In addition, words such as "anticipate," "believe," "expect" and "intend" indicate a forward-looking statement, although not all forward-looking statements include these words. The forward-looking statements contained in this quarterly report on Form 10-Q 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 "Risk Factors" and elsewhere in this Form 10-Q. Other factors that could cause actual results to differ materially include:
• changes in the economy;
• risks associated with possible disruption in our operations or the economy generally due to terrorism or natural disasters; and
• future changes in laws or regulations and conditions in our operating areas.

We have based the forward-looking statements included in this quarterly report on Form 10-Q on information available to us on the date of this quarterly 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 Securities and Exchange Commission, or the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.
Except as otherwise specified, references to "the Company," "we," "us," and "our," refer to Fifth Street Finance Corp. 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 Mezzanine Partners III, L.P. were exchanged for 12,480,972 shares of common stock in Fifth Street Finance Corp.
Our 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. The Company's shares are currently listed on the New York Stock Exchange under the symbol "FSC."
Critical Accounting Policies
The preparation of financial statements in accordance with accounting principles generally accepted in the United States (GAAP) requires management to make certain estimates and assumptions affecting amounts reported in the 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.
We base the fair value of our investments on the enterprise value of the portfolio companies in which we invest. The enterprise value is the value at which an enterprise could be sold in a transaction between two willing parties other than through a forced or liquidation sale. Typically, private companies are bought and sold based on multiples of EBITDA, cash flows, net income, revenues, or in limited cases, book value. There is no single methodology for determining enterprise value. Enterprise value is generally described as a range of values from which a single estimate of enterprise value is derived. In determining the enterprise value of a portfolio company, we analyze various factors, including the portfolio company's historical and projected financial results. We also generally prepare and analyze discounted cash flow models based on our projections of the future free cash flows of the business and industry derived capital costs. We review external events, including mergers and acquisitions, and include these events in the enterprise valuation process.
Due to the inherent uncertainty in the valuation process, our estimate of fair value may differ materially from the values that would have been used had a ready market for the securities existed. In addition, changes in the market environment and other events that may occur over the lives of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned. We determine the fair value of each individual investment and record changes in fair value as unrealized appreciation or depreciation.
If there is adequate enterprise value to support the repayment of the debt, the fair value of our loan or debt security normally corresponds to cost plus accumulated unearned income unless the borrower's condition or other factors lead to a determination of fair value at a different amount. The fair value of equity interests in portfolio companies is determined based on various factors, including revenues, EBITDA and cash flow from operations of the portfolio company and other pertinent factors such as recent offers to purchase a portfolio company's securities, financing events or other liquidation events.

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 valuation conclusions are then reviewed and discussed with the principals of our investment adviser;

• An independent valuation firm engaged by the Board of Directors reviews these preliminary valuations on a selected basis and submits a report to us;

• The Valuation Committee of our Board of Directors reviews the preliminary valuations and the report of the independent valuation firm, and the deal team responds and supplements the preliminary valuations to reflect any comments provided by the Valuation Committee; and

• The Board of Directors discusses valuations and determines the fair value of each investment in our portfolio in good faith.

The fair value of our investments at September 30, 2007 was determined by the general partner of Fifth Street Mezzanine Partners III, L.P. and at June 30, 2008 was determined by our Board of Directors.
Our Board of Directors has engaged an independent valuation firm to provide us with valuation assistance with respect to at least 90% of the cost basis of our investment portfolio in any given quarter. Upon completion of its process each quarter, the independent valuation firm 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 an independent valuation firm 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.
An independent valuation firm, Murray, Devine & Co., Inc., provided us with assistance in our determination of the fair value of 91.9% of our portfolio for the quarter ended December 31, 2007, 92.1% of our portfolio for the quarter ended March 31, 2008 and 91.7% of our portfolio for the quarter ended June 30, 2008.
In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, Fair Value Measurement ("SFAS No. 157"). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements, but does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently analyzing the effect of adoption of this statement on our financial position, including our net asset value, and results of operations. We will adopt this statement on a prospective basis beginning in the quarter ending December 31, 2008. Adoption of this statement could have a material effect on our financial statements, including our net asset value. However, the actual impact on our financial statements for the period of adoption and subsequent to the period of adoption cannot be determined at this time as it will be influenced by the estimates of fair value for that period and the number and amount of investments we originate, acquire or exit.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities ("SFAS 159"), which provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities and to more easily understand the effect of the company's choice to use fair value on its earnings. SFAS 159 also requires entities to display the fair value of the selected assets and liabilities on the face of the combined balance sheet. SFAS 159 does not eliminate disclosure requirements of other accounting standards, including fair value measurement disclosures in SFAS 157. This Statement is effective as of the beginning of an entity's first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of Statement 157. At this time, we are evaluating the implications of SFAS 159, and its impact on the financial statements has not yet been determined.
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 and write off any previously accrued and uncollected interest 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 will receive a variety of fees in the ordinary course of our business, including origination fees. We will account for our fee income in accordance with Emerging Issues Task Force Issue 00-21 "Accounting for Revenue Arrangements with Multiple Deliverables" ("EITF 00-21"). EITF 00-21 addresses certain aspects of a company's accounting for arrangements containing multiple revenue-generating activities. In some arrangements, the different revenue-generating activities (deliverables) are sufficiently separable and there exists sufficient evidence of their fair values to separately account for some or all of the deliverables (i.e., there are separate units of accounting). EITF 00-21 states that the total consideration received for the arrangement be allocated to each unit based upon each unit's relative fair value. In other arrangements, some or all of the deliverables are not independently functional, or there is not sufficient evidence of their fair values to account for them separately. The timing of revenue recognition for a given unit of accounting depends on the nature of the deliverable(s) in that accounting unit (and the corresponding revenue recognition model) and whether the general conditions for revenue recognition have been met. Fee income for which fair value cannot be reasonably ascertained is recognized using the interest method in accordance with Statement of Financial Accounting Standards No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases," ("SFAS No. 91"). We will recognize fee income in accordance with SFAS No. 91. In addition, we will capitalize and offset direct loan origination costs against the origination fees received and only defer the net fee.
Payment-in-Kind (PIK) Interest
Our loans typically contain a 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 may need to be paid out to stockholders in the form of distributions, even though we have not yet collected the cash. We will stop accruing PIK interest and write off any accrued and uncollected interest when it is determined that PIK interest is no longer collectable. Accrued PIK interest represented $3.1 million or 1.4% of our portfolio of investments (excluding unearned income) as of June 30, 2008. The net increase in loan balances as a result of contracted PIK arrangements are separately identified on our 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.
A summary of the composition of our investment portfolio at cost and fair value, excluding unearned income, as a percentage of total investments is shown in following tables:

              Cost              June 30, 2008      September 30, 2007

              First lien debt          34.8    %                  6.3    %
              Second lien debt         61.3    %                 87.5    %
              Equity                    1.7    %                  2.0    %
              Equity grants             2.2    %                  4.2    %

                                     100.00    %               100.00    %


              Fair Value        June 30, 2008      September 30, 2007

              First lien debt          36.8    %                  6.3    %
              Second lien debt         60.9    %                 87.4    %
              Equity                    1.0    %                  2.1    %
              Equity grants             1.3    %                  4.2    %

                                     100.00    %               100.00    %

Set forth below are tables showing the industry composition of our portfolio at cost and fair value as of June 30, 2008 and September 30, 2007 (excluding unearned income):

  Cost:                                     June 30, 2008      September 30, 2007

  Media: Advertising                                5.6    %                 14.0    %
  Food Distributors                                 5.3    %                 13.4    %
  Household Products / Specialty Chemicals          5.1    %                 12.6    %
  Healthcare Services                               4.3    %                 11.1    %
  Data Processing and Outsourced Services           6.1    %                 10.9    %
  Commodity Chemicals                               3.9    %                  9.8    %
  Restaurants                                       8.5    %                  8.5    %
  Leisure Facilities                                2.9    %                  7.5    %
  Construction & Engineering                        4.6    %                  6.6    %
  Building Products                                 3.1    %                  5.6    %
  Trailer Leasing Services                          7.5    %                  0.0    %
  Footwear and Apparel                              7.9    %                  0.0    %
  Lumber Products                                   4.5    %                  0.0    %
  Capital Goods                                     3.2    %                  0.0    %
  Home Furnishing Retail                            4.9    %                  0.0    %
  Healthcare Facilities                            10.3    %                  0.0    %
  Housewares & Specialties                          5.2    %                  0.0    %
  Manufacturing - Machine Products                  7.1    %                  0.0    %

  Total                                          100.00    %               100.00    %




 Fair Value:                               June 30, 2008       September 30, 2007

 Media: Advertising                                5.8    %                13.9    %
 Food Distributors                                 5.6    %                13.4    %
 Household Products / Specialty Chemicals          2.7    %                12.6    %
 Healthcare Services                               4.6    %                11.4    %
 Data Processing and Outsourced Services           6.4    %                10.9    %
 Commodity Chemicals                               4.1    %                 9.9    %
 Restaurants                                       8.6    %                 8.2    %
 Leisure Facilities                                3.1    %                 7.5    %
 Construction & Engineering                        4.9    %                 6.7    %
 Building Products                                 3.3    %                 5.5    %
 Trailer Leasing Services                          7.8    %                 0.0    %
 Footwear and Apparel                              8.3    %                 0.0    %
 Lumber Products                                   2.5    %                 0.0    %
 Capital Goods                                     3.4    %                 0.0    %
 Home Furnishing Retail                            5.0    %                 0.0    %
 Healthcare Facilities                            10.9    %                 0.0    %
 Housewares & Specialties                          5.5    %                 0.0    %
 Manufacturing - Machine Products                  7.5    %                 0.0    %

 Total                                          100.00    %              100.00    %

Portfolio Asset Quality
We employ a grading system to assess and monitor the credit risk of our loan portfolio. We rate all loans 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, excluding unearned income, as of June 30, 2008 and September 30, 2007:

                                                          June 30, 2008                                          September 30, 2007
                     Investment at Fair       Percentage of Total                            Investment at      Percentage of Total
Investment Rating          Value                   Portfolio            Leverage Ratio        Fair Value             Portfolio            Leverage Ratio

1. $ 14,126,633 6.5 % 3.59 $ - - % -
2. 183,518,524 84.3 % 3.73 80,147,085 89.10 % 3.48
3. 20,097,286 9.2 % 7.07 9,810,060 10.90 % 5.14
4. - - % - - - % -
5. - - % - - - % -

Total $ 217,742,443 100.00 % 4.03 $ 89,957,145 100.00 % 3.70

Loans and Debt Securities on Non-Accrual Status At June 30, 2008 none of our loans or debt securities were on non-accrual status.
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 cost. Net unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio. We were formed as a Delaware limited partnership (Fifth Street Mezzanine Partners III, L.P.) on February 15, 2007 and we had limited operations through June 30, 2007. As a result, there is limited comparability for the nine months ended June 30 2008 and the prior period from February 15, 2007 (inception) through June 30, 2007. Comparison for the three months ended June 30, 2008 and 2007 Total Investment Income Total investment income included interest and dividend income on our investments, fee income and other investment income. Fee income consists principally of loan and arrangement fees, annual administrative fees, unused fees, prepayment fees, amendment fees, equity structuring fees and waiver fees. Other investment income consists primarily of the accelerated recognition of deferred financing fees received from our portfolio companies on the repayment of the outstanding investment, the sale of the investment or reduction of available credit, and interest on cash and cash equivalents on deposit with financial institutions. Total investment income for the three months ended June 30, 2008 and 2007 was approximately $9.2 million and $1.5 million, respectively. For the three months ended June 30, 2008, this amount consisted of interest income of approximately $128,000 from cash and cash equivalents, $8.6 million of interest and dividend income from portfolio investments (which included $1.6 million in payment-in-kind or PIK interest and dividends), and $455,000 in fee income. For the three months ended June 30, 2007, this amount primarily consisted of approximately $1.4 million of interest income from portfolio investments (which included $226,000 in payment-in-kind or PIK interest), and $83,000 in fee income. The increase in our total investment income for the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 was primarily attributable to an increase in the weighted average fair value balance outstanding of our interest-bearing investment portfolio during the quarter ended June 30, 2008. During the three months ended June 30, 2008, the weighted average fair value balance outstanding of our interest-bearing investment portfolio was approximately $215.8 million as compared to approximately $33.1 million during the three months ended June 30, 2007. This $182.7 million increase is substantially the result of additional capital financing from the issuance of common stock in June 2008, contributions from partners after June 30, 2007, and borrowings. The increase in total investment income was partially offset by a decrease in the weighted average yield of our investments. Our weighted average yield on debt investments was 16.5% at June 30, 2008, and 17.6% at June 30, 2007. The weighted average yield on debt investments at June 30, 2008 included a cash component of 13.5%. The weighted average yield decreased as a result of a shift in our portfolio mix towards more senior secured investments and an overall decrease in market interest rates.

Expenses
Expenses for the three months ended June 30, 2008 and 2007 were approximately $4.1 million and $1.6 million, respectively. Expenses increased for the three months ended June 30, 2008 as compared to the three months ended June 30, 2007 by approximately $2.5 million, primarily as a result of increases in management and incentive fees of $1.8 million, higher interest expenses of $360,000, and higher administrator expenses of $379,000.
The increase in management fees reflects the increase in the Company's total assets as reflected in the growth of the investment portfolio. 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. The increase in . . .