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Fifth Street Finance : Files Proxy

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Fifth Street Finance (FSC) has filed its Definitive Proxy Statement in preparation for its Special Shareholders Meeting at which shareholders will be asked approve Oaktree Capital as the new Investment Advisor of the BDC and the revised terms of the Agreement. Moreover, 5 new Oaktree-friendly Directors will be elected to the Board. The BDC Reporter has read the key provisions of the Proxy. We have focused principally on the new fee arrangements under Oaktree because of their long term impact on shareholder returns. We begin with the details, analyze the impact and end with a comment:


NEWS

There are several changes being made to the current Fee arrangements:

First, the Base Management Fee is being reduced from 1.75% of assets to 1.5%.

Second, the Incentive Fee  and Capital Gain fee is being reduced to 17.5% from 20.0%

Third, the  quarterly threshold level at which the Incentive Fee will be charged is being lowered to 1.50%  from 1.75%.

Fourth, the Total Return Requirement is being eliminated.

The key differences are spelt out best in two tables on page 21 on.


ANALYSIS

The Proxy includes two tables which seek to quantify the difference in fees payable on a pro-Forma basis, looking back over a twelve month period ending in March 2017.

The second table is the most useful for existing FSC shareholders as it assumes what the impact on fees if the new 3 Year Look Back Total Return provision that the current Investment Advisor agreed to recently had been in existence all year.

The table shows clearly that shareholders will benefit from the lower Base Management Fee.

However, by playing with the threshold rate and getting rid of the Total Return feature, FSC shareholders would be paying Oaktree more than FSAM in Incentive fees, notwithstanding the reduction from 20% to 17.5%.

The savings on Management Fees is about 14% and the loss on Incentive fees is about (14%).

However, because the size of the overall Management fees is greater than Incentive Fees, there is an absolute savings to shareholders  of ($2.5mn) or (4.6%).

As before, FSC will continue to pay out a substantial amount in Incentive Fees even if the fund is loss making when Realized and Unrealized changes  are taken  into account.

The only “hurdle” which Oaktree will have to meet is achieving a yield above 1.5% per quarter. Effectively, as the Investment Advisor takes on higher risk and thus higher yielding investment assets it’s Incentive fee will be higher.


VIEW

Whatever benefits FSC shareholders will receive from having Oaktree as Investment Advisor – and those should be substantial- the compensation arrangements are mostly a draw.

Oaktree has much prior experience in its hundreds of partnership agreements drafting terms that are favorable to the manager and this is no exception.

Here, Oaktree “gives”  in the form of lower absolute fee levels in both Management Fee and Incentive Fee, and “takes away” by lowering the threshold level and the Total Return look back.

That last item could have been a major brake on Incentive Fees in the years ahead if the fund does not perform well on an overall basis.

Clever

Given that many shareholders are not familiar with the arcane forms of fee calculation, Oaktree has focused on making concessions on the typical “headline” fees while making manager friendly changes in the less understood parts of the fee calculation formula.

We estimate that’s once Oaktree gets rid of the fund’s non performing loans, shareholders will end up paying as much as they did to FSAM.

No Voice

It’s the great irony that FSC’s Board should have agreed to a change in Investment Advisor without any revealed “shopping process” to any other parties, and agreed with Oaktree a  compensation arrangement equally as expensive as before, where big fees are paid out regardless of performance and rewards the management for taking on more risk, and shareholders are cheering rather than booing.

Stay Calm And Carry On

This is as much a reflection on the intense frustration and dislike that most shareholders had for FSAM as the BDC’s manager as the respect afforded Oaktree as the designated savior.

Yet that frustration/ sense of relief should not blind FSC shareholders to the fact that FSAM negotiated a deal for its management rights to the BDC which was principally to its own benefit, and which leaves the BDC – whatever it’s new name- saddled with a still expensive and lopsided fee arrangement.

Eye On Its Prize

If FSC shareholders had hoped to get some redress from FSAM as the Investment Advisor leaves the stage, they will have been disappointed. FSAM departs in the same manner as they operated as Investment Advisor- with its eyes on its own best interests and with no countervailing Board or shareholders or regulator to contend with. It’s a great shame, but should also be a warning to elated FSC and FSFR owners that they are dealing with highly sophisticated managers with a fiduciary duty to their own shareholders to maximize their returns and are able to set terms almost at will.

This Is A Business

We doubt Oaktree will do as poor a job running the BDC as has FSAM, but the same principles of self interest apply and shareholders need to remember that and pay close attention. Or at least read the BDC Reporter which will continue to review disclosures such as these with shareholders first in mind.

Spelt Out

If we have been too polite and not made ourselves clear, the BDC Reporter believes that the new compensation agreement with Oaktree  – setting aside all that has happened in the past with with FSAM  and not taking into account what may or may not be superior credit management in the future- is a pretty average-to-poor deal for FSC shareholders.

This article was tidied up, heading added and spelling errors collected as part of its re-release to all readers on August 29, 2017
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