len Tannenbaum gave an example in which the company could make an investment at 8%, sell rights to half of the investment at 5%, and retain the other half. In leveraging an investment this way, Fifth Street's best case return is 11% per year, significantly higher than the 8% initial return.
The downside, however, is that backlevering increases risk if a borrower defaults. In such an event, Fifth Street would have second claim to the assets, receiving cash flows only after the first investor is repaid in full.
The Foolish bottom line
Competition is heating up for BDCs, forcing them to get creative to earn higher returns. In recent months, BDCs have had a simple choice: invest in higher-risk debt to earn higher returns or leverage lower-risk debt to earn a similar return.
Many, like Fifth Street, are deploying leverage to lower-risk, lower-yielding debt in lieu of investing in higher-risk, higher-yielding debt. It's an interesting strategy that can pay off handsomely when matched with good underwriting standards. With yields dropping, leverage from a loan program or backlevering is the best catalyst for a growing dividend at Fifth Street Finance.
Jordan Wathen has no position in any stocks mentioned, and neither does The Motley Fool. 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.