Fifth Street Finance Corp. May Turn Down a Great Deal for Shareholders

By Markets Fool.com

I'm becoming increasingly disgruntled with Fifth Street Finance Corp. . The company's latest quarterly conference call revealed a perfect example of its disregard for its shareholders.

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Fifth Street Finance primarily makes money by lending to private companies. It borrows at one rate and lends at a higher rate. It's a simple business.

The company also makes money as an originator. Recently, the company highlighted its ability to originate new deals and then syndicate a portion to other investors. In simplified terms, it gives borrowers $0.99 on the dollar for a loan and then sells the loan at a face value of $1, effectively carving out a 1% origination fee for its efforts.

Rich Petrocelli, the company's chief financial officer, explains:

The economics typically on a syndication can be 50 basis points to 100 basis points of extra income, but it really depends on the loan. Fortunately when you take down the entire piece, you take additional risk, and so we're able to capture some of that when we syndicate down. That's been one of our initiatives is the capital markets, that's what we're really pleased about, the increased volume from our capital markets desk.

This is a fairly simple concept: Fifth Street Finance can create more wealth for shareholders by originating loans at a discount to resell. It's not unlike a retailer, which simply buys inventory at one price to sell at a higher price. It adds another source of income alongside the company's interest and dividend income, which comes from its portfolio of investments.

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But then, later in the call, CEO Len Tannenbaum is asked about share repurchases at the current price. Fifth Street Finance currently trades at a roughly 10% discount to its book value. Thus it can effectively buy $1 of its existing portfolio on the open market for $0.90 by repurchasing its own shares.

Here's Tannenbaum's response:

I don't think it's appropriate to forecast to use the buyback or not. But I think in the past we've said it's certainly not to trade. We issue stock and we buy back stock. And if it's traded at a substantial discount, we will use it.

Assume you managed Fifth Street Finance and it was your job to create the most wealth possible for your shareholders. You can buy $1 bills for $0.99 (new loans) or you can buy $1 bills for $0.90 (repurchasing stock). Which would you choose?

Well, if you truly have the interests of shareholders in mind, the obvious choice is simply to buy back stock -- lots of it. You can get very rich buying $1 bills for $0.90 over and over again -- and you can do it a heck of a lot faster paying $0.90 for $1 bills than you can paying $0.99. Never mind that you probably have a better understanding of the risks inherent in seasoned loans in your portfolio versus new loans to new borrowers.

I find it telling that the same company that will "trade" loans to earn 1% on each turn won't "trade" its stock to make 10% on each turn. The reason lies in the underlying incentives: Repurchasing shares, despite being a better deal for shareholders, cuts into the profits of Fifth Street's external manager, Fifth Street Asset Management.

The article Fifth Street Finance Corp. May Turn Down a Great Deal for Shareholders originally appeared on Fool.com.

Jordan Wathen and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.