CHICAGO--(BUSINESS WIRE)--Fitch Ratings has downgraded Fifth Street Finance Corp.'s (FSC) long-term Issuer Default Rating (IDR), secured debt rating, and unsecured debt rating to 'BB+' from 'BBB-'. The Rating Watch Negative assigned to FSC on July 31, 2014 has been removed. The Rating Outlook is Negative. A complete list of affected ratings is included at the end of this release.
KEY RATING DRIVERS
The rating downgrade reflects FSC's higher leverage levels, combined with increased portfolio risk, an inconsistent dividend policy, material portfolio growth in a very competitive underwriting environment, asset quality deterioration, and weaker operating performance.
During 2014, FSC increased the upper-bound of its long-term leverage target from 0.7 times (x) to 0.8x, excluding SBA debt, which is exempt from regulatory asset coverage calculations, but is included in Fitch's assessment of FSC's leverage. Including SBA debt in FSC's leverage calculation translates to total leverage tolerance of 0.96x. Fitch views the increased leverage target as aggressive, particularly given the portfolio shift into second lien securities and increased use of leveraged off-balance sheet vehicles, including the senior loan fund (SLF) and Healthcare Finance Group LLC (HFG).
Furthermore, regulatory leverage exceeded the company's new limit in three of the last four quarters, and amounted to 0.83x at Dec. 31, 2014, or 0.99x including SBA debt. This compares to 0.61x average leverage for investment grade-rated peers as of Sept. 30, 2014.
On Feb. 20, 2015, FSC's stock was trading at a 21.3% discount to net asset value, which is likely to restrict the firm from accessing the equity markets for some time. As a result, cash generated from portfolio repayments and sales will be needed to reduce leverage, which could constrain FSC's ability to take advantage of investment opportunities, relative to the peer group.
The increased leverage target comes as FSC's investment portfolio has gradually shifted into riskier assets, in Fitch's view. Although FSC remains a senior lender with 55.9% of the portfolio invested in first lien positions, at Dec. 31, 2014, this is down from 70.1% at Sept. 30, 2012. Fitch also calculates an adjusted measure of first lien exposure, converting investments recorded as loans to HFG and First Star Aviation to equity, as FSC wholly owns those companies and is in a first-loss position. On this basis, as of Dec. 31, 2014, Fitch calculates that FSC's first lien and equity exposures stood at 49.9% and 15.9% of the portfolio, respectively.
While positions in HFG and the SLF represent investments in diversified pools of loans, they are akin to equity investments in lowly-levered CLOs, which incrementally alters the firm's risk profile. Management has articulated its intention to grow the SLF and/or add similar programs as an important driver of earnings growth, which combined with an elevated leverage tolerance, is viewed by Fitch as consistent with a below investment grade credit profile.
FSC announced a steep (34.5%) dividend cut in February 2015, citing a slower-than-expected ramp of the SLF and reduced fee expectations, given more limited capital available for growth. The dividend cut followed a 10% increase in the dividend in July 2014; above run-rate core earnings, which was viewed as aggressive by Fitch in the face of a still challenging yield spread environment and unsustainable non-accrual levels. In November 2013, FSC cut its dividend 13%, a move that was deemed prudent by Fitch. The inconsistent dividend policy speaks to poor financial planning and has likely cost the firm some credibility with equity investors; an important source of growth capital.
FSC's investment portfolio grew 49.6% in 2013, followed by 17.9% additional expansion in 2014. Fitch remains cautious of outsized portfolio growth in the current credit environment, which is generally characterized by tighter yield spreads, higher underlying portfolio company leverage, and weaker covenant packages. Fitch believes significant exposure to more recent vintages could yield outsized asset quality issues down the road.
While Fitch believes industrywide credit metrics are at unsustainable levels longer term, FSC did stand-out in the fourth quarter of 2014; moving four investments to non-accrual status, with one more expected in the first quarter of 2015. Non-accruals accounted for 4.03% of the portfolio at cost, and 2.33% at fair value, as of Dec. 31, 2014, compared with the investment grade peer average of 0.90% at cost, and 0.55% at fair value, as of Sept. 30, 2014. FSC recorded a $17.6 million realized loss and additional $48.2 million in unrealized losses, which reduced book value by 2.6% and inflated leverage by 0.04x.
The removal of the Rating Watch Negative reflects the decreased near-term risk of not covering the dividend, as a result of management's conservative realignment to core earnings. In place of this near-term concern, however, are longer-term uncertainties relating to management's fundamental risk appetite regarding leverage, portfolio risk, growth, and dividend management, which together support the assignment of a Negative Rating Outlook.
RATING SENSITIVITIES
The ratings could be adversely affected by further deterioration in asset quality, which yields sizeable realized losses and prevents the firm from reducing leverage to a level commensurate with its risk profile. A reduction in dividend coverage, a weakening liquidity profile, and/or an equity market discount that puts the firm at a competitive disadvantage could also drive negative rating momentum.
Resolution of the Negative Outlook could develop over time based on a track record of dividend coverage, solid credit performance of post-crisis vintages, improved operating consistency, and the maintenance of leverage at an appropriate level given the asset risk. The portfolio risk profile will be analyzed in the context of portfolio mix and diversity and underlying portfolio company leverage and yields.
Fitch has removed from Rating Watch Negative and downgraded the following ratings:
Fifth Street Finance Corp.
--Long-term IDR to 'BB+' from 'BBB-';
--Secured debt to 'BB+' from 'BBB-';
--Unsecured debt to 'BB+' from 'BBB-'.
The Rating Outlook is Negative.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Global Financial Institutions Rating Criteria' (January 2014);
--'Investment Manager and Alternative Funds Criteria' (December 2013).
Applicable Criteria and Related Research:
Global Financial Institutions Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=732397
Investment Manager and Alternative Funds Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=725057
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=980196
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