Description

We are recommending Fifth Street Finance (“FSC”) neither for what it is, nor for what it has been, but rather for what it is going to become.  The asset purchase agreement that replaces FSC’s current investment advisor, Fifth Street Asset Management (“FSAM”) with Oaktree Capital Management, L.P. (“Oaktree”) instantaneously lifts FSC out from the bottom of the trash heap of investment vehicles burdened by excessive fees, conflicted management and performance notable for its consistency in underwhelming even the most dismal expectations.  

Because of the suddenness of this transformation from zero to hero, FSC can be purchased at a substantial (26%) discount to its recently reported NAV.  Based on where the subset of comparable, competently managed vehicles trade, we expect this discount to completely collapse within the next 12 months.  Modelling a year forward NAV of $6.45 per share (a 10% discount to the latest report) and an 8% dividend yield (versus the 9.45% yield currently indicated) gives us an expected return of 30% over the next 12 months, which seems exceptional on a risk-adjusted basis given the current set up.

About Fifth Street Finance

FSC is no stranger to the VIC.  It was written up by Banjo at a 58% discount to NAV in October 2008 and by MSG at a 30% discount in July 2015.  There is a lot of valuable background in the writeups and the numerous message posts for both, but, if nothing else, please read the yuletide poem David shared for MSG’s writeup in post 24 on December 22,2015.

While you could have made very good money from the first writeup (indeed Banjo initiated the recommendation at a 58% discount to NAV and exited at a 20% premium!) and, if you were nimble, some, but less, from the second writeup, FSC really has been a testimony to what Buffett meant by “cigar butt” investing.  There were many points through its existence in which a trader could get that one puff by buying it at an extreme discount to NAV but you had to throw it back on the ground before the horrific dynamics of high fees and poor management caught up with you.

FSC was founded by Leonard Tannenbaum in 1998.  It is a Business Development Company (BDC).  A BDC is a closed-end investment company regulated by the Investment Company Act of 1940.  BDCs invest in smaller companies and have a pass-through tax structure requiring distribution of 90% of the taxable income they generate.  While some of the governance requirements associated with electing to become a BDC are notably friendly to shareholders, the space has some notoriety for slowly bilking retail investors with high fees and conflicted compensation incentives.  FSC provides mostly debt-based financing to small and mid-sized companies, primarily in connection with private equity sponsors.

FSC’s portfolio is managed by Fifth Street Asset Management Inc. (“FSAM”), an investment adviser led by Leonard Tannenbaum as Chairman and CEO.  In addition to FSC, FSAM manages the Fifth Street Street Senior Floating Rate Corp. (FSFR), two private collateralized loan obligations (“CLOs”), and a credit hedge fund.  The original contract between FSC and FSAM included a 2% management fee and a 20% incentive fee (with no lookback or high water mark).  FSC needed to earn an 8% hurdle rate before the incentive fee could be charged, after which the incentive fee would be fully paid before FSC could split the incremental return on an 80/20 basis with FSAM in a given year.  The fee structure is clearly onerous even if the manager had demonstrated solid performance, which, of course, it did not.  Further, the lack of the lookback or high water mark feature incentivized the manager to take more credit risk than would be optimal for FSC holders because FSAM was primarily paid based on the yield generated by the portfolio and not its total return over time.  FSAM went public in November 2014.

At June 30, 2017, FSC’s $1.8 billion investment portfolio was diversified across 133 companies, 107 of which were completed in connection with private equity sponsors.  At fair value, 89.4% of the portfolio consisted of debt investments and 74.1% of portfolio was in senior secured loans.  The average debt investment size was $16 million.  According to the company, 90% of the portfolio was performing at or above expectations.

Performance History

FSC’s initial offering came at $14.12 per share on June 11, 2008.  From this offering until the time of this writeup (August 11, 2017) the company’s shares generated a total return of 1.9% (NOT annualized) including dividends reinvested in the security, or an annualized return of 0.2%.  Throughout its existence, the company’s shares often traded at large discounts to its NAV.  With its substantial cashflow from coupon and principal payments, the company had the opportunity to dramatically increase shareholder value by repurchasing shares below NAV.  However, despite the announcement of numerous share repurchase programs, the company’s sharecount never decreased on a quarterly basis until the 4th fiscal quarter (3rd calendar quarter) of 2015, when the company initiated and completed a very modest $5 million buyback.

Activism

The combination of poor performance, excessive fees, conflicted incentives and a persistent, unexploited discount to NAV finally brought forward an activist to shake things up for the benefit of FSC’s beleaguered shareholders.  In November, 2015, RiverNorth Capital Management, LLC (“RiverNorth”), a Chicago based investment manager with aver $3 billion in assets under management, including funds subadvised by highly reputable managers such as Oaktree and DoubleLine Capital Management, L.P., launched a campaign to replace three board members with their own nominees at the upcoming shareholders’ meeting and to cancel the Investment Advisory Agreement between FSC and FSAM.

FSAM responded to RiverNorth’s demands by offering some small concessions, including reducing its base management fee from 2% to 1.75% and announcing a $100 million share repurchase authorization.  As mentioned above, FSC had a long history of announcing sizeable buyback authorizations without executing on them in a way meaningfully enough to actually reduce the sharecount from one quarter to the next, so this announcement was appropriately taken with a grain of salt by RiverNorth and other FSC holders.

Our view was that RiverNorth actually had a fighting chance in this proxy standoff.  They owned just under 9% of the stock themselves and we could do the math to get up to 35% of institutional holders supporting their nominees and contract cancellation.  The question was whether enough retail was aware and willing to go along.  This was never put to the test, however, as FSAM and Tannenbaum came to an agreement with RiverNorth in February 2016 to purchase their shares at a substantial premium to the market ($6.25, when the shares were trading around $4.75) and end the battle.  FSC shareholders, including ourselves, were left in the cold, and the press and blogsites exploded with greenmail hashtags.

Insider and Company Share Purchases

While the battle was lost, along with some of RiverNorth’s reputation, to a certain extent this saga started the wheels moving in shareholders’ favor.  For one thing, the RiverNorth campaign scared Tannenbaum and FSAM enough for them to buy gobs of FSC shares in the open market to secure as many votes as possible against the RiverNorth proposals.  Between this and the share purchases required by Tannenbaum and FSAM to complete the deal with RiverNorth, Tannenbaum’s economic interest in FSC grew to almost 24 million shares (combining what Tannenbaum held personally and his 52% interest in the shares held by FSAM).

There are many interesting stories about Leonard Tannenbaum that are beyond the scope of this writeup. However, one thing that is clear from these anecdotes is that while Lenny may not be the guy you want to manage your money, you can be sure that he knows how to manage HIS money.  When Tannenbaum’s ownership in FSC grew to $110 million in value (assuming $5 per share), it seemed possible that he might even care more about FSC than about FSAM.  After all, FSAM was just another activist campaign away from potentially losing most of its value and Tannenbaum’s 52% ownership was actually worth less than his FSC stake at market.

Throughout 2016, FSC actually did repurchase $50 million worth of their stock, in accordance with another stipulation in the RiverNorth agreement, but also in the face of wide skepticism from the investor community (see some of the messages about this under MSG’s writeup).  Tannenbaum then personally purchased 1.3 million more shares during the last two weeks of March 2017.  That, coupled with the announcement of the departure of Patrick Dalton, FSC’s CEO, from the company and its board, was probably the tell that Tannenbaum was working on something to maximize the value of his holdings in FSC.

The Oaktree Transaction

On July 13, 2017, FSAM entered into an agreement with Oaktree that would terminate the Investment Advisory Agreement between both FSC and FSFR and FSAM and replace FSAM with Oaktree as the investment advisor for both BDCs.  The new advisory agreement with Oaktree proposes lowering the management fee from 1.75% to 1.5% and the incentive fee from 20% to 17.5%.  However, it would also decrease the hurdle rate to 6%, making it more likely that Oaktree would earn their incentive fee, and there still is no lookback feature or high water mark.  The total expenses under this proposal were benchmarked at 3.1% of assets based on the 12 months ended March 31, 2017 versus a peer group median of 3.3%.  The transaction is contingent upon approval by the stockholders of FSC, FSFR, and FSAM, as well as regulatory approvals.  We believe the deal risk is very low given the large insider holdings of all these entities and the obvious benefits for the shareholders of FSC and FSFR.  The transaction is expected to close in the first fiscal quarter of 2018 (that is, by the end of the fourth calendar quarter or by year end 2017).

About Oaktree

For many VIC members, Oaktree and its co-chairman Howard Marks need no introduction.  We rank Marks with Buffett in the pantheon of rational investors able to implement a simple but enormously effective investment philosophy on a large scale, and his firm has an incontrovertible long term track record to prove it.  Their open-end strategies have consistently outperformed their benchmarks across their high-yield bond, U.S. senior loan, and convertible strategies.  We look forward to his investment memos quarter after quarter.  The firm is a global debt investing powerhouse with $100 billion of assets under management, including $40.6 billion in corporate debt, $25.8 billion of distressed debt and $5.4 billion in convertible securities.  The company employs more than 900 professionals in 18 cities across 3 countries.  Oaktree’s Strategic Credit team designated to serve as the manager’s executive officers consists of 12 investment professionals, led by Edgar Lee, with more than 50 years of combined investment experience.  This team will have access to over 270 other investment professionals across Oaktree, including 12 mezzanine sourcing professionals and 10 traders, in addition to others, including 24 legal professionals and 27 tax professionals.

Comparables

Listed below are what we view are comparables for FSC.  This is substantially similar to the peer group list used by FSC’s board to determine the fairness of the proposed Oaktree fee structure in its proxy.  Given Oaktree’s size and reputation, combined with the fact that the proposed fee structure is at or below the peer group average, we see no reason why FSC’s price to book should be below the 1.12 multiple average shown here.

Valuation

On August 9, 2017, the company reported its NAV of $7.17 per share as at June 30, 2017.   We have been holding off on this writeup until we saw that number because we thought it was possible that the company would take abnormally large markdowns to clear the decks and set up an easy hurdle for Oaktree coming in.  As mentioned above, if we haircut this NAV by 10%, our target price 12 months hence is 1.0 times this, or $6.45 per share.  The return from here, including an assumed lower 8% dividend yield, is just under 30%.

Catalyst

Closing of Oaktree Transaction (expected by year end 2017), Quarterly reports under new manager