Fifth Street Finance (NASDAQ:FSC) will report earnings on May 8, and the results are sure to be some of the most important.
This will be the second quarterly earnings report since the company slashed its dividend to $0.0833 per month, or $1.00 per year.
Looking into Fifth Street Finance
Fifth Street Finance laid out a five-point plan to earn its dividend in 2013. So far, the plan seems to be working. Well, working in the sense that it can now cover its new dividend rate.
In January, the company's newsletter indicated that it was working near the low end of its ideal leverage ratio of 0.6-0.7, excluding borrowings from the SBA. In April, the newsletter indicated that leverage had turned higher, rising to the "upper end" of its 0.6-0.7 leverage range during the March quarter. This is, without doubt, good for Fifth Street Finance, and its dividend coverage.
Fifth Street Finance had previously underutilized its SBA borrowings, but a March press release indicates the drag may have come to an end. Its second SBA-licensed fund is now using its full capacity, which suggests originations caught up with its borrowing ability. Investors should remember that in its third-quarter earnings report, Fifth Street Finance had borrowed too much from the SBA, and thus paid interest on funds it couldn't invest.
Also noteworthy are several key originations. The company's venture lending platform secured at least three deals in the first calendar quarter. One major deal was a $30 million second-lien loan to Five9 (NASDAQ:FIVN), a company that recently went public. Fifth Street Finance scored warrants for its participation in the loan to Five9, providing additional upside beyond the interest due.
An SEC filing for Five9 shows that it issued warrants for 178,000 shares of common stock at $10.12 per share in February 2014, likely in connection with the debt investment by Fifth Street Finance. At a current price of just over $7 per share, its Five9 warrants are currently out of the money, but they represent the upside potential in venture debt financing.
Finally, on Monday, Fifth Street Finance earned an improved outlook rating from Standard & Poor's from "stable" to "positive" on its BBB- credit rating.
The elephant in the room
Among the biggest developments is Fifth Street Finance's new Senior Loan Fund. In April, the company noted that the Senior Loan Fund was in the "documentation stage." By April, the company noted it was establishing its first SLF partnership, and in talks to bring in additional partners.
The SLF could be huge for Fifth Street Finance. Rivals Ares Capital Corporation (NASDAQ:ARCC) and Golub Capital (NASDAQ:GBDC) already have senior loan fund-like platforms, which allow them to invest in lower-yielding debt with higher leverage to generate double-digit returns.
Typically, a senior loan fund allows a BDC to profit in two ways. First, from a portion of the origination fees, and secondly from interest after all first-lien debt investors are paid. Expect this to be a focus on the next conference call. A senior loan fund can quite easily deliver 15%+ annual returns on equity. Ares Capital's annual report revealed a 14.8% yield on its Senior Secured Loan Program as of December 31, 2013. That yield excludes the contribution of one-time fees and prepayment penalties, which can add significantly to the total return of a senior loan fund.
Yield compression led to a declining dividend in 2013, but Fifth Street Finance appears to be back on track. With new originations coming in ahead of expectations in March, the senior loan fund under development, and a higher credit outlook, it's surprising to find the company trading below its last reported NAV of $9.85 per share.
If Fifth Street Finance's financials reconcile with positive news this quarter, the discount of 5% to net asset value is unwarranted.
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.