Analysts grill Fifth Street management over legal issues

Class-action lawsuits and shareholder criticism dominated the third-quarter earnings call as Fifth Street Finance Corp’s investment advisor faced fresh criticism over rising legal costs and falling earnings at the underperforming BDC.  

The management of Fifth Street Finance Corp (FSC) faced renewed questions over class action lawsuits and shareholder demands for strategic changes at the $2.6 billion business development company (BDC), yesterday.

The BDC, whose investments are managed by an affiliate of Fifth Street Asset Management (FSAM), has been criticised for poor performance while enriching the external manager. It is also facing legal costs from a class action lawsuit, while RiverNorth Capital Management, an activist shareholder, has demanded strategic changes, including a new investment advisor and board members.

Fifth Street management has continued to say the lawsuits were filed without merit and that RiverNorth’s letter was “inflammatory and misleading”.

Speaking on the BDC’s third-quarter earnings call yesterday, Jonathan Bock, a senior analyst with Wells Fargo Securities, said: “Tell us which items you considered to be both inflammatory and misleading, because they seem to be pretty much statements of fact?”

Todd Owens, chief executive of FSC, did not directly answer the question, but said the firm continued to believe that FSAM was the right manager for the portfolio. “We have built, over 17 years, a very strong business that sources, originates and manages a portfolio of middle-market assets,” he said.

He added that the firm was open to having a conversation about the issues in the RiverNorth letter with shareholders, a point queried by Troy Ward, managing director and BDC analyst at Keefe, Bruyette & Woods: “It sounds like you’re only taking questions from analysts and not your shareholders, which I find a bit surprising, considering that three times on this call, you’ve said you’ve welcomed an open dialogue with your shareholders.”

In its prepared remarks, Fifth Street management said that it expected legal costs to rise, which would have a negative impact on earnings.

Asked whether that would result in a cut in dividends, Owens said that he was “comfortable” with the dividend level (18 cents per share, the same as FSC’s net investment income for the quarter) and being able to cover it going forward.

Wells Fargo’s Bock questioned why the legal costs should be borne by shareholders when the battle involved the external manager.

Steven Noreika, FSC’s chief financial officer, replied that costs would be borne by both the external manager and the BDC, but Fifth Street management did not know how they would be split or by how much the costs would rise.

RiverNorth’s letter raised concerns over the BDC’s significant underperformance compared with its peers, excessive compensation to the external manager and the potential harm from the legal actions.

According to the letter, FSC’s external manager was paid fees of $334.7 million between 2008 and 30 June 2015, during which time its book value declined from $13.20 per share to $9.13 per share.

Bock’s report following the earnings call suggested the manager would have to cut fees to appease investors and that while Fifth Street management said replacing the manager was not a likely outcome, such an outcome could be possible.

“To the extent RiverNorth submits a competing proxy to terminate the management contract, they simply need 50 percent of the outstanding shares voting in favor of termination,” Bock wrote.

The BDC also reported declining assets and income during the third quarter, while some portfolio companies saw markdowns, resulting in about $17.5 million in unrealised losses.

FSC has seen $134 million in realised losses since 2011, according to Bock. Assets dropped to $2.6 billion in the third quarter, a decrease of $82.6 million year-on-year. Net investment income fell to $28.2 million in the third quarter from $37.6 million a year ago.