OREANDA-NEWS. Fitch Ratings has downgraded the long-term Issuer Default Rating (IDR), senior secured and senior unsecured notes of Fifth Street Finance Corp. (FSC) to 'BB' from 'BB+'. The Rating Outlook remains Negative. Today's rating actions have been taken as part of Fitch's periodic review of Business Development Companies (BDCs), which comprises 10 publicly rated firms.

BDC INDUSTRY OUTLOOK

Fitch's outlook for the BDC sector is negative; reflecting competitive underwriting conditions, earnings pressure, underperforming energy investments, unsustainable asset quality metrics, increased activist pressure, and limited access to growth capital. While some firms are better positioned, given their more conservative financial profiles and portfolio characteristics, others are likely to see rating pressure over the outlook horizon.

BDCs are heavily dependent on the equity markets to fund portfolio growth, but access to the market has been almost non-existent over the last 18 months as share prices continue to trade at steep discounts to net asset value (NAV). At March 7, 2016, rated BDCs were trading at a 18.3% average discount to NAV, thus preventing most from issuing stock without significantly diluting existing shareholders. While the reduction in portfolio growth is viewed favorably by Fitch, given tough underwriting conditions, some firms may struggle to close the trading gap, leaving them at a competitive disadvantage if and when investment opportunities arise.

The decline in commodity prices has yielded the first notable crack in asset quality performance for BDCs. More broadly, asset quality metrics remain at unsustainably low levels, in Fitch's opinion. While strong portfolio company performance has been supported by an improving economic environment, low interest rates are likely masking some potential underlying company-specific issues, as issuers have been able to refinance themselves out of trouble rather easily in recent years. Fitch believes asset quality metrics are likely to deteriorate over the near term; however, the pace of deterioration will be somewhat dependent upon the rate of change in interest rates, the backdrop of the broader economic environment, differing sector exposures, and the integrity of individual firms' underwriting.

Fitch has not observed a marked increase in leverage levels for the sector, with average leverage for investment grade-rated BDCs of 0.74x at year-end 2015 compared to 0.60x at year-end 2014. However, there is a wide dispersion of leverage around the average, and those with the most energy exposure often also have the highest leverage ratios. Share repurchase activity has also increased in the sector in recent quarters, which could inflate leverage ratios further. Fitch believes that BDCs heavily focused on maximizing leverage run the risk of having less dry powder to deploy when if and when underwriting conditions improve, thus weakening earnings upside.

KEY RATING DRIVERS
IDRS AND SENIOR DEBT
The rating downgrades reflect FSC's continued asset quality deterioration and higher leverage relative to peers but lower than Fitch's last rating actions, compounded by a weakening franchise as a result of accounting misstatements and inconsistencies in strategy, growth plans, fee structure, dividend policy, and share repurchase activity. Additionally, pending shareholder lawsuits are expected to continue to be a distraction for management and are likely to negatively impact operating performance, as elevated legal expenses weigh on net investment income (NII) and dividend coverage in the near term.

The maintenance of the Negative Rating outlook reflects the potential for further asset quality deterioration and longer-term uncertainties with respect to management's fundamental risk appetite regarding leverage, portfolio risk, growth, and dividend management.

Ratings remain supported by the senior secured nature of the majority of FSC's collateral, limited exposure to oil and gas investments, low interest rate risk, appropriate funding and liquidity profiles and the regulatory framework (Investment Company Act of 1940) under which BDCs operate.

FSC targets leverage of 0.6x-0.8 times (x), excluding Small Business Administration (SBA) debt, which is exempt from regulatory asset coverage calculations. Regulatory leverage was 0.74x, as of Dec. 31, 2015, which is consistent with management's target. However, Fitch assesses FSC's leverage inclusive of SBA debt. On this basis, GAAP leverage, amounted to 0.91x, which is higher than the peer average of 0.64x, as of Sept. 30, 2015.

Fitch views the leverage target as aggressive, particularly given the firm's shift into second lien investments and increased use of leveraged off-balance sheet vehicles, such as the senior loan fund (SLF). While FSC's position in the SLF is an investment in a diversified pool of loans, it is akin to an equity investment in a lowly-levered collateralized loan obligation, which incrementally alters the firm's risk profile. The shift into riskier assets combined with management's current leverage tolerance, is consistent with a below investment grade rating, in Fitch's view.

In November 2015, the FSC's board reauthorized its $100 million share repurchase program through Nov. 30, 2016. Following investor concerns regarding the continued share price discount to NAV and the lack of meaningful deployment of the program, management indicated that it intends to make substantive repurchases during the second quarter of 2016 (March 2016 quarter). While Fitch understands the motivation for the stock buyback, meaningful share repurchases are viewed unfavorably given the firm's current leverage levels. In addition, leverage could be further impaired by incremental credit issues in the portfolio or volatility in portfolio valuations, given market spread widening. Fitch would view a reduction in debt, via portfolio repayment proceeds, favorably, as it would enhance the firm's asset coverage cushion.

Depressed share prices and governance concerns have ignited shareholder activism campaigns against three BDCs over the last several months, including FSC. Hedge fund manager RiverNorth Capital Management, LLC (RiverNorth), launched its campaign against FSC in November 2015, citing concerns about Fifth Street Asset Management's (FSAM) track record as FSC's external manager, the appropriateness of FSC's management fee structure and deployment of the share repurchase program. Seeking change at FSC, RiverNorth purchased approximately 6% of FSC's outstanding shares, nominated three members to FSC's board and sought to terminate the investment advisory agreement between FSAM and FSC.

With approval from its board, FSC permanently reduced the base management paid to FSAM from 2.00% to 1.75%, and committed to repurchase up to $50 million of shares by end-2016. On Feb. 19, 2016, RiverNorth announced that it had reached an agreement to sell its holdings of FSC's shares to an affiliate of FSAM and its Chairman and CEO at $6.25 per share, a 32% premium to FSC's current share price, and in exchange withdraw its proxy proposal to terminate FSC's advisory agreement and not contest FSC's director nominees in the 2016 annual meeting of shareholders.

Fitch views the outcome of RiverNorth's activist campaign as neutral to FSC's financial profile, but negative from a franchise perspective, given the public attention that accompanied the campaign. The resolution of RiverNorth's dispute with FSC through the sale offer is viewed cautiously by Fitch, as the settlement has not resulted in strengthened oversight, which could lead to further lawsuits and negative attention in the future. Generally speaking, activist campaigns on Fitch-rated entities do not have a rating impact until and unless Fitch believes the activist has a credible chance of implementing its desired changes and that the changes would be materially adverse to creditors. Fitch believes that not all activist activities have weakened credit profiles of target companies, as some have had neutral to mildly positive effects on ratings and/or governance.

Despite industrywide pressure on credit metrics FSC stood out in first-quarter 2016 (1Q16), with non-accruals at 6.4% of the portfolio at cost, and 3.8% at fair value, which is well above the peer average. During 1Q16, one material healthcare investment moved to non-accrual status, while FSC recorded $1.4 million of net realized gains, offset by $90.8 million in net unrealized depreciation, which reduced NAV by 6.7% and inflated leverage by 0.06x.

FSC does not have meaningful energy exposure, amounting to $63.4 million, or 2.6% of the total portfolio at cost. The firm's three energy investments were carried at 61.5% of fair value, as of Dec. 31, 2015, including a first-lien investment in an oil and gas equipment services company on cash non-accrual status since fiscal fourth-quarter 2014 (quarter ended Sept. 30). Given the current market environment, Fitch expects FSC to incur incremental unrealized depreciation on its energy investments over the near term. That said; Fitch conducted a stress test on the firm's energy exposure along with the rest of the peer group and views the valuation declines to the firm's overall leverage profile to be manageable. Regulatory leverage, excluding SBA debt, would only increase four basis points to 0.78x based on Dec. 31, 2015 balances, which remains within the 1:1 limit.

Fitch views FSC's liquidity profile to be sound, with $82.6 million of unrestricted cash and $449.7 million of availability under its funding facilities, subject to borrowing base requirements. Cash flows from principal repayments and investment sales amounted to $343.4 million, a 21% reduction compared to the same period last year, as refinancing activity and prepayments slowed. Fitch believes the pace of repayment could slow further in 2016, particularly if loan yields increase.

FSC's funding profile is fairly diverse, with unsecured debt representing 45.5% of total outstanding debt as of Dec. 31, 2015. The firm accessed the convertible note market in 2011, the retail note market in 2012 and 2013, and the institutional bond market in 2014. The next scheduled maturity is the $115 million convertible note, due April 1, 2016. Fitch expects FSC will refinance the maturity with available capacity under its corporate revolver, which will then have $270.5 million of remaining capacity, all else equal. FSC has no other maturities until August 2018 when the corporate revolver expires. Fitch believes FSC has sufficient liquidity to address upcoming debt maturities, although funding flexibility will be reduced.

NII coverage of the dividend, adjusting for paid-in-kind income, amounted to 105.3% of dividends paid, as of Dec. 31, 2015. NII coverage of the dividend has averaged 99.3% since 2010. While NII coverage has improved since the steep dividend cut in 2015, Fitch has viewed FSC's dividend policy as erratic given numerous cuts and increases since inception. The inconsistent policy speaks to poor financial planning, in Fitch's opinion, and has likely caused the firm some credibility with equity investors, an important source of growth capital. That said; under current management, FSC has shifted its policy to set the dividend based on past earnings rather than a forward looking view, and the current dividend is also set at the upper bound of the incentive hurdle, which should provide additional cushion to the dividend going forward.

RATING SENSITIVITIES
Fitch believes the resolution of the Negative Outlook could develop over a longer period of time, based on a track record of management consistency, stronger dividend coverage, solid asset quality performance of post-crisis vintages, improved operating consistency, and the maintenance of leverage at appropriate levels relative to portfolio risk.

However, the ratings could be adversely affected by further deterioration in asset quality, yielding sizeable realized losses, preventing the firm from reducing leverage commensurate with its risk profile. A reduction in dividend coverage, and/or a weakening liquidity profile could also drive negative rating momentum.

Fitch has downgraded the following ratings:

Fifth Street Finance Corp.
--Long-term IDR to 'BB' from 'BB+';
--Senior secured debt to 'BB' from 'BB+';
--Senior unsecured debt to 'BB' from 'BB+'.

The Rating Outlook remains Negative.