Fifth Street Finance Corp. (NASDAQ: FSC) offered an olive branch to investors, but it may be too little, too late. The company announced that its Board of Directors agreed to cut its management fee from 2% of assets annually to 1.75%. All other features of the fee agreement will remain the same.
Does it matter?
The primary problem is not that Fifth Street's management fees are too high, but rather that the formula for calculating incentive fees excludes capital losses. Under the current fee structure, Fifth Street's external manager stands to collect incentive fees for good performance even when it loses money for shareholders!
So far, Medley Capital (MCC -3.26%) is the only BDC to take this problem head-on by restructuring its fee agreement so that capital losses are included in its calculation of incentive fees. Fifth Street Finance's announced fee change does not get to the root of the problem; it offers a small reduction in base management fees with no change to the problematic incentive fee structure.
Using Fifth Street Finance's numbers for the fiscal year ended Sept. 30, 2015, I calculate that a 0.25% reduction in annual management fees would have a minimal impact on the company's financial results. (My calculations may differ because I'm using the most recent share count as of November, rather than weighted-average shares outstanding.)
Adjusting its fiscal 2015 results as if the new management fee were retroactive, I calculate that the company's net investment income would rise by just under $5 million for the full fiscal year. Net investment income would thus round to $0.80 per share, up from $0.76 per share for the actual 2015 year.
Net income, which includes capital gains and losses, would grow to about $0.14 per share for the fiscal year, up from the reported amount of $0.10 per share. The manager would stand to earn about $0.50 per share in fees vs. the actual amount of $0.53 per share.
Despite a fee cut, little changes for the shareholders. Investors who own 100% of the company would have claim to about $0.14 of net income per share for fiscal 2015. Meanwhile, the manager would still walk with fees tallying to $0.50 per share. I find it indefensible.
In my opinion, this announced fee reduction is little more than fodder for a positive press release. Notably, the fee reduction appears to be the result of a unilateral decision by Fifth Street Finance. It's likely that RiverNorth, an activist investor that has singled out fees as a leading cause of the company's underperformance, will find the token reduction to be just that -- a token reduction.
It's my view that Fifth Street Finance shareholders deserve better. At the annual meeting, shareholders will have the option to vote on whether or not to kick the current manager to the curb. If this is Fifth Street's best offer, your capital is probably best managed by someone else on better terms.