Search the web
Welcome, Guest
[Sign Out, My Account]
EDGAR_Online

Quotes & Info
Enter Symbol(s):
e.g. YHOO, ^DJI
Symbol Lookup | Financial Search
FSC > SEC Filings for FSC > Form 10-K on 28-Nov-2012All Recent SEC Filings

Show all filings for FIFTH STREET FINANCE CORP

Form 10-K for FIFTH STREET FINANCE CORP


28-Nov-2012

Annual Report


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 forward-looking statements, 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:

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 business development companies, 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.

Except as otherwise specified, references to the "Company," "we," "us," and "our," refer to Fifth Street Finance Corp.

All amounts are in thousands, except share and per share amounts, percentages and as otherwise indicated.

Overview

We are a specialty finance company that lends to and invests in small and mid-sized companies primarily 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.


Table of Contents

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 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 stock was listed on the New York Stock Exchange until November 28, 2011 when the Company transferred the listing to the NASDAQ Global Select Market, where it continues to trade under the symbol "FSC."

Current Market Conditions

Since mid-2007, the global financial markets have experienced 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 investment portfolio by strategically investing in small and mid-sized companies when and where appropriate. 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.

Critical Accounting Policies

Basis of Presentation

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.


Table of Contents

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 market approach, or, in certain cases, an alternative methodology potentially including an asset liquidation or expected recovery model.

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 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 (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.

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 our finance department;

Preliminary valuations are then reviewed and discussed with 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;

Our finance department compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms;

Our finance department 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 our finance department 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 regarding the fair value of the investments in our portfolio; and

Our Board of Directors discusses the 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, 2012, and September 30, 2011, was determined by our Board of Directors. Our Board of Directors has authorized the engagement of independent valuation firms to provide us with valuation assistance. We will continue to engage independent valuation firms to provide us with


Table of Contents

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 the valuation of our portfolio investments at fair value as determined in good faith pursuant to our valuation policy and a consistently applied valuation process.

We intend to have a portion of the portfolio valued by an independent third party on a quarterly basis, with a substantial portion being valued over the course of each fiscal year. The percentages of our portfolio, at fair value, valued by independent valuation firms by period were as follows:

              For the quarter ended December 31, 2007       91.9 %
              For the quarter ended March 31, 2008          92.1 %
              For the quarter ended June 30, 2008           91.7 %
              For the quarter ended September 30, 2008      92.8 %
              For the quarter ended December 31, 2008      100.0 %
              For the quarter ended March 31, 2009          88.7 %
              For the quarter ended June 30, 2009           92.1 %(1)
              For the quarter ended September 30, 2009      28.1 %
              For the quarter ended December 31, 2009       17.2 %(2)
              For the quarter ended March 31, 2010          26.9 %
              For the quarter ended June 30, 2010           53.1 %
              For the quarter ended September 30, 2010      61.8 %
              For the quarter ended December 31, 2010       73.9 %
              For the quarter ended March 31, 2011          82.0 %
              For the quarter ended June 30, 2011           82.9 %
              For the quarter ended September 30, 2011      91.2 %
              For the quarter ended December 31, 2011       89.1 %
              For the quarter ended March 31, 2012          87.3 %
              For the quarter ended June 30, 2012           84.3 %
              For the quarter ended September 30, 2012      79.6 %

(1) 96.0% excluding our investment in IZI Medical Products, Inc., which closed on June 30, 2009 and therefore was not valued by an independent valuation firm during such period

(2) 24.8% excluding four investments that closed in December 2009 and therefore were not valued by an independent valuation firm during such period

As of September 30, 2012 and September 30, 2011, approximately 92.7% and 92.6%, respectively, of our total assets represented investments in portfolio companies valued at fair value.

Revenue Recognition

Interest and Dividend Income

Interest income, adjusted for accretion of original issue discount, or OID, 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 loan origination fees, if any, 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, advisory and structuring fees, are classified as fee income and recognized as they are earned.


Table of Contents

We have also structured exit fees across certain of our portfolio investments to be received upon the future exit of those investments. Exit fees are payable upon the exit of a debt security. 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. The receipt of such fees is contingent upon the occurrence of one of the events listed above for each of the investments. A percentage of these fees is included in net investment income over the life of the loan. As of September 30, 2012, we had structured $6.6 million in aggregate exit fees across eight portfolio investments upon the future exit of those investments.

Payment-in-Kind (PIK) Interest

Our loans typically contain contractual PIK interest provisions. 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. The accrual of PIK interest on our debt investments increases the recorded cost basis of these investments in our consolidated financial statements and, as a result, increases the cost basis of these investments for purposes of computing the capital gains incentive fee payable by us to our investment adviser.

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 $18.4 million and represented 1.4% of the fair value of our portfolio of investments as of September 30, 2012 and $22.7 million or 2.0% as of September 30, 2011. 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 a first, second or subordinated lien on the assets of the


Table of Contents

portfolio company and generally have terms of up to six years (but an expected average life of between three and four years). We are currently focusing our origination efforts on a prudent mix of first lien, second lien and subordinated loans which we believe will provide superior risk-adjusted returns while maintaining adequate credit protection. The mix may change over time based on market conditions and management's view of where the best risk adjusted returns are available.

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,
                                              2012                2011
         Cost:
         First lien debt                           70.06 %             77.05 %
         Second lien debt                          10.71               13.97
         Subordinated debt                         15.92                7.40
         Purchased equity                           2.72                0.97
         Equity grants                              0.37                0.53
         Limited partnership interests              0.22                0.08

         Total                                    100.00 %            100.00 %

                                          September 30,       September 30,
                                              2012                2011
         Fair value:
         First lien debt                           70.06 %             78.14 %
         Second lien debt                          10.35               12.80
         Subordinated debt                         15.95                7.25
         Purchased equity                           3.00                1.12
         Equity grants                              0.43                0.60
         Limited partnership interests              0.21                0.09

         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,
                                                  2012                 2011
     Cost:
     Healthcare services                               13.32 %              19.65 %
     Diversified support services                       8.78 %               4.80
     Education services                                 7.81 %               2.57
     Healthcare equipment                               6.53 %               6.16
     Internet software & services                       5.81 %               3.79
     Oil & gas equipment services                       4.75 %               7.11
     Leisure products                                   4.38 %               1.17
     Advertising                                        4.23 %               1.72
     Construction and engineering                       3.65 %               4.23
     IT consulting & other services                     3.55 %               3.74
     Pharmaceuticals                                    3.18 %               2.36
     Diversified financial services                     3.03 %               1.15
     Apparel, accessories & luxury goods                2.99 %               2.68
     Electronic equipment & instruments                 2.85 %               3.01
     Specialty stores                                   2.60 %               2.99
     Integrated telecommunication services              2.52 %               2.25


Table of Contents
                                              September 30,        September 30,
                                                  2012                 2011
     Household products                                 2.34 %               2.70
     Leisure facilities                                 2.34 %               3.29
     Home improvement retail                            2.24 %               2.42
     Industrial machinery                               1.66 %               0.90
     Environmental & facilities services                1.66 %               1.41
     Human resources & employment services              1.53 %               1.77
     Restaurants                                        1.51 %               1.21
     Distributors                                       1.51 %               1.61
     Air freight and logistics                          1.49 %               1.56
     Food distributors                                  1.43 %               1.80
     Research & consulting services                     1.09 %               0.00
     Construction materials                             0.55 %               0.58
     Electronic manufacturing services                  0.30 %               1.75
     Multi-sector holdings                              0.21 %               0.09
     Auto parts & equipment                             0.08 %               1.63
     Building products                                  0.06 %               0.58
     Movies & entertainment                             0.02 %               0.02
     Fertilizers & agricultural chemicals               0.00 %               2.49
     Healthcare technology                              0.00 %               1.77
     Trucking                                           0.00 %               1.48
     Data processing & outsourced services              0.00 %               1.10
     Housewares & specialties                           0.00 %               0.46
     Food retail                                        0.00 %

     Total                                            100.00 %             100.00 %

     Fair value:
     Healthcare services                               13.58 %              20.67 %
     Diversified support services                       8.77                 5.02
     Education services                                 7.71                 2.69
     Healthcare equipment                               6.53                 6.42
     Internet software & services                       6.15                 3.91
     Oil & gas equipment services                       4.82                 7.38
     Leisure products                                   4.38                 1.22
     Advertising                                        4.20                 1.80
     Construction & engineering                         3.88                 3.20
     IT consulting & other services                     3.55                 4.42
     Pharmaceuticals                                    3.18                 2.46
     Diversified financial services                     3.05                 1.19
     Apparel, accessories & luxury goods                2.98                 3.00
     Electronic equipment & instruments                 2.82                 3.11
     Specialty stores                                   2.65                 3.14
     Integrated telecommunication services              2.55                 2.36
     Leisure facilities                                 2.36                 3.43
     Household products                                 2.32                 2.67
     Home improvement retail                            2.19                 2.46
     Industrial machinery                               1.69                 0.97
     Human resources & employment services              1.57                 1.87
     Distributors                                       1.56                 1.69
     Restaurants                                        1.51                 1.06
     Food distributors                                  1.43                 1.88
     Air freight & logistics                            1.24                 1.54
     Research & consulting services                     1.10                 0.00

. . .

  Add FSC to Portfolio     Set Alert         Email to a Friend  
Get SEC Filings for Another Symbol: Symbol Lookup
Quotes & Info for FSC - All Recent SEC Filings
Copyright © 2014 Yahoo! Inc. All rights reserved. Privacy Policy - Terms of Service
SEC Filing data and information provided by EDGAR Online, Inc. (1-800-416-6651). All information provided "as is" for informational purposes only, not intended for trading purposes or advice. Neither Yahoo! nor any of independent providers is liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. By accessing the Yahoo! site, you agree not to redistribute the information found therein.