On Tuesday, Fifth Street Finance (NASDAQ: FSC) joined two other business-development companies in one of the few clubs you don't want to be part of: the activist target club.
It isn't undeserved. The activist, RiverNorth, points out that Fifth Street Finance's 34% discount to book value makes it the cheapest of any BDC with a market cap of $500 million or more.
There really isn't much excuse for it. Fifth Street Finance doesn't own collateralized loan obligation equity, which the market currently hates. It doesn't have meaningful oil exposure, which has also proved problematic. Rather, its valuation reflects the belief of the market and RiverNorth that its underwriting is poor and its management is self-serving.
What RiverNorth wants
Having effectively acquired 6% of Fifth Street Finance's shares outstanding, RiverNorth has a few demands for the company.
- Reduce management and incentive fees. (It called the 2-and-20 structure "absurd.")
- Require a total-return high-water mark for incentive fees, which would require the manager to generate income to pay a meaningful dividend and preserve book value to earn performance-based fees.
- Increase the size of the stock buyback program to repurchase shares below NAV.
I think you'd be hard-pressed to find a Fifth Street Finance shareholder opposed to any of this plan. All of these objectives would probably result in significantly higher earnings, book value, and valuation per share at the expense of Fifth Street Asset Management (NASDAQ: FSAM). As I've explained before, one of the biggest problems with Fifth Street Finance is that it's taking extra risk with shareholder capital entirely for the benefit of its management team.
RiverNorth's action plan
The activist is starting first with the Fifth Street Finance board of directors, which currently has nine members, four of which are employed by Fifth Street Asset Management. It put up three nominees, which could significantly change the board's composition.
|
Independent Directors |
"Interested" Directors | |
|---|---|---|
|
Current composition |
5 |
4 |
|
Up for election this year |
2 |
2 |
|
"Ideal" composition |
7 (3 from RiverNorth) |
2 |
By replacing two interested directors and one existing independent director with RiverNorth nominees, it would have significantly more power to effect the changes it sees necessary. RiverNorth asked Fifth Street to skip the election process altogether and simply reconstitute the board to include RiverNorth's slate.
You can see how useful RiverNorth's board members would be. Its three nominees would outnumber the remaining two interested directors, forcing the BDC's "independent" directors to vote in the best interests of shareholders or publicly show that they have zero interest in real corporate governance. Checkmate.
If that doesn't work, RiverNorth seems content to simply start breaking things. The company currently intends to push for ending the management agreement between Fifth Street Finance and its external manager, Fifth Street Asset Management. The board would then need to find a new manager, probably on much better terms. To do that, it just needs an affirmative vote from a majority of Fifth Street Finance's shareholders to break the agreement with no penalty attached.
This is why shares of Fifth Street Asset Management plummeted by nearly 26% in a single trading day as RiverNorth published its letter. It primarily earns its income by pulling fees from Fifth Street Finance. (That Fifth Street Asset Management also pushed back its earnings release for the third quarter isn't helping, either.)
The manager has a choice. It can play nicely, and probably give up a portion of fee income it currently earns from Fifth Street Finance because of shareholder-friendly repurchases and direct fee concessions. Or it can play hardball with RiverNorth and risk the entirety of its fee stream on a shareholder vote.
Reasonable people should be able to find common ground, but it's a net win for Fifth Street Finance and a net loss for Fifth Street Asset Management any way you slice it. The BDC's shareholders may have just hit a two-outer on Fifth Street.
