5 Things Fifth Street Finance Corp. Management Wants You to Know

By Markets Fool.com

Fifth Street Finance reported an unimpressive fiscal first quarter on Monday, failing to earn its dividend from net investment income and announcing several underperforming investments in the portfolio. The dividend was also cut, from $0.09 per share, per month to $0.06.

Continue Reading Below

It wasn't pretty, but the conference call did shed light on where the company can go from here.

1. No dividend in February
The curious gap between January and March dividends was explained by CEO Todd Owens, who said on the conference call that Fifth Street has "elected not to pay a February dividend because our net investment income did not cover our dividend for the last two quarters."

Basically, it's an adjustment period. The new dividend of $0.06 per month will start in March, so don't fret too much when you don't receive a dividend in February -- no dividend was declared for that month.

2. It was slow going in the high-yield senior loan fund
Taking a page out of the playbook of its competitors, Fifth Street Finance launched a senior loan fund in 2014. The fund uses more leverage on lower-yielding loans, and currently produces an annualized return on equity of roughly 17% per year before any credit losses. That's good.

But to be a meaningful contributor the bottom line, it needs to grow. Fifth Street's CFO, Rich Petrocelli, noted its slow growth: "The SLF only grew by approximately $10 million during the quarter. It's grown since the end of the quarter."

Continue Reading Below

If I had to hazard a guess, the slow growth of the SLF is likely due to the competition it faces from another Fifth Street-managed fund, Fifth Street Floating Rate , which holds the same kind of assets as Fifth Street Finance's SLF. Fifth Street Floating Rate raised millions of dollars to put to work in August 2014; Fifth Street Finance probably took second in the list of priorities.

3. On new deals in the middle market
Loan prices are down, yields are up, and many are categorizing the recent activity in loan prices to be part of a broader "dislocation" in the markets. How does that play into the types of deal flow that Fifth Street Finance and other lenders are seeing?

President and CIO Ivelin Dimitrov characterized it as being a feeding frenzy for some of the highest-quality transactions. "It really is a flight to quality. Some deals are getting done and it's a feeding frenzy and everybody's trying to be in it, and there's other deals that are not getting the same kind of reception."

It's all or nothing, it seems. If there is any bright spot to weak earnings across the BDC industry, it's that it should shake out some of the competition for new deals.

4. A clarification on nonaccrual assets
Fifth Street put four investments on payment-in-kind nonaccrual this quarter. Ordinarily, I would take that to mean that the company would not accrue earnings that came from PIK interest.

Petrocelli clarified that "[w]hen an investment pays both cash and PIK, and it's on PIK non-accrual, what that implies that...we're not accruing the cash income as well as the PIK income."

Said another way: The four investments placed on PIK nonaccrual this quarter are on full nonaccrual. Fifth Street Finance isn't accruing any of the interest. This helps clarify an earlier comment by Dimitrov, who suggested the nonaccruals would reduce annual interest income by $12.7 million.

5. Dividends, buybacks, and management compensation
When asked about avenues for creating shareholder value by reducing costs, buying back stock, or paying a bigger dividend in the future, Owens had this to say:

As I said in our observations we are continuing to think about all aspects of our business including share buybacks. ...

So I think part of the decision that we've made here, Jonathan, again, as we've said in the call to set the dividend level below where we expect our NII to be and to stabilize the divided and hopefully also to provide more stability to the NAV per share. That was part of the unpinning of the decision process that we went through and resetting the level of the dividends.

But we continue, as we have in the past -- we also evaluate the appropriateness of the fees and are thinking about that as a management team and as a board.

In short, the dividend was cut to reflect management's expectations for future net investment income. Fifth Street has discussed cutting fees or buying back stock, but historical precedent suggests that neither a buyback nor fee cut are in the cards at this time.

The company approved a $100 million repurchase plan in November 2014 but as of the end of the quarter, it had not been used. And as its external manager is now a publicly traded company with its own earnings to defend, a fee cut appears to be something bordering on the impossible.

The article 5 Things Fifth Street Finance Corp. Management Wants You to Know originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.