Fifth Street Senior Floating: Dividend Sustainability Analyzed
February was a hard month for the two public Business Development Companies managed by affiliates of Fifth Street Asset Management. As we reported, Fifth Street Finance (FSC) fessed up to a doubling of loans on non-accrual and cut its recurring distribution from an annual pace of $0.72 to $0.50, a 30% drop. Moreover, the External Manager-headed by new Chief Executive Patrick Dalton-promised a drastic change in investment strategy going forward for FSC, as well as new personnel and a quarterly pay-out versus monthly. Getting less attention was a similar re-assessment underway at sister BDC with the longer name: Fifth Street Senior Floating Rate Corp. (FSFR). On the February 10 Conference Call, the new man in charge promised “a plan to reposition and optimize FSFR’s portfolio to drive enhanced returns to shareholders”. However, Mr Dalton warned that FSFR-like FSC-“may experience some further volatility, specifically around investments currently on non-accrual, or on our watch list”. Again, the distribution was reduced from $0.90 annualized to $0.76 – a 16% reduction. FSFR, too, will be switching back to a quarterly pay-out.
The markets were shocked by the FSC news and dividend cut, with the market capitalization of the BDC dropping by nearly a fifth in the hours after the announcement, before rallying and ending on Friday February 17 (16.9%) down. As this chart shows, investors were more forgiving of the FSFR news, with the stock price dropping at half the pace of its sister company. However, in both cases the new CEO indicated the distribution levels would be revisited in the months ahead as new strategies are implemented, leaving open the possibility of a further cut in distributions down the road. FSFR investors, already bludgeoned by three dividend cuts since early 2015, should be asking themselves if the latest reduction was the last one for a while or not. The BDC Reporter decided to take a look into the latest 10-Q, earnings release and Conference Call transcript for clues.
BEST PLACE TO START
We start with the IVQ 2016 results as a starting point.
Investment assets were pegged at $0.5bn at fair market value and investment income was $11.6mn.
Net Investment Income came in at $5.9mn, or $0.20 a share.
Leverage was in the Company’s self mandated range of 0.8x-0.9x debt to equity, albeit at the lower end at 0.8x (0.79x to quote the press release religiously).
However, there are a number of items that make the sustainability of this $0.20 a quarter of Net Investment Income Per Share suspect.
Here’s an easy one, which shows up in the press release: a $250,000 from insurance recoveries.
That’s a pay-out from FSFR’s insurance company relating to legal bills associated with the defense of the activist assault on the BDC last year, which we have covered at great length.
Shareholders foot the bill for these type of struggles between billion dollar asset management firms (the activist was RiverNorth Capital Management, LLC with $3.1bn of Assets Under Management).
In case you missed the ending of this “activist” drama (and we’re using the term in a sarcastic manner that our writing may not effectively convey), RiverNorth was bought off by FSAM and FSFR.
Anyway, the $250,000 insurance recovery is a one-time item.
NON ACCRUAL COMING UP ?
Next, on the Conference Call, Mr Dalton warned that portfolio company Metalogix (also known as Metamorph US 3, LLC) might shortly switch to a cash non-accrual status:
Metalogix, which is on PIK non-accrual, is a provider of enterprise data migration and management tools, primarily for Microsoft SharePoint. The company has experienced challenges as the market has been pivoting away from using on-premise systems, which comprise a majority of the company’s business. Additionally, there has been a recent change in management causing further disruption. Although the company is current on its cash interest payments, we believe that there may be future liquidity constraints, and are following the company closely.
If that were to occur, FSFR would be losing close to $1.0mn in annual interest income until the situation is resolved.
COST OF BORROWING
Third, and ironically given all the happy talk about the benefits of higher interest rates for lenders, FSFR’s interest expense bill is on the rise.
The BDC borrows on a Revolver from Citibank, East West Bank and a Securitization. All are tied to LIBOR, which has been rising.
For example, the Citibank interest rate increased by 23% through 2016, reaching a “weighted average interest rate” (page 43 of the 10-Q) of 3.213% at year end 2016, from 2.639% a year before.
The East West Bank facility (admittedly barely used) was at 3.5% at year end 2016.
The biggest source of debt financing is FSFR’s complex securitization, with $178mn in Notes Payable.
The effective interest rate cost has increased to 2.902% at December 31, 2016 from 2.275% at December 31, 2015. That’s a 27% increase in the cost of debt capital in a year.
(Not helping is an increase in the spread on one of the tranches of the securitization which kicked in from October 2016, going from 1.55% to 2.1%).
GOING TO GET WORSE ?
Looking forward, if we assume the $250mn in LIBOR-tied debt increases by 0.25%, that will increase annual interest expense by another $0.625mn.
We can already hear some readers shouting at us about how higher interest rates will also benefit FSFR.
However, as so much in BDC-land it’s not that simple and the 10-Q is not explicit enough for us to be certain, but we believe the “floors” on FSFR’s loans will be obviating any benefit from an increase in LIBOR in the short to medium term.
We refer you to page 80 of the 10-Q which shows that a 100 basis points increase in LIBOR (not even the puny 25 basis points we assumed) results in half a million dollars in lower earnings at FSFR.
The 10-Q is vague, but does say 100% of FSFR’s loans are subject to a floor. Where some other BDCs might relay the average effective floor rate, FSFR only tells us that the floors are “between 0% and 2%”.
(Just to quibble, we’re not sure if a 0% floor is a floor).
Most likely the average floor is somewhere north of 1.0% or another 1.0% increase from the December 2016 level would not result in an aggregate loss.
As a result, we’re assuming the next 25 basis point increase in LIBOR will result in higher interest expense, but won’t materially help investment income.
[HAPPY DAYS AHEAD ?
For FSFR shareholders looking for the pay-off from higher LIBOR, the chart suggests a 200 bps increase will throw off $1.8mn in incremental earnings.
Not to be depressing, but that is unlikely to happen any time soon (probably not before 2018 or 2019 if you believe the Fed’s charts).
In any case, we would be much more worried about credit quality than earnings should PFLT’s borrowers interest bill increase by 25% (assuming today’s loan yield would jump from 8.5% to 10.5%).]
JOINT VENTURE IMPACT
This counter-intuitive impact from LIBOR is also affecting one of FSFR’s crown jewel investments: its joint venture with the Glick family.
We compared net investment at the JV between the IVQ 2015 and IVQ 2016 and found a drop from $1.215mn to $0.733mn, a 40% drop.
Much of that is because greater than half the loans owned are funded with a Credit Suisse Revolver tied to 3 Month Libor and a spread of 2.5%.
Also, the JV is shrinking in size (from $192mn in loans to $170mn) as credit issues begin to impact.
We point out in passing that the JV booked ($7.4mn) in Unrealized Depreciation in the IVQ 2016, wiping out nominal Member’s Equity. See page 41.
The partners in the JV have invested $81.3mn in total in debt and equity capital below Credit Suisse, so the Unrealized Loss represents nearly a tenth of capital committed.
Looking at FSFR’s own stake $71.1mn has been invested but the latest value is $61.7mn.
Given that the JV only became active in April 2015, a write-down of 13% in less than two years during a period of record low credit losses makes one wonder.
GETTING WORSE II
Nor is the outlook very encouraging.
The JV has 2 portfolio loans out of 32 on Non Accrual, and another 2 on our Watch List.
Between higher interest rates and credit problems, income from the JV may continue to decline. We’ll assume ($0.25mn) a quarter lower in 2017, or ($1.0mn annualized).
We also wonder if FSFR will be able to expand its JV program-as suggested on the Conference Call-if the economics of the deal continue to deteriorate.
Admittedly, we’ve been skeptical of most BDC JV arrangements from the outset so take our concerns in that context.
CAN I HAVE SOME MORE SIR ?
Unfortunately, there’s more…
As all our readers know, BDCs pay distributions not from the Net Investment Income we and everybody else discusses in articles like these, but from Taxable Income.
We note that the 10-Q is showing IVQ 2016 GAAP Net Investment Income of $5,884,050.
However, estimated Taxable Income (see page 47) is $5,495,706.
That’s 18.7 cents a share, already below the new distribution level.
We don’t know if this quarter’s Taxable Income calculation is an anomaly, so we won’t make any strong assertions.
DOWN THE ROAD
Looking down the road, and taking Mr Dalton’s promise at face value (see below) that there is going to be a shift in loan origination to safer loans, there is likely to be an impact on profitability.
Utilizing Fifth Street’s direct originations platform, we will prioritize investing in floating-rate senior secured loans with lower loss given default characteristics, while shying away from cyclical industries and commodity risk. Additionally, we plan to focus on companies that exhibit high levels of sustainable free cash flow.
Currently, the existing portfolio yields an average of 8.5%.
Over time, if FSFR migrates to lower risk loans (and even if they don’t, as competition narrows lending spreads) the average portfolio yield may drop.
For our purposes we’ll assume a 1% drop to 7.5%.
Netting out the JV and the two troubled credits mentioned above that’s $465mn in loan assets at cost that could be affected or ($4.65mn) in lower Investment Income.
This might be modestly offset by lower Incentive Fees. For our purposes, we’ve assumed an eventual loss of ($2.5mn) annually net.
ADDING IT ALL UP
It’s a very rough and ready way to calculate such things, but if we add up all the items we’ve discussed above and annualize the annual impact, that’s ($4.5mn).
Deduct that from the Taxable Income level at December 31, 2016 and that’s 20% lower.
On a per share basis, that suggests Taxable Income could drop to 15 cents a share a quarter or $0.60 a year.
That’s obviously much lower than the $0.80 a year earnings annualized in the IVQ 2016 and below the new $0.76 a year distribution rate.
Of course, FSFR has various mechanisms available to boost net investment income, but most would require either a change of investment or compensation policy.
Despite all the talk about shifting to lower risk loans FSFR could choose to go the other way and take on riskier and higher yielding loans.
FSFR could “leverage itself up” by growing the portfolio with new borrowed money.
However, the BDC is already pretty close to maximum leverage.
Moreover, the contribution of new loans at the new, “safer” rate of 7.5% once interest expense, operating costs and management fees are considered would be minor.
If FSFR took debt up by $25mn, we calculate the incremental Net Investment Income achieved would be about $0.5mn a year.
That too is unlikely given the 6 Watch List companies on its books, the dropping value of the JV and the already high leverage.
Finally, the BDC’s External Manager could bite the bullet and amend or waive its Advisory Agreement to reduce/eliminate the Incentive Fee.
On an annualized basis that’s running at a $4mn annual rate.
However, all the other factors affecting FSFR are probably going to erode much of that Incentive Fee going forward so there’s less “savings” there than meets the eye.
Anyway, the External Manager has been famously unwilling to offer more than very modest concessions to shareholders.
We will generously assume that FSAM is motivated by its responsibility to its own public shareholders to maximize revenues.
Nothing in certain, and the BDC Reporter is on the outside looking in, with only the somewhat sparse publicly available information as a guide.
(The new CEO did not take questions after his first Conference Call, and the 10-Q leaves out or is opaque on some key facts, as we’ve pointed out).
Nonetheless, the weight of the evidence suggests that even barring any further deterioration in credit quality, FSFR will not be able to maintain a $0.76 a year distribution pace for long.
We would expect that within a period of 18 months the distribution will have to be cut again.
The cavalry-in the case of FSFR and its shareholders-might be a sharp increase in the LIBOR rate, which would boost Investment Income by higher yields on the portfolio.
On paper that would boost earnings and “protect” the dividend.
However, as the BDC Reporter always mutter to itself, looking at earnings for a BDC without looking at risk is a recipe for disaster.
IF WE WERE IN CHARGE OF THE PLAYBOOK
We’d much rather see Mr Dalton prepare FSFR’s shareholders for substantially lower earnings than in the past if achieved by way of a safer, less leveraged and more granular portfolio.
The harsh truth for shareholders in such a business model is that the likely return on equity (Net Investment dividend by Net Asset Value) will probably be only 5%-6% per annum and the distribution $0.50-$60.
Safety-even if achieved (and there’s no guarantee) is expensive and generates a low return, especially with an Investment Advisor bent on maximizing its own income.
“COMPARISONS ARE ODIOUS” BUT NOT THIS ONE
We’ve seen that a business model of targeting lower risk non-investment grade loans can be successful, as PennantPark Floating Rate (PFLT) proved by issuing new equity close to par in mid month.
PFLT went public at $15.00 in 2011 at a price of $15.00 and closed 2016 with an NAV of $14.11.
FSFR also came public at $15.00 in 2013, but has seen its NAV drop to $10.86.
PFLT has paid an unchanged distribution since its IPO. FSFR, as we’ve shown, has not and seems poised for another leg down.
However, the trade-off is a low return on equity (7.9% at PFLT at a relatively high debt to equity level just before the new offering); keeping the cost of capital very low and maintaining an (almost) clean sheet from a credit standpoint.
FSFR has not yet managed to achieve that mix so far, but tomorrow is another day.