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Fifth Street Finance: Special Proxy For Fee Reduction

BACKGROUND: On February 9, 2017, Fifth Street Finance (FSC) filed a preliminary Proxy regarding a Special Meeting of shareholders to be called to vote on a new Investment Advisory Agreement between the BDC and its External Manager Fifth Street Management (“FSM”). FSM is an indirect partially owned subsidiary of Fifth Street Asset Management (“FSAM”). FSAM is a leading, Chicago-based asset management organization, which is publicly traded under the FSAM, but is majority owned and controlled by its CEO and Chairman Leonard Tannenbaum.

The proxy materials were released on the same day as FSC published its financial results for the quarter ended December 31, 2016, and announced a new, lower distribution rate and a switch back from monthly pay-outs to a quarterly schedule. As we reported at the time, FSC’s stock dropped on the news.

On the FSC Conference Call, the new CEO of the under-performing BDC Patrick Dalton discussed the contents of the new Proxy:

“Next, I would like to discuss FSC’s fee structure and the changes we’re proposing to our shareholders. As a reminder, in January of 2016 FSC’s base management fee on total gross assets excluding cash and cash equivalents was permanently reduced from 2% to 1.75%. This 25 basis point cut was voluntary and pertained to all fee earning assets without thresholds, placing our fee structure at the median for the industry.

At this time, we are proposing to adjust our part one incentive fee and introduce a permanent total return hurdle which may decrease the incentive fee by 25% per quarter after taking into account any realized and unrealized losses. This permanent total return of hurdle will have the look back feature to expand every quarter scaling up to three year look back once fully phased and will become effective retroactive to January 1, 2017 mirroring my start date. We believe that implementing a permanent total return hurdle is another step towards increasing the alignment between our manager, FSAM and the shareholders of FSC, while still allowing FSAM to remain competitive and attracting the best talent to manage FSC’s shareholders capital.

We also believe this fee structure is among the most competitive of our BDC peers with total assets greater than $2 billion, as only one other peer has a permanent total return hurdle. In conjunction with implementing a total return of hurdle, we are seeking to move the hurdle rate used in calculating the incentive fee to 7% which is in line with our peer group. This hurdle rate should allow us reposition the portfolio into safer, lower yielding assets which should reduce future credit losses and allow us to be more competitive in winning or participating in new deals. We believe that this is a prudent move and over the long term should provide for more stable NAV and attractive return on equity for our shareholders.

We are putting these proposed changes to a vote during a special meeting of our shareholders. We filed a preliminary draft with FSC’s special meeting proxy with the SEC this morning which all shareholders can view at this time.

Additionally, we urge all of our shareholders to be on the lookout for the special meeting proxy which should be mailed out to you in the coming weeks. We look forward to discussing these proposed changes with our investors in the weeks ahead.”

No questions were allowed on the Conference Call, so no further discussion occurred about this or any other subject.

The BDC Reporter has reviewed the preliminary Proxy. (Preliminary in that the date of the vote has not been set and certain key numbers have been omitted, but nothing which keeps us from an initial view).

Basically, FSM is offering and FSC is agreeing to reduce its Incentive Fee by as much as 25% under certain conditions.

The Proxy also envisages that the threshold yield at which the Incentive Fee will be paid will drop from 8.0% to 7.0%. More on that in a minute.

This follows a prior reduction in the Management Fee from 2.0% to 1.75% on assets.

DEVILISH

As always, the devil is in the details.

Warning: There are a lot of details and the devil is in all of them.

NOT EXACTLY A FEE REDUCTION

The key point is that FSC is not permanently reducing the 20% Incentive Fee in the same way as the Management Fee was cut.

The Incentive Fee gets reduced under certain circumstances and for what is likely to be a finite period of time.

That will occur if and when the total return of the BDC (when Realized and Unrealized Gains and Losses are figured in along with Net Investment Income) should drop below a set base level.

Eventually the calculation of total return will be for a rolling 12 quarter (3 year) period.

However, the calculation will initially begin as of December 2016 and every new quarter added to the calculation till the end of 2019, when the rolling 3 years goes into actual effect.

The devil in that detail (explicitly called out in the Proxy) is that Incentive Fees in 2017 will not be reduced by the big drop in Net Asset Value that FSC just announced in 2016.

HOW THIS MIGHT PLAY OUT

We are always impressed by the cunning of asset managers where fees calculations are concerned.

However, we shouldn’t be as the charging of fees is the key to their profitability, and much depends on getting it right.

This is a very complicated subject and takes 5 pages in the Proxy (with charts) to describe.

The BDC Reporter did its best to follow along, sharpened its pencil and did some calculations.

You’ll have to read along and suffer with us through some turgid math, but the conclusions seem crystal clear to our eye.

IF BAD THINGS HAPPEN…

FSC is promising  that if the BDC continues to rack up Realized and Unrealized Losses, the Incentive Fee will be cut by 25% because of the Total Return concept introduced by this new agreement.

That’s all well and good (and some might say a long time coming given that FSC’s performance has been poor for years-see below).

HISTORIC PERFORMANCE

So let’s see how much that will benefit FSC shareholders, already buffeted by yet another dividend cut and a drop in NAV from $9.89 at the end of 2011 to $7.31 now.

That’s a 26% drop, or about (5%)a year on average.

In 2016, the drop in NAV was (13%).

Since FSC’s IPO, one-third of all capital raised has been “lost” to Realized and Unrealized Losses and distributions in excess of earnings.

FSC’s distribution-using the new level of $0.125 a quarter from IIIQ 2017-has dropped 60% since its highest point in 2010.

The latest dividend cut was the fourth since 2011.

Etc., etc.

SMALL POTATOES

Anyway, in the IVQ of 2016, the Incentive Fee (called the Part I Incentive Fee) was $4mn, or $16mn annualized.

A potential and maximum reduction of 25% would save FSC shareholders $4mn a year ($1mn a quarter) in investment fee expenses.

FSC has 143 million shares outstanding.

$1mn in lower fees in a quarter is 0.7 of 1 cent,  or 2.8 cents annually.

The latest FSC Net Investment Income Per Share Per Year running rate was $0.64.

The lower Incentive Fee could increase Net Investment Income Per Share by 4% a year.

From the BDC Reporter’s perspective (and we may be in the minority on this point) that seems like a very, very modest concession.

As we’ll see there’s even less than meets the eyes.

PERSPECTIVE

Let’s compare the benefits to FSC’s shareholders with all the fees the BDC pays out to FSM (and we won’t even include any administrative payments to cover overhead and personnel at the External Manager).

Annualizing the IVQ 2016 FSC Management Fee and the pro-forma 25% lower Incentive Fee, the External Manager will still be receiving $46mn in total fees.

Effectively, this “concession” from the External Manager-if it happens at all-amounts to less than 10% of all compensation paid to FSM.

DIVIDING UP THE PIE

We like to look at what proportion of total investment income a BDC pays out to shareholders and the External Manager once interest and operating costs are deducted.

The way you share out the pie is very instructive in determining how “shareholder friendly” a BDC is.

In this case, with the new $0.50 a year proposed FSC distribution, we know shareholders will be receiving an estimated $72mn in distributions ($0.5 x143mn) once the full pay-out resumes months from now.

As we’ve shown, FSM will be paid somewhere between $46mn-$50mn.

That means 40% or so of every net dollar generated by FSC will go to its External Manager and that’s after two fee amendments.

THAT WILL BE THEN. WHAT ABOUT NOW ?

That seems on the high side to the BDC Reporter, but the pie sharing looks even worse if you consider the next few months.

Thanks to the fact that FSC is only paying a 2 cents a share distribution in March and the same 2 for the entire IIQ of 2017 we have the unusual situation that the External Manager will be more highly paid than all its shareholders for several months.

Here’s the basic math: Shareholders will be getting $5.7mn in distributions from the March and IIQ 2017 distribution.

By contrast, FSC (even if the Incentive Fee is cut by 25% which we’ve assumed in these numbers) will be earning $15.3mn in that four month period…

IF NAV IS STABLE OR CLIMBS…

Of course, all the above calculations-and the very modest savings to FSC shareholders-assume that the 25% reduction in the Incentive Fee is triggered by a drop in FSC’s NAV.

However, let’s consider a scenario where FSC’s NAV stabilizes or climbs in 2017 and beyond.

In the current quarter, the BDC has written down many investments drastically and they might be written up in future periods.

(Banks have been doing this for years but that’s another topic).

In this case, we can readily envisage a scenario where the Incentive Fee actually increases in 2017, notwithstanding this new agreement.

If shareholders approve the new 7% threshold, the starting point from which the 20% Incentive Fee gets charged will be lower than the 8% of NAV currently being used.

Assuming that FSC nets a positive number on the combination of its Realized and Unrealized changes in its asset values, the Incentive Fee will remain at 20%.

With a lower threshold for calculating the Incentive Fee and no reduction in the 20% being paid to FSM, the absolute dollars going out the door could be higher (and certainly not lower) than before under the current arrangement.

CONCLUSION

This has been arduous to write and must be arduous to read so we are going to spell out our conclusions:

  • The proposed Incentive Fee reduction by FSC may or may not occur depending on what happens to the value of the portfolio after December 31, 2016.
  • If a reduction does kick in because the BDC is under-performing on a total return basis, the savings will be very modest both in per share terms and as a percentage of total compensation paid out.
  • The External Manager will continue to earn fees-with or without the 25% Incentive Fee giveback-equal to 40% of all investment income generated minus interest and operating costs.
  • However, for the next several months, the External Manager will be receiving about 75% of the income coming out of the BDC as distributions to shareholders have been drastically cut back but fees have not.
  • It’s quite possible there will be no Incentive Fee reduction at all given that FSC has given itself a generous baseline for calculating its total return.
  • Under certain circumstances, FSC might even have to pay an even higher Incentive Fee to FSM due to the new lower threshold for Net Investment Income being requested.
  • We have no doubt shareholders will approve the new fee arrangement because something is better than nothing, but to paraphrase Queen Victoria: “We are not impressed”.