NEW YORK--(BUSINESS WIRE)--Fitch Ratings has placed the Fifth Street Finance Corp.'s (FSC) 'BBB-' Issuer Default Rating and senior unsecured debt rating on Rating Watch Negative. A complete list of affected ratings is included at the end of this release.
KEY RATING DRIVERS
The Rating Watch Negative reflects an inconsistent dividend policy, increasing leverage, material portfolio growth and expansion into new business verticals. While certain of these individual concerns are also present at other Business Development Companies (BDCs), Fitch believes the combined presence of these factors at FSC increases the company's risk profile.
FSC recently announced a dividend increase, beginning in September 2014, which follows a dividend cut in December 2013. The revised dividend is above current run-rate core earnings, and suggests the potential need for increased leverage and/or additional portfolio growth in a challenging credit environment.
FSC's dividend coverage (defined as net investment income (NII) divided by dividends) had been consistently running below 100% when management announced a decrease in its monthly dividend in November 2013; a move deemed prudent by Fitch, particularly given the low-yield environment. NII has since been in-line with the lowered dividend.
Fitch believes the announced dividend increase reflects an expectation for incremental revenue provided by the ramp-up of FSC's senior loan fund (SLF), which could provide increased returns. However, Fitch believes the higher dividend level is aggressive in the face of a still challenging yield spread environment and unsustainable non-accrual levels, and does not leave much room for error. As a result, the higher dividend target could encourage outsized risk taking which could include looser underwriting and/or higher sustained leverage.
FSC's leverage has recently exceeded its articulated target of 0.6x to 0.7x debt-to-equity, excluding SBA debt, which is exempt from regulatory asset coverage calculations. Leverage amounted to 0.84x at March 31, 2014, or 0.97x times including SBA debt, which Fitch views as high, even with the senior loan focus, and compares to 0.63x average leverage for investment grade peers. While Fitch believes leverage has likely declined since quarter-end, given the recent $131.8 million equity raise, leverage may need to run above target in order to sustain earnings at the new dividend level, given the tight yield spread environment.
Fitch believes asset quality at FSC, and in the BDC sector more generally, is at unsustainably strong levels, and the company may not have a cushion to cover the dividend if credit quality issues arise. FSC has also been a frequent issuer of common equity, which Fitch expects to continue, and believes this could further pressure dividend coverage, as the distribution burden continues to rise.
FSC has also grown the portfolio rapidly, at 50% in calendar year 2013 and 13% in the first quarter of 2014, which compares to average growth for investment grade peers of 18% and 3%, respectively. Fitch remains cautious about outsized portfolio growth in the current credit environment. Vintage concentrations in the portfolio could yield asset quality deterioration down the road, and thus, weaken dividend coverage.
Beginning in 2013, FSC also modestly expanded into new business verticals including venture lending and aircraft leasing which accounted for approximately 2.9% and 3% of the portfolio at fair value, respectively, as of March 31, 2014. FSC's underwriting acumen in these verticals is unproven, although the company has added additional staff with relevant experience. The ultimate performance of these verticals will take some time to observe.
Resolution of the Rating Watch Negative will be driven by an assessment of near-term dividend coverage, leverage, and portfolio risk. Failure to fund the higher dividend level with core NII over the next two to three quarters would likely result in a one notch rating downgrade, as it would speak to poor financial planning. While ability to cover the dividend over the next two to three quarters would be viewed positively, this on its own may not result in the Rating Outlook being returned to Stable. Rather, a Negative Rating Outlook may follow resolution of the Rating Watch Negative in order to reflect the longer term concerns with respect to leverage levels, growth, new business verticals and the broader industry competitive dynamics.
Conversely, a return to a Stable Outlook would be dependent upon a track record of consistent dividend coverage, at the new level, the maintenance of leverage within the targeted range, and an observation of portfolio credit performance, given the outsized growth, relative to peers, in recent quarters, and expansion into new product verticals and structures (SLF). The portfolio risk profile will be analyzed in the context of portfolio mix and diversity and underlying portfolio company leverage and yields. Fitch believes this assessment could take 12-24 months to observe.
Additionally, Fitch sees a number of emerging industry challenges that could pressure ratings for the industry more broadly or at least increase rating differentiation amongst BDCs over a longer-term horizon. These challenges include a potential increase in regulatory leverage limits and increased competition, which are yielding tighter market spreads and looser underwriting terms, including higher underlying portfolio company leverage and weaker covenant packages. Should competition continue to intensify, market yields could decline further, which would reduce earnings generation and pressure dividend coverage for the space.
Headquartered in Greenwich, CT, FSC is an externally managed BDC, formed in 2007 with an objective to generate both current income and capital appreciation through debt and equity investments. As of March 31, 2014, the company had investments in 124 portfolio companies amounting to approximately $2.7 billion at fair value.
Fitch has placed the following ratings on Rating Watch Negative:
Fifth Street Finance Corp.
--Long-term IDR 'BBB-';
--Secured debt 'BBB-';
--Unsecured debt 'BBB-'.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Global Financial Institutions Criteria' (January 2014);
--'Investment Manager and Alternative Funds Criteria' (December 2013).
Applicable Criteria and Related Research:
Global Financial Institutions Rating Criteria
Investment Manager and Alternative Funds Criteria