Fifth Street Capital's IPO: High Risk Lender Cloaked as Private Investment Fund

On June 11, Bill Simpson wrote an analysis of Fifth Street Capital (FSC). In its June 18 IPO, the company raised approximately $141.2 million in gross proceeds.

All shares were offered by the company.

The text of Mr. Simpson's original writeup follows:

• • •

Fifth Street Capital plans on offering 10 million shares at a range of $14.12 - $15.12. Goldman Sachs and UBS are lead managing the deal, Wachovia, BMO and Stifel are co-managing. Post-ipo FSC will have 22.5 million shares outstanding for a market cap of $329 million on a pricing of $14.62. FSC will use the bulk of ipo proceeds to invest in small and medium size pre-ipo stage companies.

Toll Brothers (TOL) founder and former President Bruce E. Toll will own 9% of FSC post-ipo. Mr. Toll is the father-in-law of FSC CEO and President Leonard M. Tannenbaum. In addition, Genworth Life and Greenlight Capital will each own 5% of FSC post-ipo.

From the prospectus:

We are a specialty finance company that lends to and invests in small and mid-sized companies in connection with investments by private equity sponsors. We define small and mid-sized companies as those with annual revenues between $25 million and $250 million.

FSC commenced operations in 2/07. FSC is a private investment operation that makes 'piggyback' investments in pre-ipo stage companies. We've seen a number of private equity 'quick flip' ipos this decade. Nearly all of them come saddled with hefty debt, placed onto the back of the underlying entity to fund the purchase by the private equity operation. FSC helps fund these acquisitions by lending money to the underlying entity. That money usually ends up in the hands of the private equity firm to help fund the takeover.

FSC is managed by Fifth Street Management, headed by 36 year old Leonard Tannenbaum. Mr. Tannenbaum has led the investment of approximately $450 million since 1998.

As of 3/08, FSC's portfolio totaled $192 million and comprised investment in 19 companies. The bulk of FSC's investment is debt based, usually straight first or second tier loans coupled with a small ($200k or so) equity investment. Average investment size is $5-$40 million. Average annual yield on their debt investments is a substantial at 16.7%. The high yield on investments would appear to indicate that FSC's investments are placed with many companies unable to leverage themselves via normal credit routes. This fits with FSC's profile of doing deals in conjunction with private equity sponsored investments.

Note that if FSC prices in range, it will increase FSC's assets under management by approximately 70%.

FSC's management fee structure mirrors that of a hedge fund. For the type of investments FSC makes and the return since inception, the fee structure looks excessive. FSC is essentially a lender working with private equity operations. Yet they want public shareholders to pay them as if they're running a top tier high return and in demand hedge fund. FSC's management fee structure post-ipo will be 2% of gross assets annually as well as 20% of net investment income/capital gains. In other words, 2% of assets under management and 20% of any/all returns.

**FSC is essentially a 'high risk' lender, yet they want public investors to pay management fees akin to successful hedge and investment funds. In the prospectus, FSC estimates that if they are able to generate a 5% annual return their first five years, public investor fees/expenses would total $300 on a $1000 investment.

Portfolio companies - FSC's current portfolio companies can be found here: http://www.fifthstreetfinance.com/portfolio.html

Risk - All of FSC's originations have been first or second lien on the investment company's assets. However, the bulk of FSC's investment portfolio is small to mid-size consumer discretionary operations, with the remainder all relying on US economic health in one form or another. That in and of itself is not really a negative even with the difficult current economic climate, as long as solid due diligence is in place. The issue here is that FSC's investments/loans are in conjunction with private equity leveraged investments, meaning the underlying companies in which FSC invests are taking on significant debt in order to fund the private equity investment. High leverage always increases the odds of default down the line and FSC's business plan pretty much guarantees they will be making these type of investments going forward.

Note that FSC does plan on leveraging their investments. Prior ipo FSC had approximately $35 million in debt at an average interest rate of 4.15%. FSC does plan on borrowing at lower rates to lend at higher rates going forward. Again FSC mirrors a high risk lender more than a private investment fund.

Financials

FSC will have approximately $150 million in cash post ipo. This cash will be utilized to lend to and invest in small businesses in accordance with the business plan.

Assuming a pricing of $14.62, book value post-ipo will be $13.80.

FSC does plan on distributing essentially all net income quarterly to shareholders.

Fiscal year ends 9/30 annually. FY '08 will end 9/30/08.

FSC marks their investment to market quarterly. For the six months ending 3/31/08, FSC's unrealized depreciation on their investments lost $2 million.

For the six months ending 3/31/08, FSC had interest and fee income of $12.3 million. Management and incentive fees totaled 22% of revenues. Other operating expenses totaled 13%. Factoring in depreciation on investment loss, net income per share was $0.25.

Going forward, we can expect FSC to put the ipo monies to work, which should increase FSC's interest income. I would estimate, assuming no massive investment depreciation, net income for FY '08 will total approximately $0.60 per share.

Assuming again no defaults and no massive investment writedowns, I would expect distributions to shareholders to total $0.60-$0.75 in FSC's first four quarters public. On a pricing of $14.62, FSC would yield approximately 4%-4 1/2% in its first year public.

Conclusion - I don't see a compelling reason to own this ipo in range. This is essentially a high risk lender cloaked as a closed end investment fund coming public above book value. I'm not a huge fan of the hefty incentive fee structure here as well as the risky nature of FSC's investments assisting the funding of private equity buyouts. In a sluggish US economic climate, lending at an average of 16.7% yield to companies loading up on leverage to fund private equity investments does not interest me.

 

Comments

[syndicat]

Maybe at $10 FSC is worth a shot.

This is probably the best 2008 example of an offering
that should not have come to market.

Most of the shares were sold to retail customers of
the co-managers.

[mlkr]

VERY GOOD WORK! Down to $9.00s as i am dropping my note! Could be great if you do a similar piece on BX.