|Shares Out. (in M):||0||P/E|
|Market Cap (in $M):||126||P/FCF|
|Net Debt (in $M):||0||EBIT||0||0|
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At $5.59, FSC currently trades at 42% of NAV and yields over 22%. Unlike many BDC’s, FSC only recently went public, and most of FSC’s investments were made after the credit markets tightened and were made with reasonable leverage multiples and substantial equity support. With no debt currently outstanding, approximately $20m in cash, and revolver availability of $50m, FSC has the ability to continue to invest at favorable terms at a time when there is very little competition for deals. Worst case, additional capital will not be available at reasonable terms and FSC may miss some opportunities to grow its portfolio (BDC’s can legally use up to 2:1 leverage). While this might reduce management and incentive fees earned by the investment advisor, shareholders of FSC shouldn’t really care about this – in fact, risk is reduced by the firm not being fully leveraged. While it might seem that management could be incentivized to raise capital that is more costly, or potentially dilutive, in order to maximize assets (and thus fees earned), the management team and board own a large amount of stock, and for these reasons their interests are much more aligned with those of shareholders than they would otherwise be. Management has been buying stock at much higher levels as recently as September 9, when the CEO bought at $10.50 and higher. He has purchased 158k shares since the June 2008 IPO.
FSC is a business development company (BDC) which specializes in providing financing for small private equity deals. Specifically, the company originates first or second lien senior secured loans, typically in $10-12m increments. Because FSC lends to smaller companies and the paper is typically behind bank debt, FSC earns an average yield of approximately 16.5% on its investments, over 90% of which is fixed rate and approximately 13.5% is cash (the other 3% or so is PIK). It is expensive capital, and with FSC’s portfolio-wide leverage multiple around 4x at June 30 (and only 3.7x if $20m of underperforming, but still performing, loans are isolated), in addition to strong covenants and collateral packages, these seem to be reasonably attractive pieces of paper. As of September 30, FSC had made approximately $297m of investments across 24 companies. Notably, FSC recently released its September 2008 investor letter, in which the company disclosed that it still has no non-performing loans in the portfolio.
Margin of Safety
Upside here is obvious if all goes well. The shares returning to NAV sometime in the next few years would result in a 136% gain, and that’s before the annual yield of 22%, assuming no change in NAV or the dividend.
The way we are evaluating this investment, particularly given the many other highly attractive investment opportunities present in the current market, is to try and determine how we can go wrong. Given the terrific lending environment (from the perspective of any lender with cash), in which FSC is now occasionally even taking the place of the traditional bank lender in the capital structure but still commanding mezzanine-like terms, it seems a stretch to assume any substantial losses from loans originated from this point forward. Also, since total cash plus availability currently stands somewhere around $70m, and existing investments around $283m, FSC may have already deployed 80% of its currently available capital. On this basis, the stock’s current trading price of $5.59 implies that the invested portfolio is worth approximately 37.5% of its 6/30/08 fair value (with the September quarter’s investments marked at cost). So we would have to assume about a 75% default rate and only a 17% recovery rate on this hypothetically defaulted paper, or some similarly dire scenario (with an absolute minimum default rate of 62.5%). Seeing as Fifth Street has experienced management, strong lending discipline oriented toward capital preservation, and an established track record, with no incomplete recoveries since it began managing funds in 1998, this seems beyond the realm of possibility, no matter how bad things get. Now let’s assume that every single one of these 24 portfolio companies ends up in default. As of 9/30/08, 38% of invested capital was first lien, 59% was second lien and 3% was equity. So we have about $297m invested (at cost) in total, of which $113m might be first lien, $175m might be second lien and $9m equity. Assuming equity is wiped out, second lien paper recovers 20% and first lien paper recovers 60%, we are still looking at an implied liquidation value of 113*60% + 175*20% + 20 (cash) = $123m, or $5.43 per share (a 3% discount to Friday’s close). This hardly seems possible, but it does show that in a truly draconian scenario, it will still be difficult to lose money buying FSC shares anywhere near current prices.
Stock Performance Discussion
FSC went public in June 2008 at $14.12, with the offering lead-managed by Goldman, UBS and Wachovia. Essentially, the manager’s third mezzanine fund, Fifth Street Fund III, was converted to a BDC format in the spring and subsequently taken public, raising $129m in net proceeds. The stock has since dropped like a rock (it was one of 20 IPO’s to price in Q2, compared to 25 which were pulled), despite 6.4% holder Greenlight Capital buying another 3.1% of the company in the open market on its first day of trading in the $12+ range. Since the IPO, FSC has traded in line with more troubled BDC’s which were very active lending during 2006 and early 2007, before the credit market began to correct. Now, FSC actually trades below all but the most troubled BDC’s. It is a broken IPO, exacerbated by a severe bear market.
I estimate that FSC has approximately $20m in cash as of 9/30/2008, as well as $50m availability under a revolver with BMO priced at L+150 and maturing in January 2009. According to the company (as recently as Friday 10/10/08), there is no question whether or not the $50m revolver will be renewed, and the only question is whether FSC will be able to secure additional financing beyond the $50m level. Originally, the plan had been to replace the $50m revolver after the IPO with a $250m facility at L+250, but this is clearly out of the question in today’s environment. With $70m of availability at 9/30, and originations running in the $25-75m range on a quarterly basis (and at the high end in this favorable environment), FSC could be out of dry powder by early 2009. Stock cannot be issued below NAV without shareholder approval, so there is no concern of a dilutive equity financing. However, Bruce Toll (of Toll Brothers) is on the board and has been willing to lend FSC money before (he loaned FSC $15m before the IPO in the form of a 2.5 year preferred yielding 8%). He is the CEO’s father-in-law and has been outspoken in his confidence in Tannenbaum. I also imagine capital might be available from Greenlight Capital or other strategic investors who recognize the favorable environment. However, NAV should not be impacted negatively should capital be unavailable. Dividend growth could be negatively impacted if FSC can’t lever beyond the 1.17:1.00 level implied by using the whole $50m revolver, however this is not our biggest concern.
Earnings & Dividends
In the spirit of brevity, FSC is the fund, not the investment adviser. FSC earns investment income (and some small fees) from its portfolio companies, and it pays a 2% management fee and 20% incentive fee (after clearing an 8% hurdle rate) to its investment adviser. There is also about $1m a quarter of G&A at the FSC level, as well as interest expense on the revolver (if drawn). That’s about it for net operating income. Realized and unrealized gains/losses on investments are the other components, leading to net income. As a RIC, FSC avoids federal taxes at the corporate level, as long as it pays out its income in the form of dividends.
Main drivers to net income and free cash flow are the cash interest rate assumed on the portfolio (13.5-14.0%), the PIK rate (2.5-3.0%), the original issue discount (about 0.6% annually), assets under management (which drives the management and incentive fees), average leverage used, cost of debt (currently L+150), G&A, and of course any defaults. Of course dividends are likely to grow as the portfolio becomes more invested. On a fully-invested (but unlevered) basis, at least a 10% net return on NAV seems achievable, which would imply a quarterly dividend of approximately 33c a share on current NAV (vs. 31c just paid in September). Tannenbaum recently said in an interview aired on Bloomberg in September that he intended to raise FSC’s dividend every quarter. I am not assuming any increase when I calculate FSC’s yield.
We have discussed the margin of safety in this investment. Beyond this, we can briefly touch on relative valuation. On a relative basis, FSC also appears attractive. Excluding some particularly troubled BDC’s with issues ranging from fraud to management turnover to excess leverage to unfavorable exposures to CLO’s and or/ bad loans made between late 2005 and early 2007, such as ALD, GNV, KCAP, MCGC, PCAP and TICC, the rest of the group seems to trade around 64% of NAV and yields approximately 17%. This would imply 51% and 30% upside, respectively, for FSC shares from Friday’s close. However, FSC may be the best-positioned BDC on the market, given that the vast majority of its assets were deployed after valuations began to rationalize. FSC’s predecessor fund was launched in February 2007 and invested just $50m in the first half of 2007, since which the small market lending environment seems to have become much more rational.
Management & Board Incentives
Management is solid. The CFO is very accessible to shareholders, and I recommend speaking to him with any questions about the business, valuation principles or the underlying portfolio (which I am not going to evaluate in detail, but which can be researched to some extent despite being largely comprised of small private companies with no public histories). Len Tannenbaum, the CEO, has some very significant votes of confidence, not the least of which comes from Greenlight Capital. Tannenbaum has served on the board of BAGL (controlled by Greenlight), and David Einhorn was on the board of Fifth Street’s predecessor fund. What is most interesting, perhaps, is that Einhorn has clearly taken certain elements of the BDC sector to task (ALD). It is my understanding that Tannenbaum and the major holders (Greenlight, Genworth, Bruce Toll) wanted to position FSC as the model BDC in terms of valuation integrity, disclosure and the pursuit of real shareholder value... the “anti-Allied.” I don’t want to overstate my confidence in management, as this is a newly public company and much remains to be proven, but I believe management is conservative, experienced and has a fair amount to lose, which seems like a good combination for those in charge of lending our capital.
Most importantly, management and board members own over 13% of the company, with significant insider buying by the CEO and others quite recently. I expect that if the stock remains anywhere near this range following the opening of the insider window (after reporting earnings), we will see additional insider buying. Insider ownership is particularly important in an industry where firms are incentivized to lever up in order to increase the asset base on which fees are earned, sometimes forgoing underwriting diligence in the process. Aggressive leverage can eventually expose shareholders to liquidity risk in the event that NAV becomes impaired, causing a BDC to inadvertently trip the 2:1 leverage limit, and potentially requiring shareholders to approve dilutive equity raises (or participate in rights offerings).
The upcoming earnings report, and/or the resumption of insider buying when the window opens could each help… but being paid 22% to wait certainly mitigates the need for a firm “catalyst”.
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