Undisclosed

MARCH 2017

Pharmaceuticals

TerSera Therapeutics is a Lake Forest, IL-based pharmaceutical company that acquires and develops specialty pharmaceutical products and companies with a focus on select therapeutic areas. The company’s first platform acquisition, Zoladex, is a long-established hormonal therapy used in the treatment of prostate cancer, breast cancer and endometriosis.

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Undisclosed

MARCH 2017

Pharmaceuticals

Systems, Inc. is a Germantown, WI-based manufacturer and designer of hydraulic, pneumatic and mechanical loading dock leveling equipment, as well as truck restraints and specialty dock equipment. The company has four brands, Poweramp, DLM, McGuire and Allied Solutions, that provide products to retail, food distribution, trucking and warehouse companies worldwide.

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Undisclosed

FEBRUARY 2017

Pharmaceuticals

Teaching Strategies, LLC is a Bethesda, MD-based provider of developmentally appropriate learning solutions for early childhood education. The company offers curriculum, web-based assessment products, professional development and family resources to programs serving children from birth to grade 3.

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Undisclosed

FEBRUARY 2017

Pharmaceuticals

Inteliquent is a Plymouth, MN-based communications enabler offering network-based voice and messaging services to wireless, cable, carriers, and communication service providers. Inteliquent's comprehensive suite of services include Inbound Voice, Outbound Voice, Toll Free, Neutral Tandem and Messaging services.

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Undisclosed

MARCH 2017

Pharmaceuticals

Dash Financial Technologies is a New York, NY-based trading technology provider to the institutional trading community. With a suite of highly customizable tools, Dash designs and delivers intelligent, high performance solutions in four product categories: Trading Technologies, Execution Services, Analytics and Regulatory Technologies.

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$ Million

JANUARY 1970

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$80.0 Million

DECEMBER 2016

Advertising

Impact Sales is a Boise, ID-based sales and marketing agency that provides outsourced sales, marketing and merchandising services to companies in the consumer packaged goods industry. The company offers corporate initiatives, such as promotional and sales plan display programs, as well as retail sales coverage and analytical services.

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$ Million

JANUARY 2017

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$ Million

JANUARY 1970

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$ Million

OCTOBER 2016

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Middling Quarter for Middle Market

At $10.2 billion, middle market sponsored volume fell 12% from the second quarter, though it remains up from the $8.2 billion issued in the first quarter⁽¹⁾. From a cumulative standpoint, sponsored volume continues to fall short of 2015’s run rate: year-to-date volume stands at $30 billion, a 19% decline from the comparable period last year (see Figure 1, right). 2016 may now shape up to be the slowest for sponsored lending since 2009.

We believe a number of factors have been driving current market conditions. Geopolitical uncertainty, including the aftermath of Brexit and the upcoming presidential election, has led many investors to hit pause on new investments⁽²⁾. In addition, valuation multiples remain at high levels. While updated third quarter multiples have yet to be released, results from the second quarter show how heated competition has become. For instance, the lower end of the middle market (under $25 million in enterprise value), which has seen increased interest as sponsors widen their sourcing strategies, reached a median EV/EBITDA multiple of 6.1x, approaching an all-time high (see Figure 2, below and right)⁽³⁾.

Investor Interest Strains Supply

In our view, the overabundance of liquidity chasing too few deals remains an ongoing factor exacerbating the supply/demand imbalance. Yet in spite of supply constraints, there is mounting evidence that some investors may be prepared to allocate even more capital to private debt—especially direct lending. As the credit cycle continues to mature, some investors may be adopting more defensive postures: Historically, middle market loans have experienced fewer defaults and have had a higher rate of recovery compared to broadly syndicated loans⁽⁴⁾.

Perhaps reflecting this notion, nearly 60% of the private debt investor respondents in Preqin’s H2 2016 Investor Outlook Survey expected to invest additional funds into direct lending in the next 12 months⁽⁵⁾. That forecast comes in a year when middle market loan fundraising—which stands at $24.5 billion in capital raised to date—has already eclipsed 2015’s total of $22.4 billion⁽⁶⁾.

Break From Tradition

Looking ahead, we expect the usual seasonal pick-up in activity and forecast a moderate increase for the fourth quarter. Yet, rather than wait for the market to solidify, some creative alternative lenders are choosing to innovate. For instance, some lenders are making a concerted outreach to non-traditional players like family offices looking for direct exposure rather than investing through a private equity sponsored vehicle⁽⁷⁾. On the other hand, Fifth Street, in addition to supporting deals from existing sponsor relationships, is exploring other avenues, including deals in the venture space with targets that have significant enterprise value and positive EBITDA.

Borrowers Have the Upper Hand

With the supply/demand imbalance and market uncertainty lingering, we believe conditions currently favor borrowers. For instance, as competition heats up among middle market lenders, we have seen documentation requirements growing more relaxed.

While lenders generally regard “covenant-lite” as anathema in the middle market, other aggressive terms have begun to emerge. In particular, “covenant-loose” structures have surfaced that impose a leverage test, but with such wide parameters that the borrower has a greater chance of defaulting on payment before actually failing the test⁽⁸⁾. We see these most pronounced on deals with higher yields and believe the trade-off between pricing and terms is likely to persist; however, Fifth Street is generally avoiding such structures and continues to maintain underwriting discipline when deploying capital.

Regarding pricing, middle market average new-issue yields fell significantly last quarter to 6.09%, compared to 6.90% in Q2 and 7.10% in Q1⁽⁹⁾. Select lenders emphasizing quality are having an even more challenging time finding attractive yields. This late in the credit cycle, we believe emphasizing first lien debt and focusing on defensive industries seems prudent; however, the spread differential between first and second lien middle market term loans stands at over 500 basis points⁽⁶⁾. The silver lining, as we discuss later, is that borrowing conditions are favorable for alternative lenders looking to improve their capital structures, in our view.

Investors Draw the Line

Despite the more borrower friendly environment, investors generally seem to have erred on the side of caution and some are pushing back when riskier credits are involved⁽¹⁰⁾. Unlike last quarter when 62% of first lien middle market term loans flexed down, in the third quarter flex activity overall was much more subdued. Moreover, only 7% of term loans flexed down versus 13% that flexed higher (Figure 3, below)⁽¹⁾.

% of MM First-Lien TLs That Have Flexed⁽¹¹⁾

Source: Thomson Reuters LPC’s Middle Market 3Q16 Review.

The Refinancing Wave

Fortunately, the surge of refinancings in the larger leveraged loan market during the third quarter did not surface to the same degree in the middle market⁽¹⁾. Over half of total leveraged loan issuance in the broadly-syndicated space was comprised of refinancings and repricings, as persistently low interest rates and robust investor demand allowed companies to cut costs and reduce debt through new borrowings⁽¹²⁾. While we believe this wave is likely to continue until mergers and acquisitions and LBO activity gain momentum, the middle market has so far bucked the trend. Approximately 70% of middle market sponsored issuance can be attributed to new money volume in 2016—a pattern that continued to hold during the third quarter⁽¹⁾.

Nevertheless, we continue to adopt a selective approach when it comes to dividend recapitalizations. In many cases, we are an incumbent lender, which allows us to operate from a position of strength, choosing the ones that we believe prove mutually beneficial. To help mitigate the downside risk that re-leveraging portfolio companies may lead to, we continue to advocate for a conservative approach that emphasizes quality deals with leading sponsors.

Improving Conditions for BDCs

Within the alternative lending landscape, one segment has experienced a recent rally: BDCs. The Wells Fargo Business Development Company Index has surged 20% year to date—its best performance since 2012⁽¹³⁾.

We believe benign broader equity market conditions have certainly played a role. However, other forces are also strengthening BDC valuations, in our view. Dividend reductions, investors seeking yield and stabilization in the price of oil are key contributors⁽¹⁴⁾, but we also believe the prospect of floating rates is resonating more with investors. While the Federal Reserve didn’t raise rates in September, it hovers on the precipice of another rate hike likely by year end, with Bloomberg calculating the market’s expectation of a rate hike in December at 64%⁽¹⁵⁾. Some investors in search of yield may be proactively positioning as the case strengthens.

Notably, after remaining fixed for the past eight years, U.S. leveraged loans are getting closer to floating again. That is because LIBOR floors, which were initially designed to protect investors during the credit crisis and have typically been structured at 100 basis points in recent years, will dissipate when LIBOR crosses the threshold of 1%. Once LIBOR exceeds the floor, interest rates will again be tied to the benchmark, positioning lenders for higher distributions and possibly piquing investor interest even further. On October 24, 2016, the 3-month LIBOR rate was 0.88.

Wells Fargo BDC Index Total Return vs. S&P 500 Total Return

Source: FactSet and Wells Fargo Business Development Company Index.

Fifth Street Activity

Celebrating the $10 Billion Loan Landmark

As lending dynamics become more competitive, Fifth Street’s ability to source, underwrite and manage the majority of our portfolio investments continues to set us apart. Our middle market, sponsor-focused origination platform has also helped propel us to an exciting milestone: committing $10 billion of loans since inception to small and mid-sized companies.

As a leading lending partner to the private equity community, we’re proud of the longstanding relationships we have cultivated over the last 18 years. We believe our private equity sponsor clients appreciate the value-added financing solutions we provide and trust that we will deliver in a timely manner and on the promised terms.

These relationships, along with our size and scale, have enabled us to maintain a stable pipeline of attractive investment opportunities across various market environments and enabled us to selectively invest in these $10 billion of loans. More importantly, our sponsor-focused origination platform continues to be a key driver of value for our shareholders today.

Spotlight on YETI

One particularly memorable deal tangibly demonstrates the power of our platform. Based in Austin, Texas, YETI is a designer and marketer of premium coolers. When we provided a one-stop financing facility of $47.5 million back in 2012, we recognized YETI’s potential. The transaction, which was funded by Fifth Street Finance Corp. and included co-investment rights, provided us an equity stake in YETI, which is still outstanding as of June 30, 2016.

While it was our first deal with YETI’s sponsor, Cortec Group, they were attracted to our deep understanding of the company’s objectives. They were also impressed with our ability to rapidly evaluate and execute on a compelling opportunity in a tight time frame. At the time, we noted that YETI’s universal value proposition with high quality products was in the infancy of its life cycle and today, we continue to look forward to seeing what their next stage of growth has in store.

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$84.7 Million

AUGUST 2016

Environmental & Facilities Services

Hoffman Southwest Corporation is a Mission Viejo, CA-based provider of comprehensive water flow solutions services. The company has three complementary divisions: HSW Roto-Rooter, ProPipe and Western Drain, all of which help maintain healthy underground infrastructures in the Western United States.

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$ Million

JANUARY 1970

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$ Million

JULY 2016

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Sponsored Loan Volume Rebounds, Remains Light

The slight increase in sponsored loan volume forecasted in our last Capital Markets Outlook materialized this quarter, although the actual pick-up in activity was not commensurate with the recovery in the broader leveraged loan market⁽¹⁾. Middle market sponsored loan volume increased to $9.2 billion in the second quarter versus the depressed level in the first quarter of $7.9 billion. However, totaling just $17.1 billion, first half volume has declined 30% from the comparable period last year. Moreover, monthly sponsored issuance so far this year remains well below the $5.2 billion long-term average for the preceding five-year period from 2010 to 2015 (see Figure 1, right).

Middle Market Headwinds

In looking at the middle market landscape, we believe a number of factors are suppressing M&A momentum. We are hearing from private equity sponsors that auction activity has been erratic and overall deal quality has somewhat deteriorated. The challenge in deploying dry powder remains an ongoing theme as sponsors continue to lose deals to strategic acquirers and mismatched pricing expectations between buyers and sellers persist. In addition, softening economic growth has hampered the sponsor-to-sponsor trade⁽²⁾. We have observed many sponsors adopting a “wait and see” mentality, preferring to invest in existing assets, with many executing on tuck-in acquisitions with an eye towards exiting when conditions improve.

New Entrants Undeterred

Despite supply constraints, a steady stream of capital has flooded the middle market in 2016. Consider that nearly $17 billion of capital has been raised or announced so far this year—more than half the $22.4 billion tracked in all of 2015 (see Figure 2, right). As investors continue to embrace the asset class, we expect new direct lending funds to multiply as well, ensuring that conditions remain competitive. Yet, in an already competitive field, new entrants must overcome a key hurdle: scale, which we believe has allowed existing lenders to retain a first mover advantage. Scale tends to confer access to deal flow, promote selectivity and deepen sponsor relationships.

As scale becomes a key differentiator, separately managed accounts (SMAs) represent an increasingly popular vehicle for platform enhancement⁽³⁾. SMAs provide lenders with an additional source of capital, which in turn can facilitate the ability to commit to larger hold sizes. As previously announced, Fifth Street closed an SMA with a large, well-respected institutional investor earlier this year. In our experience, investors find SMAs particularly appealing because they can be tailored to their specific needs relative to pooled vehicles like mutual funds, co-mingled funds or CLOs. For instance, an SMA can vary the diversity of underlying assets by hold size, tranche industry and leverage.

The Chosen Few

While new entrants proliferate, not all will survive. We believe the ongoing imbalance between supply and demand benefits top tier players with longstanding relationships at the expense of market newcomers. In today’s market, we are seeing many transactions being clubbed up between two to three sponsor-designated lenders, rather than being broadly syndicated (which allows a greater amount of smaller players to access deals). As a result, in our observation, market participants that lack an established platform tend to fall outside the consideration set.

Moreover, in today’s market, add-ons have become increasingly prevalent⁽²⁾. Both add-ons and tuck-in acquisitions tend to be smaller in size compared to new buyout transactions, and they are typically handled by the incumbent lender. Competitors who lack access to an established origination portfolio as well as deep, recurrent sponsor partnerships, may very well miss this deal flow too.

Unitranche Trend Continues

Another area where we see scale as a differentiating factor is with unitranche loans, which combine senior and subordinated tranches at a blended cost. As we noted last quarter, sponsors have been gravitating towards unitranche structures, given heightened uncertainty and challenging conditions in the second lien market⁽⁴⁾. These facilities provide sponsors with a streamlined solution that typically has a greater certainty of close.

Despite improving conditions, we note that unitranche loans continue to attract strong sponsor interest—and now, even for larger transactions. Historically, one-stop facilities have generally ranged from $100 million to $300 million in size⁽⁵⁾. However, this quarter marked the announcement of a $1 billion unitranche facility—the largest ever on record⁽⁶⁾.

In general, from a lender’s perspective, unitranche loans are appealing because they tend to offer higher yields. Notably, this quarter, larger transactions have become increasingly attractive relative to smaller middle market deals. In the latter, heavy competition has fueled unusually competitive pricing—an inverse of conditions we typically see, where larger deals are priced at a discount to smaller deals. Therefore, select lenders with the wherewithal to focus on unitranche transitions at the upper end of the market are likely able to achieve better risk-adjusted returns⁽⁴⁾.

Lender Dynamics Shift

Unitranche loans aside, lenders experienced slightly less favorable dynamics this quarter. From our perspective, certain constructive signs we saw in the first quarter have somewhat receded. For instance, yields declined, although they remain above the lows of the same period last year (see Figure 3, right). In addition, 62% of middle market institutional first lien loans flexed down in 2Q16⁽⁷⁾. On the other hand, leverage levels—which tightened in the first quarter—are now back on the rise.

With yields below 1Q16 levels, sponsors have started to take advantage of refinancing opportunities. We believe this has spurred an unfavorable bias towards dividend recapitalizations (see sidebar, right). Re-leveraging portfolio companies in order to fund sponsor dividends leaves less of a cushion for lenders, who face limited upside, but significant downside. To avoid this, we believe lenders will need heightened vigilance to identify quality deals with top tier sponsors.

Energy: Time to Test the Waters?

As we have noted throughout the dislocation, we have maintained limited energy exposure across the platform for quite some time. Given the recent stabilization in oil prices, we are now considering selectively increasing portfolio exposure. However, we maintain that lending cannot be viewed through the same lens as more liquid, tradable securities given that credit investing involves taking a view over a multi-year time horizon.

Additionally, as of May, the trailing 12-month energy high yield bond default rate stands at 13%⁽⁹⁾. Relative to history, that compares unfavorably to 1999 when oversupply caused oil prices to dip to $19 per barrel. At that time, the default rate stood just over 9%⁽¹⁰⁾. Today’s default rate already exceeds the last oil dip and Fitch is projecting that it may reach 20% by year-end⁽⁹⁾.

Yet, despite the potential for further downward pressure, energy bonds have rallied back to levels that seem unsustainable, in our view. One bright spot we see is the approval of some key Shale projects, the economics of which appear to work at current price levels. If stability persists, we may see domestic production ramp back up. However, we question whether smaller and mid-size shale producers will gain access to much-needed credit. Until banks write down their current losses, we believe the extension of new credit will be hampered.

Trailing 12-Month Energy High Yield Bond Default Rate (%)^(9)(10)

Source: Fitch Ratings and Kallanish Energy

Too Soon to Judge Brexit’s Impact

No discussion of this quarter would be complete without mentioning Brexit. While it is difficult to gauge the long-term impact, we do see a risk in underestimating the potential aftershocks.

Some have expressed concerns that Brexit will have a material ripple effect on the global economy. In the immediate aftermath, we are clearly seeing U.S. markets propelled higher as global uncertainty drives capital into the relative safety of more liquid markets. That aside, we believe there will be a delay before the consequences are fully felt in terms of a potential slowdown in M&A activity or broad reductions in UK and European financial services.

When combined with the tendency for the middle market to remain more insulated—and lag trends seen in the broader leveraged loan space—we think those potential repercussions are more likely a 2017 concern.

Fifth Street Activity

Well-Positioned for Today’s Dynamics

Fifth Street’s scale and proprietary origination platform are allowing us to find compelling opportunities amidst a slower middle market environment and broader market volatility. While others may be broad-brushing or avoiding entire industries, diligent and careful underwriting has enabled us to find attractive investments others may have overlooked.

One example is First Star Aviation, a wholly-owned portfolio company of Fifth Street Finance Corp. (FSC). First Star has a track record of purchasing and opportunistically selling planes in its portfolio and recently sold one of its planes. The sale price was higher than the original purchase price and, when factoring in the lease payments made over the life of FSC’s hold period, FSC realized a gross IRR of 19.1%.

We have also seen repeat activity owing to deep relationships with top tier sponsors. For instance, after we provided a unitranche facility in May 2015, LegalZoom—a Permira funds-owned company—returned for additional financing to support international growth. We served as both Lead Arranger & Administrative Agent for the deal, which occurred in March 2016.

Scale was a key factor placing us in the consideration set on another recent deal. We closed $110 million of senior secured credit facilities when we served as Administrative Agent, Joint Lead Arranger and Joint Bookrunner supporting the recapitalization of Ob Hospitalist Group, Inc. The company is sponsored by a fund in the Private Equity Group of Ares Management, L.P. and was tightly clubbed between Fifth Street and two other established lending platforms.

As a leading loan origination platform, we are well-positioned to win these types of first lien deals in partnership with established sponsors. We plan to continue our emphasis on quality deals higher in the capital structure given our view of where we currently stand in the credit cycle.

Robust Unitranche Pipeline

Our ability to hold larger transactions is positioning us to take advantage of attractively priced unitranche opportunities. Two-thirds of the high-priority, active deals currently in our pipeline represent unitranche facilities. The magnitude of these facilities has also trended upward, as the average deal size has grown by over 20% versus one year ago⁽¹³⁾.

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$160.0 Million

JUNE 2016

Internet Software & Services

ANCILE is an Elkridge, MD-based software provider that facilitates employee training and education on over 100 business applications, including SAP, Salesforce, Oracle, IBM and others. The company’s solutions help organizations recognize the full potential of the technology they use by increasing employee understanding, proficiency and adoption.

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Undisclosed

AUGUST 2016

Internet Software & Services

Ping Identity is a Denver, CO-based provider of identity and access management software. The company’s next generation solutions enable enterprises around the world to manage access to applications and increase security across their IT systems.

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$110.0 Million

JUNE 2016

Healthcare Services

OB Hospitalist Group is a Mauldin, SC-based developer and manager of 24/7, on-site OB/GYN hospitalist programs. The company collaborates with partner hospitals, physicians and staff to create customized solutions that align with each patient’s objectives and expectations. Ob Hospitalist Group ensures each partner hospital is staffed with a strong Board Certified, OB/GYN physician team, and provides comprehensive and financially viable programs that raise the quality of care for women, newborns and families.

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Undisclosed

APRIL 2016

Integrated Telecommunication Services

Onvoy is a Minneapolis, MN-based provider of wholesale voice-enabling services across the U.S. Through its intuitive software-based Application Program Interface and nationwide carrier-grade network, the company helps clients build, provision and support more innovative and integrated communication services through easy-to-use voice, messaging and mobility solutions.

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$ Million

APRIL 2016

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Volume Declines Dramatically

Totaling just $7.33 billion, sponsored middle market loan volume reached a six-year low in the first quarter—exceptionally weak even when viewed against the traditional seasonal pattern of lighter volume. On the heels of a sluggish year in 2015, we remained cautious in our outlook for the new year; yet, volume dropped more precipitously than expected. Sponsored issuance was down 45% from the fourth quarter of 2015 and 31% on a year-over-year basis (see Figure 1, right).

The Story Behind the Slump

A number of factors contributed to the Q1 slowdown. U.S. private equity investment is clearly experiencing a lull. Although add-on acquisitions remained comparatively stable in the first quarter, LBO volume dropped 55% quarter over quarter and 49% year over year (See Figure 2, right and below).

The decline in transaction activity can be partly attributed to mismatched expectations between buyers and sellers. From a buyer’s perspective, few could justify paying for valuations based on peak EBITDA in a slowing economy—especially when faced with more expensive financing due to rising yields. On the other hand, heavy competition from strategic acquirers helped reinforce the belief among high quality sellers that they still held the upper hand.

All of this unfolded against the backdrop of a weakening macroeconomic picture. Fluctuating oil prices and credit woes in energy and commodities, combined with concerns of spillover effects from slowing global growth, rattled investors who were already uneasy heading into 2016. Factor in a particularly unpredictable election year and ongoing debate over central bank policy response, and confidence has faltered even more.

Demand Takes a Breather

Also playing a role are investor challenges, which range from a lack of liquidity in the CLO and BDC markets to a general slowdown in fundraising among private debt vehicles. For instance, private debt capital formation totaled just $3.9 billion in the first quarter—a lackluster pace that failed to match the rapid expansion of $91 billion seen for all of last year⁽¹⁾.

Likewise, anemic CLO issuance undermined demand, although it did gather momentum as the quarter unfolded. Cumulative Q1 2016 issuance stood at $8.2 billion, a pronounced decline from $29.8 billion for the same period last year⁽²⁾.

Meanwhile, most of the BDC universe traded below book value, making it very difficult to grow via follow-on equity offerings. Finally, energy exposure at traditional banks stood in the regulatory cross-hairs, creating a risk-off mentality which diminished the appetite for credit (see sidebar). In short, the cumulative impact on deal flow poses challenges; however, we believe it has also created opportunities for discerning lenders.

Proceed with Caution
or Green Shoots Ahead?

As the quarter drew to a close, the overall leveraged loan market appeared to regain some stability, aided by renewed confidence in U.S. economic expansion, a strong rally in global equities and a rush of inflows into the high yield bond market.

We believe this general improvement in sentiment bodes well for the middle market, which tends to follow suit. Based on our pipeline activity, we remain hopeful for a brisker pace of private equity M&A activity in the quarters ahead. However, our expectations for a material increase from today’s depressed levels are tempered by our outlook for lackluster volume for the year as a whole.

Amid Weakness,
Lenders See Silver Lining

Fear of a deteriorating credit environment has definitely put investors on edge, contributing to another uptick in yields this quarter. U.S. middle market term loan yields widened to 7.3% from 7.1% one quarter ago and 6.7% for the same period last year⁽³⁾. Middle market lenders note that they are finally receiving adequate compensation for risk, while also acknowledging they are beginning to see some cracks in their portfolios.

Though few would characterize it as a default wave, there has been a noticeable stall in earnings, earnings growth and revenues. By the end of 2016, Moody’s projects the loan only default rate will climb to 4.2%. While the middle market typically lags the broader market in this respect, one might view the trend as a harbinger of things to come (see Figure 3, below).

From a sector standpoint, we continue to emphasize healthcare and technology relative to cyclical sectors, thanks to favorable macro trends and the ability to draw on proprietary insights to help unlock potential value.

We have also noticed that prudent lenders have begun to adjust terms in response to market conditions and the potential for an economic pullback in the next few years. In some instances, lenders are able to dictate and achieve more conservative terms. Tighter covenant packages and fewer “large market terms” were among the noticeable trends during the quarter.

Moody’s Speculative Grade Default Rate

Source: Thomson Reuters LPC’s 2Q16 MM Investor Outlook Survey.

Sponsors Gravitate to Unitranche

A subdued environment and ongoing credit woes are also having an impact on structure. Prudent middle market lenders like Fifth Street are continuing to adopt defensive positions, moving up the capital stack into first lien, higher priority assets.

From a sponsor standpoint, the unitranche structure seems to have become even more popular. The surge can likely be traced to heightened uncertainty combined with an uptick in senior pricing and a fall-off in second lien volume. With a risk-off mode prevailing for much of the quarter, second lien issuance was anemic, totaling only $47.5 million—a level not seen since Q1 2010 (see Figure 5, below).

In some instances, the unitranche structure is favored by sponsors who want to circumvent the auction process entirely. In these cases, sponsors are approaching lenders to get a deal done expeditiously without attracting the kind of attention that could prompt a bidding war. Heightened uncertainty has also inured to the benefit of lenders with deep private equity relationships and the wherewithal to hold larger positions. These select lenders are gaining ground as sponsors are increasingly shifting away from “underwrite to syndicate” solutions and toward “buy and hold” solutions with their most trusted debt providers. This helps explain the increasing number of “pari passu” unitranches, and the decrease in first out/last out structures.

Middle Market Second Lien Issuance

Source: Thomson Reuters LPC (4/8/16).

Too Early For Energy

With oil prices strengthening over the quarter, we see some lenders considering increasing their portfolio exposure. In fact, oil and gas loan bids regained a small piece of lost territory, closing the quarter just below 60, up 5 points from February’s low point⁽²⁾. However, as we noted last quarter, we continue to believe that energy has further downside potential and has not yet reached a bottom.

While rig count has declined in the U.S., we believe oil producers like Saudi Arabia and Iran have yet to reconcile their disparate views on supply. For instance, Iran has not yet agreed to take part in the current freeze under discussion. In our view, the oil issue has devolved into a case of each side waiting for the other to blink first.

With oversupply being a key driver behind today’s depressed oil price levels, it’s difficult for us to foresee stabilization until these two major players set aside their regional rivalry and agree to work together to reassert a balance. That said, an additional 1.2 million barrels of demand is expected to come on this year. When coupled with a potential reduction of 800,000 barrels of supply in the U.S., output may stabilize this fall.

Fifth Street Activity

The Table is Set for Good Vintage

Due to broader market volatility and uncertainty, we have noticed a widening of spreads in the middle market, creating opportunities for strong risk-adjusted returns. As a result, we have been able to find attractive pricing at the higher end of the capital structure for select deals and look forward to continuing to invest in this more lender friendly environment.

As previously mentioned, we believe that lenders with flexible, long term capital will look back favorably on the vintages of 2016 and 2017 similarly to those of 2009 and 2010.

Relationships Mean More Than Ever

Despite a slower quarter, Fifth Street remains well positioned on several fronts. In times of uncertainty, relationships come to the fore. We are proud to be one of the premier lending partners to sponsors in the middle market due to the quality and breadth of our platform, relationships and people.

Fifth Street is also widely recognized for our unitranche specialty, with the ability to hold loans up to $250 million on our balance sheet. In these times, our top sponsors have been relying on us even more to delve deeply into each transaction and find creative ways to ensure their timely and effective completion.

For sponsors, experience also counts. Lenders like Fifth Street—who have successfully navigated past economic cycles and demonstrated a steadfast willingness to support sponsors and their portfolio companies through growth phases as well as setbacks— top their shortlist.
As always, our main priority remains supporting our sponsors and deepening those relationships by showing both flexibility and strength.

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Undisclosed

AUGUST 2016

Research & Consulting Services

Lytx, Inc. is a San Diego, CA-based provider of video-based safety solutions for commercial and public sector transportation fleets. The company’s solutions work to reduce accidents and improve driver behavior while helping clients realize lower operating and insurance costs.

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$43.0 Million

OCTOBER 2015

Advertising

Ansira is a St. Louis, MO-based marketing firm that focuses on both client channel partners and direct marketing to consumers. Ansira uses their customer engagement marketing services to assist many Fortune 1000 brands.

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$125.0+ Million

DECEMBER 2015

Healthcare Equipment

Argon is a Plano, TX-based global manufacturer and supplier of single-use specialty medical devices used for interventional radiology and cardiology, vascular surgery and critical care procedures.

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$131.0 Million

OCTOBER 2015

Internet Software & Services

NAVEX Global Inc. is a Lake Oswego, OR-based ethics and compliance software provider that helps organizations contain risks, maintain an ethical culture and stay compliant to regulations, such as Sarbanes-Oxley, Dodd-Frank, the UK Bribery Act and numerous others.

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$ Million

JANUARY 2016

news-media

No Late Rescue
for Loan Volume

In 2015, sponsored middle market loan volume reached $50.3 billion, down 28% from 2014, falling below expectations and capping the weakest year for volume since 2009 (See Figure 1, below). Issuance dropped every quarter year-over-year, and 4Q15 was no exception. Despite volume rising 7% from the third quarter, at $13.4 billion, fourth quarter volume was still down nearly 25% from the prior year period.

For many lenders, including Fifth Street, the typical seasonal push that occurs at calendar year end was muted in 2015⁽¹⁾. A number of factors contributed to the protracted slowdown in sponsored deals, including an increase in borrowing costs and buyer/seller divergence stemming from lower deal quality and lofty valuations, as strategic buyers continued to drive up multiples. Combined, these factors have created a more challenging environment for sponsors, many of whom we believe have chosen to wait on the sidelines in hopes of better returns.

Quarterly Sponsored Issuance

Source: Thomson Reuters LPC’s Middle Market 4Q15 Review (1/8/16).

Vintage Years on Tap

While many lenders expect volumes to be flat in 2016⁽²⁾, we hold a more hopeful view for middle market sponsored lending. With backlog down from recent years, we are not expecting a rebound in the first quarter, but believe things should pick up later in 2016, as the market gradually adjusts to the new reality of higher borrowing costs.

Private equity firms have raised considerable capital and have record amounts of dry powder at their disposal. The level of unspent capital reached a record of $752 billion by the end of 2015, up from $695 billion the prior year, which will need to be put to work at some point (See Figure 2, right).

We believe that years from now, lenders with capital to invest in new loans will look back on the vintages of 2016 and 2017 as similar to the favorable vintages of 2009 and 2010. With spreads widening, it seems that prudent lenders will start getting adequately paid for risk. Given crashing oil prices and the disarray in high-yield, we think the table is set—as it was in the aftermath of the financial crisis of 2008—for lenders to deploy capital into deals with strong risk-adjusted returns. It could be an exciting opportunity for lenders with long-term capital and the flexibility to selectively deploy it. However, absent discerning underwriting, capital is not enough. Instead, a high level of selectivity driven by superior sourcing represents the key to success in our view.

Yields Widen, Hurting
Dividend Recapitalizations

For the first time in a few years, yields are significantly higher in the middle market. Assuming a three-year duration, the average yield for a middle market first-lien term loan is at the highest level since 2012, climbing to 7.14% for the quarter, up from 6.25% in 3Q15 and 5.96% in 2Q15⁽³⁾. Notably, higher yields have created significant headwinds for dividend recapitalizations, which had volume of just $4.3 billion for all of 2015, representing a 38% decline from 2014 and the lowest level in six years (See Figure 3, below).

Middle Market Dividend Recap Volume

Source: Thomson Reuters LPC’s Middle Market 4Q15 Review (1/8/16).

Flight to Quality
Impacts Second Lien

Amidst weaker volume, there still appears to be ample capacity in the middle market. However, lenders continue to gravitate to certain credits over others, with many focused on plain vanilla companies with no noise and minimal adjustments. Additionally, in a noticeable flight to quality, many lenders continue to migrate to senior, floating rate securities⁽¹⁾. This is not unexpected, as periods of volatility tend to create a risk-off response and a move up the capital structure.

To that end, middle market second lien volume reached just $2.5 billion for the year—a 64% decline from 2014⁽³⁾. The diminished appetite for second lien volume can also be traced to a weakened buyer base: many BDCs are currently trading below book value, while hedge funds have had to reassess and redeploy their own assets in the wake of a tumultuous 2015. The heightened uncertainty has unsettled sponsors, many of whom are proceeding straight to the unitranche product given the certainty of close, versus a first and second lien structure⁽⁴⁾.

Given the sharp drop-off in second lien bids, yields on middle market second-liens moved drastically wider this quarter. The average yield has risen to 12.31%, up 249bps from 9.82% in 3Q15 (See Figure 5, below). The resulting supply/demand imbalance leads us to believe that selective opportunities for strong-risk adjusted returns in second lien may lie ahead.

First and Second Lien Yields: Middle Market and Large Corp.

Source: Thomson Reuters LPC’s 2015 Review / 2016 Preview (1/13/16).
Note: Only includes yield data from deals with first lien / second lien structures.

Markets Shrug Off the Fed

The Fed’s recent interest-rate hike was both widely anticipated and priced-in by market participants and, in our view, has had a de minimis impact on the middle market.

Amid weak economic indicators, we expect the Fed to proceed slowly and cautiously with future increases. Since uncertainty remains in the markets, we believe policymakers will try to avoid adding to it with interest rate surprises. For that reason, the middle market should be able to absorb future increases without undue stress.

Anticipating a slow rise in interest rates, Fifth Street has continued to position itself to take advantage of an up rate environment, seeking to blend down the level of LIBOR floors in its deal structures. Generally speaking, lenders don’t generate additional income and benefit from a rising interest rate environment until LIBOR surpasses the LIBOR floor, which had typically been structured at 100 basis points in recent years. By beginning to complete new deals with lower or no LIBOR floors, lenders are beginning to focus more on capturing spread and benefitting earlier from the rise in rates.

Recently, Fifth Street led its first deal in some time with no LIBOR floor and in the coming months, we expect to see LIBOR floors under pressure.

Where Will Middle Market
Lending Go in 2016?

Regardless of the pace of future rate hikes, we believe that the cost of capital is unlikely to go down. However, if the economy remains stable and we do not see a drastic increase in supply, we would expect purchase price multiples to stabilize over the next several quarters.

While no one can predict where credit quality will go, we are anticipating patchy growth and sector divergence. For instance, as we have noted for some time, we see ongoing strength in healthcare and technology. On the other hand, we continue to maintain that energy has further downside potential and has not yet reached its inflection point.

We believe it is prudent to avoid the cyclical industries while taking a more cautious approach to the higher valuation/higher leverage industries that generate high free cash flows. Conversely, we also counsel a shift toward safer, more recession-resistant sectors. Deals in the former category are still getting done; however, that universe seems to be waning today.

Fifth Street Activity

Middle Market Direct Lending continues to gain increased attention as an asset class, with many investors particularly attracted to the yield and relative protection that senior secured and unitranche loans can provide.

Due to Fifth Street’s 17-year track record of creating value through proprietary origination capabilities, discerning underwriting and portfolio management expertise, a variety of stakeholders have been looking to access our award-winning direct origination platform from a number of angles.

A Record $3 Billion in
Agented and Syndicated Loans in 2015

As we have continued to expand our capital markets presence over the last few years, the volume of our middle market syndications and club transactions has risen, which is partially attributable to increased interest from third parties to participate in our deals. These participations allow third parties, often lenders who do not have origination platforms of their own, to access loans that have not only been selected through our rigorous investment process, but are also supported by our established top-tier sponsor partnerships.

Fifth Street set a new company record last year, with over $3 billion of deals agented and syndicated in 22 deals across our platform⁽⁵⁾. This represents a 67% increase over the $1.8 billion of deals agented and syndicated in 2014.

Separately Managed Account Closing

In further testament to the strength and value of the Fifth Street platform, earlier this month, we announced the closing of a Separately Managed Account (“SMA”) with a large, well-respected institutional investor who intends to purchase $50 million of middle market loans in the SMA.

Our platform’s ability to provide customized solutions across the capital structure to middle market companies and gain access to exclusive opportunities makes an SMA a compelling product for institutions seeking middle market asset exposure. Recent interest from institutional investors also led to Fifth Street’s closing of two collateralized loan obligations (CLOs) in 2015, as well as joint ventures with each of our business development companies (BDCs) in 2014.

We are looking forward to beginning our relationship with our new client and remain excited about the prospects of growing our institutional business line.

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Healthcare Services

AccentCare is a Dallas, TX-based provider of post-acute healthcare services, ranging from personal, non-medical care to skilled home nursing, rehabilitation, hospice and attendant care services.

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Undisclosed

AUGUST 2015

Internet Software & Services

iPipeline is an Exton, PA-based provider of cloud-based software solutions for the life insurance industry. Through its SaaS solutions, it accelerates and simplifies insurance sales, compliance, operations and support.

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$150.0 Million

JULY 2015

Personal Products

Too Faced Cosmetics, LLC is an Irvine, CA-based prestige color cosmetics company providing a diversified range of eye, face and lip products through in-store and online channels, both domestically and internationally.

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MAY 2015

Diversified Support Services

Garretson Resolution Group is a Cincinnati, OH-based provider of outsourced medical lien resolution and complex settlement administration services to lawyers representing both plaintiffs and defendants in personal injury settlements.

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Undisclosed

DECEMBER 2014

Leisure Facilities

Eos Fitness is a Phoenix, AZ-based 'High-Value Low-Price' fitness club chain operating locations across the Southwestern U.S.

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$ Million

JANUARY 1970

Uncategorized

Fifth Street Asset Management (“Fifth Street” or the “Firm”), headquartered in Greenwich, CT, is seeking a Senior Associate to work closely with the Firm’s Head of Institutional Business Development and Collateralized Loan Obligations on institutional capital raising and important strategic initiatives.

Responsibilities will include, but will not be limited to:

• Developing a thorough understanding of Fifth Street and its broad-based capabilities as well as the motivations and preferences of different types of institutional investors (i.e., pension funds & their consultants, endowments, insurance companies, family offices, etc.).
• Supporting institutional marketing activities:
• Ensuring all firm marketing materials are consistently up to date and optimized;
• Preparation of due diligence questionnaires (“DDQs”) and drafting responses to formal requests for proposals (“RFPs”);
• Maintaining up-to-date investor details in the Firm’s various data bases; and
• Modeling contemplated structures.
• Planning and coordinating road shows (deal and non-deal specific).
• Attending select investor meetings and conferences with senior management, taking appropriate notes and “owning” the requisite follow up (ensuring that such is done on a timely basis consistent with the Firm’s high standards).
• Performing various ad hoc analysis and tasks as necessary.

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$ Million

JANUARY 1970

our-newsletter

Middle Market Origination Report: Positioned for a Strong Finish to 2015

Middle market loan volume is down roughly 30% in the first three quarters of 2015 when compared to 2014 (1). We believe that reduced volumes are the result of a slowdown in LBO activity driven by higher purchase price multiples and recent market volatility. However, the year has followed a normal seasonal pattern and our pipeline has been building into year end, setting the stage for the December quarter. Notwithstanding the overall reduction in volumes, lenders with direct origination franchises, such as Fifth Street, have demonstrated the ability to uncover pockets of opportunity even in challenging market environments. During the first half of 2015, FSC and FSFR had gross originations of $821.3 million, which is in line with the first half of last year where FSC and FSFR had $820.0 million of gross originations.

SEC Proposes Liquidity Management Rules for Mutual Funds and ETFs

On September 22nd the SEC proposed legislation that requires open-end mutual funds and exchange-traded funds to better manage their liquidity. The legislation would obligate these funds to classify the liquidity of each portfolio asset and place a 15% limit on assets deemed to be illiquid. We believe that the implementation of these rules could present an opportunity for FSC and FSFR given that the new guidelines could reduce mutual fund and ETF demand for middle market broadly syndicated loans, as they may be less likely to purchase those assets. The proposed legislation is currently in the comment period and will need additional approval from the SEC Commissioners before it is implemented. While it is still in the early stages, we believe that the new liquidity management rules could positively impact the Fifth Street platform.

Technology Spotlight: Opportunities in Venture Debt

A recent trend in the technology investment space has been the proliferation of companies with valuations exceeding $1 billion – or “unicorns.” In order to achieve such lofty valuations, companies are issuing equity securities that not only behave like debt through their liquidation preferences, but also guarantee investors a multiple on investment, thus forcing these companies to pursue growth at all cost. In contrast, venture debt is far less dilutive and allows the company to adjust its operating strategy based on prevailing market conditions as the growth bar is much lower. As a result, we are cautiously optimistic that there will be more opportunities for our venture lending team to prudently invest in healthy, growing companies that will generate strong risk-adjusted returns. We focus on companies that have sustainable business models with non-cyclical demand drivers, as exhibited by investments FSC recently closed in Swipely, a payments and analytics company, and Quorum, a disaster recovery firm.

Executive Focus: Comments from FSC’s CEO and FSFR’s President, Todd Owens

Why do you think the BDC industry is trading below book value and how can the disparity be improved?

Over the last 18 months, the BDC industry has been negatively impacted by a number of events: the exclusion of BDCs from stock indexes, which reduced institutional investor interest; the plunge in oil prices and its impact on energy-focused businesses; concern around the credit cycle and the steady decline in yields paradoxically coupled with increasing concerns that rates would soon rise. As a result, BDC stock prices have been under pressure and the industry is trading at levels that we haven’t seen since the credit crisis in 2009. I think investors are weary of credit generally and concerned specifically about the balance sheet exposures (particularly energy) in the BDC space. As the industry reports results that reduce these concerns, I hope that we will see renewed investor interest in the sector.

What are some trends you are seeing in the BDC industry?

Volumes are lower this year than last, though still following the typical seasonal pattern. As a result, we expect that we will see seasonally higher origination volumes as we head into year end. Pricing and terms have been reasonably static over the course of this year, though there is some hope that the volatility we have seen in the broader markets will translate into marginally better pricing in the middle market. On the credit side, we are seeing a reversion to mean, with a more typical level of credit issues in the industry and in our portfolio, which is a change from the largely benign credit environment over the last several years.

What opportunities are there for FSC and FSFR?

The investment tailwinds for the BDC industry continue. Regulatory pressure on banks is real and, if anything, increasing, which impairs the ability of banks to compete for middle market assets. More recently, the SEC liquidity proposals are likely to reduce the appetite of mutual funds and ETFs for these less liquid assets. As a result, I expect BDCs and other non-bank capital sources to continue taking market share. Having said that, as we head into an environment with increasing credit risk and market volatility, we need to be thoughtful about putting capital to work into high-quality assets with strong risk-adjusted returns. While we have the opportunity to grow our market shares, the risks around credit have increased as well.

FSC Completes Share Repurchases

During August and September, FSC executed on its previously announced plan to repurchase shares in the open market, completing an approximately $20 million buyback. Management and the Board of Directors will continue to evaluate repurchasing shares on the open market, as we seek ways to continue providing strong risk-adjusted returns to our shareholders and stabilize our net asset value per share.

Addressing the Recent Class Action Lawsuits

On October 22nd, we filed a Form 8-K that addresses two class action lawsuits filed against FSC. FSC believes that the claims are without merit and intends to vigorously defend itself against the plaintiffs’ allegations.

* * *

We look forward to discussing our fiscal year results during FSC’s and FSFR’s respective earnings calls. FSC’s conference call is scheduled for December 1, 2015, and FSFR’s is scheduled for December 8, 2015. Information related to the earnings calls can be found on our Investor Relations website.

Sincerely,

The Fifth Street Team

(1) Thomson Reuters LPC’s 4Q15 MM Investor Outlook Survey, 10/2/15. Middle market is defined as companies with EBITDA of $50MM or less.

About Fifth Street Finance Corp.

Fifth Street Finance Corp. is a leading specialty finance company that provides custom-tailored financing solutions to small and mid-sized companies, primarily in connection with investments by private equity sponsors. The company originates and invests in one-stop financings, first lien, second lien, mezzanine debt and equity co-investments. FSC's investment objective is to maximize its portfolio's total return by generating current income from its debt investments and capital appreciation from its equity investments. The company has elected to be regulated as a business development company and is externally managed by a subsidiary of Fifth Street Asset Management Inc. (NASDAQ:FSAM), a nationally recognized credit-focused asset manager with over $5 billion in assets under management across multiple public and private vehicles. With a track record of over 17 years, Fifth Street's platform has the ability to hold loans up to $250 million and structure and syndicate transactions up to $500 million. Fifth Street received the 2015 ACG New York Champion's Award for "Lender Firm of the Year," and other previously received accolades include the ACG New York Champion's Award for "Senior Lender Firm of the Year," "Lender Firm of the Year" by The M&A Advisor and "Lender of the Year" by Mergers & Acquisitions. FSC's website can be found at fsc.fifthstreetfinance.com.

About Fifth Street Senior Floating Rate Corp.

Fifth Street Senior Floating Rate Corp. is a specialty finance company that provides financing solutions in the form of floating rate senior secured loans to mid-sized companies, primarily in connection with investments by private equity sponsors. FSFR's investment objective is to maximize its portfolio's total return by generating current income from its debt investments while seeking to preserve its capital. The company has elected to be regulated as a business development company and is externally managed by a subsidiary of Fifth Street Asset Management Inc. (NASDAQ:FSAM), a nationally recognized credit-focused asset manager with over $5 billion in assets under management across multiple public and private vehicles. With a track record of over 17 years, Fifth Street's platform has the ability to hold loans up to $250 million and structure and syndicate transactions up to $500 million. Fifth Street received the 2015 ACG New York Champion's Award for "Lender Firm of the Year," and other previously received accolades include the ACG New York Champion's Award for "Senior Lender Firm of the Year," "Lender Firm of the Year" by The M&A Advisor and "Lender of the Year" by Mergers & Acquisitions. FSFR's website can be found at fsfr.fifthstreetfinance.com.

Forward-Looking Statements

This press release may contain certain forward-looking statements, including statements with regard to the future performance of FSC and/or FSFR. Words such as “believes,” “expects,” “estimates,” “projects,” “anticipates,” and “future” or similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ materially from those projected in these forward-looking statements, and these factors are identified from time to time in the companies’ respective filings with the Securities and Exchange Commission (as applicable). The companies do not undertake any obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

CONTACT:

Investor Contact:
Robyn Friedman, Senior Vice President, Head of Investor Relations
(203) 681-3720
ir@fifthstreetfinance.com

Media Contact:
Nick Rust
Prosek Partners
(212) 279-3115 ext. 252
pro-fifthstreet@prosek.com

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$ Million

JANUARY 1970

Uncategorized

Fifth Street is seeking an Executive Assistant for its Greenwich, CT office. The ideal candidate must have prior experience working as an Administrative / Executive assistant. They must exhibit exceptional organizational skills, strong attention to detail and the ability to multi-task in a fast paced environment. Responsibilities will be complex and confidential requiring the utmost level of discretion and independent judgment. Employees in this role will have constant contact with high levels of internal and external management.

Responsibilities will include but are not limited to:

• Provide direct support to the CEO and Chief of Staff
• Provide backup support to others on the Administrative team
• Coordinate frequent and complex travel arrangements for the team including scheduling of Investor Relations road shows
• Prepare and review materials for meetings
• Oversee calendar management
• Answer incoming calls, file, fax, bind and send packages
• Manage expense reports
• Must be flexible to handle any needs that may arise

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$ Million

OCTOBER 2015

news-media

Banking on the Fourth Quarter

Despite disappointing middle market deal flow so far this year, lenders expect fourth quarter activity to be seasonally higher. With year-to-date volume trailing by roughly 30% versus the prior year, most middle market participants have experienced lackluster volumes in 2015⁽¹⁾. However, in our observation, select lenders (especially those with a direct origination platform) saw a pickup in activity heading into September.

Overall, the middle market still looks healthy as compared to the Broadly Syndicated Loan (“BSL”) space, which has succumbed to wider market volatility. Both middle market investor demand and appetite to finance new transactions show solid underpinnings. Additionally, pricing remains relatively stable, as compared to the BSL and high yield markets, owing to the middle market’s ongoing supply/demand imbalance. Looking ahead, lenders anticipate an uptick in activity, based on growing deal pipelines. Though they expect non-sponsored issuance to remain flat, lenders are counting on an increase in sponsored transactions (See Figure 1, right), which to date have only reached $35.7 billion this year (versus $51.9 billion during the corresponding period in 2014)⁽¹⁾.

As Predicted, Energy Disappoints

Within leveraged lending, sector performance diverged widely this quarter. The broad S&P Leveraged Loan Index was essentially flat, while the oil and gas sector retreated materially. Following HY, cracks have surfaced in the BSL space and, to a lesser extent, in the middle market. As we have maintained for some time, defaults in the energy sector will likely materialize as companies confront a refinancing wall. In our opinion, this realization has contributed to the sector’s most recent rise in yields, reaching 1,139 bps towards the end of September, as opposed to 653 bps at the same time last year (See Figure 2). Higher yields may appear tempting—and at some point, opportunities will emerge—however, in our view, we have yet to reach the inflection point.

Overall Secondary Yield by Sector

Source: Thomson Reuters LPC Middle Market Weekly; As of 9/25/15.

BSL: A Harbinger of Things to Come?

Sector rotation and a flight to quality continue to characterize the BSL space and echoes of these trends can be seen in the middle market as well. For instance, many lenders remain partial to first lien positions, seeking the relative safety provided by participating higher in the capital structure.

From our standpoint, these developments are not atypical, given the juncture in the credit cycle and the increased volatility buffeting the equity and high yield bond markets. However, the extreme volatility that flared in August has yet to spill over into the loan markets, let alone the middle market segment. Instead, the middle market remains more heavily influenced by competitive dynamics. Banks are still grappling with Basel III requirements and Leveraged Lending Guidance (LLG). Plus, healthy competition by alternative lenders for high quality assets continues to fill the void as banks exit or reduce commitments.

On the whole, we believe the middle market is mostly stable. Pricing ticked up slightly after the August flash crash, but has since normalized. In general, terms and leverage have followed suit. That said, on the margin, for select credits with tier one sponsors and fortress balance sheets, we have seen a bit fuller leverage and slightly more borrower-friendly terms. For instance, pristine credits with attractive recurring revenue and greater than 50% equity checks have benefited from leverage in excess of 6x for one-stop or traditional first lien/second lien structures. We have also seen some select borrowers with this profile enjoy covenant-lite terms, despite being sub-$50 million credits. However, these remain the exception rather than the rule, as lenders are generally employing discipline—conditions we do not foresee changing in the fourth quarter.

Debt to EBITDA for MM LBOs

Source: Thomson Reuters LPC Middle Market Weekly; As of 10/9/15. Note: Debt to EBITDA data for middle market institutional LBOs. 1Q09-3Q09 did not have enough deals to show an accurate quarterly figure. Average quarterly EBITDA ranges between $40-$60MM in any given quarter.

Antares Debuts under New Management

Last quarter, the market was keenly focused on the sale of GE Capital’s sponsor finance business to the Canada Pension Plan Investment Board. While many speculated about the potential impact, from our perspective, it seemed too early for decisive conclusions. However, we did contend that the effects were unlikely to be immediate. Three months later, we have seen Antares Capital resurface under the auspices of the Canada Pension Plan. Though our paths have only crossed a few times, on the surface, the new entity appears to be a disciplined competitor in terms of both pricing and size.

 

BDCs Potential Beneficiaries of New Liquidity Rules

A Q&A with Leonard M. Tannenbaum
Founder & Chief Executive Officer, FSAM

In late September, the Securities and Exchange Commission (“SEC”) proposed several rule changes under the banner of the “liquidity risk management program.” Although the changes are targeted at the mutual fund industry, BDCs may become unintended beneficiaries.

How would you describe the proposed rule changes as defined by the SEC?
The SEC has proposed stronger measures to manage liquidity risks among open-end mutual funds and exchange traded funds (ETFs) when facing redemptions during periods of market turbulence. The new rules require funds to classify their assets according to how easily they could be converted to cash. Funds would then be mandated to keep a certain percentage of their portfolio in assets that could be liquidated, without materially impacting pricing, within a three-day window.

What challenges do the underlying assets in ‘40 Act mutual funds and bond ETFs currently face with respect to liquidity?
These rule changes come at a time when the bond market is already hampered by less liquidity due to post-financial crisis regulation. In particular, Wall Street has been unable to make a market with any depth in corporate bonds. Prior to 2008, broker dealers would hold inventories; however, those inventories have fallen by nearly 80% in the post-crisis world⁽³⁾. Given the lack of trading depth in the corporate bond market, formalizing guidelines around liquidity seems sensible, in our view.

If the SEC’s proposed rules are enacted, do you expect closed-end structures to benefit from greater demand from investors who want exposure to middle market loans?
Closed-end structures, which include BDCs, stand to benefit since the rules do not apply to them. As “permanent capital” vehicles, BDCs do not face the same issues with respect to redemptions.

How will the changes impact financing for mid-market borrowers and their sponsors?
If open-end funds have less latitude to hold illiquid assets, larger middle market issuers and their sponsors might find they have fewer options when it comes to financing. With less competition, BDCs and private funds would be well-positioned to capture a greater share of the opportunity.

With a more limited investment universe, will returns decline for ‘40 Act mutual funds and ETFs?
The consequence of these proposed changes will be to increase holdings of more liquid but lower-yield securities. As a result, returns should decline. For example, funds may have a greater propensity to hold Treasuries, cash and other highly liquid marketable securities alongside debt. Yet, holding cash is suboptimal, since it drags on returns. Mutual funds might also elect to “right-size.” It is inherently easier to get rid of a smaller position than a larger position. So, funds might need to reduce their assets under management to make it easier to comply.

How can liquidity requirements and alpha generation co-exist for “liquid alts” strategies?
The newly proposed rules are especially tricky for funds that market themselves under the misnomer “liquid alternative.” These assets are not liquid—they are based on indicative quotes that are stale and not actionable. Part of the problem is that there is no single definition of “liquid.” Liquidity captures a point in time in a “normal” market. How do you define that? Simply because something isn’t “locked up” doesn’t necessarily make it liquid and being able to sell something in theory differs from being able to sell it in practice. Based on our 17 year-plus track record of originating and holding these types of assets, we know that only about 5% of issuance ever trades again after the first two weeks—beyond that, a bond is typically held until maturity. Bottom line: if a firm isn’t prepared to adhere to liquidity requirements, it should consider a hedge fund LP structure with quarterly redemptions.

 

Fifth Street Activity

New regulations are reshaping the middle market landscape—ranging from the SEC’s liquidity management program to new risk retention rules for CLOs. In both cases, Fifth Street is at the forefront in responding, seeing through to the opportunities these challenges bring. For instance, as of 9/30/15, Fifth Street agented and syndicated $2.39 billion of deals (compared to $1.8 billion in all of 2014), according to Thomson Reuters LPC League Tables. Part of this can be attributed to winning a greater share of lead left business with larger sponsors—a trend we expect to continue as we streamline our syndication process, as highlighted further below.

Modernizing Middle Market Lending

As previously announced, Fifth Street Asset Management has provided seed funding for MMKT Exchange LLC (“MMKT”), a new digital platform designed to introduce efficiency, liquidity and transparency to the outdated middle market loan syndication process, while increasing accessibility to a broader base of purchasers. This quarter, MMKT secured $5.9 million in backing from a group of strategic high net worth and institutional investors attracted by its value proposition.

The process for middle market loan syndications remains inefficient and cumbersome and has not changed in any meaningful way over the last few decades. Transactions are often agreed upon by phone, then settled by fax or email. Utilizing a first-class technology-based workflow solution, MMKT will deliver a secure, end-to-end platform that streamlines this process, saving time and money for all those involved.

A big problem today in the loan market is that many loans are not based on actual bids and offers, but instead on indicative quotes that may not be updated. The MMKT Exchange is intended to eventually expand into trading existing loans, which will help increase the amount of real bids, offers and quotes, bringing more liquidity and transparency to the industry.

Fifth Street Dominates 2015 Middle Market CLO Issuance

Despite the turbulent market conditions and broader market volatility in August, Fifth Street Asset Management was able to price and close Fifth Street SLF II, Ltd. (“FS SLF II”), a $416.6 million CLO. FSAM’s second actively managed CLO, FS SLF II also represents the third debt securitization across the broader platform since our inaugural issue in February 2015. Cumulatively, the three securitizations account for roughly 20% of all middle market CLO capital raised so far this year⁽⁴⁾.

With a four-year reinvestment period, FS SLF II is mainly invested in middle market senior secured loans sourced and originated through the Fifth Street platform. Fifth Street CLO Management LLC retained five percent of the securities in every class, which ranged from from Aaa/AAA through Ba3 along with unrated subordinated notes.

In our view, the expansion of our CLO platform and healthy demand from institutional investors endorses both the power of our direct origination platform as well as the potential of the middle market.

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Internet Software & Services

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Healthcare Services

BAART operates outpatient clinics across the country that provide methadone treatment and counseling services to assist patients with opioid addictions. MedMark Services, Inc. is a growing, specialty healthcare organization, providing addiction treatment and primary care services with an emphasis on quality, patient focused healthcare. Combined, they create the third largest methadone provider in the U.S.

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Environmental & Facilities Services

Valet Waste is a Tampa, FL-based national provider of value-added amenity services to the multifamily housing industry. Its fully insured and uniformed professional valets collect waste and recyclables from residents' doorsteps five nights per week, and manage multifamily communities' on-site trash issues by streamlining waste from the doorstep to the dumpster with its proven systems.

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Internet Software & Services

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news-media

Click below to listen to the recorded webinar, held on September 9, 2015.

Download the Webinar Presentation PDF

Webinar Overview

Are your clients tired of searching for yield in today’s low interest rate environment? The answer may lie in Business Development Companies, or BDCs – an income producing alternative asset class that has generally flown under investors’ radars – until now.

BDCs were created by Congress in 1980 to help stimulate lending in the U.S. and enable public investors to invest in private, growing businesses. Today, this growing industry is a powerful force in middle market lending with a market capitalization of ~$33 billion.¹

Governed by the Investment Company Act of 1940, BDCs are pass-through entities, similar to REITs, that can bypass corporate income taxes as long as they distribute at least 90% of taxable annual net income as dividends to shareholders. BDCs are known for their dividend yields that can reach double-digits – a rare commodity these days well-suited for retirees and other income-seeking investors. In fact, the industry is currently trading at a discount, below net asset value (NAV),¹ allowing for an attractive buying opportunity.

However, not all BDCs are the same or offer the same quality of investments. In fact, BDCs can adopt very different approaches, depending on each management’s philosophy. Listen to our fireside chat webinar to learn more about this emerging asset class and what to look for when evaluating these alternatives. Selectivity counts – and certain BDCs can allow clients to receive:

• Attractive, recurring dividends
• Access to risk-averse portfolios of private, middle market credits
• Liquidity
• Diversification across many industries
• Floating rate exposure (helping to position for rising interest rates)

Fifth Street Finance Corp. (NASDAQ: FSC), one of the largest publicly-traded BDCs in the country by market capitalization,1 provides custom-tailored financing solutions to small and mid-sized companies, primarily in connection with investments with private equity sponsors. As of June 30, 2015, FSC’s $2.3 billion portfolio had 132 portfolio companies across 36 industries and 78% of the portfolio consisted of senior secured loans. FSC has a current dividend yield of 11.8%.^1,2

For more information, please visit fifthstreetfinance.com/fa.

1) As of 7/31/15.
2) Based on the annualized monthly dividend of $0.06 per share declared by FSC’s Board of Directors through November 2015.

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$ Million

JANUARY 1970

Uncategorized

Fifth Street is currently seeking a Manager/Vice President to be based in our Greenwich, CT office and report directly to the Senior Vice President, Finance. The selected individual will be responsible for: (1) Compliance with all relevant SEC and related regulatory reporting requirements and (2) The development of accounting policy and process changes as they relate to technical accounting best practices and standards. The aim is to maintain financial controls to preserve the integrity and compliance of the firm’s reporting standards. This position oversees the implementation of these standards and liaises additionally with appropriate regulatory bodies.

Responsibilities will include but are not limited to:

• Responsible for the quarterly and annual SEC reporting process for two publicly traded business development companies, Fifth Street Finance Corp. (NASDAQ: FSC) and Fifth Street Senior Floating Rate Corp. (NASDAQ: FSFR), in addition to a publicly-traded alternative asset manager, Fifth Street Asset Management (NASDAQ: FSAM). Includes the preparation and review of Forms 10-K, 10-Q, 8-K, proxy and other filings as well as earnings releases and related documents. Provide support to senior management for quarterly Audit Committee and other meetings in review of such documents.
• Analyze new and proposed accounting standards issued by the SEC and the FASB to determine the impact on the company. Implement and document new accounting standards as required and lead the development of a formalized company-wide accounting policy manual.
• Primary responsibility for the company’s Sarbanes Oxley compliance and documentation process, including interacting with external auditors and internal process owners across departments.
• Establish, communicate and monitor accounting policies and procedures, act as primary liaison with external auditors.
• Assist in ad hoc projects with various departments such as assisting in accounting system integrations and proposing improvements and efficiencies to the existing reporting processes.

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$245.0 Million

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Software

MediaOcean is a New York, NY-based software company that enables agencies to manage and coordinate the entire advertising workflow, from planning and buying, to analyzing and optimizing, to invoicing and payments. Its open platform integrates media suppliers, data providers, ad servers and third-party technologies—allowing agencies to build optimal solutions for business and operations.

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JUNE 2015

Healthcare Services

All Metro Health Care is a Lynbrook, NY-based provider of home and community based services, primarily non-skilled personal care aide services, including light housekeeping, homemaking, bathing and grooming to seniors and high needs individuals.

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$ Million

JANUARY 1970

Uncategorized

Fifth Street is seeking a healthcare-focused Associate candidate to join the investment team. The Associate position is on the transaction team; this team executes new investments in both the debt and equity parts of the capital structure in private equity sponsored leveraged buyout transactions and manages Fifth Street’s 100+ portfolio companies.

As an Associate you will be an integral part of the team, leading analyst teams and working closely with directors and partners on live deals. You will be challenged and given the opportunity to contribute to the overall success of the firm. Fifth Street is committed to providing you the tools and opportunities necessary to advance your learning and your career as rapidly as possible. Potential candidates should be able to demonstrate a track record of success, innovation, and creativity in their prior work experience.

Responsibilities will include but are not limited to: (1) Execute investments in both the debt and equity parts of the capital structure in private equity sponsored leveraged buyout transactions; (2) Evaluate and analyze potential investment opportunities; (3) Perform and coordinate extensive legal and underwriting due diligence processes; and (4) Manage and supervise junior staff.

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$ Million

AUGUST 2015

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$ Million

JULY 2015

news-media

Modest Improvement,
But Still Trailing

While U.S. middle market loan volume registered a slight uptick this quarter, the market has yet to approach levels seen one year ago. Although sponsored issuance gathered momentum in 2Q, increasing modestly to $11.9 billion, issuance for the first six months only reached $22 billion—the weakest first half in five years (See Figure 1).

At $1 trillion, M&A volume in the U.S. has reached historic levels in 2015⁽¹⁾; however, purchases by investment grade companies have overshadowed private equity purchases. On the other hand, the middle market represents a haven for private equity sponsors who are currently being outbid by cash-rich corporate buyers in the Broadly Syndicated Loan ("BSL") space. Many sponsors believe middle market conditions are more favorable than the BSL space, partially due to the prevalence of alternative lenders who continue to fill the void left by traditional banks hampered by strict capital requirements and leveraged lending guidelines.

Annual Sponsored Issuance

Source: Thomson Reuters LPC; As of 6/30/15.

Healthcare Leads the Pack

Despite sluggish conditions in the first half of 2015, we remain cautiously optimistic for the second half, given the seasonality of the M&A market. Although middle market valuations remain frothy and liquidity excessive, we have noticed an increase in deal flow in select industry verticals such as healthcare. At $5.3 billion, healthcare represented the top sector by volume in the first half of the year (See Figure 2, right). This sector tends to exhibit lower leverage and improved economics when compared to other traditional sectors. We believe this dynamic exists because many lenders shy away from the complex reimbursement models which characterizes these credits and necessitates specialized origination and underwriting expertise.

Pricing Squeeze Persists,
While Middle Market Maintains Yield Premium

Driven by too much liquidity chasing too few deals and a slowly improving economy, pricing continues to show signs of downward pressure. During the second quarter of 2015, middle market term loan yields declined to 5.74%, with tightening occurring throughout the capital stack (See Figure 3). While first lien pricing responded more quickly and by the largest magnitude, second lien followed suit, albeit to a lesser extent.

Despite the decline, middle market spreads still maintained their premium over large corporate spreads, where term loan pricing fell to 4.66%. Through the first half of the year, the 100+ basis points yield differential has held fast. The premium was re-established after disappearing during the broader market sell-off at the end of 2014. In our view, this yield differential represents an attractive liquidity premium for middle market investors. Investors seem to agree, as evidenced by the brisk pace of middle market fundraising so far this year. At over $8 billion, 2015's visible middle market capital raising appears on track to surpass levels reached last year⁽²⁾.

As the economy continues to improve, our investment vehicles remain positioned for potential interest rate increases. We continue to see select deals decreasing LIBOR floors from 100 basis points to 75 basis points or 50 basis points, though the trend is still modest. Generally speaking, completing new deals with LIBOR floors below 100 basis points should slightly offset the negative impact of rising interest rates up to 100 basis points. After LIBOR rises more than 100 basis points, lenders (with a mix of floating and fixed rate liabilities) should generate additional income and benefit from a rising interest rate environment.

Middle Market and Large Corporate Average Yields (Monthly)

Source: Thomson Reuters LPC; As of 6/30/2015.
There was not enough data to show an average for March 2015.
Middle market borrowers have revenues & deal size equal to or less than $500MM. Large corporate borrowers have sales over $500MM.

Sizing Up the GE Exit

The landscape surrounding middle market leveraged lending continues to change, as evidenced by the sale of GE Capital's sponsor finance business to the Canada Pension Plan Investment Board. There is considerable uncertainty surrounding the sale's impact and, from our perspective, it seems premature to make a definitive assessment. With competition and liquidity both pervasive, the effects are unlikely to be immediate in our view.

We believe that the sale may be a harbinger of things to come, with more financial institutions exiting this space due to leveraged lending guidelines.

Middle Market CLOs Make Strides,
But Still Have a Ways to Go

A flurry of last minute activity buoyed 6/30/15 YTD U.S. collateralized loan obligation ("CLO") volume to $58.68 billion. BSL CLOs accounted for $55.32 billion, or 94% of total issuance, while middle market CLOs totaled $3.36 billion (or 6%) during the period. As Figure 5 below demonstrates, the CLO market has rebounded considerably from its post-financial crisis trough. However, much of that recovery has been driven by BSL CLOs, whose 2014 volume of over $116 billion actually exceeded pre-crisis peak levels. Demand for middle market CLOs has strengthened as well, but not nearly to the same extent. From our perspective, we believe demand will continue to increase as a result of attractive yields, more conservative structures and favorable correlation statistics to broader liquid market alternatives.

However, several factors are still holding back the recovery of middle market CLOs. Generally speaking, investors remain somewhat wary of the relatively smaller size of the underlying borrowers and less liquid nature of middle market loans. In addition, middle market CLOs have a much thinner investor base for rated notes—especially for Aaa/AAA-rated notes. To spur growth, middle market CLOs need a deeper and more expansive investor base, as evidenced by the current difficulty placing Aaa/AAA notes (which account for 50+% of these structures).

In addition, the broader macroeconomic environment and cyclical summer slowdown haven't helped. Recent capital markets volatility has given investors pause as macroeconomic concerns ranging from a potential Greek exit to a slowdown in China have diminished investors' appetite for risk. These uncertainties have caused liabilities to trend wider, particularly in the middle market, with recent quality issues pricing Aaa/AAAs north of L+195 basis points.

These pressures have pushed out the timeline for a variety of deals. However, as the typical summer slowdown concludes and some of the recent macro events subside, we expect the market to 'find its footing,' suggesting that the pace of fourth quarter activity should be brisk.

Middle Market CLO Volume

Source: Thomson Reuters LPC, Wells Fargo; As of 6/30/2015.

Fifth Street Activity

We are delighted to announce that Fifth Street was named "Lender Firm of the Year" at the 5th Annual ACG New York Champion's Awards—the second consecutive year that the platform has received a firm of the year distinction. The honor confirms our status as a premier lender to private equity sponsors in the middle market—one of the key drivers of the increased interest we are seeing in our platform.

We are currently in active discussions with various institutions that lack access to middle market direct lending. These prospective partners are looking to tap into our leading sponsor-focused origination platform, which has a multifaceted and nationwide sourcing strategy – soon to include a San Francisco office for which we recently signed a lease. In particular, we are noticing considerable interest in our first lien and one-stop financing transactions, which we believe have the strongest risk/reward trade-offs in today's environment.

Key Hire

The ability to attract experienced institutional investors as partners is a vote of confidence in Fifth Street's sourcing, underwriting and portfolio management expertise. As a result, we made a strategic hire during the second quarter to help us capitalize on this potentially significant opportunity and to execute on our vision of continuing to build a leading, diversified credit-focused asset manager. The addition of David Heilbrunn (Managing Director and management committee member) supports this goal of driving growth across Fifth Street's business lines, specifically focusing on expanding our growing structured credit products platform, developing institutional client relationships and optimizing various financing arrangements.

CLO Risk Retention Rules Create Opportunities

While CLO managers do not have to comply with U.S. and European risk retention rules until next year, firms are already gauging the impact of these rules. Established firms with access to permanent capital like Fifth Street have already developed viable solutions. However, new firms that lack the scale to retain the risk outright are approaching larger players to discuss a range of options including joint ventures. As a result, we believe this may drive industry consolidation among newer market participants.

Focused on Capital Preservation

Given the current market environment, some investors appear ambivalent towards investing in credit at this juncture in the cycle. They appear conflicted around timing their entry, particularly if the cycle has reached an inflection point. However, we believe our defensive positioning and differentiated credit portfolio may help alleviate investors' concerns. Fifth Street's award-winning origination platform allows us to uncover pockets of opportunity, while maintaining strict underwriting standards and a focus on capital preservation. We have continued to focus on senior secured instruments and have limited our exposure to cyclical industries, including energy, consumer-driven businesses and companies with direct retail exposure. While our size, scale and deep sponsor relationships allow us to source ~1,000 middle market loan opportunities per year, our single most important job is making smart investments in relatively secure credits with appropriate risk-adjusted returns, which is evidenced by a selectivity ratio of ~4%⁽⁴⁾.

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$ Million

JANUARY 1970

our-newsletter

Sale of GE Capital's Sponsor Business

As evidenced by the sale of GE Capital's sponsor finance business to the Canada Pension Plan Investment Board, the landscape surrounding middle market leveraged lending continues to change. Due to regulatory headwinds, we see a continued disintermediation of leveraged lending from the traditional banking sector, characterized by declining bank participation in middle market leveraged lending, while participation from non-bank lenders has increased year-over-year. We believe that borrowers and sponsors favor a collaborative partnership approach, which non-bank lenders are typically able to provide through more flexible financing solutions, large hold sizes and diversified product offerings. The non-bank lending space has become more institutionalized, gaining market share and influence. For example, during the second quarter through mid-June, non-bank lenders captured 8.0% of left lead mandates that LCD has tracked, by volume, and 9.6% by number of loans, up from 3.4% and 6.4%, respectively, in the first quarter.

Middle Market Supply and Demand Imbalance Persists

On the macro front, an overall supply/demand imbalance continues to define the middle market as the ongoing disintermedmiation of leveraged lending from the traditional banking sector intensifies. U.S. syndicated loan issuance increased quarter-over-quarter, mainly driven by refinancings, but when compared to the previous year, volume for the second quarter lagged behind last year's totals. In line with the quarter-over-quarter increase in volume, since the first quarter, we have witnessed an increase in deal flow from select industry verticals such as healthcare, which is exhibiting relatively lower leverage and wider spreads, as compared to other traditional sectors. We believe this dynamic exists due to lenders shying away from the complex reimbursement environment which characterizes these credits. Fifth Street's established origination platform allows us to uncover such pockets of opportunity. Our size, scale and ability to allocate across our platform positions us to maintain a steady flow of high quality loans.

Focused on Capital Preservation

As a leading middle market sponsor-backed lending platform, Fifth Street seeks to provide sponsors with both balance sheet flexibility and high-touch, value-added services. We focus on capital preservation and maintain strict underwriting standards when deploying capital into new loans. We feel confident in FSC and FSFR's conservative positioning, as we have continued to focus on senior secured instruments, since we believe the current risk/reward trade-off is strongest in first lien and one-stop transactions. FSC opportunistically invests in second lien and mezzanine transactions when there are strong risk-adjusted return opportunities. Additionally, as we continue to position the portfolios of both FSC and FSFR, we have limited our exposure to cyclical industries, including energy, consumer-driven businesses and companies with direct retail exposure.

As the economy continues to grow, we are positioning our investment vehicles for potential interest rate increases. We believe FSC, with 74.0% floating rate assets, and FSFR, as a pure play, ~100% floating rate vehicle, are well-positioned for potential interest rate rises. We are seeing continued pressure on LIBOR floors, with select deals decreasing LIBOR floors from 100 basis points to 75 basis points or 50 basis points. Generally speaking, completing new deals with LIBOR floors below 100 basis points should slightly decrease the negative impact of rising interest rates up to 100 basis points. After LIBOR rises more than 100 basis points, both FSC and FSFR should generate additional income and benefit from a rising interest rate environment.

Refocusing FSC on Core Middle Market Lending Businesses

As previously announced, FSC sold its portfolio company, Healthcare Finance Group, LLC ("HFG") to MidCap Financial. HFG is a specialty lender providing asset-backed lending and term loan products to various segments of the healthcare industry. FSC acquired HFG in June of 2013 and, together with management, expanded the company's suite of products and capabilities, positioning it for future growth. Upon the sale of HFG, FSC generated approximately an 8.5% net return on its total investment.

During FSC's recent strategic review, management decided that it was important to refocus FSC on its core lending businesses, including middle market sponsor-backed lending, aircraft and technology venture. This decision was made because we believe that the middle market provides relatively strong opportunities and investing in its core lending businesses should allow FSC to generate higher risk-adjusted returns.

Prospective Management Fee Reduction at FSC Finalized

FSC has entered into a waiver with its investment adviser, a subsidiary of Fifth Street Asset Management Inc. (NASDAQ:FSAM) ("FSAM"), in which FSC's investment adviser has agreed to waive 1% of FSC's base management fee for increases in capital related to the issuance of new equity. FSC's current base management fee is 2% of FSC's gross assets, excluding cash, but going forward, the fee related to the new equity raised will be 1%. This waiver is effective until January 1, 2017 and it is the intention of FSAM to renew the waiver on an annual basis going forward.

The reduction in base management fee will benefit all shareholders equally, regardless of when they invested and was implemented to create additional operating leverage, allowing our shareholders to benefit from economies of scale as FSC grows.

FSFR Has Successfully Optimized Its Capital Structure

During the first half of 2015, we worked hard to strengthen FSFR's capital structure, closing on three different financing facilities, in order to position it for improved profitability and future growth. FSFR was able to capitalize on an attractive capital markets environment to optimize its capital structure and lock in low-cost, long-term financing.

In January, FSFR closed on a $175.0 million credit facility provided by Citibank, which provided FSFR with the necessary leverage to reach its target leverage range of 0.8x to 0.9x debt-to-equity. Then, in June, FSFR closed a $309.0 million debt securitization transaction, in which it issued $222.6 million of long-term secured notes to refinance its existing $200.0 million credit facility arranged by Natixis, New York Branch. The third financing was completed in connection with FSFR Glick JV LLC ("FSFR Glick JV"), in which the joint venture entered into a $200.0 million credit facility with Credit Suisse AG, Cayman Islands Branch, providing the ability to lever up to two times debt-to-equity.

By improving FSFR's capital structure, management believes that FSFR is well-positioned to continue investing in senior secured floating rate loans and take advantage of positive business trends.

Strategic Partnerships Continue to Expand

We continue to make significant progress in both funding and expanding our joint ventures at FSC and FSFR. The ability to attract experienced institutional investors as partners is a vote of confidence in Fifth Street's origination platform, underwriting and portfolio management expertise.

As of June 30, 2015, FSFR Glick JV, the joint venture between FSFR and entities controlled by members of the Glick Family, was approximately 45% ramped out of the total anticipated investment capacity of $300.0 million. Consistent with our initial projections, we expect the joint venture to provide FSFR with a low-teens weighted average annualized return on investment when fully ramped.

Subsequent to the June quarter, Senior Loan Fund JV I LLC ("SLF JV I"), the joint venture between FSC and a subsidiary of the Kemper Corporation, closed on $200.0 million of additional leverage sourced from Credit Suisse AG, Cayman Islands Branch. This additional leverage for SLF JV I should allow the joint venture to expand up to its anticipated investment capacity of $600.0 million.

We continue to have discussions with third parties about additional partnerships, as we have ample capacity to grow these and other similar joint ventures. The joint ventures expand each BDC's investment capacity to underwrite senior secured middle market loans and provide an efficient way to finance assets that enhance returns for our shareholders.

We look forward to discussing our June quarterly results in more detail during FSC's and FSFR's respective quarterly earnings calls, which will both be held in August.

Sincerely,

The Fifth Street Team

About Fifth Street Finance Corp.

Fifth Street Finance Corp. is a leading specialty finance company that provides custom-tailored financing solutions to small and mid-sized companies, primarily in connection with investments by private equity sponsors. The company originates and invests in one-stop financings, first lien, second lien, mezzanine debt and equity co-investments. FSC's investment objective is to maximize its portfolio's total return by generating current income from its debt investments and capital appreciation from its equity investments. The company has elected to be regulated as a business development company and is externally managed by a subsidiary of Fifth Street Asset Management Inc. (NASDAQ:FSAM), a nationally recognized credit-focused asset manager with over $6 billion in assets under management (as of March 31, 2015) across multiple public and private vehicles. With a track record of over 17 years, Fifth Street's platform has the ability to hold loans up to $250 million and structure and syndicate transactions up to $500 million. Fifth Street received the 2015 ACG New York Champion's Award for "Lender Firm of the Year," and other previously received accolades include the ACG New York Champion's Award for "Senior Lender Firm of the Year," "Lender Firm of the Year" by The M&A Advisor and "Lender of the Year" by Mergers & Acquisitions. FSC's website can be found at fsc.fifthstreetfinance.com.

About Fifth Street Senior Floating Rate Corp.

Fifth Street Senior Floating Rate Corp. is a specialty finance company that provides financing solutions in the form of floating rate senior secured loans to mid-sized companies, primarily in connection with investments by private equity sponsors. FSFR's investment objective is to maximize its portfolio's total return by generating current income from its debt investments while seeking to preserve its capital. The company has elected to be regulated as a business development company and is externally managed by a subsidiary of Fifth Street Asset Management Inc. (NASDAQ:FSAM), a nationally recognized credit-focused asset manager with over $6 billion in assets under management (as of March 31, 2015) across multiple public and private vehicles. With a track record of over 17 years, Fifth Street's platform has the ability to hold loans up to $250 million and structure and syndicate transactions up to $500 million. Fifth Street received the 2015 ACG New York Champion's Award for "Lender Firm of the Year," and other previously received accolades include the ACG New York Champion's Award for "Senior Lender Firm of the Year," "Lender Firm of the Year" by The M&A Advisor and "Lender of the Year" by Mergers & Acquisitions. FSFR's website can be found at fsfr.fifthstreetfinance.com.

Forward-Looking Statements

This press release may contain certain forward-looking statements, including statements with regard to the future performance of FSC and/or FSFR. Words such as "believes," "expects," "estimates," "projects," "anticipates," and "future" or similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ materially from those projected in these forward-looking statements, and these factors are identified from time to time in the companies' respective filings with the Securities and Exchange Commission (as applicable). The companies do not undertake any obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

CONTACT:

Investor Contact:
Robyn Friedman, Vice President, Investor Relations
(203) 681-3720
ir@fifthstreetfinance.com

Media Contact:
Nick Rust
Prosek Partners
(212) 279-3115 ext. 252
pro-fifthstreet@prosek.com

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Diversified Support Services

Motion Recruitment Partners is a Boston, MA-based provider of value-added recruitment services and solutions. The company offers permanent and contractor placement of IT professionals as well as Recruitment Process Outsourcing services.

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Specialized Consumer Services

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Leisure Facilities

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Internet Software & Services

PowerPlan is an Atlanta, GA-based provider of integrated and mission-critical project, asset, depreciation, and tax management solutions for asset-intensive companies.

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Published in the May issue of Bloomberg Markets

By Jon Asmundsson

When Leonard Tannenbaum set up shop in the basement of an office building in Mount Kisco, New York, his plan for his one-man investing business was about as basic as you can get. “Early on, the idea was to make money,” Tannenbaum says. “How do I make money? How do I get an edge?”

It was 1998, and he was 27 years old, a Wharton MBA with two years as an analyst at Merrill Lynch and a couple of stints at fund firms, Bloomberg Markets reports in its May issue. He even sublet out half of the 800-square-foot (74-square-meter) space. Tannenbaum asked himself: “Is there a better mousetrap to develop?”

The mousetrap Tannenbaum built almost made him a billionaire last year. When the initial public offering of Fifth Street Asset Management was being marketed at $24 to $26 a share, Tannenbaum’s stake in the company would have been worth more than $1 billion at the upper end of the initial range.

Now headquartered in a 120,000-square-foot, light-filled building in Greenwich, Connecticut, Fifth Street manages more than $6 billion altogether. Its vehicles include a $70 million long-short credit hedge fund, a private senior loan fund, and a $309 million collateralized loan obligation. Most of the firm’s assets, though, are in two publicly traded business development companies: Fifth Street Finance Corp. and Fifth Street Senior Floating Rate Corp.

Read the entire article here.

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$ Million

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news-media

Taking a Pause

Middle market issuance has been off to a slower start this year, partially due to softer M&A activity (See Figure 1). Prior to the broader market sell-off at year end, new money deals were on the rise and leverage was ticking up—helping sponsors justify purchase premiums. Now, a reversal of fortunes has taken hold. Last year's reset ushered in a pullback in leverage as well as greater deal selectivity, widening the bid-ask spread and dampening the appetite for M&A. Although sponsored loan volume stands at just $9 billion year-to-date, we expect the middle market lending environment to improve over the year. However, for the near term, we are likely to see opportunistic refinancing and dividend recapitalizations dominating new money transactions.

Sponsored: Quarterly New Money vs. Refinancing

Source: Thomson Reuters LPC; As of 3/31/15.
Larger Middle Market Deal Size $100MM to $500MM. Traditional Middle Market Deal Size is less than $100MM.

The "Haves" and "Have Nots"

While market bifurcation has persisted for some time—with high quality credits attracting a disproportionate share of interest from lenders—many have noted an intensification as of late. Credits that are perceived as having a "clean story" have typically been oversubscribed, leading spreads to flex down. On the other hand, so-called marginal credits have tended to flex wider or, in some cases, have been pulled from the market altogether. According to S&P Capital IQ LCD, as the March quarter unfolded, the percent of loans flexing down has been hovering in the 50-60% range, compared to 25-30% at year-end. Conversely, only about 10% of loans have been flexing up versus 25-40% just one quarter ago (See Figure 2).

A Wake Up Call for Banks

Banks have been aggressively pursuing straight, down-the-middle credits that can be structured as Term Loan A transactions. These plain vanilla credits are highly desirable for traditional lenders, who have been hampered by U.S. regulators' leveraged lending guidelines relative to the level of funds they have to lend.

Issued in March 2013, the leveraged lending guidance is not new. However, as regulators underscore their seriousness—and banks digest their full impact—the guidelines are weighing more heavily in the decision-making process. The guidelines stipulate two hurdles: each transaction must fall below a six times leverage threshold as well as a 50% amortization rate, deleveraging over a five- to seven-year period. The latter has emerged as a prominent tripwire, although a transaction that fails either test typically prompts a decline. Such declines are transcending pre-existing relationships; they are not uncommon even for borrowers or sponsors seeking incremental funds from a current lender or agent. In those cases, borrowers and sponsors usually circumvent the banks to approach non-bank lenders directly.

Not surprisingly, Thomson Reuter's most recent Middle Market Survey indicated a significant increase in the number of lenders who anticipate a material drop off in banks' abilities to commit to highly leveraged transactions. Typifying this trend was GE Capital, which garnered headlines with its recent announcement to scale back or sell off its commercial lending arm.
(See Figure 3).

How Will Leveraged Lending Guidance Impact Banks' Ability
to Invest in Leveraged Loans?

Source: Thomson Reuters LPC's 15th Annual Middle Market Roundtable Survey Results; Note: "HLT" refers to Highly Levered Transactions.

Developments in Pricing and Structure

As the guidelines continue to have a cooling effect on banks' lending, unitranche structures have gained widespread momentum. Having expanded their market share in 2014, many expect them to make further inroads in 2015 as sponsors favor this structure over other solutions (see Figure 4, right).

From a pricing perspective, price discovery for both first lien and second lien at the beginning of the year has given way to clearer delineation for first lien (and even slight tightening for superior credits). However, second lien remains more opaque with price discovery still apparent.

Eyes on the Fed

Cautious optimism with respect to the economy has brought the interest rate hike question to the forefront. How will a potential rise in interest rates impact the middle market? Some investors assume that portfolio companies may come under greater financial stress as interest payments on floating-rate debt increases. Prudent credit managers, however, have often factored in those risks when originating deals. In fact, portfolio companies' cash flows could potentially improve if rising interest rates signal some sort of fundamental improvement in the economy.

In addition, credit managers invested in floating rate investments stand to reap the benefits of additional income when interest rates eventually rise. With 84% of FSAM's credit-focused AUM in floating rate investments, we believe that the Fifth Street platform is well-positioned.

Fixed & Floating Rate Debt Investments as a %
of FSAM's Credit-Focused AUM

Generally speaking, interest rates will need to rise at least 75-100 bps for lenders to reap the benefits of additional income, factoring in interest rate floors. The market average Libor floor is approximately 100 bps; however, we believe the market will anticipate the benefit ahead of time.

To quantify the impact more broadly, consider Fifth Street Senior Floating Rate Corp. (FSFR), a pure play with a portfolio of ~100% senior, floating rate loans. Figure 6 below reflects the benefit to FSFR's net spread income at various rate levels. Yet, with a current yield of over 11%⁽²⁾, FSFR represents more than just an interest rate play—it offers compelling income independent of the direction of interest rates.

FSFR's Estimated Annual Change in Net Spread Income from Interest Rate Changes

Fifth Street Activity

As a management team, we are confident about our business and the range of growth opportunities we are seeing. While our business development companies, Fifth Street Finance Corp. (FSC) and Fifth Street Senior Floating Rate Corp. (FSFR), have historically driven our strong growth, we remain committed to diversifying the asset management platform through other growth initiatives. Two initiatives that we are actively pursuing are the expansion of our CLO business and our hedge fund.

Debut CLO

During the quarter, FSAM announced the closing of its first collateralized loan obligation (CLO), Fifth Street Senior Loan Fund I, LLC ("CLO I"). At $309.5 million, the CLO invests primarily in middle market senior secured loans sourced and originated through the Fifth Street platform. As a first-time issuer, FSAM was pleased with the institutional interest displayed—a validation of the strength of our direct origination platform. CLO I represents an important milestone in the continued growth of this product line. We are also continuing to evaluate the securitization of Fifth Street Senior Loan Fund II, LLC (SLF II) and are in active conversations with prospective investors as we look to raise our third senior loan fund, Senior Loan Fund III.

Strong Hedge Fund Results

Elsewhere, we are pleased to announce that our hedge fund marked its second anniversary in February⁽³⁾. Primarily focused on yield-oriented, uncorrelated, and liquid corporate credit assets and equities, the hedge fund has generated consistent results, with 25 out of 26 months of positive net returns⁽³⁾. The hedge fund has approximately $80 million of AUM⁽⁴⁾ and continues to grow as a result of its unique alpha strategy.

Direct Lending Momentum

Beyond our existing products, we continue to explore other strategies in the direct lending space, which appear to be gathering momentum as a distinct asset class. According to Preqin, direct lending fundraising has already climbed fourfold since 2012 ($7.1 billion versus $29.1 billion of inflows in 2014), with room for further expansion. Over 60% of investors cited it as the most attractive investment opportunity in the current market⁽⁵⁾. Such robust interest comes as no surprise given that many global investors seek incremental returns without undue risk. Direct lending can also provide protection from rising interest rates and premium yields relative to traditional fixed income along with stronger asset protection. With an award-winning direct origination platform and a core focus on middle market credit strategies, we believe Fifth Street is well-equipped to capitalize on future momentum in the direct lending space. Our highly selective, sponsor-focused platform emphasizes scale, discipline and a focus on capital preservation.

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xMatters is a San Ramon, CA-based software company which provides intelligent communications products for IT and business operations. The company helps large enterprise customers collaborate, communicate and respond more quickly and effectively to a wide range of incidents.

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