Fitch Ratings has downgraded the long-term Issuer Default Rating (IDR),
senior secured and senior unsecured notes of Fifth Street Finance Corp.
(FSC) to 'BB' from 'BB+'. The Rating Outlook remains Negative. Today's
rating actions have been taken as part of Fitch's periodic review of
Business Development Companies (BDCs), which comprises 10 publicly rated
firms.
BDC INDUSTRY OUTLOOK
Fitch's outlook for the BDC sector is negative; reflecting competitive
underwriting conditions, earnings pressure, underperforming energy
investments, unsustainable asset quality metrics, increased activist
pressure, and limited access to growth capital. While some firms are
better positioned, given their more conservative financial profiles and
portfolio characteristics, others are likely to see rating pressure over
the outlook horizon.
BDCs are heavily dependent on the equity markets to fund portfolio
growth, but access to the market has been almost non-existent over the
last 18 months as share prices continue to trade at steep discounts to
net asset value (NAV). At March 7, 2016, rated BDCs were trading at a
18.3% average discount to NAV, thus preventing most from issuing stock
without significantly diluting existing shareholders. While the
reduction in portfolio growth is viewed favorably by Fitch, given tough
underwriting conditions, some firms may struggle to close the trading
gap, leaving them at a competitive disadvantage if and when investment
opportunities arise.
The decline in commodity prices has yielded the first notable crack in
asset quality performance for BDCs. More broadly, asset quality metrics
remain at unsustainably low levels, in Fitch's opinion. While strong
portfolio company performance has been supported by an improving
economic environment, low interest rates are likely masking some
potential underlying company-specific issues, as issuers have been able
to refinance themselves out of trouble rather easily in recent years.
Fitch believes asset quality metrics are likely to deteriorate over the
near term; however, the pace of deterioration will be somewhat dependent
upon the rate of change in interest rates, the backdrop of the broader
economic environment, differing sector exposures, and the integrity of
individual firms' underwriting.
Fitch has not observed a marked increase in leverage levels for the
sector, with average leverage for investment grade-rated BDCs of 0.74x
at year-end 2015 compared to 0.60x at year-end 2014. However, there is a
wide dispersion of leverage around the average, and those with the most
energy exposure often also have the highest leverage ratios. Share
repurchase activity has also increased in the sector in recent quarters,
which could inflate leverage ratios further. Fitch believes that BDCs
heavily focused on maximizing leverage run the risk of having less dry
powder to deploy when if and when underwriting conditions improve, thus
weakening earnings upside.
KEY RATING DRIVERS
IDRS AND SENIOR DEBT
The rating downgrades reflect FSC's continued asset quality
deterioration and higher leverage relative to peers but lower than
Fitch's last rating actions, compounded by a weakening franchise as a
result of accounting misstatements and inconsistencies in strategy,
growth plans, fee structure, dividend policy, and share repurchase
activity. Additionally, pending shareholder lawsuits are expected to
continue to be a distraction for management and are likely to negatively
impact operating performance, as elevated legal expenses weigh on net
investment income (NII) and dividend coverage in the near term.
The maintenance of the Negative Rating outlook reflects the potential
for further asset quality deterioration and longer-term uncertainties
with respect to management's fundamental risk appetite regarding
leverage, portfolio risk, growth, and dividend management.
Ratings remain supported by the senior secured nature of the majority of
FSC's collateral, limited exposure to oil and gas investments, low
interest rate risk, appropriate funding and liquidity profiles and the
regulatory framework (Investment Company Act of 1940) under which BDCs
operate.
FSC targets leverage of 0.6x-0.8 times (x), excluding Small Business
Administration (SBA) debt, which is exempt from regulatory asset
coverage calculations. Regulatory leverage was 0.74x, as of Dec. 31,
2015, which is consistent with management's target. However, Fitch
assesses FSC's leverage inclusive of SBA debt. On this basis, GAAP
leverage, amounted to 0.91x, which is higher than the peer average of
0.64x, as of Sept. 30, 2015.
Fitch views the leverage target as aggressive, particularly given the
firm's shift into second lien investments and increased use of leveraged
off-balance sheet vehicles, such as the senior loan fund (SLF). While
FSC's position in the SLF is an investment in a diversified pool of
loans, it is akin to an equity investment in a lowly-levered
collateralized loan obligation, which incrementally alters the firm's
risk profile. The shift into riskier assets combined with management's
current leverage tolerance, is consistent with a below investment grade
rating, in Fitch's view.
In November 2015, the FSC's board reauthorized its $100 million share
repurchase program through Nov. 30, 2016. Following investor concerns
regarding the continued share price discount to NAV and the lack of
meaningful deployment of the program, management indicated that it
intends to make substantive repurchases during the second quarter of
2016 (March 2016 quarter). While Fitch understands the motivation for
the stock buyback, meaningful share repurchases are viewed unfavorably
given the firm's current leverage levels. In addition, leverage could be
further impaired by incremental credit issues in the portfolio or
volatility in portfolio valuations, given market spread widening. Fitch
would view a reduction in debt, via portfolio repayment proceeds,
favorably, as it would enhance the firm's asset coverage cushion.
Depressed share prices and governance concerns have ignited shareholder
activism campaigns against three BDCs over the last several months,
including FSC. Hedge fund manager RiverNorth Capital Management, LLC
(RiverNorth), launched its campaign against FSC in November 2015, citing
concerns about Fifth Street Asset Management's (FSAM) track record as
FSC's external manager, the appropriateness of FSC's management fee
structure and deployment of the share repurchase program. Seeking change
at FSC, RiverNorth purchased approximately 6% of FSC's outstanding
shares, nominated three members to FSC's board and sought to terminate
the investment advisory agreement between FSAM and FSC.
With approval from its board, FSC permanently reduced the base
management paid to FSAM from 2.00% to 1.75%, and committed to repurchase
up to $50 million of shares by end-2016. On Feb. 19, 2016, RiverNorth
announced that it had reached an agreement to sell its holdings of FSC's
shares to an affiliate of FSAM and its Chairman and CEO at $6.25 per
share, a 32% premium to FSC's current share price, and in exchange
withdraw its proxy proposal to terminate FSC's advisory agreement and
not contest FSC's director nominees in the 2016 annual meeting of
shareholders.
Fitch views the outcome of RiverNorth's activist campaign as neutral to
FSC's financial profile, but negative from a franchise perspective,
given the public attention that accompanied the campaign. The resolution
of RiverNorth's dispute with FSC through the sale offer is viewed
cautiously by Fitch, as the settlement has not resulted in strengthened
oversight, which could lead to further lawsuits and negative attention
in the future. Generally speaking, activist campaigns on Fitch-rated
entities do not have a rating impact until and unless Fitch believes the
activist has a credible chance of implementing its desired changes and
that the changes would be materially adverse to creditors. Fitch
believes that not all activist activities have weakened credit profiles
of target companies, as some have had neutral to mildly positive effects
on ratings and/or governance.
Despite industrywide pressure on credit metrics FSC stood out in
first-quarter 2016 (1Q16), with non-accruals at 6.4% of the portfolio at
cost, and 3.8% at fair value, which is well above the peer average.
During 1Q16, one material healthcare investment moved to non-accrual
status, while FSC recorded $1.4 million of net realized gains, offset by
$90.8 million in net unrealized depreciation, which reduced NAV by 6.7%
and inflated leverage by 0.06x.
FSC does not have meaningful energy exposure, amounting to $63.4
million, or 2.6% of the total portfolio at cost. The firm's three energy
investments were carried at 61.5% of fair value, as of Dec. 31, 2015,
including a first-lien investment in an oil and gas equipment services
company on cash non-accrual status since fiscal fourth-quarter 2014
(quarter ended Sept. 30). Given the current market environment, Fitch
expects FSC to incur incremental unrealized depreciation on its energy
investments over the near term. That said; Fitch conducted a stress test
on the firm's energy exposure along with the rest of the peer group and
views the valuation declines to the firm's overall leverage profile to
be manageable. Regulatory leverage, excluding SBA debt, would only
increase four basis points to 0.78x based on Dec. 31, 2015 balances,
which remains within the 1:1 limit.
Fitch views FSC's liquidity profile to be sound, with $82.6 million of
unrestricted cash and $449.7 million of availability under its funding
facilities, subject to borrowing base requirements. Cash flows from
principal repayments and investment sales amounted to $343.4 million, a
21% reduction compared to the same period last year, as refinancing
activity and prepayments slowed. Fitch believes the pace of repayment
could slow further in 2016, particularly if loan yields increase.
FSC's funding profile is fairly diverse, with unsecured debt
representing 45.5% of total outstanding debt as of Dec. 31, 2015. The
firm accessed the convertible note market in 2011, the retail note
market in 2012 and 2013, and the institutional bond market in 2014. The
next scheduled maturity is the $115 million convertible note, due April
1, 2016. Fitch expects FSC will refinance the maturity with available
capacity under its corporate revolver, which will then have $270.5
million of remaining capacity, all else equal. FSC has no other
maturities until August 2018 when the corporate revolver expires. Fitch
believes FSC has sufficient liquidity to address upcoming debt
maturities, although funding flexibility will be reduced.
NII coverage of the dividend, adjusting for paid-in-kind income,
amounted to 105.3% of dividends paid, as of Dec. 31, 2015. NII coverage
of the dividend has averaged 99.3% since 2010. While NII coverage has
improved since the steep dividend cut in 2015, Fitch has viewed FSC's
dividend policy as erratic given numerous cuts and increases since
inception. The inconsistent policy speaks to poor financial planning, in
Fitch's opinion, and has likely caused the firm some credibility with
equity investors, an important source of growth capital. That said;
under current management, FSC has shifted its policy to set the dividend
based on past earnings rather than a forward looking view, and the
current dividend is also set at the upper bound of the incentive hurdle,
which should provide additional cushion to the dividend going forward.
RATING SENSITIVITIES
Fitch believes the resolution of the Negative Outlook could develop over
a longer period of time, based on a track record of management
consistency, stronger dividend coverage, solid asset quality performance
of post-crisis vintages, improved operating consistency, and the
maintenance of leverage at appropriate levels relative to portfolio risk.
However, the ratings could be adversely affected by further
deterioration in asset quality, yielding sizeable realized losses,
preventing the firm from reducing leverage commensurate with its risk
profile. A reduction in dividend coverage, and/or a weakening liquidity
profile could also drive negative rating momentum.
Fitch has downgraded the following ratings:
Fifth Street Finance Corp.
--Long-term IDR to 'BB' from 'BB+';
--Senior secured debt to 'BB' from 'BB+';
--Senior unsecured debt to 'BB' from 'BB+'.
The Rating Outlook remains Negative.
Date of Relevant Committee: March 8, 2016.
Additional information is available on www.fitchratings.com
Applicable Criteria
Global Non-Bank Financial Institutions Rating Criteria (pub. 28 Apr 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=865351
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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1000678
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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