OAKTREE SPECIALTY LENDING CORP
10-Ks and 10-Qs
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
UNITED STATES SECURITIES AND
EXCHANGE COMMISSION
Washington, DC 20549
Washington, DC 20549
Form 10-K
| (Mark One) | ||
|
þ
|
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 |
|
| For the fiscal year ended September 30, 2010 | ||
|
OR
|
||
|
o
|
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 |
|
COMMISSION
FILE NUMBER: 1-33901
Fifth Street Finance
Corp.
(EXACT NAME OF REGISTRANT AS
SPECIFIED IN ITS CHARTER)
| DELAWARE | 26-1219283 | |
|
(State or jurisdiction of
incorporation or organization) |
(I.R.S. Employer
Identification No.) |
|
| 10 Bank Street, 12 th Floor | 10606 | |
| White Plains, NY | (Zip Code) | |
| (Address of principal executive office) |
REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE:
(914) 286-6800
SECURITIES
REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
|
Name of Each Exchange
|
||
|
Title of Each Class
|
on Which Registered
|
|
| Common Stock, par value $0.01 per share | New York Stock Exchange |
SECURITIES
REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
None
None
Indicate by check mark if the registrant is a well-known
seasoned issuer, as defined in Rule 405 of the Securities
Act. YES
o
No
þ
Indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or Section 15(d) of the
Act. YES
o
No
þ
Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter periods as the registrant
was required to file such reports), and (2) has been
subject to such filing requirements for the past
90 days. YES
þ
NO
o
Indicate by check mark whether the registrant has submitted
electronically and posted on its corporate Web site, if any,
every Interactive Data File required to be submitted and posted
pursuant to Rule 405 of
Regulation S-T
during the preceding 12 months (or for such shorter period
that the registrant was required to submit and post such
files). Yes
o
No
o
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of
Regulation S-K
is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in
Part III of this
Form 10-K
or any amendment to this
Form 10-K.
þ
Indicate by check mark whether the registrant is a large
accelerated filer, an accelerated filer, a non-accelerated
filer, or a smaller reporting company. See the definitions of
“large accelerated filer,” “accelerated
filer” and “smaller reporting company” in
Rule 12b-2
of the Exchange Act. (Check one):
|
Large accelerated filer
o
|
Accelerated filer þ |
Non-accelerated filer
o
(Do not check if a smaller reporting company) |
Smaller reporting company o |
Indicate by check mark whether the registrant is a shell company
(as defined in Rule
12b-2
of the
Act) YES
o
NO
þ
The aggregate market value of the registrant’s common stock
held by non-affiliates of the registrant as of March 31,
2010 is $525,730,940. The registrant had 54,550,290 shares
of common stock outstanding as of September 30, 2010.
DOCUMENTS
INCORPORATED BY REFERENCE
None
TABLE OF
CONTENTS
| Item 1. | Business |
General
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. Our investment objective is to maximize our
portfolio’s total return by generating current income from
our debt investments and capital appreciation from our equity
investments. We are externally managed and advised by Fifth
Street Management LLC, which we also refer to as our
“investment adviser”.
As of September 30, 2010, we had originated
$668.9 million of funded debt and equity investments and
our portfolio totaled $563.8 million at fair value and was
comprised of 38 investments, 35 of which were in operating
companies and three of which were in private equity funds. The
three investments in private equity funds represented less than
1% of the fair value of our assets at September 30, 2010.
The weighted average annual yield of our debt investments as of
September 30, 2010 was approximately 14.0%, which included
a cash component of 11.8%.
Our investments generally range in size from $5 million to
$60 million and are principally in the form of first and
second lien debt investments, which may also include an equity
component. We are currently focusing our origination efforts on
first lien loans. As of September 30, 2010, substantially
all of our debt investments were secured by first or second
priority liens on the assets of our portfolio companies.
Moreover, we held equity investments consisting of common stock,
preferred stock, or other equity interests in 19 out of 38
portfolio companies as of September 30, 2010.
Fifth Street Mezzanine Partners III, L.P., our predecessor fund,
commenced operations as a private partnership on
February 15, 2007. Effective as of January 2, 2008,
Fifth Street Mezzanine Partners III, L.P. merged with and into
us. We were formed in late 2007 for the purpose of acquiring
Fifth Street Mezzanine Partners III, L.P. and continuing its
business as a public entity. We are an externally managed,
closed-end, non-diversified management investment company that
has elected to be regulated as a business development company
under the Investment Company Act of 1940, or the 1940 Act.
As a business development company, we are required to comply
with regulatory requirements, including limitations on our use
of debt. We are permitted to, and expect to, finance our
investments through borrowings. However, as a business
development company, we are only generally allowed to borrow
amounts such that our asset coverage, as defined in the 1940
Act, equals at least 200% after such borrowing. The amount of
leverage that we employ will depend on our assessment of market
conditions and other factors at the time of any proposed
borrowing. See “Item 1. Business —
Regulation — Business Development Company
Regulations.”
We have also elected to be treated for federal income tax
purposes as a regulated investment company, or RIC, under
Subchapter M of the Internal Revenue Code, or the Code. See
“Item 1. Business — Regulation —
Taxation as a Regulated Investment Company.” As a RIC, we
generally will not have to pay corporate-level federal income
taxes on any net ordinary income or capital gains that we
distribute to our stockholders if we meet certain
source-of-income,
distribution and asset diversification requirements.
In addition, we maintain a wholly-owned subsidiary that is
licensed as a small business investment company, or SBIC, and
regulated by the Small Business Administration, or the SBA. See
“Item 1. Business — Regulation —
Small Business Investment Company Regulations.” The SBIC
license allows us, through our wholly-owned subsidiary, to issue
SBA-guaranteed debentures. We applied for exemptive relief from
the Securities and Exchange Commission, or SEC, to permit us to
exclude the debt of our SBIC subsidiary guaranteed by the SBA
from the 200% asset coverage ratio we are required to maintain
under the 1940 Act. Pursuant to the 200% asset coverage ratio
limitation, we are permitted to borrow one dollar for every
dollar we have in assets less all liabilities and indebtedness
not represented by debt securities issued by us or loans
obtained by us. For example, as of September 30, 2010, we
had approximately $642.2 million in assets less all
liabilities and indebtedness not represented by debt securities
issued by us or loans obtained by us, which
1
would permit us to borrow up to approximately
$642.2 million, notwithstanding other limitations on our
borrowings pursuant to our credit facilities.
If we receive an exemption from the SEC for our SBA debt, we
will have increased capacity to fund up to $150 million
(the maximum amount of SBA-guaranteed debentures an SBIC may
currently have outstanding once certain conditions have been
met) of investments with SBA-guaranteed debentures in addition
to being able to fund investments with borrowings up to the
maximum amount of debt that the 200% asset coverage ratio
limitation would allow us to incur. As a result, we would, in
effect, be permitted to have a lower asset coverage ratio than
the 200% asset coverage ratio limitation under the 1940 Act and,
therefore, we could have more debt outstanding than assets to
cover such debt. For example, we would be able to borrow up to
$150 million more than the approximately
$642.2 million permitted under the asset coverage ratio
limit as of September 30, 2010. For additional information
on SBA regulations that affect our access to SBA-guaranteed
debentures, see “Risk Factors — Risks Relating to
Our Business and Structure — Our SBIC
subsidiary’s investment adviser has no prior experience
managing an SBIC and any failure to comply with SBA regulations,
resulting from our SBIC subsidiary’s investment
adviser’s lack of experience or otherwise, could have an
adverse effect on our operations.”
Our principal executive office is located at 10 Bank Street,
12
th
floor, White Plains, New York 10606 and our telephone number is
(914) 286-6800.
The
Investment Adviser
Our investment adviser is affiliated with Fifth Street Capital
LLC, a private investment firm founded and managed by Leonard M.
Tannenbaum who has led the investment of over $900 million
in small and mid-sized companies, including the investments made
by us, since 1998. Mr. Tannenbaum and his respective
private investment firms have acted as the lead (and often sole)
first or second lien investor in over 70 investment
transactions. The other investment funds managed by these
private investment firms generally are fully committed and,
other than follow-on investments in existing portfolio
companies, are no longer making investments.
We benefit from our investment adviser’s ability to
identify attractive investment opportunities, conduct diligence
on and value prospective investments, negotiate investments and
manage a diversified portfolio of those investments. The
principals of our investment adviser have broad investment
backgrounds, with prior experience at investment funds,
investment banks and other financial services companies and have
developed a broad network of contacts within the private equity
community. This network of contacts provides our principal
source of investment opportunities.
The principals of our investment adviser are
Mr. Tannenbaum, our chief executive officer and our
investment adviser’s managing partner, Bernard D. Berman,
our president, chief compliance officer and secretary and a
partner of our investment adviser, Ivelin M. Dimitrov, our
co-chief investment officer and a partner of our investment
adviser, Chad Blakeman, our co-chief investment officer, Juan E.
Alva, a partner of our investment adviser, Casey J.
Zmijeski, a partner of our investment adviser and William H.
Craig, our chief financial officer.
Business
Strategy
Our investment objective is to maximize our portfolio’s
total return by generating current income from our debt
investments and capital appreciation from our equity
investments. We have adopted the following business strategy to
achieve our investment objective:
| • | Capitalize on our investment adviser’s strong relationships with private equity sponsors. Our investment adviser has developed an extensive network of relationships with private equity sponsors that invest in small and mid-sized companies. We believe that the strength of these relationships is due to a common investment philosophy, a consistent market focus, a rigorous approach to diligence and a reputation for delivering on commitments. In addition to being our principal source of originations, we believe that private equity sponsors provide significant benefits including incremental due diligence, additional monitoring capabilities and a potential source of capital and operational expertise for our portfolio companies. |
2
| • | Focus on established small and mid-sized companies. We believe that there are fewer finance companies focused on transactions involving small and mid-sized companies than larger companies, and that this is one factor that allows us to negotiate favorable investment terms. Such favorable terms include higher debt yields and lower leverage levels, more significant covenant protection and greater equity grants than typical of transactions involving larger companies. We generally invest in companies with established market positions, seasoned management teams, proven products and services and strong regional or national operations. We believe that these companies possess better risk-adjusted return profiles than newer companies that are building management or in early stages of building a revenue base. | |
| • | Continue our growth of direct originations. As of September 30, 2010, we directly originated 100% of our debt investments, although we may not directly originate 100% of our investments in the future. Over the last several years, the principals of our investment adviser have developed an origination strategy designed to ensure that the number and quality of our investment opportunities allows us to continue to directly originate substantially all of our investments. We believe that the benefits of direct originations include, among other things, our ability to control the structuring of investment protections and to generate origination and exit fees. | |
| • | Employ disciplined underwriting policies and rigorous portfolio management. Our investment adviser has developed an extensive underwriting process which includes a review of the prospects, competitive position, financial performance and industry dynamics of each potential portfolio company. In addition, we perform substantial diligence on potential investments, and seek to invest along side private equity sponsors who have proven capabilities in building value. As part of the monitoring process, our investment adviser will analyze monthly and quarterly financial statements versus the previous periods and year, review financial projections, meet with management, attend board meetings and review all compliance certificates and covenants. | |
| • | Structure our debt investments to minimize risk of loss and achieve attractive risk-adjusted returns. We structure our debt investments on a conservative basis with high cash yields, cash origination fees, low leverage levels and strong investment protections. As of September 30, 2010, the weighted average annualized yield of our debt investments was approximately 14.0%, which includes a cash component of 11.8%. Our debt investments have strong protections, including default penalties, information rights, board observation rights, and affirmative, negative and financial covenants, such as lien protection and prohibitions against change of control. We believe these protections, coupled with the other features of our investments described above, should allow us to reduce our risk of capital loss and achieve attractive risk adjusted returns; however, there can be no assurance that we will be able to successfully structure our investments to minimize risk of loss and achieve attractive risk-adjusted returns. | |
| • | Benefiting from lower, fixed, long-term cost of capital. The SBIC license held by our wholly-owned subsidiary allows it to issue SBA-guaranteed debentures. SBA-guaranteed debentures carry long-term fixed rates that are generally lower than rates on comparable bank and other debt. Because we expect lower cost SBA leverage to become a more significant part of our capital base through our SBIC subsidiary, our relative cost of debt capital should be lower than many of our competitors. In addition, the SBIC leverage that we receive through our SBIC subsidiary will represent a stable, long-term component of our capital structure that should permit the proper matching of duration and cost compared to our portfolio investments. | |
| • | Leverage the skills and experience of our investment adviser. The principals of our investment adviser have broad investment backgrounds, with prior experience at private investment funds, investment banks and other financial services companies and they also have experience managing distressed companies. |
3
| We believe that our investment adviser’s expertise in valuing, structuring, negotiating and closing transactions provides us with a competitive advantage by allowing us to provide financing solutions that meet the needs of our portfolio companies while adhering to our underwriting standards. |
Investment
Criteria
The principals of our investment adviser have identified the
following investment criteria and guidelines for use in
evaluating prospective portfolio companies and they use these
criteria and guidelines in evaluating investment opportunities
for us. However, not all of these criteria and guidelines were,
or will be, met in connection with each of our investments.
| • | Established companies with a history of positive operating cash flow. We seek to invest in established companies with sound historical financial performance. We typically focus on companies with a history of profitability on an operating cash flow basis. We do not intend to invest in start-up companies or companies with speculative business plans. | |
| • | Ability to exert meaningful influence. We target investment opportunities in which we will be the lead/sole investor in our tranche and in which we can add value through active participation, often through advisory positions. | |
| • | Private equity sponsorship. We generally seek to invest in companies in connection with private equity sponsors who have proven capabilities in building value. We believe that a private equity sponsor can serve as a committed partner and advisor that will actively work with the company and its management team to meet company goals and create value. We assess a private equity sponsor’s commitment to a portfolio company by, among other things, the capital contribution it has made or will make in the portfolio company. | |
| • | Seasoned management team. We generally will require that our portfolio companies have a seasoned management team, with strong corporate governance. We also seek to invest in companies that have proper incentives in place, including having significant equity interests, to motivate management to act in accordance with our interests. | |
| • | Defensible and sustainable business. We seek to invest in companies with proven products and/or services and strong regional or national operations. | |
| • | Exit strategy. We generally seek to invest in companies that we believe possess attributes that will provide us with the ability to exit our investments. We expect to exit our investments typically through one of three scenarios: (i) the sale of the company resulting in repayment of all outstanding debt, (ii) the recapitalization of the company through which our loan is replaced with debt or equity from a third party or parties or (iii) the repayment of the initial or remaining principal amount of our loan then outstanding at maturity. In some investments, there may be scheduled amortization of some portion of our loan which would result in a partial exit of our investment prior to the maturity of the loan. |
Deal
Origination
Our deal originating efforts are focused on building
relationships with private equity sponsors that are focused on
investing in the small and mid-sized companies that we target.
We divide the country geographically into Eastern, Central and
Western regions and emphasize active, consistent sponsor
coverage. Over the last ten years, the investment professionals
of our investment adviser have developed an extensive network of
relationships with these private equity sponsors. We estimate
that there are approximately 1,400 of such private equity firms
and our investment adviser has active relationships with
approximately 140 of them. An active relationship is one through
which our investment adviser has received at least one
investment opportunity from the private equity sponsor within
the last year.
Our investment adviser reviewed over 500 potential investment
transactions with private equity sponsors for the year ended
September 30, 2010. All of the investment transactions that
we have completed to date
4
were originated through our investment adviser’s
relationships with private equity sponsors. We believe that our
investment adviser has a reputation as a reliable, responsive
and efficient source of funding to support private equity
investments. We believe that this reputation and the
relationships of our investment adviser with private equity
sponsors will provide us with significant investment
opportunities.
Our origination process is designed to efficiently evaluate a
large number of opportunities and to identify the most
attractive of such opportunities. A significant number of
opportunities that clearly do not fit our investment criteria
are screened by the partners of our investment adviser when they
are initially identified. If an originator believes that an
opportunity fits our investment criteria and merits
consideration, the investment is presented to our investment
adviser’s Investment Committee. This is the first stage of
our origination process, the “Review” stage. During
this stage, the originator gives a preliminary description of
the opportunity. This is followed by preliminary due diligence,
from which an investment summary is created. The opportunity may
be discussed several times by the full Investment Committee of
our investment adviser, or subsets of that Committee. At any
point in this stage, we may reject the opportunity, and, indeed,
we have historically decided not to proceed with more than 80%
of the investment opportunities reviewed by our investment
adviser’s Investment Committee.
For the subset of opportunities that we decide to pursue, we
issue preliminary term sheets and classify them in the
“Term Sheet Issued” stage. This term sheet serves as a
basis for negotiating the critical terms of a transaction. At
this stage we begin our underwriting and investment approval
process, as more fully described below. After the term sheet for
a potential transaction has been fully negotiated, the
transaction is presented to our investment adviser’s
Investment Committee for approval. If the deal is approved, the
term sheet is signed. Approximately half of the term sheets we
issue result in an executed term sheet. Our underwriting and
investment approval process is ongoing during this stage, during
which we begin documentation of the loan. The final stage,
“Closings,” culminates with the funding of an
investment only after all due diligence is satisfactorily
completed and all closing conditions, including the
sponsor’s funding of its investment in the portfolio
company, have been satisfied.
Underwriting
Underwriting
Process and Investment Approval
We make our investment decisions only after consideration of a
number of factors regarding the potential investment including,
but not limited to: (i) historical and projected financial
performance; (ii) company and industry specific
characteristics, such as strengths, weaknesses, opportunities
and threats; (iii) composition and experience of the
management team; and (iv) track record of the private
equity sponsor leading the transaction. Our investment adviser
uses a proprietary scoring system that evaluates each
opportunity. This methodology is employed to screen a high
volume of potential investment opportunities on a consistent
basis.
If an investment is deemed appropriate to pursue, a more
detailed and rigorous evaluation is made along a variety of
investment parameters, not all of which may be relevant or
considered in evaluating a potential investment opportunity. The
following outlines the general parameters and areas of
evaluation and due diligence for investment decisions, although
not all will necessarily be considered or given equal weighting
in the evaluation process.
Management
assessment
Our investment adviser makes an in-depth assessment of the
management team, including evaluation along several key metrics:
| • | The number of years in their current positions; | |
| • | Track record; | |
| • | Industry experience; | |
| • | Management incentive, including the level of direct investment in the enterprise; |
5
| • | Background investigations; and | |
| • | Completeness of the management team (lack of positions that need to be filled). |
Industry
dynamics
An evaluation of the industry is undertaken by our investment
adviser that considers several factors. If considered
appropriate, industry experts will be consulted or retained. The
following factors are analyzed by our investment adviser:
| • | Sensitivity to economic cycles; | |
| • | Competitive environment, including number of competitors, threat of new entrants or substitutes; | |
| • | Fragmentation and relative market share of industry leaders; | |
| • | Growth potential; and | |
| • | Regulatory and legal environment. |
Business
model and financial assessment
Prior to making an investment decision, our investment adviser
will undertake a review and analysis of the financial and
strategic plans for the potential investment. There is
significant evaluation of and reliance upon the due diligence
performed by the private equity sponsor and third party experts
including accountants and consultants. Areas of evaluation
include:
| • | Historical and projected financial performance; | |
| • | Quality of earnings, including source and predictability of cash flows; | |
| • | Customer and vendor interviews and assessments; | |
| • | Potential exit scenarios, including probability of a liquidity event; | |
| • | Internal controls and accounting systems; and | |
| • | Assets, liabilities and contingent liabilities. |
Private
equity sponsor
Among the most critical due diligence investigations is the
evaluation of the private equity sponsor making the investment.
A private equity sponsor is typically the controlling
shareholder upon completion of an investment and as such is
considered critical to the success of the investment. The
private equity sponsor is evaluated along several key criteria,
including:
| • | Investment track record; | |
| • | Industry experience; | |
| • | Capacity and willingness to provide additional financial support to the company through additional capital contributions, if necessary; and | |
| • | Reference checks. |
Investments
We target debt investments that will yield meaningful current
income and provide the opportunity for capital appreciation
through equity securities. We typically structure our debt
investments with the maximum seniority and collateral that we
can reasonably obtain while seeking to achieve our total return
target. In most cases, our debt investment will be
collateralized by a first or second lien on the assets of the
portfolio company. As of September 30, 2010, substantially
all of our debt investments were secured by first or second
priority liens on the assets of the portfolio company.
6
We tailor the terms of our debt investments to the facts and
circumstances of the transaction and prospective portfolio
company, negotiating a structure that seeks to protect our
rights and manage our risk while creating incentives for the
portfolio company to achieve its business plan. A substantial
source of return is monthly cash interest that we collect on our
debt investments. As of September 30, 2010, we directly
originated 100% of our loans, although we may not directly
originate 100% of our investments in the future. We are
currently focusing our new origination efforts on first lien
loans. We believe that the risk-adjusted returns from these
loans are superior to second lien investments and offer superior
credit quality. However, we may choose to originate second lien
and unsecured loans in the future.
| • | First Lien Loans. Our first lien loans generally have terms of four to six years, provide for a variable or fixed interest rate, contain prepayment penalties and are secured by a first priority security interest in all existing and future assets of the borrower. Our first lien loans may take many forms, including revolving lines of credit, term loans and acquisition lines of credit. | |
| • | Second Lien Loans. Our second lien loans generally have terms of four to six years, primarily provide for a fixed interest rate, contain prepayment penalties and are secured by a second priority security interest in all existing and future assets of the borrower. Our second lien loans often include payment-in-kind, or PIK, interest, which represents contractual interest accrued and added to the principal that generally becomes due at maturity. As of September 30, 2010, all of our second lien loans had intercreditor agreements requiring a standstill period of no more than 180 days. During the standstill period, we are generally restricted from exercising remedies against the borrower or the collateral in order to provide the first lien lenders time to cure any breaches or defaults by the borrower. | |
| • | Unsecured Loans. Our unsecured investments generally have terms of five to six years and provide for a fixed interest rate. We may make unsecured investments on a stand-alone basis, or in connection with a senior secured loan, a junior secured loan or a “one-stop” financing. Our unsecured investments may include payment-in-kind, or PIK, interest, which represents contractual interest accrued and added to the principal that generally becomes due at maturity, and an equity component, such as warrants to purchase common stock in the portfolio company. |
We typically structure our debt investments to include covenants
that seek to minimize our risk of capital loss. Our debt
investments have strong protections, including default
penalties, information rights, board observation rights, and
affirmative, negative and financial covenants, such as lien
protection and prohibitions against change of control. Our debt
investments also have substantial prepayment penalties designed
to extend the life of the average loan, which we believe will
help to grow our portfolio.
Equity
Investments
When we make a debt investment, we may be granted equity in the
company in the same class of security as the sponsor receives
upon funding. In addition, we may from time to time make
non-control, equity
co-investments
in connection with private equity sponsors. We generally seek to
structure our equity investments, such as direct equity
co-investments, to provide us with minority rights provisions
and event-driven put rights. We also seek to obtain limited
registration rights in connection with these investments, which
may include “piggyback” registration rights.
Private
Equity Fund Investments
We make investments in the private equity funds of certain of
our equity sponsors. In general, we make these investments where
we have a long term relationship and are comfortable with the
sponsor’s business model and investment strategy. As of
September 30, 2010, we had investments in three private
equity funds, which represented less than 1% of the fair value
of our assets as of such date.
7
Portfolio
Management
Active
Involvement in our Portfolio Companies
As a business development company, we are obligated to offer to
provide managerial assistance to our portfolio companies and to
provide it if requested. In fact, we provide managerial
assistance to our portfolio companies as a general practice and
we seek investments where such assistance is appropriate. We
monitor the financial trends of each portfolio company to assess
the appropriate course of action for each company and to
evaluate overall portfolio quality. We have several methods of
evaluating and monitoring the performance of our investments,
including but not limited to, the following:
| • | review of monthly and quarterly financial statements and financial projections for portfolio companies; | |
| • | periodic and regular contact with portfolio company management to discuss financial position requirements and accomplishments; | |
| • | attendance at board meetings; | |
| • | periodic formal update interviews with portfolio company management and, if appropriate, the private equity sponsor; and | |
| • | assessment of business development success, including product development, profitability and the portfolio company’s overall adherence to its business plan. |
Rating
Criteria
In addition to various risk management and monitoring tools, we
use an investment rating system to characterize and monitor the
credit profile and our expected level of returns on each
investment in our portfolio. We use a five-level numeric rating
scale. The following is a description of the conditions
associated with each investment rating:
| • | Investment Rating 1 is used for investments that are performing above expectations and/or a capital gain is expected. | |
| • | Investment Rating 2 is used for investments that are performing substantially within our expectations, and whose risks remain neutral or favorable compared to the potential risk at the time of the original investment. All new loans are initially rated 2. | |
| • | Investment Rating 3 is used for investments that are performing below our expectations and that require closer monitoring, but where we expect no loss of investment return (interest and/or dividends) or principal. Companies with a rating of 3 may be out of compliance with financial covenants. | |
| • | Investment Rating 4 is used for investments that are performing below our expectations and for which risk has increased materially since the original investment. We expect some loss of investment return, but no loss of principal. | |
| • | Investment Rating 5 is used for investments that are performing substantially below our expectations and whose risks have increased substantially since the original investment. Investments with a rating of 5 are those for which some loss of principal is expected. |
In the event that we determine that an investment is
underperforming, or circumstances suggest that the risk
associated with a particular investment has significantly
increased, we will undertake more aggressive monitoring of the
effected portfolio company. While our investment rating system
identifies the relative risk for each investment, the rating
alone does not dictate the scope
and/or
frequency of any monitoring that we perform. The frequency of
our monitoring of an investment is determined by a number of
factors, including, but not limited to, the trends in the
financial performance of the portfolio company, the investment
structure and the type of collateral securing our investment, if
any.
8
The following table shows the distribution of our investments on
the 1 to 5 investment rating scale at fair value as of
September 30, 2010:
|
Investment Rating
|
Fair Value | % of Portfolio | ||||||
|
1
|
$ | 89,150,457 | 15.81 | % | ||||
|
2
|
424,494,799 | 75.29 | % | |||||
|
3
|
18,055,528 | 3.20 | % | |||||
|
4
|
23,823,120 | 4.23 | % | |||||
|
5
|
8,297,412 | 1.47 | % | |||||
|
Total
|
$ | 563,821,316 | 100.00 | % | ||||
Exit
Strategies/Refinancing
As of September 30, 2010, we had structured
$7.1 million in aggregate exit fees across 10 portfolio
investments to be received upon the future exit of those
investments. We expect to exit our investments typically through
one of three scenarios: (i) the sale of the company
resulting in repayment of all outstanding debt, (ii) the
recapitalization of the company in which our loan is replaced
with debt or equity from a third party or parties or
(iii) the repayment of the initial or remaining principal
amount of our loan then outstanding at maturity. In some
investments, there may be scheduled amortization of some portion
of our loan which would result in a partial exit of our
investment prior to the maturity of the loan.
Valuation
of Portfolio Investments
As a business development company, we generally invest in
illiquid securities including debt and equity investments of
small and mid-sized companies. All of our investments are
recorded at fair value as determined in good faith by our Board
of Directors.
Authoritative accounting guidance defines fair value as the
price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market
participants at the measurement date. Where available, fair
value is based on observable market prices or parameters or
derived from such prices or parameters. Where observable prices
or inputs are not available or reliable, valuation techniques
are applied. These valuation techniques involve some level of
management estimation and judgment, the degree of which is
dependent on the price transparency for the investments or
market and the investments’ complexity.
In accordance with authoritative accounting guidance, we perform
detailed valuations of our debt and equity investments on an
individual basis, using market, income, and bond yield
approaches as appropriate. In general, we utilize a bond yield
method for the majority of our investments, as long as it is
appropriate. If, in our judgment, the bond yield approach is not
appropriate, we may use the enterprise value approach, or, in
certain cases, an alternative methodology potentially including
an asset liquidation or expected recovery model.
Under the market approach, we estimate the enterprise value of
the portfolio companies in which we invest. There is no one
methodology to estimate enterprise value and, in fact, for any
one portfolio company, enterprise value is best expressed as a
range of fair values, from which we derive a single estimate of
enterprise value. To estimate the enterprise value of a
portfolio company, we analyze various factors, including the
portfolio company’s historical and projected financial
results. Typically, private companies are valued based on
multiples of EBITDA, cash flows, net income, revenues, or in
limited cases, book value. We generally require portfolio
companies to provide annual audited and quarterly and monthly
unaudited financial statements, as well as annual projections
for the upcoming fiscal year.
Under the income approach, we generally prepare and analyze
discounted cash flow models based on projections of the future
free cash flows of the business.
Under the bond yield approach, we use bond yield models to
determine the present value of the future cash flow streams of
our debt investments. We review various sources of transactional
data, including private
9
mergers and acquisitions involving debt investments with similar
characteristics, and assess the information in the valuation
process.
Our Board of Directors undertakes a multi-step valuation process
each quarter in connection with determining the fair value of
our investments:
| • | The quarterly valuation process begins with each portfolio company or investment being initially valued by the deal team within the investment adviser responsible for the portfolio investment; | |
| • | Preliminary valuations are then reviewed and discussed with the principals of the investment adviser; | |
| • | Separately, independent valuation firms engaged by our Board of Directors prepare preliminary valuations on a selected basis and submit the reports to us; | |
| • | The deal team compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms; | |
| • | The deal team prepares a valuation report for the Valuation Committee of our Board of Directors; | |
| • | The Valuation Committee of our Board of Directors is apprised of the preliminary valuations of the independent valuation firms; | |
| • | The Valuation Committee of our Board of Directors reviews the preliminary valuations, and the deal team responds and supplements the preliminary valuations to reflect any comments provided by the Valuation Committee; | |
| • | The Valuation Committee of our Board of Directors makes a recommendation to the Board of Directors; and | |
| • | Our Board of Directors discusses valuations and determines the fair value of each investment in our portfolio in good faith. |
The fair value of all of our investments at September 30,
2010 and September 30, 2009 was determined by our Board of
Directors. Our Board of Directors is solely responsible for the
valuation of the portfolio investments at fair value as
determined in good faith pursuant to our valuation policy and a
consistently applied valuation process.
Our Board of Directors has engaged independent valuation firms
to provide us with valuation assistance. Upon completion of
their process each quarter, the independent valuation firms
provide us with a written report regarding the preliminary
valuations of selected portfolio securities as of the close of
such quarter. We will continue to engage independent valuation
firms to provide us with assistance regarding our determination
of the fair value of selected portfolio securities each quarter;
however, our Board of Directors is ultimately and solely
responsible for determining the fair value of our investments in
good faith.
10
The percentages of our portfolio at fair value for which
independent valuation firms provided us with valuation
assistance by period were as follows:
|
Percentage of
|
||||
|
Portfolio at
|
||||
| Fair Value | ||||
|
For the quarter ending December 31, 2007
|
91.9 | % | ||
|
For the quarter ending March 31, 2008
|
92.1 | % | ||
|
For the quarter ending June 30, 2008
|
91.7 | % | ||
|
For the quarter ending September 30, 2008
|
92.8 | % | ||
|
For the quarter ending December 31, 2008
|
100.0 | % | ||
|
For the quarter ending March 31, 2009
|
88.7 | %(1) | ||
|
For the quarter ending June 30, 2009
|
92.1 | % | ||
|
For the quarter ending September 30, 2009
|
28.1 | % | ||
|
For the quarter ending December 31, 2009
|
17.2 | %(2) | ||
|
For the quarter ending March 31, 2010
|
26.9 | % | ||
|
For the quarter ending June 30, 2010
|
53.1 | % | ||
|
For the quarter ending September 30, 2010
|
61.8 | % | ||
| (1) | 96.0% excluding our investment in IZI Medical Products, Inc., which closed on June 30, 2009 and therefore was not part of the independent valuation process | |
| (2) | 24.8% excluding four investments that closed in December 2009 and therefore were not part of the independent valuation process |
We intend to have valuation firms provide us with valuation
assistance on a portion of our portfolio on a quarterly basis
and a substantial portion of our portfolio on an annual basis.
Determination of fair values involves subjective judgments and
estimates. The notes to our financial statements refer to the
uncertainty with respect to the possible effect of such
valuations, and any change in such valuations, on our financial
statements.
Competition
We compete for investments with a number of business development
companies and investment funds (including private equity funds
and mezzanine funds), as well as traditional financial services
companies such as commercial banks and other sources of
financing. Many of these entities have greater financial and
managerial resources than we do. We believe we are able to be
competitive with these entities primarily on the basis of the
experience and contacts of our management team, our responsive
and efficient investment analysis and decision-making processes,
the investment terms we offer, and our willingness to make
smaller investments.
We believe that some of our competitors make loans with interest
rates and returns that are comparable to or lower than the rates
and returns that we target. Therefore, we do not seek to compete
solely on the interest rates and returns that we offer to
potential portfolio companies. For additional information
concerning the competitive risks we face, see
“Item 1A. Risk Factors — Risks Relating to
Our Business and Structure — We may face increasing
competition for investment opportunities, which could reduce
returns and result in losses.”
Employees
We do not have any employees. Our
day-to-day
investment operations are managed by our investment adviser. See
“— Investment Advisory Agreement.” Our investment
adviser employs a total of 19 investment professionals,
including its principals. In addition, we reimburse our
administrator, FSC, Inc., for the allocable portion of overhead
and other expenses incurred by it in performing its obligations
under an administration agreement, including the compensation of
our chief financial officer and chief compliance officer, and
their staff. FSC, Inc. has voluntarily determined to forgo
receiving reimbursement for the services performed for us
11
by our chief compliance officer, Bernard D. Berman, given his
compensation arrangement with our investment adviser. However,
although FSC, Inc. currently intends to forgo its right to
receive such reimbursement, it is under no obligation to do so
and may cease to do so at any time in the future. For a more
detailed discussion of the administration agreement, see
“Item 1. Business — Administration
Agreement.”
Investment
Advisory Agreement
Overview
of Our Investment Adviser
Management
Services
Our investment adviser, Fifth Street Management, is registered
as an investment adviser under the Investment Advisers Act of
1940, or the “Advisers Act.” Our investment adviser
serves pursuant to the investment advisory agreement in
accordance with the 1940 Act. Subject to the overall supervision
of our Board of Directors, our investment adviser manages our
day-to-day
operations and provides us with investment advisory services.
Under the terms of the investment advisory agreement, our
investment adviser:
| • | determines the composition of our portfolio, the nature and timing of the changes to our portfolio and the manner of implementing such changes; | |
| • | determines what securities we purchase, retain or sell; | |
| • | identifies, evaluates and negotiates the structure of the investments we make; and | |
| • | executes, monitors and services the investments we make. |
Our investment adviser’s services under the investment
advisory agreement may not be exclusive and it is free to
furnish similar services to other entities so long as its
services to us are not impaired.
Management
Fee
We pay our investment adviser a fee for its services under the
investment advisory agreement consisting of two
components — a base management fee and an incentive
fee. The cost of both the base management fee payable to our
investment adviser and any incentive fees earned by our
investment adviser will ultimately be borne by our common
stockholders.
Base
Management Fee
The base management fee is calculated at an annual rate of 2% of
our gross assets, which includes any borrowings for investment
purposes. The base management fee is payable quarterly in
arrears, and is calculated based on the value of our gross
assets at the end of each fiscal quarter, and appropriately
adjusted on a pro rata basis for any equity capital raises or
repurchases during such quarter. The base management fee for any
partial month or quarter will be appropriately pro rated. Our
investment adviser permanently waived the portion of the base
management fee attributable to cash and cash equivalents (as
defined in the notes to our Consolidated Financial Statements)
as of the end of each quarter beginning March 31, 2010. As
a result, our base management fee will be calculated at an
annual rate of 2% of our gross assets, including any investments
made with borrowings, but excluding any cash and cash
equivalents (as defined in the notes to our Consolidated
Financial Statements) as of the end of each quarter.
Incentive
Fee
The incentive fee has two parts. The first part is calculated
and payable quarterly in arrears based on our
“Pre-Incentive Fee Net Investment Income” for the
immediately preceding fiscal quarter. For this purpose,
“Pre-Incentive Fee Net Investment Income” means
interest income, dividend income and any other income (including
any other fees (other than fees for providing managerial
assistance), such as commitment, origination, structuring,
diligence and consulting fees or other fees that we receive from
portfolio companies) accrued during the fiscal quarter, minus
our operating expenses for the quarter (including the base
management fee, expenses payable under the administration
agreement with FSC, Inc., and any interest expense and
12
dividends paid on any issued and outstanding preferred stock,
but excluding the incentive fee). Pre-Incentive Fee Net
Investment Income includes, in the case of investments with a
deferred interest feature (such as original issue discount, debt
instruments with PIK interest and zero coupon securities),
accrued income that we have not yet received in cash.
Pre-Incentive Fee Net Investment Income does not include any
realized capital gains, realized capital losses or unrealized
capital appreciation or depreciation. Pre-Incentive Fee Net
Investment Income, expressed as a rate of return on the value of
our net assets at the end of the immediately preceding fiscal
quarter, will be compared to a “hurdle rate” of 2% per
quarter (8% annualized), subject to a
“catch-up”
provision measured as of the end of each fiscal quarter. Our net
investment income used to calculate this part of the incentive
fee is also included in the amount of our gross assets used to
calculate the 2% base management fee. The operation of the
incentive fee with respect to our Pre-Incentive Fee Net
Investment Income for each quarter is as follows:
| • | no incentive fee is payable to the investment adviser in any fiscal quarter in which our Pre-Incentive Fee Net Investment Income does not exceed the hurdle rate of 2% (the “preferred return” or “hurdle”); | |
| • | 100% of our Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the hurdle rate but is less than or equal to 2.5% in any fiscal quarter (10% annualized) is payable to the investment adviser. We refer to this portion of our Pre-Incentive Fee Net Investment Income (which exceeds the hurdle rate but is less than or equal to 2.5%) as the “catch-up.” The “catch-up” provision is intended to provide our investment adviser with an incentive fee of 20% on all of our Pre-Incentive Fee Net Investment Income as if a hurdle rate did not apply when our Pre-Incentive Fee Net Investment Income exceeds 2.5% in any fiscal quarter; and | |
| • | 20% of the amount of our Pre-Incentive Fee Net Investment Income, if any, that exceeds 2.5% in any fiscal quarter (10% annualized) is payable to the investment adviser once the hurdle is reached and the catch-up is achieved. |
The following is a graphical representation of the calculation
of the income-related portion of the incentive fee:
Quarterly
Incentive Fee Based on “Pre-Incentive Fee Net Investment
Income”
Pre-Incentive Fee Net Investment Income
(expressed as a percentage of the value of net assets)
(expressed as a percentage of the value of net assets)
Percentage
of Pre-Incentive Fee Net Investment
Income allocated to income-related portion of incentive fee
Income allocated to income-related portion of incentive fee
The second part of the incentive fee is determined and payable
in arrears as of the end of each fiscal year (or upon
termination of the investment advisory agreement, as of the
termination date) and equals 20% of our realized capital gains,
if any, on a cumulative basis from inception through the end of
each fiscal year, computed net of all realized capital losses
and unrealized capital depreciation on a cumulative basis, less
the aggregate amount of any previously paid capital gain
incentive fees, provided that, the incentive fee determined as
of September 30, 2008 was calculated for a period of
shorter than twelve calendar months to take into account any
realized capital gains computed net of all realized capital
losses and unrealized capital depreciation from inception.
13
Example
1: Income Related Portion of Incentive Fee for Each Fiscal
Quarter
Alternative
1
Assumptions
Investment income (including interest, dividends, fees, etc.) =
1.25%
Hurdle rate(1) = 2%
Management fee(2) = 0.5%
Other expenses (legal, accounting, custodian, transfer agent, etc.)(3) = 0.2%
Pre-Incentive Fee Net Investment Income
(investment income − (management fee + other expenses) = 0.55%
Hurdle rate(1) = 2%
Management fee(2) = 0.5%
Other expenses (legal, accounting, custodian, transfer agent, etc.)(3) = 0.2%
Pre-Incentive Fee Net Investment Income
(investment income − (management fee + other expenses) = 0.55%
Pre-Incentive Fee Net Investment Income does not exceed hurdle
rate, therefore there is no income-related incentive fee.
Alternative
2
Assumptions
Investment income (including interest, dividends, fees, etc.) =
2.9%
Hurdle rate(1) = 2%
Management fee(2) = 0.5%
Other expenses (legal, accounting, custodian, transfer agent,
etc.)(3) = 0.2%
Pre-Incentive Fee Net Investment Income
(investment income − (management fee + other
expenses) = 2.2%
| Incentive fee |
= 100% × Pre-Incentive Fee Net Investment Income (subject
to
“catch-up”)(4)
= 100% × (2.2% − 2%) = 0.2% |
Pre-Incentive Fee Net Investment Income exceeds the hurdle rate,
but does not fully satisfy the
“catch-up”
provision, therefore the income related portion of the incentive
fee is 0.2%.
Alternative
3
Assumptions
Investment income (including interest, dividends, fees, etc.) =
3.5%
Hurdle rate(1) = 2%
Management fee(2) = 0.5%
Other expenses (legal, accounting, custodian, transfer agent,
etc.)(3) = 0.2%
Pre-Incentive Fee Net Investment Income
(investment income − (management fee + other
expenses) = 2.8%
Incentive fee = 100% × Pre-Incentive Fee Net Investment
Income (subject to
“catch-up”)(4)
Incentive fee = 100% ×
“catch-up”
+ (20% × (Pre-Incentive Fee Net Investment
Income − 2.5%))
| Catch up |
= 2.5% − 2%
= 0.5% |
|
Incentive fee
|
= (100% × 0.5%) + (20% × (2.8% − 2.5%)) |
= 0.5% + (20% × 0.3%)
= 0.5% + 0.06%
= 0.56%
Pre-Incentive Fee Net Investment Income exceeds the hurdle rate,
and fully satisfies the
“catch-up”
provision, therefore the income related portion of the incentive
fee is 0.56%.
| (1) | Represents 8% annualized hurdle rate. | |
| (2) | Represents 2% annualized base management fee. | |
| (3) | Excludes organizational and offering expenses. |
14
| (4) | The “catch-up” provision is intended to provide our investment adviser with an incentive fee of 20% on all Pre-Incentive Fee Net Investment Income as if a hurdle rate did not apply when our net investment income exceeds 2.5% in any fiscal quarter. |
Example
2: Capital Gains Portion of Incentive Fee(*):
Alternative
1:
Assumptions
Year 1: $20 million investment made in Company A
(“Investment A”), and $30 million investment made
in Company B (“Investment B”)
Year 2: Investment A sold for $50 million and fair market
value (“FMV”) of Investment B determined to be
$32 million
Year 3: FMV of Investment B determined to be $25 million
Year 4: Investment B sold for $31 million
The capital gains portion of the incentive fee would be:
Year 1: None
Year 2: Capital gains incentive fee of
$6 million — ($30 million realized capital
gains on sale of Investment A multiplied by 20%)
Year 3: None — $5 million (20% multiplied by
($30 million cumulative capital gains less $5 million
cumulative capital depreciation)) less $6 million (previous
capital gains fee paid in Year 2)
Year 4: Capital gains incentive fee of $200,000 —
$6.2 million ($31 million cumulative realized capital
gains multiplied by 20%) less $6 million (capital gains
incentive fee taken in Year 2)
Alternative
2
Assumptions
Year 1: $20 million investment made in Company A
(“Investment A”), $30 million investment made in
Company B (“Investment B”) and $25 million
investment made in Company C (“Investment C”)
Year 2: Investment A sold for $50 million, FMV of
Investment B determined to be $25 million and FMV of
Investment C determined to be $25 million
Year 3: FMV of Investment B determined to be $27 million
and Investment C sold for $30 million
Year 4: FMV of Investment B determined to be $35 million
Year 5: Investment B sold for $20 million
The capital gains incentive fee, if any, would be:
Year 1: None
Year 2: $5 million capital gains incentive fee —
20% multiplied by $25 million ($30 million realized
capital gains on Investment A less unrealized capital
depreciation on Investment B)
Year 3: $1.4 million capital gains incentive
fee(1) — $6.4 million (20% multiplied by
$32 million ($35 million cumulative realized capital
gains less $3 million unrealized capital depreciation))
less $5 million capital gains incentive fee received in
Year 2
Year 4: None
Year 5: None — $5 million (20% multiplied by
$25 million (cumulative realized capital gains of
$35 million less realized capital losses of
$10 million)) less $6.4 million cumulative capital
gains incentive fee paid in Year 2 and Year 3(2)
| * | The hypothetical amounts of returns shown are based on a percentage of our total net assets and assume no leverage. There is no guarantee that positive returns will be realized and actual returns may vary from those shown in this example. |
15
| (1) | As illustrated in Year 3 of Alternative 1 above, if Fifth Street were to be wound up on a date other than its fiscal year end of any year, Fifth Street may have paid aggregate capital gains incentive fees that are more than the amount of such fees that would be payable if Fifth Street had been wound up on its fiscal year end of such year. | |
| (2) | As noted above, it is possible that the cumulative aggregate capital gains fee received by our investment adviser ($6.4 million) is effectively greater than $5 million (20% of cumulative aggregate realized capital gains less net realized capital losses or net unrealized depreciation ($25 million)). |
Payment
of Our Expenses
Our primary operating expenses are the payment of a base
management fee and any incentive fees under the investment
advisory agreement and the allocable portion of overhead and
other expenses incurred by FSC, Inc. in performing its
obligations under the administration agreement. Our investment
management fee compensates our investment adviser for its work
in identifying, evaluating, negotiating, executing and servicing
our investments. We bear all other expenses of our operations
and transactions, including (without limitation) fees and
expenses relating to:
| • | offering expenses; | |
| • | the investigation and monitoring of our investments; | |
| • | the cost of calculating our net asset value; | |
| • | the cost of effecting sales and repurchases of shares of our common stock and other securities; | |
| • | management and incentive fees payable pursuant to the investment advisory agreement; | |
| • | fees payable to third parties relating to, or associated with, making investments and valuing investments (including third-party valuation firms); | |
| • | transfer agent and custodial fees; | |
| • | fees and expenses associated with marketing efforts (including attendance at investment conferences and similar events); | |
| • | federal and state registration fees; | |
| • | any exchange listing fees; | |
| • | federal, state and local taxes; | |
| • | independent directors’ fees and expenses; | |
| • | brokerage commissions; | |
| • | costs of proxy statements, stockholders’ reports and notices; | |
| • | costs of preparing government filings, including periodic and current reports with the SEC; | |
| • | fidelity bond, liability insurance and other insurance premiums; and | |
| • | printing, mailing, independent accountants and outside legal costs and all other direct expenses incurred by either our investment adviser or us in connection with administering our business, including payments under the administration agreement that will be based upon our allocable portion of overhead and other expenses incurred by FSC, Inc. in performing its obligations under the administration agreement and the compensation of our chief financial officer and chief compliance officer, and their staff. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us by our chief compliance officer, Bernard D. Berman, given his compensation arrangement with our investment adviser. However, although FSC, Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future. |
16
Duration
and Termination
The investment advisory agreement was first approved by our
Board of Directors on December 13, 2007 and by a majority
of the limited partners of Fifth Street Mezzanine Partners III,
L.P. through a written consent first solicited on
December 14, 2007. On March 14, 2008, our Board of
Directors, including all of the directors who are not
“interested persons” as defined in the 1940 Act,
approved an amendment to the investment advisory agreement that
revised the investment advisory agreement to clarify the
calculation of the base management fee. Such amendment was also
approved by a majority of our outstanding voting securities
through a written consent first solicited on April 7, 2008.
Unless earlier terminated as described below, the investment
advisory agreement, as amended, will remain in effect for a
period of two years from the date it was approved by the Board
of Directors and will remain in effect from
year-to-year
thereafter if approved annually by the Board of Directors or by
the affirmative vote of the holders of a majority of our
outstanding voting securities, including, in either case,
approval by a majority of our directors who are not interested
persons. The investment advisory agreement will automatically
terminate in the event of its assignment. The investment
advisory agreement may be terminated by either party without
penalty upon not more than 60 days’ written notice to
the other. The investment advisory agreement may also be
terminated, without penalty, upon the vote of a majority of our
outstanding voting securities.
Indemnification
The investment advisory agreement provides that, absent willful
misfeasance, bad faith or gross negligence in the performance of
their respective duties or by reason of the reckless disregard
of their respective duties and obligations, our investment
adviser and its officers, managers, agents, employees,
controlling persons, members (or their owners) and any other
person or entity affiliated with it, are entitled to
indemnification from us for any damages, liabilities, costs and
expenses (including reasonable attorneys’ fees and amounts
reasonably paid in settlement) arising from the rendering of our
investment adviser’s services under the investment advisory
agreement or otherwise as our investment adviser.
Organization
of our Investment Adviser
Our investment adviser is a Delaware limited liability company
that registered as an investment adviser under the Advisers Act.
The principal address of our investment adviser is 10 Bank
Street,
12
th
Floor, White Plains, NY 10606.
Board
Approval of the Investment Advisory Agreement
At a meeting of our Board of Directors held on February 24,
2010, our Board of Directors unanimously voted to approve the
investment advisory agreement. In reaching a decision to approve
the investment advisory agreement, the Board of Directors
reviewed a significant amount of information and considered,
among other things:
| • | the nature, quality and extent of the advisory and other services to be provided to us by Fifth Street Management; | |
| • | the fee structures of comparable externally managed business development companies that engage in similar investing activities; | |
| • | our projected operating expenses and expense ratio compared to business development companies with similar investment objectives; | |
| • | any existing and potential sources of indirect income to Fifth Street Management from its relationship with us and the profitability of that relationship, including through the investment advisory agreement; | |
| • | information about the services to be performed and the personnel performing such services under the investment advisory agreement; |
17
| • | the organizational capability and financial condition of Fifth Street Management and its affiliates; and | |
| • | various other matters. |
Based on the information reviewed and the discussions detailed
above, the Board of Directors, including all of the directors
who are not “interested persons” as defined in the
1940 Act, concluded that the investment advisory fee rates and
terms are reasonable in relation to the services provided and
approved the investment advisory agreement and the
administration agreement as being in the best interests of our
stockholders.
Administration
Agreement
We have also entered into an administration agreement with FSC,
Inc. under which FSC, Inc. provides administrative services for
us, including office facilities and equipment and clerical,
bookkeeping and recordkeeping services at such facilities. Under
the administration agreement, FSC, Inc. also performs, or
oversees the performance of, our required administrative
services, which includes being responsible for the financial
records which we are required to maintain and preparing reports
to our stockholders and reports filed with the SEC. In addition,
FSC, Inc. assists us in determining and publishing our net asset
value, overseeing the preparation and filing of our tax returns
and the printing and dissemination of reports to our
stockholders, and generally overseeing the payment of our
expenses and the performance of administrative and professional
services rendered to us by others. For providing these services,
facilities and personnel, we reimburse FSC, Inc. the allocable
portion of overhead and other expenses incurred by FSC, Inc. in
performing its obligations under the administration agreement,
including rent and our allocable portion of the costs of
compensation and related expenses of our chief financial officer
and chief compliance officer, and their staff. FSC, Inc. has
voluntarily determined to forgo receiving reimbursement for the
services performed for us by our chief compliance officer,
Bernard D. Berman, given his compensation arrangement with our
investment adviser. However, although FSC, Inc. currently
intends to forgo its right to receive such reimbursement, it is
under no obligation to do so and may cease to do so at any time
in the future. FSC, Inc. may also provide on our behalf
managerial assistance to our portfolio companies. The
administration agreement may be terminated by either party
without penalty upon 60 days’ written notice to the
other party.
The administration agreement provides that, absent willful
misfeasance, bad faith or gross negligence in the performance of
their respective duties or by reason of the reckless disregard
of their respective duties and obligations, FSC, Inc. and its
officers, managers, agents, employees, controlling persons,
members and any other person or entity affiliated with it are
entitled to indemnification from us for any damages,
liabilities, costs and expenses (including reasonable
attorneys’ fees and amounts reasonably paid in settlement)
arising from the rendering of services under the administration
agreement or otherwise as administrator for us.
License
Agreement
We have also entered into a license agreement with Fifth Street
Capital LLC pursuant to which Fifth Street Capital LLC has
agreed to grant us a non-exclusive, royalty-free license to use
the name “Fifth Street.” Under this agreement, we will
have a right to use the “Fifth Street” name, for so
long as Fifth Street Management or one of its affiliates remains
our investment adviser. Other than with respect to this limited
license, we will have no legal right to the “Fifth
Street” name.
Exchange
Act Reports
We maintain a website at
www.fifthstreetfinance.com
. The
information on our website is not incorporated by reference in
this annual report on
Form 10-K.
We make available on or through our website certain reports and
amendments to those reports that we file with or furnish to the
SEC in accordance with the Securities Exchange Act of 1934, as
amended (the “Exchange Act”). These include our annual
reports on
Form 10-K,
our quarterly reports on
Form 10-Q
and our current reports on
Form 8-K.
We make this information available on our website free of charge
as soon as reasonably practicable after we electronically file
the information with, or furnish it to, the SEC.
18
Regulation
Business
Development Company Regulations
We have elected to be regulated as a business development
company under the 1940 Act. The 1940 Act contains prohibitions
and restrictions relating to transactions between business
development companies and their affiliates, principal
underwriters and affiliates of those affiliates or underwriters.
The 1940 Act requires that a majority of the directors be
persons other than “interested persons,” as that term
is defined in the 1940 Act. In addition, the 1940 Act provides
that we may not change the nature of our business so as to cease
to be, or to withdraw our election as, a business development
company unless approved by a majority of our outstanding voting
securities.
The 1940 Act defines “a majority of the outstanding voting
securities” as the lesser of (i) 67% or more of the
voting securities present at a meeting if the holders of more
than 50% of our outstanding voting securities are present or
represented by proxy or (ii) more than 50% of our
outstanding voting securities.
As a business development company, we will not generally be
permitted to invest in any portfolio company in which our
investment adviser or any of its affiliates currently have an
investment or to make any co-investments with our investment
adviser or its affiliates without an exemptive order from the
SEC. We currently do not intend to apply for an exemptive order
that would permit us to co-invest with vehicles managed by our
investment adviser or its affiliates.
Qualifying
Assets
Under the 1940 Act, a business development company may not
acquire any asset other than assets of the type listed in
Section 55(a) of the 1940 Act, which are referred to as
qualifying assets, unless, at the time the acquisition is made,
qualifying assets represent at least 70% of the company’s
total assets. The principal categories of qualifying assets
relevant to our business are any of the following:
(1) Securities purchased in transactions not involving any
public offering from the issuer of such securities, which issuer
(subject to certain limited exceptions) is an eligible portfolio
company, or from any person who is, or has been during the
preceding 13 months, an affiliated person of an eligible
portfolio company, or from any other person, subject to such
rules as may be prescribed by the SEC. An eligible portfolio
company is defined in the 1940 Act as any issuer which:
(a) is organized under the laws of, and has its principal
place of business in, the United States;
(b) is not an investment company (other than a small
business investment company wholly owned by the business
development company) or a company that would be an investment
company but for certain exclusions under the 1940 Act; and
(c) satisfies any of the following:
(i) does not have any class of securities that is traded on
a national securities exchange;
(ii) has a class of securities listed on a national
securities exchange, but has an aggregate market value of
outstanding voting and non-voting common equity of less than
$250 million;
(iii) is controlled by a business development company or a
group of companies including a business development company and
the business development company has an affiliated person who is
a director of the eligible portfolio company; or
(iv) is a small and solvent company having total assets of
not more than $4 million and capital and surplus of not
less than $2 million;
(2) Securities of any eligible portfolio company that we
control;
(3) Securities purchased in a private transaction from a
U.S. issuer that is not an investment company or from an
affiliated person of the issuer, or in transactions incident
thereto, if the issuer is in bankruptcy and subject to
reorganization or if the issuer, immediately prior to the
purchase of its
19
securities was unable to meet its obligations as they came due
without material assistance other than conventional lending or
financing arrangements;
(4) Securities of an eligible portfolio company purchased
from any person in a private transaction if there is no ready
market for such securities and we already own 60% of the
outstanding equity of the eligible portfolio company;
(5) Securities received in exchange for or distributed on
or with respect to securities described in (1) through
(4) above, or pursuant to the exercise of warrants or
rights relating to such securities; or
(6) Cash, cash equivalents, U.S. government securities
or high-quality debt securities maturing in one year or less
from the time of investment.
In addition, a business development company must be operated for
the purpose of making investments in the types of securities
described in (1), (2) or (3) above.
Managerial
Assistance to Portfolio Companies
In order to count portfolio securities as qualifying assets for
the purpose of the 70% test, we must either control the issuer
of the securities or must offer to make available to the issuer
of the securities (other than small and solvent companies
described above) significant managerial assistance; except that,
where we purchase such securities in conjunction with one or
more other persons acting together, one of the other persons in
the group may make available such managerial assistance. Making
available managerial assistance means, among other things, any
arrangement whereby the business development company, through
its directors, officers or employees, offers to provide, and, if
accepted, does so provide, significant guidance and counsel
concerning the management, operations or business objectives and
policies of a portfolio company.
Temporary
Investments
Pending investment in other types of “qualifying
assets,” as described above, our investments may consist of
cash, cash equivalents, U.S. government securities or
high-quality debt securities maturing in one year or less from
the time of investment, which we refer to, collectively, as
temporary investments, so that 70% of our assets are qualifying
assets. Typically, we will invest in U.S. Treasury bills or
in repurchase agreements, provided that such agreements are
fully collateralized by cash or securities issued by the
U.S. government or its agencies. A repurchase agreement
(which is substantially similar to a secured loan) involves the
purchase by an investor, such as us, of a specified security and
the simultaneous agreement by the seller to repurchase it at an
agreed-upon
future date and at a price that is greater than the purchase
price by an amount that reflects an
agreed-upon
interest rate. There is no percentage restriction on the
proportion of our assets that may be invested in such repurchase
agreements. However, if more than 25% of our total assets
constitute repurchase agreements from a single counterparty, we
would not meet the diversification tests in order to qualify as
a RIC for U.S. federal income tax purposes. Thus, we do not
intend to enter into repurchase agreements with a single
counterparty in excess of this limit. Our investment adviser
will monitor the creditworthiness of the counterparties with
which we enter into repurchase agreement transactions.
Senior
Securities
We are permitted, under specified conditions, to issue multiple
classes of debt and one class of stock senior to our common
stock if our asset coverage, as defined in the 1940 Act, is at
least equal to 200% immediately after each such issuance. In
addition, while any senior securities remain outstanding, we may
be prohibited from making distribution to our stockholders or
repurchasing such securities or shares unless we meet the
applicable asset coverage ratios at the time of the distribution
or repurchase. We may also borrow amounts up to 5% of the value
of our total assets for temporary or emergency purposes without
regard to asset coverage. For a discussion of the risks
associated with leverage, see “Risk Factors —
Risks Relating to Our Business and Structure —
Regulations governing our operation as a business development
company and RIC affect our ability to raise, and the way in
which we raise, additional capital or borrow for investment
purposes,
20
which may have a negative effect on our growth” and
“— Because we borrow money, the potential for
loss on amounts invested in us will be magnified and may
increase the risk of investing in us.”
Common
Stock
We are not generally able to issue and sell our common stock at
a price below net asset value per share. We may, however, sell
our common stock, warrants, options or rights to acquire our
common stock, at a price below the current net asset value of
the common stock if our Board of Directors determines that such
sale is in our best interests and that of our stockholders, and
our stockholders approve such sale. In any such case, the price
at which our securities are to be issued and sold may not be
less than a price which, in the determination of our Board of
Directors, closely approximates the market value of such
securities (less any distributing commission or discount). We
may also make rights offerings to our stockholders at prices per
share less than the net asset value per share, subject to
applicable requirements of the 1940 Act. See “Risk
Factors — Risks Relating to Our Business and
Structure — Regulations governing our operation as a
business development company affect our ability to raise, and
the way in which we raise, additional capital or borrow for
investment purposes, which may have a negative effect on our
growth.”
Code
of Ethics
We have adopted a code of ethics pursuant to
Rule 17j-1
under the 1940 Act and we have also approved the investment
adviser’s code of ethics that was adopted by it under
Rule 17j-1
under the 1940 Act and
Rule 204A-1
of the Advisers Act. These codes establish procedures for
personal investments and restrict certain personal securities
transactions. Personnel subject to the code may invest in
securities for their personal investment accounts, including
securities that may be purchased or held by us, so long as such
investments are made in accordance with the code’s
requirements. You may also read and copy the codes of ethics at
the SEC’s Public Reference Room located at
100 F Street, NE, Washington, DC 20549. You may obtain
information on the operation of the Public Reference Room by
calling the SEC at
1-800-SEC-0330.
In addition, the codes of ethics are available on the EDGAR
Database on the SEC’s Internet site at
http://www.sec.gov.
Compliance
Policies and Procedures
We and our investment adviser have adopted and implemented
written policies and procedures reasonably designed to prevent
violation of the federal securities laws and are required to
review these compliance policies and procedures annually for
their adequacy and the effectiveness of their implementation.
Our chief compliance officer is responsible for administering
these policies and procedures.
Proxy
Voting Policies and Procedures
We have delegated our proxy voting responsibility to our
investment adviser. The proxy voting policies and procedures of
our investment adviser are set forth below. The guidelines are
reviewed periodically by our investment adviser and our
non-interested directors, and, accordingly, are subject to
change.
Introduction
As an investment adviser registered under the Advisers Act, our
investment adviser has a fiduciary duty to act solely in the
best interests of its clients. As part of this duty, it
recognizes that it must vote client securities in a timely
manner free of conflicts of interest and in the best interests
of its clients.
These policies and procedures for voting proxies for the
investment advisory clients of our investment adviser are
intended to comply with Section 206 of, and Rule 206(4)-6
under, the Advisers Act.
Proxy
policies
Our investment adviser will vote proxies relating to our
securities in the best interest of our stockholders. It will
review on a
case-by-case
basis each proposal submitted for a stockholder vote to
determine its impact
21
on the portfolio securities held by us. Although our investment
adviser will generally vote against proposals that may have a
negative impact on our portfolio securities, it may vote for
such a proposal if there exists compelling long-term reasons to
do so.
The proxy voting decisions of our investment adviser are made by
the senior officers who are responsible for monitoring each of
our investments. To ensure that its vote is not the product of a
conflict of interest, it will require that: (a) anyone
involved in the decision making process disclose to its chief
compliance officer any potential conflict that he or she is
aware of and any contact that he or she has had with any
interested party regarding a proxy vote; and (b) employees
involved in the decision making process or vote administration
are prohibited from revealing how our investment adviser intends
to vote on a proposal in order to reduce any attempted influence
from interested parties.
Proxy
voting records
You may obtain information, without charge, regarding how we
voted proxies with respect to our portfolio securities by making
a written request for proxy voting information to: Chief
Compliance Officer, 10 Bank Street,
12
th
Floor, White Plains, NY 10606.
Other
We will be subject to periodic examination by the SEC for
compliance with the 1940 Act.
We are required to provide and maintain a bond issued by a
reputable fidelity insurance company to protect us against
larceny and embezzlement. Furthermore, as a business development
company, we are prohibited from protecting any director or
officer against any liability to us or our stockholders arising
from willful misfeasance, bad faith, gross negligence or
reckless disregard of the duties involved in the conduct of such
person’s office.
Exchange
Act and Sarbanes-Oxley Act Compliance
We are subject to the reporting and disclosure requirements of
the Exchange Act, including the filing of quarterly, annual and
current reports, proxy statements and other required items. In
addition, we are subject to the Sarbanes-Oxley Act, which
imposes a wide variety of regulatory requirements on
publicly-held companies and their insiders. For example:
| • | pursuant to Rule 13a-14 of the Exchange Act, our chief executive officer and chief financial officer are required to certify the accuracy of the financial statements contained in our periodic reports; | |
| • | pursuant to Item 307 of Regulation S-K, our periodic reports are required to disclose our conclusions about the effectiveness of our disclosure controls and procedures; and | |
| • | pursuant to Rule 13a-15 of the Exchange Act, our management is required to prepare a report regarding its assessment of our internal control over financial reporting. Our independent registered public accounting firm is required to audit our internal control over financial reporting. |
The Sarbanes-Oxley Act requires us to review our current
policies and procedures to determine whether we comply with the
Sarbanes-Oxley Act and the regulations promulgated thereunder.
We intend to monitor our compliance with all regulations that
are adopted under the Sarbanes-Oxley Act and will take actions
necessary to ensure that we are in compliance therewith.
Small
Business Investment Company Regulations
In August 2009, we formed Fifth Street Mezzanine Partners IV,
L.P., a wholly-owned subsidiary of ours. In February 2010, Fifth
Street Mezzanine Partners IV, L.P. received final approval to be
licensed by the United States Small Business Administration, or
SBA, as a small business investment company, or SBIC.
22
The SBIC license allows our SBIC subsidiary to obtain leverage
by issuing SBA-guaranteed debentures, subject to the issuance of
a capital commitment by the SBA and other customary procedures.
SBA-guaranteed debentures are non-recourse, interest only
debentures with interest payable semi-annually and have a ten
year maturity. The principal amount of SBA-guaranteed debentures
is not required to be paid prior to maturity but may be prepaid
at any time without penalty. The interest rate of SBA-guaranteed
debentures is fixed on a semi-annual basis at a market-driven
spread over U.S. Treasury Notes with
10-year
maturities.
SBICs are designed to stimulate the flow of private equity
capital to eligible small businesses. Under SBA regulations,
SBICs may make loans to eligible small businesses and invest in
the equity securities of small businesses. Under present SBA
regulations, eligible small businesses include businesses that
have a tangible net worth not exceeding $18 million and
have average annual fully taxed net income not exceeding
$6 million for the two most recent fiscal years. In
addition, an SBIC must devote 25% of its investment activity to
“smaller” concerns as defined by the SBA. A smaller
concern is one that has a tangible net worth not exceeding
$6 million and has average annual fully taxed net income
not exceeding $2 million for the two most recent fiscal
years. SBA regulations also provide alternative size standard
criteria to determine eligibility, which depend on the industry
in which the business is engaged and are based on such factors
as the number of employees and gross sales. According to SBA
regulations, SBICs may make long-term loans to small businesses,
invest in the equity securities of such businesses and provide
them with consulting and advisory services.
SBA regulations currently limit the amount that our SBIC
subsidiary may borrow up to a maximum of $150 million when
it has at least $75 million in regulatory capital, receives
a capital commitment from the SBA and has been through an
examination by the SBA subsequent to licensing. As of
September 30, 2010, our SBIC subsidiary had
$75 million in regulatory capital and the SBA had issued a
capital commitment to our SBIC subsidiary in the amount of
$150 million.
The SBA restricts the ability of SBICs to repurchase their
capital stock. SBA regulations also include restrictions on a
“change of control” or transfer of an SBIC and require
that SBICs invest idle funds in accordance with SBA regulations.
In addition, our SBIC subsidiary may also be limited in its
ability to make distributions to us if it does not have
sufficient capital, in accordance with SBA regulations.
Our SBIC subsidiary is subject to regulation and oversight by
the SBA, including requirements with respect to maintaining
certain minimum financial ratios and other covenants. Receipt of
an SBIC license does not assure that our SBIC subsidiary will
receive SBA guaranteed debenture funding, which is dependent
upon our SBIC subsidiary continuing to be in compliance with SBA
regulations and policies. The SBA, as a creditor, will have a
superior claim to our SBIC subsidiary’s assets over our
stockholders in the event we liquidate our SBIC subsidiary or
the SBA exercises its remedies under the SBA-guaranteed
debentures issued by our SBIC subsidiary upon an event of
default.
The New
York Stock Exchange Corporate Governance Regulations
The New York Stock Exchange has adopted corporate governance
regulations that listed companies must comply with. We are in
compliance with such corporate governance listing standards
applicable to business development companies.
Taxation
as a Regulated Investment Company
As a business development company, we have elected to be
treated, and intend to qualify annually, as a RIC under
Subchapter M of the Code, beginning with our 2008 taxable year.
As a RIC, we generally will not have to pay
corporate-level U.S. federal income taxes on any
income that we distribute to our stockholders as dividends. To
continue to qualify as a RIC, we must, among other things, meet
certain
source-of-income
and asset diversification requirements (as described below). In
addition, to qualify for RIC tax treatment we must distribute to
our stockholders, for each taxable year, at least 90% of our
“investment company taxable income,” which is
generally our ordinary income plus the excess of our realized
net short-term capital gains over our realized net long-term
capital losses (the “Annual Distribution Requirement”).
23
If we:
| • | qualify as a RIC; and | |
| • | satisfy the Annual Distribution Requirement, |
then we will not be subject to U.S. federal income tax on
the portion of our income we distribute (or are deemed to
distribute) to stockholders. We will be subject to
U.S. federal income tax at the regular corporate rates on
any income or capital gains not distributed (or deemed
distributed) to our stockholders.
We will be subject to a 4% nondeductible U.S. federal
excise tax on certain undistributed income unless we distribute
in a timely manner an amount at least equal to the sum of
(1) 98% of our net ordinary income for each calendar year,
(2) 98% of our capital gain net income for the one-year
period ending October 31 in that calendar year and (3) any
income recognized, but not distributed, in preceding years (the
“Excise Tax Avoidance Requirement”). We generally will
endeavor in each taxable year to make sufficient distributions
to our stockholders to avoid any U.S. federal excise tax on
our earnings.
In order to qualify as a RIC for U.S. federal income tax
purposes, we must, among other things:
| • | continue to qualify as a business development company under the 1940 Act at all times during each taxable year; | |
| • | derive in each taxable year at least 90% of our gross income from dividends, interest, payments with respect to loans of certain securities, gains from the sale of stock or other securities, net income from certain “qualified publicly traded partnerships,” or other income derived with respect to our business of investing in such stock or securities (the “90% Income Test”); and | |
| • | diversify our holdings so that at the end of each quarter of the taxable year: |
| • | at least 50% of the value of our assets consists of cash, cash equivalents, U.S. Government securities, securities of other RICs, and other securities if such other securities of any one issuer do not represent more than 5% of the value of our assets or more than 10% of the outstanding voting securities of the issuer; and | |
| • | no more than 25% of the value of our assets is invested in the securities, other than U.S. government securities or securities of other RICs, of one issuer, of two or more issuers that are controlled, as determined under applicable Code rules, by us and that are engaged in the same or similar or related trades or businesses or of certain “qualified publicly traded partnerships” (the “Diversification Tests”). |
We may be required to recognize taxable income in circumstances
in which we do not receive cash. For example, if we hold debt
obligations that are treated under applicable tax rules as
having original issue discount (such as debt instruments with
PIK interest or, in certain cases, increasing interest rates or
issued with warrants), we must include in income each year a
portion of the original issue discount that accrues over the
life of the obligation, regardless of whether cash representing
such income is received by us in the same taxable year. We may
also have to include in income other amounts that we have not
yet received in cash, such as PIK interest and deferred loan
origination fees that are paid after origination of the loan or
are paid in non-cash compensation such as warrants or stock.
Because any original issue discount or other amounts accrued
will be included in our investment company taxable income for
the year of accrual, we may be required to make a distribution
to our stockholders in order to satisfy the Annual Distribution
Requirement, even though we will not have received any
corresponding cash amount.
Although we do not presently expect to do so, we are authorized
to borrow funds and to sell assets in order to satisfy
distribution requirements. However, under the 1940 Act, we are
not permitted in certain circumstances to make distributions to
our stockholders while our debt obligations and other senior
securities are outstanding unless certain “asset
coverage” tests are met. Moreover, our ability to dispose
of assets to meet our distribution requirements may be limited
by (1) the illiquid nature of our portfolio
and/or
(2) other requirements relating to our status as a RIC,
including the Diversification Tests. If we dispose of assets in
24
order to meet the Annual Distribution Requirement or the Excise
Tax Avoidance Requirement, we may make such dispositions at
times that, from an investment standpoint, are not advantageous.
Pursuant to a recent revenue procedure (Revenue Procedure
2010-12)
issued by the Internal Revenue Service, or IRS, the IRS has
indicated that it will treat distributions from certain publicly
traded RICs (including business development companies) that are
paid part in cash and part in stock as dividends that would
satisfy the RIC’s annual distribution requirements and
qualify for the dividends paid deduction for federal income tax
purposes. In order to qualify for such treatment, the revenue
procedure requires that at least 10% of the total distribution
be payable in cash and that each stockholder have a right to
elect to receive its entire distribution in cash. If too many
stockholders elect to receive cash, each stockholder electing to
receive cash must receive a proportionate share of the cash to
be distributed (although no stockholder electing to receive cash
may receive less than 10% of such stockholder’s
distribution in cash). This revenue procedure applies to
distributions declared on or before December 31, 2012 with
respect to taxable years ending on or before December 31,
2011. We do not currently intend to pay dividends in shares of
our common stock pursuant to the revenue procedure any time in
the near future.
| Item 1A. | Risk Factors |
RISK
FACTORS
Investing in our common stock involves a number of
significant risks. In addition to the other information
contained in this annual report on
Form 10-K,
you should consider carefully the following information before
making an investment in our common stock. The risks set out
below are not the only risks we face. Additional risks and
uncertainties not presently known to us or not presently deemed
material by us might also impair our operations and performance.
If any of the following events occur, our business, financial
condition and results of operations could be materially and
adversely affected. In such case, our net asset value and the
trading price of our common stock could decline, and you may
lose part or all of your investment.
Risks
Relating to Economic Conditions
The
current state of the economy and financial markets increases the
likelihood of adverse effects on our financial position and
results of operations.
The U.S. capital markets experienced extreme volatility and
disruption over the past several years, leading to recessionary
conditions and depressed levels of consumer and commercial
spending. Disruptions in the capital markets increased the
spread between the yields realized on risk-free and higher risk
securities, resulting in illiquidity in parts of the capital
markets. While recent indicators suggest improvement in the
capital markets, we cannot provide any assurance that these
conditions will not worsen. If these conditions continue or
worsen, the prolonged period of market illiquidity may have an
adverse effect on our business, financial condition, and results
of operations. Unfavorable economic conditions also could
increase our funding costs, limit our access to the capital
markets or result in a decision by lenders not to extend credit
to us. These events could limit our investment originations,
limit our ability to grow and negatively impact our operating
results.
In addition, to the extent that recessionary conditions continue
or worsen, the financial results of small to mid-sized
companies, like those in which we invest, will continue to
experience deterioration, which could ultimately lead to
difficulty in meeting debt service requirements and an increase
in defaults. Additionally, the end markets for certain of our
portfolio companies’ products and services have
experienced, and continue to experience, negative economic
trends. The performances of certain of our portfolio companies
have been, and may continue to be, negatively impacted by these
economic or other conditions, which may ultimately result in our
receipt of a reduced level of interest income from our portfolio
companies
and/or
losses or charge offs related to our investments, and, in turn,
may adversely affect distributable income.
25
Economic
recessions or downturns could impair the ability of our
portfolio companies to repay loans, which, in turn, could
increase our non-performing assets, decrease the value of our
portfolio, reduce our volume of new loans and harm our operating
results, which would have an adverse effect on our results of
operations.
Many of our portfolio companies are and may be susceptible to
economic slowdowns or recessions and may be unable to repay our
loans during such periods. Therefore, our non-performing assets
are likely to increase and the value of our portfolio is likely
to decrease during such periods. Adverse economic conditions
also may decrease the value of collateral securing some of our
loans and the value of our equity investments. In this regard,
as a result of recent economic conditions and their impact on
certain of our portfolio companies, we have agreed to modify the
payment terms of our investments in eleven of our portfolio
companies as of September 30, 2010. Such modified terms
include changes in
payment-in-kind
interest provisions
and/or
cash
interest rates. These modifications, and any future
modifications to our loan agreements as a result of the recent
economic conditions or otherwise, may limit the amount of
interest income that we recognize from the modified investments,
which may, in turn, limit our ability to make distributions to
our stockholders and have an adverse effect on our results of
operations.
Risks
Relating to Our Business and Structure
Changes
in interest rates may affect our cost of capital and net
investment income.
Because we may borrow to fund our investments, a portion of our
net investment income may be dependent upon the difference
between the interest rate at which we borrow funds and the
interest rate at which we invest these funds. A portion of our
investments will have fixed interest rates, while a portion of
our borrowings will likely have floating interest rates. As a
result, a significant change in market interest rates could have
a material adverse effect on our net investment income. In
periods of rising interest rates, our cost of funds could
increase, which would reduce our net investment income. We may
hedge against such interest rate fluctuations by using standard
hedging instruments such as interest rate swap agreements,
futures, options and forward contracts, subject to applicable
legal requirements, including without limitation, all necessary
registrations (or exemptions from registration) with the
Commodity Futures Trading Commission. These activities may limit
our ability to participate in the benefits of lower interest
rates with respect to the hedged borrowings. Adverse
developments resulting from changes in interest rates or hedging
transactions could have a material adverse effect on our
business, financial condition and results of operations.
We
have a limited operating history.
Fifth Street Mezzanine Partners III, L.P. commenced operations
on February 15, 2007. On January 2, 2008, Fifth Street
Mezzanine Partners III, L.P. merged with and into Fifth Street
Finance Corp., a Delaware corporation. As a result, we are
subject to all of the business risks and uncertainties
associated with any new business, including the risk that we
will not achieve our investment objective and that the value of
our common stock could decline substantially.
We
currently have a limited number of investments in our investment
portfolio. As a result, a loss on one or more of those
investments would have a more adverse effect on our company than
the effect such a loss would have on a company with a larger and
more diverse investment portfolio.
As a company with a limited operating history, we have not had
the opportunity to invest in a large number of portfolio
companies. As a result, until we have increased the number of
investments in our investment portfolio, a loss on one or more
of our investments would affect us more adversely than such loss
would affect a company with a larger and more diverse investment
portfolio.
26
A
significant portion of our investment portfolio is and will
continue to be recorded at fair value as determined in good
faith by our Board of Directors and, as a result, there is and
will continue to be uncertainty as to the value of our portfolio
investments.
Under the 1940 Act, we are required to carry our portfolio
investments at market value or, if there is no readily available
market value, at fair value as determined by our Board of
Directors. Typically, there is not a public market for the
securities of the privately held companies in which we have
invested and will generally continue to invest. As a result, we
value these securities quarterly at fair value as determined in
good faith by our Board of Directors.
Certain factors that may be considered in determining the fair
value of our investments include the nature and realizable value
of any collateral, the portfolio company’s earnings and its
ability to make payments on its indebtedness, the markets in
which the portfolio company does business, comparison to
comparable publicly-traded companies, discounted cash flow and
other relevant factors. Because such valuations, and
particularly valuations of private securities and private
companies, are inherently uncertain, may fluctuate over short
periods of time and may be based on estimates, our
determinations of fair value may differ materially from the
values that would have been used if a ready market for these
securities existed. Due to this uncertainty, our fair value
determinations may cause our net asset value on a given date to
materially understate or overstate the value that we may
ultimately realize upon the sale of one or more of our
investments. As a result, investors purchasing our common stock
based on an overstated net asset value would pay a higher price
than the realizable value of our investments might warrant.
Our
ability to achieve our investment objective depends on our
investment adviser’s ability to support our investment
process; if our investment adviser were to lose any of its
principals, our ability to achieve our investment objective
could be significantly harmed.
As discussed above, we were organized on February 15, 2007.
We have no employees and, as a result, we depend on the
investment expertise, skill and network of business contacts of
the principals of our investment adviser. The principals of our
investment adviser evaluate, negotiate, structure, execute,
monitor and service our investments. Our future success will
depend to a significant extent on the continued service and
coordination of the principals of our investment adviser. The
departure of any of these individuals could have a material
adverse effect on our ability to achieve our investment
objective.
Our ability to achieve our investment objective depends on our
investment adviser’s ability to identify, analyze, invest
in, finance and monitor companies that meet our investment
criteria. Our investment adviser’s capabilities in
structuring the investment process, providing competent,
attentive and efficient services to us, and facilitating access
to financing on acceptable terms depend on the employment of
investment professionals in adequate number and of adequate
sophistication to match the corresponding flow of transactions.
To achieve our investment objective, our investment adviser may
need to hire, train, supervise and manage new investment
professionals to participate in our investment selection and
monitoring process. Our investment adviser may not be able to
find investment professionals in a timely manner or at all.
Failure to support our investment process could have a material
adverse effect on our business, financial condition and results
of operations.
Our
investment adviser has no prior experience managing a business
development company or a RIC.
The 1940 Act and the Code impose numerous constraints on the
operations of business development companies and RICs that do
not apply to the other investment vehicles previously managed by
the principals of our investment adviser. For example, under the
1940 Act, business development companies are required to invest
at least 70% of their total assets primarily in securities of
qualifying U.S. private or thinly traded companies.
Moreover, qualification for taxation as a RIC under subchapter M
of the Code requires satisfaction of
source-of-income
and diversification requirements and our ability to avoid
corporate-level taxes on our income and gains depends on our
satisfaction of distribution requirements. The failure to comply
with these provisions in a timely manner could prevent us from
qualifying as a business development company or RIC or could
force us to pay unexpected taxes and penalties, which could be
material. Our investment adviser does
27
not have any prior experience managing a business development
company or RIC. Its lack of experience in managing a portfolio
of assets under such constraints may hinder its ability to take
advantage of attractive investment opportunities and, as a
result, achieve our investment objective.
Our
business model depends to a significant extent upon strong
referral relationships with private equity sponsors, and the
inability of the principals of our investment adviser to
maintain or develop these relationships, or the failure of these
relationships to generate investment opportunities, could
adversely affect our business.
We expect that the principals of our investment adviser will
maintain and develop their relationships with private equity
sponsors, and we will rely to a significant extent upon these
relationships to provide us with potential investment
opportunities. If the principals of our investment adviser fail
to maintain their existing relationships or develop new
relationships with other sponsors or sources of investment
opportunities, we will not be able to grow our investment
portfolio. In addition, individuals with whom the principals of
our investment adviser have relationships are not obligated to
provide us with investment opportunities, and, therefore, there
is no assurance that such relationships will generate investment
opportunities for us.
We may
face increasing competition for investment opportunities, which
could reduce returns and result in losses.
We compete for investments with other business development
companies and investment funds (including private equity funds
and mezzanine funds), as well as traditional financial services
companies such as commercial banks and other sources of funding.
Many of our competitors are substantially larger and have
considerably greater financial, technical and marketing
resources than we do. For example, some competitors may have a
lower cost of capital and access to funding sources that are not
available to us. In addition, some of our competitors may have
higher risk tolerances or different risk assessments than we
have. These characteristics could allow our competitors to
consider a wider variety of investments, establish more
relationships and offer better pricing and more flexible
structuring than we are able to do. We may lose investment
opportunities if we do not match our competitors’ pricing,
terms and structure. If we are forced to match our
competitors’ pricing, terms and structure, we may not be
able to achieve acceptable returns on our investments or may
bear substantial risk of capital loss. A significant part of our
competitive advantage stems from the fact that the market for
investments in small and mid-sized companies is underserved by
traditional commercial banks and other financial sources. A
significant increase in the number
and/or
the
size of our competitors in this target market could force us to
accept less attractive investment terms. Furthermore, many of
our competitors have greater experience operating under, or are
not subject to, the regulatory restrictions that the 1940 Act
imposes on us as a business development company.
Our
incentive fee may induce our investment adviser to make
speculative investments.
The incentive fee payable by us to our investment adviser may
create an incentive for it to make investments on our behalf
that are risky or more speculative than would be the case in the
absence of such compensation arrangement, which could result in
higher investment losses, particularly during cyclical economic
downturns. The way in which the incentive fee payable to our
investment adviser is determined, which is calculated separately
in two components as a percentage of the income (subject to a
hurdle rate) and as a percentage of the realized gain on
invested capital, may encourage our investment adviser to use
leverage to increase the return on our investments or otherwise
manipulate our income so as to recognize income in quarters
where the hurdle rate is exceeded. Under certain circumstances,
the use of leverage may increase the likelihood of default,
which would disfavor the holders of our common stock.
The incentive fee payable by us to our investment adviser also
may create an incentive for our investment adviser to invest on
our behalf in instruments that have a deferred interest feature.
Under these investments, we would accrue the interest over the
life of the investment but would not receive the cash income
from the investment until the end of the investment’s term,
if at all. Our net investment income used to calculate the
income portion of our incentive fee, however, includes accrued
interest. Thus, a portion of the incentive fee would be based on
income that we have not yet received in cash and may never
receive in cash if the portfolio
28
company is unable to satisfy such interest payment obligation to
us. Consequently, while we may make incentive fee payments on
income accruals that we may not collect in the future and with
respect to which we do not have a formal “claw back”
right against our investment adviser per se, the amount of
accrued income written off in any period will reduce the income
in the period in which such write-off was taken and thereby
reduce such period’s incentive fee payment.
In addition, our investment adviser receives the incentive fee
based, in part, upon net capital gains realized on our
investments. Unlike the portion of the incentive fee based on
income, there is no performance threshold applicable to the
portion of the incentive fee based on net capital gains. As a
result, our investment adviser may have a tendency to invest
more in investments that are likely to result in capital gains
as compared to income producing securities. Such a practice
could result in our investing in more speculative securities
than would otherwise be the case, which could result in higher
investment losses, particularly during economic downturns.
Given the subjective nature of the investment decisions made by
our investment adviser on our behalf, we will be unable to
monitor these potential conflicts of interest between us and our
investment adviser.
Our
base management fee may induce our investment adviser to incur
leverage.
The fact that our base management fee is payable based upon our
gross assets, which would include any borrowings for investment
purposes, may encourage our investment adviser to use leverage
to make additional investments. Under certain circumstances, the
use of increased leverage may increase the likelihood of
default, which would disfavor holders of our common stock. Given
the subjective nature of the investment decisions made by our
investment adviser on our behalf, we will not be able to monitor
this potential conflict of interest.
Because
we borrow money, the potential for loss on amounts invested in
us will be magnified and may increase the risk of investing in
us.
Borrowings, also known as leverage, magnify the potential for
loss on invested equity capital. If we continue to use leverage
to partially finance our investments, through borrowings from
banks and other lenders, you will experience increased risks of
investing in our common stock. If the value of our assets
decreases, leveraging would cause net asset value to decline
more sharply than it otherwise would have had we not leveraged.
Similarly, any decrease in our income would cause net income to
decline more sharply than it would have had we not borrowed.
Such a decline could negatively affect our ability to make
common stock distribution payments. Leverage is generally
considered a speculative investment technique.
Substantially
all of our assets are subject to security interests under
secured credit facilities and if we default on our obligations
under the facilities, we may suffer adverse consequences,
including the lenders foreclosing on our assets.
As of September 30, 2010, except for assets that were
funded through our SBIC subsidiary, substantially all of our
assets were pledged as collateral under our credit facilities.
If we default on our obligations under these facilities, the
lenders may have the right to foreclose upon and sell, or
otherwise transfer, the collateral subject to their security
interests. In such event, we may be forced to sell our
investments to raise funds to repay our outstanding borrowings
in order to avoid foreclosure and these forced sales may be at
times and at prices we would not consider advantageous.
Moreover, such deleveraging of our company could significantly
impair our ability to effectively operate our business in the
manner in which we have historically operated. As a result, we
could be forced to curtail or cease new investment activities
and lower or eliminate the dividends that we have historically
paid to our stockholders.
In addition, if the lenders exercise their right to sell the
assets pledged under our credit facilities, such sales may be
completed at distressed sale prices, thereby diminishing or
potentially eliminating the amount of cash available to us after
repayment of the amounts outstanding under the credit facilities.
29
Because
we intend to distribute between 90% and 100% of our income to
our stockholders in connection with our election to be treated
as a RIC, we will continue to need additional capital to finance
our growth. If additional funds are unavailable or not available
on favorable terms, our ability to grow will be
impaired.
In order to qualify for the tax benefits available to RICs and
to minimize corporate-level taxes, we intend to distribute to
our stockholders between 90% and 100% of our annual taxable
income, except that we may retain certain net capital gains for
investment, and treat such amounts as deemed distributions to
our stockholders. If we elect to treat any amounts as deemed
distributions, we must pay income taxes at the corporate rate on
such deemed distributions on behalf of our stockholders. As a
result of these requirements, we will likely need to raise
capital from other sources to grow our business. As a business
development company, we generally are required to meet a
coverage ratio of total assets, less liabilities and
indebtedness not represented by senior securities, to total
senior securities, which includes all of our borrowings and any
outstanding preferred stock, of at least 200%. These
requirements limit the amount that we may borrow. Because we
will continue to need capital to grow our investment portfolio,
these limitations may prevent us from incurring debt and require
us to raise additional equity at a time when it may be
disadvantageous to do so.
While we expect to be able to borrow and to issue additional
debt and equity securities, we cannot assure you that debt and
equity financing will be available to us on favorable terms, or
at all. Also, as a business development company, we generally
are not permitted to issue equity securities priced below net
asset value without stockholder approval. If additional funds
are not available to us, we could be forced to curtail or cease
new investment activities, and our net asset value and share
price could decline.
Our
ability to enter into transactions with our affiliates is
restricted.
We are prohibited under the 1940 Act from participating in
certain transactions with certain of our affiliates without the
prior approval of the members of our independent directors and,
in some cases, the SEC. Any person that owns, directly or
indirectly, 5% or more of our outstanding voting securities is
our affiliate for purposes of the 1940 Act and we are generally
prohibited from buying or selling any securities (other than our
securities) from or to such affiliate, absent the prior approval
of our independent directors. The 1940 Act also prohibits
certain “joint” transactions with certain of our
affiliates, which could include investments in the same
portfolio company (whether at the same or different times),
without prior approval of our independent directors and, in some
cases, the SEC. If a person acquires more than 25% of our voting
securities, we are prohibited from buying or selling any
security (other than any security of which we are the issuer)
from or to such person or certain of that person’s
affiliates, or entering into prohibited joint transactions with
such person, absent the prior approval of the SEC. Similar
restrictions limit our ability to transact business with our
officers or directors or their affiliates. As a result of these
restrictions, we may be prohibited from buying or selling any
security (other than any security of which we are the issuer)
from or to any portfolio company of a private equity fund
managed by our investment adviser without the prior approval of
the SEC, which may limit the scope of investment opportunities
that would otherwise be available to us.
There
are significant potential conflicts of interest which could
adversely impact our investment returns.
Our executive officers and directors, and certain members of our
investment adviser, serve or may serve as officers, directors or
principals of entities that operate in the same or a related
line of business as we do or of investment funds managed by our
affiliates. Accordingly, they may have obligations to investors
in those entities, the fulfillment of which might not be in the
best interests of us or our stockholders. For example,
Mr. Tannenbaum, our chief executive officer and managing
partner of our investment adviser, is the managing partner of
Fifth Street Capital LLC, a private investment firm. Although
the other investment funds managed by Fifth Street Capital LLC
and its affiliates generally are fully committed and, other than
follow-on investments in existing portfolio companies, are no
longer making investments, in the future, the principals of our
investment adviser may manage other funds which may from time to
time have overlapping investment objectives with those of us and
accordingly invest in, whether principally or secondarily, asset
classes similar to those targeted by us. If this should occur,
the principals of our investment adviser would face conflicts of
30
interest in the allocation of investment opportunities to us and
such other funds. Although our investment professionals will
endeavor to allocate investment opportunities in a fair and
equitable manner, we and our common stockholders could be
adversely affected in the event investment opportunities are
allocated among us and other investment vehicles managed or
sponsored by, or affiliated with, our executive officers,
directors, and members of our investment adviser.
The
incentive fee we pay to our investment adviser relating to
capital gains may be effectively greater than 20%.
As a result of the operation of the cumulative method of
calculating the capital gains portion of the incentive fee we
pay to our investment adviser, the cumulative aggregate capital
gains fee received by our investment adviser could be
effectively greater than 20%, depending on the timing and extent
of subsequent net realized capital losses or net unrealized
depreciation. For additional information on this calculation,
see the disclosure in footnote 2 to Example 2 under the caption
“Item 1. Business — Investment Advisory
Agreement — Management Fee — Incentive
Fee.” We cannot predict whether, or to what extent, this
payment calculation would affect your investment in our stock.
The
involvement of our investment adviser’s investment
professionals in our valuation process may create conflicts of
interest.
Our portfolio investments are generally not in publicly traded
securities. As a result, the values of these securities are not
readily available. We value these securities at fair value as
determined in good faith by our Board of Directors based upon
the recommendation of the Valuation Committee of our Board of
Directors. In connection with that determination, investment
professionals from our investment adviser prepare portfolio
company valuations based upon the most recent portfolio company
financial statements available and projected financial results
of each portfolio company. The participation of our investment
adviser’s investment professionals in our valuation process
could result in a conflict of interest as our investment
adviser’s management fee is based, in part, on our gross
assets.
A
failure on our part to maintain our qualification as a business
development company would significantly reduce our operating
flexibility.
If we fail to continuously qualify as a business development
company, we might be subject to regulation as a registered
closed-end investment company under the 1940 Act, which would
significantly decrease our operating flexibility. In addition,
failure to comply with the requirements imposed on business
development companies by the 1940 Act could cause the SEC to
bring an enforcement action against us. For additional
information on the qualification requirements of a business
development company, see the disclosure under the caption
“Item 1. Business — Regulation —
Business Development Company Regulations.”
Regulations
governing our operation as a business development company and
RIC affect our ability to raise, and the way in which we raise,
additional capital or borrow for investment purposes, which may
have a negative effect on our growth.
As a result of the annual distribution requirement to qualify
for tax free treatment at the corporate level on income and
gains distributed to stockholders, we need to periodically
access the capital markets to raise cash to fund new
investments. We generally are not able to issue or sell our
common stock at a price below net asset value per share, which
may be a disadvantage as compared with other public companies or
private investment funds. We may, however, sell our common
stock, or warrants, options or rights to acquire our common
stock, at a price below the current net asset value of the
common stock if our Board of Directors and independent directors
determine that such sale is in our best interests and the best
interests of our stockholders, and our stockholders as well as
those stockholders that are not affiliated with us approve such
sale. In any such case, the price at which our securities are to
be issued and sold may not be less than a price that, in the
determination of our Board of Directors, closely approximates
the market value of such securities (less any underwriting
commission or discount). If our common stock trades at a
discount to net asset value, this restriction could adversely
affect our ability to raise capital.
31
We also may make rights offerings to our stockholders at prices
less than net asset value, subject to applicable requirements of
the 1940 Act. If we raise additional funds by issuing more
shares of our common stock or issuing senior securities
convertible into, or exchangeable for, our common stock, the
percentage ownership of our stockholders may decline at that
time and such stockholders may experience dilution. Moreover, we
can offer no assurance that we will be able to issue and sell
additional equity securities in the future, on terms favorable
to us or at all.
In addition, we may issue “senior securities,”
including borrowing money from banks or other financial
institutions only in amounts such that our asset coverage, as
defined in the 1940 Act, equals at least 200% after such
incurrence or issuance. Our ability to issue different types of
securities is also limited. Compliance with these requirements
may unfavorably limit our investment opportunities and reduce
our ability in comparison to other companies to profit from
favorable spreads between the rates at which we can borrow and
the rates at which we can lend. As a business development
company, therefore, we may need to issue equity more frequently
than our privately owned competitors, which may lead to greater
stockholder dilution.
We expect to continue to borrow for investment purposes. If the
value of our assets declines, we may be unable to satisfy the
asset coverage test, which could prohibit us from paying
dividends and could prevent us from qualifying as a RIC. If we
cannot satisfy the asset coverage test, we may be required to
sell a portion of our investments and, depending on the nature
of our debt financing, repay a portion of our indebtedness at a
time when such sales may be disadvantageous.
In addition, we may in the future seek to securitize our
portfolio securities to generate cash for funding new
investments. To securitize loans, we would likely create a
wholly-owned subsidiary and contribute a pool of loans to the
subsidiary. We would then sell interests in the subsidiary on a
non-recourse basis to purchasers and we would retain all or a
portion of the equity in the subsidiary. An inability to
successfully securitize our loan portfolio could limit our
ability to grow our business or fully execute our business
strategy and may decrease our earnings, if any. The
securitization market is subject to changing market conditions
and we may not be able to access this market when we would
otherwise deem appropriate. Moreover, the successful
securitization of our portfolio might expose us to losses as the
residual investments in which we do not sell interests will tend
to be those that are riskier and more apt to generate losses.
The 1940 Act also may impose restrictions on the structure of
any securitization.
Our
SBIC subsidiary’s investment adviser has no prior
experience managing an SBIC and any failure to comply with SBA
regulations, resulting from our SBIC subsidiary’s
investment adviser’s lack of experience or otherwise, could
have an adverse effect on our operations.
On February 3, 2010, our wholly-owned subsidiary, Fifth
Street Mezzanine Partners IV, L.P., received a license,
effective February 1, 2010, from the SBA to operate as an
SBIC under Section 301(c) of the Small Business Investment
Act of 1958 and is regulated by the SBA. The SBIC license allows
our SBIC subsidiary to obtain leverage by issuing SBA-guaranteed
debentures, subject to the issuance of a capital commitment by
the SBA and other customary procedures. The SBA places certain
limitations on the financing terms of investments by SBICs in
portfolio companies and prohibits SBICs from providing funds for
certain purposes or to businesses in a few prohibited
industries. Compliance with SBIC requirements may cause our SBIC
subsidiary to forego attractive investment opportunities that
are not permitted under SBA regulations.
Further, SBA regulations require that an SBIC be periodically
examined and audited by the SBA to determine its compliance with
the relevant SBA regulations. The SBA prohibits, without prior
SBA approval, a “change of control” of an SBIC or
transfers that would result in any person (or a group of persons
acting in concert) owning 10% or more of a class of capital
stock of an SBIC. If our SBIC subsidiary fails to comply with
applicable SBA regulations, the SBA could, depending on the
severity of the violation, limit or prohibit its use of
debentures, declare outstanding debentures immediately due and
payable,
and/or
limit
it from making new investments. In addition, the SBA can revoke
or suspend a license for willful or repeated violation of, or
willful or repeated failure to observe, any provision of the
Small Business Investment Act of 1958 or any rule or regulation
promulgated thereunder. These actions by the SBA would, in turn,
negatively affect us because our SBIC subsidiary is our
wholly-owned subsidiary. Our SBIC subsidiary’s investment
adviser does
32
not have any prior experience managing an SBIC. Its lack of
experience in complying with SBA regulations may hinder its
ability to take advantage of our SBIC subsidiary’s access
to SBA-guaranteed debentures.
Any failure to comply with SBA regulations could have an adverse
effect on our operations.
We may
experience fluctuations in our quarterly results.
We could experience fluctuations in our quarterly operating
results due to a number of factors, including our ability or
inability to make investments in companies that meet our
investment criteria, the interest rate payable on the debt
securities we acquire, the level of our expenses, variations in
and the timing of the recognition of realized and unrealized
gains or losses, the degree to which we encounter competition in
our market and general economic conditions. As a result of these
factors, results for any period should not be relied upon as
being indicative of performance in future periods.
Our
Board of Directors may change our investment objective,
operating policies and strategies without prior notice or
stockholder approval, the effects of which may be
adverse.
Our Board of Directors has the authority to modify or waive our
current investment objective, operating policies and strategies
without prior notice and without stockholder approval. We cannot
predict the effect any changes to our current investment
objective, operating policies and strategies would have on our
business, net asset value, operating results and value of our
stock. However, the effects might be adverse, which could
negatively impact our ability to pay you distributions and cause
you to lose part or all of your investment.
We
will be subject to corporate-level income tax if we are unable
to maintain our qualification as a RIC under Subchapter M of the
Code or do not satisfy the annual distribution
requirement.
To maintain RIC status and be relieved of federal taxes on
income and gains distributed to our stockholders, we must meet
the following annual distribution, income source and asset
diversification requirements.
| • | The annual distribution requirement for a RIC will be satisfied if we distribute to our stockholders on an annual basis at least 90% of our net ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any. Because we may use debt financing, we are subject to an asset coverage ratio requirement under the 1940 Act and we may be subject to certain financial covenants under our debt arrangements that could, under certain circumstances, restrict us from making distributions necessary to satisfy the distribution requirement. If we are unable to obtain cash from other sources, we could fail to qualify for RIC tax treatment and thus become subject to corporate-level income tax. | |
| • | The income source requirement will be satisfied if we obtain at least 90% of our income for each year from dividends, interest, gains from the sale of stock or securities or similar sources. | |
| • | The asset diversification requirement will be satisfied if we meet certain asset diversification requirements at the end of each quarter of our taxable year. To satisfy this requirement, at least 50% of the value of our assets must consist of cash, cash equivalents, U.S. government securities, securities of other RICs, and other acceptable securities; and no more than 25% of the value of our assets can be invested in the securities, other than U.S. government securities or securities of other RICs, of one issuer, of two or more issuers that are controlled, as determined under applicable Code rules, by us and that are engaged in the same or similar or related trades or businesses or of certain “qualified publicly traded partnerships.” Failure to meet these requirements may result in our having to dispose of certain investments quickly in order to prevent the loss of RIC status. Because most of our investments will be in private companies, and therefore will be relatively illiquid, any such dispositions could be made at disadvantageous prices and could result in substantial losses. |
33
If we fail to qualify for or maintain RIC status or to meet the
annual distribution requirement for any reason and are subject
to corporate income tax, the resulting corporate taxes could
substantially reduce our net assets, the amount of income
available for distribution and the amount of our distributions.
We may
not be able to pay you distributions, our distributions may not
grow over time and a portion of our distributions may be a
return of capital.
We intend to pay distributions to our stockholders out of assets
legally available for distribution. We cannot assure you that we
will achieve investment results that will allow us to make a
specified level of cash distributions or
year-to-year
increases in cash distributions. Our ability to pay
distributions might be adversely affected by, among other
things, the impact of one or more of the risk factors described
in this annual report on
Form 10-K.
In addition, the inability to satisfy the asset coverage test
applicable to us as a business development company can limit our
ability to pay distributions. All distributions will be paid at
the discretion of our Board of Directors and will depend on our
earnings, our financial condition, maintenance of our RIC
status, compliance with applicable business development company
regulations and such other factors as our Board of Directors may
deem relevant from time to time. We cannot assure you that we
will pay distributions to our stockholders in the future.
When we make distributions, we will be required to determine the
extent to which such distributions are paid out of current or
accumulated earnings and profits. Distributions in excess of
current and accumulated earnings and profits will be treated as
a non-taxable return of capital to the extent of an
investor’s basis in our stock and, assuming that an
investor holds our stock as a capital asset, thereafter as a
capital gain.
We may
have difficulty paying our required distributions if we
recognize income before or without receiving cash representing
such income.
For federal income tax purposes, we include in income certain
amounts that we have not yet received in cash, such as original
issue discount or accruals on a contingent payment debt
instrument, which may occur if we receive warrants in connection
with the origination of a loan or possibly in other
circumstances. Such original issue discount is included in
income before we receive any corresponding cash payments. We
also may be required to include in income certain other amounts
that we do not receive in cash.
Since, in certain cases, we may recognize income before or
without receiving cash representing such income, we may have
difficulty meeting the annual distribution requirement necessary
to be relieved of federal taxes on income and gains distributed
to our stockholders. Accordingly, we may have to sell some of
our investments at times
and/or
at
prices we would not consider advantageous, raise additional debt
or equity capital or forgo new investment opportunities for this
purpose. If we are not able to obtain cash from other sources,
we may fail to satisfy the annual distribution requirement and
thus become subject to corporate-level income tax.
We may
in the future choose to pay dividends in our own stock, in which
case you may be required to pay tax in excess of the cash you
receive.
We may distribute taxable dividends that are payable in part in
our stock. Taxable stockholders receiving such dividends will be
required to include the full amount of the dividend as ordinary
income (or as long-term capital gain to the extent such
distribution is properly designated as a capital gain dividend)
to the extent of our current and accumulated earnings and
profits for United States federal income tax purposes. As a
result, a U.S. stockholder may be required to pay tax with
respect to such dividends in excess of any cash received. If a
U.S. stockholder sells the stock it receives as a dividend
in order to pay this tax, the sales proceeds may be less than
the amount included in income with respect to the dividend,
depending on the market price of our stock at the time of the
sale. Furthermore, with respect to
non-U.S. stockholders,
we may be required to withhold U.S. tax with respect to
such dividends, including in respect of all or a portion of such
dividend that is payable in stock. In addition, if a significant
number of our stockholders determine to sell shares of our stock
in order to pay taxes owed on dividends, it may put downward
pressure on the trading price of our stock.
34
In addition, as discussed elsewhere in this annual report on
Form 10-K,
our loans typically contain a
payment-in-kind
(“PIK”) interest provision. The PIK interest, computed
at the contractual rate specified in each loan agreement, is
added to the principal balance of the loan and recorded as
interest income. To avoid the imposition of corporate-level tax
on us, this non-cash source of income needs to be paid out to
stockholders in cash distributions or, in the event that we
determine to do so, in shares of our common stock, even though
we have not yet collected and may never collect the cash
relating to the PIK interest. As a result, if we distribute
taxable dividends in the form of our common stock, we may have
to distribute a stock dividend to account for PIK interest even
though we have not yet collected the cash.
Our
wholly-owned SBIC subsidiary may be unable to make distributions
to us that will enable us to maintain RIC status, which could
result in the imposition of an entity-level tax.
In order for us to continue to qualify for RIC tax treatment and
to minimize corporate-level taxes, we are required to distribute
substantially all of our net ordinary income and net capital
gain income, including income from certain of our subsidiaries,
which includes the income from our SBIC subsidiary. We are
partially dependent on our SBIC subsidiary for cash
distributions to enable us to meet the RIC distribution
requirements. Our SBIC subsidiary may be limited by the Small
Business Investment Act of 1958, and SBA regulations governing
SBICs, from making certain distributions to us that may be
necessary to maintain our status as a RIC. We may have to
request a waiver of the SBA’s restrictions for our SBIC
subsidiary to make certain distributions to maintain our RIC
status. We cannot assure you that the SBA will grant such waiver
and if our SBIC subsidiary is unable to obtain a waiver,
compliance with the SBA regulations may result in loss of RIC
tax treatment and a consequent imposition of an entity-level tax
on us.
Changes
in laws or regulations governing our operations may adversely
affect our business or cause us to alter our business
strategy.
We and our portfolio companies are subject to regulation at the
local, state and federal level. New legislation may be enacted
or new interpretations, rulings or regulations could be adopted,
including those governing the types of investments we are
permitted to make or that impose limits on our ability to pledge
a significant amount of our assets to secure loans, any of which
could harm us and our stockholders, potentially with retroactive
effect.
Additionally, any changes to the laws and regulations governing
our operations relating to permitted investments may cause us to
alter our investment strategy in order to avail ourselves of new
or different opportunities. Such changes could result in
material differences to the strategies and plans set forth in
this annual report on
Form 10-K
and may result in our investment focus shifting from the areas
of expertise of our investment adviser to other types of
investments in which our investment adviser may have less
expertise or little or no experience. Thus, any such changes, if
they occur, could have a material adverse effect on our results
of operations and the value of your investment.
We have identified deficiencies in our internal control
over financial reporting from time to time. Future control
deficiencies could prevent us from accurately and timely
reporting our financial results.
We have identified deficiencies in our internal control over
financial reporting from time to time, including significant
deficiencies and material weaknesses. A “significant
deficiency” is a deficiency, or a combination of
deficiencies, in internal control over financial reporting that
is less severe than a material weakness, yet important enough to
merit attention by those responsible for oversight of a
company’s financial reporting. A material weakness is a
deficiency, or combination of deficiencies, in internal control
over financial reporting, such that there is a reasonable
possibility that a material misstatement of a company’s
annual or interim financial statements will not be prevented or
detected on a timely basis.
Our failure to identify deficiencies in our internal control
over financial reporting in a timely manner or remediate any
deficiencies, or the identification of material weaknesses or
significant deficiencies in the future could prevent us from
accurately and timely reporting our financial results.
35
Risks
Relating to Our Investments
Our
investments in portfolio companies may be risky, and we could
lose all or part of our investment.
Investing in small and mid-sized companies involves a number of
significant risks. Among other things, these companies:
| • | may have limited financial resources and may be unable to meet their obligations under their debt instruments that we hold, which may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of us realizing any guarantees from subsidiaries or affiliates of our portfolio companies that we may have obtained in connection with our investments, as well as a corresponding decrease in the value of the equity components of our investments; | |
| • | may have shorter operating histories, narrower product lines, smaller market shares and/or significant customer concentrations than larger businesses, which tend to render them more vulnerable to competitors’ actions and market conditions, as well as general economic downturns; | |
| • | are more likely to depend on the management talents and efforts of a small group of persons; therefore, the death, disability, resignation or termination of one or more of these persons could have a material adverse impact on our portfolio company and, in turn, on us; | |
| • | generally have less predictable operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, and may require substantial additional capital to support their operations, finance expansion or maintain their competitive position; and | |
| • | generally have less publicly available information about their businesses, operations and financial condition. If we are unable to uncover all material information about these companies, we may not make a fully informed investment decision, and as a result may lose part or all of our investment. |
In addition, in the course of providing significant managerial
assistance to certain of our portfolio companies, certain of our
officers and directors may serve as directors on the boards of
such companies. To the extent that litigation arises out of our
investments in these companies, our officers and directors may
be named as defendants in such litigation, which could result in
an expenditure of funds (through our indemnification of such
officers and directors) and the diversion of management time and
resources.
An
investment strategy focused primarily on privately held
companies presents certain challenges, including the lack of
available information about these companies.
We invest primarily in privately held companies. Generally,
little public information exists about these companies,
including typically a lack of audited financial statements and
ratings by third parties. We must therefore rely on the ability
of our investment adviser to obtain adequate information to
evaluate the potential risks of investing in these companies.
These companies and their financial information may not be
subject to the Sarbanes-Oxley Act and other rules that govern
public companies. If we are unable to uncover all material
information about these companies, we may not make a fully
informed investment decision, and we may lose money on our
investments. These factors could affect our investment returns.
If we
make unsecured debt investments, we may lack adequate protection
in the event our portfolio companies become distressed or
insolvent and will likely experience a lower recovery than more
senior debtholders in the event our portfolio companies defaults
on their indebtedness.
We may make unsecured debt investments in portfolio companies in
the future. Unsecured debt investments are unsecured and junior
to other indebtedness of the portfolio company. As a
consequence, the holder of an unsecured debt investment may lack
adequate protection in the event the portfolio company becomes
distressed or insolvent and will likely experience a lower
recovery than more senior debtholders in the event the portfolio
company defaults on its indebtedness. In addition, unsecured
debt investments of small and mid-sized companies are often
highly illiquid and in adverse market conditions may experience
steep declines in valuation even if they are fully performing.
36
If we
invest in the securities and obligations of distressed or
bankrupt companies, such investments may be subject to
significant risks, including lack of income, extraordinary
expenses, uncertainty with respect to satisfaction of debt,
lower-than expected investment values or income potentials and
resale restrictions.
We are authorized to invest in the securities and other
obligations of distressed or bankrupt companies. At times,
distressed debt obligations may not produce income and may
require us to bear certain extraordinary expenses (including
legal, accounting, valuation and transaction expenses) in order
to protect and recover our investment. Therefore, to the extent
we invest in distressed debt, our ability to achieve current
income for our stockholders may be diminished.
We also will be subject to significant uncertainty as to when
and in what manner and for what value the distressed debt we
invest in will eventually be satisfied (e.g., through a
liquidation of the obligor’s assets, an exchange offer or
plan of reorganization involving the distressed debt securities
or a payment of some amount in satisfaction of the obligation).
In addition, even if an exchange offer is made or plan of
reorganization is adopted with respect to distressed debt held
by us, there can be no assurance that the securities or other
assets received by us in connection with such exchange offer or
plan of reorganization will not have a lower value or income
potential than may have been anticipated when the investment was
made.
Moreover, any securities received by us upon completion of an
exchange offer or plan of reorganization may be restricted as to
resale. As a result of our participation in negotiations with
respect to any exchange offer or plan of reorganization with
respect to an issuer of distressed debt, we may be restricted
from disposing of such securities.
The
lack of liquidity in our investments may adversely affect our
business.
We invest, and will continue to invest, in companies whose
securities are not publicly traded, and whose securities will be
subject to legal and other restrictions on resale or will
otherwise be less liquid than publicly traded securities. In
fact, all of our assets may be invested in illiquid securities.
The illiquidity of these investments may make it difficult for
us to sell these investments when desired. In addition, if we
are required to liquidate all or a portion of our portfolio
quickly, we may realize significantly less than the value at
which we had previously recorded these investments. Our
investments are usually subject to contractual or legal
restrictions on resale or are otherwise illiquid because there
is usually no established trading market for such investments.
The illiquidity of most of our investments may make it difficult
for us to dispose of them at a favorable price, and, as a
result, we may suffer losses.
We may
not have the funds or ability to make additional investments in
our portfolio companies.
After our initial investment in a portfolio company, we may be
called upon from time to time to provide additional funds to
such company or have the opportunity to increase our investment
through the exercise of a warrant to purchase common stock.
There is no assurance that we will make, or will have sufficient
funds to make, follow-on investments. Any decisions not to make
a follow-on investment or any inability on our part to make such
an investment may have a negative impact on a portfolio company
in need of such an investment, may result in a missed
opportunity for us to increase our participation in a successful
operation or may reduce the expected yield on the investment.
Our
portfolio companies may incur debt that ranks equally with, or
senior to, our investments in such companies.
We invest primarily in first and second lien debt issued by
small and mid-sized companies. Our portfolio companies may have,
or may be permitted to incur, other debt that ranks equally
with, or senior to, the debt in which we invest. By their terms,
such debt instruments may entitle the holders to receive
payments of interest or principal on or before the dates on
which we are entitled to receive payments with respect to the
debt instruments in which we invest. Also, in the event of
insolvency, liquidation, dissolution, reorganization or
bankruptcy of a portfolio company, holders of debt instruments
ranking senior to our investment in that portfolio company would
typically be entitled to receive payment in full before we
receive any distribution. After repaying such senior creditors,
such portfolio company may not have any remaining assets to use
for
37
repaying its obligation to us. In the case of debt ranking
equally with debt instruments in which we invest, we would have
to share on an equal basis any distributions with other
creditors holding such debt in the event of an insolvency,
liquidation, dissolution, reorganization or bankruptcy of the
relevant portfolio company.
The
disposition of our investments may result in contingent
liabilities.
Most of our investments will involve private securities. In
connection with the disposition of an investment in private
securities, we may be required to make representations about the
business and financial affairs of the portfolio company typical
of those made in connection with the sale of a business. We may
also be required to indemnify the purchasers of such investment
to the extent that any such representations turn out to be
inaccurate or with respect to certain potential liabilities.
These arrangements may result in contingent liabilities that
ultimately yield funding obligations that must be satisfied
through our return of certain distributions previously made to
us.
There
may be circumstances where our debt investments could be
subordinated to claims of other creditors or we could be subject
to lender liability claims.
Even though we have structured some of our investments as senior
loans, if one of our portfolio companies were to go bankrupt,
depending on the facts and circumstances, including the extent
to which we actually provided managerial assistance to that
portfolio company, a bankruptcy court might recharacterize our
debt investment and subordinate all or a portion of our claim to
that of other creditors. We may also be subject to lender
liability claims for actions taken by us with respect to a
borrower’s business or instances where we exercise control
over the borrower. It is possible that we could become subject
to a lender’s liability claim, including as a result of
actions taken in rendering significant managerial assistance.
Second
priority liens on collateral securing loans that we make to our
portfolio companies may be subject to control by senior
creditors with first priority liens. If there is a default, the
value of the collateral may not be sufficient to repay in full
both the first priority creditors and us.
Certain loans that we make to portfolio companies will be
secured on a second priority basis by the same collateral
securing senior secured debt of such companies. The first
priority liens on the collateral will secure the portfolio
company’s obligations under any outstanding senior debt and
may secure certain other future debt that may be permitted to be
incurred by the company under the agreements governing the
loans. The holders of obligations secured by the first priority
liens on the collateral will generally control the liquidation
of and be entitled to receive proceeds from any realization of
the collateral to repay their obligations in full before us. In
addition, the value of the collateral in the event of
liquidation will depend on market and economic conditions, the
availability of buyers and other factors. There can be no
assurance that the proceeds, if any, from the sale or sales of
all of the collateral would be sufficient to satisfy the loan
obligations secured by the second priority liens after payment
in full of all obligations secured by the first priority liens
on the collateral. If such proceeds are not sufficient to repay
amounts outstanding under the loan obligations secured by the
second priority liens, then we, to the extent not repaid from
the proceeds of the sale of the collateral, will only have an
unsecured claim against the company’s remaining assets, if
any.
The rights we may have with respect to the collateral securing
the loans we make to our portfolio companies with senior debt
outstanding may also be limited pursuant to the terms of one or
more intercreditor agreements that we enter into with the
holders of senior debt. Under such an intercreditor agreement,
at any time that obligations that have the benefit of the first
priority liens are outstanding, any of the following actions
that may be taken with respect to the collateral will be at the
direction of the holders of the obligations secured by the first
priority liens: the ability to cause the commencement of
enforcement proceedings against the collateral; the ability to
control the conduct of such proceedings; the approval of
amendments to collateral documents; releases of liens on the
collateral; and waivers of past defaults under collateral
documents. We may not have the ability to control or direct such
actions, even if our rights are adversely affected.
38
We
generally do not and will not control our portfolio
companies.
We do not, and do not expect to, control most of our portfolio
companies, even though we may have board representation or board
observation rights, and our debt agreements may contain certain
restrictive covenants. As a result, we are subject to the risk
that a portfolio company in which we invest may make business
decisions with which we disagree and the management of such
company, as representatives of the holders of their common
equity, may take risks or otherwise act in ways that do not
serve our interests as a debt investor. Due to the lack of
liquidity for our investments in non-traded companies, we may
not be able to dispose of our interests in our portfolio
companies as readily as we would like or at an appropriate
valuation. As a result, a portfolio company may make decisions
that could decrease the value of our portfolio holdings.
Defaults
by our portfolio companies would harm our operating
results.
A portfolio company’s failure to satisfy financial or
operating covenants imposed by us or other lenders could lead to
defaults and, potentially, termination of its loans and
foreclosure on its secured assets, which could trigger
cross-defaults under other agreements and jeopardize a portfolio
company’s ability to meet its obligations under the debt or
equity securities that we hold. We may incur expenses to the
extent necessary to seek recovery upon default or to negotiate
new terms, which may include the waiver of certain financial
covenants, with a defaulting portfolio company.
We may
not realize gains from our equity investments.
Certain investments that we have made in the past and may make
in the future include warrants or other equity securities. In
addition, we have made in the past and may make in the future
direct equity investments in companies. Our goal is ultimately
to realize gains upon our disposition of such equity interests.
However, the equity interests we receive may not appreciate in
value and, in fact, may decline in value. Accordingly, we may
not be able to realize gains from our equity interests, and any
gains that we do realize on the disposition of any equity
interests may not be sufficient to offset any other losses we
experience. We also may be unable to realize any value if a
portfolio company does not have a liquidity event, such as a
sale of the business, recapitalization or public offering, which
would allow us to sell the underlying equity interests. We often
seek puts or similar rights to give us the right to sell our
equity securities back to the portfolio company issuer. We may
be unable to exercise these puts rights for the consideration
provided in our investment documents if the issuer is in
financial distress.
We are
subject to certain risks associated with foreign
investments.
We may make investments in foreign companies. Investing in
foreign companies may expose us to additional risks not
typically associated with investing in U.S. companies.
These risks include changes in foreign exchange rates, exchange
control regulations, political and social instability,
expropriation, imposition of foreign taxes, less liquid markets
and less available information than is generally the case in the
U.S., higher transaction costs, less government supervision of
exchanges, brokers and issuers, less developed bankruptcy laws,
difficulty in enforcing contractual obligations, lack of uniform
accounting and auditing standards and greater price volatility.
Our success will depend, in part, on our ability to anticipate
and effectively manage these and other risks. We cannot assure
you that these and other factors will not have a material
adverse effect on our business as a whole.
We may
expose ourselves to risks if we engage in hedging
transactions.
We have and may in the future enter into hedging transactions,
which may expose us to risks associated with such transactions.
We may utilize instruments such as forward contracts and
interest rate swaps, caps, collars and floors to seek to hedge
against fluctuations in the relative values of our portfolio
positions and amounts due under our credit facilities from
changes in market interest rates. Use of these hedging
instruments may include counterparty credit risk. Utilizing such
hedging instruments does not eliminate the possibility of
fluctuations in the values of such positions and amounts due
under our credit facilities or prevent losses if the
39
values of such positions decline. However, such hedging can
establish other positions designed to gain from those same
developments, thereby offsetting the decline in the value of
such portfolio positions. Such hedging transactions may also
limit the opportunity for gain if the values of the underlying
portfolio positions should increase. Moreover, it may not be
possible to hedge against an interest rate fluctuation that is
so generally anticipated that we are not able to enter into a
hedging transaction at an acceptable price.
The success of our hedging transactions will depend on our
ability to correctly predict movements and interest rates.
Therefore, while we may enter into such transactions to seek to
reduce interest rate risks, unanticipated changes in interest
rates may result in poorer overall investment performance than
if we had not engaged in any such hedging transactions. In
addition, the degree of correlation between price movements of
the instruments used in a hedging strategy and price movements
in the portfolio positions being hedged may vary. Moreover, for
a variety of reasons, we may not seek to establish a perfect
correlation between such hedging instruments and the portfolio
holdings or credit facilities being hedged. Any such imperfect
correlation may prevent us from achieving the intended hedge and
expose us to risk of loss. See also “— Changes in
interest rates may affect our cost of capital and net investment
income.”
Risks
Relating to Our Common Stock
Shares
of closed-end investment companies, including business
development companies, may trade at a discount to their net
asset value.
Shares of closed-end investment companies, including business
development companies, may trade at a discount from net asset
value. This characteristic of closed-end investment companies
and business development companies is separate and distinct from
the risk that our net asset value per share may decline. We
cannot predict whether our common stock will trade at, above or
below net asset value.
Investing
in our common stock may involve an above average degree of
risk.
The investments we make in accordance with our investment
objective may result in a higher amount of risk than alternative
investment options and a higher risk of volatility or loss of
principal. Our investments in portfolio companies involve higher
levels of risk, and therefore, an investment in our shares may
not be suitable for someone with lower risk tolerance.
The
market price of our common stock may fluctuate
significantly.
The market price and liquidity of the market for shares of our
common stock may be significantly affected by numerous factors,
some of which are beyond our control and may not be directly
related to our operating performance. These factors include:
| • | significant volatility in the market price and trading volume of securities of business development companies or other companies in our sector, which are not necessarily related to the operating performance of these companies; | |
| • | inability to obtain any exemptive relief that may be required by us from the SEC; | |
| • | changes in regulatory policies, accounting pronouncements or tax guidelines, particularly with respect to RICs, business development companies and SBICs; | |
| • | loss of our BDC or RIC status or our SBIC subsidiary’s status as an SBIC; | |
| • | changes in earnings or variations in operating results; | |
| • | changes in the value of our portfolio of investments; | |
| • | any shortfall in revenue or net income or any increase in losses from levels expected by investors or securities analysts; | |
| • | departure of our investment adviser’s key personnel; and | |
| • | general economic trends and other external factors. |
40
Certain
provisions of our restated certificate of incorporation and
amended and restated bylaws as well as the Delaware General
Corporation Law could deter takeover attempts and have an
adverse impact on the price of our common stock.
Our restated certificate of incorporation and our amended and
restated bylaws as well as the Delaware General Corporation Law
contain provisions that may have the effect of discouraging a
third party from making an acquisition proposal for us. These
anti-takeover provisions may inhibit a change in control in
circumstances that could give the holders of our common stock
the opportunity to realize a premium over the market price for
our common stock.
| Item 1B. | Unresolved Staff Comments |
None.
| Item 2. | Properties |
We do not own any real estate or other physical properties
materially important to our operations; however, we lease office
space for our principal executive office at 10 Bank Street,
12
th
floor, White Plains, NY 10606. Our investment adviser also
maintains additional office space at 500 W. Putnam
Ave., Suite 400, Greenwich, CT 06830. We may from time to
time lease satellite office space elsewhere, but these leases
are generally not material to our operations. We believe that
our current office facilities are adequate for our business as
we intend to conduct it.
| Item 3. | Legal Proceedings |
Although we may, from time to time, be involved in litigation
arising out of our operations in the normal course of business
or otherwise, we are currently not a party to any pending
material legal proceedings.
41
| Item 5. | Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |
Price
Range of Common Stock
Our common stock is traded on the New York Stock Exchange under
the symbol “FSC.” The following table sets forth, for
each fiscal quarter during the two most recently completed
fiscal years, the range of high and low sales prices of our
common stock as reported on the New York Stock Exchange:
| High | Low | |||||||
|
Fiscal year ended September 30, 2009
|
||||||||
|
First quarter
|
$ | 10.24 | $ | 5.02 | ||||
|
Second quarter
|
$ | 8.48 | $ | 5.80 | ||||
|
Third quarter
|
$ | 11.14 | $ | 6.92 | ||||
|
Fourth quarter
|
$ | 11.36 | $ | 9.02 | ||||
|
Fiscal year ended September 30, 2010
|
||||||||
|
First quarter
|
$ | 10.99 | $ | 9.35 | ||||
|
Second quarter
|
$ | 12.13 | $ | 10.45 | ||||
|
Third quarter
|
$ | 13.64 | $ | 10.49 | ||||
|
Fourth quarter
|
$ | 11.30 | $ | 9.79 | ||||
The last reported price for our common stock on
November 23, 2010 was $11.67 per share. As of
November 23, 2010, we had 13 stockholders of record,
which did not include stockholders for whom shares are held in
nominee or “street” name.
Sales of
Unregistered Securities
While we did not engage in any sales of unregistered securities
during the fiscal year ended September 30, 2010, we issued
a total of 170,803 shares of common stock under our
dividend reinvestment plan (“DRIP”). This issuance was
not subject to the registration requirements of the Securities
Act of 1933, as amended. The aggregate value the shares of our
common stock issued under our DRIP was approximately
$2.0 million.
Distributions
Our dividends, if any, are determined by our Board of Directors.
We have elected to be treated for federal income tax purposes as
a RIC under Subchapter M of the Code. As long as we qualify as a
RIC, we will not be taxed on our investment company taxable
income or realized net capital gains, to the extent that such
taxable income or gains are distributed, or deemed to be
distributed, to stockholders on a timely basis.
To maintain RIC tax treatment, we must, among other things,
distribute at least 90% of our net ordinary income and realized
net short-term capital gains in excess of realized net long-term
capital losses, if any. Depending on the level of taxable income
earned in a tax year, we may choose to carry forward taxable
income in excess of current year distributions into the next tax
year and pay a 4% excise tax on such income. Any such carryover
taxable income must be distributed through a dividend declared
prior to filing the final tax return related to the year in
which such taxable income was generated. We may, in the future,
make actual distributions to our stockholders of our net capital
gains. We can offer no assurance that we will achieve
42
results that will permit the payment of any cash distributions
and, if we issue senior securities, we may be prohibited from
making distributions if doing so causes us to fail to maintain
the asset coverage ratios stipulated by the 1940 Act or if
distributions are limited by the terms of any of our borrowings.
See “Item 1. Business —
Regulation — Taxation as a Regulated Investment
Company.”
We have adopted an “opt out” dividend reinvestment
plan for our common stockholders. As a result, if we make a cash
distribution, then stockholders’ cash distributions will be
automatically reinvested in additional shares of our common
stock, unless they specifically “opt out” of the
dividend reinvestment plan so as to receive cash distributions.
Pursuant to a recent revenue procedure (Revenue Procedure
2010-12)
issued by the Internal Revenue Service, or IRS, the IRS has
indicated that it will treat distributions from certain publicly
traded RICs (including business development companies) that are
paid part in cash and part in stock as dividends that would
satisfy the RIC’s annual distribution requirements and
qualify for the dividends paid deduction for federal income tax
purposes. In order to qualify for such treatment, the revenue
procedure requires that at least 10% of the total distribution
be payable in cash and that each stockholder have a right to
elect to receive its entire distribution in cash. If too many
stockholders elect to receive cash, each stockholder electing to
receive cash must receive a proportionate share of the cash to
be distributed (although no stockholder electing to receive cash
may receive less than 10% of such stockholder’s
distribution in cash). This revenue procedure applies to
distributions declared on or before December 31, 2012 with
respect to taxable years ending on or before December 31,
2011. We do not currently intend to pay dividends in shares of
our common stock pursuant to the revenue procedure any time in
the near future.
The following table reflects the dividend distributions per
share that our Board of Directors has declared and we have paid,
including shares issued under our DRIP, on our common stock from
October 1, 2008 through September 30, 2010:
|
Amount
|
DRIP Shares
|
DRIP Shares
|
||||||||||||||||||||||||
|
Date Declared
|
Record Date
|
Payment Date
|
per Share | Cash Distribution | Issued | Value | ||||||||||||||||||||
|
December 9, 2008
|
December 19, 2008 | December 29, 2008 | $ | 0.32 | $ | 6.4 million | 105,326 | $ | 0.8 million | |||||||||||||||||
|
December 9, 2008
|
December 30, 2008 | January 29, 2009 | 0.33 | 6.6 million | 139,995 | 0.8 million | ||||||||||||||||||||
|
December 18, 2008
|
December 30, 2008 | January 29, 2009 | 0.05 | 1.0 million | 21,211 | 0.1 million | ||||||||||||||||||||
|
April 14, 2009
|
May 26, 2009 | June 25, 2009 | 0.25 | 5.6 million | 11,776 | 0.1 million | ||||||||||||||||||||
|
August 3, 2009
|
September 8, 2009 | September 25, 2009 | 0.25 | 7.5 million | 56,890 | 0.6 million | ||||||||||||||||||||
|
November 12, 2009
|
December 10, 2009 | December 29, 2009 | 0.27 | 9.7 million | 44,420 | 0.5 million | ||||||||||||||||||||
|
January 12, 2010
|
March 3, 2010 | March 30, 2010 | 0.30 | 12.9 million | 58,689 | 0.7 million | ||||||||||||||||||||
|
May 3, 2010
|
May 20, 2010 | June 30, 2010 | 0.32 | 14.0 million | 42,269 | 0.5 million | ||||||||||||||||||||
|
August 2, 2010
|
September 1, 2010 | September 29, 2010 | 0.10 | 5.2 million | 25,425 | 0.3 million | ||||||||||||||||||||
43
Stock
Performance Graph
The following graph compares the cumulative
27-month
total return to shareholders on Fifth Street Finance
Corp.’s common stock relative to the cumulative total
returns of the NYSE Composite index, the NASDAQ Financial index
and a customized peer group of six companies that includes the
following investment companies, which have elected to be
regulated as business development companies under the 1940 Act:
Apollo Investment Corp., Ares Capital Corp., Blackrock Kelso
Capital Corp., Gladstone Capital Corp., MCG Capital Corp. and
MVC Capital Inc. The graph assumes that the value of the
investment in the common stock of each company, in each index,
and in the peer group was $100 on June 12, 2008 (the date
our common stock began to trade on the NYSE Stock Market in
connection with our initial public offering), assumes the
reinvestment of all cash dividends prior to any tax effect, and
tracks the investment through to September 30, 2010. The
comparisons in the graph below are based on historical data and
are not intended to forecast the possible future performance of
our common stock.
Comparison
of 27 Month Cumulative Total Stockholder Return*
Among Fifth Street Finance Corp., the NYSE Composite Index,
the NASDAQ Financial Index and a Peer Group
Among Fifth Street Finance Corp., the NYSE Composite Index,
the NASDAQ Financial Index and a Peer Group
| * | $100 invested on June 12, 2008 in stock or May 31, 2008 in index, including reinvestment of dividends. |
| June 12, 2008 | Jun-08 | Sep-08 | Dec-08 | Mar-09 | Jun-09 | Sep-09 | Dec-09 | Mar-10 | Jun-10 | Sep-10 | ||||||||||||||||||||||||||||||||||
|
Fifth Street Finance Corp
|
100.00 | 84.90 | 85.31 | 69.97 | 71.73 | 95.66 | 106.87 | 107.87 | 119.76 | 116.79 | 119.14 | |||||||||||||||||||||||||||||||||
|
NYSE Composite
|
100.00 | 92.29 | 80.76 | 79.80 | 54.23 | 64.87 | 76.35 | 79.80 | 83.17 | 72.73 | 82.31 | |||||||||||||||||||||||||||||||||
|
NASDAQ Financial
|
100.00 | 86.46 | 94.51 | 76.87 | 61.86 | 68.85 | 75.77 | 76.87 | 83.57 | 74.69 | 75.75 | |||||||||||||||||||||||||||||||||
|
Peer Group
|
100.00 | 85.96 | 97.79 | 61.85 | 36.79 | 59.04 | 85.19 | 93.78 | 120.34 | 102.39 | 122.41 | |||||||||||||||||||||||||||||||||
Open
Market Stock Repurchase Program
In October 2008, our Board of Directors authorized a stock
repurchase program to acquire up to $8 million of our
outstanding common stock. Stock repurchases under this program
were made through the open market at times and were in such
amounts as our management deemed appropriate. The stock
repurchase program expired December 2009.
44
In October 2010, our Board of Directors authorized a stock
repurchase program to acquire up to $20 million of our
outstanding common stock. Stock repurchases under this program
are to be made through the open market at times and in such
amounts as our management deems appropriate, provided it is
below the most recently published net asset value per share. The
stock repurchase program expires December 31, 2011 and may
be limited or terminated by the Board of Directors at any time
without prior notice.
| Item 6. | Selected Financial Data |
The following selected financial data should be read together
with our financial statements and the related notes and the
discussion under “Management’s Discussion and Analysis
of Financial Condition and Results of Operations” which is
included elsewhere in this annual report on
Form 10-K.
Effective as of January 2, 2008, Fifth Street Mezzanine
Partners III, L.P. merged with and into Fifth Street Finance
Corp. The financial information as of and for the period from
inception (February 15, 2007) to September 30,
2007, and for the fiscal years ended September 30, 2008,
2009, and 2010 set forth below was derived from our audited
financial statements and related notes for Fifth Street
Mezzanine Partners III, L.P. and Fifth Street Finance Corp.,
respectively.
|
At and for the
|
At and for the
|
At and for the
|
At September 30, 2007
|
|||||||||||||
|
Year Ended
|
Year Ended
|
Year Ended
|
and for the period
|
|||||||||||||
|
September 30,
|
September 30,
|
September 30,
|
February 15, 2007
|
|||||||||||||
| 2010 | 2009 | 2008 | through September 30, 2007 | |||||||||||||
| (In thousands, except per share amounts) | ||||||||||||||||
|
Statement of Operations data:
|
||||||||||||||||
|
Total investment income
|
$ | 70,538 | $ | 49,828 | $ | 33,219 | $ | 4,296 | ||||||||
|
Base management fee, net
|
9,275 | 5,889 | 4,258 | 1,564 | ||||||||||||
|
Incentive fee
|
10,756 | 7,841 | 4,118 | — | ||||||||||||
|
All other expenses
|
7,483 | 4,736 | 4,699 | 1,773 | ||||||||||||
|
Net investment income
|
43,024 | 31,362 | 20,144 | 959 | ||||||||||||
|
Unrealized depreciation on interest rate swap
|
(773 | ) | — | — | — | |||||||||||
|
Unrealized appreciation (depreciation) on investments
|
(1,055 | ) | (10,795 | ) | (16,948 | ) | 123 | |||||||||
|
Realized gain (loss) on investments
|
(18,780 | ) | (14,373 | ) | 62 | — | ||||||||||
|
Net increase in partners’ capital/net assets resulting from
operations
|
22,416 | 6,194 | 3,258 | 1,082 | ||||||||||||
|
Per share data:
|
||||||||||||||||
|
Net asset value per common share at period end
|
$ | 10.43 | $ | 10.84 | $ | 13.02 | $ | N/A | ||||||||
|
Market price at period end
|
11.14 | 10.93 | 10.05 | N/A | ||||||||||||
|
Net investment income
|
0.95 | 1.27 | 1.29 | N/A | ||||||||||||
|
Net realized and unrealized loss on investments and interest
rate swap
|
(0.46 | ) | (1.02 | ) | (1.08 | ) | N/A | |||||||||
|
Net increase in partners’ capital/net assets resulting from
operations
|
0.49 | 0.25 | 0.21 | N/A | ||||||||||||
|
Dividends paid
|
0.99 | 1.20 | 0.61 | N/A | ||||||||||||
|
Balance Sheet data at period end:
|
||||||||||||||||
|
Total investments at fair value
|
$ | 563,821 | $ | 299,611 | $ | 273,759 | $ | 88,391 | ||||||||
|
Cash and cash equivalents
|
76,765 | 113,205 | 22,906 | 17,654 | ||||||||||||
|
Other assets
|
11,340 | 3,071 | 2,484 | 1,285 | ||||||||||||
|
Total assets
|
651,926 | 415,887 | 299,149 | 107,330 | ||||||||||||
|
Total liabilities
|
82,754 | 5,331 | 4,813 | 514 | ||||||||||||
|
Total net assets
|
569,172 | 410,556 | 294,336 | 106,816 | ||||||||||||
|
Other data:
|
||||||||||||||||
|
Weighted average annual yield on debt investments(1)
|
14.0 | % | 15.7 | % | 16.2 | % | 16.8 | % | ||||||||
|
Number of investments at period end
|
38 | 28 | 24 | 10 | ||||||||||||
| (1) | Weighted average annual yield is calculated based upon our debt investments at the end of the period. |
45
| Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion should be read in connection with
our Consolidated Financial Statements and the notes thereto
included elsewhere in this annual report on
Form 10-K.
Some of the statements in this annual report on
Form 10-K
constitute forward-looking statements because they relate to
future events or our future performance or financial condition.
The forward-looking statements contained in this annual report
on
Form 10-K
may include statements as to:
| • | our future operating results and dividend projections; | |
| • | our business prospects and the prospects of our portfolio companies; | |
| • | the impact of the investments that we expect to make; | |
| • | the ability of our portfolio companies to achieve their objectives; | |
| • | our expected financings and investments; | |
| • | the adequacy of our cash resources and working capital; and | |
| • | the timing of cash flows, if any, from the operations of our portfolio companies. |
In addition, words such as “anticipate,”
“believe,” “expect,” “project” and
“intend” indicate a forward-looking statement,
although not all forward-looking statements include these words.
The forward-looking statements contained in this annual report
on
Form 10-K
involve risks and uncertainties. Our actual results could differ
materially from those implied or expressed in the
forward-looking statements for any reason, including the factors
set forth in “Item 1A. Risk Factors” and
elsewhere in this annual report on
Form 10-K.
Other factors that could cause actual results to differ
materially include but are not limited to:
| • | changes in the economy and the financial markets; | |
| • | risks associated with possible disruption in our operations or the economy generally due to terrorism or natural disasters; | |
| • | future changes in laws or regulations (including the interpretation of these laws and regulations by regulatory authorities) and conditions in our operating areas, particularly with respect to BDCs, SBICs or RICs; and | |
| • | other considerations that may be disclosed from time to time in our publicly disseminated documents and filings. |
We have based the forward-looking statements included in this
annual report on
Form 10-K
on information available to us on the date of this annual
report, and we assume no obligation to update any such
forward-looking statements. Although we undertake no obligation
to revise or update any forward-looking statements, whether as a
result of new information, future events or otherwise, you are
advised to consult any additional disclosures that we may make
directly to you or through reports that we in the future may
file with the SEC, including annual reports on
Form 10-K,
quarterly reports on
Form 10-Q
and current reports on
Form 8-K.
Overview
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. Our investment objective is to maximize
our portfolio’s total return by generating current income
from our debt investments and capital appreciation from our
equity investments.
We were formed as a Delaware limited partnership (Fifth Street
Mezzanine Partners III, L.P.) on February 15, 2007.
Effective as of January 2, 2008, Fifth Street Mezzanine
Partners III, L.P. merged with and into Fifth Street Finance
Corp. At the time of the merger, all outstanding partnership
interests in Fifth Street
46
Mezzanine Partners III, L.P. were exchanged for
12,480,972 shares of common stock in Fifth Street Finance
Corp.
Our Consolidated Financial Statements prior to January 2,
2008 reflect our operations as a Delaware limited partnership
(Fifth Street Mezzanine Partners III, L.P.) prior to our merger
with and into a corporation (Fifth Street Finance Corp.).
On June 17, 2008, we completed an initial public offering
of 10,000,000 shares of our common stock at the offering
price of $14.12 per share. Our shares are listed on the New York
Stock Exchange under the symbol “FSC.”
On July 21, 2009, we completed a follow-on public offering
of 9,487,500 shares of our common stock, which included the
underwriters’ exercise of their over-allotment option, at
the offering price of $9.25 per share.
On September 25, 2009, we completed a follow-on public
offering of 5,520,000 shares of our common stock, which
included the underwriters’ exercise of their over-allotment
option, at the offering price of $10.50 per share.
On January 27, 2010, we completed a follow-on public
offering of 7,000,000 shares of our common stock, which did
not include the underwriters’ exercise of their
over-allotment option, at the offering price of $11.20 per
share. On February 25, 2010, we sold 300,500 shares of
our common stock at the offering price of $11.20 per share upon
the underwriters’ exercise of their over-allotment option
in connection with this offering.
On June 21, 2010, we completed a follow-on public offering
of 9,200,000 shares of our common stock, which included the
underwriters’ exercise of their over-allotment option, at
the offering price of $11.50 per share.
Current
Market Conditions
Since mid-2007, the global financial markets have been in a
great deal of turmoil, experiencing stress, volatility,
illiquidity, and disruption. This turmoil appears to have peaked
in the fall of 2008, resulting in several major financial
institutions becoming insolvent, being acquired, or receiving
government assistance. While the turmoil in the financial
markets appears to have abated somewhat, the global economy
continues to experience economic uncertainty. Economic
uncertainty impacts our business in many ways, including
changing spreads, structures, and purchase multiples as well as
the overall supply of investment capital.
Despite the economic uncertainty, our deal pipeline remains
robust, with high quality transactions backed by private equity
sponsors in small to mid-sized companies. As always, we remain
cautious in selecting new investment opportunities, and will
only deploy capital in deals which are consistent with our
disciplined philosophy of pursuing superior risk-adjusted
returns.
As evidenced by our recent investment activities, we expect to
grow the business in part by increasing the average investment
size when and where appropriate. At the same time, we expect to
focus more on first lien transactions. We also expect to invest
in more floating rate facilities, with rate floors, to protect
against interest rate decreases.
Although we believe that we currently have sufficient capital
available to fund investments, a prolonged period of market
disruptions may cause us to reduce the volume of loans we
originate
and/or
fund,
which could have an adverse effect on our business, financial
condition, and results of operations. In this regard, because
our common stock has at times traded at a price below our then
current net asset value per share and we are limited in our
ability to sell our common stock at a price below net asset
value per share, we may be limited in our ability to raise
equity capital.
47
Critical
Accounting Policies
FASB
Accounting Standards Codification
The issuance of
FASB Accounting Standards
Codification
tm
(the “Codification”) on July 1, 2009 (effective
for interim or annual reporting periods ending after
September 15, 2009), changes the way that
U.S. generally accepted accounting principles
(“GAAP”) are referenced. Beginning on that date, the
Codification officially became the single source of
authoritative nongovernmental GAAP; however, SEC registrants
must also consider rules, regulations, and interpretive guidance
issued by the SEC or its staff. The switch affects the way
companies refer to GAAP in financial statements and in their
accounting policies. References to standards will consist solely
of the number used in the Codification’s structural
organization.
Consistent with the effective date of the Codification,
financial statements for periods ending after September 15,
2009, refer to the Codification structure, not pre-Codification
historical GAAP.
Basis
of Presentation
Effective January 2, 2008, Fifth Street Mezzanine Partners
III, L.P. (the “Partnership”), a Delaware limited
partnership organized on February 15, 2007, merged with and
into Fifth Street Finance Corp. The merger involved the exchange
of shares between companies under common control. In accordance
with the guidance on exchanges of shares between entities under
common control, our results of operations and cash flows for the
fiscal year ended September 30, 2008 are presented as if
the merger had occurred as of October 1, 2007. Accordingly,
no adjustments were made to the carrying value of assets and
liabilities (or the cost basis of investments) as a result of
the merger. Prior to January 2, 2008, references to Fifth
Street are to the Partnership. After January 2, 2008,
references to Fifth Street, FSC, “we” or
“our” are to Fifth Street Finance Corp., unless the
context otherwise requires. Fifth Street’s financial
results for the fiscal year ended September 30, 2007 refer
to the Partnership.
The preparation of financial statements in accordance with GAAP
requires management to make certain estimates and assumptions
affecting amounts reported in the Consolidated Financial
Statements. We have identified investment valuation and revenue
recognition as our most critical accounting estimates. We
continuously evaluate our estimates, including those related to
the matters described below. These estimates are based on the
information that is currently available to us and on various
other assumptions that we believe to be reasonable under the
circumstances. Actual results could differ materially from those
estimates under different assumptions or conditions. A
discussion of our critical accounting policies follows.
Investment
Valuation
We are required to report our investments that are not publicly
traded or for which current market values are not readily
available at fair value. The fair value is deemed to be the
price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market
participants at the measurement date.
Under Accounting Standards Codification 820,
Fair Value
Measurements and Disclosures
(“ASC 820”), which we
adopted effective October 1, 2008, we perform detailed
valuations of our debt and equity investments on an individual
basis, using market based, income based, and bond yield
approaches as appropriate. In general, we utilize a bond yield
method for the majority of our investments, as long as it is
appropriate. If, in our judgment, the bond yield approach is not
appropriate, we may use the enterprise value approach, or, in
certain cases, an alternative methodology potentially including
an asset liquidation or expected recovery model.
Under the market approach, we estimate the enterprise value of
the portfolio companies in which we invest. There is no one
methodology to estimate enterprise value and, in fact, for any
one portfolio company, enterprise value is best expressed as a
range of fair values, from which we derive a single estimate of
48
enterprise value. To estimate the enterprise value of a
portfolio company, we analyze various factors, including the
portfolio company’s historical and projected financial
results. Typically, private companies are valued based on
multiples of EBITDA (Earnings Before Interest, Taxes,
Depreciation and Amortization), cash flows, net income,
revenues, or in limited cases, book value. We generally require
portfolio companies to provide annual audited and quarterly and
monthly unaudited financial statements, as well as annual
projections for the upcoming fiscal year.
Under the income approach, we generally prepare and analyze
discounted cash flow models based on our projections of the
future free cash flows of the business. Under the bond yield
approach, we use bond yield models to determine the present
value of the future cash flow streams of our debt investments.
We review various sources of transactional data, including
private mergers and acquisitions involving debt investments with
similar characteristics, and assess the information in the
valuation process.
Under the bond yield approach, we use bond yield models to
determine the present value of the future cash flow streams of
our debt investments. We review various sources of transactional
data, including private mergers and acquisitions involving debt
investments with similar characteristics, and assess the
information in the valuation process.
Our Board of Directors undertakes a multi-step valuation process
each quarter in connection with determining the fair value of
our investments:
| • | Our quarterly valuation process begins with each portfolio company or investment being initially valued by the deal team within our investment adviser responsible for the portfolio investment; | |
| • | Preliminary valuations are then reviewed and discussed with the principals of our investment adviser; | |
| • | Separately, independent valuation firms engaged by our Board of Directors prepare preliminary valuations on a selected basis and submit reports to us; | |
| • | The deal team compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms; | |
| • | The deal team prepares a valuation report for the Valuation Committee of our Board of Directors; | |
| • | The Valuation Committee of our Board of Directors is apprised of the preliminary valuations of the independent valuation firms; | |
| • | The Valuation Committee of our Board of Directors reviews the preliminary valuations, and the deal team responds and supplements the preliminary valuations to reflect any comments provided by the Valuation Committee; | |
| • | The Valuation Committee of our Board of Directors makes a recommendation to the Board of Directors; and | |
| • | Our Board of Directors discusses valuations and determines the fair value of each investment in our portfolio in good faith. |
The fair value of all of our investments at September 30,
2010, and September 30, 2009, was determined by our Board
of Directors. Our Board of Directors is solely responsible for
the valuation of our portfolio investments at fair value as
determined in good faith pursuant to our valuation policy and
our consistently applied valuation process.
Our Board of Directors has engaged independent valuation firms
to provide us with valuation assistance. Upon completion of its
process each quarter, the independent valuation firms provides
us with a written report regarding the preliminary valuations of
selected portfolio securities as of the close of such quarter.
We will continue to engage independent valuation firms to
provide us with assistance regarding our determination of
49
the fair value of selected portfolio securities each quarter;
however, our Board of Directors is ultimately and solely
responsible for determining the fair value of our investments in
good faith.
The portions of our portfolio valued, as a percentage of the
portfolio at fair value, by independent valuation firms by
period were as follows:
|
For the quarter ending December 31, 2007
|
91.9 | % | ||
|
For the quarter ending March 31, 2008
|
92.1 | % | ||
|
For the quarter ending June 30, 2008
|
91.7 | % | ||
|
For the quarter ending September 30, 2008
|
92.8 | % | ||
|
For the quarter ending December 31, 2008
|
100.0 | % | ||
|
For the quarter ending March 31, 2009
|
88.7 | %(1) | ||
|
For the quarter ending June 30, 2009
|
92.1 | % | ||
|
For the quarter ending September 30, 2009
|
28.1 | % | ||
|
For the quarter ending December 31, 2009
|
17.2 | %(2) | ||
|
For the quarter ending March 31, 2010
|
26.9 | % | ||
|
For the quarter ending June 30, 2010
|
53.1 | % | ||
|
For the quarter ending September 30, 2010
|
61.8 | % |
| (1) | 96.0% excluding our investment in IZI Medical Products, Inc., which closed on June 30, 2009 and therefore was not part of the independent valuation process | |
| (2) | 24.8% excluding four investments that closed in December 2009 and therefore were not part of the independent valuation process |
Our $50 million credit facility with Bank of Montreal was
terminated effective September 16, 2009. The facility
required independent valuations for at least 90% of the
portfolio on a quarterly basis. With the termination of this
facility, this valuation test is no longer required. However, we
still intend to have a portion of the portfolio valued by an
independent third party on an quarterly basis, with a
substantial portion being valued on an annual basis.
As of September 30, 2010 and September 30, 2009,
approximately 86.5% and 72.0%, respectively, of our total assets
represented investments in portfolio companies valued at fair
value.
Revenue
Recognition
Interest
and Dividend Income
Interest income, adjusted for amortization of premium and
accretion of original issue discount, is recorded on the accrual
basis to the extent that such amounts are expected to be
collected. We stop accruing interest on investments when it is
determined that interest is no longer collectible. Distributions
from portfolio companies are recorded as dividend income when
the distribution is received.
Fee
Income
We receive a variety of fees in the ordinary course of business.
Certain fees, such as origination fees, are capitalized and
amortized in accordance with
ASC 310-20
Nonrefundable Fees and Other Costs
. In accordance with
ASC 820, the net unearned fee income balance is netted
against the cost and fair value of the respective investments.
Other fees, such as servicing fees, are classified as fee income
and recognized as they are earned on a monthly basis.
We have also structured exit fees across certain of our
portfolio investments to be received upon the future exit of
those investments. These fees are to be paid to us upon the
sooner to occur of (i) a sale of the borrower or
substantially all of the assets of the borrower, (ii) the
maturity date of the loan, or (iii) the date when full
prepayment of the loan occurs. Exit fees are fees which are
earned and payable upon the exit of a debt security and, similar
to a prepayment penalty, are not accrued or otherwise included
in net
50
investment income until received. The receipt of such fees as
well as the timing of our receipt of such fees are contingent
upon a successful exit event for each of the investments.
Payment-in-Kind
(PIK) Interest
Our loans typically contain a contractual PIK interest
provision. The PIK interest, which represents contractually
deferred interest added to the loan balance that is generally
due at the end of the loan term, is generally recorded on the
accrual basis to the extent such amounts are expected to be
collected. We generally cease accruing PIK interest if there is
insufficient value to support the accrual or if we do not expect
the portfolio company to be able to pay all principal and
interest due. Our decision to cease accruing PIK interest
involves subjective judgments and determinations based on
available information about a particular portfolio company,
including whether the portfolio company is current with respect
to its payment of principal and interest on its loans and debt
securities; monthly and quarterly financial statements and
financial projections for the portfolio company; our assessment
of the portfolio company’s business development success,
including product development, profitability and the portfolio
company’s overall adherence to its business plan;
information obtained by us in connection with periodic formal
update interviews with the portfolio company’s management
and, if appropriate, the private equity sponsor; and information
about the general economic and market conditions in which the
portfolio company operates. Based on this and other information,
we determine whether to cease accruing PIK interest on a loan or
debt security. Our determination to cease accruing PIK interest
on a loan or debt security is generally made well before our
full write-down of such loan or debt security. In addition, if
it is subsequently determined that we will not be able to
collect any previously accrued PIK interest, the fair value of
our loans or debt securities would decline by the amount of such
previously accrued, but uncollectible, PIK interest.
For a discussion of risks we are subject to as a result of our
use of PIK interest in connection with our investments, see
“Item 1A. Risk Factors — Risks Relating to
Our Business and Structure — We may have difficulty
paying our required distributions if we recognize income before
or without receiving cash representing such income,”
“— We may in the future choose to pay dividends
in our own stock, in which case you may be required to pay tax
in excess of the cash you receive” and
“— Our incentive fee may induce our investment
adviser to make speculative investments.” In addition, if
it is subsequently determined that we will not be able to
collect any previously accrued PIK interest, the fair value of
our loans or debt securities would decline by the amount of such
previously accrued, but uncollectible, PIK interest.
To maintain our status as a RIC, PIK income must be paid out to
our stockholders in the form of dividends even though we have
not yet collected the cash and may never collect the cash
relating to the PIK interest. Accumulated PIK interest was
$19.3 million and represented 3.4% of the fair value of our
portfolio of investments as of September 30, 2010 and
$12.1 million or 4.0% as of September 30, 2009. The
net increase in loan balances as a result of contracted PIK
arrangements are separately identified in our Consolidated
Statements of Cash Flows.
Portfolio
Composition
Our investments principally consist of loans, purchased equity
investments and equity grants in privately-held companies. Our
loans are typically secured by either a first or second lien on
the assets of the portfolio company, generally have terms of up
to six years (but an expected average life of between three and
four years) and typically bear interest at fixed rates and, to a
lesser extent, at floating rates. We are currently focusing our
new debt origination efforts on first lien loans. We believe
that the risk-adjusted returns from these loans are superior to
second lien investments at this time and offer superior credit
quality. However, we may choose to originate second lien and
unsecured loans in the future.
51
A summary of the composition of our investment portfolio at cost
and fair value as a percentage of total investments is shown in
the following tables:
|
September 30,
|
September 30,
|
|||||||
| 2010 | 2009 | |||||||
|
Cost:
|
||||||||
|
First lien debt
|
72.61 | % | 46.82 | % | ||||
|
Second lien debt
|
25.42 | % | 50.08 | % | ||||
|
Subordinated debt
|
0.80 | % | 0.00 | % | ||||
|
Purchased equity
|
0.39 | % | 1.27 | % | ||||
|
Equity grants
|
0.75 | % | 1.83 | % | ||||
|
Limited partnership interests
|
0.03 | % | 0.00 | % | ||||
|
Total
|
100.00 | % | 100.00 | % | ||||
|
September 30,
|
September 30,
|
|||||||
| 2010 | 2009 | |||||||
|
Fair value:
|
||||||||
|
First lien debt
|
73.84 | % | 47.40 | % | ||||
|
Second lien debt
|
24.45 | % | 51.37 | % | ||||
|
Subordinated debt
|
0.78 | % | 0.00 | % | ||||
|
Purchased equity
|
0.11 | % | 0.17 | % | ||||
|
Equity grants
|
0.79 | % | 1.06 | % | ||||
|
Limited partnership interests
|
0.03 | % | 0.00 | % | ||||
|
Total
|
100.00 | % | 100.00 | % | ||||
The industry composition of our portfolio at cost and fair value
as a percentage of total investments were as follows:
|
September 30,
|
September 30,
|
|||||||
| 2010 | 2009 | |||||||
|
Cost:
|
||||||||
|
Healthcare services
|
14.76 | % | 15.53 | % | ||||
|
Healthcare equipment
|
13.61 | % | 0.00 | % | ||||
|
Education services
|
7.58 | % | 0.00 | % | ||||
|
Home improvement retail
|
5.51 | % | 0.00 | % | ||||
|
Food distributors
|
5.13 | % | 2.73 | % | ||||
|
Fertilizers and agricultural chemicals
|
4.51 | % | 0.00 | % | ||||
|
Diversified support services
|
4.43 | % | 0.00 | % | ||||
|
Construction and engineering
|
4.22 | % | 5.89 | % | ||||
|
Footwear and apparel
|
3.97 | % | 6.85 | % | ||||
|
Healthcare technology
|
3.63 | % | 11.37 | % | ||||
|
Media — advertising
|
3.35 | % | 4.10 | % | ||||
|
Food retail
|
3.31 | % | 0.00 | % | ||||
|
Manufacturing — mechanical products
|
3.16 | % | 4.71 | % | ||||
|
Emulsions manufacturing
|
2.95 | % | 3.59 | % | ||||
|
Trailer leasing services
|
2.88 | % | 5.21 | % | ||||
|
Air freight and logistics
|
2.36 | % | 3.29 | % | ||||
|
Merchandise display
|
2.25 | % | 3.98 | % | ||||
|
Data processing and outsourced services
|
2.21 | % | 4.12 | % | ||||
52
|
September 30,
|
September 30,
|
|||||||
| 2010 | 2009 | |||||||
|
Restaurants
|
2.11 | % | 6.20 | % | ||||
|
Housewares and specialties
|
2.06 | % | 3.68 | % | ||||
|
Capital goods
|
1.71 | % | 3.05 | % | ||||
|
Environmental and facilities services
|
1.51 | % | 2.73 | % | ||||
|
Building products
|
1.40 | % | 2.14 | % | ||||
|
Leisure facilities
|
1.16 | % | 2.20 | % | ||||
|
Household products/specialty chemicals
|
0.18 | % | 2.38 | % | ||||
|
Entertainment — theaters
|
0.03 | % | 2.32 | % | ||||
|
Multi-sector holdings
|
0.02 | % | 0.00 | % | ||||
|
Home furnishing retail
|
0.00 | % | 3.93 | % | ||||
|
Total
|
100.00 | % | 100.00 | % | ||||
|
Fair value:
|
||||||||
|
Healthcare services
|
15.83 | % | 17.21 | % | ||||
|
Healthcare equipment
|
14.40 | % | 0.00 | % | ||||
|
Education services
|
7.47 | % | 0.00 | % | ||||
|
Home improvement retail
|
5.76 | % | 0.00 | % | ||||
|
Food distributors
|
5.38 | % | 3.00 | % | ||||
|
Fertilizers and agricultural chemicals
|
4.76 | % | 0.00 | % | ||||
|
Diversified support services
|
4.66 | % | 0.00 | % | ||||
|
Construction and engineering
|
4.23 | % | 5.96 | % | ||||
|
Footwear and apparel
|
4.18 | % | 7.37 | % | ||||
|
Healthcare technology
|
3.93 | % | 12.27 | % | ||||
|
Media — advertising
|
3.52 | % | 4.37 | % | ||||
|
Food retail
|
3.50 | % | 0.00 | % | ||||
|
Manufacturing — mechanical products
|
3.20 | % | 5.03 | % | ||||
|
Emulsions manufacturing
|
3.02 | % | 4.05 | % | ||||
|
Air freight and logistics
|
2.49 | % | 3.60 | % | ||||
|
Merchandise display
|
2.35 | % | 4.36 | % | ||||
|
Data processing and outsourced services
|
2.26 | % | 4.44 | % | ||||
|
Restaurants
|
2.15 | % | 5.94 | % | ||||
|
Capital goods
|
1.81 | % | 3.26 | % | ||||
|
Leisure facilities
|
1.25 | % | 2.38 | % | ||||
|
Building products
|
1.21 | % | 2.06 | % | ||||
|
Environmental and facilities services
|
0.91 | % | 2.04 | % | ||||
|
Trailer leasing services
|
0.82 | % | 3.29 | % | ||||
|
Housewares and specialties
|
0.66 | % | 1.90 | % | ||||
|
Household products/specialty chemicals
|
0.19 | % | 1.50 | % | ||||
|
Entertainment — theaters
|
0.05 | % | 2.52 | % | ||||
|
Multi-sector holdings
|
0.01 | % | 0.00 | % | ||||
|
Home furnishing retail
|
0.00 | % | 3.45 | % | ||||
|
Total
|
100.00 | % | 100.00 | % | ||||
53
Portfolio
Asset Quality
We employ a grading system to assess and monitor the credit risk
of our investment portfolio. We rate all investments on a scale
from 1 to 5. The system is intended to reflect the performance
of the borrower’s business, the collateral coverage of the
loan, and other factors considered relevant to making a credit
judgment.
| • | Investment Rating 1 is used for investments that are performing above expectations and/or a capital gain is expected. | |
| • | Investment Rating 2 is used for investments that are performing substantially within our expectations, and whose risks remain neutral or favorable compared to the potential risk at the time of the original investment. All new loans are initially rated 2. | |
| • | Investment Rating 3 is used for investments that are performing below our expectations and that require closer monitoring, but where we expect no loss of investment return (interest and/or dividends) or principal. Companies with a rating of 3 may be out of compliance with financial covenants. | |
| • | Investment Rating 4 is used for investments that are performing below our expectations and for which risk has increased materially since the original investment. We expect some loss of investment return, but no loss of principal. | |
| • | Investment Rating 5 is used for investments that are performing substantially below our expectations and whose risks have increased substantially since the original investment. Investments with a rating of 5 are those for which some loss of principal is expected. |
The following table shows the distribution of our investments on
the 1 to 5 investment rating scale at fair value, as of
September 30, 2010 and September 30, 2009:
|
Investment
|
September 30, 2010 | September 30, 2009 | ||||||||||||||||||||||
|
Rating
|
Fair Value | % of Portfolio | Leverage Ratio | Fair Value | % of Portfolio | Leverage Ratio | ||||||||||||||||||
|
1
|
$ | 89,150,457 | 15.81 | % | 2.97 | $ | 22,913,497 | 7.65 | % | 1.70 | ||||||||||||||
|
2
|
424,494,799 | 75.29 | % | 4.31 | 248,506,393 | 82.94 | % | 4.34 | ||||||||||||||||
|
3
|
18,055,528 | 3.20 | % | 13.25 | 6,122,236 | 2.04 | % | 10.04 | ||||||||||||||||
|
4
|
23,823,120 | 4.23 | % | 8.13 | 16,377,904 | 5.47 | % | 8.31 | ||||||||||||||||
|
5
|
8,297,412 | 1.47 | % | NM | (1) | 5,691,107 | 1.90 | % | NM | (1) | ||||||||||||||
|
Total
|
$ | 563,821,316 | 100.00 | % | 4.53 | $ | 299,611,137 | 100.00 | % | 4.42 | ||||||||||||||
| (1) | Due to operating performance this ratio is not measurable and, as a result, is excluded from the total portfolio calculation. |
As a result of current economic conditions and their impact on
certain of our portfolio companies, we have agreed to modify the
payment terms of our investments in eleven of our portfolio
companies as of September 30, 2010. Such modified terms
include increased
payment-in-kind
interest provisions
and/or
reduced cash interest rates. These modifications, and any future
modifications to our loan agreements as a result of the current
economic conditions or otherwise, may limit the amount of
interest income that we recognize from the modified investments,
which may, in turn, limit our ability to make distributions to
our stockholders.
Loans and
Debt Securities on Non-Accrual Status
Five investments did not pay all of their scheduled monthly cash
interest payments for the year ended September 30, 2010. As
of September 30, 2010, we had also stopped accruing PIK
interest and original issue discount (“OID”) on these
five investments. As of September 30, 2009, we had stopped
accruing PIK interest and OID on five investments, including two
investments that had not paid their scheduled monthly cash
interest payments. As of September 30, 2008, no investments
were on non-accrual status.
54
The non-accrual status of our portfolio investments as of
September 30, 2010, September 30, 2009 and
September 30, 2008 was as follows:
| September 30, 2010 | September 30, 2009 | September 30, 2008 | ||||
|
Lighting by Gregory, LLC
|
Cash non-accrual | Cash non-accrual | — | |||
|
CPAC, Inc.
|
— | PIK non-accrual | — | |||
|
MK Network, LLC
|
Cash non-accrual | — | — | |||
|
Martini Park, LLC
|
— | PIK non-accrual | — | |||
|
Vanguard Vinyl, Inc.
|
Cash non-accrual | — | — | |||
|
Nicos Polymers & Grinding, Inc.
|
Cash non-accrual | PIK non-accrual | — | |||
|
Premier Trailer Leasing, Inc.
|
Cash non-accrual | Cash non-accrual | — |
Non-accrual interest amounts related to the above investments
for the years ended September 30, 2010 September 30,
2009 and September 30, 2008 were as follows:
| September 30, 2010 | September 30, 2009 | September 30, 2008 | ||||||||||
|
Cash interest income
|
$ | 5,804,101 | $ | 2,938,190 | $ | — | ||||||
|
PIK interest income
|
1,903,005 | 1,398,347 | — | |||||||||
|
OID income
|
328,792 | 402,522 | — | |||||||||
|
Total
|
$ | 8,035,898 | $ | 4,739,059 | $ | — | ||||||
Discussion
and Analysis of Results and Operations
Results
of Operations
The principal measure of our financial performance is the net
income (loss) which includes net investment income (loss), net
realized gain (loss) and net unrealized appreciation
(depreciation). Net investment income is the difference between
our income from interest, dividends, fees, and other investment
income and total expenses. Net realized gain (loss) on
investments is the difference between the proceeds received from
dispositions of portfolio investments and their stated costs.
Net unrealized appreciation (depreciation) is the net change in
the fair value of our investment portfolio and derivative
instruments.
Comparison
of years ended September 30, 2010 and September 30,
2009
Total
Investment Income
Total investment income for the years ended September 30,
2010 and September 30, 2009 was $70.5 million and
$49.8 million, respectively. For the year ended
September 30, 2010, this amount primarily consisted of
$63.9 million of interest income from portfolio investments
(which included $10.0 million of PIK interest), and
$6.0 million of fee income. For the year ended
September 30, 2009, this amount primarily consisted of
$46.0 million of interest income from portfolio investments
(which included $7.4 million of PIK interest), and
$3.5 million of fee income.
The increase in our total investment income for the year ended
September 30, 2010 as compared to the year ended
September 30, 2009 was primarily attributable to a net
increase of eight debt investments in our portfolio in the
year-over-year
period, partially offset by scheduled amortization repayments
received and other debt payoffs during the same period.
Expenses
Expenses (net of the permanently waived portion of the base
management fee) for the years ended September 30, 2010 and
September 30, 2009 were $27.5 million and
$18.4 million, respectively. Expenses
55
increased for the year ended September 30, 2010 as compared
to the year ended September 30, 2009 by $9.1 million,
primarily as a result of increases in the base management fee,
the incentive fee, interest expense, administrator expense, and
other general and administrative expenses.
The increase in base management and incentive fees resulted from
an increase in our total assets as reflected in the growth of
the investment portfolio, offset partially by our investment
adviser’s unilateral decision to waive $727,000 and
$172,000 of the base management fee for the years ended
September 30, 2010 and September 30, 2009,
respectively.
Net
Investment Income
As a result of the $20.7 million increase in total
investment income as compared to the $9.1 million increase
in total expenses, net investment income for the year ended
September 30, 2010 reflected a $11.6 million, or
37.2%, increase compared to the year ended September 30,
2009.
Realized
Gain (Loss) on Investments
Net realized gain (loss) on investments is the difference
between the proceeds received from dispositions of portfolio
investments and their stated costs. Realized losses may also be
recorded in connection with our determination that certain
investments are considered worthless securities
and/or
meet
the conditions for loss recognition per the applicable tax rules.
During the year ended September 30, 2010, we recorded the
following investment realization events:
| • | In October 2009, we received a cash payment in the amount of $0.1 million representing a payment in full of all amounts due in connection with the cancellation of our loan agreement with American Hardwoods Industries, LLC. We recorded a $0.1 million reduction to the previously recorded $10.4 million realized loss on the investment in American Hardwoods; | |
| • | In March 2010, we recorded a realized loss in the amount of $2.9 million in connection with the sale of a portion of our interest in CPAC, Inc.; | |
| • | In August 2010, we received a cash payment of $7.6 million from Storyteller Theaters Corporation in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction; | |
| • | In September 2010, we restructured our investment in Rail Acquisition Corp. Although the full amount owed under the loan agreement remained intact, the restructuring resulted in a material modification of the terms of the loan agreement. As such, we recorded a realized loss in the amount of $2.6 million in accordance with EITF Abstract Issue No. 96-19; | |
| • | In September 2010, we sold our investment in Martini Park, LLC and received a cash payment in the amount of $0.1 million. We recorded a realized loss on this investment in the amount of $4.0 million; and | |
| • | In September 2010, we exited our investment in Rose Tarlow, Inc. and received a cash payment in the amount of $3.6 million in full settlement of the debt investment. We recorded a realized loss on this investment in the amount of $9.3 million. |
During the year ended September 30, 2009, we exited our
investment in American Hardwoods Industries, LLC and recorded a
realized loss of $10.4 million, and recorded a
$4.0 million realized loss on our investment in CPAC, Inc.
in connection with our determination that the investment was
permanently impaired based on, among other things, our analysis
of changes in the portfolio company’s business operations
and prospects.
Net
Change in Unrealized Appreciation or Depreciation
Net unrealized appreciation or depreciation is the net change in
the fair value of our investment portfolio during the reporting
period, including the reversal of previously recorded unrealized
appreciation or depreciation when gains or losses are realized.
56
During the year ended September 30, 2010, we recorded net
unrealized depreciation of $1.8 million. This consisted of
$19.1 million of net unrealized depreciation on debt
investments and $0.8 million of net unrealized depreciation
on interest rate swaps, offset by $17.6 million of
reclassifications to realized losses and $0.5 million of
net unrealized appreciation on equity investments. During the
year ended September 30, 2009, we recorded net unrealized
depreciation of $10.8 million. This consisted of
$23.1 million of net unrealized depreciation on debt
investments and $2.0 million of net unrealized depreciation
on equity investments, offset by $14.3 million of
reclassifications to realized losses.
Comparison
of years ended September 30, 2009 and September 30,
2008
Total
Investment Income
Total investment income for the years ended September 30,
2009 and September 30, 2008 was $49.8 million and
$33.2 million, respectively. For the year ended
September 30, 2009, this amount primarily consisted of
$46.0 million of interest income from portfolio investments
(which included $7.4 million of PIK interest), and
$3.5 million of fee income. For the year ended
September 30, 2008, this amount primarily consisted of
$30.5 million of interest income from portfolio investments
(which included $4.9 million of PIK interest), and
$1.8 million of fee income.
The increase in our total investment income for the year ended
September 30, 2009 as compared to the year ended
September 30, 2008 was primarily attributable to a net
increase of two debt investments in our portfolio in the
year-over-year
period, partially offset by debt repayments received during the
same period.
Expenses
Expenses (net of the permanently waived portion of the base
management fee) for the years ended September 30, 2009 and
September 30, 2008 were $18.4 million and
$13.1 million, respectively. Expenses increased for the
year ended September 30, 2009 as compared to the year ended
September 30, 2008 by $5.3 million, primarily as a
result of increases in base management fee, incentive fees and
other general and administrative expenses.
The increase in base management fee resulted from an increase in
our total assets as reflected in the growth of the investment
portfolio offset partially by our investment adviser’s
unilateral decision to waive $172,000 of the base management fee
for the year ended September 30, 2009. Incentive fees were
implemented effective January 2, 2008 when Fifth Street
Mezzanine Partners III, L.P. merged with and into Fifth Street
Finance Corp., and reflect the growth of our net investment
income before such fees.
Net
Investment Income
As a result of the $16.6 million increase in total
investment income as compared to the $5.3 million increase
in total expenses, net investment income for the year ended
September 30, 2009 reflected a $11.3 million, or
55.7%, increase compared to the year ended September 30,
2008.
Realized
Gain (Loss) on Investments
Net realized gain (loss) on investments is the difference
between the proceeds received from dispositions of portfolio
investments and their stated costs. During the year ended
September 30, 2009, we exited our investment in American
Hardwoods Industries, LLC and recorded a realized loss of
$10.4 million, and recorded a $4.0 million realized
loss on our investment in CPAC, Inc. in connection with our
determination that the investment was permanently impaired based
on, among other things, our analysis of changes in the portfolio
company’s business operations and prospects. During the
year ended September 30, 2008, we sold our equity
investment in Filet of Chicken and realized a gain of $62,000.
Net
Change in Unrealized Appreciation or Depreciation
Net unrealized appreciation or depreciation is the net change in
the fair value of our investment portfolio during the reporting
period, including the reversal of previously recorded unrealized
appreciation or
57
depreciation when gains or losses are realized. During the year
ended September 30, 2009, we recorded net unrealized
depreciation of $10.8 million. This consisted of
$23.1 million of net unrealized depreciation on debt
investments and $2.0 million of net unrealized depreciation
on equity investments, offset by $14.3 million of
reclassifications to realized losses. During the year ended
September 30, 2008, we recorded net unrealized depreciation
of $16.9 million. This consisted of $12.1 million of
net unrealized depreciation on debt investments and
$4.8 million of net unrealized depreciation on equity
investments.
Financial
Condition, Liquidity and Capital Resources
Cash
Flows
We have a number of alternatives available to fund the growth of
our investment portfolio and our operations, including, but not
limited to, raising equity, increasing debt, or funding from
operational cash flow. Additionally, we may reduce investment
size by syndicating a portion of any given transaction.
For the year ended September 30, 2010, we experienced a net
decrease in cash and cash equivalents of $36.4 million.
During that period, we used $239.2 million of cash in
operating activities, primarily for the funding of
$325.5 million of investments, partially offset by
$44.5 million of principal payments received and
$43.0 million of net investment income. During the same
period cash provided by financing activities was
$202.7 million, primarily consisting of $179.1 million
of proceeds from issuances of our common stock and
$73.0 million of SBA borrowings, partially offset by
$41.8 million of cash dividends paid, $1.3 million of
offering costs paid and $6.3 million of deferred financing
costs paid. We intend to fund our future distribution
obligations through operating cash flow or with funds obtained
through future equity offerings or credit facilities, as we deem
appropriate.
For the year ended September 30, 2009, we experienced a net
increase in cash and cash equivalents of $90.3 million.
During that period, we used $19.7 million of cash in
operating activities, primarily for the funding of
$62.0 million of investments, partially offset by
$18.3 million of principal payments received and
$31.4 million of net investment income. During the same
period cash provided by financing activities was
$110.0 million, primarily consisting of $138.6 million
of proceeds from issuance of our common stock, partially offset
by $27.1 million of cash dividends paid, $1.0 million
of offering costs paid and $0.5 million paid to repurchase
shares of our common stock on the open market.
For the year ended September 30, 2008, we experienced a net
increase in cash and equivalents of $5.3 million. During
that period, we used $179.4 million of cash in operating
activities primarily for the funding of $202.4 million of
investments, partially offset by $2.2 million of principal
payments received and $20.1 million of net investment
income. During the same period cash provided by financing
activities was $184.6 million, primarily consisting of
$131.3 million of proceeds from issuance of our common
stock, partially offset by $8.9 million of cash dividends
paid and $1.5 million of offering costs paid.
As of September 30, 2010, we had $76.8 million in cash
and cash equivalents, portfolio investments (at fair value) of
$563.8 million, $3.8 million of interest and fees
receivable, $73.0 million of SBA debentures payable, no
borrowings outstanding under our credit facilities, and unfunded
commitments of $49.5 million.
As of September 30, 2009, we had $113.2 million in
cash and cash equivalents, portfolio investments (at fair value)
of $299.6 million, $2.9 million of interest
receivable, no borrowings outstanding and unfunded commitments
of $9.8 million.
As of September 30, 2008, we had $22.9 million in cash
and cash equivalents, portfolio investments (at fair value) of
$273.8 million, $2.4 million of interest receivable,
no borrowings outstanding under our secured revolving credit
facility and unfunded commitments of $24.7 million.
Other
Sources of Liquidity
We intend to continue to generate cash primarily from cash flows
from operations, including interest earned from the temporary
investment of cash in U.S. government securities and other
high-quality debt investments that mature in one year or less,
future borrowings and future offerings of securities. In the
future,
58
we may also securitize a portion of our investments in first and
second lien senior loans or unsecured debt or other assets. To
securitize loans, we would likely create a wholly-owned
subsidiary and contribute a pool of loans to the subsidiary. We
would then sell interests in the subsidiary on a non-recourse
basis to purchasers and we would retain all or a portion of the
equity in the subsidiary. Our primary use of funds is
investments in our targeted asset classes and cash distributions
to holders of our common stock.
Although we expect to fund the growth of our investment
portfolio through the net proceeds from future equity offerings,
including our dividend reinvestment plan, and issuances of
senior securities or future borrowings, to the extent permitted
by the 1940 Act, our plans to raise capital may not be
successful. In this regard, because our common stock has at
times traded at a price below our then-current net asset value
per share and we are limited in our ability to sell our common
stock at a price below net asset value per share, we may be
limited in our ability to raise equity capital.
In addition, we intend to distribute between 90% and 100% of our
taxable income to our stockholders in order to satisfy the
requirements applicable to RICs under Subchapter M of the Code.
See “Regulated Investment Company Status and
Distributions” below. Consequently, we may not have the
funds or the ability to fund new investments, to make additional
investments in our portfolio companies, to fund our unfunded
commitments to portfolio companies or to repay borrowings. In
addition, the illiquidity of our portfolio investments may make
it difficult for us to sell these investments when desired and,
if we are required to sell these investments, we may realize
significantly less than their recorded value.
Also, as a business development company, we generally are
required to meet a coverage ratio of total assets, less
liabilities and indebtedness not represented by senior
securities, to total senior securities, which include all of our
borrowings and any outstanding preferred stock, of at least
200%. This requirement limits the amount that we may borrow. As
of September 30, 2010, we were in compliance with this
requirement. To fund growth in our investment portfolio in the
future, we anticipate needing to raise additional capital from
various sources, including the equity markets and the
securitization or other debt-related markets, which may or may
not be available on favorable terms, if at all.
Finally, in light of the conditions in the financial markets and
the U.S. economy overall, we, through a wholly-owned
subsidiary, sought and obtained a license from the SBA to
operate an SBIC.
In this regard, on February 3, 2010, our wholly-owned
subsidiary, Fifth Street Mezzanine Partners IV, L.P., received a
license, effective February 1, 2010, from the SBA to
operate as an SBIC under Section 301(c) of the Small
Business Investment Act of 1958. SBICs are designated to
stimulate the flow of private equity capital to eligible small
businesses. Under SBA regulations, SBICs may make loans to
eligible small businesses and invest in the equity securities of
small businesses.
The SBIC license allows our SBIC subsidiary to obtain leverage
by issuing SBA-guaranteed debentures, subject to the issuance of
a capital commitment by the SBA and other customary procedures.
SBA-guaranteed debentures are non-recourse, interest only
debentures with interest payable semi-annually and have a ten
year maturity. The principal amount of SBA-guaranteed debentures
is not required to be paid prior to maturity but may be prepaid
at any time without penalty. The interest rate of SBA-guaranteed
debentures is fixed on a semi-annual basis at a market-driven
spread over U.S. Treasury Notes with
10-year
maturities.
SBA regulations currently limit the amount that our SBIC
subsidiary may borrow to a maximum of $150 million when it
has at least $75 million in regulatory capital, receives a
capital commitment from the SBA and has been through an
examination by the SBA subsequent to licensing. As of
September 30, 2010, our SBIC subsidiary had
$75 million in regulatory capital. The SBA has issued a
capital commitment to our SBIC subsidiary in the amount of
$150 million, and $73 million of SBA debentures were
outstanding as of September 30, 2010 that bore an interest
rate of 3.50%, including the SBA annual charge of 0.285%.
We applied for exemptive relief from the SEC on
September 9, 2009 and filed an amended application on
February 8, 2010 to permit us to exclude the debt of our
SBIC subsidiary guaranteed by the SBA from our 200% asset
coverage test under the 1940 Act. If we receive an exemption for
this SBA debt, we would have increased flexibility under the
200% asset coverage test.
59
Significant
capital transactions that occurred from October 1, 2008
through September 30, 2010
The following table reflects the dividend distributions per
share that our Board of Directors has declared and we have paid,
including shares issued under our DRIP, on our common stock from
October 1, 2008 through September 30, 2010:
|
Amount
|
Cash
|
DRIP Shares
|
DRIP Shares
|
|||||||||||||||||
|
Date Declared
|
Record Date
|
Payment Date
|
per Share | Distribution | Issued | Value | ||||||||||||||
|
December 9, 2008
|
December 19, 2008 | December 29, 2008 | $ | 0.32 | $ | 6.4 million | 105,326 | $ | 0.8 million | |||||||||||
|
December 9, 2008
|
December 30, 2008 | January 29, 2009 | 0.33 | 6.6 million | 139,995 | 0.8 million | ||||||||||||||
|
December 18, 2008
|
December 30, 2008 | January 29, 2009 | 0.05 | 1.0 million | 21,211 | 0.1 million | ||||||||||||||
|
April 14, 2009
|
May 26, 2009 | June 25, 2009 | 0.25 | 5.6 million | 11,776 | 0.1 million | ||||||||||||||
|
August 3, 2009
|
September 8, 2009 | September 25, 2009 | 0.25 | 7.5 million | 56,890 | 0.6 million | ||||||||||||||
|
November 12, 2009
|
December 10, 2009 | December 29, 2009 | 0.27 | 9.7 million | 44,420 | 0.5 million | ||||||||||||||
|
January 12, 2010
|
March 3, 2010 | March 30, 2010 | 0.30 | 12.9 million | 58,689 | 0.7 million | ||||||||||||||
|
May 3, 2010
|
May 20, 2010 | June 30, 2010 | 0.32 | 14.0 million | 42,269 | 0.5 million | ||||||||||||||
|
August 2, 2010
|
September 1, 2010 | September 29, 2010 | 0.10 | 5.2 million | 25,425 | 0.3 million | ||||||||||||||
The following table reflects shareholder transactions that
occurred from October 1, 2008 through September 30,
2010:
|
Gross
|
||||||||||||||
|
Proceeds
|
||||||||||||||
|
Date
|
Transaction
|
Shares | Share Price | (Uses) | ||||||||||
|
October 27, 2008
|
Repurchase shares | 39,000 | $ | 5.96 | $ | (0.2 million | ) | |||||||
|
October 28, 2008
|
Repurchase shares | 39,000 | 5.89 | (0.2 million | ) | |||||||||
|
July 21, 2009
|
Public offering(1) | 9,487,500 | 9.25 | 87.8 million | ||||||||||
|
September 25, 2009
|
Public offering(1) | 5,520,000 | 10.50 | 58.0 million | ||||||||||
|
January 27, 2010
|
Public offering | 7,000,000 | 11.20 | 78.4 million | ||||||||||
|
February 25, 2010
|
Underwriters’ exercise of
over-allotment |
300,500 | 11.20 | 3.4 million | ||||||||||
|
June 21, 2010
|
Public offering(1) | 9,200,000 | 11.50 | 105.8 million | ||||||||||
| (1) | Includes the underwriters’ full exercise of their over-allotment option |
Borrowings
On November 16, 2009, Fifth Street Funding, LLC, a
consolidated wholly-owned bankruptcy remote, special purpose
subsidiary (“Funding”), and we entered into a Loan and
Servicing Agreement (“Agreement”), with respect to a
three-year credit facility (“Wells Fargo facility”)
with Wells Fargo Bank, National Association (“Wells
Fargo”), as successor to Wachovia Bank, National
Association (“Wachovia”), Wells Fargo Securities, LLC,
as administrative agent, each of the additional institutional
and conduit lenders party thereto from time to time, and each of
the lender agents party thereto from time to time, in the amount
of $50 million, with an accordion feature which allowed for
potential future expansion of the facility up to
$100 million. The facility bore interest at LIBOR plus 4.0%
per annum and had a maturity date of November 16, 2012.
On May 26, 2010, we amended the Wells Fargo facility to
expand the borrowing capacity under that facility. Pursuant to
the amendment, we received an additional $50 million
commitment, thereby increasing the size of the facility from
$50 million to $100 million, with an accordion feature
that allows for potential future expansion of that facility from
a total of $100 million up to a total of $150 million.
In addition, the interest rate of the Wells Fargo facility was
reduced from LIBOR plus 4% per annum to LIBOR plus 3.5% per
annum, with no LIBOR floor, and the maturity date of the
facility was extended from November 16, 2012 to
May 26, 2013. The facility may be extended for up to two
additional years upon the mutual consent of Wells Fargo and each
of the lender parties thereto.
60
In connection with the Wells Fargo facility, we concurrently
entered into (i) a Purchase and Sale Agreement with
Funding, pursuant to which we will sell to Funding certain loan
assets we have originated or acquired, or will originate or
acquire and (ii) a Pledge Agreement with Wells Fargo,
pursuant to which we pledged all of our equity interests in
Funding as security for the payment of Funding’s
obligations under the Agreement and other documents entered into
in connection with the Wells Fargo facility.
The Agreement and related agreements governing the Wells Fargo
facility required both Funding and us to, among other things
(i) make representations and warranties regarding the
collateral as well as each of our businesses, (ii) agree to
certain indemnification obligations, and (iii) comply with
various covenants, servicing procedures, limitations on
acquiring and disposing of assets, reporting requirements and
other customary requirements for similar credit facilities. The
Wells Fargo facility agreements also include usual and customary
default provisions such as the failure to make timely payments
under the facility, a change in control of Funding, and the
failure by Funding or us to materially perform under the
Agreement and related agreements governing the facility, which,
if not complied with, could accelerate repayment under the
facility, thereby materially and adversely affecting our
liquidity, financial condition and results of operations.
The Wells Fargo facility is secured by all of the assets of
Funding, and all of our equity interest in Funding. We intend to
use the net proceeds of the Wells Fargo facility to fund a
portion of our loan origination activities and for general
corporate purposes. Each loan origination under the facility is
subject to the satisfaction of certain conditions. We cannot be
assured that Funding will be able to borrow funds under the
Wells Fargo facility at any particular time or at all. As of
September 30, 2010, we had no borrowings outstanding under
the Wells Fargo facility.
On May 27, 2010, we entered into a three-year secured
syndicated revolving credit facility (“ING facility”)
pursuant to a Senior Secured Revolving Credit Agreement
(“ING Credit Agreement”) with certain lenders party
thereto from time to time and ING Capital LLC, as administrative
agent. The ING facility allows for us to borrow money at a rate
of either (i) LIBOR plus 3.5% per annum or (ii) 2.5%
per annum plus an alternate base rate based on the greatest of
the Prime Rate, Federal Funds Rate plus 0.5% per annum or LIBOR
plus 1% per annum, and has a maturity date of May 27, 2013.
The ING facility also allows us to request letters of credit
from ING Capital LLC, as the issuing bank. The initial
commitment under the ING facility is $90 million, and the
ING facility includes an accordion feature that allows for
potential future expansion of the facility up to a total of
$150 million. The ING facility is secured by substantially
all of our assets, as well as the assets of two of our
wholly-owned subsidiaries, FSFC Holdings, Inc. and FSF/MP
Holdings, Inc., subject to certain exclusions for, among other
things, equity interests in our SBIC subsidiary and equity
interests in Funding as further set forth in a Guarantee, Pledge
and Security Agreement (“ING Security Agreement”)
entered into in connection with the ING Credit Agreement, among
FSFC Holdings, Inc., FSF/MP Holdings, Inc., ING Capital LLC, as
collateral agent, and us. Neither our SBIC subsidiary nor
Funding is party to the ING facility and their respective assets
have not been pledged in connection therewith. The ING facility
provides that we may use the proceeds and letters of credit
under the facility for general corporate purposes, including
acquiring and funding leveraged loans, mezzanine loans,
high-yield securities, convertible securities, preferred stock,
common stock and other investments.
Pursuant to the ING Security Agreement, FSFC Holdings, Inc. and
FSF/MP Holdings, Inc. guaranteed the obligations under the ING
Security Agreement, including our obligations to the lenders and
the administrative agent under the ING Credit Agreement.
Additionally, we pledged our entire equity interests in FSFC
Holdings, Inc. and FSF/MP Holdings, Inc. to the collateral agent
pursuant to the terms of the ING Security Agreement.
The ING Credit Agreement and related agreements governing the
ING facility required FSFC Holdings, Inc., FSF/MP Holdings, Inc.
and us to, among other things (i) make representations and
warranties regarding the collateral as well as each of our
businesses, (ii) agree to certain indemnification
obligations, and (iii) agree to comply with various
affirmative and negative covenants and other customary
requirements for similar credit facilities. The ING facility
documents also include usual and customary default provisions
such as the failure to make timely payments under the facility,
the occurrence of a change in control, and the failure by us to
materially perform under the ING Credit Agreement and related
agreements governing the facility, which, if
61
not complied with, could accelerate repayment under the
facility, thereby materially and adversely affecting our
liquidity, financial condition and results of operations.
Each loan or letter of credit originated under the ING facility
is subject to the satisfaction of certain conditions. We cannot
be assured that we will be able to borrow funds under the ING
facility at any particular time or at all.
Through September 30, 2010, there had been no borrowings or
repayments on the ING facility.
As of September 30, 2010, except for assets that were
funded through our SBIC subsidiary, substantially all of our
assets were pledged as collateral under the Wells Fargo facility
or the ING facility.
Interest expense for the years ended September 30, 2010,
2009 and 2008 was $1.9 million, $0.6 million, and
$0.9 million, respectively.
The following table describes significant financial covenants
with which we must comply under each of our credit facilities on
a quarterly basis:
|
Facility
|
Financial Covenant
|
Description
|
Target Value | Reported Value (1) | ||||
|
Wells Fargo facility
|
Minimum shareholders’ equity (inclusive of affiliates) | Net assets shall not be less than $200 million plus the aggregate net proceeds of all sales of equity interests after November 16, 2009 | $334 million | $569 million | ||||
| Minimum shareholders’ equity (exclusive of affiliates) | Net assets exclusive of affiliates other than Funding shall not be less than $250 million | $250 million | $494 million | |||||
| Asset coverage ratio | Asset coverage ratio shall not be less than 2.00:1 | 2.00:1 | 8.37:1 | |||||
|
ING facility
|
Minimum shareholders’ equity | Net assets shall not be less than the greater of (a) 55% of total assets; and (b) $385 million plus the aggregate net proceeds of all sales of equity interests after February 24, 2010 | $436 million | $569 million | ||||
| Asset coverage ratio | Asset coverage ratio shall not be less than 2.25:1 | 2.25:1 | 17.26:1 | |||||
| Interest coverage ratio | Interest coverage ratio shall not be less than 2.50:1 | 2.50:1 | 73.94:1 | |||||
| Eligible portfolio investments test | Aggregate value of (a) Cash and cash equivalents and (b) Portfolio investments rated 1, 2 or 3 shall not be less than $175 million | $175 million | $289 million |
| (1) | As contractually required, we report financial covenants based on the last filed quarterly or annual report, in this case our Form 10-Q for the quarter ended June 30, 2010. We were also in compliance with all financial covenants under these credit facilities based on the financial information filed in this Form 10-K for the year ended September 30, 2010. |
62
We and our SBIC subsidiary are also subject to certain
regulatory requirements relating to our borrowings. For a
discussion of such requirements, see “Item 1.
Business — Regulation — Business Development
Company Regulations” and “— Small Business
Investment Company Regulations.”
The following table reflects credit facility and debenture
transactions that occurred from October 1, 2008 through
September 30, 2010. Amounts available and drawn are as of
September 30, 2010.
|
Total
|
||||||||||||||||||
|
Facility
|
Upfront
|
Amount
|
Interest
|
|||||||||||||||
| Amount | fee Paid | Availability | Drawn | Rate | ||||||||||||||
|
Bank of Montreal
|
December 30, 2008 | Renewed credit facility | $50 million | $0.3 million | $ | — | $ | — | LIBOR + 3.25% | |||||||||
| September 16, 2009 | Terminated credit facility | |||||||||||||||||
|
Wells Fargo facility
|
November 16, 2009 | Entered into credit facility | 50 million | $0.8 million | LIBOR + 4.00% | |||||||||||||
| May 26, 2010 | Expanded credit facility | 100 million | $0.9 million | 42 million (1 | ) | — | LIBOR + 3.50% | |||||||||||
|
ING facility
|
May 27, 2010 | Entered into credit facility | 90 million | $0.8 million | 90 million | — | LIBOR + 3.50% | |||||||||||
|
SBA
|
February 16, 2010 | Received capital commitment | 75 million | $0.8 million | ||||||||||||||
| September 21, 2010 | Received capital commitment | 150 million | $0.8 million | 150 million | 73 million | 3.50% (2) | ||||||||||||
| (1) | Availability to increase upon our decision to further collateralize the facility. | |
| (2) | Includes the SBA annual charge of 0.285%. |
Off-Balance
Sheet Arrangements
We may be a party to financial instruments with off-balance
sheet risk in the normal course of business to meet the
financial needs of our portfolio companies. As of
September 30, 2010, our only off-balance sheet arrangements
consisted of $49.5 million of unfunded commitments, which
was comprised of $46.7 million to provide debt financing to
certain of our portfolio companies and $2.8 million related
to unfunded limited partnership interests. As of
September 30, 2009, our only off-balance sheet arrangements
consisted of $9.8 million, which was comprised of
$7.8 million to provide debt financing to certain of our
portfolio companies and $2.0 million related to unfunded
limited partnership interests. Such commitments involve, to
varying degrees, elements of credit risk in excess of the amount
recognized in the Statement of Assets and Liabilities and are
not reflected on our Consolidated Statement of Assets and
Liabilities.
Contractual
Obligations
On February 3, 2010, our SBIC subsidiary received a
license, effective February 1, 2010, from the SBA to
operate as an SBIC. The SBIC license allows our SBIC subsidiary
to obtain leverage by issuing SBA-guaranteed debentures, subject
to the issuance of a capital commitment by the SBA and other
customary procedures. SBA-guaranteed debentures are
non-recourse, interest only debentures with interest payable
semi-annually and have a ten year maturity. The principal amount
of SBA-guaranteed debentures is not required to be paid prior to
maturity but may be prepaid at any time without penalty. The
interest rate of SBA-guaranteed debentures is fixed on a
semi-annual basis at a market-driven spread over
U.S. Treasury Notes with
10-year
maturities. As of September 30, 2010, we had
$73 million of SBA debentures payable that bore an interest
rate of 3.50%, including the SBA annual charge of 0.285%.
On November 16, 2009, we entered into the Wells Fargo
facility in the amount of $50 million with an accordion
feature, which allowed for potential future expansion of the
Wells Fargo facility up to $100 million. The Wells Fargo
facility bore interest at LIBOR plus 4% per annum and had a
maturity date of November 26, 2012. On May 26, 2010,
we amended the Wells Fargo facility to expand our borrowing
capacity under that facility. Pursuant to the amendment, we
received an additional $50 million commitment, thereby
increasing the size of the Wells Fargo facility from
$50 million to $100 million, with an accordion feature
that allows for potential future expansion of that facility from
a total of $100 million up to a total of $150 million.
In addition, the interest rate of the Wells Fargo facility was
reduced from LIBOR plus 4% per annum to LIBOR plus 3.5% per
annum, with no LIBOR floor, and the maturity date of the
facility was extended from November 16, 2012 to
May 26, 2013.
63
On May 27, 2010, we entered into the ING facility, which
allows for us to borrow money at a rate of either (i) LIBOR
plus 3.5% per annum or (ii) 2.5% per annum plus an
alternate base rate based on the greatest of the Prime Rate,
Federal Funds Rate plus 0.5% per annum or LIBOR plus 1% per
annum, and has a maturity date of May 27, 2013. The ING
facility also allows us to request letters of credit from ING
Capital LLC, as the issuing bank. The initial commitment under
the ING facility is $90 million, and the ING facility
includes an accordion feature that allows for potential future
expansion of the facility up to a total of $150 million.
As of September 30, 2010, we had no borrowings outstanding
under either the Wells Fargo facility or the ING facility.
The following table reflects our contractual obligations arising
from the SBA debentures payable, the Wells Fargo Facility and
the ING Facility:
| Payments Due by Period as of September 30, 2010 | ||||||||||||||||||||
| Total | < 1 year | 1-3 years | 3-5 years | > 5 years | ||||||||||||||||
|
SBA debentures payable
|
$ | 73,000,000 | $ | — | $ | — | $ | — | $ | 73,000,000 | ||||||||||
|
Interest due on SBA debentures
|
25,423,995 | 2,407,998 | 5,116,999 | 5,110,000 | 12,788,998 | |||||||||||||||
|
Wells fargo facility
|
— | — | — | — | — | |||||||||||||||
|
ING facility
|
— | — | — | — | — | |||||||||||||||
|
Total
|
$ | 98,423,995 | $ | 2,407,998 | $ | 5,116,999 | $ | 5,110,000 | $ | 85,788,998 | ||||||||||
A summary of the composition of unfunded commitments (consisting
of revolvers, term loans and limited partnership interests) as
of September 30, 2010 and September 30, 2009 is shown
in the table below:
|
September 30,
|
September 30,
|
|||||||
| 2010 | 2009 | |||||||
|
Storyteller Theaters Corporation
|
$ | — | $ | 1,750,000 | ||||
|
HealthDrive Corporation
|
1,500,000 | 1,500,000 | ||||||
|
IZI Medical Products, Inc.
|
2,500,000 | 2,500,000 | ||||||
|
Trans-Trade, Inc.
|
500,000 | 2,000,000 | ||||||
|
Riverlake Equity Partners II, LP (limited partnership interest)
|
966,360 | 1,000,000 | ||||||
|
Riverside Fund IV, LP (limited partnership interest)
|
864,175 | 1,000,000 | ||||||
|
ADAPCO, Inc.
|
5,750,000 | — | ||||||
|
AmBath/ReBath Holdings, Inc.
|
1,500,000 | — | ||||||
|
JTC Education, Inc.
|
9,062,453 | — | ||||||
|
Tegra Medical, LLC
|
4,000,000 | — | ||||||
|
Vanguard Vinyl, Inc.
|
1,250,000 | — | ||||||
|
Flatout, Inc.
|
1,500,000 | — | ||||||
|
Psilos Group Partners IV, LP (limited partnership interest)
|
1,000,000 | — | ||||||
|
Mansell Group, Inc.
|
2,000,000 | — | ||||||
|
NDSSI Holdings, Inc.
|
1,500,000 | — | ||||||
|
Eagle Hospital Physicians, Inc.
|
2,500,000 | — | ||||||
|
Enhanced Recovery Company, LLC
|
3,623,148 | — | ||||||
|
Epic Acquisition, Inc.
|
2,700,000 | — | ||||||
|
Specialty Bakers, LLC
|
2,000,000 | — | ||||||
|
Rail Acquisition Corp.
|
4,798,897 | — | ||||||
|
Total
|
$ | 49,515,033 | $ | 9,750,000 | ||||
We have entered into two contracts under which we have material
future commitments, the investment advisory agreement, pursuant
to which Fifth Street Management LLC has agreed to serve as our
investment
64
adviser, and the administration agreement, pursuant to which
FSC, Inc. has agreed to furnish us with the facilities and
administrative services necessary to conduct our
day-to-day
operations.
Regulated
Investment Company Status and Dividends
Effective as of January 2, 2008, Fifth Street Mezzanine
Partners III, L.P. merged with and into Fifth Street Finance
Corp., which has elected to be treated as a business development
company under the 1940 Act. We elected, effective as of
January 2, 2008, to be treated as a RIC under Subchapter M
of the Code. As long as we qualify as a RIC, we will not be
taxed on our investment company taxable income or realized net
capital gains, to the extent that such taxable income or gains
are distributed, or deemed to be distributed, to stockholders on
a timely basis.
Taxable income generally differs from net income for financial
reporting purposes due to temporary and permanent differences in
the recognition of income and expenses, and generally excludes
net unrealized appreciation or depreciation until realized.
Dividends declared and paid by us in a year may differ from
taxable income for that year as such dividends may include the
distribution of current year taxable income or the distribution
of prior year taxable income carried forward into and
distributed in the current year. Distributions also may include
returns of capital.
To maintain RIC tax treatment, we must, among other things,
distribute, with respect to each taxable year, at least 90% of
our investment company taxable income (i.e., our net ordinary
income and our realized net short-term capital gains in excess
of realized net long-term capital losses, if any). As a RIC, we
are also subject to a federal excise tax, based on distributive
requirements of our taxable income on a calendar year basis
(e.g., calendar year 2010). We anticipate timely distribution of
our taxable income within the tax rules; however, we may incur a
U.S. federal excise tax for the calendar year 2010. We
intend to distribute to our stockholders between 90% and 100% of
our annual taxable income (which includes our taxable interest
and fee income). However, in future periods, we will be
partially dependent on our SBIC subsidiary for cash
distributions to enable us to meet the RIC distribution
requirements. Our SBIC subsidiary may be limited by the Small
Business Investment Act of 1958, and SBA regulations governing
SBICs, from making certain distributions to us that may be
necessary to enable us to maintain our status as a RIC. We may
have to request a waiver of the SBA’s restrictions for our
SBIC subsidiary to make certain distributions to maintain our
RIC status. We cannot assure you that the SBA will grant such
waiver. Also, the financial covenants under the Wells Fargo
facility could, under certain circumstances, restrict Fifth
Street Funding, LLC from making distributions to us and, as a
result, hinder our ability to satisfy the distribution
requirement. In addition, we may retain for investment some or
all of our net taxable capital gains (i.e., realized net
long-term capital gains in excess of realized net short-term
capital losses) and treat such amounts as deemed distributions
to our stockholders. If we do this, our stockholders will be
treated as if they received actual distributions of the capital
gains we retained and then reinvested the net after-tax proceeds
in our common stock. Our stockholders also may be eligible to
claim tax credits (or, in certain circumstances, tax refunds)
equal to their allocable share of the tax we paid on the capital
gains deemed distributed to them. To the extent our taxable
earnings for a fiscal taxable year fall below the total amount
of our dividends for that fiscal year, a portion of those
dividend distributions may be deemed a return of capital to our
stockholders.
We may not be able to achieve operating results that will allow
us to make distributions at a specific level or to increase the
amount of these distributions from time to time. In addition, we
may be limited in our ability to make distributions due to the
asset coverage test for borrowings applicable to us as a
business development company under the 1940 Act and due to
provisions in our credit facilities. If we do not distribute a
certain percentage of our taxable income annually, we will
suffer adverse tax consequences, including possible loss of our
status as a RIC. We cannot assure stockholders that they will
receive any distributions or distributions at a particular level.
Pursuant to a recent revenue procedure (Revenue Procedure
2010-12),
or
the Revenue Procedure, issued by the Internal Revenue Service,
or IRS, the IRS has indicated that it will treat distributions
from certain publicly traded RICs (including BDCs) that are paid
part in cash and part in stock as dividends that would satisfy
the RIC’s annual distribution requirements and qualify for
the dividends paid deduction for federal
65
income tax purposes. In order to qualify for such treatment, the
Revenue Procedure requires that at least 10% of the total
distribution be payable in cash and that each stockholder have a
right to elect to receive its entire distribution in cash. If
too many stockholders elect to receive cash, each stockholder
electing to receive cash must receive a proportionate share of
the cash to be distributed (although no stockholder electing to
receive cash may receive less than 10% of such
stockholder’s distribution in cash). This Revenue Procedure
applies to distributions declared on or before December 31,
2012 with respect to taxable years ending on or before
December 31, 2011. We have no current intention of paying
dividends in shares of our stock.
Related
Party Transactions
We have entered into an investment advisory agreement with Fifth
Street Management LLC, our investment adviser. Fifth Street
Management is controlled by Leonard M. Tannenbaum, its managing
member and the chairman of our Board of Directors and our chief
executive officer. Pursuant to the investment advisory
agreement, fees payable to our investment adviser will be equal
to (a) a base management fee of 2.0% of the value of our
gross assets, which includes any borrowings for investment
purposes, and (b) an incentive fee based on our
performance. Our investment adviser agreed to permanently waive
that portion of its base management fee attributable to our
assets held in the form of cash and cash equivalents as of the
end of each quarter beginning March 31, 2010. The incentive
fee consists of two parts. The first part is calculated and
payable quarterly in arrears and equals 20% of our
“Pre-Incentive Fee Net Investment Income” for the
immediately preceding quarter, subject to a preferred return, or
“hurdle,” and a “catch up” feature. The
second part is determined and payable in arrears as of the end
of each fiscal year (or upon termination of the investment
advisory agreement) and equals 20% of our “Incentive Fee
Capital Gains,” which equals our realized capital gains on
a cumulative basis from inception through the end of the year,
if any, computed net of all realized capital losses and
unrealized capital depreciation on a cumulative basis, less the
aggregate amount of any previously paid capital gain incentive
fee.
The investment advisory agreement may be terminated by either
party without penalty upon no fewer than 60 days’
written notice to the other. Since we entered into the
investment advisory agreement in December 2007, we have paid our
investment adviser $8.4 million, $13.7 million and
$20.0 million for the fiscal years ended September 30,
2008, September 30, 2009, and September 30, 2010,
respectively, under the investment advisory agreement.
Pursuant to the administration agreement with FSC, Inc., which
is controlled by Mr. Tannenbaum, FSC, Inc. will furnish us
with the facilities and administrative services necessary to
conduct our
day-to-day
operations, including equipment, clerical, bookkeeping and
recordkeeping services at such facilities. In addition, FSC,
Inc. will assist us in connection with the determination and
publishing of our net asset value, the preparation and filing of
tax returns and the printing and dissemination of reports to our
stockholders. We will pay FSC, Inc. our allocable portion of
overhead and other expenses incurred by it in performing its
obligations under the administration agreement, including a
portion of the rent and the compensation of our chief financial
officer and chief compliance officer and their respective
staffs. FSC, Inc. has voluntarily determined to forgo receiving
reimbursement for the services performed for us by our chief
compliance officer, Bernard D. Berman, given his compensation
arrangement with our investment adviser. Although FSC, Inc.
currently intends to forgo its right to receive such
reimbursement, it is under no obligation to do so and may cease
to do so at any time in the future. The administration agreement
may be terminated by either party without penalty upon no fewer
than 60 days’ written notice to the other. Since we
entered into the administration agreement in December 2007, we
have paid FSC, Inc. approximately $1.6 million,
$1.3 million and $2.0 million for the fiscal years
ended September 30, 2008, September 30, 2009 and
September 30, 2010, respectively, under the administration
agreement.
We have also entered into a license agreement with Fifth Street
Capital LLC pursuant to which Fifth Street Capital LLC has
agreed to grant us a non-exclusive, royalty-free license to use
the name “Fifth Street.” Under this agreement, we will
have a right to use the “Fifth Street” name, for so
long as Fifth Street Management LLC or one of its affiliates
remains our investment adviser. Other than with respect to this
limited license, we will have no legal right to the “Fifth
Street” name. Fifth Street Capital LLC is controlled by
Mr. Tannenbaum, its managing member.
66
Recent
Developments
On October 1, 2010, we closed a $63.5 million senior
secured debt facility to support the acquisition of a provider
of technology solutions. The investment is backed by a private
equity sponsor and $51.0 million was funded at closing. The
terms of this investment include a $12.5 million revolver
at an interest rate of LIBOR + 7.5% per annum, a
$29.0 million Term Loan A at an interest rate of LIBOR +
7.5% per annum and a $22.0 million Term Loan B at an
interest rate of 12.5% per annum. This is a first lien facility
with a scheduled maturity of five years.
On October 1, 2010, we received a cash payment of
$8.6 million from Goldco, Inc. in full satisfaction of all
obligations under the loan agreement. The debt investment was
exited at par.
On October 13, 2010, Nicos Polymers & Grinding,
Inc., an existing portfolio company, filed for Chapter 11
bankruptcy as part of a restructuring of that investment. The
bankruptcy was subsequently moved to a court mandated mediation
process. On November 15, 2010, we and the major shareholder
of Nicos Polymers & Grinding, Inc. agreed to a binding
term sheet to settle the restructuring via an out of court
foreclosure process. The restructuring will result in Nicos
Polymers & Grinding retaining $10.0 million of
senior term debt at an interest rate of 8.0% with a scheduled
maturity of seven years, along with a $1.0 million to
$3.0 million expandable revolving line of credit.
On October 22, 2010, our Board of Directors authorized a
stock repurchase program to acquire up to $20 million of
our outstanding common stock. Stock repurchases under this
program are to be made through the open market at times and in
such amounts as our management deems appropriate, provided that
the price is below the most recently published net asset value
per share. The stock repurchase program expires
December 31, 2011 and may be limited or terminated by the
Board of Directors at any time without prior notice.
On October 22, 2010, our Board of Directors approved an
amendment to our DRIP to allow for a 5% discount on newly issued
shares purchased through the DRIP, provided the shares will not
be issued at a price below the most recently published net asset
value per share.
On October 27, 2010, we paid a dividend in the amount of
$0.10 per share to stockholders of record on October 6,
2010.
On November 4, 2010, we held a foreclosure auction of the
assets of Vanguard Vinyl, Inc., an existing portfolio company,
as part of a loan restructuring. The restructuring broke up
Vanguard Vinyl, Inc. into two operating companies. One operating
company, located in California will maintain $0.8 million
of senior secured term debt at an interest rate of 8.0%, along
with a $0.4 million revolving line of credit; both loans
have a scheduled maturity of three years. The other operating
company will manage operations in Utah with $2.0 million of
senior secured term debt at an interest rate of 8.0%, along with
a $1.0 million revolving line of credit; both loans have a
scheduled maturity of three years. The Hawaii operations will
maintain $3.8 million of senior secured term debt at an
interest rate of 8% with a scheduled maturity of six months.
On November 5, 2010, we amended the Wells Fargo facility
to, among other things, provide for the issuance from time to
time of letters of credit for the benefit of our portfolio
companies. The letters of credit are subject to certain
restrictions, including a borrowing base limitation and an
aggregate sublimit of $15.0 million.
On November 15, 2010, our SBIC subsidiary drew
$6.0 million from its SBA commitment to use to fund future
investments.
On November 16, 2010, we received a cash payment of
$11.0 million from TBA Global, LLC in full satisfaction of
all obligations under the loan agreement. The debt investment
was exited at par.
On November 16, 2010, we drew $10.0 million on the
Wells Fargo facility.
On November 19, 2010, we closed a $45.5 million senior
secured debt facility to support the acquisition of a provider
of technology-based services. The investment is backed by a
private equity sponsor and $39.5 million was funded at
closing. The terms of this investment include a
$6.0 million revolver at an interest
67
rate of LIBOR + 7.0% per annum with a 2% LIBOR floor, a
$16.4 million Term Loan A at an interest rate of LIBOR +
8.0% per annum with a 2% LIBOR floor, a $21.0 million Term
Loan B at an interest rate of LIBOR + 10.25% per annum with a 2%
LIBOR floor, and a $2.1 million membership interest. This
is a first lien facility with a scheduled maturity of five years.
On November 24, 2010, we paid a dividend in the amount of
$0.11 per share to stockholders of record on November 3,
2010.
On November 30, 2010, our Board of Directors declared the
following monthly dividends:
| • | $0.1066 per share, payable on January 31, 2011 to stockholders of record on January 4, 2011; | |
| • | $0.1066 per share, payable on February 28, 2011 to stockholders of record on February 1, 2011; and | |
| • | $0.1066 per share, payable on March 31, 2011 to stockholders of record on March 1, 2011. |
Recently
Issued Accounting Standards
See Note 2 to the Consolidated Financial Statements for a
description of recent accounting pronouncements, including the
expected dates of adoption and the anticipated impact on the
Consolidated Financial Statements.
| Item 7A. | Quantitative and Qualitative Disclosures about Market Risk |
We are subject to financial market risks, including changes in
interest rates. Changes in interest rates may affect both our
cost of funding and our interest income from portfolio
investments, cash and cash equivalents and idle funds
investments. Our risk management systems and procedures are
designed to identify and analyze our risk, to set appropriate
policies and limits and to continually monitor these risks and
limits by means of reliable administrative and information
systems and other policies and programs. Our investment income
will be affected by changes in various interest rates, including
LIBOR and prime rates, to the extent any of our debt investments
include floating interest rates. The significant majority of our
debt investments are made with fixed interest rates for the term
of the investment. However, as of September 30, 2010, 32.8%
of our debt investment portfolio (at fair value) and 31.4% of
our debt investment portfolio (at cost) bore interest at
floating rates. As of September 30, 2010, based on our
applicable levels of floating-rate debt investments, a 1.0%
change in interest rates would not have a material effect on our
level of interest income from debt investments.
Based on our review of interest rate risk, we determine whether
or not any hedging transactions are necessary to mitigate
exposure to changes in interest rates. On August 16, 2010,
we entered into an interest rate swap agreement that expires on
August 15, 2013, for a total notional amount of
$100 million, for the purposes of hedging the interest rate
risk related to the Wells facility and the ING facility. Under
the interest rate swap agreement, we will pay a fixed interest
rate of 0.99% and receive a floating rate based on the
prevailing one-month LIBOR.
Our investments are carried at fair value as determined in good
faith by our Board of Directors in accordance with the 1940 Act
(See “Item 7. Management’s Discussion and
Analysis of Financial Condition and Results of
Operations — Critical Accounting Policies —
Investment Valuation”). Our valuation methodology utilizes
discount rates in part in valuing our investments, and changes
in those discount rates may have an impact on the valuation of
our investments. Assuming no changes in our investment and
capital structure, a hypothetical increase or decrease in
discount rates of 100 basis points would increase or
decrease our net assets resulting from operations by
$12 million.
68
| Item 8. | Consolidated Financial Statements and Supplementary Data |
Index to
Consolidated Financial Statements
| 70 | ||||
| 72 | ||||
| 73 | ||||
| 74 | ||||
| 75 | ||||
| 76 | ||||
| 86 |
69
REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Fifth Street Finance Corp.:
In our opinion, the accompanying consolidated statement of
assets and liabilities, including the consolidated schedule of
investments, and the related consolidated statements of
operations, changes in net assets and cash flows, present
fairly, in all material respects, the financial position of
Fifth Street Finance Corp. (“the Company”) at
September 30, 2010, and the results of its operations, the
changes in its net assets and its cash flows for the year ended
September 30, 2010, in conformity with accounting
principles generally accepted in the United States of America.
In addition, in our opinion, the financial statement schedule
listed in the index appearing under Item 15(2) presents
fairly, in all material respects, the information set forth
therein when read in conjunction with the related consolidated
financial statements. Also in our opinion, the Company
maintained, in all material respects, effective internal control
over financial reporting as of September 30, 2010, based on
criteria established in
Internal Control —
Integrated Framework
issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). The
Company’s management is responsible for these financial
statements, for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness
of internal control over financial reporting, included in
Management’s Report on Internal Control over Financial
Reporting appearing on page 119 of the annual report to
stockholders. Our responsibility is to express an opinion on
these financial statements and on the Company’s internal
control over financial reporting based on our integrated audit.
We conducted our audit in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are
free of material misstatement and whether effective internal
control over financial reporting was maintained in all material
respects. Our audit of the financial statements included
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by
management, and evaluating the overall financial statement
presentation. Our audit of internal control over financial
reporting included obtaining an understanding of internal
control over financial reporting, assessing the risk that a
material weakness exists, and testing and evaluating the design
and operating effectiveness of internal control based on the
assessed risk. Our audit also included performing such other
procedures as we considered necessary in the circumstances. We
believe that our audit provides a reasonable basis for our
opinion.
A company’s internal control over financial reporting is a
process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with
generally accepted accounting principles. A company’s
internal control over financial reporting includes those
policies and procedures that (i) pertain to the maintenance
of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the
company; (ii) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of
financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the
company are being made only in accordance with authorizations of
management and directors of the company; and (iii) provide
reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the
company’s assets that could have a material effect on the
financial statements.
Because of its inherent limitations, internal control over
financial reporting may not prevent or detect misstatements.
Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers
LLP
New York, New York
December 1, 2010
70
REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders of
Fifth Street Finance Corp.
We have audited the accompanying consolidated statement of
assets and liabilities, including the consolidated schedule of
investments, of Fifth Street Finance Corp. (a Delaware
corporation) (the “Company”) as of September 30,
2009, and the related consolidated statements of operations,
changes in net assets, and cash flows and the financial
highlights (included in Note 12) for the years ended
September 30, 2009 and 2008. Our audits of the basic
financial statements included the Schedule of Investments In and
Advances to Affiliates. These financial statements, financial
highlights and financial statement schedule are the
responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and
financial highlights are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating
the overall financial statement presentation. Our procedures
included physical inspection or confirmation of securities owned
as of September 30, 2009. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial
highlights referred to above present fairly, in all material
respects, the financial position of Fifth Street Finance Corp.
as of September 30, 2009, and the results of its
operations, changes in net assets and its cash flows and
financial highlights for the years ended September 30, 2009
and 2008 in conformity with accounting principles generally
accepted in the United States of America. Also, in our opinion,
the related financial statement schedule, when considered in
relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information set
forth therein.
/s/ GRANT
THORNTON LLP
New York, New York
December 9, 2009
71
Fifth
Street Finance Corp.
|
September 30,
|
September 30,
|
|||||||
| 2010 | 2009 | |||||||
| ASSETS | ||||||||
|
Investments at Fair Value:
|
||||||||
|
Control investments (cost September 30, 2010: $12,195,029;
cost September 30, 2009: $12,045,029)
|
$ | 3,700,000 | $ | 5,691,107 | ||||
|
Affiliate investments (cost September 30, 2010:
$50,133,521; cost September 30, 2009: $71,212,035)
|
47,222,059 | 64,748,560 | ||||||
|
Non-control/Non-affiliate investments (cost September 30,
2010: $530,168,045; cost September 30, 2009: $243,975,221)
|
512,899,257 | 229,171,470 | ||||||
|
Total Investments at Fair Value (cost September 30,
2010: $592,496,595; cost September 30, 2009:
$327,232,285)
|
563,821,316 | 299,611,137 | ||||||
|
Cash and cash equivalents
|
76,765,254 | 113,205,287 | ||||||
|
Interest and fees receivable
|
3,813,757 | 2,866,991 | ||||||
|
Due from portfolio company
|
103,426 | 154,324 | ||||||
|
Deferred financing costs
|
5,465,964 | — | ||||||
|
Collateral posted to bank and other assets
|
1,956,013 | 49,609 | ||||||
|
Total Assets
|
$ | 651,925,730 | $ | 415,887,348 | ||||
| LIABILITIES AND NET ASSETS | ||||||||
|
Liabilities:
|
||||||||
|
Accounts payable, accrued expenses and other liabilities
|
$ | 1,322,282 | $ | 723,856 | ||||
|
Base management fee payable
|
2,875,802 | 1,552,160 | ||||||
|
Incentive fee payable
|
2,859,139 | 1,944,263 | ||||||
|
Due to FSC, Inc.
|
1,083,038 | 703,900 | ||||||
|
Interest payable
|
282,640 | — | ||||||
|
Payments received in advance from portfolio companies
|
1,330,724 | 190,378 | ||||||
|
Offering costs payable
|
— | 216,720 | ||||||
|
SBA debentures payable
|
73,000,000 | — | ||||||
|
Total Liabilities
|
82,753,625 | 5,331,277 | ||||||
|
Net Assets:
|
||||||||
|
Common stock, $0.01 par value, 150,000,000 shares
authorized, 54,550,290 and 37,878,987 shares issued and
outstanding at September 30, 2010 and September 30,
2009
|
545,503 | 378,790 | ||||||
|
Additional
paid-in-capital
|
619,759,984 | 439,989,597 | ||||||
|
Net unrealized depreciation on investments and interest rate swap
|
(29,448,713 | ) | (27,621,147 | ) | ||||
|
Net realized loss on investments
|
(33,090,961 | ) | (14,310,713 | ) | ||||
|
Accumulated undistributed net investment income
|
11,406,292 | 12,119,544 | ||||||
|
Total Net Assets
|
569,172,105 | 410,556,071 | ||||||
|
Total Liabilities and Net Assets
|
$ | 651,925,730 | $ | 415,887,348 | ||||
See notes to Consolidated Financial Statements.
72
Fifth
Street Finance Corp.
|
Year
|
Year
|
Year
|
||||||||||
|
Ended
|
Ended
|
Ended
|
||||||||||
|
September 30,
|
September 30,
|
September 30,
|
||||||||||
| 2010 | 2009 | 2008 | ||||||||||
|
Interest income:
|
||||||||||||
|
Control investments
|
$ | 182,827 | $ | — | $ | — | ||||||
|
Affiliate investments
|
7,619,018 | 10,632,844 | 8,804,543 | |||||||||
|
Non-control/Non-affiliate investments
|
46,089,945 | 27,931,097 | 16,800,945 | |||||||||
|
Interest on cash and cash equivalents
|
237,557 | 208,824 | 750,605 | |||||||||
|
Total interest income
|
54,129,347 | 38,772,765 | 26,356,093 | |||||||||
|
PIK interest income:
|
||||||||||||
|
Control investments
|
— | — | — | |||||||||
|
Affiliate investments
|
1,227,133 | 1,634,116 | 1,539,934 | |||||||||
|
Non-control/Non-affiliate investments
|
8,776,935 | 5,821,173 | 3,357,464 | |||||||||
|
Total PIK interest income
|
10,004,068 | 7,455,289 | 4,897,398 | |||||||||
|
Fee income:
|
||||||||||||
|
Control investments
|
— | — | — | |||||||||
|
Affiliate investments
|
1,433,206 | 1,101,656 | 702,463 | |||||||||
|
Non-control/Non-affiliate investments
|
4,537,837 | 2,440,538 | 1,105,576 | |||||||||
|
Total fee income
|
5,971,043 | 3,542,194 | 1,808,039 | |||||||||
|
Dividend and other income:
|
||||||||||||
|
Control investments
|
— | — | — | |||||||||
|
Affiliate investments
|
— | — | 26,740 | |||||||||
|
Non-control/Non-affiliate investments
|
433,317 | 22,791 | 130,971 | |||||||||
|
Other income
|
— | 35,396 | — | |||||||||
|
Total dividend and other income
|
433,317 | 58,187 | 157,711 | |||||||||
|
Total investment income
|
70,537,775 | 49,828,435 | 33,219,241 | |||||||||
|
Expenses:
|
||||||||||||
|
Base management fee
|
10,002,326 | 6,060,690 | 4,258,334 | |||||||||
|
Incentive fee
|
10,756,040 | 7,840,579 | 4,117,554 | |||||||||
|
Professional fees
|
1,348,908 | 1,492,554 | 1,389,541 | |||||||||
|
Board of Directors fees
|
278,418 | 310,250 | 249,000 | |||||||||
|
Organizational costs
|
— | — | 200,747 | |||||||||
|
Interest expense
|
1,929,389 | 636,901 | 917,043 | |||||||||
|
Administrator expense
|
1,321,546 | 796,898 | 978,387 | |||||||||
|
Line of credit guarantee expense
|
— | — | 83,333 | |||||||||
|
Transaction fees
|
— | — | 206,726 | |||||||||
|
General and administrative expenses
|
2,604,051 | 1,500,197 | 674,360 | |||||||||
|
Total expenses
|
28,240,678 | 18,638,069 | 13,075,025 | |||||||||
|
Base management fee waived
|
(727,067 | ) | (171,948 | ) | — | |||||||
|
Net expenses
|
27,513,611 | 18,466,121 | 13,075,025 | |||||||||
|
Net investment income
|
43,024,164 | 31,362,314 | 20,144,216 | |||||||||
|
Unrealized depreciation on interest rate swap
|
(773,435 | ) | — | — | ||||||||
|
Unrealized appreciation (depreciation) on investments:
|
||||||||||||
|
Control investments
|
(2,141,107 | ) | (1,792,015 | ) | — | |||||||
|
Affiliate investments
|
3,294,482 | 286,190 | (10,570,012 | ) | ||||||||
|
Non-control/Non-affiliate investments
|
(2,207,506 | ) | (9,289,492 | ) | (6,378,755 | ) | ||||||
|
Net unrealized depreciation on investments
|
(1,054,131 | ) | (10,795,317 | ) | (16,948,767 | ) | ||||||
|
Realized gain (loss) on investments:
|
||||||||||||
|
Control investments
|
— | — | — | |||||||||
|
Affiliate investments
|
(6,937,100 | ) | (4,000,000 | ) | — | |||||||
|
Non-control/Non-affiliate investments
|
(11,843,148 | ) | (10,373,200 | ) | 62,487 | |||||||
|
Total realized gain (loss) on investments
|
(18,780,248 | ) | (14,373,200 | ) | 62,487 | |||||||
|
Net increase in net assets resulting from operations
|
$ | 22,416,350 | $ | 6,193,797 | $ | 3,257,936 | ||||||
|
Net Investment Income per common share — basic and
diluted(1)
|
$ | 0.95 | $ | 1.27 | $ | 1.29 | ||||||
|
Earnings per common share — basic and diluted(1)
|
$ | 0.49 | $ | 0.25 | $ | 0.21 | ||||||
|
Weighted average common shares — basic and diluted
|
45,440,584 | 24,654,325 | 15,557,469 | |||||||||
| (1) | The earnings and net investment income per share calculations for the year ended September 30, 2008 are based on the assumption that if the number of shares issued at the time of the merger on January 2, 2008 (12,480,972 shares of common stock) had been issued at the beginning of the fiscal year on October 1, 2007, the Company’s earnings and net investment income per share would have been $0.21 and $1.29 per share, respectively. |
See notes to Consolidated Financial Statements.
73
Fifth
Street Finance Corp.
|
Year Ended
|
Year Ended
|
Year Ended
|
||||||||||
|
September 30,
|
September 30,
|
September 30,
|
||||||||||
| 2010 | 2009 | 2008 | ||||||||||
|
Operations:
|
||||||||||||
|
Net investment income
|
$ | 43,024,164 | $ | 31,362,314 | $ | 20,144,216 | ||||||
|
Net unrealized depreciation on investments and interest rate swap
|
(1,827,566 | ) | (10,795,317 | ) | (16,948,767 | ) | ||||||
|
Net realized gain (loss) on investments
|
(18,780,248 | ) | (14,373,200 | ) | 62,487 | |||||||
|
Net increase in net assets resulting from operations
|
22,416,350 | 6,193,797 | 3,257,936 | |||||||||
|
Stockholder transactions:
|
||||||||||||
|
Distributions to stockholders from net investment income
|
(43,737,416 | ) | (29,591,657 | ) | (10,754,721 | ) | ||||||
|
Net decrease in net assets from stockholder transactions
|
(43,737,416 | ) | (29,591,657 | ) | (10,754,721 | ) | ||||||
|
Capital share transactions:
|
||||||||||||
|
Issuance of preferred stock
|
— | — | 15,000,000 | |||||||||
|
Issuance of common stock, net
|
178,017,945 | 137,625,075 | 129,448,456 | |||||||||
|
Issuance of common stock under dividend reinvestment plan
|
1,919,155 | 2,455,499 | 1,882,200 | |||||||||
|
Redemption of preferred stock
|
— | — | (15,000,000 | ) | ||||||||
|
Repurchases of common stock
|
— | (462,482 | ) | — | ||||||||
|
Issuance of common stock upon conversion of partnership interests
|
— | — | 169,420,000 | |||||||||
|
Redemption of partnership interest for common stock
|
— | — | (169,420,000 | ) | ||||||||
|
Fractional shares paid to partners from conversion
|
— | — | (358 | ) | ||||||||
|
Capital contributions from partners
|
— | — | 66,497,000 | |||||||||
|
Capital withdrawals by partners
|
— | — | (2,810,369 | ) | ||||||||
|
Net increase in net assets from capital share transactions
|
179,937,100 | 139,618,092 | 195,016,929 | |||||||||
|
Total increase in net assets
|
158,616,034 | 116,220,232 | 187,520,144 | |||||||||
|
Net assets at beginning of period
|
410,556,071 | 294,335,839 | 106,815,695 | |||||||||
|
Net assets at end of period
|
$ | 569,172,105 | $ | 410,556,071 | $ | 294,335,839 | ||||||
|
Net asset value per common share
|
$ | 10.43 | $ | 10.84 | $ | 13.02 | ||||||
|
Common shares outstanding at end of period
|
54,550,290 | 37,878,987 | 22,614,289 | |||||||||
See notes to Consolidated Financial Statements.
74
Fifth
Street Finance Corp.
|
Year Ended
|
Year Ended
|
Year Ended
|
||||||||||
|
September 30,
|
September 30,
|
September 30,
|
||||||||||
| 2010 | 2009 | 2008 | ||||||||||
|
Cash flows from operating activities:
|
||||||||||||
|
Net increase in net assets resulting from operations
|
$ | 22,416,350 | $ | 6,193,797 | $ | 3,257,936 | ||||||
|
Net unrealized depreciation on investments and interest rate swap
|
1,827,566 | 10,795,317 | 16,948,767 | |||||||||
|
Net realized (gains) losses on investments
|
18,780,248 | 14,373,200 | (62,487 | ) | ||||||||
|
PIK interest income
|
(10,004,068 | ) | (7,455,289 | ) | (4,897,398 | ) | ||||||
|
Recognition of fee income
|
(5,971,043 | ) | (3,542,194 | ) | (1,808,039 | ) | ||||||
|
Accretion of original issue discount on investments
|
(893,077 | ) | (842,623 | ) | (954,436 | ) | ||||||
|
Amortization of deferred financing costs
|
798,492 | — | — | |||||||||
|
Other income
|
— | (35,396 | ) | — | ||||||||
|
Changes in operating assets and liabilities:
|
||||||||||||
|
PIK interest income received in cash
|
1,618,762 | 428,140 | 114,412 | |||||||||
|
Fee income received
|
11,882,094 | 3,895,559 | 5,478,011 | |||||||||
|
Increase in interest receivable
|
(946,766 | ) | (499,185 | ) | (1,613,183 | ) | ||||||
|
(Increase) decrease in due from portfolio company
|
50,898 | (73,561 | ) | 46,952 | ||||||||
|
Decrease in prepaid management fees
|
— | — | 252,586 | |||||||||
|
Increase in collateral posted to bank and other assets
|
(1,906,404 | ) | (14,903 | ) | (34,706 | ) | ||||||
|
Increase (decrease) in accounts payable, accrued expenses and
other liabilities
|
(176,705 | ) | 156,170 | 150,584 | ||||||||
|
Increase in base management fee payable
|
1,323,642 | 170,948 | 1,381,212 | |||||||||
|
Increase in incentive fee payable
|
914,876 | 130,250 | 1,814,013 | |||||||||
|
Increase in due to FSC, Inc.
|
379,138 | 129,798 | 574,102 | |||||||||
|
Increase (decrease) in interest payable
|
282,640 | (38,750 | ) | 28,816 | ||||||||
|
Increase in payments received in advance from portfolio companies
|
1,140,346 | 56,641 | 133,737 | |||||||||
|
Purchase of investments
|
(325,527,419 | ) | (61,950,000 | ) | (202,402,611 | ) | ||||||
|
Proceeds from the sale of investments
|
306,178 | 144,000 | 62,487 | |||||||||
|
Principal payments received on investments (scheduled repayments
and revolver paydowns)
|
21,776,331 | 6,951,902 | 2,152,992 | |||||||||
|
Principal payments received on investments (payoffs)
|
22,767,681 | 11,350,000 | — | |||||||||
|
Net cash used in operating activities
|
(239,160,240 | ) | (19,676,179 | ) | (179,376,253 | ) | ||||||
|
Cash flows from financing activities:
|
||||||||||||
|
Dividends paid in cash
|
(41,818,261 | ) | (27,136,158 | ) | (8,872,521 | ) | ||||||
|
Repurchases of common stock
|
— | (462,482 | ) | — | ||||||||
|
Capital contributions
|
— | — | 66,497,000 | |||||||||
|
Capital withdrawals
|
— | — | (2,810,369 | ) | ||||||||
|
Borrowings under SBA debentures payable
|
73,000,000 | — | — | |||||||||
|
Borrowings under credit facilities
|
43,000,000 | 29,500,000 | 79,250,000 | |||||||||
|
Repayments of borrowings under credit facilities
|
(43,000,000 | ) | (29,500,000 | ) | (79,250,000 | ) | ||||||
|
Proceeds from the issuance of common stock
|
179,125,148 | 138,578,307 | 131,316,000 | |||||||||
|
Proceeds from the issuance of manditorily redeemable preferred
stock
|
— | — | 15,000,000 | |||||||||
|
Redemption of preferred stock
|
— | — | (15,000,000 | ) | ||||||||
|
Deferred financing costs paid
|
(6,264,457 | ) | — | — | ||||||||
|
Offering costs paid
|
(1,322,223 | ) | (1,004,577 | ) | (1,501,179 | ) | ||||||
|
Redemption of partnership interests for cash
|
— | — | (358 | ) | ||||||||
|
Net cash provided by financing activities
|
202,720,207 | 109,975,090 | 184,628,573 | |||||||||
|
Net increase (decrease) in cash and cash equivalents
|
(36,440,033 | ) | 90,298,911 | 5,252,320 | ||||||||
|
Cash and cash equivalents, beginning of period
|
113,205,287 | 22,906,376 | 17,654,056 | |||||||||
|
Cash and cash equivalents, end of period
|
$ | 76,765,254 | $ | 113,205,287 | $ | 22,906,376 | ||||||
|
Supplemental Information:
|
||||||||||||
|
Cash paid for interest
|
$ | 848,257 | $ | 425,651 | $ | 888,227 | ||||||
|
Non-cash financing activities:
|
||||||||||||
|
Issuance of shares of common stock under dividend reinvestment
plan
|
$ | 1,919,155 | $ | 2,455,499 | $ | 1,882,200 | ||||||
|
Reinvested shares of common stock under dividend reinvestment
plan
|
$ | — | $ | — | $ | (1,882,200 | ) | |||||
|
Redemption of partnership interests
|
$ | — | $ | — | $ | (173,699,632 | ) | |||||
|
Issuance of shares of common stock in exchange for partnership
interests
|
$ | — | $ | — | $ | 173,699,632 | ||||||
See notes to Consolidated Financial Statements.
75
Fifth
Street Finance Corp.
September 30,
2010
|
Portfolio Company/Type of Investment(1)(2)(5)
|
Industry
|
Principal(8) | Cost | Fair Value | ||||||||||
|
Control Investments(3)
|
||||||||||||||
|
Lighting By Gregory, LLC(13)(14)
|
Housewares &
Specialties |
|||||||||||||
|
First Lien Term Loan A, 9.75% due 2/28/2013
|
$ | 5,419,495 | $ | 4,728,589 | $ | 1,503,716 | ||||||||
|
First Lien Term Loan B, 14.5% due 2/28/2013
|
8,575,783 | 6,906,440 | 2,196,284 | |||||||||||
|
First Lien Bridge Loan, 8% due 10/15/2010
|
152,312 | 150,000 | — | |||||||||||
|
97.38% membership interest
|
410,000 | — | ||||||||||||
| 12,195,029 | 3,700,000 | |||||||||||||
|
Total Control Investments
|
$ | 12,195,029 | $ | 3,700,000 | ||||||||||
|
Affiliate Investments(4)
|
||||||||||||||
|
O’Currance, Inc.
|
Data Processing
& Outsourced Services |
|||||||||||||
|
First Lien Term Loan A, 16.875% due 3/21/2012
|
10,961,448 | $ | 10,869,262 | $ | 10,805,775 | |||||||||
|
First Lien Term Loan B, 16.875%, 3/21/2012
|
1,853,976 | 1,828,494 | 1,896,645 | |||||||||||
|
1.75% Preferred Membership interest in O’Currance Holding
Co., LLC
|
130,413 | 38,592 | ||||||||||||
|
3.3% Membership Interest in O’Currance Holding Co., LLC
|
250,000 | — | ||||||||||||
| 13,078,169 | 12,741,012 | |||||||||||||
|
MK Network, LLC(13)(14)
|
Education
services |
|||||||||||||
|
First Lien Term Loan A, 13.5% due 6/1/2012
|
9,740,358 | 9,539,188 | 7,913,140 | |||||||||||
|
First Lien Term Loan B, 17.5% due 6/1/2012
|
4,926,187 | 4,748,004 | 3,938,660 | |||||||||||
|
First Lien Revolver, Prime + 1.5% (10% floor), due 6/1/2010(10)
|
— | — | — | |||||||||||
|
11,030 Membership Units(6)
|
771,575 | — | ||||||||||||
| 15,058,767 | 11,851,800 | |||||||||||||
|
Caregiver Services, Inc.
|
Healthcare
services |
|||||||||||||
|
Second Lien Term Loan A, LIBOR+6.85% (12% floor) due 2/25/2013
|
7,141,190 | 6,813,431 | 7,113,622 | |||||||||||
|
Second Lien Term Loan B, 16.5% due 2/25/2013
|
14,692,015 | 14,102,756 | 14,179,626 | |||||||||||
|
1,080,399 shares of Series A Preferred Stock
|
1,080,398 | 1,335,999 | ||||||||||||
| 21,996,585 | 22,629,247 | |||||||||||||
|
Total Affiliate Investments
|
$ | 50,133,521 | $ | 47,222,059 | ||||||||||
|
Non-Control/Non-Affiliate Investments(7)
|
||||||||||||||
|
CPAC, Inc.
|
Household
Products |
|||||||||||||
|
Subordinated Term Loan, 12.5% due 6/1/2012
|
1,064,910 | $ | 1,064,910 | $ | 1,064,910 | |||||||||
| 1,064,910 | 1,064,910 | |||||||||||||
|
Vanguard Vinyl, Inc.(9)(13)(14)
|
Building
Products |
|||||||||||||
|
First Lien Term Loan, 12% due 3/30/2013
|
7,000,000 | 6,827,373 | 5,812,199 | |||||||||||
|
First Lien Revolver, LIBOR+7% (10% floor) due 3/30/2013
|
1,250,000 | 1,207,895 | 1,029,268 | |||||||||||
|
25,641 Shares of Series A Preferred Stock
|
253,846 | — | ||||||||||||
|
25,641 Shares of Common Stock
|
2,564 | — | ||||||||||||
| 8,291,678 | 6,841,467 | |||||||||||||
|
Repechage Investments Limited
|
Restaurants | |||||||||||||
|
First Lien Term Loan, 15.5% due 10/16/2011
|
3,708,971 | 3,475,906 | 3,486,342 | |||||||||||
|
7,500 shares of Series A Preferred Stock of
Elephant & Castle, Inc.
|
750,000 | 354,114 | ||||||||||||
| 4,225,906 | 3,840,456 | |||||||||||||
76
Fifth
Street Finance Corp.
Consolidated
Schedule of Investments
September 30,
2010
|
Portfolio Company/Type of Investment(1)(2)(5)
|
Industry
|
Principal(8) | Cost | Fair Value | ||||||||||
|
Traffic Control & Safety Corporation(9)
|
Construction and
Engineering |
|||||||||||||
|
Second Lien Term Loan, 15% due 5/28/2015
|
19,969,524 | 19,724,493 | 19,440,090 | |||||||||||
|
Subordinated Loan, 15% due 5/28/2015
|
4,577,800 | 4,577,800 | 4,404,746 | |||||||||||
|
24,750 shares of Series B Preferred Stock
|
247,500 | — | ||||||||||||
|
43,494 shares of Series D Preferred Stock(6)
|
434,937 | — | ||||||||||||
|
25,000 shares of Common Stock
|
2,500 | — | ||||||||||||
| 24,987,230 | 23,844,836 | |||||||||||||
|
Nicos Polymers & Grinding Inc.(9)(13)(14)
|
Environmental
& facilities services |
|||||||||||||
|
First Lien Term Loan A, LIBOR+5% (10% floor), due 7/17/2012
|
3,154,876 | 3,040,465 | 1,782,181 | |||||||||||
|
First Lien Term Loan B, 13.5% due 7/17/2012
|
6,180,185 | 5,713,125 | 3,347,672 | |||||||||||
|
3.32% Interest in Crownbrook Acquisition I LLC
|
168,086 | — | ||||||||||||
| 8,921,676 | 5,129,853 | |||||||||||||
|
TBA Global, LLC(9)
|
Advertising | |||||||||||||
|
Second Lien Term Loan B, 14.5% due 8/3/2012
|
10,840,081 | 10,594,939 | 10,625,867 | |||||||||||
|
53,994 Senior Preferred Shares
|
215,975 | 215,975 | ||||||||||||
|
191,977 Shares A Shares
|
191,977 | 179,240 | ||||||||||||
| 11,002,891 | 11,021,082 | |||||||||||||
|
Fitness Edge, LLC
|
Leisure
Facilities |
|||||||||||||
|
First Lien Term Loan A, LIBOR+5.25% (10% floor), due 8/8/2012
|
1,250,000 | 1,245,136 | 1,247,418 | |||||||||||
|
First Lien Term Loan B, 15% due 8/8/2012
|
5,631,547 | 5,575,477 | 5,674,493 | |||||||||||
|
1,000 Common Units
|
42,908 | 118,132 | ||||||||||||
| 6,863,521 | 7,040,043 | |||||||||||||
|
Filet of Chicken(9)
|
Food
Distributors |
|||||||||||||
|
Second Lien Term Loan, 14.5% due 7/31/2012
|
9,316,518 | 9,063,155 | 8,964,766 | |||||||||||
| 9,063,155 | 8,964,766 | |||||||||||||
|
Boot Barn(9)
|
Apparel,
accessories & luxury goods and Footwear |
|||||||||||||
|
Second Lien Term Loan, 14.5% due 10/3/2013
|
23,545,479 | 23,288,566 | 23,477,539 | |||||||||||
|
247.06 shares of Series A Preferred Stock
|
247,060 | 71,394 | ||||||||||||
|
1,308 shares of Common Stock
|
131 | — | ||||||||||||
| 23,535,757 | 23,548,933 | |||||||||||||
|
Premier Trailer Leasing, Inc.(9)(13)(14)
|
Trucking | |||||||||||||
|
Second Lien Term Loan, 16.5% due 10/23/2012
|
18,452,952 | 17,063,645 | 4,597,412 | |||||||||||
|
285 shares of Common Stock
|
1,140 | — | ||||||||||||
| 17,064,785 | 4,597,412 | |||||||||||||
|
Pacific Press Technologies, Inc.(9)
|
||||||||||||||
|
Second Lien Term Loan, 14.75% due 7/10/2013
|
Industrial
machinery |
10,071,866 | 9,798,901 | 9,829,869 | ||||||||||
|
33,786 shares of Common Stock
|
344,513 | 402,894 | ||||||||||||
| 10,143,414 | 10,232,763 | |||||||||||||
|
Goldco, LLC
|
||||||||||||||
|
Second Lien Term Loan, 17.5% due 1/31/2013
|
Restaurants | 8,355,688 | 8,259,479 | 8,259,479 | ||||||||||
| 8,259,479 | 8,259,479 | |||||||||||||
|
Rail Acquisition Corp.(9)
|
Electronic
manufacturing services |
|||||||||||||
|
First Lien Term Loan, 17% due 9/1/2013
|
16,315,866 | 13,536,969 | 12,854,425 | |||||||||||
|
First Lien Revolver, 7.85% due 9/1/2013
|
5,201,103 | 5,201,103 | 5,201,103 | |||||||||||
| 18,738,072 | 18,055,528 | |||||||||||||
77
Fifth
Street Finance Corp.
Consolidated
Schedule of Investments
September 30,
2010
|
Portfolio Company/Type of Investment(1)(2)(5)
|
Industry
|
Principal(8) | Cost | Fair Value | ||||||||||
|
Western Emulsions, Inc.(9)
|
Construction
materials |
|||||||||||||
|
Second Lien Term Loan, 15% due 6/30/2014
|
17,864,713 | 17,475,899 | 17,039,751 | |||||||||||
| 17,475,899 | 17,039,751 | |||||||||||||
|
Storyteller Theaters Corporation
|
Movies
& entertainment |
|||||||||||||
|
1,692 shares of Common Stock
|
169 | 61,613 | ||||||||||||
|
20,000 shares of Preferred Stock
|
200,000 | 200,000 | ||||||||||||
| 200,169 | 261,613 | |||||||||||||
|
HealthDrive Corporation(9)
|
Healthcare
services |
|||||||||||||
|
First Lien Term Loan A, 10% due 7/17/2013
|
6,662,970 | 6,324,339 | 6,488,990 | |||||||||||
|
First Lien Term Loan B, 13% due 7/17/2013
|
10,178,726 | 10,068,726 | 9,962,414 | |||||||||||
|
First Lien Revolver, 12% due 7/17/2013
|
500,000 | 489,000 | 508,967 | |||||||||||
| 16,882,065 | 16,960,371 | |||||||||||||
|
idX Corporation
|
Distributors | |||||||||||||
|
Second Lien Term Loan, 14.5% due 7/1/2014
|
13,588,794 | 13,350,633 | 13,258,317 | |||||||||||
| 13,350,633 | 13,258,317 | |||||||||||||
|
Cenegenics, LLC
|
Healthcare
services |
|||||||||||||
|
First Lien Term Loan, 17% due 10/27/2014
|
20,172,004 | 19,257,215 | 19,544,864 | |||||||||||
|
414,419 Common Units(6)
|
598,382 | 1,417,886 | ||||||||||||
| 19,855,597 | 20,962,750 | |||||||||||||
|
IZI Medical Products, Inc.
|
Healthcare
technology |
|||||||||||||
|
First Lien Term Loan A, 12% due 3/31/2014
|
4,449,775 | 4,387,947 | 4,406,684 | |||||||||||
|
First Lien Term Loan B, 16% due 3/31/2014
|
17,258,033 | 16,702,405 | 17,092,868 | |||||||||||
|
First Lien Revolver, 10% due 3/31/2014(11)
|
— | (35,000 | ) | (35,000 | ) | |||||||||
|
453,755 Preferred units of IZI Holdings, LLC
|
453,755 | 676,061 | ||||||||||||
| 21,509,107 | 22,140,613 | |||||||||||||
|
Trans-Trade, Inc.
|
Air freight
& logistics |
|||||||||||||
|
First Lien Term Loan, 15.5% due 9/10/2014
|
12,751,463 | 12,536,099 | 12,549,159 | |||||||||||
|
First Lien Revolver, 12% due 9/10/2014
|
1,500,000 | 1,468,667 | 1,491,373 | |||||||||||
| 14,004,766 | 14,040,532 | |||||||||||||
|
Riverlake Equity Partners II, LP
|
Multi-sector
holdings |
|||||||||||||
|
1.87% limited partnership interest
|
33,640 | 33,640 | ||||||||||||
| 33,640 | 33,640 | |||||||||||||
|
Riverside Fund IV, LP
|
Multi-sector
holdings |
|||||||||||||
|
0.33% limited partnership interest
|
135,825 | 135,825 | ||||||||||||
| 135,825 | 135,825 | |||||||||||||
|
ADAPCO, Inc.
|
Fertilizers
& agricultural chemicals |
|||||||||||||
|
First Lien Term Loan A, 10% due 12/17/2014
|
9,000,000 | 8,789,498 | 8,806,763 | |||||||||||
|
First Lien Term Loan B, 14% due 12/17/2014
|
14,225,615 | 13,892,772 | 13,897,677 | |||||||||||
|
First Lien Term Revolver, 10% due 12/17/2014
|
4,250,000 | 4,012,255 | 4,107,420 | |||||||||||
| 26,694,525 | 26,811,860 | |||||||||||||
78
Fifth
Street Finance Corp.
Consolidated
Schedule of Investments
September 30,
2010
|
Portfolio Company/Type of Investment(1)(2)(5)
|
Industry
|
Principal(8) | Cost | Fair Value | ||||||||||
|
Ambath/Rebath Holdings, Inc.
|
Home
improvement retail |
|||||||||||||
|
First Lien Term Loan A, LIBOR+7% (10% floor) due 12/30/2014
|
9,500,000 | 9,277,900 | 9,127,886 | |||||||||||
|
First Lien Term Loan B, 15% due 12/30/2014
|
22,423,729 | 21,920,479 | 21,913,276 | |||||||||||
|
First Lien Term Revolver, LIBOR+6.5% (9.5% floor) due 12/30/2014
|
1,500,000 | 1,432,500 | 1,442,696 | |||||||||||
| 32,630,879 | 32,483,858 | |||||||||||||
|
JTC Education, Inc.
|
Education
services |
|||||||||||||
|
First Lien Term Loan, LIBOR+9.5% (12.5% floor) due 12/31/2014
|
31,054,688 | 30,243,946 | 30,660,049 | |||||||||||
|
First Lien Revolver, LIBOR+9.5% (12.5% floor) due 12/31/2014(11)
|
— | (401,111 | ) | (401,111 | ) | |||||||||
| 29,842,835 | 30,258,938 | |||||||||||||
|
Tegra Medical, LLC
|
Healthcare
equipment |
|||||||||||||
|
First Lien Term Loan A, LIBOR+7% (10% floor) due 12/31/2014
|
26,320,000 | 25,877,206 | 26,250,475 | |||||||||||
|
First Lien Term Loan B, 14% due 12/31/2014
|
22,098,966 | 21,729,057 | 22,114,113 | |||||||||||
|
First Lien Revolver, LIBOR+7% (10% floor) due 12/31/2014(11)
|
— | (66,667 | ) | (66,667 | ) | |||||||||
| 47,539,596 | 48,297,921 | |||||||||||||
|
Flatout, Inc.
|
Food retail | |||||||||||||
|
First Lien Term Loan A, 10% due 12/31/2014
|
7,300,000 | 7,120,671 | 7,144,136 | |||||||||||
|
First Lien Term Loan B, 15% due 12/31/2014
|
12,862,760 | 12,539,879 | 12,644,316 | |||||||||||
|
First Lien Revolver, 10% due 12/31/2014(11)
|
— | (38,136 | ) | (38,136 | ) | |||||||||
| 19,622,414 | 19,750,316 | |||||||||||||
|
Psilos Group Partners IV, LP
|
Multi-sector
holdings |
|||||||||||||
|
2.53% limited partnership interest(12)
|
— | — | ||||||||||||
| — | — | |||||||||||||
|
Mansell Group, Inc.
|
Advertising | |||||||||||||
|
First Lien Term Loan A, LIBOR+7% (10% floor) due 4/30/2015
|
5,000,000 | 4,909,720 | 4,915,885 | |||||||||||
|
First Lien Term Loan B, LIBOR+9% (13.5% floor) due 4/30/2015
|
4,025,733 | 3,952,399 | 3,946,765 | |||||||||||
|
First Lien Revolver, LIBOR+6% (9% floor) due 4/30/2015(11)
|
— | (36,667 | ) | (36,667 | ) | |||||||||
| 8,825,452 | 8,825,983 | |||||||||||||
|
NDSSI Holdings, Inc.
|
Electronic
equipment & instruments |
|||||||||||||
|
First Lien Term Loan, LIBOR+9.75% (13.75% floor) due 9/10/2014
|
30,245,558 | 29,684,880 | 29,409,043 | |||||||||||
|
First Lien Revolver, LIBOR+7% (10% floor) due 9/10/2014
|
3,500,000 | 3,409,615 | 3,478,724 | |||||||||||
| 33,094,495 | 32,887,767 | |||||||||||||
|
Eagle Hospital Physicians, Inc.
|
Healthcare
services |
|||||||||||||
|
First Lien Term Loan, LIBOR+8.75% (11.75% floor) due 8/11/2015
|
8,000,000 | 7,783,892 | 7,783,892 | |||||||||||
|
First Lien Revolver, LIBOR+5.75% (8.75% floor) due 8/11/2015
|
— | (64,394 | ) | (64,394 | ) | |||||||||
| 7,719,498 | 7,719,498 | |||||||||||||
|
Enhanced Recovery Company, LLC
|
Diversified
support services |
|||||||||||||
|
First Lien Term Loan A, LIBOR+7% (9% floor) due 8/13/2015
|
15,500,000 | 15,171,867 | 15,171,867 | |||||||||||
|
First Lien Term Loan B, LIBOR+10% (13% floor) due 8/13/2015
|
11,014,977 | 10,782,174 | 10,782,174 | |||||||||||
|
First Lien Revolver, LIBOR+7% (9% floor) due 8/13/2015
|
376,852 | 292,196 | 292,196 | |||||||||||
| 26,246,237 | 26,246,237 | |||||||||||||
79
Fifth
Street Finance Corp.
Consolidated
Schedule of Investments
September 30,
2010
|
Portfolio Company/Type of Investment(1)(2)(5)
|
Industry
|
Principal(8) | Cost | Fair Value | ||||||||||
|
Epic Acquisition, Inc.
|
Healthcare
services |
|||||||||||||
|
First Lien Term Loan A, LIBOR+8% (11% floor) due 8/13/2015
|
7,750,000 | 7,554,728 | 7,554,728 | |||||||||||
|
First Lien Term Loan B, 15.25% due 8/13/2015
|
13,555,178 | 13,211,532 | 13,211,532 | |||||||||||
|
First Lien Revolver, LIBOR+6.5% (9.5% floor) due 8/13/2015
|
300,000 | 223,634 | 223,634 | |||||||||||
| 20,989,894 | 20,989,894 | |||||||||||||
|
Specialty Bakers LLC
|
Food
distributors |
|||||||||||||
|
First Lien Term Loan A, LIBOR+8.5% due 9/15/2015
|
9,000,000 | 8,755,670 | 8,755,670 | |||||||||||
|
First Lien Term Loan B, LIBOR+11% (13.5% floor) due 9/15/2015
|
11,000,000 | 10,704,008 | 10,704,008 | |||||||||||
|
First Lien Revolver, LIBOR+8.5% due 9/15/2015
|
2,000,000 | 1,892,367 | 1,892,367 | |||||||||||
| 21,352,045 | 21,352,045 | |||||||||||||
|
Total Non-Control/Non-Affiliate Investments
|
$ | 530,168,045 | $ | 512,899,257 | ||||||||||
|
Total Portfolio Investments
|
$ | 592,496,595 | $ | 563,821,316 | ||||||||||
| (1) | All debt investments are income producing. Equity is non-income producing unless otherwise noted. | |
| (2) | See Note 3 to the Consolidated Financial Statements for portfolio composition by geographic region. | |
| (3) | Control Investments are defined by the Investment Company Act of 1940 (“1940 Act”) as investments in companies in which the Company owns more than 25% of the voting securities or maintains greater than 50% of the board representation. | |
| (4) | Affiliate Investments are defined by the 1940 Act as investments in companies in which the Company owns between 5% and 25% of the voting securities. | |
| (5) | Equity ownership may be held in shares or units of companies related to the portfolio companies. | |
| (6) | Income producing through payment of dividends or distributions. | |
| (7) | Non-Control/Non-Affiliate Investments are defined by the 1940 Act as investments that are neither Control Investments nor Affiliate Investments. | |
| (8) | Principal includes accumulated PIK interest and is net of repayments. | |
| (9) | Interest rates have been adjusted on certain term loans and revolvers. These rate adjustments are temporary in nature due to financial or payment covenant violations in the original credit agreements, or permanent in nature per loan amendment or waiver documents. The table below summarizes these rate adjustments by portfolio company: |
80
Fifth
Street Finance Corp.
Consolidated
Schedule of Investments
September 30,
2010
|
Portfolio Company
|
Effective date
|
Cash interest
|
PIK interest
|
Reason
|
||||
|
Nicos Polymers & Grinding, Inc.
|
February 10, 2008 | + 2.0% on Term Loan A & B | Per waiver agreement | |||||
|
TBA Global, LLC
|
February 15, 2008 | + 2.0% on Term Loan B | Per waiver agreement | |||||
|
Vanguard Vinyl, Inc.
|
April 1, 2008 | + 0.5% on Term Loan | Per loan amendment | |||||
|
Filet of Chicken
|
January 1, 2009 | + 1.0% on Term Loan | Tier pricing per waiver agreement | |||||
|
Boot Barn
|
January 1, 2009 | + 1.0% on Term Loan | + 2.5% on Term Loan | Tier pricing per waiver agreement | ||||
|
HealthDrive Corporation
|
April 30, 2009 | + 2.0% on Term Loan A | Per waiver agreement | |||||
|
Premier Trailer Leasing, Inc.
|
August 4, 2009 | + 4.0% on Term Loan | Default interest per credit agreement | |||||
|
Rail Acquisition Corp.
|
May 1, 2010 | − 4.5% on Term Loan | − 0.5% on Term Loan | Per restructuring agreement | ||||
|
Traffic Control & Safety Corp.
|
May 28, 2010 | − 4.0% on Term Loan | + 1.0% on Term Loan | Per restructuring agreement | ||||
|
Pacific Press Technologies, Inc.
|
July 1, 2010 | − 2.0% on Term Loan | − 0.75% on Term Loan | Per waiver agreement | ||||
|
Western Emulsions, Inc.
|
September 30, 2010 | + 3.0% on Term Loan | Per loan agreement | |||||
| (10) | Revolving credit line has been suspended and is deemed unlikely to be renewed in the future. | |
| (11) | Amounts represent unearned income related to undrawn commitments. | |
| (12) | Represents an unfunded commitment to fund limited partnership interest. | |
| (13) | Investment was on cash non-accrual status as of September 30, 2010. | |
| (14) | Investment was on PIK non-accrual status as of September 30, 2010. |
81
Fifth
Street Finance Corp.
Consolidated
Schedule of Investments
September 30,
2009
|
Portfolio Company/Type of
|
||||||||||||||
|
Investment(1)(2)(5)
|
Industry
|
Principal(8) | Cost | Fair Value | ||||||||||
|
Control Investments(3)
|
||||||||||||||
|
Lighting by Gregory, LLC (15)(16)
|
Housewares & Specialties | |||||||||||||
|
First Lien Term Loan A, 9.75% due 2/28/2013
|
$ | 4,800,003 | $ | 4,728,589 | $ | 2,419,627 | ||||||||
|
First Lien Term Loan B, 14.5% due 2/28/2013
|
7,115,649 | 6,906,440 | 3,271,480 | |||||||||||
|
97.38% membership interest
|
410,000 | — | ||||||||||||
| 12,045,029 | 5,691,107 | |||||||||||||
|
Total Control Investments
|
$ | 12,045,029 | $ | 5,691,107 | ||||||||||
|
Affiliate Investments(4)
|
||||||||||||||
|
O’Currance, Inc.
|
Data Processing & Outsourced Services | |||||||||||||
|
First Lien Term Loan A, 16.875% due 3/21/2012
|
$ | 10,526,514 | $ | 10,370,246 | $ | 10,186,501 | ||||||||
|
First Lien Term Loan B, 16.875% due 3/21/2012
|
2,765,422 | 2,722,952 | 2,919,071 | |||||||||||
|
1.75% Preferred Membership Interest in O’Currance Holding
Co., LLC
|
130,413 | 130,413 | ||||||||||||
|
3.3% Membership Interest in O’Currance Holding Co., LLC
|
250,000 | 53,831 | ||||||||||||
| 13,473,611 | 13,289,816 | |||||||||||||
|
CPAC, Inc.(9)(16)
|
Household Products | |||||||||||||
|
Second Lien Term Loan, 17.5% due 4/13/2012
|
11,398,948 | 9,506,805 | 4,448,661 | |||||||||||
|
Charge-off of cost basis of impaired loan(12)
|
(4,000,000 | ) | — | |||||||||||
|
2,297 shares of Common Stock
|
2,297,000 | — | ||||||||||||
| 7,803,805 | 4,448,661 | |||||||||||||
|
Elephant & Castle, Inc.
|
Restaurants | |||||||||||||
|
Second Lien Term Loan, 15.5% due 4/20/2012
|
8,030,061 | 7,553,247 | 7,311,604 | |||||||||||
|
7,500 shares of Series A Preferred Stock
|
750,000 | 492,469 | ||||||||||||
| 8,303,247 | 7,804,073 | |||||||||||||
|
MK Network, LLC
|
Healthcare technology | |||||||||||||
|
First Lien Term Loan A, 13.5% due 6/1/2012
|
9,500,000 | 9,220,111 | 9,033,826 | |||||||||||
|
First Lien Term Loan B, 17.5% due 6/1/2012
|
5,212,692 | 4,967,578 | 5,163,544 | |||||||||||
|
First Lien Revolver, Prime + 1.5% (10% floor), due 6/1/2010(10)
|
— | — | — | |||||||||||
|
11,030 Membership Units(6)
|
771,575 | — | ||||||||||||
| 14,959,264 | 14,197,370 | |||||||||||||
|
Martini Park, LLC(9)(16)
|
Restaurants | |||||||||||||
|
First Lien Term Loan, 14% due 2/20/2013
|
4,390,798 | 3,408,351 | 2,068,303 | |||||||||||
|
5% membership interest
|
650,000 | — | ||||||||||||
| 4,058,351 | 2,068,303 | |||||||||||||
|
Caregiver Services, Inc.
|
Healthcare services | |||||||||||||
|
Second Lien Term Loan A, LIBOR+6.85% (12% floor) due 2/25/2013
|
8,570,595 | 8,092,364 | 8,225,400 | |||||||||||
|
Second Lien Term Loan B, 16.5% due 2/25/2013
|
14,242,034 | 13,440,995 | 13,508,338 | |||||||||||
|
1,080,399 shares of Series A Preferred Stock
|
1,080,398 | 1,206,599 | ||||||||||||
| 22,613,757 | 22,940,337 | |||||||||||||
|
Total Affiliate Investments
|
$ | 71,212,035 | $ | 64,748,560 | ||||||||||
|
Non-Control/Non-Affiliate Investments(7)
|
||||||||||||||
|
Best Vinyl Acquisition Corporation(9)
|
Building Products | |||||||||||||
|
Second Lien Term Loan, 12% due 3/30/2013
|
$ | 7,000,000 | $ | 6,779,947 | $ | 6,138,582 | ||||||||
|
25,641 Shares of Series A Preferred Stock
|
253,846 | 20,326 | ||||||||||||
|
25,641 Shares of Common Stock
|
2,564 | — | ||||||||||||
| 7,036,357 | 6,158,908 | |||||||||||||
|
Traffic Control & Safety Corporation
|
Construction and Engineering | |||||||||||||
|
Second Lien Term Loan, 15% due 6/29/2014
|
19,310,587 | 19,025,031 | 17,693,780 | |||||||||||
|
24,750 shares of Series B Preferred Stock
|
247,500 | 158,512 | ||||||||||||
|
25,000 shares of Common Stock
|
2,500 | — | ||||||||||||
| 19,275,031 | 17,852,292 | |||||||||||||
82
Fifth
Street Finance Corp.
Consolidated
Schedule of Investments
September 30,
2009
|
Portfolio Company/Type of
|
||||||||||||||
|
Investment(1)(2)(5)
|
Industry
|
Principal(8) | Cost | Fair Value | ||||||||||
|
Nicos Polymers & Grinding Inc.(9)(16)
|
Environmental & facilities services | |||||||||||||
|
First Lien Term Loan A, LIBOR+5% (10% floor), due 7/17/2012
|
3,091,972 | 3,040,465 | 2,162,593 | |||||||||||
|
First Lien Term Loan B, 13.5% due 7/17/2012
|
5,980,128 | 5,716,250 | 3,959,643 | |||||||||||
|
3.32% Interest in Crownbrook Acquisition I LLC
|
168,086 | — | ||||||||||||
| 8,924,801 | 6,122,236 | |||||||||||||
|
TBA Global, LLC(9)
|
Media: Advertising | |||||||||||||
|
Second Lien Term Loan A, LIBOR+5% (10% floor), due 8/3/2010
|
2,583,805 | 2,576,304 | 2,565,305 | |||||||||||
|
Second Lien Term Loan B, 14.5% due 8/3/2012
|
10,797,936 | 10,419,185 | 10,371,277 | |||||||||||
|
53,994 Senior Preferred Shares
|
215,975 | 162,621 | ||||||||||||
|
191,977 Shares A Shares
|
191,977 | — | ||||||||||||
| 13,403,441 | 13,099,203 | |||||||||||||
|
Fitness Edge, LLC
|
Leisure Facilities | |||||||||||||
|
First Lien Term Loan A, LIBOR+5.25% (10% floor), due 8/8/2012
|
1,750,000 | 1,740,069 | 1,753,262 | |||||||||||
|
First Lien Term Loan B, 15% due 8/8/2012
|
5,490,743 | 5,404,192 | 5,321,281 | |||||||||||
|
1,000 Common Units
|
42,908 | 70,354 | ||||||||||||
| 7,187,169 | 7,144,897 | |||||||||||||
|
Filet of Chicken(9)
|
Food Distributors | |||||||||||||
|
Second Lien Term Loan, 14.5% due 7/31/2012
|
9,307,547 | 8,922,946 | 8,979,657 | |||||||||||
| 8,922,946 | 8,979,657 | |||||||||||||
|
Boot Barn(9)
|
Apparel, accessories & luxury goods and Footwear | |||||||||||||
|
Second Lien Term Loan, 14.5% due 10/3/2013
|
22,518,091 | 22,175,818 | 22,050,462 | |||||||||||
|
24,706 shares of Series A Preferred Stock
|
247,060 | 32,259 | ||||||||||||
|
1,308 shares of Common Stock
|
131 | — | ||||||||||||
| 22,423,009 | 22,082,721 | |||||||||||||
|
Premier Trailer Leasing, Inc. (15)(16)
|
Trucking | |||||||||||||
|
Second Lien Term Loan, 16.5% due 10/23/2012
|
17,855,617 | 17,063,645 | 9,860,940 | |||||||||||
|
285 shares of Common Stock
|
1,140 | — | ||||||||||||
| 17,064,785 | 9,860,940 | |||||||||||||
|
Pacific Press Technologies, Inc.
|
Industrial machinery | |||||||||||||
|
Second Lien Term Loan, 14.75% due 1/10/2013
|
9,813,993 | 9,621,279 | 9,606,186 | |||||||||||
|
33,463 shares of Common Stock
|
344,513 | 160,299 | ||||||||||||
| 9,965,792 | 9,766,485 | |||||||||||||
|
Rose Tarlow, Inc.(9)
|
Home Furnishing Retail | |||||||||||||
|
First Lien Term Loan, 12% due 1/25/2014
|
10,191,188 | 10,016,956 | 8,827,182 | |||||||||||
|
First Lien Revolver, LIBOR+4% (9% floor) due 1/25/2014(10)
|
1,550,000 | 1,538,806 | 1,509,219 | |||||||||||
|
0.00% membership interest in RTMH Acquisition Company(14)
|
1,275,000 | — | ||||||||||||
|
0.00% membership interest in RTMH Acquisition Company(14)
|
25,000 | — | ||||||||||||
| 12,855,762 | 10,336,401 | |||||||||||||
|
Goldco, LLC
|
Restaurants | |||||||||||||
|
Second Lien Term Loan, 17.5% due 1/31/2013
|
8,024,147 | 7,926,647 | 7,938,639 | |||||||||||
| 7,926,647 | 7,938,639 | |||||||||||||
|
Rail Acquisition Corp.
|
Electronic manufacturing services | |||||||||||||
|
First Lien Term Loan, 17% due 4/1/2013
|
15,668,956 | 15,416,411 | 15,081,138 | |||||||||||
| 15,416,411 | 15,081,138 | |||||||||||||
|
Western Emulsions, Inc.
|
Construction materials | |||||||||||||
|
Second Lien Term Loan, 15% due 6/30/2014
|
11,928,600 | 11,743,630 | 12,130,945 | |||||||||||
| 11,743,630 | 12,130,945 | |||||||||||||
83
Fifth
Street Finance Corp.
Consolidated
Schedule of Investments
September 30,
2009
|
Portfolio Company/Type of
|
||||||||||||||
|
Investment(1)(2)(5)
|
Industry
|
Principal(8) | Cost | Fair Value | ||||||||||
|
Storyteller Theaters Corporation
|
Movies & entertainment | |||||||||||||
|
First Lien Term Loan, 15% due 7/16/2014
|
7,275,313 | 7,166,749 | 7,162,190 | |||||||||||
|
First Lien Revolver, LIBOR+3.5% (10% floor), due 7/16/2014
|
250,000 | 234,167 | 223,136 | |||||||||||
|
1,692 shares of Common Stock
|
169 | — | ||||||||||||
|
20,000 shares of Preferred Stock
|
200,000 | 156,256 | ||||||||||||
| 7,601,085 | 7,541,582 | |||||||||||||
|
HealthDrive Corporation(9)
|
Healthcare facilities | |||||||||||||
|
First Lien Term Loan A, 10% due 7/17/2013
|
7,800,000 | 7,574,591 | 7,731,153 | |||||||||||
|
First Lien Term Loan B, 13% due 7/17/2013
|
10,076,089 | 9,926,089 | 9,587,523 | |||||||||||
|
First Lien Revolver, 12% due 7/17/2013
|
500,000 | 485,000 | 534,693 | |||||||||||
| 17,985,680 | 17,853,369 | |||||||||||||
|
idX Corporation
|
Distributors | |||||||||||||
|
Second Lien Term Loan, 14.5% due 7/1/2014
|
13,316,247 | 13,014,576 | 13,074,682 | |||||||||||
| 13,014,576 | 13,074,682 | |||||||||||||
|
Cenegenics, LLC
|
Healthcare services | |||||||||||||
|
First Lien Term Loan, 17% due 10/27/2013
|
10,372,069 | 10,076,277 | 10,266,770 | |||||||||||
|
116,237 Common Units(6)
|
151,108 | 515,782 | ||||||||||||
| 10,227,385 | 10,782,552 | |||||||||||||
|
IZI Medical Products, Inc.
|
Healthcare technology | |||||||||||||
|
First Lien Term Loan A, 12% due 3/31/2014
|
5,600,000 | 5,504,943 | 5,547,944 | |||||||||||
|
First Lien Term Loan B, 16% due 3/31/2014
|
17,042,500 | 16,328,120 | 16,532,244 | |||||||||||
|
First Lien Revolver, 10% due 3/31/2014(11)
|
— | (45,000 | ) | (45,000 | ) | |||||||||
|
453,755 Preferred units of IZI Holdings, LLC
|
453,755 | 530,016 | ||||||||||||
| 22,241,818 | 22,565,204 | |||||||||||||
|
Trans-Trade, Inc.
|
Air freight & logistics | |||||||||||||
|
First Lien Term Loan, 15.5% due 9/10/2014
|
11,016,042 | 10,798,229 | 10,838,952 | |||||||||||
|
First Lien Revolver, 12% due 9/10/2014(11)
|
— | (39,333 | ) | (39,333 | ) | |||||||||
| 10,758,896 | 10,799,619 | |||||||||||||
|
Riverlake Equity Partners II, LP(13)
|
Multi-sector holdings | |||||||||||||
|
0.14% limited partnership interest
|
||||||||||||||
| — | — | |||||||||||||
|
Riverside Fund IV, LP(13)
|
Multi-sector holdings | |||||||||||||
|
0.92% limited partnership interest
|
||||||||||||||
| — | — | |||||||||||||
|
Total Non-Control/Non-Affiliate Investments
|
$ | 243,975,221 | $ | 229,171,470 | ||||||||||
|
Total Portfolio Investments
|
$ | 327,232,285 | $ | 299,611,137 | ||||||||||
| (1) | All debt investments are income producing. Equity is non-income producing unless otherwise noted. | |
| (2) | See Note 3 to Consolidated Financial Statements for summary geographic location. | |
| (3) | Control Investments are defined by the Investment Company Act of 1940 (“1940 Act”) as investments in companies in which the Company owns more than 25% of the voting securities or maintains greater than 50% of the board representation. | |
| (4) | Affiliate Investments are defined by the 1940 Act as investments in companies in which the Company owns between 5% and 25% of the voting securities. | |
| (5) | Equity ownership may be held in shares or units of companies related to the portfolio companies. | |
| (6) | Income producing through payment of dividends or distributions. | |
| (7) | Non-Control/Non-Affiliate Investments are defined by the 1940 Act as investments that are neither Control Investments nor Affiliate Investments. |
84
Fifth
Street Finance Corp.
Consolidated
Schedule of Investments
September 30,
2009
| (8) | Principal includes accumulated PIK interest and is net of repayments. | |
| (9) | Interest rates have been adjusted on certain term loans and revolvers. These rate adjustments are temporary in nature due to financial or payment covenant violations in the original credit agreements, or permanent in nature per loan amendment or waiver documents. The table below summarizes these rate adjustments by portfolio company: |
|
Portfolio Company
|
Effective date
|
Cash interest
|
PIK interest
|
Reason
|
||||
|
Nicos Polymers & Grinding, Inc.
|
February 10, 2008 | — | + 2.0% on Term Loan A & B | Per waiver agreement | ||||
|
TBA Global, LLC
|
February 15, 2008 | — | + 2.0% on Term Loan A & B | Per waiver agreement | ||||
|
Best Vinyl Acquisition Corporation
|
April 1, 2008 | + 0.5% on Term Loan | — | Per loan amendment | ||||
|
Martini Park, LLC
|
October 1, 2008 | − 6.0% on Term Loan | + 6.0% on Term Loan | Per waiver agreement | ||||
|
CPAC, Inc.
|
November 21, 2008 | — | + 1.0% on Term Loan | Per waiver agreement | ||||
|
Rose Tarlow, Inc.
|
January 1, 2009 | + 0.5% on Term Loan, + 3.0% on Revolver | + 2.5% on Term Loan | Tier pricing per waiver agreement | ||||
|
Filet of Chicken
|
January 1, 2009 | + 1.0% on Term Loan | — | Tier pricing per waiver agreement | ||||
|
Boot Barn
|
January 1, 2009 | + 1.0% on Term Loan | + 2.5% on Term Loan | Tier pricing per waiver agreement | ||||
|
HealthDrive Corporation
|
April 30, 2009 | + 2.0% on Term Loan A | — | Per waiver agreement |
| (10) | Revolving credit line has been suspended and is deemed unlikely to be renewed in the future. | |
| (11) | Amounts represent unearned income related to undrawn commitments. | |
| (12) | All or a portion of the loan is considered permanently impaired and, accordingly, the charge-off of the cost basis has been recorded as a realized loss for financial reporting purposes. | |
| (13) | Represents unfunded limited partnership interests that were closed prior to September 30, 2009. | |
| (14) | Represents a de minimis membership interest percentage. | |
| (15) | Investment was on cash non-accrual status as of September 30, 2009. | |
| (16) | Investment was on PIK non-accrual status as of September 30, 2009. |
See notes to Consolidated Financial Statements.
85
FIFTH
STREET FINANCE CORP.
| Note 1. | Organization |
Fifth Street Mezzanine Partners III, L.P. (the
“Partnership”), a Delaware limited partnership, was
organized on February 15, 2007 to primarily invest in debt
securities of small and middle market companies. FSMPIII GP, LLC
was the Partnership’s general partner (the “General
Partner”). The Partnership’s investments were managed
by Fifth Street Management LLC (the “Investment
Adviser”). The General Partner and Investment Adviser were
under common ownership.
Effective January 2, 2008, the Partnership merged with and
into Fifth Street Finance Corp. (the “Company”), an
externally managed, closed-end, non-diversified management
investment company that has elected to be treated as a business
development company under the Investment Company Act of 1940
(the “1940 Act”). The merger involved the exchange of
shares between companies under common control. In accordance
with the guidance on exchanges of shares between entities under
common control, the Company’s results of operations and
cash flows for the year ended September 30, 2008 are
presented as if the merger had occurred as of October 1,
2007. Accordingly, no adjustments were made to the carrying
value of assets and liabilities (or the cost basis of
investments) as a result of the merger. Fifth Street Finance
Corp. is managed by the Investment Adviser. Prior to
January 2, 2008, references to the Company are to the
Partnership. Since January 2, 2008, references to the
Company, FSC, “we” or “our” are to Fifth
Street Finance Corp., unless the context otherwise requires.
The Company also has certain wholly-owned subsidiaries,
including subsidiaries that are not consolidated for income tax
purposes, which hold certain portfolio investments of the
Company. The subsidiaries are consolidated with the Company, and
the portfolio investments held by the subsidiaries are included
in the Company’s Consolidated Financial Statements. All
significant intercompany balances and transactions have been
eliminated.
The Company’s shares are currently listed on the New York
Stock Exchange under the symbol “FSC.” The following
table reflects common stock offerings that have occurred since
inception:
|
Date
|
Transaction | Shares | Offering price | Gross proceeds | ||||||||||
|
June 17, 2008
|
Initial public offering | 10,000,000 | $ | 14.12 | $ | 141.2 million | ||||||||
|
July 21, 2009
|
Follow-on public offering (including underwriters’ exercise of over-allotment option) | 9,487,500 | $ | 9.25 | $ | 87.8 million | ||||||||
|
September 25, 2009
|
Follow-on public offering (including underwriters’ exercise of over-allotment option) | 5,520,000 | $ | 10.50 | $ | 58.0 million | ||||||||
|
January 27, 2010
|
Follow-on public offering | 7,000,000 | $ | 11.20 | $ | 78.4 million | ||||||||
|
February 25, 2010
|
Underwriters’ exercise of over-allotment option | 300,500 | $ | 11.20 | $ | 3.4 million | ||||||||
|
June 21, 2010
|
Follow-on public offering (including underwriters’ exercise of over-allotment option) | 9,200,000 | $ | 11.50 | $ | 105.8 million | ||||||||
On February 3, 2010, the Company’s consolidated
wholly-owned subsidiary, Fifth Street Mezzanine Partners IV,
L.P., received a license, effective February 1, 2010, from
the United States Small Business Administration, or SBA, to
operate as a small business investment company, or SBIC, under
Section 301(c) of the Small Business Investment Act of
1958. SBICs are designated to stimulate the flow of private
equity capital to eligible small businesses. Under SBA
regulations, SBICs may make loans to eligible small businesses
and invest in the equity securities of small businesses.
The SBIC license allows the Company’s SBIC subsidiary to
obtain leverage by issuing SBA-guaranteed debentures, subject to
the issuance of a capital commitment by the SBA and other
customary procedures.
86
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
SBA-guaranteed debentures are non-recourse, interest only
debentures with interest payable semi-annually and have a ten
year maturity. The principal amount of SBA-guaranteed debentures
is not required to be paid prior to maturity but may be prepaid
at any time without penalty. The interest rate of SBA-guaranteed
debentures is fixed on a semi-annual basis at a market-driven
spread over U.S. Treasury Notes with
10-year
maturities.
SBA regulations currently limit the amount that the
Company’s SBIC subsidiary may borrow to a maximum of
$150 million when it has at least $75 million in
regulatory capital, receives a capital commitment from the SBA
and has been through an examination by the SBA subsequent to
licensing. As of September 30, 2010, the Company’s
SBIC subsidiary had $75 million in regulatory capital. The
SBA has issued a capital commitment to the Company’s SBIC
subsidiary in the amount of $150 million, and
$73 million of SBA debentures were outstanding as of
September 30, 2010.
The SBA restricts the ability of SBICs to repurchase their
capital stock. SBA regulations also include restrictions on a
“change of control” or transfer of an SBIC and require
that SBICs invest idle funds in accordance with SBA regulations.
In addition, the Company’s SBIC subsidiary may also be
limited in its ability to make distributions to the Company if
it does not have sufficient capital, in accordance with SBA
regulations.
The Company’s SBIC subsidiary is subject to regulation and
oversight by the SBA, including requirements with respect to
maintaining certain minimum financial ratios and other
covenants. Receipt of an SBIC license does not assure that the
SBIC subsidiary will receive SBA-guaranteed debenture funding
and is dependent upon the SBIC subsidiary continuing to be in
compliance with SBA regulations and policies.
The SBA, as a creditor, will have a superior claim to the SBIC
subsidiary’s assets over the Company’s stockholders in
the event the Company liquidates the SBIC subsidiary or the SBA
exercises its remedies under the SBA-guaranteed debentures
issued by the SBIC subsidiary upon an event of default.
The Company has applied for exemptive relief from the Securities
and Exchange Commission (“SEC”) to permit it to
exclude the debt of the SBIC subsidiary guaranteed by the SBA
from the 200% asset coverage test under the 1940 Act. If the
Company receives an exemption for this SBA debt, the Company
would have increased flexibility under the 200% asset coverage
test.
| Note 2. | Significant Accounting Policies |
FASB
Accounting Standards Codification
The issuance of
FASB Accounting Standards
Codification
tm
(the “Codification”) on July 1, 2009 (effective
for interim or annual reporting periods ending after
September 15, 2009), changes the way that
U.S. generally accepted accounting principles
(“GAAP”) are referenced. Beginning on that date, the
Codification officially became the single source of
authoritative nongovernmental GAAP; however, SEC registrants
must also consider rules, regulations and interpretive guidance
issued by the SEC or its staff. The switch affects the way
companies refer to GAAP in financial statements and in their
accounting policies. References to standards will consist solely
of the number used in the Codification’s structural
organization.
Consistent with the effective date of the Codification,
financial statements for periods ending after September 15,
2009, refer to the Codification structure, not pre-Codification
historical GAAP.
Basis
of Presentation and Liquidity:
The Consolidated Financial Statements of the Company have been
prepared in accordance with GAAP and pursuant to the
requirements for reporting on
Form 10-K
and
Regulation S-X.
In the opinion of management, all adjustments of a normal
recurring nature considered necessary for the fair presentation
of the Consolidated Financial Statements have been made. The
financial results of the Company’s portfolio investments
are not consolidated in the Company’s Consolidated
Financial Statements.
87
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Although the Company expects to fund the growth of its
investment portfolio through the net proceeds from the recent
and future equity offerings, the Company’s dividend
reinvestment plan, and issuances of senior securities or future
borrowings, to the extent permitted by the 1940 Act, the Company
cannot assure that its plans to raise capital will be
successful. In addition, the Company intends to distribute to
its stockholders between 90% and 100% of its taxable income each
year in order to satisfy the requirements applicable to
Regulated Investment Companies (“RICs”) under
Subchapter M of the Internal Revenue Code (“Code”).
Consequently, the Company may not have the funds or the ability
to fund new investments, to make additional investments in its
portfolio companies, to fund its unfunded commitments to
portfolio companies or to repay borrowings. In addition, the
illiquidity of its portfolio investments may make it difficult
for the Company to sell these investments when desired and, if
the Company is required to sell these investments, it may
realize significantly less than their recorded value.
Use of
Estimates:
The preparation of financial statements in conformity with GAAP
requires management to make certain estimates and assumptions
affecting amounts reported in the financial statements and
accompanying notes. These estimates are based on the information
that is currently available to the Company and on various other
assumptions that the Company believes to be reasonable under the
circumstances. Actual results could differ materially from those
estimates under different assumptions and conditions. The most
significant estimate inherent in the preparation of the
Company’s Consolidated Financial Statements is the
valuation of investments and the related amounts of unrealized
appreciation and depreciation.
The Consolidated Financial Statements include portfolio
investments at fair value of $563.8 million and
$299.6 million at September 30, 2010 and
September 30, 2009, respectively. The portfolio investments
represent 99.1% and 73.0% of net assets at September 30,
2010 and September 30, 2009, respectively, and their fair
values have been determined by the Company’s Board of
Directors in good faith in the absence of readily available
market values. Because of the inherent uncertainty of valuation,
the determined values may differ significantly from the values
that would have been used had a ready market existed for the
investments, and the differences could be material.
The Company classifies its investments in accordance with the
requirements of the 1940 Act. Under the 1940 Act, “Control
Investments” are defined as investments in companies in
which the Company owns more than 25% of the voting securities or
has rights to maintain greater than 50% of the board
representation; “Affiliate Investments” are defined as
investments in companies in which the Company owns between 5%
and 25% of the voting securities; and
“Non-Control/Non-Affiliate Investments” are defined as
investments that are neither Control Investments nor Affiliate
Investments.
Fair
Value Measurements:
ASC 820
Fair Value Measurements and Disclosures
(“ASC 820”), defines fair value as that would be
received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the
measurement date. A liability’s fair value is defined as
the amount that would be paid to transfer the liability to a new
obligor, not the amount that would be paid to settle the
liability with the creditor. Where available, fair value is
based on observable market prices or parameters or derived from
such prices or parameters. Where observable prices or inputs are
not available or reliable, valuation techniques are applied.
These valuation techniques involve some level of management
estimation and judgment, the degree of which is dependent on the
price transparency for the investments or market and the
investments’ complexity.
Assets recorded at fair value in the Company’s Consolidated
Statements of Assets and Liabilities are categorized based upon
the level of judgment associated with the inputs used to measure
their fair value.
88
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Hierarchical levels, defined by ASC 820 and directly
related to the amount of subjectivity associated with the inputs
to fair valuation of these assets and liabilities, are as
follows:
| • | Level 1 — Unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date. | |
| • | Level 2 — Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data at the measurement date for substantially the full term of the assets or liabilities. | |
| • | Level 3 — Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model. |
Under ASC 820, the Company performs detailed valuations of
its debt and equity investments on an individual basis, using
market, income, and bond yield approaches as appropriate. In
general, the Company utilizes a bond yield method for the
majority of its investments, as long as it is appropriate. If,
in the Company’s judgment, the bond yield approach is not
appropriate, it may use the enterprise value approach, or, in
certain cases, an alternative methodology potentially including
an asset liquidation or expected recovery model.
Under the market approach, the Company estimates the enterprise
value of the portfolio companies in which it invests. There is
no one methodology to estimate enterprise value and, in fact,
for any one portfolio company, enterprise value is best
expressed as a range of fair values, from which the Company
derives a single estimate of enterprise value. To estimate the
enterprise value of a portfolio company, the Company analyzes
various factors, including the portfolio company’s
historical and projected financial results. Typically, private
companies are valued based on multiples of EBITDA, cash flows,
net income, revenues, or in limited cases, book value. The
Company generally requires portfolio companies to provide annual
audited and quarterly and monthly unaudited financial
statements, as well as annual projections for the upcoming
fiscal year.
Under the income approach, the Company generally prepares and
analyzes discounted cash flow models based on projections of the
future free cash flows of the business.
Under the bond yield approach, the Company uses bond yield
models to determine the present value of the future cash flow
streams of its debt investments. The Company reviews various
sources of transactional data, including private mergers and
acquisitions involving debt investments with similar
characteristics, and assesses the information in the valuation
process.
The Company’s Board of Directors undertakes a multi-step
valuation process each quarter in connection with determining
the fair value of the Company’s investments:
| • | The quarterly valuation process begins with each portfolio company or investment being initially valued by the deal team within the Investment Adviser responsible for the portfolio investment; | |
| • | Preliminary valuations are then reviewed and discussed with the principals of the Investment Adviser; | |
| • | Separately, independent valuation firms engaged by the Board of Directors prepare preliminary valuations on a selected basis and submit the reports to the Company; | |
| • | The deal team compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms; |
89
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
| • | The deal team prepares a valuation report for the Valuation Committee of the Board of Directors; | |
| • | The Valuation Committee of the Board of Directors is apprised of the preliminary valuations of the independent valuation firms; | |
| • | The Valuation Committee of the Board of Directors reviews the preliminary valuations, and the deal team responds and supplements the preliminary valuations to reflect any comments provided by the Valuation Committee; | |
| • | The Valuation Committee of the Board of Directors makes a recommendation to the Board of Directors; and | |
| • | The Board of Directors discusses valuations and determines the fair value of each investment in the Company’s portfolio in good faith. |
The fair value of all of the Company’s investments at
September 30, 2010 and September 30, 2009 was
determined by the Board of Directors. The Board of Directors is
solely responsible for the valuation of the portfolio
investments at fair value as determined in good faith pursuant
to the Company’s valuation policy and a consistently
applied valuation process.
Realized gain or loss on the sale of investments is the
difference between the proceeds received from dispositions of
portfolio investments and their stated costs. Realized losses
may also be recorded in connection with the Company’s
determination that certain investments are considered worthless
securities
and/or
meet
the conditions for loss recognition per the applicable tax rules.
Investment
Income:
Interest income, adjusted for amortization of premium and
accretion of original issue discount, is recorded on an accrual
basis to the extent that such amounts are expected to be
collected. The Company stops accruing interest on investments
when it is determined that interest is no longer collectible. In
connection with its investment, the Company sometimes receives
nominal cost equity that is valued as part of the negotiation
process with the particular portfolio company. When the Company
receives nominal cost equity, the Company allocates its cost
basis in its investment between its debt securities and its
nominal cost equity at the time of origination. Any resulting
discount from recording the loan is accreted into interest
income over the life of the loan.
Distributions of earnings from portfolio companies are recorded
as dividend income when the distribution is received.
The Company has investments in debt securities which contain a
payment-in-kind
or “PIK” interest provision. PIK interest is computed
at the contractual rate specified in each investment agreement
and added to the principal balance of the investment and
recorded as income.
Fee income consists of the monthly collateral management fees
that the Company receives in connection with its debt
investments and the accreted portion of the debt origination and
exit fees. The Company capitalizes upfront loan origination fees
received in connection with investments. The unearned fee income
from such fees is accreted into fee income, based on the
straight line method or effective interest method as applicable,
over the life of the investment.
The Company has also structured exit fees across certain of its
portfolio investments to be received upon the future exit of
those investments. These fees are to be paid to the Company upon
the sooner to occur of (i) a sale of the borrower or
substantially all of the assets of the borrower, (ii) the
maturity date of the loan, or (iii) the date when full
prepayment of the loan occurs. Exit fees are fees which are
earned and payable upon the exit of a debt security and, similar
to a prepayment penalty, are not accrued or otherwise included
in net
90
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
investment income until received. The receipt of such fees as
well the timing of the Company’s receipt of such fees is
contingent upon a successful exit event for each of the
investments.
Cash
and Cash Equivalents:
Cash and cash equivalents consist of demand deposits and highly
liquid investments with maturities of three months or less, when
acquired. The Company places its cash and cash equivalents with
financial institutions and, at times, cash held in bank accounts
may exceed the Federal Deposit Insurance Corporation insured
limit. Included in cash and cash equivalents is
$0.9 million that is held at Wells Fargo Bank, National
Association (“Wells Fargo”) in connection with the
Company’s three-year credit facility. The Company is
restricted in terms of access to this cash until such time as
the Company submits its required monthly reporting schedules and
Wells Fargo verifies the Company’s compliance per the terms
of the credit agreement.
Deferred
Financing Costs:
Deferred financing costs consist of fees and expenses paid in
connection with the closing of credit facilities and are
capitalized at the time of payment. Deferred financing costs are
amortized using the straight line method over the terms of the
respective credit facilities. This amortization expense is
included in interest expense in the Company’s Consolidated
Statement of Operations.
Collateral
posted to bank:
Collateral posted to bank consists of cash posted as collateral
with respect to the Company’s interest rate swap. The
Company is restricted in terms of access to this collateral
until such swap is terminated or the swap agreement expires.
Cash collateral posted is held in an account at Wells Fargo.
Interest
Rate Swap:
The Company does not utilize hedge accounting and marks its
interest rate swap to fair value on a quarterly basis through
operations.
Offering
Costs:
Offering costs consist of fees and expenses incurred in
connection with the public offer and sale of the Company’s
common stock, including legal, accounting, and printing fees.
$1.1 million of offering costs have been charged to capital
during the year ended September 30, 2010.
Income
Taxes:
As a RIC, the Company is not subject to federal income tax on
the portion of its taxable income and gains distributed
currently to its stockholders as a dividend. The Company
anticipates distributing between 90% and 100% of its taxable
income and gains, within the Subchapter M rules, and thus the
Company anticipates that it will not incur any federal or state
income tax at the RIC level. As a RIC, the Company is also
subject to a federal excise tax based on distributive
requirements of its taxable income on a calendar year basis
(e.g., calendar year 2010). The Company anticipates timely
distribution of its taxable income within the tax rules;
however, the Company incurred a de minimis federal excise tax
for calendar years 2008 and 2009. In addition, the Company may
incur a federal excise tax in future years.
The purpose of the Company’s taxable subsidiaries is to
permit the Company to hold equity investments in portfolio
companies which are “pass through” entities for
federal tax purposes in order to comply with the “source
income” requirements contained in the RIC tax requirements.
The taxable subsidiaries are not
91
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
consolidated with the Company for income tax purposes and may
generate income tax expense as a result of their ownership of
certain portfolio investments. This income tax expense, if any,
is reflected in the Company’s Consolidated Statements of
Operations. The Company uses the asset and liability method to
account for its taxable subsidiaries’ income taxes. Using
this method, the Company recognizes deferred tax assets and
liabilities for the estimated future tax effects attributable to
temporary differences between financial reporting and tax bases
of assets and liabilities. In addition, the Company recognizes
deferred tax benefits associated with net operating carry
forwards that it may use to offset future tax obligations. The
Company measures deferred tax assets and liabilities using the
enacted tax rates expected to apply to taxable income in the
years in which it expects to recover or settle those temporary
differences.
ASC 740
Accounting for Uncertainty in Income Taxes
(“ASC 740”) provides guidance for how uncertain
tax positions should be recognized, measured, presented, and
disclosed in the Company’s Consolidated Financial
Statements. ASC 740 requires the evaluation of tax
positions taken or expected to be taken in the course of
preparing the Company’s tax returns to determine whether
the tax positions are “more-likely-than-not” of being
sustained by the applicable tax authority. Tax positions not
deemed to meet the more-likely-than-not threshold are recorded
as a tax benefit or expense in the current year.
Management’s determinations regarding ASC 740 may be
subject to review and adjustment at a later date based upon
factors including, but not limited to, an ongoing analysis of
tax laws, regulations and interpretations thereof. The Company
recognizes the tax benefits of uncertain tax positions only
where the position is “more likely than not” to be
sustained assuming examination by tax authorities. Management
has analyzed the Company’s tax positions, and has concluded
that no liability for unrecognized tax benefits should be
recorded related to uncertain tax positions taken on returns
filed for open tax years 2008 or 2009 or expected to be taken in
the Company’s 2010 tax return. The Company identifies its
major tax jurisdictions as U.S. Federal and New York State,
and the Company is not aware of any tax positions for which it
is reasonably possible that the total amounts of unrecognized
tax benefits will change materially in the next 12 months.
Recent
Accounting Pronouncements
In January 2010, the FASB issued Accounting Standards Update
No. 2010-06,
Fair Value Measurements and Improving Disclosures About Fair
Value Measurements (Topic 820),
which provides for improving
disclosures about fair value measurements, primarily significant
transfers in and out of Levels 1 and 2, and activity in
Level 3 fair value measurements. The new disclosures and
clarifications of existing disclosures are effective for the
interim and annual reporting periods beginning after
December 15, 2009, while the disclosures about the
purchases, sales, issuances, and settlements in the roll forward
activity in Level 3 fair value measurements are effective
for fiscal years beginning after December 15, 2010 and for
the interim periods within those fiscal years. Except for
certain detailed Level 3 disclosures, which are effective
for fiscal years beginning after December 15, 2010 and
interim periods within those years, the new guidance became
effective for the Company’s fiscal 2010 second quarter. The
adoption of this disclosure-only guidance is included in
Note 3 — Portfolio Investments and did not have
an impact on the Company’s consolidated financial results.
In September 2009, the FASB issued Accounting Standards Update
2009-12,
Fair Value Measurements and Disclosures (Topic
820) — Investments in Certain Entities That Calculate
Net Asset Value per Share (or Its Equivalent)
which provides
guidance on estimating the fair value of an alternative
investment, amending
ASC 820-10.
The amendment is effective for interim and annual periods ending
after December 15, 2009. The adoption of this guidance did
not have a material impact on either the Company’s
consolidated financial position or results of operations.
In June 2009, the FASB issued SFAS No. 166,
“Accounting for Transfers of Financial Assets —
an amendment of FASB Statement No. 140”
(“SFAS 166”) (to be included in ASC 860
“Transfers and Servicing”). SFAS 166 will require
more information about transfers of financial assets, eliminates
the qualifying special purpose entity (QSPE) concept, changes
the requirements for derecognizing financial assets
92
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
and requires additional disclosures. SFAS 166 is effective
for the first annual reporting period that begins after
November 15, 2009. The Company does not anticipate that
SFAS 166 will have a material impact on the Company’s
consolidated financial statements. This statement has not yet
been codified.
In June 2009, the FASB issued SFAS No. 167,
Amendments to FASB Interpretation No. 46(R)
which
provides guidance with respect to consolidation of variable
interest entities. This statement retains the scope of
Interpretation 46(R) with the addition of entities previously
considered qualifying special-purpose entities, as the concept
of these entities was eliminated in SFAS No. 166,
Accounting for Transfers of Financial Assets. This statement
replaces the quantitative-based risks and rewards calculation
for determining the primary beneficiary of a variable interest
entity. The approach focuses on identifying which enterprise has
the power to direct activities that most significantly impact
the entity’s economic performance and the obligation to
absorb the losses or receive the benefits from the entity. It is
possible that application of this revised guidance will change
an enterprise’s assessment of involvement with variable
interest entities. This statement, which has been codified
within ASC 810,
Consolidations
, was effective for
the Company as of September 1, 2010. The initial adoption
did not have an effect on the Company’s Consolidated
Financial Statements.
| Note 3. | Portfolio Investments |
At September 30, 2010, 99.1% of net assets or
$563.8 million was invested in 38 long-term portfolio
investments and 13.5% of net assets or $76.8 million was
invested in cash and cash equivalents. In comparison, at
September 30, 2009, 73.0% of net assets or
$299.6 million was invested in 28 long-term portfolio
investments and 27.6% of net assets or $113.2 million was
invested in cash and cash equivalents. As of September 30,
2010, primarily all of the Company’s debt investments were
secured by first or second priority liens on the assets of the
portfolio companies. Moreover, the Company held equity
investments in certain of its portfolio companies consisting of
common stock, preferred stock or limited liability company
interests designed to provide the Company with an opportunity
for an enhanced rate of return. These instruments generally do
not produce a current return, but are held for potential
investment appreciation and capital gain.
At September 30, 2010 and September 30, 2009,
$375.6 million and $281.0 million, respectively, of
the Company’s portfolio debt investments at fair value were
at fixed rates, which represented 67.2% and 95.0%, respectively,
of the Company’s total portfolio of debt investments at
fair value. During the years ended September 30, 2010, 2009
and 2008, the Company recorded realized losses of
$18.8 million, $14.4 million and 0, respectively.
During the years ended September 30, 2010, 2009 and 2008,
the Company recorded unrealized depreciation of
$1.8 million, $10.8 million and 16.9 million,
respectively.
The composition of the Company’s investments as of
September 30, 2010 and September 30, 2009 at cost and
fair value was as follows:
| September 30, 2010 | September 30, 2009 | |||||||||||||||
| Cost | Fair Value | Cost | Fair Value | |||||||||||||
|
Investments in debt securities
|
$ | 585,529,301 | $ | 558,579,951 | $ | 317,069,667 | $ | 295,921,400 | ||||||||
|
Investments in equity securities
|
6,967,294 | 5,241,365 | 10,162,618 | 3,689,737 | ||||||||||||
|
Total
|
$ | 592,496,595 | $ | 563,821,316 | $ | 327,232,285 | $ | 299,611,137 | ||||||||
93
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following table presents the financial instruments carried
at fair value as of September 30, 2010 on the
Company’s Consolidated Statement of Assets and Liabilities
for each of the three levels of hierarchy established by
ASC 820.
| Level 1 | Level 2 | Level 3 | Total | |||||||||||||
|
Cash equivalents
|
$ | — | $ | — | $ | — | $ | — | ||||||||
|
Investments in debt securities (first lien)
|
— | — | 416,323,957 | 416,323,957 | ||||||||||||
|
Investments in debt securities (second lien)
|
— | — | 137,851,248 | 137,851,248 | ||||||||||||
|
Investments in debt securities (subordinated)
|
— | — | 4,404,746 | 4,404,746 | ||||||||||||
|
Investments in equity securities (preferred)
|
— | — | 2,892,135 | 2,892,135 | ||||||||||||
|
Investments in equity securities (common)
|
— | — | 2,349,230 | 2,349,230 | ||||||||||||
|
Total investments at fair value
|
$ | — | $ | — | $ | 563,821,316 | $ | 563,821,316 | ||||||||
|
Interest rate swap
|
— | 773,435 | — | 773,435 | ||||||||||||
|
Total liabilities at fair value
|
$ | — | $ | 773,435 | $ | — | $ | 773,435 | ||||||||
The following table presents the financial instruments carried
at fair value on September 30, 2009 on the Company’s
Consolidated Statement of Assets and Liabilities for each of the
three levels of hierarchy established by ASC 820.
| Level 1 | Level 2 | Level 3 | Total | |||||||||||||
|
Cash equivalents
|
$ | — | $ | — | $ | — | $ | — | ||||||||
|
Investments in debt securities (first lien)
|
— | — | 142,016,942 | 142,016,942 | ||||||||||||
|
Investments in debt securities (second lien)
|
— | — | 153,904,458 | 153,904,458 | ||||||||||||
|
Investments in debt securities (subordinated)
|
— | — | — | — | ||||||||||||
|
Investments in equity securities (preferred)
|
— | — | 2,889,471 | 2,889,471 | ||||||||||||
|
Investments in equity securities (common)
|
— | — | 800,266 | 800,266 | ||||||||||||
|
Total investments at fair value
|
$ | — | $ | — | $ | 299,611,137 | $ | 299,611,137 | ||||||||
|
Interest rate swap
|
— | — | — | — | ||||||||||||
|
Total liabilities at fair value
|
$ | — | $ | — | $ | — | $ | — | ||||||||
When a determination is made to classify a financial instrument
within Level 3 of the valuation hierarchy, the
determination is based upon the fact that the unobservable
factors are the most significant to the overall fair value
measurement. However, Level 3 financial instruments
typically include, in addition to the unobservable or
Level 3 components, observable components (that is,
components that are actively quoted and can be validated by
external sources). Accordingly, the appreciation (depreciation)
in the tables below includes changes in fair value due in part
to observable factors that are part of the valuation methodology.
94
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following table provides a roll-forward in the changes in
fair value from September 30, 2009 to September 30,
2010, for all investments for which the Company determines fair
value using unobservable (Level 3) factors.
|
First
|
Second
|
Subordinated
|
Preferred
|
Common
|
||||||||||||||||||||
| Lien Debt | Lien Debt | Debt | Equity | Equity | Total | |||||||||||||||||||
|
Fair value as of September 30, 2009
|
$ | 142,016,942 | $ | 153,904,458 | $ | — | $ | 2,889,471 | $ | 800,266 | $ | 299,611,137 | ||||||||||||
|
Purchases and other increases
|
319,865,964 | 1,138,340 | 5,609,744 | — | 1,201,676 | 327,815,724 | ||||||||||||||||||
|
Redemptions, repayments and other decreases
|
(32,138,885 | ) | (12,966,681 | ) | (1,031,944 | ) | — | (150,000 | ) | (46,287,510 | ) | |||||||||||||
|
Net realized losses
|
(11,405,820 | ) | (611,084 | ) | — | — | (4,247,000 | ) | (16,263,904 | ) | ||||||||||||||
|
Net unrealized appreciation (depreciation)
|
(2,014,244 | ) | (3,613,785 | ) | (173,054 | ) | 2,664 | 4,744,288 | (1,054,131 | ) | ||||||||||||||
|
Transfers into (out of) level 3
|
— | — | — | — | — | — | ||||||||||||||||||
|
Fair value at September 30, 2010
|
$ | 416,323,957 | $ | 137,851,248 | $ | 4,404,746 | $ | 2,892,135 | $ | 2,349,230 | $ | 563,821,316 | ||||||||||||
|
Net unrealized appreciation (depreciation) relating to
Level 3 assets still held at September 30, 2010 and
reported within net unrealized appreciation (depreciation) on
investments in the Consolidated Statement of Operations for the
year ended September 30, 2010
|
$ | (14,247,442 | ) | $ | (4,586,955 | ) | $ | (173,054 | ) | $ | 2,664 | $ | 497,288 | $ | (18,507,499 | ) | ||||||||
95
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following table provides a roll-forward in the changes in
fair value from September 30, 2008 to September 30,
2009, for all investments for which the Company determines fair
value using unobservable (Level 3) factors.
|
First
|
Second
|
Subordinated
|
Preferred
|
Common
|
||||||||||||||||||||
| Lien Debt | Lien Debt | Debt | Equity | Equity | Total | |||||||||||||||||||
|
Fair value as of September 30, 2008
|
$ | 108,247,033 | $ | 160,907,915 | $ | — | $ | 2,430,852 | $ | 2,173,354 | $ | 273,759,154 | ||||||||||||
|
Purchases and other increases
|
54,218,598 | 14,156,161 | — | — | 1,091,644 | 69,466,403 | ||||||||||||||||||
|
Redemptions, repayments and other decreases
|
(9,727,499 | ) | (8,718,404 | ) | — | — | — | (18,445,903 | ) | |||||||||||||||
|
Net realized losses
|
— | (14,123,200 | ) | — | (250,000 | ) | — | (14,373,200 | ) | |||||||||||||||
|
Net unrealized appreciation (depreciation)
|
(10,721,190 | ) | 1,681,986 | — | 708,619 | (2,464,732 | ) | (10,795,317 | ) | |||||||||||||||
|
Transfers into (out of) level 3
|
— | — | — | — | — | — | ||||||||||||||||||
|
Fair value at September 30, 2009
|
$ | 142,016,942 | $ | 153,904,458 | $ | — | $ | 2,889,471 | $ | 800,266 | $ | 299,611,137 | ||||||||||||
|
Net unrealized appreciation (depreciation) relating to
Level 3 assets still held at September 30, 2009 and
reported within net unrealized appreciation (depreciation) on
investments in the Consolidated Statement of Operations for the
year ended September 30, 2009
|
$ | (3,365,938 | ) | $ | (19,845,148 | ) | $ | — | $ | 458,619 | $ | (2,464,732 | ) | $ | (25,217,199 | ) | ||||||||
Concurrent with its adoption of ASC 820, effective
October 1, 2008, the Company augmented the valuation
techniques it uses to estimate the fair value of its debt
investments where there is not a readily available market value
(Level 3). Prior to October 1, 2008, the Company
estimated the fair value of its Level 3 debt investments by
first estimating the enterprise value of the portfolio company
which issued the debt investment. To estimate the enterprise
value of a portfolio company, the Company analyzed various
factors, including the portfolio companies historical and
projected financial results. Typically, private companies are
valued based on multiples of EBITDA (Earnings Before Interest,
Taxes, Depreciation and Amortization), cash flow, net income,
revenues or, in limited instances, book value.
In estimating a multiple to use for valuation purposes, the
Company looked to private merger and acquisition statistics,
discounted public trading multiples or industry practices. In
some cases, the best valuation methodology may have been a
discounted cash flow analysis based on future projections. If a
portfolio company was distressed, a liquidation analysis may
have provided the best indication of enterprise value.
96
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
If there was adequate enterprise value to support the repayment
of the Company’s debt, the fair value of the Level 3
loan or debt security normally corresponded to cost plus the
amortized original issue discount unless the borrower’s
condition or other factors lead to a determination of fair value
at a different amount.
Beginning on October 1, 2008, the Company also introduced a
bond yield model to value these investments based on the present
value of expected cash flows. The significant inputs into the
model are market interest rates for debt with similar
characteristics and an adjustment for the portfolio
company’s credit risk. The credit risk component of the
valuation considers several factors including financial
performance, business outlook, debt priority and collateral
position.
The table below summarizes the changes in the Company’s
investment portfolio from September 30, 2009 to
September 30, 2010.
| Debt | Equity | Total | ||||||||||
|
Fair value at September 30, 2009
|
$ | 295,921,400 | $ | 3,689,737 | $ | 299,611,137 | ||||||
|
New investments
|
324,475,743 | 1,051,676 | 325,527,419 | |||||||||
|
Redemptions/repayments
|
(46,439,537 | ) | — | (46,439,537 | ) | |||||||
|
Net accrual of PIK interest income
|
8,385,306 | — | 8,385,306 | |||||||||
|
Accretion of original issue discount
|
893,077 | — | 893,077 | |||||||||
|
Net change in unearned income
|
(5,911,051 | ) | — | (5,911,051 | ) | |||||||
|
Net unrealized appreciation (depreciation)
|
(5,801,083 | ) | 4,746,952 | (1,054,131 | ) | |||||||
|
Net changes from unrealized to realized
|
(12,943,904 | ) | (4,247,000 | ) | (17,190,904 | ) | ||||||
|
Fair value at September 30, 2010
|
$ | 558,579,951 | $ | 5,241,365 | $ | 563,821,316 | ||||||
The Company’s off-balance sheet arrangements consisted of
$49.5 million and $9.8 million of unfunded commitments
to provide debt financing to its portfolio companies or to fund
limited partnership interests as of September 30, 2010 and
September 30, 2009, respectively. Such commitments involve,
to varying degrees, elements of credit risk in excess of the
amount recognized in the Statement of Assets and Liabilities and
are not reflected on the Company’s Consolidated Statement
of Assets and Liabilities.
97
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
A summary of the composition of the unfunded commitments
(consisting of revolvers, term loans and limited partnership
interests) as of September 30, 2010 and September 30,
2009 is shown in the table below:
| September 30, 2010 | September 30, 2009 | |||||||
|
Storyteller Theaters Corporation
|
$ | — | $ | 1,750,000 | ||||
|
HealthDrive Corporation
|
1,500,000 | 1,500,000 | ||||||
|
IZI Medical Products, Inc.
|
2,500,000 | 2,500,000 | ||||||
|
Trans-Trade, Inc.
|
500,000 | 2,000,000 | ||||||
|
Riverlake Equity Partners II, LP (limited partnership interest)
|
966,360 | 1,000,000 | ||||||
|
Riverside Fund IV, LP (limited partnership interest)
|
864,175 | 1,000,000 | ||||||
|
ADAPCO, Inc.
|
5,750,000 | — | ||||||
|
AmBath/ReBath Holdings, Inc.
|
1,500,000 | — | ||||||
|
JTC Education, Inc.
|
9,062,453 | — | ||||||
|
Tegra Medical, LLC
|
4,000,000 | — | ||||||
|
Vanguard Vinyl, Inc.
|
1,250,000 | — | ||||||
|
Flatout, Inc.
|
1,500,000 | — | ||||||
|
Psilos Group Partners IV, LP (limited partnership interest)
|
1,000,000 | — | ||||||
|
Mansell Group, Inc.
|
2,000,000 | — | ||||||
|
NDSSI Holdings, Inc.
|
1,500,000 | — | ||||||
|
Eagle Hospital Physicians, Inc.
|
2,500,000 | — | ||||||
|
Enhanced Recovery Company, LLC
|
3,623,148 | — | ||||||
|
Epic Acquisition, Inc.
|
2,700,000 | — | ||||||
|
Specialty Bakers, LLC
|
2,000,000 | — | ||||||
|
Rail Acquisition Corp.
|
4,798,897 | — | ||||||
|
Total
|
$ | 49,515,033 | $ | 9,750,000 | ||||
98
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Summaries of the composition of the Company’s investment
portfolio at cost and fair value as a percentage of total
investments are shown in the following tables:
| September 30, 2010 | September 30, 2009 | |||||||||||||||
|
Cost:
|
||||||||||||||||
|
First lien debt
|
$ | 430,200,694 | 72.61 | % | $ | 153,207,248 | 46.82 | % | ||||||||
|
Second lien debt
|
150,600,807 | 25.42 | % | 163,862,419 | 50.08 | % | ||||||||||
|
Subordinated debt
|
4,727,800 | 0.80 | % | — | 0.00 | % | ||||||||||
|
Purchased equity
|
2,330,305 | 0.39 | % | 4,170,368 | 1.27 | % | ||||||||||
|
Equity grants
|
4,467,524 | 0.75 | % | 5,992,250 | 1.83 | % | ||||||||||
|
Limited partnership interests
|
169,465 | 0.03 | % | — | 0.00 | % | ||||||||||
|
Total
|
$ | 592,496,595 | 100.00 | % | $ | 327,232,285 | 100.00 | % | ||||||||
|
Fair Value:
|
||||||||||||||||
|
First lien debt
|
$ | 416,323,957 | 73.84 | % | $ | 142,016,942 | 47.40 | % | ||||||||
|
Second lien debt
|
137,851,248 | 24.45 | % | 153,904,458 | 51.37 | % | ||||||||||
|
Subordinated debt
|
4,404,746 | 0.78 | % | — | 0.00 | % | ||||||||||
|
Purchased equity
|
625,371 | 0.11 | % | 517,181 | 0.17 | % | ||||||||||
|
Equity grants
|
4,446,529 | 0.79 | % | 3,172,556 | 1.06 | % | ||||||||||
|
Limited partnership interests
|
169,465 | 0.03 | % | — | 0.00 | % | ||||||||||
|
Total
|
$ | 563,821,316 | 100.00 | % | $ | 299,611,137 | 100.00 | % | ||||||||
The Company invests in portfolio companies located in the United
States. The following tables show the portfolio composition by
geographic region at cost and fair value as a percentage of
total investments. The geographic composition is determined by
the location of the corporate headquarters of the portfolio
company, which may not be indicative of the primary source of
the portfolio company’s business.
| September 30, 2010 | September 30, 2009 | |||||||||||||||
|
Cost:
|
||||||||||||||||
|
Northeast
|
$ | 175,370,861 | 29.60 | % | $ | 103,509,164 | 31.63 | % | ||||||||
|
West
|
133,879,457 | 22.60 | % | 98,694,596 | 30.16 | % | ||||||||||
|
Southeast
|
108,804,931 | 18.36 | % | 39,463,350 | 12.06 | % | ||||||||||
|
Midwest
|
53,336,882 | 9.00 | % | 22,980,368 | 7.02 | % | ||||||||||
|
Southwest
|
121,104,464 | 20.44 | % | 62,584,807 | 19.13 | % | ||||||||||
|
Total
|
$ | 592,496,595 | 100.00 | % | $ | 327,232,285 | 100.00 | % | ||||||||
|
Fair Value:
|
||||||||||||||||
|
Northeast
|
$ | 161,264,153 | 28.60 | % | $ | 87,895,220 | 29.34 | % | ||||||||
|
West
|
131,881,487 | 23.39 | % | 93,601,893 | 31.24 | % | ||||||||||
|
Southeast
|
109,457,070 | 19.41 | % | 39,858,633 | 13.30 | % | ||||||||||
|
Midwest
|
53,750,018 | 9.53 | % | 22,841,167 | 7.62 | % | ||||||||||
|
Southwest
|
107,468,588 | 19.07 | % | 55,414,224 | 18.50 | % | ||||||||||
|
Total
|
$ | 563,821,316 | 100.00 | % | $ | 299,611,137 | 100.00 | % | ||||||||
99
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The composition of the Company’s portfolio by industry at
cost and fair value as of September 30, 2010 and
September 30, 2009 were as follows:
| September 30, 2010 | September 30, 2009 | |||||||||||||||
|
Cost:
|
||||||||||||||||
|
Healthcare services
|
$ | 87,443,639 | 14.76 | % | $ | 50,826,822 | 15.53 | % | ||||||||
|
Healthcare equipment
|
47,539,596 | 8.02 | % | — | 0.00 | % | ||||||||||
|
Education services
|
44,901,602 | 7.58 | % | — | 0.00 | % | ||||||||||
|
Electronic equipment & instruments
|
33,094,495 | 5.59 | % | — | 0.00 | % | ||||||||||
|
Home improvement retail
|
32,630,879 | 5.51 | % | — | 0.00 | % | ||||||||||
|
Food distributors
|
30,415,200 | 5.13 | % | 8,922,946 | 2.73 | % | ||||||||||
|
Fertilizers & agricultural chemicals
|
26,694,525 | 4.51 | % | — | 0.00 | % | ||||||||||
|
Diversified support services
|
26,246,237 | 4.43 | % | — | 0.00 | % | ||||||||||
|
Construction and engineering
|
24,987,230 | 4.22 | % | 19,275,031 | 5.89 | % | ||||||||||
|
Apparel, accessories & luxury goods and Footwear
|
23,535,757 | 3.97 | % | 22,423,009 | 6.85 | % | ||||||||||
|
Healthcare technology
|
21,509,107 | 3.63 | % | 37,201,082 | 11.37 | % | ||||||||||
|
Media — Advertising
|
19,828,343 | 3.35 | % | 13,403,441 | 4.10 | % | ||||||||||
|
Food retail
|
19,622,414 | 3.31 | % | — | 0.00 | % | ||||||||||
|
Electronic manufacturing services
|
18,738,072 | 3.16 | % | 15,416,411 | 4.71 | % | ||||||||||
|
Construction materials
|
17,475,899 | 2.95 | % | 11,743,630 | 3.59 | % | ||||||||||
|
Trucking
|
17,064,785 | 2.88 | % | 17,064,785 | 5.21 | % | ||||||||||
|
Air freight and logistics
|
14,004,766 | 2.36 | % | 10,758,896 | 3.29 | % | ||||||||||
|
Distributors
|
13,350,633 | 2.25 | % | 13,014,576 | 3.98 | % | ||||||||||
|
Data processing and outsourced services
|
13,078,169 | 2.21 | % | 13,473,611 | 4.12 | % | ||||||||||
|
Restaurants
|
12,485,385 | 2.11 | % | 20,288,245 | 6.20 | % | ||||||||||
|
Housewares and specialties
|
12,195,029 | 2.06 | % | 12,045,029 | 3.68 | % | ||||||||||
|
Industrial machinery
|
10,143,414 | 1.71 | % | 9,965,792 | 3.05 | % | ||||||||||
|
Environmental and facility services
|
8,921,676 | 1.51 | % | 8,924,801 | 2.73 | % | ||||||||||
|
Building products
|
8,291,678 | 1.40 | % | 7,036,357 | 2.14 | % | ||||||||||
|
Leisure facilities
|
6,863,521 | 1.16 | % | 7,187,169 | 2.20 | % | ||||||||||
|
Household products
|
1,064,910 | 0.18 | % | 7,803,805 | 2.38 | % | ||||||||||
|
Movies & entertainment
|
200,169 | 0.03 | % | 7,601,085 | 2.32 | % | ||||||||||
|
Multi-sector holdings
|
169,465 | 0.02 | % | — | 0.00 | % | ||||||||||
|
Home furnishing retail
|
— | 0.00 | % | 12,855,762 | 3.93 | % | ||||||||||
|
Total
|
$ | 592,496,595 | 100.00 | % | $ | 327,232,285 | 100.00 | % | ||||||||
|
Fair Value:
|
||||||||||||||||
|
Healthcare services
|
$ | 89,261,760 | 15.83 | % | $ | 51,576,258 | 17.21 | % | ||||||||
|
Healthcare equipment
|
48,297,921 | 8.57 | % | — | 0.00 | % | ||||||||||
|
Education services
|
42,110,738 | 7.47 | % | — | 0.00 | % | ||||||||||
|
Electronic equipment & instruments
|
32,887,767 | 5.83 | % | — | 0.00 | % | ||||||||||
|
Home improvement retail
|
32,483,858 | 5.76 | % | — | 0.00 | % | ||||||||||
|
Food distributors
|
30,316,811 | 5.38 | % | 8,979,657 | 3.00 | % | ||||||||||
100
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
| September 30, 2010 | September 30, 2009 | |||||||||||||||
|
Fertilizers & agricultural chemicals
|
26,811,860 | 4.76 | % | — | 0.00 | % | ||||||||||
|
Diversified support services
|
26,246,237 | 4.66 | % | — | 0.00 | % | ||||||||||
|
Construction and engineering
|
23,844,836 | 4.23 | % | 17,852,292 | 5.96 | % | ||||||||||
|
Apparel, accessories & luxury goods and Footwear
|
23,548,933 | 4.18 | % | 22,082,721 | 7.37 | % | ||||||||||
|
Healthcare technology
|
22,140,613 | 3.93 | % | 36,762,574 | 12.27 | % | ||||||||||
|
Media — Advertising
|
19,847,065 | 3.52 | % | 13,099,203 | 4.37 | % | ||||||||||
|
Food retail
|
19,750,316 | 3.50 | % | — | 0.00 | % | ||||||||||
|
Electronic manufacturing services
|
18,055,528 | 3.20 | % | 15,081,138 | 5.03 | % | ||||||||||
|
Construction materials
|
17,039,751 | 3.02 | % | 12,130,945 | 4.05 | % | ||||||||||
|
Air freight and logistics
|
14,040,532 | 2.49 | % | 10,799,619 | 3.60 | % | ||||||||||
|
Distributors
|
13,258,317 | 2.35 | % | 13,074,682 | 4.36 | % | ||||||||||
|
Data processing and outsourced services
|
12,741,012 | 2.26 | % | 13,289,816 | 4.44 | % | ||||||||||
|
Restaurants
|
12,099,935 | 2.15 | % | 17,811,015 | 5.94 | % | ||||||||||
|
Industrial machinery
|
10,232,763 | 1.81 | % | 9,766,485 | 3.26 | % | ||||||||||
|
Leisure facilities
|
7,040,043 | 1.25 | % | 7,144,897 | 2.38 | % | ||||||||||
|
Building products
|
6,841,467 | 1.21 | % | 6,158,908 | 2.06 | % | ||||||||||
|
Environmental and facility services
|
5,129,853 | 0.91 | % | 6,122,236 | 2.04 | % | ||||||||||
|
Trucking
|
4,597,412 | 0.82 | % | 9,860,940 | 3.29 | % | ||||||||||
|
Housewares and specialties
|
3,700,000 | 0.66 | % | 5,691,107 | 1.90 | % | ||||||||||
|
Household products
|
1,064,910 | 0.19 | % | 4,448,661 | 1.50 | % | ||||||||||
|
Movies & entertainment
|
261,613 | 0.05 | % | 7,541,582 | 2.52 | % | ||||||||||
|
Multi-sector holdings
|
169,465 | 0.01 | % | — | 0.00 | % | ||||||||||
|
Home furnishing retail
|
— | 0.00 | % | 10,336,401 | 3.45 | % | ||||||||||
|
Total
|
$ | 563,821,316 | 100.00 | % | $ | 299,611,137 | 100.00 | % | ||||||||
The Company’s investments are generally in small and
mid-sized companies in a variety of industries. At
September 30, 2010 and September 30, 2009, the Company
had no single investment that represented greater than 10% of
the total investment portfolio at fair value. Income, consisting
of interest, dividends, fees, other investment income, and
realization of gains or losses on equity interests, can
fluctuate upon repayment of an investment or sale of an equity
interest and in any given year can be highly concentrated among
several investments. For the years ended September 30, 2010
and September 30, 2009, no individual investment produced
income that exceeded 10% of investment income.
| Note 4. | Fee Income |
The Company receives a variety of fees in the ordinary course of
business. Certain fees, such as origination fees, are
capitalized and amortized in accordance with
ASC 310-20
Nonrefundable Fees and Other Costs
. In accordance with
ASC 820, the net unearned fee income balance is netted
against the cost of the respective investments. Other fees, such
as servicing and collateral management fees, are classified as
fee income and recognized as they are earned on a monthly basis.
101
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Accumulated unearned fee income activity for the years ended
September 30, 2010 and 2009 was as follows:
|
Year Ended
|
Year Ended
|
|||||||
| September 30, 2010 | September 30, 2009 | |||||||
|
Beginning accumulated unearned fee income balance
|
$ | 5,589,630 | $ | 5,236,265 | ||||
|
Net fees received
|
11,806,209 | 3,895,559 | ||||||
|
Unearned fee income recognized
|
(5,494,968 | ) | (3,542,194 | ) | ||||
|
Ending unearned fee income balance
|
$ | 11,900,871 | $ | 5,589,630 | ||||
As of September 30, 2010, the Company had structured
$7.1 million in aggregate exit fees across
10 portfolio investments upon the future exit of those
investments. These fees are to be paid to the Company upon the
sooner to occur of (i) a sale of the borrower or
substantially all of the assets of the borrower, (ii) the
maturity date of the loan, or (iii) the date when full
prepayment of the loan occurs. Exit fees are fees which are
earned and payable upon the exit of a debt security and, similar
to a prepayment penalty, are not accrued or otherwise included
in net investment income until received. The receipt of such
fees as well the timing of the Company’s receipt of such
fees is contingent upon a successful exit event for each of the
investments.
| Note 5. | Share Data |
Effective January 2, 2008, the Partnership merged with and
into the Company. At the time of the merger, all outstanding
partnership interests in the Partnership were exchanged for
12,480,972 shares of common stock of the Company. An
additional 26 fractional shares were payable to the stockholders
in cash.
On June 17, 2008, the Company completed an initial public
offering of 10,000,000 shares of its common stock at the
offering price of $14.12 per share. The net proceeds totaled
$129.5 million after deducting investment banking
commissions of $9.9 million and offering costs of
$1.8 million.
On July 21, 2009, the Company completed a follow-on public
offering of 9,487,500 shares of its common stock, which
included the underwriters’ exercise of their over-allotment
option, at the offering price of $9.25 per share. The net
proceeds totaled $82.7 million after deducting investment
banking commissions of $4.4 million and offering costs of
$0.7 million.
On September 25, 2009, the Company completed a follow-on
public offering of 5,520,000 shares of its common stock,
which included the underwriters’ exercise of their
over-allotment option, at the offering price of $10.50 per
share. The net proceeds totaled $54.9 million after
deducting investment banking commissions of $2.8 million
and offering costs of $0.3 million.
On January 27, 2010, the Company completed a follow-on
public offering of 7,000,000 shares of its common stock at
the offering price of $11.20 per share, with 300,500 additional
shares being sold as part of the underwriters’ partial
exercise of their over-allotment option on February 25,
2010. The net proceeds totaled $77.5 million after
deducting investment banking commissions of $3.7 million
and offering costs of $0.5 million.
On April 20, 2010, at the Company’s 2010 Annual
Meeting, the Company’s stockholders approved, among other
things, amendments to the Company’s restated certificate of
incorporation to increase the number of authorized shares of
common stock from 49,800,000 shares to
150,000,000 shares and to remove the Company’s
authority to issue shares of Series A Preferred Stock.
On June 21, 2010, the Company completed a follow-on public
offering of 9,200,000 shares of its common stock, which
included the underwriters’ exercise of their over-allotment
option, at the offering price of $11.50 per share. The net
proceeds totaled $100.5 million after deducting investment
banking commissions of $4.8 million and offering costs of
$0.5 million.
102
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
No dilutive instruments were outstanding and therefore none were
reflected in the Company’s Consolidated Statement of Assets
and Liabilities at September 30, 2010. The following table
sets forth the weighted average common shares outstanding for
computing basic and diluted earnings per common share for the
years ended September 30, 2010 and September 30, 2009:
|
Year Ended
|
Year Ended
|
Year Ended
|
||||||||||
|
September 30,
|
September 30,
|
September 30,
|
||||||||||
| 2010 | 2009 | 2008 | ||||||||||
|
Weighted average common shares outstanding, basic and diluted
|
45,440,584 | 24,654,325 | 15,557,469 | |||||||||
The following table reflects the dividend distributions per
share that the Board of Directors of the Company has declared
and the Company has paid, including shares issued under the
dividend reinvestment plan (“DRIP”), on its common
stock from inception to September 30, 2010:
|
Record
|
Payment
|
Amount
|
Cash
|
DRIP Shares
|
DRIP Shares
|
|||||||||||||||||||||
|
Date Declared
|
Date | Date | per Share | Distribution | Issued | Value | ||||||||||||||||||||
|
5/1/2008
|
5/19/2008 | 6/3/2008 | $ | 0.30 | $ | 1.9 million | 133,317 | $ | 1.9 million | |||||||||||||||||
|
8/6/2008
|
9/10/2008 | 9/26/2008 | 0.31 | 5.1 million | 196,786 | (1) | 1.9 million | |||||||||||||||||||
|
12/9/2008
|
12/19/2008 | 12/29/2008 | 0.32 | 6.4 million | 105,326 | 0.8 million | ||||||||||||||||||||
|
12/9/2008
|
12/30/2008 | 1/29/2009 | 0.33 | 6.6 million | 139,995 | 0.8 million | ||||||||||||||||||||
|
12/18/2008
|
12/30/2008 | 1/29/2009 | 0.05 | 1.0 million | 21,211 | 0.1 million | ||||||||||||||||||||
|
4/14/2009
|
5/26/2009 | 6/25/2009 | 0.25 | 5.6 million | 11,776 | 0.1 million | ||||||||||||||||||||
|
8/3/2009
|
9/8/2009 | 9/25/2009 | 0.25 | 7.5 million | 56,890 | 0.6 million | ||||||||||||||||||||
|
11/12/2009
|
12/10/2009 | 12/29/2009 | 0.27 | 9.7 million | 44,420 | 0.5 million | ||||||||||||||||||||
|
1/12/2010
|
3/3/2010 | 3/30/2010 | 0.30 | 12.9 million | 58,689 | 0.7 million | ||||||||||||||||||||
|
5/3/2010
|
5/20/2010 | 6/30/2010 | 0.32 | 14.0 million | 42,269 | 0.5 million | ||||||||||||||||||||
|
8/2/2010
|
9/1/2010 | 9/29/2010 | 0.10 | 5.2 million | 25,425 | 0.3 million | ||||||||||||||||||||
| (1) | Shares were purchased on the open market and distributed. |
In October 2008, the Company’s Board of Directors
authorized a stock repurchase program to acquire up to
$8 million of the Company’s outstanding common stock.
Stock repurchases under this program were made through the open
market at times and in such amounts as Company management deemed
appropriate. The stock repurchase program expired December 2009.
In October 2008, the Company repurchased 78,000 shares of
common stock on the open market as part of its share repurchase
program.
In October 2010, the Company’s Board of Directors
authorized a stock repurchase program to acquire up to
$20 million of the Company’s outstanding common stock.
Stock repurchases under this program are to be made through the
open market at times and in such amounts as the Company’s
management deems appropriate, provided it is below the most
recently published net asset value per share. The stock
repurchase program expires December 31, 2011 and may be
limited or terminated by the Board of Directors at any time
without prior notice.
| Note 6. | Lines of Credit |
On November 16, 2009, Fifth Street Funding, LLC, a
consolidated wholly-owned bankruptcy remote, special purpose
subsidiary (“Funding”), and the Company entered into a
Loan and Servicing Agreement (“Agreement”), with
respect to a three-year credit facility (“Wells Fargo
facility”) with Wells Fargo, as successor to Wachovia Bank,
National Association (“Wachovia”), Wells Fargo
Securities, LLC, as administrative agent, each of the additional
institutional and conduit lenders party thereto from time to
time, and each of the lender agents party thereto from time to
time, in the amount of $50 million, with an accordion
feature
103
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
which allowed for potential future expansion of the facility up
to $100 million. The facility bore interest at LIBOR plus
4.0% per annum and had a maturity date of November 16, 2012.
On May 26, 2010, the Company amended the Wells Fargo
facility to expand the borrowing capacity under that facility.
Pursuant to the amendment, the Company received an additional
$50 million commitment, thereby increasing the size of the
facility from $50 million to $100 million, with an
accordion feature that allows for potential future expansion of
that facility from a total of $100 million up to a total of
$150 million. In addition, the interest rate of the Wells
Fargo facility was reduced from LIBOR plus 4% per annum to LIBOR
plus 3.5% per annum, with no LIBOR floor, and the maturity date
of the facility was extended from November 16, 2012 to
May 26, 2013. The facility may be extended for up to two
additional years upon the mutual consent of Wells Fargo and each
of the lender parties thereto.
In connection with the Wells Fargo facility, the Company
concurrently entered into (i) a Purchase and Sale Agreement
with Funding, pursuant to which the Company will sell to Funding
certain loan assets it has originated or acquired, or will
originate or acquire and (ii) a Pledge Agreement with Wells
Fargo, pursuant to which the Company pledged all of its equity
interests in Funding as security for the payment of
Funding’s obligations under the Agreement and other
documents entered into in connection with the Wells Fargo
facility.
The Agreement and related agreements governing the Wells Fargo
facility required both Funding and the Company to, among other
things (i) make representations and warranties regarding
the collateral as well as each of their businesses,
(ii) agree to certain indemnification obligations, and
(iii) comply with various covenants, servicing procedures,
limitations on acquiring and disposing of assets, reporting
requirements and other customary requirements for similar credit
facilities. The Wells Fargo facility agreements also include
usual and customary default provisions such as the failure to
make timely payments under the facility, a change in control of
Funding, and the failure by Funding or the Company to materially
perform under the Agreement and related agreements governing the
facility, which, if not complied with, could accelerate
repayment under the facility, thereby materially and adversely
affecting the Company’s liquidity, financial condition and
results of operations. The Company is currently in compliance
with all financial covenants under the Wells Fargo facility.
The Wells Fargo facility is secured by all of the assets of
Funding, and all of the Company’s equity interest in
Funding. The Company intends to use the net proceeds of the
Wells Fargo facility to fund a portion of its loan origination
activities and for general corporate purposes. Each loan
origination under the facility is subject to the satisfaction of
certain conditions. The Company cannot be assured that Funding
will be able to borrow funds under the Wells Fargo facility at
any particular time or at all. The Company had no borrowings
outstanding under the Wells Fargo facility as of
September 30, 2010.
On May 27, 2010, the Company entered into a three-year
secured syndicated revolving credit facility (“ING
facility”) pursuant to a Senior Secured Revolving Credit
Agreement (“ING Credit Agreement”) with certain
lenders party thereto from time to time and ING Capital LLC, as
administrative agent. The ING facility allows for the Company to
borrow money at a rate of either (i) LIBOR plus 3.5% per
annum or (ii) 2.5% per annum plus an alternate base rate
based on the greatest of the Prime Rate, Federal Funds Rate plus
0.5% per annum or LIBOR plus 1% per annum, and has a maturity
date of May 27, 2013. The ING facility also allows the
Company to request letters of credit from ING Capital LLC, as
the issuing bank. The initial commitment under the ING facility
is $90 million, and the ING facility includes an accordion
feature that allows for potential future expansion of the
facility up to a total of $150 million. The ING facility is
secured by substantially all of the Company’s assets, as
well as the assets of two of the Company’s wholly-owned
subsidiaries, FSFC Holdings, Inc. and FSF/MP Holdings, Inc.,
subject to certain exclusions for, among other things, equity
interests in the Company’s SBIC subsidiary and equity
interests in Funding as further set forth in a Guarantee, Pledge
and Security Agreement (“ING Security Agreement”)
entered into in connection with the ING Credit Agreement, among
FSFC Holdings, Inc., FSF/MP Holdings, Inc., ING Capital LLC, as
collateral agent, and the Company. Neither the Company’s
SBIC subsidiary nor Funding is party to the ING
104
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
facility and their respective assets have not been pledged in
connection therewith. The ING facility provides that the Company
may use the proceeds and letters of credit under the facility
for general corporate purposes, including acquiring and funding
leveraged loans, mezzanine loans, high-yield securities,
convertible securities, preferred stock, common stock and other
investments.
Pursuant to the ING Security Agreement, FSFC Holdings, Inc. and
FSF/MP Holdings, Inc. guaranteed the obligations under the ING
Security Agreement, including the Company’s obligations to
the lenders and the administrative agent under the ING Credit
Agreement. Additionally, the Company pledged its entire equity
interests in FSFC Holdings, Inc. and FSF/MP Holdings, Inc. to
the collateral agent pursuant to the terms of the ING Security
Agreement.
The ING Credit Agreement and related agreements governing the
ING facility required FSFC Holdings, Inc., FSF/MP Holdings, Inc.
and the Company to, among other things (i) make
representations and warranties regarding the collateral as well
as each of the Company’s businesses, (ii) agree to
certain indemnification obligations, and (iii) agree to
comply with various affirmative and negative covenants and other
customary requirements for similar credit facilities. The ING
facility documents also include usual and customary default
provisions such as the failure to make timely payments under the
facility, the occurrence of a change in control, and the failure
by the Company to materially perform under the ING Credit
Agreement and related agreements governing the facility, which,
if not complied with, could accelerate repayment under the
facility, thereby materially and adversely affecting the
Company’s liquidity, financial condition and results of
operations. The Company is currently in compliance with all
financial covenants under the ING facility.
Each loan or letter of credit originated under the ING facility
is subject to the satisfaction of certain conditions. The
Company cannot be assured that it will be able to borrow funds
under the ING facility at any particular time or at all.
Through September 30, 2010, there had been no borrowings or
repayments on the ING facility.
As of September 30, 2010, except for assets that were
funded through the Company’s SBIC subsidiary, substantially
all of the Company’s assets were pledged as collateral
under the Wells Fargo facility or the ING facility.
Interest expense for the years ended September 30, 2010,
2009 and 2008 was $1.9 million, $0.6 million, and
$0.9 million, respectively.
| Note 7. | Interest and Dividend Income |
Interest income is recorded on an accrual basis to the extent
that such amounts are expected to be collected. In accordance
with the Company’s policy, accrued interest is evaluated
periodically for collectability. The Company stops accruing
interest on investments when it is determined that interest is
no longer collectible. Distributions from portfolio companies
are recorded as dividend income when the distribution is
received.
The Company holds debt in its portfolio that contains a
payment-in-kind
(“PIK”) interest provision. The PIK interest, which
represents contractually deferred interest added to the loan
balance that is generally due at the end of the loan term, is
generally recorded on the accrual basis to the extent such
amounts are expected to be collected. The Company generally
ceases accruing PIK interest if there is insufficient value to
support the accrual or if the Company does not expect the
portfolio company to be able to pay all principal and interest
due. The Company’s decision to cease accruing PIK interest
involves subjective judgments and determinations based on
available information about a particular portfolio company,
including whether the portfolio company is current with respect
to its payment of principal and interest on its loans and debt
securities; monthly and quarterly financial statements and
financial projections for the portfolio company; the
Company’s assessment of the portfolio company’s
business development success, including product development,
profitability and the portfolio company’s overall adherence
to its business plan; information obtained by the Company in
105
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
connection with periodic formal update interviews with the
portfolio company’s management and, if appropriate, the
private equity sponsor; and information about the general
economic and market conditions in which the portfolio company
operates. Based on this and other information, the Company
determines whether to cease accruing PIK interest on a loan or
debt security. The Company’s determination to cease
accruing PIK interest on a loan or debt security is generally
made well before the Company’s full write-down of such loan
or debt security.
Accumulated PIK interest activity for the years ended
September 30, 2010 and September 30, 2009 was as
follows:
|
Year Ended
|
Year Ended
|
|||||||
|
September 30,
|
September 30,
|
|||||||
| 2010 | 2009 | |||||||
|
PIK balance at beginning of period
|
$ | 12,059,478 | $ | 5,367,032 | ||||
|
Gross PIK interest accrued
|
11,907,073 | 8,853,636 | ||||||
|
PIK income reserves
|
(1,903,005 | ) | (1,398,347 | ) | ||||
|
PIK interest received in cash
|
(1,618,762 | ) | (428,140 | ) | ||||
|
Loan exits
|
(1,143,830 | ) | (334,703 | ) | ||||
|
PIK balance at end of period
|
$ | 19,300,954 | $ | 12,059,478 | ||||
Five investments did not pay all of their scheduled monthly cash
interest payments for the period ended September 30, 2010.
As of September 30, 2010, the Company had also stopped
accruing PIK interest and original issue discount
(“OID”) on these five investments. At
September 30, 2009, the Company had stopped accruing PIK
interest and OID on five investments, including two investments
that had not paid all of their scheduled monthly cash interest
payments. At September 30, 2008, no investments were on
non-accrual status.
The non-accrual status of the Company’s portfolio
investments as of September 30, 2010, September 30,
2009, and September 30, 2008 was as follows:
| September 30, 2010 | September 30, 2009 | September 30, 2008 | ||||||||
|
Lighting by Gregory, LLC
|
Cash non-accrual | Cash non-accrual | — | |||||||
|
CPAC, Inc.
|
— | PIK non-accrual | — | |||||||
|
MK Network, LLC
|
Cash non-accrual | — | — | |||||||
|
Martini Park, LLC
|
— | PIK non-accrual | — | |||||||
|
Vanguard Vinyl, Inc.
|
Cash non-accrual | — | — | |||||||
|
Nicos Polymers & Grinding, Inc.
|
Cash non-accrual | PIK non-accrual | — | |||||||
|
Premier Trailer Leasing, Inc.
|
Cash non-accrual | Cash non-accrual | — | |||||||
Non-accrual interest amounts related to the above investments
for the years ended September 30, 2010, September 30,
2009 and September 30, 2008 were as follows:
|
Year ended
|
Year ended
|
Year ended
|
||||||||||
| September 30, 2010 | September 30, 2009 | September 30, 2008 | ||||||||||
|
Cash interest income
|
$ | 5,804,101 | $ | 2,938,190 | $ | — | ||||||
|
PIK interest income
|
1,903,005 | 1,398,347 | — | |||||||||
|
OID income
|
328,792 | 402,522 | — | |||||||||
|
Total
|
$ | 8,035,898 | $ | 4,739,059 | $ | — | ||||||
106
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
| Note 8. | Taxable Distributable Income and Dividend Distributions |
Taxable income differs from net increase (decrease) in net
assets resulting from operations primarily due to:
(1) unrealized appreciation (depreciation) on investments,
as investment gains and losses are not included in taxable
income until they are realized; (2) origination fees
received in connection with investments in portfolio companies,
which are amortized into interest income over the life of the
investment for book purposes, are treated as taxable income upon
receipt; (3) organizational and deferred offering costs;
(4) recognition of interest income on certain loans; and
(5) income or loss recognition on exited investments.
At September 30, 2010, the Company has a net loss
carryforward of $1.5 million to offset net capital gains,
to the extent provided by federal tax law. The capital loss
carryforward will expire in the Company’s tax year ending
September 30, 2017. During the year ended
September 30, 2010, the Company realized capital losses
from the sale of investments after October 31 and prior to year
end (“post-October capital losses”) of
$12.9 million, which for tax purposes are treated as
arising on the first day of the following year.
Listed below is a reconciliation of “net increase in net
assets resulting from operations” to taxable income for the
year ended September 30, 2010.
|
Net increase in net assets resulting from operations
|
$ | 22,416,000 | ||
|
Net change in unrealized depreciation
|
1,828,000 | |||
|
Book/tax difference due to deferred loan origination fees, net
|
6,311,000 | |||
|
Book/tax difference due to organizational and offering costs
|
(87,000 | ) | ||
|
Book/tax difference due to interest income on certain loans
|
2,748,000 | |||
|
Book/tax difference due to capital losses not recognized
|
14,922,000 | |||
|
Other book-tax differences
|
(363,000 | ) | ||
|
Taxable Distributable Income(1)
|
$ | 47,775,000 | ||
| (1) | The Company’s taxable income for 2010 is an estimate and will not be finally determined until the Company files its tax return for the fiscal year ended September 30, 2010. Therefore, the final taxable income may be different than the estimate. |
As of September 30, 2010, the components of accumulated
undistributed income on a tax basis were as follows:
|
Undistributed ordinary income, net (RIC status)
|
$ | 4,037,000 | ||
|
Realized capital losses
|
(1,539,000 | ) | ||
|
Unrealized losses, net
|
(34,606,000 | ) | ||
|
Accumulated partnership taxable income not subject to
distribution
|
6,236,000 | |||
|
Other book-tax differences
|
(26,800,000 | ) |
The Company uses the asset and liability method to account for
its taxable subsidiaries’ income taxes. Using this method,
the Company recognizes deferred tax assets and liabilities for
the estimated future tax effects attributable to temporary
differences between financial reporting and tax bases of assets
and liabilities. In addition, the Company recognizes deferred
tax benefits associated with net operating carry forwards that
it may use to offset future tax obligations. The Company
measures deferred tax assets and liabilities using the enacted
tax rates expected to apply to taxable income in the years in
which it expects to recover or settle those temporary
differences. The Company has recorded a deferred tax asset for
the difference in the book and tax basis of certain equity
investments and tax net operating losses held by its taxable
subsidiaries of $1.4 million. However, this amount has been
fully offset by a valuation allowance of $1.4 million,
since it is more likely than not that these deferred tax assets
will not be realized.
107
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Distributions to stockholders are recorded on the record date.
The Company is required to distribute annually to its
stockholders at least 90% of its net ordinary income and net
realized short-term capital gains in excess of net realized
long-term capital losses for each taxable year in order to be
eligible for the tax benefits allowed to a RIC under Subchapter
M of the Code. The Company anticipates paying out as a dividend
all or substantially all of those amounts. The amount to be paid
out as a dividend is determined by the Board of Directors and is
based on management’s estimate of the Company’s annual
taxable income. The Company maintains an “opt out”
dividend reimbursement plan for its stockholders.
To date, the Company’s Board of Directors declared the
following distributions:
|
Dividend Type
|
Date Declared | Record Date | Payment Date | Amount | ||||||||||||||
|
Quarterly
|
5/1/2008 | 5/19/2008 | 6/3/2008 | $ | 0.30 | |||||||||||||
|
Quarterly
|
8/6/2008 | 9/10/2008 | 9/26/2008 | $ | 0.31 | |||||||||||||
|
Quarterly
|
12/9/2008 | 12/19/2008 | 12/29/2008 | $ | 0.32 | |||||||||||||
|
Quarterly
|
12/9/2008 | 12/30/2008 | 1/29/2009 | $ | 0.33 | |||||||||||||
|
Special
|
12/18/2008 | 12/30/2008 | 1/29/2009 | $ | 0.05 | |||||||||||||
|
Quarterly
|
4/14/2009 | 5/26/2009 | 6/25/2009 | $ | 0.25 | |||||||||||||
|
Quarterly
|
8/3/2009 | 9/8/2009 | 9/25/2009 | $ | 0.25 | |||||||||||||
|
Quarterly
|
11/12/2009 | 12/30/2008 | 1/29/2009 | $ | 0.27 | |||||||||||||
|
Quarterly
|
1/12/2010 | 12/30/2008 | 1/29/2009 | $ | 0.30 | |||||||||||||
|
Quarterly
|
5/3/2010 | 5/26/2009 | 6/25/2009 | $ | 0.32 | |||||||||||||
|
Quarterly
|
8/2/2010 | 9/1/2010 | 9/29/2010 | $ | 0.10 | |||||||||||||
|
Monthly
|
8/2/2010 | 10/6/2010 | 10/27/2010 | $ | 0.10 | |||||||||||||
|
Monthly
|
8/2/2010 | 11/3/2010 | 11/24/2010 | $ | 0.11 | |||||||||||||
|
Monthly
|
8/2/2010 | 12/1/2010 | 12/29/2010 | $ | 0.11 | |||||||||||||
For income tax purposes, the Company estimates that these
distributions will be composed entirely of ordinary income, and
will be reflected as such on the Form
1099-DIV
for
the calendar year 2010. The Company anticipates declaring
further distributions to its stockholders to meet the RIC
distribution requirements.
As a RIC, the Company is also subject to a federal excise tax
based on distributive requirements of its taxable income on a
calendar year basis. Because the Company did not satisfy these
distribution requirements for calendar years 2008 and 2009, the
Company incurred a de minimis federal excise tax for those
calendar years.
| Note 9. | Realized Gains or Losses from Investments and Net Change in Unrealized Appreciation or Depreciation from Investments |
Realized gains or losses are measured by the difference between
the net proceeds from the sale or redemption and the cost basis
of the investment without regard to unrealized appreciation or
depreciation previously recognized, and includes investments
written-off during the period, net of recoveries. Realized
losses may also be recorded in connection with the
Company’s determination that certain investments are
considered worthless securities
and/or
meet
the conditions for loss recognition per the applicable tax
rules. Net change in unrealized appreciation or depreciation
from investments reflects the net change in the valuation of the
portfolio pursuant to the Company’s valuation guidelines
and the reclassification of any prior period unrealized
appreciation or depreciation on exited investments.
108
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
During the year ended September 30, 2010, the Company
recorded the following investment realization events:
| • | In October 2009, the Company received a cash payment in the amount of $0.1 million representing a payment in full of all amounts due in connection with the cancellation of its loan agreement with American Hardwoods Industries, LLC. The Company recorded a $0.1 million reduction to the previously recorded $10.4 million realized loss on the investment in American Hardwoods; | |
| • | In March 2010, the Company recorded a realized loss in the amount of $2.9 million in connection with the sale of a portion of its interest in CPAC, Inc.; | |
| • | In August 2010, the Company received a cash payment of $7.6 million from Storyteller Theaters Corporation in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction; |
| • | In September 2010, the Company restructured its investment in Rail Acquisition Corp. Although the full amount owed under the loan agreement remained intact, the restructuring resulted in a material modification of the terms of the loan agreement. As such, the Company recorded a realized loss in the amount of $2.6 million in accordance with ASC 470-50; |
| • | In September 2010, the Company sold its investment in Martini Park, LLC and received a cash payment in the amount of $0.1 million. The Company recorded a realized loss on this investment in the amount of $4.0 million; and | |
| • | In September 2010, the Company exited its investment in Rose Tarlow, Inc. and received a cash payment in the amount of $3.6 million in full settlement of the debt investment. The Company recorded a realized loss on this investment in the amount of $9.3 million. |
During the year ended September 30, 2009 the Company exited
its investment in American Hardwoods Industries, LLC and
recorded a realized loss of $10.4 million, and recorded a
$4.0 million realized loss on one of its portfolio company
investments in connection with the determination that the
investment was permanently impaired based on, among other
things, analysis of changes in the portfolio company’s
business operations and prospects. During the year ended
September 30, 2008 the Company sold its equity investment
in Filet of Chicken and realized a gain of $62,000.
During the years ended September 30, 2010, 2009 and 2008,
the Company recorded net unrealized depreciation of
$1.8 million, $10.8 million, and $16.9 million,
respectively. For the year ended September 30, 2010, the
Company’s net unrealized depreciation consisted of
$18.7 million of net unrealized depreciation on debt
investments, $0.5 million of net unrealized depreciation on
equity investments and $0.7 million of net unrealized
depreciation on interest rate swaps, offset by
$17.2 million of reclassifications to realized losses.
| Note 10. | Concentration of Credit Risks |
The Company places its cash in financial institutions and at
times such balances may be in excess of the FDIC insured limit.
The Company limits its exposure to credit loss by depositing its
cash with high credit quality financial institutions and
monitoring their financial stability.
| Note 11. | Related Party Transactions |
The Company has entered into an investment advisory agreement
with the Investment Adviser. Under the investment advisory
agreement, the Company pays the Investment Adviser a fee for its
services under the investment advisory agreement consisting of
two components - a base management fee and an incentive fee.
109
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Base
management Fee
The base management fee is calculated at an annual rate of 2% of
the Company’s gross assets, which includes any borrowings
for investment purposes. The base management fee is payable
quarterly in arrears, and will be calculated based on the value
of the Company’s gross assets at the end of each fiscal
quarter, and appropriately adjusted on a pro rata basis for any
equity capital raises or repurchases during such quarter. The
base management fee for any partial month or quarter will be
appropriately prorated.
In addition to the proration described above, for the quarter
ended September 30, 2009, the Investment Advisor waived
$172,000 of the base management fee on a portion of the proceeds
raised in connection with the equity offerings the Company
completed in 2009 and which were held in cash or cash
equivalents at September 30, 2009.
Also, On January 6, 2010, the Company announced that the
Investment Adviser had voluntarily agreed to take the following
actions:
| • | To waive the portion of its base management fee for the quarter ended December 31, 2009 attributable to four new portfolio investments, as well as cash and cash equivalents. The amount of the management fee waived was $727,000; and | |
| • | To permanently waive that portion of its base management fee attributable to the Company’s assets held in the form of cash and cash equivalents as of the end of each quarter beginning March 31, 2010. |
For purposes of the waiver, cash and cash equivalents is as
defined in the notes to the Company’s Consolidated
Financial Statements.
For the years ended September 30, 2010, 2009 and 2008, base
management fees were $9.3 million, $5.9 million,
$4.3 million, respectively. At September 30, 2010, the
Company had a liability on its Consolidated Statement of Assets
and Liabilities in the amount of $2.9 million reflecting
the unpaid portion of the base management fee payable to the
Investment Adviser.
Incentive
Fee
The incentive fee portion of the investment advisory agreement
has two parts. The first part is calculated and payable
quarterly in arrears based on the Company’s
“Pre-Incentive Fee Net Investment Income” for the
immediately preceding fiscal quarter. For this purpose,
“Pre-Incentive Fee Net Investment Income” means
interest income, dividend income and any other income (including
any other fees (other than fees for providing managerial
assistance), such as commitment, origination, structuring,
diligence and consulting fees or other fees that the Company
receives from portfolio companies) accrued during the fiscal
quarter, minus the Company’s operating expenses for the
quarter (including the base management fee, expenses payable
under the Company’s administration agreement with FSC,
Inc., and any interest expense and dividends paid on any issued
and outstanding indebtedness or preferred stock, but excluding
the incentive fee). Pre-Incentive Fee Net Investment Income
includes, in the case of investments with a deferred interest
feature (such as original issue discount, debt instruments with
PIK interest and zero coupon securities), accrued income that
the Company has not yet received in cash. Pre-Incentive Fee Net
Investment Income does not include any realized capital gains,
realized capital losses or unrealized capital appreciation or
depreciation. Pre-Incentive Fee Net Investment Income, expressed
as a rate of return on the value of the Company’s net
assets at the end of the immediately preceding fiscal quarter,
will be compared to a “hurdle rate” of 2% per quarter
(8% annualized), subject to a
“catch-up”
provision measured as of the end of each fiscal quarter. The
Company’s net investment income used to calculate this part
of the incentive fee is also included in the amount of its gross
assets used to
110
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
calculate the 2% base management fee. The operation of the
incentive fee with respect to the Company’s Pre-Incentive
Fee Net Investment Income for each quarter is as follows:
| • | No incentive fee is payable to the Investment Adviser in any fiscal quarter in which the Company’s Pre-Incentive Fee Net Investment Income does not exceed the hurdle rate of 2% (the “preferred return” or “hurdle”); | |
| • | 100% of the Company’s Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the hurdle rate but is less than or equal to 2.5% in any fiscal quarter (10% annualized) is payable to the Investment Adviser. The Company refers to this portion of its Pre-Incentive Fee Net Investment Income (which exceeds the hurdle rate but is less than or equal to 2.5%) as the “catch-up.” The “catch-up” provision is intended to provide the Investment Adviser with an incentive fee of 20% on all of the Company’s Pre-Incentive Fee Net Investment Income as if a hurdle rate did not apply when the Company’s Pre-Incentive Fee Net Investment Income exceeds 2.5% in any fiscal quarter; and | |
| • | 20% of the amount of the Company’s Pre-Incentive Fee Net Investment Income, if any, that exceeds 2.5% in any fiscal quarter (10% annualized) is payable to the Investment Adviser once the hurdle is reached and the catch-up is achieved (20% of all Pre-Incentive Fee Net Investment Income thereafter is allocated to the Investment Adviser). |
The second part of the incentive fee will be determined and
payable in arrears as of the end of each fiscal year (or upon
termination of the investment advisory agreement, as of the
termination date), commencing on September 30, 2008, and
will equal 20% of the Company’s realized capital gains, if
any, on a cumulative basis from inception through the end of
each fiscal year, computed net of all realized capital losses
and unrealized capital depreciation on a cumulative basis, less
the aggregate amount of any previously paid capital gain
incentive fees.
For the years ended September 30, 2010, 2009 and 2008,
incentive fees were $10.8 million, $7.8 million and
$4.1 million, respectively. At September 30, 2010, the
Company had a liability on its Consolidated Statement of Assets
and Liabilities in the amount of $2.9 million reflecting
the unpaid portion of the incentive fee payable to the
Investment Adviser.
Transaction
fees
Prior to the merger of the Partnership with and into the
Company, which occurred on January 2, 2008, the Investment
Adviser received 20% of transaction origination fees. For the
year ended September 30, 2008, payments for the transaction
fees paid to the Investment Adviser amounted to approximately
$0.2 million and were expensed as incurred.
Indemnification
The investment advisory agreement provides that, absent willful
misfeasance, bad faith or gross negligence in the performance of
their respective duties or by reason of the reckless disregard
of their respective duties and obligations, the Company’s
Investment Adviser and its officers, managers, agents,
employees, controlling persons, members (or their owners) and
any other person or entity affiliated with it, are entitled to
indemnification from the Company for any damages, liabilities,
costs and expenses (including reasonable attorneys’ fees
and amounts reasonably paid in settlement) arising from the
rendering of the Investment Adviser’s services under the
investment advisory agreement or otherwise as the Company’s
Investment Adviser.
111
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Administration
Agreement
The Company has also entered into an administration agreement
with FSC, Inc. under which FSC, Inc. provides administrative
services for the Company, including office facilities and
equipment, and clerical, bookkeeping and recordkeeping services
at such facilities. Under the administration agreement, FSC,
Inc. also performs or oversees the performance of the
Company’s required administrative services, which includes
being responsible for the financial records which the Company is
required to maintain and preparing reports to the Company’s
stockholders and reports filed with the SEC. In addition, FSC,
Inc. assists the Company in determining and publishing the
Company’s net asset value, overseeing the preparation and
filing of the Company’s tax returns and the printing and
dissemination of reports to the Company’s stockholders, and
generally overseeing the payment of the Company’s expenses
and the performance of administrative and professional services
rendered to the Company by others. For providing these services,
facilities and personnel, the Company reimburses FSC, Inc. the
allocable portion of overhead and other expenses incurred by
FSC, Inc. in performing its obligations under the administration
agreement, including rent and the Company’s allocable
portion of the costs of compensation and related expenses of the
Company’s chief financial officer and chief compliance
officer and their staff. FSC, Inc. has voluntarily determined to
forgo receiving reimbursement for the services performed for the
Company by its chief compliance officer, Bernard D. Berman,
given his compensation arrangement with the Investment Adviser.
However, although FSC, Inc. currently intends to forgo its right
to receive such reimbursement, it is under no obligation to do
so and may cease to do so at any time in the future. FSC, Inc.
may also provide, on the Company’s behalf, managerial
assistance to the Company’s portfolio companies. The
administration agreement may be terminated by either party
without penalty upon 60 days’ written notice to the
other party.
For the year ended September 30, 2010, the Company accrued
administrative expenses of $2.4 million, including
$1.1 million of general and administrative expenses, that
are due to FSC, Inc. At September 30, 2010,
$1.1 million was included in Due to FSC, Inc. in the
Consolidated Statement of Assets and Liabilities.
112
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
| Note 12. | Financial Highlights |
|
Year Ended
|
Year Ended
|
Year Ended
|
||||||||||
|
September 30,
|
September 30,
|
September 30,
|
||||||||||
| 2010(1) | 2009(1) | 2008(1)(2) | ||||||||||
|
Per Share Data(3):
|
||||||||||||
|
Net asset value at beginning of period
|
$ | 10.84 | $ | 13.02 | $ | 8.56 | ||||||
|
Net investment income
|
0.95 | 1.27 | 0.89 | |||||||||
|
Net unrealized depreciation on investments and interest rate swap
|
(0.04 | ) | (0.44 | ) | (0.75 | ) | ||||||
|
Net realized loss on investments
|
(0.42 | ) | (0.58 | ) | — | |||||||
|
Dividends paid
|
(0.96 | ) | (1.20 | ) | (0.61 | ) | ||||||
|
Issuance of common stock
|
0.06 | (1.21 | ) | 2.11 | ||||||||
|
Repurchases of common stock
|
— | (0.02 | ) | — | ||||||||
|
Capital contributions from partners
|
— | — | 2.94 | |||||||||
|
Capital withdrawals by partners
|
— | — | (0.12 | ) | ||||||||
|
Net asset value at end of period
|
$ | 10.43 | $ | 10.84 | $ | 13.02 | ||||||
|
Per share market value at beginning of period
|
$ | 10.93 | $ | 10.05 | $ | 12.12 | ||||||
|
Per share market value at end of period
|
$ | 11.14 | $ | 10.93 | $ | 10.05 | ||||||
|
Total return(4)
|
11.22 | % | 26.86 | % | (13.90 | )% | ||||||
|
Common shares outstanding at beginning of period
|
37,878,987 | 22,614,289 | — | |||||||||
|
Common shares outstanding at end of period
|
54,550,290 | 37,878,987 | 22,614,289 | |||||||||
|
Net assets at beginning of period
|
410,556,071 | 294,335,839 | 106,815,695 | |||||||||
|
Net assets at end of period
|
569,172,105 | 410,556,071 | 294,335,839 | |||||||||
|
Average net assets(5)
|
479,003,947 | 291,401,218 | 205,932,850 | |||||||||
|
Ratio of net investment income to average net assets
|
8.98 | % | 10.76 | % | 9.78 | % | ||||||
|
Ratio of total expenses to average net assets
|
5.74 | % | 6.34 | % | 6.35 | % | ||||||
|
Ratio of portfolio turnover to average investments at fair value
|
2.24 | % | 0.00 | % | 0.00 | % | ||||||
|
Weighted average outstanding debt(6)
|
22,591,839 | 5,019,178 | 11,887,427 | |||||||||
|
Average debt per share
|
$ | 0.50 | $ | 0.20 | $ | 0.76 | ||||||
| (1) | The amounts reflected in the financial highlights above represent net assets, income and expense ratios for all stockholders. | |
| (2) | Per share data for the year ended September 30, 2008 presumes the issuance of the 12,480,972 common shares at October 1, 2007 which were actually issued on January 2, 2008 in connection with the merger described above. | |
| (3) | Based on actual shares outstanding at the end of the corresponding period or weighted average shares outstanding for the period, as appropriate. | |
| (4) | Total return equals the increase or decrease of ending market value over beginning market value, plus distributions, divided by the beginning market value, assuming dividend reinvestment prices obtained under the Company’s dividend reinvestment plan. Total return is not annualized during interim periods. | |
| (5) | Calculated based upon the weighted average net assets for the period. | |
| (6) | Calculated based upon the weighted average of loans payable for the period. |
| Note 13. | Preferred Stock |
The Company’s restated certificate of incorporation had not
authorized any shares of preferred stock. However, on
April 4, 2008, the Company’s Board of Directors
approved a certificate of amendment to its restated certificate
of incorporation reclassifying 200,000 shares of its common
stock as shares of non-convertible, non-participating preferred
stock, with a par value of $0.01 and a liquidation preference of
$500 per share (“Series A Preferred Stock”) and
authorizing the issuance of up to 200,000 shares of
Series A Preferred
113
FIFTH
STREET FINANCE CORP.
NOTES TO
CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Stock. The Company’s certificate of amendment was also
approved by the holders of a majority of the shares of its
outstanding common stock through a written consent first
solicited on April 7, 2008. On April 24, 2008, the
Company filed its certificate of amendment and on April 25,
2008, it sold 30,000 shares of Series A Preferred
Stock to a company controlled by Bruce E. Toll, one of the
Company’s directors at that time. During the year ended
September 30, 2008, the Company paid dividends of $234,000
on the 30,000 shares of Series A Preferred Stock. The
dividend payment is considered and included in interest expense
for accounting purposes since the preferred stock has a
mandatory redemption feature. On June 30, 2008, the Company
redeemed 30,000 shares of Series A Preferred Stock at
the mandatory redemption price of 101% of the liquidation
preference or $15,150,000. The $150,000 is considered and
included in interest expense for accounting purposes due to the
stock’s mandatory redemption feature.
On April 20, 2010, at the Company’s 2010 Annual
Meeting, the Company’s stockholders approved, among other
things, amendments to the Company’s restated certificate of
incorporation to increase the number of authorized shares of
common stock from 49,800,000 shares to
150,000,000 shares and to remove the Company’s
authority to issue shares of Series A Preferred Stock.
| Note 14. | Interest Rate Swaps |
In August 2010, the Company entered into a three-year interest
rate swap agreement to mitigate its exposure to adverse
fluctuations in interest rates for a total notional amount of
$100.0 million. Under the interest rate swap agreement, the
Company will pay a fixed interest rate of 0.99% and receive a
floating rate based on the prevailing one-month LIBOR, which as
of September 30, 2010 was 0.26%. For the year ended
September 30, 2010, the Company recorded $0.8 million
of unrealized depreciation related to this swap agreement. As of
September 30, 2010, this swap agreement had a fair value of
$(0.8 million), which is included in “accounts
payable, accrued expenses and other liabilities” in the
Company’s Consolidated Statements of Assets and Liabilities.
As of September 30, 2010, the Company has posted
$1.9 million of cash as collateral with respect to the
interest rate swap. The Company is restricted in terms of access
to this collateral until such swap is terminated or the swap
agreement expires. Cash collateral posted is held in an account
at Wells Fargo.
Swaps contain varying degrees of off-balance sheet risk which
could result from changes in the market values of underlying
assets, indices or interest rates and similar items. As a
result, the amounts recognized in the Consolidated Statement of
Assets and Liabilities at any given date may not reflect the
total amount of potential losses that the Company could
ultimately incur.
114
Schedule 12-14
Fifth
Street Finance Corp.
Schedule
of Investments in and Advances to Affiliates
|
Amount of
|
||||||||||||||||||||
|
Interest,
|
||||||||||||||||||||
|
Fees or
|
Fair Value
|
|||||||||||||||||||
|
Dividends
|
Fair Value
|
at
|
||||||||||||||||||
|
Credited in
|
at October 1,
|
Gross
|
Gross
|
September 30,
|
||||||||||||||||
|
Portfolio Company/Type of Investment(1)
|
Income(2) | 2009 | Additions(3) | Reductions(4) | 2010 | |||||||||||||||
|
Control Investments
|
||||||||||||||||||||
|
Lighting by Gregory, LLC
|
||||||||||||||||||||
|
First Lien Term Loan A, 9.75% due 2/28/2013
|
$ | 82,486 | $ | 2,419,627 | $ | — | $ | (915,911 | ) | $ | 1,503,716 | |||||||||
|
First Lien Term Loan B, 14.5% due 2/28/2013
|
100,341 | 3,271,480 | — | (1,075,196 | ) | 2,196,284 | ||||||||||||||
|
First Lien Bridge Loan, 8% due 10/15/2010
|
— | — | 150,000 | (150,000 | ) | — | ||||||||||||||
|
97.38% membership interest
|
— | — | — | — | — | |||||||||||||||
|
Total Control Investments
|
$ | 182,827 | $ | 5,691,107 | $ | 150,000 | $ | (2,141,107 | ) | $ | 3,700,000 | |||||||||
|
Affiliate Investments
|
||||||||||||||||||||
|
O’Currance, Inc.
|
||||||||||||||||||||
|
First Lien Term Loan A, 16.875% due 3/21/2012
|
1,928,958 | 10,186,501 | 899,299 | (280,025 | ) | 10,805,775 | ||||||||||||||
|
First Lien Term Loan B, 16.875% due 3/21/2012
|
420,577 | 2,919,071 | 152,040 | (1,174,466 | ) | 1,896,645 | ||||||||||||||
|
1.75% Preferred Membership Interest in O’Currance Holding
Co., LLC
|
— | 130,413 | — | (91,821 | ) | 38,592 | ||||||||||||||
|
3.3% Membership Interest in O’Currance Holding Co., LLC
|
— | 53,831 | — | (53,831 | ) | — | ||||||||||||||
|
CPAC, Inc.
|
||||||||||||||||||||
|
Second Lien Term Loan, 17.5% due 4/13/2012
|
1,234,701 | 4,448,661 | 3,625,144 | (8,073,805 | ) | — | ||||||||||||||
|
2,297 shares of Common Stock
|
— | — | — | — | — | |||||||||||||||
|
Elephant & Castle, Inc.
|
||||||||||||||||||||
|
Second Lien Term Loan, 15.5% due 4/20/2012
|
68,289 | 7,311,604 | 309,935 | (7,621,539 | ) | — | ||||||||||||||
|
7,500 shares of Series A Preferred Stock
|
— | 492,469 | — | (492,469 | ) | — | ||||||||||||||
|
MK Network, LLC
|
||||||||||||||||||||
|
First Lien Term Loan A, 13.5% due 6/1/2012
|
1,460,576 | 9,033,826 | 510,044 | (1,630,730 | ) | 7,913,140 | ||||||||||||||
|
First Lien Term Loan B, 17.5% due 6/1/2012
|
957,980 | 5,163,544 | 334,625 | (1,559,509 | ) | 3,938,660 | ||||||||||||||
|
First Lien Revolver, Prime + 1.5% (10% floor), due 6/1/2010
|
— | — | — | — | — | |||||||||||||||
|
11,030 Membership Units
|
— | — | — | — | — | |||||||||||||||
|
Martini Park, LLC
|
||||||||||||||||||||
|
First Lien Term Loan, 14% due 2/20/2013
|
228,975 | 2,068,303 | 3,631,618 | (5,699,921 | ) | — | ||||||||||||||
|
5% membership interest
|
— | — | 650,000 | (650,000 | ) | — | ||||||||||||||
|
Caregiver Services, Inc.
|
||||||||||||||||||||
|
Second Lien Term Loan A, LIBOR+6.85% (12% floor) due 2/25/2013
|
1,084,474 | 8,225,400 | 372,270 | (1,484,048 | ) | 7,113,622 | ||||||||||||||
|
Second Lien Term Loan B, 16.5% due 2/25/2013
|
2,894,827 | 13,508,338 | 1,355,767 | (684,479 | ) | 14,179,626 | ||||||||||||||
|
1,080,399 shares of Series A Preferred Stock
|
— | 1,206,599 | 129,400 | — | 1,335,999 | |||||||||||||||
|
Total Affiliate Investments
|
$ | 10,279,357 | $ | 64,748,560 | $ | 11,970,142 | $ | (29,496,643 | ) | $ | 47,222,059 | |||||||||
|
Total Control & Affiliate Investments
|
$ | 10,462,184 | $ | 70,439,667 | $ | 12,120,142 | $ | (31,637,750 | ) | $ | 50,922,059 | |||||||||
This schedule should be read in connection with the
Company’s Consolidated Financial Statements, including the
Schedules of Investments and Notes to the Consolidated Financial
Statements.
115
| (1) | The principal amount and ownership detail as shown in the Consolidated Schedules of Investments. | |
| (2) | Represents the total amount of interest, fees and dividends credited to income for the portion of the year an investment was included in the Control or Non-Control/Non-Affiliate categories, respectively. | |
| (3) | Gross additions include increases in the cost basis of investments resulting from new portfolio investments, follow-on Investments and accrued PIK interest, and the exchange of one or more existing securities for one or more new securities. Gross additions also include net increases in unrealized appreciation or net decreases in unrealized depreciation as well as the movement of an existing portfolio company into this category or out of a different category. | |
| (4) | Gross reductions include decreases in the cost basis of investment resulting from principal payments or sales and exchanges of one or more existing securities for one or more new securities. Gross reductions also include net increases in unrealized depreciation or net decreases in unrealized appreciation as well as the movement of an existing portfolio company out of this category and into a different category. |
116
Schedule 12-14
Fifth
Street Finance Corp.
Schedule
of Investments in and Advances to Affiliates
|
Amount of
|
||||||||||||||||||||
|
Interest,
|
||||||||||||||||||||
|
Fees or
|
Fair Value
|
|||||||||||||||||||
|
Dividends
|
Fair Value
|
at
|
||||||||||||||||||
|
Credited in
|
at October 1,
|
Gross
|
Gross
|
September 30,
|
||||||||||||||||
|
Portfolio Company/Type of Investment(1)
|
Income(2) | 2008 | Additions(3) | Reductions(4) | 2009 | |||||||||||||||
|
Control Investments
|
||||||||||||||||||||
|
Lighting by Gregory, LLC
|
||||||||||||||||||||
|
First Lien Term Loan A, 9.75% due 2/28/2013
|
$ | — | $ | — | $ | 3,044,732 | $ | (625,105 | ) | $ | 2,419,627 | |||||||||
|
First Lien Term Loan B, 14.5% due 2/28/2013
|
— | — | 4,138,390 | (866,910 | ) | 3,271,480 | ||||||||||||||
|
97.38% membership interest
|
— | — | 300,000 | (300,000 | ) | — | ||||||||||||||
|
Total Control Investments
|
$ | — | $ | — | $ | 7,483,122 | $ | (1,792,015 | ) | $ | 5,691,107 | |||||||||
|
Affiliate Investments
|
||||||||||||||||||||
|
O’Currance, Inc.
|
||||||||||||||||||||
|
First Lien Term Loan A, 16.875% due 3/21/2012
|
1,856,153 | 9,888,488 | 511,758 | (213,745 | ) | 10,186,501 | ||||||||||||||
|
First Lien Term Loan B, 16.875% due 3/21/2012
|
573,147 | 3,581,245 | 367,826 | (1,030,000 | ) | 2,919,071 | ||||||||||||||
|
1.75% Preferred Membership Interest in O’Currance Holding
Co., LLC
|
— | 130,413 | — | — | 130,413 | |||||||||||||||
|
3.3% Membership Interest in O’Currance Holding Co., LLC
|
— | 97,156 | — | (43,325 | ) | 53,831 | ||||||||||||||
|
CPAC, Inc.
|
||||||||||||||||||||
|
Second Lien Term Loan, 17.5% due 4/13/2012
|
1,318,008 | 3,626,497 | 4,932,164 | (4,110,000 | ) | 4,448,661 | ||||||||||||||
|
2,297 shares of Common Stock
|
— | — | — | — | — | |||||||||||||||
|
Elephant & Castle, Inc.
|
||||||||||||||||||||
|
Second Lien Term Loan, 15.5% due 4/20/2012
|
1,472,389 | 7,145,198 | 449,845 | (283,439 | ) | 7,311,604 | ||||||||||||||
|
7,500 shares of Series A Preferred Stock
|
— | 196,386 | 296,083 | — | 492,469 | |||||||||||||||
|
MK Network, LLC
|
||||||||||||||||||||
|
First Lien Term Loan A, 13.5% due 6/1/2012
|
1,462,272 | 9,115,152 | 161,959 | (243,285 | ) | 9,033,826 | ||||||||||||||
|
First Lien Term Loan B, 17.5% due 6/1/2012
|
872,070 | — | 5,581,544 | (418,000 | ) | 5,163,544 | ||||||||||||||
|
First Lien Revolver, Prime + 1.5% (10% floor), due 6/1/2010
|
17,111 | (11,113 | ) | 17,113 | (6,000 | ) | — | |||||||||||||
|
11,030 Membership Units
|
— | 760,441 | 186,780 | (947,221 | ) | — | ||||||||||||||
|
Rose Tarlow, Inc.
|
||||||||||||||||||||
|
First Lien Term Loan, 12% due 1/25/2014
|
1,128,302 | 9,796,648 | 177,084 | (9,973,732 | ) | — | ||||||||||||||
|
First Lien Revolver, LIBOR+4% (9% floor) due 1/25/2014
|
123,460 | 323,333 | 1,214,827 | (1,538,160 | ) | — | ||||||||||||||
|
6.9% membership interest in RTMH Acquisition Company
|
— | 591,939 | — | (591,939 | ) | — | ||||||||||||||
|
0.1% membership interest in RTMH Acquisition Company
|
— | 11,607 | — | (11,607 | ) | — | ||||||||||||||
|
Martini Park, LLC
|
||||||||||||||||||||
|
First Lien Term Loan, 14% due 2/20/2013
|
475,732 | 2,719,236 | 220,000 | (870,933 | ) | 2,068,303 | ||||||||||||||
|
5% membership interest
|
— | — | — | — | — | |||||||||||||||
|
Caregiver Services, Inc.
|
||||||||||||||||||||
|
Second Lien Term Loan A, LIBOR+6.85% (12% floor) due 2/25/2013
|
1,263,662 | 9,381,973 | 288,785 | (1,445,358 | ) | 8,225,400 | ||||||||||||||
|
Second Lien Term Loan B, 16.5% due 2/25/2013
|
2,806,310 | 12,811,951 | 1,101,389 | (405,002 | ) | 13,508,338 | ||||||||||||||
|
1,080,399 shares of Series A Preferred Stock
|
— | 1,183,867 | 22,732 | — | 1,206,599 | |||||||||||||||
|
Total Affiliate Investments
|
$ | 13,368,616 | $ | 71,350,417 | $ | 15,529,889 | $ | (22,131,746 | ) | $ | 64,748,560 | |||||||||
|
Total Control & Affiliate Investments
|
$ | 13,368,616 | $ | 71,350,417 | $ | 23,013,011 | $ | (23,923,761 | ) | $ | 70,439,667 | |||||||||
117
This schedule should be read in connection with the
Company’s Consolidated Financial Statements, including the
Schedules of Investments and Notes to the Consolidated Financial
Statements.
| (1) | The principal amount and ownership detail as shown in the Consolidated Schedules of Investments. | |
| (2) | Represents the total amount of interest, fees and dividends credited to income for the portion of the year an investment was included in the Control or Non-Control/Non-Affiliate categories, respectively. | |
| (3) | Gross additions include increases in the cost basis of investments resulting from new portfolio investments, follow-on Investments and accrued PIK interest, and the exchange of one or more existing securities for one or more new securities. Gross additions also include net increases in unrealized appreciation or net decreases in unrealized depreciation as well as the movement of an existing portfolio company into this category or out of a different category. | |
| (4) | Gross reductions include decreases in the cost basis of investment resulting from principal payments or sales and exchanges of one or more existing securities for one or more new securities. Gross reductions also include net increases in unrealized depreciation or net decreases in unrealized appreciation as well as the movement of an existing portfolio company out of this category and into a different category. |
118
| Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure |
Not applicable.
| Item 9A. | Controls and Procedures |
| (a) | Evaluation of Disclosure Controls and Procedures |
As of September 30, 2010 (the end of the period covered by
this report), management, with the participation of our Chief
Executive Officer and Chief Financial Officer, evaluated the
effectiveness of the design and operation of our disclosure
controls and procedures (as defined in
Rule 13a-15(e)
and
15d-15(e)
of
the Securities and Exchange Act of 1934, as amended). Based on
that evaluation, our Chief Executive Officer and Chief Financial
Officer concluded that, at the end of such period, our
disclosure controls and procedures were effective and provided
reasonable assurance that information required to be disclosed
in our periodic SEC filings is recorded, processed, summarized
and reported within the time periods specified in the SEC’s
rules and forms, and that such information is accumulated and
communicated to our management, including our Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow
timely decisions regarding required disclosure. However, in
evaluating the disclosure controls and procedures, management
recognized that any controls and procedures, no matter how well
designed and operated can provide only reasonable assurance of
achieving the desired control objectives, and management
necessarily was required to apply its judgment in evaluating the
cost-benefit relationship of such possible controls and
procedures.
| (b) | Management’s Report on Internal Control Over Financial Reporting |
Management is responsible for establishing and maintaining
adequate internal control over financial reporting as such term
is defined in Exchange Act
Rule 13a-15(f),
and for performing an assessment of the effectiveness of
internal control over financial reporting as of
September 30, 2010. Internal control over financial
reporting is a process designed by, or under the supervision of,
our principal executive and principal financial officers, or
persons performing similar functions, and effected by our Board
of Directors, management and other personnel, to provide
reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for
external purposes in accordance with generally accepted
accounting principles. Our internal control over financial
reporting includes those policies and procedures that
(i) pertain to the maintenance of records that in
reasonable detail accurately and fairly reflect the transactions
and dispositions of assets of the company; (ii) provide
reasonable assurance that transactions are recorded as necessary
to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and
expenditures are being made only in accordance with
authorizations; and (iii) provide reasonable assurance
regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of our assets that could have a
material effect on the financial statements.
Because of its inherent limitations, internal control over
financial reporting may not prevent or detect misstatements.
Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial
statement preparation and presentation.
Management performed an assessment of the effectiveness of our
internal control over financial reporting as of
September 30, 2010 based upon the criteria set forth in
Internal Control — Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission
(“COSO”). Based on our assessment, management
determined that our internal control over financial reporting
was effective as of September 30, 2010.
| (c) | Report of the Independent Registered Public Accounting Firm |
The effectiveness of our internal control over financial
reporting as of September 30, 2010 has been audited by
PricewaterhouseCoopers LLP, an independent registered public
accounting firm, as stated in their report which appears herein.
119
| (d) | Changes in Internal Controls Over Financial Reporting |
There have been no changes in our internal control over
financing reporting that occurred during the fourth fiscal
quarter of 2010 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial
reporting.
| Item 9B. | Other Information |
None
120
We will file a definitive Proxy Statement for our 2011 Annual
Meeting of Stockholders with the Securities and Exchange
Commission, pursuant to Regulation 14A, not later than
120 days after the end of our fiscal year. Accordingly,
certain information required by Part III has been omitted
under General Instruction G(3) to
Form 10-K.
Only those sections of our definitive Proxy Statement that
specifically address the items set forth herein are incorporated
by reference.
| Item 10. | Directors, Executive Officers and Corporate Governance |
The information required by Item 10 is hereby incorporated
by reference from our definitive Proxy Statement relating to our
2011 Annual Meeting of Stockholders, to be filed with the
Securities and Exchange Commission within 120 days
following the end of our fiscal year.
| Item 11. | Executive Compensation |
The information required by Item 11 is hereby incorporated
by reference from our definitive Proxy Statement relating to our
2011 Annual Meeting of Stockholders, to be filed with the
Securities and Exchange Commission within 120 days
following the end of our fiscal year.
| Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |
The information required by Item 12 is hereby incorporated
by reference from our definitive Proxy Statement relating to our
2011 Annual Meeting of Stockholders, to be filed with the
Securities and Exchange Commission within 120 days
following the end of our fiscal year.
| Item 13. | Certain Relationships and Related Transactions, and Director Independence |
The information required by Item 13 is hereby incorporated
by reference from our definitive Proxy Statement relating to our
2011 Annual Meeting of Stockholders, to be filed with the
Securities and Exchange Commission within 120 days
following the end of our fiscal year.
| Item 14. | Principal Accountant Fees and Services |
The information required by Item 14 is hereby incorporated
by reference from our definitive Proxy Statement relating to our
2011 Annual Meeting of Stockholders, to be filed with the
Securities and Exchange Commission within 120 days
following the end of our fiscal year.
121
| Item 15. | Exhibits and Financial Statement Schedules |
The following documents are filed or incorporated by reference
as part of this Annual Report:
| 1. | Consolidated Financial Statements |
| Page | ||||
|
Reports of Independent Registered Public Accounting Firm
|
70 | |||
|
Consolidated Statement of Assets and Liabilities as of
September 30, 2010 and 2009
|
72 | |||
|
Statements of Operations for the Years Ended September 30,
2010, 2009 and 2008
|
73 | |||
|
Consolidated Statements of Changes in Net Assets for the Years
Ended September 30, 2010, 2009 and 2008
|
74 | |||
|
Consolidated Statements of Cash Flows for the Years Ended
September 30, 2010, 2009 and 2008
|
75 | |||
|
Consolidated Schedules of Investments as of September 30,
2010 and 2009
|
76 | |||
|
Notes to Consolidated Financial Statements
|
86 | |||
| 2. | Financial Statement Schedule |
The following financial statement schedule is filed herewith:
Schedule 12-14 —
Investments in and advances to affiliates 115
| 3. | Exhibits required to be filed by Item 601 of Regulation S-K |
The following exhibits are filed as part of this report or
hereby incorporated by reference to exhibits previously filed
with the SEC:
| 3 | .1 | Restated Certificate of Incorporation of the Registrant (Incorporated by reference to Exhibit 3.1 filed with Fifth Street Finance Corp.’s Form 8-A (File No. 001-33901) filed on January 2, 2008). | ||
| 3 | .2 | Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation (Incorporated by reference to Exhibit (a)(2) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-146743) filed on June 6, 2008). | ||
| 3 | .3 | Certificate of Correction to the Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation (Incorporated by reference to Exhibit (a)(3) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-146743) filed on June 6, 2008). | ||
| 3 | .4 | Certificate of Amendment to Registrant’s Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 filed with Fifth Street Finance Corp.’s Quarterly Report on Form 10-Q (File No. 814-0075) filed on May 5, 2010). | ||
| 3 | .5 | Amended and Restated By-laws of the Registrant (Incorporated by reference to Exhibit 3.2 filed with Fifth Street Finance Corp.’s Form 8-A (File No. 001-33901) filed on January 2, 2008). | ||
| 4 | .1 | Form of Common Stock Certificate (Incorporated by reference to Exhibit 4.1 filed with Fifth Street Finance Corp.’s Form 8-A (File No. 001-33901) filed on January 2, 2008). | ||
| 10 | .1 | Amended and Restated Dividend Reinvestment Plan (Incorporated by reference to Exhibit 10.1 filed with Fifth Street Finance Corp.’s Form 8-K (File No. 001-33901) filed on October 28, 2010). | ||
| 10 | .2 | Form of Amended and Restated Investment Advisory Agreement by and between Registrant and Fifth Street Management LLC (Incorporated by reference to Exhibit (g) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-146743) filed on May 8, 2008). | ||
| 10 | .3 | Custodial Agreement (Incorporated by reference to Exhibit (j) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-146743) filed on June 6, 2008). | ||
| 10 | .4 | Form of Administration Agreement by and between Registrant and FSC, Inc. (Incorporated by reference to Exhibit (k)(1) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-146743) filed on May 8, 2008). |
122
| 10 | .5 | Form of License Agreement by and between Registrant and Fifth Street Capital LLC (Incorporated by reference to Exhibit (k)(2) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-146743) filed on May 8, 2008). | ||
| 10 | .6* | Amended and Restated Loan and Servicing Agreement among Fifth Street Funding, LLC, Registrant, Wells Fargo Securities, LLC, and Wells Fargo Bank, National Association, dated as of November 5, 2010. | ||
| 10 | .7 | Purchase and Sale Agreement by and between Registrant and Fifth Street Funding, LLC, dated as of November 16, 2009. | ||
| 10 | .8 | Pledge Agreement by and between Registrant and Wells Fargo Bank, National Association, dated as of November 16, 2009. | ||
| 10 | .9 | Omnibus Amendment No. 1 relating to Registrant’s credit facility with Wells Fargo Bank, National Association, dated as of May 26, 2010 (Incorporated by reference to Exhibit (k)(6) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-16612) filed on June 4, 2010). | ||
| 10 | .10 | Senior Secured Revolving Credit Agreement among Registrant, ING Capital LLC, Royal Bank of Canada, UBS Loan Finance LLC and Morgan Stanley Bank, N.A., dated as of May 27, 2010 (Incorporated by reference to Exhibit (k)(7) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-16612) filed on June 4, 2010). | ||
| 10 | .11 | Guarantee, Pledge and Security Agreement among Registrant, FSFC Holdings, Inc., FSF/MP Holdings, Inc. and ING Capital LLC, dated as of May 27, 2010 (Incorporated by reference to Exhibit (k)(8) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-16612) filed on June 4, 2010). | ||
| 21 |
Subsidiaries of Registrant and jurisdiction of
incorporation/organizations:
Fifth Street Funding, LLC — Delaware Fifth Street Fund of Funds, LLC — Delaware Fifth Street Mezzanine Partners IV, L.P. — Delaware FSMP IV GP, LLC — Delaware FSFC Holdings, Inc. — Delaware FSF/MP Holdings, Inc. — Delaware |
|||
| 31 | .1* | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. | ||
| 31 | .2* | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. | ||
| 32 | .1* | Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U. S. C. 1350). | ||
| 32 | .2* | Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U. S. C. 1350). |
| * | Filed herewith. |
123
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
FIFTH STREET FINANCE CORP.
| By: |
/s/ Leonard
M. Tannenbaum
|
Leonard M. Tannenbaum
Chairman and Chief Executive Officer
| By: |
/s/ William
H. Craig
|
William H. Craig
Chief Financial Officer
Date: December 1, 2010
Pursuant to the requirements of the Securities Exchange Act of
1934, this report has been signed below by the following persons
on behalf of the registrant and in the capacities and on the
dates indicated.
|
Signature
|
Title
|
Date
|
||||
|
/s/
LEONARD
M. TANNENBAUM
|
Chairman and Chief Executive Officer (principal executive officer) | December 1, 2010 | ||||
|
/s/
WILLIAM
H. CRAIG
|
Chief Financial Officer
(principal financial officer) |
December 1, 2010 | ||||
|
/s/
BERNARD
D. BERMAN
|
President, Secretary and Chief Compliance Officer | December 1, 2010 | ||||
|
/s/
RICHARD
P. DUTKIEWICZ
|
Director | December 1, 2010 | ||||
|
/s/
BRIAN
S. DUNN
|
Director | December 1, 2010 | ||||
|
/s/
BYRON
J. HANEY
|
Director | December 1, 2010 | ||||
|
/s/
FRANK
C. MEYER
|
Director | December 1, 2010 | ||||
|
/s/
DOUGLAS
F. RAY
|
Director | December 1, 2010 | ||||
124
TABLE OF CONTENTS
Part IItem 1. BusinessItem 1A. Risk FactorsItem 1B. Unresolved Staff CommentsItem 2. PropertiesItem 3. Legal ProceedingsPart IIItem 5. Market For Registrant S Common Equity, Related Stockholder Matters and Issuer Purchases Of Equity SecuritiesItem 6. Selected Financial DataItem 7. Management S Discussion and Analysis Of Financial Condition and Results Of OperationsItem 7A. Quantitative and Qualitative Disclosures About Market RiskItem 8. Consolidated Financial Statements and Supplementary DataNote 1. OrganizationNote 2. Significant Accounting PoliciesNote 3. Portfolio InvestmentsNote 4. Fee IncomeNote 5. Share DataNote 6. Lines Of CreditNote 7. Interest and Dividend IncomeNote 8. Taxable Distributable Income and Dividend DistributionsNote 9. Realized Gains Or Losses From Investments and Net Change in Unrealized Appreciation Or Depreciation From InvestmentsNote 10. Concentration Of Credit RisksNote 11. Related Party TransactionsNote 12. Financial HighlightsNote 13. Preferred StockNote 14. Interest Rate SwapsItem 9. Changes in and Disagreements with Accountants on Accounting and Financial DisclosureItem 9A. Controls and ProceduresItem 9B. Other InformationPart IIIItem 10. Directors, Executive Officers and Corporate GovernanceItem 11. Executive CompensationItem 12. Security Ownership Of Certain Beneficial Owners and Management and Related Stockholder MattersItem 13. Certain Relationships and Related Transactions, and Director IndependenceItem 14. Principal Accountant Fees and ServicesPart IVItem 15. Exhibits and Financial Statement Schedules