Fifth Street Finance's Fee Cut Does Nothing for Shareholders

By Markets Fool.com

When Fifth Street Finance slashed its fees from 2% of assets to 1.75% of assets this year, it pitched it as a way to improve earnings and shareholder value. In reality, its first calendar quarter earnings show that cutting the base management fee has done nothing to improve the company's earnings.

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Can't fool a calculator

Understanding the complex fee agreement is the first step to showing why changes to the base management fee have little to no impact on shareholder returns.

Fifth Street Finance pays fees in two parts. First, it pays a base management fee, which is equal to 2% of all assets minus cash and cash equivalents. Second, it pays an incentive fee (performance fee) wherein its manager collects 20% of returns if its returns exceed a so-called hurdle rate of 8% per year.

The incentive fee has a quirk, however. Rather than collect 20% of all returns, incentive fees are actually collected in a step function on a quarterly basis.

Under the fee structure, company management receives:

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  • Nothing when quarterly operating returns on equity are below 2%.
  • All of the earnings between 2% and 2.5% when quarterly operating returns on equity fall between 2% and 2.5%.
  • A 20% cut of earnings that exceed a quarterly operating return on equity of 2.5%.

This results in an interesting situation where, when pre-fee returns on quarterly equity sit between 2% and 2.5%, a reduction in the base management fee is offset by an increase in incentive fees. This is exactly what happened at Fifth Street Finance.

Real-world numbers

Below, I've shown the actual fees reported under the current fee structure (1.75% base fees) to compare them to the fees that would have been charged if the fee structure were never changed.

Metric

1.75% Base Management Fee (Current Structure)

2.0% Base Management Fee (Old Structure)

Difference

Base management fee

$10,006

$11,436

-$1,430

Incentive fee

$4,173

$2,743

+$1,430

Net investment income

$25,343

$25,343

$0

Data source: SEC filings and calculations by author.

This table makes the impact pretty apparent. Base management fees fell, but incentive fees increased by an offsetting amount. The net result is that cutting the base management fee had no impact to its fiscal second-quarter earnings results.

This is just another unfortunate example of how externally managed companies can tinker with fee agreements and press releases to fool investors into thinking a boondoggle is a boon for shareholders.

The article Fifth Street Finance's Fee Cut Does Nothing for Shareholders 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.