Aug 7, 2009
Executives
Stacey Thorne - VP, IR Len Tannenbaum - President and CEO William Craig - CFO
Analysts
Troy Ward - Stifel Nicolaus Casey Alexander - Gilford Securities Brett Miller - Dialectic Capital
Operator
Good day and welcome to the Fifth Street Finance Corporation third quarter 2009 earnings conference call. Today’s conference is being recorded.
At this time, I’d turn the conference over to Stacey Thorne. Please go ahead.
Stacey Thorne
Thank you, Audra. Good morning and welcome everyone.
My name is Stacey Thorne and I am the VP of Investor Relations. This is the conference call to discuss the results for Fifth Street Finance Corp.
for the third fiscal quarter ended June 30, 2009. I have with me this morning Len Tannenbaum, CEO and President; Bernard Berman, the Chief Compliance Officer, Executive VP and Secretary; and William Craig, the Chief Financial Officer.
Before I begin I would like to point out that this call is being recorded. Replay information is included in our press release yesterday and is posted on our website.
Please note that this call is the property of Fifth Street Finance Corp. and any unauthorized rebroadcast of this call of any form is strictly prohibited.
I would like to also call your attention to the customary Safe Harbor disclosure in our press release yesterday regarding forward-looking information. Today’s conference call includes forward-looking statements and projections and we ask that you refer to our most recent filings with the SEC for important factors that would cause actual results to differ materially from these projections.
We do not undertake to update our forward-looking statements, unless required by law. To obtain copies of our latest SEC filings, please visit our website or call Investor Relations at 914-286-6811.
The format for today’s call is as follows; Len will provide an overview; Bill will summarize the financials and then we will open up the line for Q-and-A. With that, I’ll turn it over to Len.
Len Tannenbaum
Thanks Stacey. I am pleased to report that from Fifth Street’s perspective the macroeconomic environment continues to improve.
We began to see a turnaround at the end of last quarter. As you see from the Fifth Street’s small business index that we post on our website every month, we continued to see stabilization across our portfolio.
Our Board of Directors declared a dividend of $0.25 per share for our fourth fiscal quarter consistent with the third quarter’s dividend. We continue to target the lower end of our 90% to 100% payout range.
I continue to expect that the dividend should increase by the end of the calendar depending primarily on our investment pace. In July, we had a very successful follow-on offering with raising additional $82.6 million.
We appreciate the continued support of our shareholders. Our philosophy is that the dividends should be paid out of earnings net of losses.
Obviously, visibility on higher earnings from leverage, a faster investment pace or improved performance should increase the dividend going forward. We currently have no debt and $68 million of cash in the bank as of July 31st.
We have full availability on our $50 million Bank of Montreal facility. We continued to pursue additional leverage, but we only feel comfortable taking on this additional leverage if we have a duration match with our assets.
Our average loan is repaid after approximately three years. The SBA would provide a long-term source of capital should we receive a license.
We continued to progress through the license application process. We are also working with the lending partners to develop a larger longer-term solution for additional leverage.
Another sign of positive progress in the economy is that several of our companies are finding ways to refinance this out of our loans. A significant portfolio holding is currently exploring strategic options with a reputable investment bank.
Elephant & Castle is continuing to pursue a refinancing solution for part of their debt. And as these are both second lien securities, these exits would allow us to continue our shift to financing primarily first lien securities.
We currently have 46% of the portfolio in first lien securities at fair value and expect that ratio to continue to increase. We believe that we will achieve at least a 65% first lien portfolio by the end of calendar 2010.
This environment in which many of our competitors are being forced to deleverage or evaluate the market, continues to create great lending opportunities with the best risk adjusted returns we have ever seen. We are excited to be one of the few firms that will continue to deploy capital in this environment.
Over 85% of our capital has been deployed since July 2007, when the credit dislocation began. As I indicated in the past monthly newsletter, Fifth Street has a cumulative exit fees which currently represents $6.2 million over ten of our securities.
This will add additional income over the coming years as the loans are repaid. We will be disclosing our exit fee balance going forward on a quarterly basis.
Fifth Street continues to build upon its scalable platform by hiring talented individuals. To find a list of our open positions, please visit our website.
With substantial available capital, we expect a significant increase in new originations, thereby gaining additional market share with premier middle market private equity funds. Early indications are that we will have a busy first quarter of our 2010 fiscal year that’s the September through December period.
As a 100% originator, it takes over 100 days on average to close the loan. We look forward to continuing to execute on our business plan and delivering results.
With that, let me hand it over to Bill.
William Craig
Thanks Len. With respect to our balance sheet ending June 30th, 2009 total assets were $295.6 million, which included investments of $290.7 million at fair value and cash of $1.6 million.
Liabilities were $22.9 million and stockholders’ equity was $272.7 million. While we had $18.5 million in borrowings outstanding at June 30th, we currently have no borrowings outstanding under our secured credit facility and $68 million in cash as a result of the offering.
Our weighted average yield on investments was 16.2% at June 30th, 2009 which includes a cash component of 13.4%. Our net asset value per share at June 30th, 2009 was $11.95.
I would like to review our earnings. For the quarter, total investment income was $12.8 million and total expenses were $4.9 million, resulting in net investment income of $7.9 million.
We ended with net investment income per common share of $0.35 and earnings per common share of $0.26. We continued to value all of our investments on a quarterly basis internally and at least 90% of our investments are valued by an outside third party on a quarterly basis as well.
For the three months ended June 30th, 2009 we had $1.9 million in unrealized depreciation. This is composed of $2.8 million of unrealized depreciation and evaluation and $0.9 million in unrealized appreciation due to FAS 157.
At June 30th 2009, 95% or approximately $272 million of our interest-bearing investment portfolio consists of fixed rate loans and 5% or nearly $15 million consists of floating rate loans. All of our floating rate loans carry a minimum interest rate floor of at least 9% which protects our return in a low rate environment.
With respect to the portfolio, during the three months ended June 30th, 2009 we invested $2.2 million of additional funding across two existing portfolio companies. At June 30th, 2009 our portfolio consisted of investments in 26 companies, all of which were completed in connection with an investment by a private equity sponsor and these investments at fair value consisted of 46% first lien loans, 53% second lien loans and the remaining 1% equity investments.
Two investments did not pay all of their scheduled monthly cash interest payments for the three months ended June 30th 2009. As of June 30th, 2009 we have stopped accruing pick interest in original issue discount on six investments including the two investments that had not paid all of their scheduled monthly cash interest payments.
On a percentage basis, 97.6% of the portfolio is current with respect to payments as of June 30th, 2009. With respect to our ratings in June 30th, 2009 the distribution of our debt investments on the one to five investment rating scale at fair value was as follows Investment rating one investments totaling $23 million or 7.9% of the portfolio.
Investment rating two investments totaled $228.4 million or 78.6% of the total portfolio. Investment rating three investments totaled $28.3 million or 9.7% of the total portfolio.
Investment rating four investments totaled $4.1 million or 1.4% of the total portfolio and investment rating five investments totaled $6.9 million or 2.4% of the total portfolio. The percentage of one and two rated securities for June 30th, 2009 was 86.48% versus 85.62% for the quarter ended March 31st, 2009.
We are closely monitoring all of our investments and continued to provide managerial assistance as needed to help the companies navigate through the current economic downturn. With respect to recent developments, on July 1st, 2009 we invested an incremental $300,000 in Lighting by Gregory, one of our existing portfolio companies, to purchase controlling interest in the company.
In addition, on July 29th, 2009 we invested $400,000 in Lighting by Gregory, as an addition to the Term A loan. On July 14th, 2009 we received a letter from the SBA indicating that our SBIC subsidiary's application had been accepted for processing and that our SBIC subsidiary is eligible to make pre-licensing investments.
Our SBIC subsidiary has not at this time been approved or denied approval for a license. On July 21st, 2009 we completed a public offering of 9.5 million shares of our common stock, which included the underwriters' full exercise of their over-allotment option, at a price of $9.25 per share.
The net proceeds totaled approximately $82.6 million after deducting investment banking commissions of approximately $4.4 million and offering costs of approximately $750,000. We sold our shares at a price below our then-current net asset value per share, pursuant to the authority granted by our common stockholders at a special meeting of stockholders held on June 24th, 2009.
On July 21st, 2009 we repaid in full the outstanding balance of $16.5 million on our secured revolving credit facility with Bank of Montreal. On August 3rd, 2009 we declared a $0.25 per share dividend to our common stockholders of record as of September 8, 2009.
The dividend is payable upon September 25th, 2009. On August 3rd, 2009 we cancelled our loan agreement with American Hardwoods Industries Holdings, in return for a cash payment of $144,000 and a contingent payment of $106,000, which is payable upon the future sale of the business or its assets.
The fair value of this investment was $65,000 at June 30th, 2009. With that, let me turn it back over to Stacey.
Stacey Thorne
Thanks Bill. For the month, Fifth Street did not report quarterly earnings; we released a monthly newsletter.
If you would like to be added to our mailing list and receive these communications directly, please either call me directly at 914-286-6811 or send a request e-mail to [email protected]. Alternatively, e-mail letters can be sent through the shareholder tools link under the Investor Relations tab on our website, www.fifthstreetfinance.com.
Thank you everyone for participating on the call. I will now turn it over to Audra, to open up the line for questions.
Operator
Thank you. (Operator instructions).
We will go first to Troy Ward at Stifel Nicolaus.
Troy Ward - Stifel Nicolaus
Great, thank you. Good morning.
Len Tannenbaum
Good morning.
Troy Ward - Stifel Nicolaus
Quickly on – Len, on – can you speak about your expectation for origination versus the size – related to the size of the transactions you are looking at compared to maybe what you’ve looked at historically?
Len Tannenbaum
In general, the size is going to go up somewhat, because are doing primarily first lien one-stop transactions. So while the size of the company probably is constant to slightly increasing and it will be increasing only because our private equity sponsors have grown with their fund size.
The size of transactions I think are going to be between 10 and 30 primarily.
Troy Ward - Stifel Nicolaus
Okay. And what is your average size now, is it around 11.5
Len Tannenbaum
It is. It’s about 11.5, and so we expect it to move up to towards middle market.
Troy Ward - Stifel Nicolaus
Okay. And if I recall, you are going to be able to split larger investments in both the SBIC and the balance sheet?
Len Tannenbaum
Yes, it’s advantageous for us because we can slip between the SBA subsidiary should we receive a license and other parts of the balance sheet, one which make a payment credit line and one which just maybe an unlevered asset base.
Troy Ward - Stifel Nicolaus
And then quickly on non-accruals, can you tell us what the cost basis of non-accruals is in the quarter?
William Craig
The cost basis of the investments or the – it’s in the Q.
Troy Ward - Stifel Nicolaus
I didn’t see the cost basis in the Q.
William Craig
I’ll have to get back to you on that.
Troy Ward - Stifel Nicolaus
Okay. And Len, if you can just talk to us for a minute, first all, we would like to say, obviously, we really appreciate the amount of transparency you gave in particularly on PIK.
In referring to PIK, you talked about you have six investments right now that you are not accruing the PIK. Obviously as a shareholder, as MBDC’s we have seen some negative happenings with reversal of PIK, can you speak to your policy on when you accrue PIK and when you don’t?
Len Tannenbaum
Sure. I think a lot of it’s driven by our auditors who are relatively conservative and have now crafted a policy that I guess the national office is comfortable with.
It has to do with how far we write down a security and as we write down a security significantly, we have to stop accruing PIK according to their – I mean that’s the general idea in the way we look at it. Basically, every security three, four, and five with the exception of Rose Tarlow has been put on PIK non-accrual.
As you know, that is really – even though we mark down securities very proactively, we don’t view PIK non-accrual anymore as an indicator that wouldn’t happen to collect the PIK down the road. It is simply a formula that the auditors are deploying.
Now what that does for our shareholders which I think is very beneficial and we are happy about is when we put something on PIK non-accrual, it doesn’t come into the NII cancellation, so it makes a much pure and higher-quality NII calculation. In addition, when we put something on PIK non-accrual, we as a management company do not take an incentive base.
So we take the – we do not believe that we should take an incentive of anything that’s questionable that we will collect PIK in the future. So for our shareholders, it’s two beneficial outcomes.
Troy Ward - Stifel Nicolaus
Okay. And then – so by that footnote in the Q, you said you had six investments that you are not accruing PIK, including two that my guess is cash interest payment, is – there was just two that are non-accrual on a cash basis?
Len Tannenbaum
Yes.
Troy Ward - Stifel Nicolaus
Okay. And then one last question, on your investment ratings, I thought there was some movement in some of the buckets, can you talk briefly about – looks like both one and two moved around a bit, both leverage ratio and the amount, what happened there?
Len Tannenbaum
We had one security that has continued to do exceptionally well. And while we don’t like moving things up unless they continue to do improve exceptional performance, this company continues to prove exceptional performance, so it moved to rating category one.
Because that company which obviously has a lower debt to EBITDA due to the EBITDA increasing dramatically, we had a rating two category that quarter-over-quarter looks like it declined or increased rather in debt to EBITDA from I don’t know, 4.0 something to 4.2 something. And what really happened is if you look at category one and two together, we have pretty much stability across debt to EBITDA and I think that’s the way the view is going forward sort at three, four, and five as a basket and look at one and two as a basket.
Troy Ward - Stifel Nicolaus
Right. And then one last one, can you just give us a kind of an update or a vision of what you expect to see – what’s your plans for Lighting by Gregory, now that you’ve taken control of that company?
Len Tannenbaum
Our plans are – Mark and his team are spending a lot of time there. Fortunately, Lighting by Gregory is a New York City based company, where we understand and have a lot of experience in this field, this type of company.
The management team is thrilled that we have taken over the company from a West Coast sponsor who wasn’t paying the right amount of attention to this company and story and means. The company is basically cash flow breakeven.
We think it will get better if the economy improves which it looks like it’s all indications from our index and from our other data points is that it’s improving. This company used to generate enormous amounts of cash when we started and we expect that as housing improves and lighting improves, this company again will generate a lot of cash.
Troy Ward - Stifel Nicolaus
And finally just any additional color you can provide on potential for an additional credit facility – are the markets loosening up a little bit with regard to getting that additional facility?
Len Tannenbaum
I think the markets are definitely loosening up. I think the credit dislocation provided by CIT’s block [ph] has caused a – which is good for us in some instances, right, because price dislocation is always good for lenders in terms of lending.
It may keep other banks occupied in terms of their timeframe and that pretty much any bank non-CIT that is evolved in asset-backed lending or factoring is quite busy with a lot of the applications for loans. Having said that, because we raised so much capital and extremely successfully follow-on offering, you can imagine that number of lending institutions are anxious to lend to us.
It takes time to develop anything and everything takes longer than you expect. But I am still – we are still on the right path and progressing forward in – with our relationships.
Troy Ward - Stifel Nicolaus
That’s great. Thanks guys.
Operator
Next we will move to Casey Alexander at Gilford Securities.
Casey Alexander - Gilford Securities
Yes, good morning.
Len Tannenbaum
Good morning.
Casey Alexander - Gilford Securities
To what extent was net investment income impacted by the cost for the SBIC filing? Will we see the same level of impact in this current quarter and also should we expect and model in some costs for the offering that just took place in the current quarter?
Len Tannenbaum
Yes, offering, I believe the raise is capitalized as a cost base.
Casey Alexander - Gilford Securities
I just wanted to make sure.
Len Tannenbaum
And the SBA was under $100,000.
William Craig
Yes, so far.
Len Tannenbaum
For the quarter.
William Craig
Right.
Casey Alexander - Gilford Securities
And would you expect to see something the same three SBIC or more or less in the current quarter?
Len Tannenbaum
Most of the cost that are involved with the SBA is in filling of this very, very thick application and that has been filed, accepted and now we are going to go through and answer comments by the SBA in a frequent back and forth. So the cost will increase a little bit, but increase not materially to our results.
Casey Alexander - Gilford Securities
Okay. All right, great.
Thank you.
Operator
Next, we will move to Brett Miller at Dialectic Capital.
Brett Miller - Dialectic Capital
Hi guys, how you’re doing? Just two quick questions.
One is reviewing just the general credit portfolio. Is it pretty in line with what you were thinking thought some things in terms of leverage moved up on the four and five, just want to see what your thoughts were and if that was expected is the first question?
Len Tannenbaum
Yes, I think the whole portfolio is acting just as we thought about two weeks ago, four weeks ago, six weeks ago. Now just to remind you, we are in both middle market, lower middle market.
There will be movement and there should be movement between all the rating categories and I expect continued movement up – this time up and down. So you may see equal ups and downs and you may see dramatic moves fours to twos and twos to threes and threes to ones and – because as the economy turns and as we are seeing a turn in the economy, a number of companies which have cut their cost structure to benefit from that should show reasonably to that growth.
Brett Miller - Dialectic Capital
All right. Great, thank you.
And then just one last question, I saw in your press release of July 14th, you guys received an application in (inaudible) you guys should be able to process and do things for small business and investment community. You’ve not been approved or denied.
I just want to confirm that’s just general sort of legal language and your application is ongoing or is there anything I should I guess further question on that?
Len Tannenbaum
Yes, application is ongoing and we are moving along the process and the SBA is being responsive.
Brett Miller - Dialectic Capital
Got it. This is just – in other words, this is just how the process goes, et cetera, and there is nothing to read into per se.
Len Tannenbaum
Nothing to read into it. The only – the only thing we are pointing out is you may see us identify some new loans as accounting as regulatory capital towards our SBA $75 million of regulatory capital we put up before we act as leverage.
So now we are able to identify those loans.
Brett Miller - Dialectic Capital
And when is that likelihood you think that you will be approved at this point? Do you have any insights into that?
Len Tannenbaum
I think you have to call lots of different people for reference points, but what I can tell you is, so far, we have overcome whatever hurdles there are and we’ve moved along the process. The process typically takes about a year.
We entered the process last November.
Brett Miller - Dialectic Capital
Got it, okay, great. Well I appreciate the questions and good quarter.
Thank you.
Operator
And next we will move to David Jordan with Monarch Capital. Mr.
Jordan your line is open, please go ahead. You may have your phone on mute.
I’m hearing no response, we will move on. And at this time, we have no further questions in the queue.
Len Tannenbaum
Thanks everyone for attending and I know it was a non-eventful solid quarter and which is probably why lots more questions weren’t asked. But we expect and we hope to continue to execute on these boring solid quarters and just delivering our results.
So thanks everyone for participating.
Operator
And that does conclude today’s conference. Again, thank you for your participation.