An Analysis of a BDC Reveals a Shocking Picture

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An Analysis of a BDC Reveals a Shocking Picture


After reading Jason Zweig’s good piece, “Should You Bottle Up Your Money in ‘Baby Bonds’?” I said to myself, “But what does the prospectus look like?”  So I went to EDGAR, and pulled up the prospectus for Fifth Street Finance Corp’s 5.875% Senior Notes due 2024.

Please understand — I get squeamish with the unsecured bonds of exotic financial companies.  Losses on the bonds of financial companies when they fail tend to be far worse than those of industrials or utilities.  That is a major reason why financial bonds typically yield more than similarly rated non-financial bonds.  They are more risky.

So, looking through the deal summary terms, we learn:

  • At $75 million, the deal is small.
  • It’s a 12-year deal — that’s done to confuse buyers, because it gets priced off the 10-year Treasury, giving the illusion of more spread.
  • Quarterly pay of interest which raises the effective yield a touch.
  • Senior subordinated, but…
  • effectively subordinated to all our existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness, including without limitation, the $206.3 million of borrowings under our credit facilities outstanding as of October 10, 2012; and
  • structurally subordinated to all existing and future indebtedness and other obligations of any of our subsidiaries, including without limitation, the indebtedness of Fifth Street Funding, LLC, Fifth Street Funding II, LLC and our SBIC subsidiaries.
  • The bonds are callable at par after 5 years.

The structural protections here are weak.  You are lending to a financial holding company where many of the assets are pledged to other creditors.  More on that in a moment.

The risk factors for a business development company like Fifth Street Finance Corp. (NASDAQ:FSC) are significant, and can be found here, all eighteen-plus pages of them.  But the risk factors of the debt are more significant, and can be found here.  Here are the main headings:

  • The Notes will be unsecured and therefore will be effectively subordinated to any secured indebtedness we have currently incurred or may incur in the future.
  • The Notes will be structurally subordinated to the indebtedness and other liabilities of our subsidiaries.
  • The indenture under which the Notes will be issued will contain limited protection for holders of the Notes.
  • There is no existing trading market for the Notes and, even if the NYSE approves the listing of the Notes, an active trading market for the Notes may not develop, which could limit your ability to sell the Notes or the market price of the Notes. 
  • If we default on our obligations to pay our other indebtedness, we may not be able to make payments on the Notes.

Unsecured holding company debt can be weak, because with some subsidiaries there may be regulatory limits or private limits to upstreaming capital to the holding companies.  That puts financial holding companies in a weak position, because when financial conditions get bad liquidity can get very tight.

And with business development companies [BDCs], which own and finance small-to-medium sized businesses, there is a lot of idiosyncratic risk including:

  • Your downside is 100%, but your upside is capped.
  • BDCs tend to be speculative investors.
  • Many of the assets held are subject to third-party security interests, which lessens the rights of unsecured lenders to the holding company.
  • BDCs, life REITs, have to pay out 90%+ of taxable income in order not to face corporate taxation.  That forces BDCs to continually go to the credit markets for financing.  But what if the market is no longer favorable for a year or two?
  • BDCs are placid weather vehicles, and more so the bonds.  One might be better off holding 30% Treasuries and 70% BDC stock.  At least you have more downside protection, and more upside.

So put me in the camp of those that have no interest in BDC debt.  It is a weak instrument, and regardless of what the rating agencies say, they are not investment grade risks.

By David Merkel, CFA of Aleph Blog

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