The biggest difference in the world of non-bank lenders is credit availability -- the ability to borrow money at attractive interest rates. The lower a firm's borrowing costs, the fatter the spread between its cost of funds and yields on its investments.
Fifth Street Finance (NASDAQ:FSC) took a step backward on Monday, getting a downgrade from Fitch (from BBB- to BB+), a move from investment grade to junk.
Ratings cuts don't come without explanation. In a press release, Fitch highlighted concerns about Fifth Street Finance's use of leverage, its hidden equity exposures, and the company's lack of a responsible dividend policy.
On above-average portfolio leverage
Fifth Street Finance has long teetered on the limit for leverage for BDCs rated investment grade. The limit is generally seen to be roughly 0.85 times equity, or $0.85 of debt on balance sheet for every $1 in equity to keep an investment-grade rating. In its explanation, Fitch noted that the company has run with higher leverage for some time:
During 2014, FSC increased the upper-bound of its long-term leverage target from 0.7 times (x) to 0.8x, excluding SBA debt, which is exempt from regulatory asset coverage calculations, but is included in Fitch's assessment of FSC's leverage. Including SBA debt in FSC's leverage calculation translates to total leverage tolerance of 0.96x.
Furthermore, regulatory leverage exceeded the company's new limit in three of the last four quarters, and amounted to 0.83x at Dec. 31, 2014, or 0.99x including SBA debt. This compares to 0.61x average leverage for investment grade-rated peers as of Sept. 30, 2014.
In other words, Fifth Street Finance's regulatory leverage sits at just 0.83 times equity, but when its SBA debt is included, which doesn't count against its regulated limit of one times equity, leverage sits at 0.99 times equity.
It goes without saying that to work back up to an investment-grade rating, Fifth Street will invariably need to take its foot off the gas pedal. And to do so, it will have to sell assets and repay debt, cutting into its earnings power going forward.
Now you know why Fifth Street decided to cut its dividend so aggressively from $0.09 per share, per month, to $0.06 per share, per month. It wasn't just about its falling fee income; it was also a clue that it may have to cut back on leverage.
It's become commonplace for BDCs to disguise equity positions as debt. Many BDCs hold controlling stakes in operating companies, and how they structure these investments is generally up to their own discretion.
Suppose you have a $20 investment portfolio that is invested entirely in a small neighborhood lemonade stand that you control. The lemonade stand has an enterprise value of $100 -- $80 comes from a bank loan and $20 is funded by your equity.
Rather than disclose your $20 investment as an equity investment, you structure it so that $18 is a debt investment, and only $2 is equity.
In effect, you suggest that this lemonade stand business, worth $100, is financed with $80 of bank debt, plus your contribution of $18 in debt plus $2 of equity. Thus, $98 in total debt and only $2 of equity.
In doing so, you can claim that 90% of your invested capital ($18 of $20 in total) is a secured debt position. It makes for a lovely pie chart in your presentations to investors, where you can claim to manage your portfolio with a careful balance of risk. A whopping 90% of your assets are in secured debt and only 10% are in equity, you could say.
But a more careful observation would find that 100% of your investment is an equity investment. No rational person will accept the idea that you can run a lemonade stand, or any business for that matter, with $98 of debt and only $2 of equity. In reality, the business has $80 of bank debt and $20 of equity. You've just chosen to further slice and dice up the real equity into $18 of "debt" and $2 of "equity."
Fifth Street Finance uses this maneuver with some of its portfolio companies, including Healthcare Finance Group and First Star Aviation, a healthcare and aircraft lender, respectively. Doing so allows it to report that its equity amounts to about 6% of the portfolio at fair value. Fitch says that's nonsense -- if you take out the gimmicks, equity exposures are more like 15.9% of the portfolio.
I tend to agree with Fitch's assessment. Fifth Street Finance's equity exposures are understated on its balance sheet, exposing it to perhaps more volatility than is apparent from a top-down survey of its debt and equity figures. Frankly, this may be something to examine across the industry. Count on some future articles on adjusting equity exposures on BDC balance sheets; Fifth Street is hardly the only BDC that does this.
On credibility with investors
Fifth Street's inconsistent dividend policy is costing it valuable reputational capital. Dividends were cut to start 2014, only to be raised in the summer of 2014, despite an inability to cover the new rate with earnings. Of course, the dividend increase in July 2014 proved to be pie in the sky, so the dividend was lowered when it reported earnings for the fourth calendar quarter.
We also shouldn't forget that in the fall of 2014, shareholders of another Fifth Street-managed fund were beaten over the head with a huge dilutive stock sale, all to make the asset manager a little more money. These actions have snowballed into a huge credibility problem.
Suffice it to say, Fifth Street hasn't been a very good steward of shareholder confidence. Fitch cited it as another reason for a downgrade: "The inconsistent dividend policy speaks to poor financial planning and has likely cost the firm some credibility with equity investors; an important source of growth capital."
Unlike the ratings agencies, I don't have to avoid offending anyone with careful language. Here's what Fitch really means: It's hard to believe that Fifth Street Finance shares will trade back to net asset value, which would allow it to grow, given its poor treatment of shareholders in recent history.
Where shareholders go from here
Fifth Street Finance will likely try to regain its investment-grade rating. After all, it has a relatively large $115 million debt maturity in 2016 -- one it would invariably prefer to refinance with long-term debt at low interest rates. It could theoretically roll this maturity into its credit facilities, but doing so would be imprudent.
And because "substantially all" of the company's assets are pledged to its credit facilities or the SBA, it isn't as though it can put up collateral to raise money through a round of inexpensive, collateralized debt.
Luckily, Standard & Poor's still rates Fifth Street Finance as an investment-grade credit, though that is subject to change. And I believe that probably will change -- ratings agencies tend to follow one another.
It's going to be a long slog from here. Fifth Street Finance will have to start slashing its leverage to get back on the good side of the credit agencies. And that could mean that its recently announced dividend cut to $0.06 per share, per month, wasn't aggressive enough to put it in position to move back to a BBB-rating -- the rating agencies' best-case rating for BDCs.
The only real lever, then, is slashing the management fee, which seems unlikely, given that its asset manager is now a public company that is dependent on the fee stream. Getting out from under this recent downgrade could prove to be daunting -- and I don't think you want to tag along for the ride.