Fifth Street Finance Corp. (NASDAQ: FSC) capped off the calendar year with a less than remarkable fourth quarter, earning just $0.23 per share in net investment income vs. a quarterly dividend of $0.27 per share. In addition, net asset value plummeted in the fourth quarter to $9.17 per share from $9.64 per share in the prior quarter.

On the back of poor investment performance and lower income, the company also announced it would be slashing its dividend going forward, revealing a new dividend of $0.06 per month compared to $0.0917 per month. Shares dropped 14% at the market open.

The most puzzling of dividend policies
Fifth Street Finance's dividend has been all over the map. It cut its dividend to $0.083 to start 2014, raised it to $0.09107 per month in July, and now, in January 2015, it becomes clear that the dividend will have to be cut once again.

It's not exactly surprising. I warned last quarter that roughly one-fifth of Fifth Street Finance's revenue came from volatile fee income. Fee income is easy to generate when shares trade above book value and new originations can be made quickly. It appeared then that the company's dividend would inevitably have to be cut if its originations fell.

Of course, the calendar fourth quarter being Fifth Street's best for new originations and fee income, it didn't have to bite the bullet this quarter. It closed $716.6 million in new investments, compared to $912.7 million in originations in the same quarter last year.

Going forward, however, its capacity to generate fee income is weakened by its balance sheet leverage. Its debt-to-equity ratio stands at 1.1-to-1, higher than the statutory limit of 1-to-1 leverage, thanks to SBIC leverage, which is excluded in calculating its BDC leverage limit.

Unable to raise new capital with share issuance (Fifth Street cannot issue shares at prices under net asset value) and with its debt leverage nearly exhausted, new originations will have to come from rotating the portfolio by selling existing investments and making new ones. 

Reducing its dividend to $0.06 per month enables it to earn its dividend in a "steady-state" environment, where fee income makes up a smaller portion of top-line total investment income.

Realized and unrealized losses mount
Last quarter, Fifth Street Finance's portfolio company Miche Bag stuck out like a sore thumb, held at a considerable discount to its cost basis. This quarter, we learned the portfolio company was restructured. Fifth Street recorded a $17.9 million realized loss, equal to roughly $0.11 per share.

In addition, unrealized losses were daunting. The company reported unrealized depreciation of $0.31 per share in the fourth quarter. Four investments, Phoenix Brands Merger Sub, TransTrade Operators, CCCG, and JTC Education were all placed on PIK non-accrual as of December 31, 2014.

That designation implies that Fifth Street Finance is no longer recognizing paid-in-kind interest from these companies as income. Further deterioration -- perhaps the dividend cut is somewhat of an indicator of what's to come -- would lead to cash non-accrual, resulting in the loss of virtually all the income coming from these four investments. That bodes poorly for future quarters, given that these investments make up 4% of the portfolio at cost.

Resetting the dividend resets expectations, but after an abysmal history of realized and unrealized capital losses in the last year and over its cumulative history, yield-seeking investors may want to consider taking their lumps and moving on.