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Fifth Street Companies: Oaktree To Buy FSAM, Manage FSC and FSFR.

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After weeks of negotiations Fifth Street Asset Management (FSAM) and Oaktree Capital Management, an affiliate of Oaktree Capital Group, LLC (OAK) , a publicly listed asset manager based in Los Angeles have agreed on a transaction whereby the latter acquires the investment advisory rights to Fifth Street Finance (FSC) and Fifth Street Senior Floating (FSFR) for $320mn. There are many details involved which the BDC News Of The Day reviews below. We also provide some initial, off-the-cuff analysis and our views as to whether this is a Good Thing for FSC and FSFR shareholders. We also share our own investment approach going forward.

DETAILS

Oaktree is not acquiring FSAM itself or any of its balance sheet assets. The entire transaction – and payment – relates to the proposed transfer to Oaktree of the rights to manage the two public BDCs, and to receive Management and Incentive Fees therefrom. FSAM itself, deprived admittedly of its only remaining income producing activities, will continue after the close and after each shareholder has received a Special Distribution of $2.75 a share.

Given that we are the BDC Reporter and not the BDC Investment Advisor Reporter we won’t spend much time on the details of that portion of the transaction that relates to FSAM, and will focus on the impact on the FSC and FSFR.

Stepping Up

Essentially Oaktree – and its personnel – will step into the role of Investment Advisor at both funds, and change their names,  with FSC becoming  Oaktree Specialty Lending Corp. (OCSL) and FSFR becoming Oaktree Strategic Income Corp. (OCSI), and tweak their investment strategies.

“Oaktree has stated that they intend to keep FSC and FSFR separate with different risk profiles.

They expect for OCSL (FSC) to have more flexibility to invest in junior and unsecured tranches and in dislocated credits. Compared to OSCI, Oaktree anticipates that a more meaningful portion of OCSL’s earnings may come from capital gains.

They intend for OCSI (formerly FSFR) to be a stable source of current income for investors with the portfolio likely skewed towards the first lien, senior secured end of the capital structure. Over time, Oaktree intends to shift OCSI’s investment focus away from “senior” obligations to broaden its investment scope.

We believe Oaktree’s experience will allow it to reposition the portfolios and enhance the value of FSC and FSFR over time”.

Meet The New Fees. Much Like The Old Fees.

Oaktree is proposing a new fee schedule. FSFR’s Management Fee will remain unchanged; the hurdle for the Incentive Fee will be 6% and the Incentive Fee will be 17.5%.

FSC gets a reduction in the Management Fee to 1.5% (from 1.75%) but ditto on the hurdle and Incentive Fee. Same as FSFR’s.

Management

As one would expect Oaktree will be managing the portfolio with its own staff (although some FSC employees may be re hired or retained as consultants). Oaktree points to its $100bn under management and staff of 300 investment professionals.

One Time Costs

Oaktree has required FSAM and its affiliates absorb a number of one time costs that would otherwise be chargeable to the BDCs (as they have in the past at great expense to shareholders).

Most notably, the legal costs associated with the ongoing SEC investigations will not be charged to the funds.

Moreover FSC and FSFR shareholders will not pay the Proxy costs of the change-over, which are being divided between FSAM (mostly) and Oaktree.

Approvals

Mr Tannenbaum and FSAM have agreed to vote on behalf of Oaktree when the change in Investment Advisory contract is put to the two funds shareholders for approval.

The Boards of both FSC and FSFR have already approved and recommended the change of Investment Advisor.

New Proxy materials will be arriving shortly.

Buyer and Seller hope to complete by year end.

Board Changes

As part of the transaction there is only one existing Director at each of FSC and FSFR who will continue.

Oaktree will designate one of its own to the Board of each BDC and several “independent directors”.

Better Offer

Technically, FSAM can still walk away if a better offer comes along, but would have to pay a break-up fee of $9.5mn.

FSAM has agreed not to actively solicit a better offer, but can review a superior unsolicited offer should one come along.

Small Print

There are provisions in the agreement between FSAM and Oaktree about what happens if the NAV of FSC and FSFR are lower than the currently stated value and if the management fees to be received by the new Investment Advisor are lower than anticipated.

However, most of the protections and payments involved benefit Oaktree, rather than FSC and FSFR.


ANALYSIS

Given all the moving parts in the Acquisition Agreement, the BDC Reporter understands why the transaction took so long to negotiate.

Besides buying the Investment Advisory contracts of FSC and FSFR, Oaktree was concerned about i) the ongoing SEC investigation into FSAM’s business practices and how that might affect FSC and FSFR.

ii) The accuracy of the current valuations of FSC and FSFR’s portfolio.

Work To Be Done

In that regard, we get the impression that Oaktree’s team has not yet gone through the two BDCs portfolios with a  “fine tooth comb” as some investors may assume.

In fact, with the closing of the transaction still months away, Oaktree was evidently concerned about buying a “pig in a poke”.

Complex calculations had to be agreed upon – and the sources of cash to pay them if required – if FSC and FSFR’s NAV falls more than 7.5% of the number at March 31, 2017.

Page 64 of the Agreement spells out the numbers, which combined come to $100mn.

iii) Future credit losses from misrepresentations or actions taken by FSAM while it was Investment Advisor to the two BDCs.

Reps & Warranties

In a provision which seems pre-determined to cause future disagreement amongst the parties and provide lawyers on both sides with many billing hours, Oaktree can claim damages from FSAM.

In the Agreement – for readers who might want to read the Agreement themselves this is called a Buyer Specified Indemnifiable Event. See page 64.

Basically if any representation in Articles III and IV are thought by Oaktree to have been untrue, they can claim from FSAM.

In this regard a $45mn escrow will be set up, secured (in a delicious irony) by FSAM’s ownership of shares in FSC and FSFR.

(Clearly Oaktree don’t expect FSAM to have any other assets left in the medium term after this transaction closes, following the pay-off of its lenders, many employees and the Special Distribution).

OUR VIEW

Shareholders in FSC and FSFR are currently celebrating their “liberation” from FSAM’s management of the two BDCs.

Of course, Oaktree is a bigger and more respected name and does not come with all the baggage of the last few years of erratic managerial decision making and poor credit performance.

Not to mention a crashing stock price and lower distributions.

Word Of Caution-As Always

However, before rushing to the streets with flags and flowers there are a few hard facts to consider.

First and foremost FSC and FSFR shareholders have to recognize that this transaction was negotiated for the respective benefit of FSAM and Oaktree.

Nobody representing the interests of the two BDC funds was involved.

Yes, the Boards of FSFR and FSC did give a thumbs up, but they have not proved themselves effective stewards of the funds over the years, so their credibility has to be in question.

Clearly Oaktree has taken a couple of steps to “sweeten the pot” for FSC and FSFR shareholders to ensure their approval of the transfer of power.

Fruits Of Despair

However one of the final consequences of having FSAM as External Manager is that shareholders in FSC and FSFR were desperate (as we noted at the top) for a change. Any change.

As a result, Oaktree has not had to offer much to FSC and FSFR shareholders and been able to give FSAM and its shareholders (principally Len Tannenbaum) that much better a purchase price.

The fee reductions offered by Oaktree to FSC and FSFR are very modest.

FSFR gets no Management Fee reduction whatsoever. The “hurdle rate” for the Incentive Fee remains at 6.0% annually. Only the Incentive Fee has been trimmed: from 20% to 17.5%.

That’s just a (12.5%) reduction.

Last quarter the Incentive Fee (which FSFR calls its “Part I Incentive Fee”) was $287,351. A 12.5% reduction will save FSFR shareholders $36,000 or $144,000 a year.

That’s half a cent per share savings. Per year.

By contrast – and using the same latest FSFR numbers – the Investment Advisor will earn $6.6mn a year, plus get reimbursement for part of their overhead.

FSC gets a small reduction in its Management Fee from 1.75% to 1.5%. Otherwise, the compensation structure is the same.

The Road Not Taken

Critically Oaktree has avoided including any of the more “shareholder friendly” provisions that some Investment Advisors have agreed to in recent years.

For example, not getting paid fees based on PIK income until received. (That can be 5-7 years out, so can understand the reluctance).

Or, deferring or waiving the Incentive Fee if on a Total Return basis (including Unrealized Depreciation in the calculation) shareholder returns are negative.

Here – as in so many other cases – the Investment Advisor will continue to be paid an Incentive Fee even if NAV, earnings and distributions are dropping.

Just look at FSFR’s own numbers for evidence of how that works.

Capital Gains Question Mark

Also no word on how capital gains fees will work after the new Investment Advisor comes on.

Will the “cost” of FSC and FSFR’s investments be fixed at their value at the time of the switch over and any Realized Gains achieved thereafter be based on an increase from that base ?

Will that capital gain fee be calculated from the funds inception or on annual basis (one of the newer mechanisms clever Investment Advisors are using to boost their fees) ?

Consequences

Tired and angry FSC and FSFR shareholders will gratefully accept these terms because we do not live in a perfect world, but by doing so the ultimate return achievable from holding the stock is stunted and the shares worth less than might otherwise have been the case.

The Road Avoided

However, if the Boards of FSC and FSFR had done their proper fiduciary duty – in the BDC Reporter’s opinion – and sought out a new Investment Advisor given the poor performance by FSAM – as they are allowed to do, the terms that would have been received would have been far superior than what’s being proffered here.

We don’t blame Oaktree , which only has so much money to spend for the prospective fee stream to be received from FSC and FSFR, but the failure of BDC corporate governance.

The big institutions which invest in BDCs, the investment banks which bring the BDCs to market and the regulators all shoulder a portion of the responsibility, as well as the Board, and the stock exchanges which allow insiders undue influence and control.

If Oaktree was dealing directly with FSC and FSFR we would imagine that – effectively – some of the $320mn being paid FSAM would be benefiting the public fund shareholders.

Culmination Of What ?

We wonder aloud how many potential asset managers did the “independent” members of FSC and FSFR Board contact before Oaktree was plumped on as the best buyer, as long as FSAM was first “paid off” for the management rights ?

The press release from FSAM says the choice of Oaktree was “the culmination” of a “strategic review” led by FSAM and its financial advisors. However, that begs the question as to whether FSAM or FSC / FSFR’s Boards should have been in charge of deciding who their Investment Advisor should be.

Not Just A Matter Of Fairness

Anyway, the BDC Reporter is not just pointing out the inequities involved – which are common in the public company space and in BDC governance – because those will continue however much we wring our hands and spill our digital ink.

More importantly, we seek to highlight for FSC and FSFR shareholders that because the accession of Oaktree has not been negotiated on a normal basis there are potential risks to be faced which might reduce the value of FSC and FSFR down the road, besides a less than ideal compensation structure.

First of all, there is little chance an unsolicited offer will come along, given that Oaktree has negotiated a high break-up fee and received the support of FSAM and Mr Tannenbaum for their offer.  As we saw when TICC Management attempted to sell  its Investment Advisory contract, any third party suitor who throws a hat into the ring is likely to be deemed non-worthy.  In any case, with any buyer needing to go through FSAM to get to FSC and FSFR,  a higher offer will only benefit FSAM and Mr Tannenbaum, and might leave even less for FSC and FSFR shareholders. That “zero sum game” we spoke of earlier in real-life action.

Unprotected

Second, FSC and FSFR shareholders will get no protection from the FSAM escrow if after Oaktree takes charge it’s found that Net Asset Value, earnings and credit quality at their respective funds are found to be weaker than expected.

Oaktree is protected by the terms of the Acquisition Agreement, but FSC and FSFR shareholders are not.

Dividend (Un)Assured

We read the Q&A that was included in the filings and noted that no strong reassurances were made about the maintenance or support of the distributions at either FSC or FSFR.

The otherwise effusive Q&A only noted that FSC had already announced a $0.125 dividend for September and FSFR was already paid up in June. After that, it’s up to the Board of Directors.

Our unscientific reading of that answer suggests a cut in either BDC’s distribution before or after the Oaktree deal closes remains possible.

Given that Oaktree has spent so much time and built so many protections against a possible downward surprise at FSC and FSFR shareholders may want to pay attention, even if they do not benefit from the escrow.


CURRENT MARKET

As you’d expect FSC an FSFR’s stock prices have jumped on the news. The delay in closing the deal caused the prices to slip but that’s now in the rear view mirror.

FSC is trading at $5.35, up 15% on the day. That’s almost at the YTD high, just before the Investment Advisor announced poor performance and a dividend cut. The price is above the $5.01 reached after the leaked news of the deal came public. However, the price is still at a big discount to the NAV of $7.23.  The price is 10.7x the latest distribution and over 10x the $0.13 IQ 2017 Net Investment Income Per Share.

FSFR is at $8.71, up 9%. The price remains well below the YTD high of $10.20, and below NAV of $10.83. Net Investment Income Per Share is running at an annual $0.68 rate. As a result, FSFR is trading at a multiple of 12.8X.

Ironically, FSAM – which has fared best under this transaction – is down to $4.30 or (5.5%), as investors appear to believe that the Oaktree deal was not as rosy an anticipated.


Our Investment Approach

Would we buy shares at these prices we (don’t) hear you ask ? No is our answer.

Except for our Special Situations portfolio we are a long term holders of BDC stock, and target players with track records of sustainable distributions and business models which make sense to us.

We’d like to know more about what FSC and FSFR’s portfolio looks like in the IIIQ or IVQ 2017 after the transition is done.

Plus, we’d like to know more about how Oaktree proposes to manage the BDCs. So far we’ve been treated to very broad principles, which tell us almost nothing.

(Plus, there’s still that small chance the deal does not go though for any number of reasons, leaving FSC and FSFR managed by an essentially self liquidating asset manager).

Given the speed and secrecy of this transaction nobody seems to be asking what this huge asset manager’s credentials are in middle market lending.

The market seems excited about the brand name, but we like to look underneath the hood before locking away our capital indefinitely.

Investors who like to trade in and out of BDC positions might see opportunity for FSC and FSFR’s stock prices to rise closer to their NAV now greater clarity is available.

That’s too risky for us, but may suit others.

Disclosures

We sold the FSFR position we took for our Special Situations portfolio in anticipation of this deal back in May. (We sold out our FSC position earlier because of a very small size).

We remain invested in FSC’s Baby Bonds. Even if the deal does not go ahead, the Notes should get repaid in full.

If the deal does proceed, the Notes (FSCE and FSCFL) will benefit from the new Investment Manager.

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