Investors Are Unfairly Punishing Fifth Street Finance Corp.

Fifth Street Finance Corp. released fourth-quarter earnings, and investors aren't happy.

The company failed to cover its dividend with earnings, while announcing that it would cut its monthly dividend from $0.095 per share to $0.0833 per share, or $1 per year. As I write this, shares are down nearly 8% from their pre-earnings price.

No one likes a falling dividend, but it was bound to happen. Fifth Street Finance hasn't covered its dividend in several quarters.

For opportunistic investors, this might be a great time to buy a good BDC at a discount. Here are three reasons why.

1. Price vs. value
Fifth Street Finance now trades at $9.36, or a 5% discount to its reported net asset value of $9.85. Thus, for each share of stock you buy at $9.36, you're getting $9.85 worth of cash, and debt and equity investments.

Based on the new dividend of $1 per year, you're also getting a stock that will yield 10.7% per year. That yield makes Fifth Street Finance very attractive. It now yields more than Ares Capital , another highly rated BDC. It's also close to the yield you receive from Prospect Capital , a BDC with much more risk on the balance sheet.

2. Its deal flow will come back
Fifth Street Finance can't find good places to put money to work. This is partially a company problem -- it works with private equity sponsors to find new originations. If private equity buyouts slow, so do Fifth Street's new investment volumes. Rivals Ares Capital and Prospect Capital have more diversified origination platforms, so they can underwrite new investments even when private equal deals slow. Fifth Street, unfortunately, doesn't have that advantage.

CEO Leonard Tannenbaum commented on the earnings call that Fifth Street Finance had a "lousy" net origination number (new investments minus investments sold or realized) of $120 million for the quarter. But there's no reason to believe the company's $147 million in cash will just sit there. The fourth quarter of the calendar year is especially busy for private equity firms who want to get deals done before the New Year.

3. Fifth Street focuses on risk
The company is writing better loans following the financial crisis, looking primarily for first-lien loans from high-quality borrowers. On the conference call, the company revealed its average credit is leveraged at 4.5-4.7 times earnings before interest, taxes, depreciation and amortization, or EBITDA. In recent years, leverage multiples have only gone up while yields have dropped precipitously.

The fact is that it's a tough market for conservative BDCs. Private equity buyers want the cheapest possible debt financing at the highest multiple possible. To win deals, BDCs have to take on more risk, lower their return expectations, or both.

If Fifth Street Finance doesn't like the terms, it doesn't negotiate. I like that. Investors should, too. In fact, the company announced a new repurchase authorization of $100 million to buy shares below their net asset value.

A buyback plan is commendable. First, it says to the market that Fifth Street Finance would rather buy its existing portfolio than take new risks in lower priced, higher risk loans. Secondly, it shows that management isn't simply concerned about growing their fee income. Fifth Street could easily write terrible loans just to put money to work to earn its 2% management fee. It isn't doing that. Instead, it prefers shrinking the balance sheet, even if it isn't advantageous for management.

The Foolish bottom line
Fifth Street Finance doesn't have the best origination platform, nor does it have an origination network to find its own deals. But it does have capable and talented managers who are clearly working in the shareholders' best interests, even if that means slashing the dividend.

With the stock trading below NAV and with a forward yield of 10.7%, it looks like one of the better buys in the BDC space. If it can put its cash to work in the next year, investors could earn as much as 16% in combined dividends and capital appreciation if Fifth Street Finance trades back up to NAV. 

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The article Investors Are Unfairly Punishing Fifth Street Finance Corp. originally appeared on

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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