FIFTH STREET ASSET MGMT INC FSAM
December 18, 2014 - 4:41pm EST by
UCB1868
2014 2015
Price: 12.80 EPS 0.94 1.30
Shares Out. (in M): 50 P/E 13.6 9.8
Market Cap (in $M): 640 P/FCF 13.6 9.8
Net Debt (in $M): 0 EBIT 58 105
TEV ($): 640 TEV/EBIT 11.0 6.1

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  • Asset Management
  • BDC GP

Description

Introduction: Fifth Street Asset Management (FSAM) is a credit-focused alternative asset manager with $6.0 billion under management. FSAM collects management and performance fees from the funds that it manages. Approximately 95% of the company’s assets reside in two publicly-traded business development companies (BDCs): Fifth Street Finance Co. (FSC) and Fifth Street Sr. Floating Rate Co. (FSFR). FSAM priced its IPO at $17 / share on October 29, 2014.

Summary: Fifth Street Asset Management (FSAM) is an inexpensive value stock that is expected to increase earnings over the next few years. It trades at a forward P/E of less than 10x even though its permanent asset base is very valuable. The company is expected to pay $1.20 in dividends in 2015. The opportunity exists because FSAM’s IPO was very poorly received. I believe that the stock is worth $18+ over the next 12 months. It currently trades at $12.80 and has a $640 million market cap.

The Structure

Fifth Street Asset Management (FSAM) is the asset manager for several Fifth Street funds. Two of these firms, Fifth Street Capital (FSC) and Fifth Street Sr. Floating Rate Co. (FSFR), are publicly-traded. These funds are “externally” managed. I put “externally” in quotation marks as, in reality, all of the Fifth Street firms are managed out of the same offices in Greenwich, CT. Many of Fifth Street’s execs, in fact, have roles at multiple Fifth Street entities. Most notably, Fifth Street’s founder, Leonard (“Len”) Tannenbaum, serves as the CEO of both FSAM and FSC. He also manages Fifth Street’s small hedge fund. The structure of Fifth Street could create some conflicts of interest. I will discuss this issue later. For now, note that I am recommending FSAM, not FSC or FSFR. It is entirely possible that all three stocks are undervalued at current prices. I recommend FSAM over the other two stocks, though, since I would rather earn fees than pay them. I, in other words, would rather be the blood-sucking vampire than the person being drained of blood.

The fees collected by Fifth Street Asset Management should grow steadily over the foreseeable future. The great thing about this investment idea is that FSAM’s investment firms are primarily solid business development companies (BDCs) with growing assets and permanent capital. Over 90% of FSAM’s fee earning assets reside in permanent capital vehicles. “Permanent” capital means that Fifth Street’s funds do not have redemption provisions or requirements to return capital when investments are closed. Investor equity is locked in as these funds (unlike mutual funds, for example) are not subject to withdrawals. Fifth Street has increased its asset base from less than $1.1 billion in 2010 to $6.0 billion today (58.2% CAGR). FSAM’s fee-earning assets under management (AUM) are $4.8 billion. The firm intends to distribute 80-90% of its after-tax earnings as dividends. There is concentration risk as approximately 90% of Fifth Street’s assets are held in Fifth Street Finance. Here is the summary of the investment vehicles:

PERMANENT CAPITAL

Fifth Street Finance (FSC)

BDC, created in 2008, 11.6% annual gross IRR, $4.9 bil. assets under management (AUM), $4.1 bil. fee-earning AUM

Fifth Street Senior Floating Rate (FSFR)

BDC, created in 2013, 9.8% annual gross IRR, $532 mil. AUM, $323 fee-earning AUM

INSTITUTIONAL PRODUCTS

Fifth Street Credit Opportunity Fund

Hedge fund, founded in 2013, 20.0% annual IRR, $57.2 mil. AUM, $35.7 mil. fee-earning AUM

Credit Funds

Launched in 2014, AUM of $520 mil., $332 mil. fee-earning AUM

Structured Equity

$4.8 mil. AUM, $4.5 mil. fee-earning AUM

Fifth Street intends to launch separately managed accounts next year. It plans to convert some funds to collateralized loan obligations (CLOs). Fifth Street could, someday, branch out into areas such as mutual funds or ETFs. Fifth Street Asset Management is organized as an investor-friendly C-Corp.

What We Really Care About: The Fees!!

Fifth Street Asset Management generates nearly all of its revenue from base management fees and Part I incentive fees from its publicly-traded funds. FSAM also earns Part II incentive fees and other fees. Part I fees are viewed by the business development company industry as stable and recurring. It is for this reason that FSAM (somewhat confusingly) classifies both the Part I and base management fees as management fees. The base management fee for Fifth Street Finance is a 2.0% annual fee on gross assets. Fifth Street Sr. Floating Rate has a lower base management fee of 1.0% / year. The Part I performance fees are paid to FSAM based on a fixed percentage of pre-incentive fee net investment income. The Part I fees are based pre-determined hurdles of 2% / qtr. for FSC and 1.5% / qtr. for FSFR. FSAM earns incentive income once the hurdle rates are exceeded. Part I incentive fees are not subject to clawback. FSC has generated Part I fees in every quarter since its inception in 2008. FSAM’s total management fee revenue grew at a 40.2% CAGR from 2010-13. FSAM’s effective annualized management fee rate was 2.10% for the first nine months of 2014.

There are multiple sources for fees to Fifth Street Asset Management apart from the management fees. The firm’s BDCs, FSC and FSFR, are subject to Part II incentive fees equal to 20% of capital gains (paid annually). These fees have been modest, but could increase. More important, perhaps, are the performance fees that FSAM generates from its relatively small institutional funds. These fees should grow rapidly in future years as these institutional funds increase their AUM. Fifth Street’s hedge fund, for example, is subject to the typical 20% performance fee above its high water mark. FSAM, finally, receives reimbursements for administrative expenses and some managerial costs. Overall, Part I and base management fees represented approximately 94% of FSAM’s revenue in the first nine months of 2014 (about 60% base / 40% Part I).

Fifth Street Asset Management’s earnings are based on recurring and consistent fees. It is true that Part I fees vary based on performance. Fifth Street is a lender and loans can default. Poor performance, though, would not shrink the equity capital. The potential downside is, therefore, very limited while the potential upside is strong.

Business Development Companies (BDCs)

Fifth Street Asset Management’s main assets are its BDCs. These firms are in the business of originating senior loans to small- and mid-sized ($25-$500 mil. revenues) private businesses. Fifth Street targets a maximum loan size of $250 mil. ($500 mil. if part of a syndicate). Fifth Street claims to have relationships with 20 commercial banks and more than 300 private equity sponsors. This year has not been a good one for BDCs. Portfolio yields have fallen as competition has increased. Investors are concerned that BDCs might have difficulty attracting new capital. Approximately two-thirds of FSAM’s assets are provided by retail investors. Still, the commercial lenders have de-levered since the financial crisis and largely pulled back from the market. Also, the growth of the private equity market has increased the number of firms looking to borrow money. There is an excellent opportunity for non-bank lenders to meet the demand.

The recent drop in oil prices has affected the BDC market. Many oil and gas companies are laden with debt. The fall in oil prices has put these companies at risk and caused sudden panic in the high-yield credit market. This issue has negatively affected BDCs and other high-yield lenders. Someday, of course, oil prices will rise again and the market will stabilize. In the meantime, Fifth Street’s management has repeatedly stated that its BDCs have minimal exposure to oil companies.

Fifth Street’s BDCs: FSC and FSFR

Fifth Street Finance (FSC) specializes in mezzanine lending to private firms. Nearly all of its deals originate from private equity sponsors. The firm completed a $300 mil. IPO in 2008. FSC now has approximately $4.9 bil. AUM. Fifth Street Asset Management generates management fees on approximately $4.1 bil., but generates Part I fees on the full amount. More than 80% of FSC’s loans are senior secured and most (approx. ¾) are first lien loans. The expected average life of a loan is three to four years. FSC has a well-diversified loan portfolio of more than 125 loans in nearly 40 industries. Some of its largest areas of lending include healthcare (15.0% of loans at 9/30/14), education (9.4%), advertising (6.6%), and internet services (6.3%). Nearly all of its borrowers are based in North America. Its lending standards are high and non-accruals are very low. There was only one loan on which FSC had stopped accruing cash interest as of 9/30/14. FSC is approximately the sixth-largest public BDC in terms of market cap. It has reported an above average gross IRR of 11.6% since 2008.

Fifth Street Sr. Floating Rate Co. (FSFR) completed a $100 mil. IPO in 2013. It now has a market cap of more than $400 million. Its portfolio consists of 42 investments. As its name suggests, 100% of FSFR’s loans are senior floating-rate loans to mid-sized companies. FSFR’s average loan size of $5 mil. is about one-fifth the size of a typical FSC loan. Due to its limited history, Fifth Street’s management set a low management fee for FSFR to attract capital. FSFR has generated gross IRR of 9.8%. Its stock price has plummeted from a high of $15.10 in March to about $10 today. Fifth Street execs recently bought a significant amount of FSFR on the open market.

Fifth Street’s BDCs are trading below their book values. They can and will raise capital when its BDCs are trading above their NAVs. Fifth Street Finance has completed more than 18 equity and debt deals since its IPO. At the present time, however, capital raises would dilute existing shareholders. It is for this reason that BDCs require shareholder approval to raise equity when their stock prices falls below their NAVs. Fifth Street Finance’s management said on its Q4 conference call that it would not ask for shareholder approval for an equity raise. I doubt that the fund could get this approval anyway. Since it is currently difficult for Fifth Street’s BDCs to raise capital, investors are concerned that the firm will not meet its asset targets. The BDCs can, however, lever up to increase their capacity. FSFR, especially, has room to take on more debt. FSC and FSFR have also set up joint ventures to help with this situation.

The Joint Ventures

Fifth Street’s BDCs have set up joint ventures (or “sidecars”) that will be accretive to their ROEs. The sidecars increase the capacity for the BDCs, allowing for additional leverage and Part I performance fees. Fifth Street Finance has a joint venture with a subsidiary of Kemper to invest in middle market and other corporate debt. The total investment in this fund is currently $200 million (87.5% FSC / 12.5% Kemper). The joint venture increases FSC’s debt-to-equity ratio and increases Part I fees. Fifth Street Sr. Floating Rate Co. has a similar joint venture with the Glick family. The initial investment in this deal is $100 mil. and has the same basic structure as the FSC / Kemper deal. These deals can be levered at greater than 1:1. The FSC deal should allow for about $600 mil. in loans. The FSFR deal should produce $300-$400 mil. in loans. The size of the sidecar deals will probably be increased. Both Kemper and the Glick family have invested with Fifth Street many times in the past. The two joint ventures will increase FSAM’s fee-earning assets under management. Over time, they should also help to increase the dividends of the BDCs so that their stock prices can increase above book value.

Co-Investment

Fifth Street recently received permission from the SEC to engage in co-investment deals. This means that multiple Fifth Street funds can invest in the same offering. There are several benefits to this type of deal. The main benefit is that Fifth Street can get involved in larger size financing deals. It can participate in deals which might otherwise be impossible. Also, Fifth Street Asset Management may receive additional fees from these deals. Fifth Street announced a $110 mil. co-investment deal on December 11, 2014.

Interest Rates

Fifth Street’s loan portfolio benefits from rising interest rates. According to Fifth Street Asset Management’s prospectus, a rising interest rate environment, “…would driver higher incentive fees to us, given the structure of our management agreements, which include fixed level performance benchmarks and do not include total return hurdles.” Approximately three-quarters of Fifth Street’s loans are floating-rate loans. Rising interest rates, therefore, increase spread income. It is true that interest rate floors mean that initial interest rate increases (up to 100bps) will hurt performance. If interest rates rise by more than 200bps, however, spread income increases greatly. The company, for example, estimates that a 400bps increase in interest rates would increase annual net spread income by more than 30% for FSC and more than 40% for FSFR. It is, obviously, impossible to predict when or if interest rates might increase enough to affect FSAM’s earnings.

Proposed New Law

A bill in Congress would allow BDCs to increase their leverage. Business development companies are currently restricted to 1:1 leverage. A proposed new law called the Small Business Credit Availability Act (H.R. 1800) would raise the limit to 2:1. The bill was passed by the U.S. House Financial Services Committee in late-2013 but has not come up for a House vote. Passage of the law would expand the lending capacity of Fifth Street’s BDCs and, therefore, FSAM’s fees. Despite this potential benefit, Fifth Street and some other firms oppose the bill. They are concerned that lending standards will fall and that the added risk will hurt the industry. Fifth Street Finance’s CFO, Alex Frank, told Reuters that, “The BDC structure is a way for retail investors to access the asset class, while enjoying the safety of the 1:1 model. All it will take is one blow up to result in the retail bid bowing out.” In a separate article, FSAM’s Chief Investment Officer, Ivelin Dimitrov, said that, “It would be inappropriate, in our view, to lever a mezzanine-focused BDC at more than 1:1.” Still, it appears to me that passage of the law could be a huge benefit for FSAM. I do not believe that the sell-side analysts have even mentioned the possibility.

Non-BDC Businesses

Fifth Street is diversifying into some non-BDC investment opportunities. These businesses are currently small, but are expected to grow rapidly over the next few years. The company expects to launch separately managed accounts in 2015. Fifth Street currently manages a hedge fund called Fifth Street Credit Opportunities Fund. This small hedge fund has $60 million in assets. This long / short fund invests in credit-related instruments. FSAM earns a quarterly management fee of 0.75% to 1.5% (annual) from the limited partners. Fifth Street also manages a Senior Loan Fund which it expects to convert to collateralized loan obligations. FSAM earns management fees based on the principal balance on these funds. One of the major areas of focus for Fifth Street’s new funds is aircraft leasing. The aircraft leasing business has been expanding rapidly since the recession. Fifth Street manages approximately $600 mil. in these non-BDC funds and expects to increase its AUM in these funds to more than $10 bil. by the end of 2017. The asset base of these types of funds is not as permanent as it is for Fifth Street’s BDCs.

The Busted IPO

Fifth Street Asset Management’s IPO was a big flop. The company originally intended to sell 8 million shares in a price range of $24-$26. The lead underwriters were Morgan Stanley, J.P. Morgan, Goldman Sachs, RBC, and Credit Suisse. The proposed IPO proved to be unpopular. On October 22, 2014, FSAM announced that it was pulling the deal. Fifth Street used the usual “market conditions” excuse, but a likely problem was that the underwriters planned to price the offering below the expected range. Fifth Street’s management was not at all happy about this possibility. The firm, according to an article on The Street, wanted Morgan Stanley to allocate more stock to retail investors. Morgan Stanley, though, did not want to burn its clients. One week later, however, Fifth Street reversed course and completed a downsized IPO for FSAM of 6 million shares at $17. The reduced price did not help. The stock price opened below $17 and has not recovered.

Fifth Street Asset Management’s IPO was unpopular for several reasons. IPOs of similar companies did not fare well in 2014. Medley Management (MDLY), most notably, completed an IPO in September, 2014. It has been a real dog. The IPO was priced below its expected range and continues to trade poorly. Ares Management (IPO in May, 2014) also trades below its IPO price despite reducing the size of its deal. There were also some company-specific reasons that encouraged people to avoid the FSAM IPO. There is concern that FSAM’s BDCs will not be able to raise funds. Also, all of the IPO proceeds went to Tannenbaum and other insiders, not the company. Tannenbaum, moreover, maintains nearly total control of the company through super-voting Class B stock. He controls approximately 91% of the voting power. Investors, of course, often dislike dual class structures. Some of them also really dislike Len Tannenbaum.

Oh, Tannenbaum!

I’m an entrepreneur. I started my company with one person in a basement in Mt. Kisco, New York. I had to lease out the other side of the basement…” – Tannenbaum, neglecting to mention that he married into wealth, 9/24/12

Len Tannenbaum, age 43, is not the most beloved CEO on Wall Street. I include this section because I believe that some part of FSAM’s undervaluation is due to investors’ feelings about him. You will find plenty of complaints about Tannenbaum among professional investors and the Motley Fool / SeekingAlpha crowd. FSAM is a recent IPO, but Fifth Street Finance (FSC) has been publicly-traded since 2008. Tannenbaum, as previously mentioned, serves as the CEO of both FSC and FSAM. He also served as the CEO of Fifth Street Sr. Floating Rate Co. (FSFR) until a few months ago. The stock prices of both FSC and FSFR have been poor performers. FSFR came public in 2013 and has never traded above its IPO price. FSC’s stock price has dropped by approximately 40% over the past four years. Both FSC and FSFR trade below their book values and have double digit dividend yields. Stockholders in these firms have not done very well. Tannenbaum, though, has done just fine.

Tannenbaum has been accused of enriching himself at the expense of shareholders. There is a possible conflict of interest here. Tannenbaum’s ownership interests in Fifth Street’s funds are small in relation to his equity interest in Fifth Street Asset Management. It is probably no coincidence, therefore, that there have been instances in which FSC and FSFR have completed capital raises to the possible detriment of shareholders. Fifth Street Finance has completed approximately 14 equity raises since its IPO. It has not raised equity when trading below its NAV since 2009. FSFR, though, completed a large secondary offering in August, 2014, at a price that was far below its NAV and 2013 IPO price. A Motley Fool writer bluntly stated that, “Leonard Tannenbaum made himself richer by choosing to make shareholders poorer.” In another article, this same writer argued (logically) that the Fifth Street funds should buy back their own stocks when trading below NAVs. He also suggested (logically) that Tannenbaum resists repurchases because they would cut into management fees. Some people might say that Tannenbaum approaches the line of unethical behavior. One former family member accused him of crossing it.

Tannenbaum was unsuccessfully sued for fraud by his former father-in-law, Bruce Toll. Toll, the co-founder of the Toll Brothers homebuilding business, operates businesses in several industries. Tannenbaum married one of Toll’s daughters, Elizabeth, in 1997. The marriage was, uh, very convenient for Merrill Lynch analyst Len Tannenbaum. He launched his first fund with $34 mil. AUM in 1998. Toll provided about ½ of the funding and took 90% of the profits. After that fund proved to be successful, Toll helped Tannenbaum to launch other funds and also guaranteed tens of millions of dollars in loans. Toll was a vocal supporter of Tannenbaum and served on Fifth Street Finance’s board. He later admitted in court filings, however, that his relationship with Tannenbaum started falling apart as early as 2006. Fifth Street ran into some serious cash flow problems at about that same time.

Toll bailed out one of Fifth Street’s troubled funds in 2007. Tannenbaum approached Toll in late-2006 and told him that one of his funds was nearing collapse. Toll responded with a bridge loan and a personal guarantee on $15 mil. in loans from Wachovia. Toll guaranteed another loan of $12 mil. two years later. Toll did not receive his usual equity compensation for these loans. Shortly after the 2009 loan was made, Tannenbaum separated from Elizabeth and began divorce proceedings. In an interesting coincidence, Tannenbaum’s current wife was promoted to Fifth Street’s VP of Investor Relations at around the same time. Elizabeth disclaimed any interest in Fifth Street in the 2010 divorce settlement. Bruce Toll, as you might imagine, was less than thrilled by this turn of events.

Toll filed a fraud lawsuit against Tannenbaum in 2011. Toll claimed that the terms of the 2007 and 2009 loans required that 50% of the fund’s profits would go to Elizabeth. Toll, evidently, knew that the marriage was in trouble before it ended. He also wanted a fee for himself. Toll, though, had nothing in writing and claimed only an oral agreement. Tannenbaum claimed that no unwritten agreement existed and refused to pay. Toll lost the case as a judge dismissed it in 2013. My view on the situation is that Toll probably had legitimate reasons to be angry with Tannenbaum. I do not, however, see any evidence of fraud. Toll is, ultimately, responsible for failing to get everything in writing.

Tannenbaum craves money and attention. His position at Fifth Street has brought plenty of both. He lives in a $10 mil. mansion in Greenwich and pays himself very well. Aside from his generous compensation, Tannenbaum has engaged in a few self-dealing transactions. Notably, he used Fifth Street to guarantee the $26 mil. mortgage on Fifth Street’s headquarters and now collects $2 mil. / year in rent from the company. Tannenbaum also uses his status to promote his conservative political views. He supports Republican politicians and runs his own PAC. He also uses his frequent media appearances to express self-serving opinions about taxes, laws, etc. Tannenbaum is one those people who thinks that the government just gets in the way of the self-reliant entrepreneurs who do everything. Fifth Street, nonetheless, recently accepted a $5 milion incentive package from the State of Connecticut. Also, Tannenbaum seems to have forgotten that it was only a few years ago that he had to be bailed out by his wealthy father-in-law. Anyway, investors should know that Tannenbaum has an agenda. This agenda is not necessarily bad for FSAM investors.

Tannenbaum’s interests are aligned with those of Fifth Street Asset Management’s shareholders. While Tannenbaum’s treatment of FSC and FSFR shareholders may be questioned, FSAM shareholders should not be too concerned. Tannenbaum is incentivized to increase FSAM’s management fees and dividends. It is true that Fifth Street Asset Management will not win any awards for great corporate governance. Tannenbaum holds super-voting FSAM stock and the IPO raised no money for the company. The good news, though, is that he has rapidly increased the AUM at the BDCs and should continue to do so. One notable fact about Tannenbaum is that he is a good buddy of David Einhorn of Greenlight Capital. Tannenbaum has served on the boards of several Greenlight-affiliated firms. Einhorn, as you may recall, wrote a book about his long battle against a lousy BDC called Allied Capital. He has encouraged Tannenbaum to manage his BDCs in a transparent way. The Fifth Street BDCs are more transparent than many others.

Comps

Fifth Street Asset Management trades at a significant discount to other asset managers. The forward P/Es of traditional asset managers (such as BLK, TROW, BEN) are in the range of 15x-20x. The forward P/Es of smaller and alternative asset managers are in the 8x-13x range. FSAM’s forward P/E of less than 10x is lower than that of many comps. Two good comps for FSAM on opposite ends of the valuation spectrum are NorthStar Asset Management (NSAM) and Medley Management (MDLY). NSAM trades at a P/E of 28x on 2015 earnings. MDLY trades at a 10x P/E on 2015 earnings. FSAM should probably be somewhere in the middle of those two. It has a faster growth rate, higher dividend yield, and less volatile earnings stream than most alternative asset managers.

Sell-Side Reports

The analyst reports on Fifth Street Asset Management have hurt the stock price. The investment banks issued their initiation reports on FSAM on November 24, 2014. These reports had no discernable impact on FSAM’s stock price. Five of the six analysts listed FSAM as a Buy / Outperform, but they were not exactly overwhelmingly bullish. Goldman Sachs initiated FSAM at Neutral. The analysts’ original 12-month price targets ranged from $17 - $20. Just three weeks later, however, several analysts cut their estimates and price targets. Credit Suisse cut its price target from $18 to $17. J.P. Morgan cuts its price target all the way from $20 to $14. The current average price target is $17. The catalyst for the target reductions was the Q3 conference call. While the quarter met expectations, Fifth Street’s management indicated that the BDCs may not be able to raise equity next year. I do not know why this news was any big surprise. It seems, at any rate, that the analysts do not want to recommend FSAM until there is more clarity.

September Quarter

Fifth Street Asset Management reported its first quarter as a public company on December 15, 2014. It held a conference call the next day. Its adjusted net income per share of $0.24 exceeded the consensus estimates by two cents per share. On the conference call, FSAM’s management highlighted its joint ventures and ability to add debt at the BDCs. There was also a lot of discussion about the new investment vehicles. Fifth Street’s hedge fund and other institutional entities are growing as expected. Fifth Street intends to open an office in Tokyo in 2015 to serve the Japanese market. FSAM will announce a $0.30 / share dividend in January. It appears that FSAM will report adjusted EPS of approximately $1.30 and pay $1.20 / share in dividends in 2015. On the downside, FSAM’s management is assuming that FSC and FSFR continue to trade below their NAVs and that they will not be able to raise equity capital in 2015. The original AUM targets were probably too high. Overall, though, FSAM’s management remains positive about the short- and long-term outlook for the firm.

Financials

Fifth Street Asset Management’s earnings and dividends are ultimately dependent on its AUM, fee rates, and expenses. It’s all rather simple. FSAM’s investment vehicles grow their assets and pay fees. FSAM collects the fees, covers its costs, and pays out its remaining income as dividends to shareholders. This is a high margin business. Compensation expenses account for approximately ¾ of the total expenses. Here are the summary historical financials from the filings:

 

 

Full year

Full year

Nine months

(in $mil.)

 

2012

2013

2014

REVENUES:

 

 

 

 

Management fees

 

$50.0

$68.4

$68.1

Base management

 

26.6

37.8

40.1

Part I

 

23.4

30.6

28.0

Other fees

 

4.6

5.2

4.4

Total revenues

 

$54.6

$73.6

$72.5

EXPENSES:

 

 

 

 

Total expenses

 

$22.6

$33.9

$35.3

Operating income

 

$32.1

$39.8

$37.2

Adjusted net income

 

$32.2

$47.2

$33.3

ANI per share (pro forma)

 

 

 

$0.67



Fifth Street Asset Management intends to pay its earnings to investors as dividends. The relevant earnings metric is Adjusted Net Income (ANI). The consensus estimates for ANI are $0.91 for 2014, $1.35 for 2015, and $2.00 for 2016. FSAM will pay a dividend of $0.30 in the 1st quarter of 2015 (based on the Q4 2014 earnings). FSAM should pay dividends of approximately $1.20 in 2015 and $1.65 - $1.85 in 2016. At $12.80, therefore, FSAM trades at 2015 P/E of about 9.8x and a 2015 dividend yield of 9.4%. FSAM’s dividends are qualified dividends.

The growth in Fifth Street Asset Management’s earnings is largely dependent on the growth in AUM for its BDCs and other investment vehicles. FSAM’s yield on its BDCs (revenues / AUM) is approximately 3.2%. Every $1 billion raised by Fifth Street’s BDCs translates into roughly $0.25 in additional EPS for FSAM. The firm is focused on raising capital in both its BDCs and its newer investment vehicles. While the future growth of FSAM’s AUM is obviously unknown, the management and sell-side analysts have made projections. Rough estimates for year-end AUM are $6.5 billion, $10.5 billion, and $15.0 billion for 2014, 2015, and 2016, respectively.

Fifth Street Asset Management does not have a lot of expenses. Compensation expenses were 28% of revenues in Q3 2014. Most of its other expenses are G&A. The Q3 operating margin was a low 54.6%, but this was impacted by several extraordinary expenses. FSAM should achieve some economies of scale as the business grows. The operating margin should improve to the high-60%s over time. I have assumed operating margins in the low-60%s for the next couple of years.

This is my basic earnings model. Just to be safe, I am using numbers that are lower than the Street estimates. I believe that there is upside to these numbers. I also believe that the stock is undervalued even if these estimates are not achieved.

 

 

 

 

in ($1000s)

 

 

 

 

2014

2015

2016

Revenues

 

 

 

Mgmt. Fees

$58

$92

$135

Part I Fees

38

51

70

Other Fees

7

26

50

Total Revenues

$103

$169

$255

Expenses

 

 

 

Compensation

$31

$49

$71

Other Expenses

14

15

20

Total Expenses

45

64

91

Operating Income

58

105

164

Taxes

20

42

65

Net income

$38

$63

$98

 

 

 

 

Adjustments

 

 

 

Compensation charges

$7

$2

$2

FSC underwriting cost

0.8

0

0

Lease termination

0.6

0

0

IPO fees

0.9

0

0

Total Adjustments

$9.3

$2.0

$2.0

 

 

 

 

Adjusted net income (ANI)

$47.2

$65.0

$100.2

Shares outstanding

50

50

50

ANI per share

$0.94

$1.30

$2.00

Dividends per share

 

$1.20

$1.75

Average AUM

$5,500

$9,500

$13,000



Valuation

I believe that Fifth Street Asset Management is undervalued. FSAM has strong growth, a high dividend yield, and collects fees on permanent capital. Recall that FSAM pays qualified dividends which are taxed at lower rates than ordinary dividends. FSAM has 50 mil. shares outstanding, so the market cap is approximately $640 million. FSAM reported $72.5 mil. in revenues and $33.3 mil. in pro forma adjusted net income for the first nine months of 2014. I am using $1.30 in adjusted EPS for 2015. Looking at the valuation of comps and considering FSAM’s permanent asset based, I have decided to use a P/E of 14x on 2015 earnings to value the stock. I believe that this is a conservative valuation. So, using this P/E and projected 2015 earnings, my 12-month price target is $18.20. Since FSAM is also expected to pay $1.20 in dividends in 2015, my implied one-year return is approximately 55%. Note that at $18.20, FSAM would still only be trading at only 9x projected 2016 EPS.

The Bottom Line

This opportunity exists because:

  • FSAM’s IPO was poorly received

  • The stock prices of related firms, FSC and FSFR, have been weak

  • Investors are concerned that the BDCs cannot raise capital due to stock prices trading below book values

  • Huge drop in oil prices has disrupted the BDC industry

  • Some investors do not like Tannenbaum

  • FSAM has limited history as a separate entity and limited float

  • The sell-side analysts have cut estimates and price targets

I recommend it because:

  • The stock is irrationally underpriced compared to peers

  • High dividend yield

  • Its base of permanent capital is very valuable

  • The BDC industry is growing

  • Oil prices will not be low forever

  • Tannenbaum’s goals are aligned with shareholders

  • AUM are expected to grow aggressively across all investment entities

  • There is upside if interest rates rise

  • Fifth Street is developing new investment vehicles

I believe that FSAM’s risks are well-known and more than reflected in the current stock price. The risk / reward at this price is very favorable.



Legal Disclaimer:

This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein.



 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

dividend announcements, equity raises, growth of new funds

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    Description

    Introduction: Fifth Street Asset Management (FSAM) is a credit-focused alternative asset manager with $6.0 billion under management. FSAM collects management and performance fees from the funds that it manages. Approximately 95% of the company’s assets reside in two publicly-traded business development companies (BDCs): Fifth Street Finance Co. (FSC) and Fifth Street Sr. Floating Rate Co. (FSFR). FSAM priced its IPO at $17 / share on October 29, 2014.

    Summary: Fifth Street Asset Management (FSAM) is an inexpensive value stock that is expected to increase earnings over the next few years. It trades at a forward P/E of less than 10x even though its permanent asset base is very valuable. The company is expected to pay $1.20 in dividends in 2015. The opportunity exists because FSAM’s IPO was very poorly received. I believe that the stock is worth $18+ over the next 12 months. It currently trades at $12.80 and has a $640 million market cap.

    The Structure

    Fifth Street Asset Management (FSAM) is the asset manager for several Fifth Street funds. Two of these firms, Fifth Street Capital (FSC) and Fifth Street Sr. Floating Rate Co. (FSFR), are publicly-traded. These funds are “externally” managed. I put “externally” in quotation marks as, in reality, all of the Fifth Street firms are managed out of the same offices in Greenwich, CT. Many of Fifth Street’s execs, in fact, have roles at multiple Fifth Street entities. Most notably, Fifth Street’s founder, Leonard (“Len”) Tannenbaum, serves as the CEO of both FSAM and FSC. He also manages Fifth Street’s small hedge fund. The structure of Fifth Street could create some conflicts of interest. I will discuss this issue later. For now, note that I am recommending FSAM, not FSC or FSFR. It is entirely possible that all three stocks are undervalued at current prices. I recommend FSAM over the other two stocks, though, since I would rather earn fees than pay them. I, in other words, would rather be the blood-sucking vampire than the person being drained of blood.

    The fees collected by Fifth Street Asset Management should grow steadily over the foreseeable future. The great thing about this investment idea is that FSAM’s investment firms are primarily solid business development companies (BDCs) with growing assets and permanent capital. Over 90% of FSAM’s fee earning assets reside in permanent capital vehicles. “Permanent” capital means that Fifth Street’s funds do not have redemption provisions or requirements to return capital when investments are closed. Investor equity is locked in as these funds (unlike mutual funds, for example) are not subject to withdrawals. Fifth Street has increased its asset base from less than $1.1 billion in 2010 to $6.0 billion today (58.2% CAGR). FSAM’s fee-earning assets under management (AUM) are $4.8 billion. The firm intends to distribute 80-90% of its after-tax earnings as dividends. There is concentration risk as approximately 90% of Fifth Street’s assets are held in Fifth Street Finance. Here is the summary of the investment vehicles:

    PERMANENT CAPITAL

    Fifth Street Finance (FSC)

    BDC, created in 2008, 11.6% annual gross IRR, $4.9 bil. assets under management (AUM), $4.1 bil. fee-earning AUM

    Fifth Street Senior Floating Rate (FSFR)

    BDC, created in 2013, 9.8% annual gross IRR, $532 mil. AUM, $323 fee-earning AUM

    INSTITUTIONAL PRODUCTS

    Fifth Street Credit Opportunity Fund

    Hedge fund, founded in 2013, 20.0% annual IRR, $57.2 mil. AUM, $35.7 mil. fee-earning AUM

    Credit Funds

    Launched in 2014, AUM of $520 mil., $332 mil. fee-earning AUM

    Structured Equity

    $4.8 mil. AUM, $4.5 mil. fee-earning AUM

    Fifth Street intends to launch separately managed accounts next year. It plans to convert some funds to collateralized loan obligations (CLOs). Fifth Street could, someday, branch out into areas such as mutual funds or ETFs. Fifth Street Asset Management is organized as an investor-friendly C-Corp.

    What We Really Care About: The Fees!!

    Fifth Street Asset Management generates nearly all of its revenue from base management fees and Part I incentive fees from its publicly-traded funds. FSAM also earns Part II incentive fees and other fees. Part I fees are viewed by the business development company industry as stable and recurring. It is for this reason that FSAM (somewhat confusingly) classifies both the Part I and base management fees as management fees. The base management fee for Fifth Street Finance is a 2.0% annual fee on gross assets. Fifth Street Sr. Floating Rate has a lower base management fee of 1.0% / year. The Part I performance fees are paid to FSAM based on a fixed percentage of pre-incentive fee net investment income. The Part I fees are based pre-determined hurdles of 2% / qtr. for FSC and 1.5% / qtr. for FSFR. FSAM earns incentive income once the hurdle rates are exceeded. Part I incentive fees are not subject to clawback. FSC has generated Part I fees in every quarter since its inception in 2008. FSAM’s total management fee revenue grew at a 40.2% CAGR from 2010-13. FSAM’s effective annualized management fee rate was 2.10% for the first nine months of 2014.

    There are multiple sources for fees to Fifth Street Asset Management apart from the management fees. The firm’s BDCs, FSC and FSFR, are subject to Part II incentive fees equal to 20% of capital gains (paid annually). These fees have been modest, but could increase. More important, perhaps, are the performance fees that FSAM generates from its relatively small institutional funds. These fees should grow rapidly in future years as these institutional funds increase their AUM. Fifth Street’s hedge fund, for example, is subject to the typical 20% performance fee above its high water mark. FSAM, finally, receives reimbursements for administrative expenses and some managerial costs. Overall, Part I and base management fees represented approximately 94% of FSAM’s revenue in the first nine months of 2014 (about 60% base / 40% Part I).

    Fifth Street Asset Management’s earnings are based on recurring and consistent fees. It is true that Part I fees vary based on performance. Fifth Street is a lender and loans can default. Poor performance, though, would not shrink the equity capital. The potential downside is, therefore, very limited while the potential upside is strong.

    Business Development Companies (BDCs)

    Fifth Street Asset Management’s main assets are its BDCs. These firms are in the business of originating senior loans to small- and mid-sized ($25-$500 mil. revenues) private businesses. Fifth Street targets a maximum loan size of $250 mil. ($500 mil. if part of a syndicate). Fifth Street claims to have relationships with 20 commercial banks and more than 300 private equity sponsors. This year has not been a good one for BDCs. Portfolio yields have fallen as competition has increased. Investors are concerned that BDCs might have difficulty attracting new capital. Approximately two-thirds of FSAM’s assets are provided by retail investors. Still, the commercial lenders have de-levered since the financial crisis and largely pulled back from the market. Also, the growth of the private equity market has increased the number of firms looking to borrow money. There is an excellent opportunity for non-bank lenders to meet the demand.

    The recent drop in oil prices has affected the BDC market. Many oil and gas companies are laden with debt. The fall in oil prices has put these companies at risk and caused sudden panic in the high-yield credit market. This issue has negatively affected BDCs and other high-yield lenders. Someday, of course, oil prices will rise again and the market will stabilize. In the meantime, Fifth Street’s management has repeatedly stated that its BDCs have minimal exposure to oil companies.

    Fifth Street’s BDCs: FSC and FSFR

    Fifth Street Finance (FSC) specializes in mezzanine lending to private firms. Nearly all of its deals originate from private equity sponsors. The firm completed a $300 mil. IPO in 2008. FSC now has approximately $4.9 bil. AUM. Fifth Street Asset Management generates management fees on approximately $4.1 bil., but generates Part I fees on the full amount. More than 80% of FSC’s loans are senior secured and most (approx. ¾) are first lien loans. The expected average life of a loan is three to four years. FSC has a well-diversified loan portfolio of more than 125 loans in nearly 40 industries. Some of its largest areas of lending include healthcare (15.0% of loans at 9/30/14), education (9.4%), advertising (6.6%), and internet services (6.3%). Nearly all of its borrowers are based in North America. Its lending standards are high and non-accruals are very low. There was only one loan on which FSC had stopped accruing cash interest as of 9/30/14. FSC is approximately the sixth-largest public BDC in terms of market cap. It has reported an above average gross IRR of 11.6% since 2008.

    Fifth Street Sr. Floating Rate Co. (FSFR) completed a $100 mil. IPO in 2013. It now has a market cap of more than $400 million. Its portfolio consists of 42 investments. As its name suggests, 100% of FSFR’s loans are senior floating-rate loans to mid-sized companies. FSFR’s average loan size of $5 mil. is about one-fifth the size of a typical FSC loan. Due to its limited history, Fifth Street’s management set a low management fee for FSFR to attract capital. FSFR has generated gross IRR of 9.8%. Its stock price has plummeted from a high of $15.10 in March to about $10 today. Fifth Street execs recently bought a significant amount of FSFR on the open market.

    Fifth Street’s BDCs are trading below their book values. They can and will raise capital when its BDCs are trading above their NAVs. Fifth Street Finance has completed more than 18 equity and debt deals since its IPO. At the present time, however, capital raises would dilute existing shareholders. It is for this reason that BDCs require shareholder approval to raise equity when their stock prices falls below their NAVs. Fifth Street Finance’s management said on its Q4 conference call that it would not ask for shareholder approval for an equity raise. I doubt that the fund could get this approval anyway. Since it is currently difficult for Fifth Street’s BDCs to raise capital, investors are concerned that the firm will not meet its asset targets. The BDCs can, however, lever up to increase their capacity. FSFR, especially, has room to take on more debt. FSC and FSFR have also set up joint ventures to help with this situation.

    The Joint Ventures

    Fifth Street’s BDCs have set up joint ventures (or “sidecars”) that will be accretive to their ROEs. The sidecars increase the capacity for the BDCs, allowing for additional leverage and Part I performance fees. Fifth Street Finance has a joint venture with a subsidiary of Kemper to invest in middle market and other corporate debt. The total investment in this fund is currently $200 million (87.5% FSC / 12.5% Kemper). The joint venture increases FSC’s debt-to-equity ratio and increases Part I fees. Fifth Street Sr. Floating Rate Co. has a similar joint venture with the Glick family. The initial investment in this deal is $100 mil. and has the same basic structure as the FSC / Kemper deal. These deals can be levered at greater than 1:1. The FSC deal should allow for about $600 mil. in loans. The FSFR deal should produce $300-$400 mil. in loans. The size of the sidecar deals will probably be increased. Both Kemper and the Glick family have invested with Fifth Street many times in the past. The two joint ventures will increase FSAM’s fee-earning assets under management. Over time, they should also help to increase the dividends of the BDCs so that their stock prices can increase above book value.

    Co-Investment

    Fifth Street recently received permission from the SEC to engage in co-investment deals. This means that multiple Fifth Street funds can invest in the same offering. There are several benefits to this type of deal. The main benefit is that Fifth Street can get involved in larger size financing deals. It can participate in deals which might otherwise be impossible. Also, Fifth Street Asset Management may receive additional fees from these deals. Fifth Street announced a $110 mil. co-investment deal on December 11, 2014.

    Interest Rates

    Fifth Street’s loan portfolio benefits from rising interest rates. According to Fifth Street Asset Management’s prospectus, a rising interest rate environment, “…would driver higher incentive fees to us, given the structure of our management agreements, which include fixed level performance benchmarks and do not include total return hurdles.” Approximately three-quarters of Fifth Street’s loans are floating-rate loans. Rising interest rates, therefore, increase spread income. It is true that interest rate floors mean that initial interest rate increases (up to 100bps) will hurt performance. If interest rates rise by more than 200bps, however, spread income increases greatly. The company, for example, estimates that a 400bps increase in interest rates would increase annual net spread income by more than 30% for FSC and more than 40% for FSFR. It is, obviously, impossible to predict when or if interest rates might increase enough to affect FSAM’s earnings.

    Proposed New Law

    A bill in Congress would allow BDCs to increase their leverage. Business development companies are currently restricted to 1:1 leverage. A proposed new law called the Small Business Credit Availability Act (H.R. 1800) would raise the limit to 2:1. The bill was passed by the U.S. House Financial Services Committee in late-2013 but has not come up for a House vote. Passage of the law would expand the lending capacity of Fifth Street’s BDCs and, therefore, FSAM’s fees. Despite this potential benefit, Fifth Street and some other firms oppose the bill. They are concerned that lending standards will fall and that the added risk will hurt the industry. Fifth Street Finance’s CFO, Alex Frank, told Reuters that, “The BDC structure is a way for retail investors to access the asset class, while enjoying the safety of the 1:1 model. All it will take is one blow up to result in the retail bid bowing out.” In a separate article, FSAM’s Chief Investment Officer, Ivelin Dimitrov, said that, “It would be inappropriate, in our view, to lever a mezzanine-focused BDC at more than 1:1.” Still, it appears to me that passage of the law could be a huge benefit for FSAM. I do not believe that the sell-side analysts have even mentioned the possibility.

    Non-BDC Businesses

    Fifth Street is diversifying into some non-BDC investment opportunities. These businesses are currently small, but are expected to grow rapidly over the next few years. The company expects to launch separately managed accounts in 2015. Fifth Street currently manages a hedge fund called Fifth Street Credit Opportunities Fund. This small hedge fund has $60 million in assets. This long / short fund invests in credit-related instruments. FSAM earns a quarterly management fee of 0.75% to 1.5% (annual) from the limited partners. Fifth Street also manages a Senior Loan Fund which it expects to convert to collateralized loan obligations. FSAM earns management fees based on the principal balance on these funds. One of the major areas of focus for Fifth Street’s new funds is aircraft leasing. The aircraft leasing business has been expanding rapidly since the recession. Fifth Street manages approximately $600 mil. in these non-BDC funds and expects to increase its AUM in these funds to more than $10 bil. by the end of 2017. The asset base of these types of funds is not as permanent as it is for Fifth Street’s BDCs.

    The Busted IPO

    Fifth Street Asset Management’s IPO was a big flop. The company originally intended to sell 8 million shares in a price range of $24-$26. The lead underwriters were Morgan Stanley, J.P. Morgan, Goldman Sachs, RBC, and Credit Suisse. The proposed IPO proved to be unpopular. On October 22, 2014, FSAM announced that it was pulling the deal. Fifth Street used the usual “market conditions” excuse, but a likely problem was that the underwriters planned to price the offering below the expected range. Fifth Street’s management was not at all happy about this possibility. The firm, according to an article on The Street, wanted Morgan Stanley to allocate more stock to retail investors. Morgan Stanley, though, did not want to burn its clients. One week later, however, Fifth Street reversed course and completed a downsized IPO for FSAM of 6 million shares at $17. The reduced price did not help. The stock price opened below $17 and has not recovered.

    Fifth Street Asset Management’s IPO was unpopular for several reasons. IPOs of similar companies did not fare well in 2014. Medley Management (MDLY), most notably, completed an IPO in September, 2014. It has been a real dog. The IPO was priced below its expected range and continues to trade poorly. Ares Management (IPO in May, 2014) also trades below its IPO price despite reducing the size of its deal. There were also some company-specific reasons that encouraged people to avoid the FSAM IPO. There is concern that FSAM’s BDCs will not be able to raise funds. Also, all of the IPO proceeds went to Tannenbaum and other insiders, not the company. Tannenbaum, moreover, maintains nearly total control of the company through super-voting Class B stock. He controls approximately 91% of the voting power. Investors, of course, often dislike dual class structures. Some of them also really dislike Len Tannenbaum.

    Oh, Tannenbaum!

    I’m an entrepreneur. I started my company with one person in a basement in Mt. Kisco, New York. I had to lease out the other side of the basement…” – Tannenbaum, neglecting to mention that he married into wealth, 9/24/12

    Len Tannenbaum, age 43, is not the most beloved CEO on Wall Street. I include this section because I believe that some part of FSAM’s undervaluation is due to investors’ feelings about him. You will find plenty of complaints about Tannenbaum among professional investors and the Motley Fool / SeekingAlpha crowd. FSAM is a recent IPO, but Fifth Street Finance (FSC) has been publicly-traded since 2008. Tannenbaum, as previously mentioned, serves as the CEO of both FSC and FSAM. He also served as the CEO of Fifth Street Sr. Floating Rate Co. (FSFR) until a few months ago. The stock prices of both FSC and FSFR have been poor performers. FSFR came public in 2013 and has never traded above its IPO price. FSC’s stock price has dropped by approximately 40% over the past four years. Both FSC and FSFR trade below their book values and have double digit dividend yields. Stockholders in these firms have not done very well. Tannenbaum, though, has done just fine.

    Tannenbaum has been accused of enriching himself at the expense of shareholders. There is a possible conflict of interest here. Tannenbaum’s ownership interests in Fifth Street’s funds are small in relation to his equity interest in Fifth Street Asset Management. It is probably no coincidence, therefore, that there have been instances in which FSC and FSFR have completed capital raises to the possible detriment of shareholders. Fifth Street Finance has completed approximately 14 equity raises since its IPO. It has not raised equity when trading below its NAV since 2009. FSFR, though, completed a large secondary offering in August, 2014, at a price that was far below its NAV and 2013 IPO price. A Motley Fool writer bluntly stated that, “Leonard Tannenbaum made himself richer by choosing to make shareholders poorer.” In another article, this same writer argued (logically) that the Fifth Street funds should buy back their own stocks when trading below NAVs. He also suggested (logically) that Tannenbaum resists repurchases because they would cut into management fees. Some people might say that Tannenbaum approaches the line of unethical behavior. One former family member accused him of crossing it.

    Tannenbaum was unsuccessfully sued for fraud by his former father-in-law, Bruce Toll. Toll, the co-founder of the Toll Brothers homebuilding business, operates businesses in several industries. Tannenbaum married one of Toll’s daughters, Elizabeth, in 1997. The marriage was, uh, very convenient for Merrill Lynch analyst Len Tannenbaum. He launched his first fund with $34 mil. AUM in 1998. Toll provided about ½ of the funding and took 90% of the profits. After that fund proved to be successful, Toll helped Tannenbaum to launch other funds and also guaranteed tens of millions of dollars in loans. Toll was a vocal supporter of Tannenbaum and served on Fifth Street Finance’s board. He later admitted in court filings, however, that his relationship with Tannenbaum started falling apart as early as 2006. Fifth Street ran into some serious cash flow problems at about that same time.

    Toll bailed out one of Fifth Street’s troubled funds in 2007. Tannenbaum approached Toll in late-2006 and told him that one of his funds was nearing collapse. Toll responded with a bridge loan and a personal guarantee on $15 mil. in loans from Wachovia. Toll guaranteed another loan of $12 mil. two years later. Toll did not receive his usual equity compensation for these loans. Shortly after the 2009 loan was made, Tannenbaum separated from Elizabeth and began divorce proceedings. In an interesting coincidence, Tannenbaum’s current wife was promoted to Fifth Street’s VP of Investor Relations at around the same time. Elizabeth disclaimed any interest in Fifth Street in the 2010 divorce settlement. Bruce Toll, as you might imagine, was less than thrilled by this turn of events.

    Toll filed a fraud lawsuit against Tannenbaum in 2011. Toll claimed that the terms of the 2007 and 2009 loans required that 50% of the fund’s profits would go to Elizabeth. Toll, evidently, knew that the marriage was in trouble before it ended. He also wanted a fee for himself. Toll, though, had nothing in writing and claimed only an oral agreement. Tannenbaum claimed that no unwritten agreement existed and refused to pay. Toll lost the case as a judge dismissed it in 2013. My view on the situation is that Toll probably had legitimate reasons to be angry with Tannenbaum. I do not, however, see any evidence of fraud. Toll is, ultimately, responsible for failing to get everything in writing.

    Tannenbaum craves money and attention. His position at Fifth Street has brought plenty of both. He lives in a $10 mil. mansion in Greenwich and pays himself very well. Aside from his generous compensation, Tannenbaum has engaged in a few self-dealing transactions. Notably, he used Fifth Street to guarantee the $26 mil. mortgage on Fifth Street’s headquarters and now collects $2 mil. / year in rent from the company. Tannenbaum also uses his status to promote his conservative political views. He supports Republican politicians and runs his own PAC. He also uses his frequent media appearances to express self-serving opinions about taxes, laws, etc. Tannenbaum is one those people who thinks that the government just gets in the way of the self-reliant entrepreneurs who do everything. Fifth Street, nonetheless, recently accepted a $5 milion incentive package from the State of Connecticut. Also, Tannenbaum seems to have forgotten that it was only a few years ago that he had to be bailed out by his wealthy father-in-law. Anyway, investors should know that Tannenbaum has an agenda. This agenda is not necessarily bad for FSAM investors.

    Tannenbaum’s interests are aligned with those of Fifth Street Asset Management’s shareholders. While Tannenbaum’s treatment of FSC and FSFR shareholders may be questioned, FSAM shareholders should not be too concerned. Tannenbaum is incentivized to increase FSAM’s management fees and dividends. It is true that Fifth Street Asset Management will not win any awards for great corporate governance. Tannenbaum holds super-voting FSAM stock and the IPO raised no money for the company. The good news, though, is that he has rapidly increased the AUM at the BDCs and should continue to do so. One notable fact about Tannenbaum is that he is a good buddy of David Einhorn of Greenlight Capital. Tannenbaum has served on the boards of several Greenlight-affiliated firms. Einhorn, as you may recall, wrote a book about his long battle against a lousy BDC called Allied Capital. He has encouraged Tannenbaum to manage his BDCs in a transparent way. The Fifth Street BDCs are more transparent than many others.

    Comps

    Fifth Street Asset Management trades at a significant discount to other asset managers. The forward P/Es of traditional asset managers (such as BLK, TROW, BEN) are in the range of 15x-20x. The forward P/Es of smaller and alternative asset managers are in the 8x-13x range. FSAM’s forward P/E of less than 10x is lower than that of many comps. Two good comps for FSAM on opposite ends of the valuation spectrum are NorthStar Asset Management (NSAM) and Medley Management (MDLY). NSAM trades at a P/E of 28x on 2015 earnings. MDLY trades at a 10x P/E on 2015 earnings. FSAM should probably be somewhere in the middle of those two. It has a faster growth rate, higher dividend yield, and less volatile earnings stream than most alternative asset managers.

    Sell-Side Reports

    The analyst reports on Fifth Street Asset Management have hurt the stock price. The investment banks issued their initiation reports on FSAM on November 24, 2014. These reports had no discernable impact on FSAM’s stock price. Five of the six analysts listed FSAM as a Buy / Outperform, but they were not exactly overwhelmingly bullish. Goldman Sachs initiated FSAM at Neutral. The analysts’ original 12-month price targets ranged from $17 - $20. Just three weeks later, however, several analysts cut their estimates and price targets. Credit Suisse cut its price target from $18 to $17. J.P. Morgan cuts its price target all the way from $20 to $14. The current average price target is $17. The catalyst for the target reductions was the Q3 conference call. While the quarter met expectations, Fifth Street’s management indicated that the BDCs may not be able to raise equity next year. I do not know why this news was any big surprise. It seems, at any rate, that the analysts do not want to recommend FSAM until there is more clarity.

    September Quarter

    Fifth Street Asset Management reported its first quarter as a public company on December 15, 2014. It held a conference call the next day. Its adjusted net income per share of $0.24 exceeded the consensus estimates by two cents per share. On the conference call, FSAM’s management highlighted its joint ventures and ability to add debt at the BDCs. There was also a lot of discussion about the new investment vehicles. Fifth Street’s hedge fund and other institutional entities are growing as expected. Fifth Street intends to open an office in Tokyo in 2015 to serve the Japanese market. FSAM will announce a $0.30 / share dividend in January. It appears that FSAM will report adjusted EPS of approximately $1.30 and pay $1.20 / share in dividends in 2015. On the downside, FSAM’s management is assuming that FSC and FSFR continue to trade below their NAVs and that they will not be able to raise equity capital in 2015. The original AUM targets were probably too high. Overall, though, FSAM’s management remains positive about the short- and long-term outlook for the firm.

    Financials

    Fifth Street Asset Management’s earnings and dividends are ultimately dependent on its AUM, fee rates, and expenses. It’s all rather simple. FSAM’s investment vehicles grow their assets and pay fees. FSAM collects the fees, covers its costs, and pays out its remaining income as dividends to shareholders. This is a high margin business. Compensation expenses account for approximately ¾ of the total expenses. Here are the summary historical financials from the filings:

     

     

    Full year

    Full year

    Nine months

    (in $mil.)

     

    2012

    2013

    2014

    REVENUES:

     

     

     

     

    Management fees

     

    $50.0

    $68.4

    $68.1

    Base management

     

    26.6

    37.8

    40.1

    Part I

     

    23.4

    30.6

    28.0

    Other fees

     

    4.6

    5.2

    4.4

    Total revenues

     

    $54.6

    $73.6

    $72.5

    EXPENSES:

     

     

     

     

    Total expenses

     

    $22.6

    $33.9

    $35.3

    Operating income

     

    $32.1

    $39.8

    $37.2

    Adjusted net income

     

    $32.2

    $47.2

    $33.3

    ANI per share (pro forma)

     

     

     

    $0.67



    Fifth Street Asset Management intends to pay its earnings to investors as dividends. The relevant earnings metric is Adjusted Net Income (ANI). The consensus estimates for ANI are $0.91 for 2014, $1.35 for 2015, and $2.00 for 2016. FSAM will pay a dividend of $0.30 in the 1st quarter of 2015 (based on the Q4 2014 earnings). FSAM should pay dividends of approximately $1.20 in 2015 and $1.65 - $1.85 in 2016. At $12.80, therefore, FSAM trades at 2015 P/E of about 9.8x and a 2015 dividend yield of 9.4%. FSAM’s dividends are qualified dividends.

    The growth in Fifth Street Asset Management’s earnings is largely dependent on the growth in AUM for its BDCs and other investment vehicles. FSAM’s yield on its BDCs (revenues / AUM) is approximately 3.2%. Every $1 billion raised by Fifth Street’s BDCs translates into roughly $0.25 in additional EPS for FSAM. The firm is focused on raising capital in both its BDCs and its newer investment vehicles. While the future growth of FSAM’s AUM is obviously unknown, the management and sell-side analysts have made projections. Rough estimates for year-end AUM are $6.5 billion, $10.5 billion, and $15.0 billion for 2014, 2015, and 2016, respectively.

    Fifth Street Asset Management does not have a lot of expenses. Compensation expenses were 28% of revenues in Q3 2014. Most of its other expenses are G&A. The Q3 operating margin was a low 54.6%, but this was impacted by several extraordinary expenses. FSAM should achieve some economies of scale as the business grows. The operating margin should improve to the high-60%s over time. I have assumed operating margins in the low-60%s for the next couple of years.

    This is my basic earnings model. Just to be safe, I am using numbers that are lower than the Street estimates. I believe that there is upside to these numbers. I also believe that the stock is undervalued even if these estimates are not achieved.

     

     

     

     

    in ($1000s)

     

     

     

     

    2014

    2015

    2016

    Revenues

     

     

     

    Mgmt. Fees

    $58

    $92

    $135

    Part I Fees

    38

    51

    70

    Other Fees

    7

    26

    50

    Total Revenues

    $103

    $169

    $255

    Expenses

     

     

     

    Compensation

    $31

    $49

    $71

    Other Expenses

    14

    15

    20

    Total Expenses

    45

    64

    91

    Operating Income

    58

    105

    164

    Taxes

    20

    42

    65

    Net income

    $38

    $63

    $98

     

     

     

     

    Adjustments

     

     

     

    Compensation charges

    $7

    $2

    $2

    FSC underwriting cost

    0.8

    0

    0

    Lease termination

    0.6

    0

    0

    IPO fees

    0.9

    0

    0

    Total Adjustments

    $9.3

    $2.0

    $2.0

     

     

     

     

    Adjusted net income (ANI)

    $47.2

    $65.0

    $100.2

    Shares outstanding

    50

    50

    50

    ANI per share

    $0.94

    $1.30

    $2.00

    Dividends per share

     

    $1.20

    $1.75

    Average AUM

    $5,500

    $9,500

    $13,000



    Valuation

    I believe that Fifth Street Asset Management is undervalued. FSAM has strong growth, a high dividend yield, and collects fees on permanent capital. Recall that FSAM pays qualified dividends which are taxed at lower rates than ordinary dividends. FSAM has 50 mil. shares outstanding, so the market cap is approximately $640 million. FSAM reported $72.5 mil. in revenues and $33.3 mil. in pro forma adjusted net income for the first nine months of 2014. I am using $1.30 in adjusted EPS for 2015. Looking at the valuation of comps and considering FSAM’s permanent asset based, I have decided to use a P/E of 14x on 2015 earnings to value the stock. I believe that this is a conservative valuation. So, using this P/E and projected 2015 earnings, my 12-month price target is $18.20. Since FSAM is also expected to pay $1.20 in dividends in 2015, my implied one-year return is approximately 55%. Note that at $18.20, FSAM would still only be trading at only 9x projected 2016 EPS.

    The Bottom Line

    This opportunity exists because:

    I recommend it because:

    I believe that FSAM’s risks are well-known and more than reflected in the current stock price. The risk / reward at this price is very favorable.



    Legal Disclaimer:

    This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein.



     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    dividend announcements, equity raises, growth of new funds

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