Every quarter, key managers of Fifth Street Finance Corp. (NASDAQ: FSC) sit down to discuss the business with analysts in a brief conference call. The company's latest call shed light on some of the company's key initiatives and how it plans to continue delivering large monthly dividends to shareholders.
I listened intently. Here are the four most important topics that all shareholders should know about.
1. Will Fifth Street Finance sell shares under book value?
Fifth Street CEO Len Tannenbaum seemed almost annoyed that this question even came up. But it needed to be asked. He answered plainly: "You'll see the proxy come out at the annual meeting, and FSC does not intend to ask for permission to sell below book, versus over, I would say, 90% of our peers that do."
Many believe Fifth Street Finance's "sister BDC" Fifth Street Floating Rate (NASDAQ: FSFR) was unnecessarily diluted by the external manager in an attempt to juice management fees before the manager's IPO. The costly, dilutive equity-raise resulted in a nearly 15% decline in net asset value for existing shareholders.
Fifth Street Finance shareholders have every reason to be legitimately concerned about dilutive stock sales. But given that the company won't seek the right to issue new shares at prices under NAV, highly dilutive share offerings can be ruled out for now. That's comforting, given the uproar that followed below-NAV sales in another Fifth Street-managed entity. (Fifth Street Finance has never asked for the ability to sell shares at prices below NAV, but everything is subject to change.)
2. On growing the "30% bucket"
BDCs must invest at least 70% of their assets in "qualifying assets" under the 1940 Act structure. Generally speaking, qualifying assets are debt and equity investments in a private, U.S.-domiciled company. For a long time, BDCs largely tried to hold 100% qualifying assets.
Sometimes it pays to bend the rules and see the nonqualifying limitation as an opportunity. BDCs are using more non-qualifying assets to help juice their asset yields in their portfolio, Fifth Street Finance included. When asked about total utilization, Todd Owens, president of Fifth Street Finance, noted that the firm is "at just under 13% in the 30% bucket," so "we have a lot of room."
As for how Fifth Street Finance would make better use of its buckets of assets, Owens also pointed out that the senior loan fund would be the primarily place to put new assets to work. "I guess really what we're focused on is the [joint venture] structure, and we're going to be looking to continue to grow either the size of the JV or additional JVs into that 30% bucket."
3. Fighting falling yields with a senior loan fund
Senior loan funds are all the rage in the world of BDCs. In a senior loan fund, BDCs buy low-yield, senior loans and then leverage them with 2-to-1 or greater leverage. Typically, BDCs can only leverage their balance sheets at 1-to-1, with many operating at a much lower ratio. In short, a senior loan fund gives a BDC a way to generate higher returns from lower-yielding assets with higher leverage.
Fifth Street Finance's SLF yielded 17% annualized in the fourth fiscal quarter. Obviously, the company would like to grow the SLF within its 30% bucket to help increase its investment yields. But there's one limitation: finding leverage.
Len Tannenbaum described the limiting factors for growing the SLF going forward:
The limiting constraint is it's not really finding new partners. We have plenty of partners interested in partnering with us there. The limiting constraint is leverage. So what will slow the SLF growth or constrain it to a degree is the fact of finding leverage partners to lever each new vehicle.
The profitability of a senior loan fund hinges on the ability to borrow at a low rate and invest at a slightly higher rate. Fifth Street Finance is finding problems sourcing more bank leverage to grow its senior loan funds. Currently, Deutsche Bank (NYSE:DB) provides financing at the paltry rate of LIBOR plus 2.5%. But it has only extended $200 million in credit; Fifth Street Finance wants access to a facility as large as $400 million, which would allow the SLF to control $600 million of senior loans if fully utilized. A bigger credit facility may be in the cards this quarter.
4. Are buybacks in play?
Fifth Street Finance approved a new $100 million share repurchase plan on Nov. 20. One analyst asked if Fifth Street planned to repurchase shares, given that the stock currently trades at a roughly 10% discount to book value. At that price, he inferred, repurchases might help juice the company's return on equity by increasing leverage while growing NAV per share.
I'm not answering the question. I don't think it's appropriate to forecast to use the buyback or not. But I think in the past we've said it's certainly not to trade. We issue stock and we buy back stock. And if it's traded at a substantial discount, we will use it. We did use it about a year ago. We had used it in the past unlike some people. But it has to trade at a substantial discount for us to feel like it's a good idea.
I interpret this as a "no." Fifth Street Finance has not historically made significant share repurchases, even when shares have traded at 10% discounts to NAV. Repurchases are probably even more unlikely, given that the external manager, Fifth Street Asset Management (NASDAQ: FSAM), is now a publicly traded company and reliant on a greater level of assets at its managed funds to produce more management fees.
Either way, it's worth reminding a management team that buying back stock at a discount is often a better solution for shareholders than making new investments at full price.