Fifth Street faces securities violations lawsuit

Firm is alleged to have inflated value of assets at its largest BDC and delayed write-downs ahead of taking the management company public.

The management of Fifth Street Finance Corp (FSC) and its parent company inflated the assets and income of the firm’s largest BDC ahead of a flotation, a lawsuit claims.

FSC, its parent Fifth Street Asset Management (FSAM), the firm’s founder Len Tannenbaum and other company executives have been accused of securities violations in a class action suit filed in the Southern District Court of New York. 

A spokesman for Fifth Street said the firm intended to “vigorously defend” the action. “We believe that the claim was filed without merit,” he said. 

The suit was filed on behalf of shareholders who purchased FSC common stock between 7 July 2014 and 6 February this year. As of last June, FSC accounted for 90 percent of the management company’s assets and was its main revenue driver.  

“During the class period, defendants engaged in a fraudulent scheme and course of business designed to artificially inflate FSC’s asset and investment income in order to increase FSAM’s revenue,” the suit claims. “FSAM, acting as the investment manager for FSC, caused FSC to dramatically expand its investment portfolio throughout 2014.”  

The vehicle increased its total assets by 28 percent to $2.7 billion year-on-year to 30 September 2014. Management fees grew by 40 percent in the same period to $86 million. Defendants highlighted this income growth in FSAM IPO materials. 

The claim argues that the growth was fuelled by increasingly speculative investments at unsustainable leverage levels and that the firm, without the knowledge of investors, delayed writing down impairments to inflate FSAM revenues.  

“Given that FSAM’s future expected cash flows are tied directly to the long-term viability of FSC and its business, defendants sought to maintain the illusion of sustainable performance in FSC’s investment portfolio until after they could cash out in the FSAM IPO,” the filing said.  

The plaintiffs argue that Fifth Street management masked the poor credit quality of some of FSC’s underlying assets as well as delayed writedowns and losses until the asset manager had been floated. Tannenbaum and other FSAM owners cashed out “for tens of millions of dollars” via the initial public offering which raised about $100 million in gross cash proceeds, the filing claimed.  

The management company went public on 30 October 2014. When FSC reported its fourth quarter 2014 earnings on 9 February, it revealed that $106 million investments had been designated non-accrual, with an additional $17 million flagged to follow in the following quarter.  

Unrealised depreciation of investments in the same reporting period stood at $62 million, while unrealised losses stood at $13.1 million and quarterly net realised losses totalled $17.6 million.  

FSC announced it would not pay a dividend in February 2015 and later cut subsequent dividends. The next monthly dividend was paid in March and fell to $0.06 per share from $0.09 per share. The dividend has remained at that level since. 

As a result of investor concerns and negative analyst reports, both the BDC and the management company’s share prices have fallen over the past year. FSC stock was trading at about $10 last September and closed at $6.25 on Friday (9 October), about 0.7x times the value of its portfolio.  

FSAM stock has more than halved in value since going public falling from $16 per share to $7.46 on Friday. 

Law firms Kang & Kang; Morgan & Morgan; Robbins Geller Rudman & Dowd; Gainey, McKenna & Egleston; Wolf Haldenstein Adler Freeman & Herz; Rosen Law Firm; and Federman & Sherwood, among others, announced the suit last week.

Greenwich, Connecticut-based Fifth Street runs FSC and another smaller BDC, Fifth Street Floating Rate Corp as well as other debt strategies. The firm had about $5.5 billion in total assets as of the second quarter and has been seeking to grow its business through other credit products.