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Fifth Street Asset Management: Sale Of Subsidiary

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Fifth Street Asset Management (FSAM) is not a BDC, but a publicly traded asset manager. Most importantly FSAM (or a subsidiary)  is the Investment Advisor to two BDCs we track: Fifth Street Finance (FSC) and Fifth Street Senior Floating (FSFR). We’ve temporarily added FSAM to our News Of The Day Watch List until the question mark about the future of the asset manager is resolved. Most every reader will know FSAM has admitted being in negotiations to be acquired since a June 30 press release. That followed a June 29 news story by the Wall Street Journal being conveniently “leaked” the news that a negotiation was underway and that Oaktree Capital – a huge asset manager with a finger in many pies -was on the other side of the table. A tentative purchase price was even mentioned, according to “some people”. Since then there’s been radio silence from all the parties and even the WSJ. The BDC Reporter has pointed out along the way that this delay in completing the transaction creates a risk for investors in all 3 Fifth Street related entities, given that the “news” of the deal has already caused huge moves in their respective stock prices. For example, within a couple of days FSAM’s stock price moved up 50%, before slipping back slightly.

Today FSAM made an announcement of a sale, but not the one expected. Here are the details. We’ve added analysis of FSAM’s dire financial standing, drawn from the latest 10-Q and added the BDC Reporter’s view of what MIGHT happen next. We end with a disclosure about our position(s) and the rationales involved for anyone interested.

DETAILS

In a press release on July 7, FSAM reported selling Fifth Street CLO Management LLC (“CLO Management”) , a wholly owned subsidiary, to Newstar Financial, Inc. (NEWS). Net of “associated indebtedness”, FSAM will receive $16mn of proceeds. The press release specified very clearly that the monies will be used to pay down FSAM’s Revolver, when the actual closing occurs in a few weeks. More on that below.

Here is what the press release said about the CLO subsidiary:

FSCM was formed in 2015 to manage Fifth Street’s middle market CLO business.  The company currently manages two CLOs, with approximately $726 million of assets under management as of March 31, 2017, backed by middle market loans, and holds certain interests in its sponsored CLOs primarily to comply with regulatory risk retention requirements.

However, like most every other attempt at building out the FSAM franchise, FSCM has not grown very much.  The value paid includes FSAM’s investment in the two CLOs that were sponsored. CLO sponsorship is a highly competitive business where even the smaller players have billions and billions of dollars under management in order to be cost effective. This is what Leonard Tannenbaum, CEO of FSAM (and its largest shareholder) said in the press release:

“Over the course of FSAM’s strategic review, it became clear to us that given the market environment and headwinds we faced over the past year and a half, it would be difficult to scale our CLO business,” said Leonard M. Tannenbaum, Chief Executive Officer of FSAM.  “We believe that exiting this business line is in the best interest of our shareholders and is an important step as we continue to enhance our liquidity position and streamline operations.”


ANALYSIS

We looked at the 10-Q for a refresher of what the “associated indebtedness” was where CLO Management was concerned.  The 10-Q shows that when the subsidiary was set up in 2015, FSAM borrowed the capital needed to invest in the CLO funds under its management. Here are the details:

On September 28, 2015, CLO Management entered into a Risk Retention Term Loan to provide financing for its purchase up to $17 million of CLO II senior notes at a variable rate based on either LIBOR or a base rate plus an applicable margin. Borrowings under the Risk Retention Term Loan totaled $16,972,565, of which $12,972,565 remains outstanding, and accrue interest at a rate based on the interest rate on the financed notes and the weighted current cost basis which was 4.23% as of March 31, 2017. The Company’s beneficial interests in CLO II in the aggregate amount of $23,260,659 at fair value are pledged as collateral for the Risk Retention Term Loan. The facility matures on September 29, 2027 with certain lenders party thereto from time to time and Natixis, New York Branch, as administrative agent and joint lead arranger, and Bleachers Finance 1 Limited as syndication agent and joint lead arranger. The Risk Retention Term Loan contains customary affirmative and negative covenants for agreements of this type, including financial maintenance requirements, delivery of financial and other information, compliance with laws, further assurances and limitations with respect to indebtedness, liens, fundamental changes, restrictive agreements, dispositions of assets, acquisitions and other investments, conduct of business and transactions with affiliates. As of March 31, 2017 and December 31, 2016, the Company had $12,972,565 of borrowings outstanding under the Risk Retention Term Loan which approximated fair value.

One Of Many

Judging by the comments from Mr Tannenbaum you might get the impression that the sale of FSCM was a one-off because of the problem with adding to the “scale” of the business. However, FSAM has been systematically selling or closing down all its ancillary businesses for several months now.  Here is one, which is a family affair,  mentioned in the latest 10-Q:

On December 22, 2014, FSM [“Fifth Street Management’] entered into a limited liability company agreement, as majority member, with Leonard Tannenbaum’s brother, as minority member, for the purpose of forming MMKT Exchange LLC (previously IMME LLC), a Delaware limited liability company (“MMKT”). MMKT was a financial technology company that sought to bring increased liquidity and transparency to middle market loans. FSM made a capital contribution of $80,000 for an 80% membership interest in MMKT. In addition, MMKT issued $5,900,000 of MMKT Notes, of which $1,300,000 was held by FSM.
On August 8, 2016, MMKT entered into an agreement with its noteholders to settle and cancel the MMKT Notes in exchange for consideration of $2,833,050, of which $634,460 was paid to FSM. As a result of the cancellation, the Company realized a gain of $2,519,049 during the fiscal year ended December 31, 2016. In connection with the settlement and cancellation of the MMKT notes, FSM incurred an expense of $100,000 that was paid to third-party noteholders in exchange for a release of claims against FSM and MMKT. On August 12, 2016, MMKT sold the rights to its platform, including all intellectual property, in exchange for $50,000 and distributed the proceeds to its noteholders, including $11,197 which was distributed to FSM. The Company recognized a gain of $50,000 related to this sale within Other income (expense) in the Consolidated Statements of Operations. On December 30, 2016, MMKT was dissolved and a final distribution of $69,480 was made to the noteholders, including $15,560 which was distributed to FSM.
Also, FSAM sponsored Fifth Street Opportunities Fund, a private fund. That too is being wound down according to the 10-Q.
Long Time Going
With the benefit of hindsight, a close reading of the 10-Q and by making common sense assumptions, the BDC Reporter presumes the wind down of FSAM’s business has been going on for well over a year now.
The 10-Q shows that FSAM “abandoned a portion of its office space in its corporate headquarters in Connecticut” as far back as April 2016, and has not yet re-leased the space. The original lease was entered into in July 2013. This must have been a decision not taken lightly given the landlord is Mr Tannenbaum himself.
We also see from the 10-Q that FSAM “redeemed” $6mn of its investment in FSOM (see above) back in the IQ of 2016.

OUR VIEW
We’re going to move from the facts to speculation, and add a warning.
The BDC Reporter is pretty much convinced there is no going back for FSAM and thus no reasonable possibility the asset manager will seek to continue to manage its two remaining “assets” FSC and FSFR. Besides the difficulty of attracting and retaining staff, there is still the issue of the $100mn in Revolver debt owed and $2mn owed the State of Connecticut (which paid for the kitting out of those offices at FSAM’s HQ).
Debt Laden
Even with the $16mn pay-down from the CLO subsidiary sale, FSAM still has $86mn in debt outstanding, virtually all on the Revolver.
However, offsetting assets are getting scarce. On its March 31, 2017 books there was $67.5mn of investments in FSC and FSFR stock. Even that number was boosted by  an end of month stock purchase at both BDCs., as this chart shows. Mr Tannenbaum did make some additional purchases in FSC as late as March 30th.
Shortfall
Should a deal not occur with Oaktree the value of FSC and FSFR assets could drop materially, leaving the value of FSAM’s position in its public BDCs worth $50mn or less and the shortfall under the debt at $40mn plus.
When you add in other expenses and the expensive retention agreements signed with senior personnel late last year (another sign that FSAM is in wind up mode) the asset manager could be $50mn-$60mn in the red once all debts are paid off.
With every other FSAM asset sold, hocked or closed down, the “sale” of the Investment Advisory contract is vital, both for FSAM’s investors and Mr Tannenbaum.
Selling What You Do Not Own
We should interrupt ourselves and point out – putting on our BDC Activist hat- that the Investment Advisory contracts for FSC and FSFR have no business being an undeclared asset of its asset manager. Technically, the Boards of both public BDCs should be acting in the best interests of their shareholders. That would mean shopping around for a less troubled asset manager, and negotiating the best Investment Advisory Agreement possible, giving FSAM 60 days notice and decamping.
It says a lot about the absence of any real corporate governance at BDCs that a would-be asset manager for the funds has to negotiate with the existing service provider rather than the Board. After all, Oaktree Capital should have been able to approach FSC and FSFR directly and save itself hundreds of millions of dollars or – at the very least – offer up those benefits to the BDCs shareholders in the form of lower fees or some other concession.
We mention this not only as a long time critic of BDC governance (a quixotic endeavor which makes nobody – including the BDC Reporter – any money given that shareholders have little influence on the outcome of these situations) but to speculate that Oaktree might be coming to the same conclusion.
If…
If that proves to be the case and the tough minded negotiators at Oaktree Capital decide to walk away, FSAM (and in the short term both FSC and FSFR) will be in a tight spot. With a lender clamoring to be paid, a big shortfall between what is owned and what is owed (which will be growing even bigger if FSC and FSFR’s stock price drops) and disappointed stakeholders across the board, a bankruptcy filing might become an option. It’s true that Mr Tannenbaum has promised FSAM’s Board to backstop the asset manager should matters with the Revolver lender get out of hand, but this may be more than the CEO and founder can bite off, even if he wants to.
Hedging Ourselves
That’s just one scenario out of many, and we’re missing many of the key facts that the two groups sitting in a conference room negotiating this transaction have at their fingertips. Nonetheless for public investors in all 3 public companies, who have been kept in the darkest dark for many months now about what’s happening to the asset manager ( we refer you to FSAM’s press release page and ask how many of the key developments mentioned above have been the subject of a public disclosure) this is a very dangerous time.
Risky Business
Should the negotiations fall apart (and we’re constantly checking the news as we write this to avoid having egg on our face) a big drop in the stock prices is likely.
Most at risk are the shareholders in FSAM, who are at risk of losing everything.
FSC and FSFR’s stock could also drop, but the funds have real assets to support their earnings over the long term. Ironically, should the Boards of FSC and FSFR take charge of their funds destiny all of a sudden their value could spike. Even Mr Tannenbaum would benefit, in his role as major shareholder.
Of course, if there is Bad News headed this way the markets will react much faster than any individual investor can, so shareholders will have to draw their conclusions in advance of any news breaking.
Likelier ?
On the other hand, this might end up with a deal between FSAM and Oaktree on terms as “leaked” on June 29, and everyone invested in the 3 entities will be satisfied. At least till the terms are revealed.
FULL DISCLOSURE
We have no position in FSAM.
We had purchased a position in FSC in May in anticipation of a buyer, and reassured that FSAM’s troubles would go some way to ensuring a deal would get done. However, we sold our (very small) position earlier in the week and took our gain, unwilling to endure what was beginning to look like a Waiting For Godot situation.
We purchased a position in FSFR on the same reasoning, except that the better fundamentals at the BDC have convinced us to hang in there and endure whatever volatility might occur. The stock price jumped from $7.50 to $8.24 on July 3rd, but has slipped slightly to $8.14. Our cost is $8.24, and NAV (for what that’s worth) is $10.83.
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