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Fifth Street Asset Management: CLO Sale Completed

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On July 26 2017 Fifth Street Asset Management (FSAM) filed an 8-K reporting the closing of the sale of its CLO Management subsidiary to NewStar Financial on July 20, 2017. The disclosure included pro-Forma results for FSAM excluding the sold subsidiary. The BDC Reporter does not cover FSAM, which is a public investment manager rather than one of the 46 public BDCs in our universe. However, we reviewed the details of the 8-K for any information that would shed any light on the coming transfer of the management contracts of Fifth Street Finance ( FSC) and Fifth Street Senior Floating Rate (FSFR) to Oaktree Capital. 


NEWS

The 8-K included financial statements through March 31, 2017 for FSAM both including and excluding  the CLO Management subsidiary.

The income statement shows FSAM remains a profitable operation through the period even though fees received from its two funds have dropped from $80mn for its whole fiscal year to under $15mn (a $60mn annual pace) in the last quarter of the period.

The income statement of FSAM has been greatly impacted by debits and credits from the lawsuits brought against FSAM and its managed entities, all the way through to the most recent quarter when $4mn in insurance recoveries were booked into income.

Roughly speaking, and ignoring all the noise from one time costs or recoveries, the IQ 2017 results show an asset manager earning about $18mn of quarterly income, and paying out $12mn in expenses. However, of the $6mn “profit” half is derived from the distributions received by FSAM as a shareholder in FSC and FSFR.

On a balance sheet basis,though, FSAM appears essentially insolvent. Total assets are $175mn, but net assets are just $3mn. Even after paying down its debts with the CLO subsidiary sale, FSAM has $92mn in borrowings to repay. The next business item is a tax arrangement payable with a book cost of  $62mn.

FSAM could easily be technically insolvent as $68mn of its assets are the value of its shares in FSC and FSFR, which are subject to constant change. If those assets were written down, FSAM would have negative equity in a New York minute.

However, not showing anywhere on its balance sheet is the imputed value of the two asset management contracts which Oaktree has valued at $320mn.


ANALYSIS

As a stand alone entity FSAM on paper is close to being out of business.  If for any reason  the management contract sales of FSC and FSFR did not go ahead, the asset manager would be in big trouble as its only major asset – the shares in FSC and FSFR – is valued well below the amount due in its Revolver. Moreover, the value of those shares could drop by a third or half if the deal does not go through, leaving FSAM potentially $50mn short in its ability to repay its lender.

Moreover, even the nominal profitability in this interconnected situation could evaporate quickly. Further write downs or drop in earnings and distributions at FSC and FSFR would reduce investment income and dividend income simultaneously, leaving FSAM potentially in the red and with little in liquidity to draw on.

Of course, if the Oaktree deal does go ahead all the numbers change. The tax payment liability has been waived by the recipients, which reduces a major item. The large payment for the management contracts gets booked. Even if never received in full due to hold backs by Oaktree to pay for various items, FSAM is still left with plenty of assets to pay off both its lender and shareholders.

Furthermore, both the value of the FSC/FSFR shares are likely to rise in value and the dividends therefrom to – hopefully – stabilize, helping both book value and income.


VIEWS

No deal is ever done till it’s closed. In this situation, Oaktree holds most of the cards and FSAM needs the transaction to go ahead to survive. If, for any reason, Oaktree pulled out a bankruptcy would be likely, unless FSAM and its lender calculated that might permanently diminish the value of the management contract assets.

As a result, we expect the deal to go through post haste as the alternatives are so unpalatable for FSAM’s principals, shareholders and lenders. This puts Oaktree in a commanding position and unlikely to face any push-back from any of the parties involved, and leaves the shareholders of FSC and FSFR no option but to accede to the change.

If there were to be any alteration of terms before the closing  – unlikely but not unthinkable – the price is likely to be borne by FSAM.

The bottom line for FSC and FSFR shareholders is that whatever they might think of the management contract terms offered by Oaktree (which the BDC Reporter believes are mediocre at best) they have no choice but to accede to the deal effectively negotiated on their behalf by FSAM.

The still high management fees, low incentive threshold and absence of any Total Return (explicitly abolished in the case of FSC as we showed yesterday) will limit shareholder returns going forward. However, shareholders of FSC and FSFR will still be grateful to Oaktree thanks to what FSAM has wrought on the two BDCs for the last several years. For Oaktree it’s a no lose situation. For FSC and FSFR shareholders the damage is already done and the change of manager can – at best – result in a marginal recoupment of what is already lost.

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