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EX-10.6 - EX-10.6 - Oaktree Specialty Lending Corpw80501exv10w6.htm
EX-32.1 - EX-32.1 - Oaktree Specialty Lending Corpw80501exv32w1.htm
EX-32.2 - EX-32.2 - Oaktree Specialty Lending Corpw80501exv32w2.htm
EX-31.2 - EX-31.2 - Oaktree Specialty Lending Corpw80501exv31w2.htm
EX-31.1 - EX-31.1 - Oaktree Specialty Lending Corpw80501exv31w1.htm
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 
Form 10-K
 
     
(Mark One)    
 
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended September 30, 2010
OR
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
COMMISSION FILE NUMBER: 1-33901
 
Fifth Street Finance Corp.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
     
DELAWARE   26-1219283
(State or jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
     
10 Bank Street, 12th Floor   10606
White Plains, NY   (Zip Code)
(Address of principal executive office)    
 
REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE:
(914) 286-6800
 
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
 
     
    Name of Each Exchange
Title of Each Class
 
on Which Registered
 
Common Stock, par value $0.01 per share   New York Stock Exchange
 
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES o     No þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  YES o     No þ
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods as the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES þ     NO o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
             
Large accelerated filer o
  Accelerated filer þ   Non-accelerated filer o
(Do not check if a smaller reporting company)
  Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act)  YES o     NO þ
 
The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant as of March 31, 2010 is $525,730,940. The registrant had 54,550,290 shares of common stock outstanding as of September 30, 2010.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
None
 


 

 
TABLE OF CONTENTS
 
             
        Page
 
 
PART I
Item 1.   Business     1  
Item 1A.   Risk Factors     25  
Item 1B.   Unresolved Staff Comments     41  
Item 2.   Properties     41  
Item 3.   Legal Proceedings     41  
 
PART II
Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     42  
Item 6.   Selected Financial Data     45  
Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations     46  
Item 7A.   Quantitative and Qualitative Disclosures about Market Risk     68  
Item 8.   Consolidated Financial Statements and Supplementary Data     69  
Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     119  
Item 9A.   Controls and Procedures     119  
Item 9B.   Other Information     120  
 
PART III
Item 10.   Directors, Executive Officers and Corporate Governance     121  
Item 11.   Executive Compensation     121  
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     121  
Item 13.   Certain Relationships and Related Transactions, and Director Independence     121  
Item 14.   Principal Accounting Fees and Services     121  
 
PART IV
Item 15.   Exhibits and Financial Statement Schedules     122  
Signatures     124  
Exhibit Index        


 

 
PART I
 
Item 1.   Business
 
General
 
We are a specialty finance company that lends to and invests in small and mid-sized companies in connection with investments by private equity sponsors. We define small and mid-sized companies as those with annual revenues between $25 million and $250 million. Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity investments. We are externally managed and advised by Fifth Street Management LLC, which we also refer to as our “investment adviser”.
 
As of September 30, 2010, we had originated $668.9 million of funded debt and equity investments and our portfolio totaled $563.8 million at fair value and was comprised of 38 investments, 35 of which were in operating companies and three of which were in private equity funds. The three investments in private equity funds represented less than 1% of the fair value of our assets at September 30, 2010. The weighted average annual yield of our debt investments as of September 30, 2010 was approximately 14.0%, which included a cash component of 11.8%.
 
Our investments generally range in size from $5 million to $60 million and are principally in the form of first and second lien debt investments, which may also include an equity component. We are currently focusing our origination efforts on first lien loans. As of September 30, 2010, substantially all of our debt investments were secured by first or second priority liens on the assets of our portfolio companies. Moreover, we held equity investments consisting of common stock, preferred stock, or other equity interests in 19 out of 38 portfolio companies as of September 30, 2010.
 
Fifth Street Mezzanine Partners III, L.P., our predecessor fund, commenced operations as a private partnership on February 15, 2007. Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into us. We were formed in late 2007 for the purpose of acquiring Fifth Street Mezzanine Partners III, L.P. and continuing its business as a public entity. We are an externally managed, closed-end, non-diversified management investment company that has elected to be regulated as a business development company under the Investment Company Act of 1940, or the 1940 Act.
 
As a business development company, we are required to comply with regulatory requirements, including limitations on our use of debt. We are permitted to, and expect to, finance our investments through borrowings. However, as a business development company, we are only generally allowed to borrow amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowing. The amount of leverage that we employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing. See “Item 1. Business — Regulation — Business Development Company Regulations.”
 
We have also elected to be treated for federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code, or the Code. See “Item 1. Business — Regulation — Taxation as a Regulated Investment Company.” As a RIC, we generally will not have to pay corporate-level federal income taxes on any net ordinary income or capital gains that we distribute to our stockholders if we meet certain source-of-income, distribution and asset diversification requirements.
 
In addition, we maintain a wholly-owned subsidiary that is licensed as a small business investment company, or SBIC, and regulated by the Small Business Administration, or the SBA. See “Item 1. Business — Regulation — Small Business Investment Company Regulations.” The SBIC license allows us, through our wholly-owned subsidiary, to issue SBA-guaranteed debentures. We applied for exemptive relief from the Securities and Exchange Commission, or SEC, to permit us to exclude the debt of our SBIC subsidiary guaranteed by the SBA from the 200% asset coverage ratio we are required to maintain under the 1940 Act. Pursuant to the 200% asset coverage ratio limitation, we are permitted to borrow one dollar for every dollar we have in assets less all liabilities and indebtedness not represented by debt securities issued by us or loans obtained by us. For example, as of September 30, 2010, we had approximately $642.2 million in assets less all liabilities and indebtedness not represented by debt securities issued by us or loans obtained by us, which


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would permit us to borrow up to approximately $642.2 million, notwithstanding other limitations on our borrowings pursuant to our credit facilities.
 
If we receive an exemption from the SEC for our SBA debt, we will have increased capacity to fund up to $150 million (the maximum amount of SBA-guaranteed debentures an SBIC may currently have outstanding once certain conditions have been met) of investments with SBA-guaranteed debentures in addition to being able to fund investments with borrowings up to the maximum amount of debt that the 200% asset coverage ratio limitation would allow us to incur. As a result, we would, in effect, be permitted to have a lower asset coverage ratio than the 200% asset coverage ratio limitation under the 1940 Act and, therefore, we could have more debt outstanding than assets to cover such debt. For example, we would be able to borrow up to $150 million more than the approximately $642.2 million permitted under the asset coverage ratio limit as of September 30, 2010. For additional information on SBA regulations that affect our access to SBA-guaranteed debentures, see “Risk Factors — Risks Relating to Our Business and Structure — Our SBIC subsidiary’s investment adviser has no prior experience managing an SBIC and any failure to comply with SBA regulations, resulting from our SBIC subsidiary’s investment adviser’s lack of experience or otherwise, could have an adverse effect on our operations.”
 
Our principal executive office is located at 10 Bank Street, 12th floor, White Plains, New York 10606 and our telephone number is (914) 286-6800.
 
The Investment Adviser
 
Our investment adviser is affiliated with Fifth Street Capital LLC, a private investment firm founded and managed by Leonard M. Tannenbaum who has led the investment of over $900 million in small and mid-sized companies, including the investments made by us, since 1998. Mr. Tannenbaum and his respective private investment firms have acted as the lead (and often sole) first or second lien investor in over 70 investment transactions. The other investment funds managed by these private investment firms generally are fully committed and, other than follow-on investments in existing portfolio companies, are no longer making investments.
 
We benefit from our investment adviser’s ability to identify attractive investment opportunities, conduct diligence on and value prospective investments, negotiate investments and manage a diversified portfolio of those investments. The principals of our investment adviser have broad investment backgrounds, with prior experience at investment funds, investment banks and other financial services companies and have developed a broad network of contacts within the private equity community. This network of contacts provides our principal source of investment opportunities.
 
The principals of our investment adviser are Mr. Tannenbaum, our chief executive officer and our investment adviser’s managing partner, Bernard D. Berman, our president, chief compliance officer and secretary and a partner of our investment adviser, Ivelin M. Dimitrov, our co-chief investment officer and a partner of our investment adviser, Chad Blakeman, our co-chief investment officer, Juan E. Alva, a partner of our investment adviser, Casey J. Zmijeski, a partner of our investment adviser and William H. Craig, our chief financial officer.
 
Business Strategy
 
Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity investments. We have adopted the following business strategy to achieve our investment objective:
 
  •  Capitalize on our investment adviser’s strong relationships with private equity sponsors.  Our investment adviser has developed an extensive network of relationships with private equity sponsors that invest in small and mid-sized companies. We believe that the strength of these relationships is due to a common investment philosophy, a consistent market focus, a rigorous approach to diligence and a reputation for delivering on commitments. In addition to being our principal source of originations, we believe that private equity sponsors provide significant benefits including incremental due diligence, additional monitoring capabilities and a potential source of capital and operational expertise for our portfolio companies.


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  •  Focus on established small and mid-sized companies.  We believe that there are fewer finance companies focused on transactions involving small and mid-sized companies than larger companies, and that this is one factor that allows us to negotiate favorable investment terms. Such favorable terms include higher debt yields and lower leverage levels, more significant covenant protection and greater equity grants than typical of transactions involving larger companies. We generally invest in companies with established market positions, seasoned management teams, proven products and services and strong regional or national operations. We believe that these companies possess better risk-adjusted return profiles than newer companies that are building management or in early stages of building a revenue base.
 
  •  Continue our growth of direct originations.  As of September 30, 2010, we directly originated 100% of our debt investments, although we may not directly originate 100% of our investments in the future. Over the last several years, the principals of our investment adviser have developed an origination strategy designed to ensure that the number and quality of our investment opportunities allows us to continue to directly originate substantially all of our investments. We believe that the benefits of direct originations include, among other things, our ability to control the structuring of investment protections and to generate origination and exit fees.
 
  •  Employ disciplined underwriting policies and rigorous portfolio management.  Our investment adviser has developed an extensive underwriting process which includes a review of the prospects, competitive position, financial performance and industry dynamics of each potential portfolio company. In addition, we perform substantial diligence on potential investments, and seek to invest along side private equity sponsors who have proven capabilities in building value. As part of the monitoring process, our investment adviser will analyze monthly and quarterly financial statements versus the previous periods and year, review financial projections, meet with management, attend board meetings and review all compliance certificates and covenants.
 
  •  Structure our debt investments to minimize risk of loss and achieve attractive risk-adjusted returns.  We structure our debt investments on a conservative basis with high cash yields, cash origination fees, low leverage levels and strong investment protections. As of September 30, 2010, the weighted average annualized yield of our debt investments was approximately 14.0%, which includes a cash component of 11.8%. Our debt investments have strong protections, including default penalties, information rights, board observation rights, and affirmative, negative and financial covenants, such as lien protection and prohibitions against change of control. We believe these protections, coupled with the other features of our investments described above, should allow us to reduce our risk of capital loss and achieve attractive risk adjusted returns; however, there can be no assurance that we will be able to successfully structure our investments to minimize risk of loss and achieve attractive risk-adjusted returns.
 
  •  Benefiting from lower, fixed, long-term cost of capital.  The SBIC license held by our wholly-owned subsidiary allows it to issue SBA-guaranteed debentures. SBA-guaranteed debentures carry long-term fixed rates that are generally lower than rates on comparable bank and other debt. Because we expect lower cost SBA leverage to become a more significant part of our capital base through our SBIC subsidiary, our relative cost of debt capital should be lower than many of our competitors. In addition, the SBIC leverage that we receive through our SBIC subsidiary will represent a stable, long-term component of our capital structure that should permit the proper matching of duration and cost compared to our portfolio investments.
 
  •  Leverage the skills and experience of our investment adviser.  The principals of our investment adviser have broad investment backgrounds, with prior experience at private investment funds, investment banks and other financial services companies and they also have experience managing distressed companies.


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  We believe that our investment adviser’s expertise in valuing, structuring, negotiating and closing transactions provides us with a competitive advantage by allowing us to provide financing solutions that meet the needs of our portfolio companies while adhering to our underwriting standards.
 
Investment Criteria
 
The principals of our investment adviser have identified the following investment criteria and guidelines for use in evaluating prospective portfolio companies and they use these criteria and guidelines in evaluating investment opportunities for us. However, not all of these criteria and guidelines were, or will be, met in connection with each of our investments.
 
  •  Established companies with a history of positive operating cash flow.  We seek to invest in established companies with sound historical financial performance. We typically focus on companies with a history of profitability on an operating cash flow basis. We do not intend to invest in start-up companies or companies with speculative business plans.
 
  •  Ability to exert meaningful influence.  We target investment opportunities in which we will be the lead/sole investor in our tranche and in which we can add value through active participation, often through advisory positions.
 
  •  Private equity sponsorship.  We generally seek to invest in companies in connection with private equity sponsors who have proven capabilities in building value. We believe that a private equity sponsor can serve as a committed partner and advisor that will actively work with the company and its management team to meet company goals and create value. We assess a private equity sponsor’s commitment to a portfolio company by, among other things, the capital contribution it has made or will make in the portfolio company.
 
  •  Seasoned management team.  We generally will require that our portfolio companies have a seasoned management team, with strong corporate governance. We also seek to invest in companies that have proper incentives in place, including having significant equity interests, to motivate management to act in accordance with our interests.
 
  •  Defensible and sustainable business.  We seek to invest in companies with proven products and/or services and strong regional or national operations.
 
  •  Exit strategy.  We generally seek to invest in companies that we believe possess attributes that will provide us with the ability to exit our investments. We expect to exit our investments typically through one of three scenarios: (i) the sale of the company resulting in repayment of all outstanding debt, (ii) the recapitalization of the company through which our loan is replaced with debt or equity from a third party or parties or (iii) the repayment of the initial or remaining principal amount of our loan then outstanding at maturity. In some investments, there may be scheduled amortization of some portion of our loan which would result in a partial exit of our investment prior to the maturity of the loan.
 
Deal Origination
 
Our deal originating efforts are focused on building relationships with private equity sponsors that are focused on investing in the small and mid-sized companies that we target. We divide the country geographically into Eastern, Central and Western regions and emphasize active, consistent sponsor coverage. Over the last ten years, the investment professionals of our investment adviser have developed an extensive network of relationships with these private equity sponsors. We estimate that there are approximately 1,400 of such private equity firms and our investment adviser has active relationships with approximately 140 of them. An active relationship is one through which our investment adviser has received at least one investment opportunity from the private equity sponsor within the last year.
 
Our investment adviser reviewed over 500 potential investment transactions with private equity sponsors for the year ended September 30, 2010. All of the investment transactions that we have completed to date


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were originated through our investment adviser’s relationships with private equity sponsors. We believe that our investment adviser has a reputation as a reliable, responsive and efficient source of funding to support private equity investments. We believe that this reputation and the relationships of our investment adviser with private equity sponsors will provide us with significant investment opportunities.
 
Our origination process is designed to efficiently evaluate a large number of opportunities and to identify the most attractive of such opportunities. A significant number of opportunities that clearly do not fit our investment criteria are screened by the partners of our investment adviser when they are initially identified. If an originator believes that an opportunity fits our investment criteria and merits consideration, the investment is presented to our investment adviser’s Investment Committee. This is the first stage of our origination process, the “Review” stage. During this stage, the originator gives a preliminary description of the opportunity. This is followed by preliminary due diligence, from which an investment summary is created. The opportunity may be discussed several times by the full Investment Committee of our investment adviser, or subsets of that Committee. At any point in this stage, we may reject the opportunity, and, indeed, we have historically decided not to proceed with more than 80% of the investment opportunities reviewed by our investment adviser’s Investment Committee.
 
For the subset of opportunities that we decide to pursue, we issue preliminary term sheets and classify them in the “Term Sheet Issued” stage. This term sheet serves as a basis for negotiating the critical terms of a transaction. At this stage we begin our underwriting and investment approval process, as more fully described below. After the term sheet for a potential transaction has been fully negotiated, the transaction is presented to our investment adviser’s Investment Committee for approval. If the deal is approved, the term sheet is signed. Approximately half of the term sheets we issue result in an executed term sheet. Our underwriting and investment approval process is ongoing during this stage, during which we begin documentation of the loan. The final stage, “Closings,” culminates with the funding of an investment only after all due diligence is satisfactorily completed and all closing conditions, including the sponsor’s funding of its investment in the portfolio company, have been satisfied.
 
Underwriting
 
Underwriting Process and Investment Approval
 
We make our investment decisions only after consideration of a number of factors regarding the potential investment including, but not limited to: (i) historical and projected financial performance; (ii) company and industry specific characteristics, such as strengths, weaknesses, opportunities and threats; (iii) composition and experience of the management team; and (iv) track record of the private equity sponsor leading the transaction. Our investment adviser uses a proprietary scoring system that evaluates each opportunity. This methodology is employed to screen a high volume of potential investment opportunities on a consistent basis.
 
If an investment is deemed appropriate to pursue, a more detailed and rigorous evaluation is made along a variety of investment parameters, not all of which may be relevant or considered in evaluating a potential investment opportunity. The following outlines the general parameters and areas of evaluation and due diligence for investment decisions, although not all will necessarily be considered or given equal weighting in the evaluation process.
 
Management assessment
 
Our investment adviser makes an in-depth assessment of the management team, including evaluation along several key metrics:
 
  •  The number of years in their current positions;
 
  •  Track record;
 
  •  Industry experience;
 
  •  Management incentive, including the level of direct investment in the enterprise;


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  •  Background investigations; and
 
  •  Completeness of the management team (lack of positions that need to be filled).
 
Industry dynamics
 
An evaluation of the industry is undertaken by our investment adviser that considers several factors. If considered appropriate, industry experts will be consulted or retained. The following factors are analyzed by our investment adviser:
 
  •  Sensitivity to economic cycles;
 
  •  Competitive environment, including number of competitors, threat of new entrants or substitutes;
 
  •  Fragmentation and relative market share of industry leaders;
 
  •  Growth potential; and
 
  •  Regulatory and legal environment.
 
Business model and financial assessment
 
Prior to making an investment decision, our investment adviser will undertake a review and analysis of the financial and strategic plans for the potential investment. There is significant evaluation of and reliance upon the due diligence performed by the private equity sponsor and third party experts including accountants and consultants. Areas of evaluation include:
 
  •  Historical and projected financial performance;
 
  •  Quality of earnings, including source and predictability of cash flows;
 
  •  Customer and vendor interviews and assessments;
 
  •  Potential exit scenarios, including probability of a liquidity event;
 
  •  Internal controls and accounting systems; and
 
  •  Assets, liabilities and contingent liabilities.
 
Private equity sponsor
 
Among the most critical due diligence investigations is the evaluation of the private equity sponsor making the investment. A private equity sponsor is typically the controlling shareholder upon completion of an investment and as such is considered critical to the success of the investment. The private equity sponsor is evaluated along several key criteria, including:
 
  •  Investment track record;
 
  •  Industry experience;
 
  •  Capacity and willingness to provide additional financial support to the company through additional capital contributions, if necessary; and
 
  •  Reference checks.
 
Investments
 
We target debt investments that will yield meaningful current income and provide the opportunity for capital appreciation through equity securities. We typically structure our debt investments with the maximum seniority and collateral that we can reasonably obtain while seeking to achieve our total return target. In most cases, our debt investment will be collateralized by a first or second lien on the assets of the portfolio company. As of September 30, 2010, substantially all of our debt investments were secured by first or second priority liens on the assets of the portfolio company.


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Debt Investments
 
We tailor the terms of our debt investments to the facts and circumstances of the transaction and prospective portfolio company, negotiating a structure that seeks to protect our rights and manage our risk while creating incentives for the portfolio company to achieve its business plan. A substantial source of return is monthly cash interest that we collect on our debt investments. As of September 30, 2010, we directly originated 100% of our loans, although we may not directly originate 100% of our investments in the future. We are currently focusing our new origination efforts on first lien loans. We believe that the risk-adjusted returns from these loans are superior to second lien investments and offer superior credit quality. However, we may choose to originate second lien and unsecured loans in the future.
 
  •  First Lien Loans.  Our first lien loans generally have terms of four to six years, provide for a variable or fixed interest rate, contain prepayment penalties and are secured by a first priority security interest in all existing and future assets of the borrower. Our first lien loans may take many forms, including revolving lines of credit, term loans and acquisition lines of credit.
 
  •  Second Lien Loans.  Our second lien loans generally have terms of four to six years, primarily provide for a fixed interest rate, contain prepayment penalties and are secured by a second priority security interest in all existing and future assets of the borrower. Our second lien loans often include payment-in-kind, or PIK, interest, which represents contractual interest accrued and added to the principal that generally becomes due at maturity. As of September 30, 2010, all of our second lien loans had intercreditor agreements requiring a standstill period of no more than 180 days. During the standstill period, we are generally restricted from exercising remedies against the borrower or the collateral in order to provide the first lien lenders time to cure any breaches or defaults by the borrower.
 
  •  Unsecured Loans.  Our unsecured investments generally have terms of five to six years and provide for a fixed interest rate. We may make unsecured investments on a stand-alone basis, or in connection with a senior secured loan, a junior secured loan or a “one-stop” financing. Our unsecured investments may include payment-in-kind, or PIK, interest, which represents contractual interest accrued and added to the principal that generally becomes due at maturity, and an equity component, such as warrants to purchase common stock in the portfolio company.
 
We typically structure our debt investments to include covenants that seek to minimize our risk of capital loss. Our debt investments have strong protections, including default penalties, information rights, board observation rights, and affirmative, negative and financial covenants, such as lien protection and prohibitions against change of control. Our debt investments also have substantial prepayment penalties designed to extend the life of the average loan, which we believe will help to grow our portfolio.
 
Equity Investments
 
When we make a debt investment, we may be granted equity in the company in the same class of security as the sponsor receives upon funding. In addition, we may from time to time make non-control, equity co-investments in connection with private equity sponsors. We generally seek to structure our equity investments, such as direct equity co-investments, to provide us with minority rights provisions and event-driven put rights. We also seek to obtain limited registration rights in connection with these investments, which may include “piggyback” registration rights.
 
Private Equity Fund Investments
 
We make investments in the private equity funds of certain of our equity sponsors. In general, we make these investments where we have a long term relationship and are comfortable with the sponsor’s business model and investment strategy. As of September 30, 2010, we had investments in three private equity funds, which represented less than 1% of the fair value of our assets as of such date.


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Portfolio Management
 
Active Involvement in our Portfolio Companies
 
As a business development company, we are obligated to offer to provide managerial assistance to our portfolio companies and to provide it if requested. In fact, we provide managerial assistance to our portfolio companies as a general practice and we seek investments where such assistance is appropriate. We monitor the financial trends of each portfolio company to assess the appropriate course of action for each company and to evaluate overall portfolio quality. We have several methods of evaluating and monitoring the performance of our investments, including but not limited to, the following:
 
  •  review of monthly and quarterly financial statements and financial projections for portfolio companies;
 
  •  periodic and regular contact with portfolio company management to discuss financial position requirements and accomplishments;
 
  •  attendance at board meetings;
 
  •  periodic formal update interviews with portfolio company management and, if appropriate, the private equity sponsor; and
 
  •  assessment of business development success, including product development, profitability and the portfolio company’s overall adherence to its business plan.
 
Rating Criteria
 
In addition to various risk management and monitoring tools, we use an investment rating system to characterize and monitor the credit profile and our expected level of returns on each investment in our portfolio. We use a five-level numeric rating scale. The following is a description of the conditions associated with each investment rating:
 
  •  Investment Rating 1 is used for investments that are performing above expectations and/or a capital gain is expected.
 
  •  Investment Rating 2 is used for investments that are performing substantially within our expectations, and whose risks remain neutral or favorable compared to the potential risk at the time of the original investment. All new loans are initially rated 2.
 
  •  Investment Rating 3 is used for investments that are performing below our expectations and that require closer monitoring, but where we expect no loss of investment return (interest and/or dividends) or principal. Companies with a rating of 3 may be out of compliance with financial covenants.
 
  •  Investment Rating 4 is used for investments that are performing below our expectations and for which risk has increased materially since the original investment. We expect some loss of investment return, but no loss of principal.
 
  •  Investment Rating 5 is used for investments that are performing substantially below our expectations and whose risks have increased substantially since the original investment. Investments with a rating of 5 are those for which some loss of principal is expected.
 
In the event that we determine that an investment is underperforming, or circumstances suggest that the risk associated with a particular investment has significantly increased, we will undertake more aggressive monitoring of the effected portfolio company. While our investment rating system identifies the relative risk for each investment, the rating alone does not dictate the scope and/or frequency of any monitoring that we perform. The frequency of our monitoring of an investment is determined by a number of factors, including, but not limited to, the trends in the financial performance of the portfolio company, the investment structure and the type of collateral securing our investment, if any.


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The following table shows the distribution of our investments on the 1 to 5 investment rating scale at fair value as of September 30, 2010:
 
                 
Investment Rating
  Fair Value     % of Portfolio  
 
1
  $ 89,150,457       15.81 %
2
    424,494,799       75.29 %
3
    18,055,528       3.20 %
4
    23,823,120       4.23 %
5
    8,297,412       1.47 %
                 
Total
  $ 563,821,316       100.00 %
                 
 
Exit Strategies/Refinancing
 
As of September 30, 2010, we had structured $7.1 million in aggregate exit fees across 10 portfolio investments to be received upon the future exit of those investments. We expect to exit our investments typically through one of three scenarios: (i) the sale of the company resulting in repayment of all outstanding debt, (ii) the recapitalization of the company in which our loan is replaced with debt or equity from a third party or parties or (iii) the repayment of the initial or remaining principal amount of our loan then outstanding at maturity. In some investments, there may be scheduled amortization of some portion of our loan which would result in a partial exit of our investment prior to the maturity of the loan.
 
Valuation of Portfolio Investments
 
As a business development company, we generally invest in illiquid securities including debt and equity investments of small and mid-sized companies. All of our investments are recorded at fair value as determined in good faith by our Board of Directors.
 
Authoritative accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available or reliable, valuation techniques are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the investments or market and the investments’ complexity.
 
In accordance with authoritative accounting guidance, we perform detailed valuations of our debt and equity investments on an individual basis, using market, income, and bond yield approaches as appropriate. In general, we utilize a bond yield method for the majority of our investments, as long as it is appropriate. If, in our judgment, the bond yield approach is not appropriate, we may use the enterprise value approach, or, in certain cases, an alternative methodology potentially including an asset liquidation or expected recovery model.
 
Under the market approach, we estimate the enterprise value of the portfolio companies in which we invest. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise value is best expressed as a range of fair values, from which we derive a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, we analyze various factors, including the portfolio company’s historical and projected financial results. Typically, private companies are valued based on multiples of EBITDA, cash flows, net income, revenues, or in limited cases, book value. We generally require portfolio companies to provide annual audited and quarterly and monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year.
 
Under the income approach, we generally prepare and analyze discounted cash flow models based on projections of the future free cash flows of the business.
 
Under the bond yield approach, we use bond yield models to determine the present value of the future cash flow streams of our debt investments. We review various sources of transactional data, including private


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mergers and acquisitions involving debt investments with similar characteristics, and assess the information in the valuation process.
 
Our Board of Directors undertakes a multi-step valuation process each quarter in connection with determining the fair value of our investments:
 
  •  The quarterly valuation process begins with each portfolio company or investment being initially valued by the deal team within the investment adviser responsible for the portfolio investment;
 
  •  Preliminary valuations are then reviewed and discussed with the principals of the investment adviser;
 
  •  Separately, independent valuation firms engaged by our Board of Directors prepare preliminary valuations on a selected basis and submit the reports to us;
 
  •  The deal team compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms;
 
  •  The deal team prepares a valuation report for the Valuation Committee of our Board of Directors;
 
  •  The Valuation Committee of our Board of Directors is apprised of the preliminary valuations of the independent valuation firms;
 
  •  The Valuation Committee of our Board of Directors reviews the preliminary valuations, and the deal team responds and supplements the preliminary valuations to reflect any comments provided by the Valuation Committee;
 
  •  The Valuation Committee of our Board of Directors makes a recommendation to the Board of Directors; and
 
  •  Our Board of Directors discusses valuations and determines the fair value of each investment in our portfolio in good faith.
 
The fair value of all of our investments at September 30, 2010 and September 30, 2009 was determined by our Board of Directors. Our Board of Directors is solely responsible for the valuation of the portfolio investments at fair value as determined in good faith pursuant to our valuation policy and a consistently applied valuation process.
 
Our Board of Directors has engaged independent valuation firms to provide us with valuation assistance. Upon completion of their process each quarter, the independent valuation firms provide us with a written report regarding the preliminary valuations of selected portfolio securities as of the close of such quarter. We will continue to engage independent valuation firms to provide us with assistance regarding our determination of the fair value of selected portfolio securities each quarter; however, our Board of Directors is ultimately and solely responsible for determining the fair value of our investments in good faith.


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The percentages of our portfolio at fair value for which independent valuation firms provided us with valuation assistance by period were as follows:
 
         
    Percentage of
 
    Portfolio at
 
    Fair Value  
 
For the quarter ending December 31, 2007
    91.9 %
For the quarter ending March 31, 2008
    92.1 %
For the quarter ending June 30, 2008
    91.7 %
For the quarter ending September 30, 2008
    92.8 %
For the quarter ending December 31, 2008
    100.0 %
For the quarter ending March 31, 2009
    88.7 %(1)
For the quarter ending June 30, 2009
    92.1 %
For the quarter ending September 30, 2009
    28.1 %
For the quarter ending December 31, 2009
    17.2 %(2)
For the quarter ending March 31, 2010
    26.9 %
For the quarter ending June 30, 2010
    53.1 %
For the quarter ending September 30, 2010
    61.8 %
 
 
(1) 96.0% excluding our investment in IZI Medical Products, Inc., which closed on June 30, 2009 and therefore was not part of the independent valuation process
 
(2) 24.8% excluding four investments that closed in December 2009 and therefore were not part of the independent valuation process
 
We intend to have valuation firms provide us with valuation assistance on a portion of our portfolio on a quarterly basis and a substantial portion of our portfolio on an annual basis.
 
Determination of fair values involves subjective judgments and estimates. The notes to our financial statements refer to the uncertainty with respect to the possible effect of such valuations, and any change in such valuations, on our financial statements.
 
Competition
 
We compete for investments with a number of business development companies and investment funds (including private equity funds and mezzanine funds), as well as traditional financial services companies such as commercial banks and other sources of financing. Many of these entities have greater financial and managerial resources than we do. We believe we are able to be competitive with these entities primarily on the basis of the experience and contacts of our management team, our responsive and efficient investment analysis and decision-making processes, the investment terms we offer, and our willingness to make smaller investments.
 
We believe that some of our competitors make loans with interest rates and returns that are comparable to or lower than the rates and returns that we target. Therefore, we do not seek to compete solely on the interest rates and returns that we offer to potential portfolio companies. For additional information concerning the competitive risks we face, see “Item 1A. Risk Factors — Risks Relating to Our Business and Structure — We may face increasing competition for investment opportunities, which could reduce returns and result in losses.”
 
Employees
 
We do not have any employees. Our day-to-day investment operations are managed by our investment adviser. See “— Investment Advisory Agreement.” Our investment adviser employs a total of 19 investment professionals, including its principals. In addition, we reimburse our administrator, FSC, Inc., for the allocable portion of overhead and other expenses incurred by it in performing its obligations under an administration agreement, including the compensation of our chief financial officer and chief compliance officer, and their staff. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us


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by our chief compliance officer, Bernard D. Berman, given his compensation arrangement with our investment adviser. However, although FSC, Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future. For a more detailed discussion of the administration agreement, see “Item 1. Business — Administration Agreement.”
 
Investment Advisory Agreement
 
Overview of Our Investment Adviser
 
Management Services
 
Our investment adviser, Fifth Street Management, is registered as an investment adviser under the Investment Advisers Act of 1940, or the “Advisers Act.” Our investment adviser serves pursuant to the investment advisory agreement in accordance with the 1940 Act. Subject to the overall supervision of our Board of Directors, our investment adviser manages our day-to-day operations and provides us with investment advisory services. Under the terms of the investment advisory agreement, our investment adviser:
 
  •  determines the composition of our portfolio, the nature and timing of the changes to our portfolio and the manner of implementing such changes;
 
  •  determines what securities we purchase, retain or sell;
 
  •  identifies, evaluates and negotiates the structure of the investments we make; and
 
  •  executes, monitors and services the investments we make.
 
Our investment adviser’s services under the investment advisory agreement may not be exclusive and it is free to furnish similar services to other entities so long as its services to us are not impaired.
 
Management Fee
 
We pay our investment adviser a fee for its services under the investment advisory agreement consisting of two components — a base management fee and an incentive fee. The cost of both the base management fee payable to our investment adviser and any incentive fees earned by our investment adviser will ultimately be borne by our common stockholders.
 
Base Management Fee
 
The base management fee is calculated at an annual rate of 2% of our gross assets, which includes any borrowings for investment purposes. The base management fee is payable quarterly in arrears, and is calculated based on the value of our gross assets at the end of each fiscal quarter, and appropriately adjusted on a pro rata basis for any equity capital raises or repurchases during such quarter. The base management fee for any partial month or quarter will be appropriately pro rated. Our investment adviser permanently waived the portion of the base management fee attributable to cash and cash equivalents (as defined in the notes to our Consolidated Financial Statements) as of the end of each quarter beginning March 31, 2010. As a result, our base management fee will be calculated at an annual rate of 2% of our gross assets, including any investments made with borrowings, but excluding any cash and cash equivalents (as defined in the notes to our Consolidated Financial Statements) as of the end of each quarter.
 
Incentive Fee
 
The incentive fee has two parts. The first part is calculated and payable quarterly in arrears based on our “Pre-Incentive Fee Net Investment Income” for the immediately preceding fiscal quarter. For this purpose, “Pre-Incentive Fee Net Investment Income” means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence and consulting fees or other fees that we receive from portfolio companies) accrued during the fiscal quarter, minus our operating expenses for the quarter (including the base management fee, expenses payable under the administration agreement with FSC, Inc., and any interest expense and


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dividends paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-Incentive Fee Net Investment Income includes, in the case of investments with a deferred interest feature (such as original issue discount, debt instruments with PIK interest and zero coupon securities), accrued income that we have not yet received in cash. Pre-Incentive Fee Net Investment Income does not include any realized capital gains, realized capital losses or unrealized capital appreciation or depreciation. Pre-Incentive Fee Net Investment Income, expressed as a rate of return on the value of our net assets at the end of the immediately preceding fiscal quarter, will be compared to a “hurdle rate” of 2% per quarter (8% annualized), subject to a “catch-up” provision measured as of the end of each fiscal quarter. Our net investment income used to calculate this part of the incentive fee is also included in the amount of our gross assets used to calculate the 2% base management fee. The operation of the incentive fee with respect to our Pre-Incentive Fee Net Investment Income for each quarter is as follows:
 
  •  no incentive fee is payable to the investment adviser in any fiscal quarter in which our Pre-Incentive Fee Net Investment Income does not exceed the hurdle rate of 2% (the “preferred return” or “hurdle”);
 
  •  100% of our Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the hurdle rate but is less than or equal to 2.5% in any fiscal quarter (10% annualized) is payable to the investment adviser. We refer to this portion of our Pre-Incentive Fee Net Investment Income (which exceeds the hurdle rate but is less than or equal to 2.5%) as the “catch-up.” The “catch-up” provision is intended to provide our investment adviser with an incentive fee of 20% on all of our Pre-Incentive Fee Net Investment Income as if a hurdle rate did not apply when our Pre-Incentive Fee Net Investment Income exceeds 2.5% in any fiscal quarter; and
 
  •  20% of the amount of our Pre-Incentive Fee Net Investment Income, if any, that exceeds 2.5% in any fiscal quarter (10% annualized) is payable to the investment adviser once the hurdle is reached and the catch-up is achieved.
 
The following is a graphical representation of the calculation of the income-related portion of the incentive fee:
 
Quarterly Incentive Fee Based on “Pre-Incentive Fee Net Investment Income”
Pre-Incentive Fee Net Investment Income
(expressed as a percentage of the value of net assets)
 
(EQUATION)
 
Percentage of Pre-Incentive Fee Net Investment
Income allocated to income-related portion of incentive fee
 
The second part of the incentive fee is determined and payable in arrears as of the end of each fiscal year (or upon termination of the investment advisory agreement, as of the termination date) and equals 20% of our realized capital gains, if any, on a cumulative basis from inception through the end of each fiscal year, computed net of all realized capital losses and unrealized capital depreciation on a cumulative basis, less the aggregate amount of any previously paid capital gain incentive fees, provided that, the incentive fee determined as of September 30, 2008 was calculated for a period of shorter than twelve calendar months to take into account any realized capital gains computed net of all realized capital losses and unrealized capital depreciation from inception.


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Example 1: Income Related Portion of Incentive Fee for Each Fiscal Quarter
 
Alternative 1
 
Assumptions
 
Investment income (including interest, dividends, fees, etc.) = 1.25%
Hurdle rate(1) = 2%
Management fee(2) = 0.5%
Other expenses (legal, accounting, custodian, transfer agent, etc.)(3) = 0.2%
Pre-Incentive Fee Net Investment Income
(investment income − (management fee + other expenses) = 0.55%
 
Pre-Incentive Fee Net Investment Income does not exceed hurdle rate, therefore there is no income-related incentive fee.
 
Alternative 2
 
Assumptions
 
Investment income (including interest, dividends, fees, etc.) = 2.9%
Hurdle rate(1) = 2%
Management fee(2) = 0.5%
Other expenses (legal, accounting, custodian, transfer agent, etc.)(3) = 0.2%
Pre-Incentive Fee Net Investment Income
(investment income − (management fee + other expenses) = 2.2%
 
  Incentive fee = 100% × Pre-Incentive Fee Net Investment Income (subject to “catch-up”)(4)
= 100% × (2.2% − 2%)
= 0.2%
 
Pre-Incentive Fee Net Investment Income exceeds the hurdle rate, but does not fully satisfy the “catch-up” provision, therefore the income related portion of the incentive fee is 0.2%.
 
Alternative 3
 
Assumptions
 
Investment income (including interest, dividends, fees, etc.) = 3.5%
Hurdle rate(1) = 2%
Management fee(2) = 0.5%
Other expenses (legal, accounting, custodian, transfer agent, etc.)(3) = 0.2%
Pre-Incentive Fee Net Investment Income
(investment income − (management fee + other expenses) = 2.8%
Incentive fee = 100% × Pre-Incentive Fee Net Investment Income (subject to “catch-up”)(4)
Incentive fee = 100% × “catch-up” + (20% × (Pre-Incentive Fee Net Investment Income − 2.5%))
  Catch up = 2.5% − 2%
  = 0.5%
 
Incentive fee  
= (100% × 0.5%) + (20% × (2.8% − 2.5%))
= 0.5% + (20% × 0.3%)
= 0.5% + 0.06%
= 0.56%
 
Pre-Incentive Fee Net Investment Income exceeds the hurdle rate, and fully satisfies the “catch-up” provision, therefore the income related portion of the incentive fee is 0.56%.
 
 
(1) Represents 8% annualized hurdle rate.
 
(2) Represents 2% annualized base management fee.
 
(3) Excludes organizational and offering expenses.


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(4) The “catch-up” provision is intended to provide our investment adviser with an incentive fee of 20% on all Pre-Incentive Fee Net Investment Income as if a hurdle rate did not apply when our net investment income exceeds 2.5% in any fiscal quarter.
 
Example 2: Capital Gains Portion of Incentive Fee(*):
 
Alternative 1:
 
Assumptions
 
Year 1: $20 million investment made in Company A (“Investment A”), and $30 million investment made in Company B (“Investment B”)
 
Year 2: Investment A sold for $50 million and fair market value (“FMV”) of Investment B determined to be $32 million
 
Year 3: FMV of Investment B determined to be $25 million
 
Year 4: Investment B sold for $31 million
 
The capital gains portion of the incentive fee would be:
 
Year 1: None
 
Year 2: Capital gains incentive fee of $6 million — ($30 million realized capital gains on sale of Investment A multiplied by 20%)
 
Year 3: None — $5 million (20% multiplied by ($30 million cumulative capital gains less $5 million cumulative capital depreciation)) less $6 million (previous capital gains fee paid in Year 2)
 
Year 4: Capital gains incentive fee of $200,000 — $6.2 million ($31 million cumulative realized capital gains multiplied by 20%) less $6 million (capital gains incentive fee taken in Year 2)
 
Alternative 2
 
Assumptions
 
Year 1: $20 million investment made in Company A (“Investment A”), $30 million investment made in Company B (“Investment B”) and $25 million investment made in Company C (“Investment C”)
 
Year 2: Investment A sold for $50 million, FMV of Investment B determined to be $25 million and FMV of Investment C determined to be $25 million
 
Year 3: FMV of Investment B determined to be $27 million and Investment C sold for $30 million
 
Year 4: FMV of Investment B determined to be $35 million
 
Year 5: Investment B sold for $20 million
 
The capital gains incentive fee, if any, would be:
 
Year 1: None
 
Year 2: $5 million capital gains incentive fee — 20% multiplied by $25 million ($30 million realized capital gains on Investment A less unrealized capital depreciation on Investment B)
 
Year 3: $1.4 million capital gains incentive fee(1) — $6.4 million (20% multiplied by $32 million ($35 million cumulative realized capital gains less $3 million unrealized capital depreciation)) less $5 million capital gains incentive fee received in Year 2
 
Year 4: None
 
Year 5: None — $5 million (20% multiplied by $25 million (cumulative realized capital gains of $35 million less realized capital losses of $10 million)) less $6.4 million cumulative capital gains incentive fee paid in Year 2 and Year 3(2)
 
 
The hypothetical amounts of returns shown are based on a percentage of our total net assets and assume no leverage. There is no guarantee that positive returns will be realized and actual returns may vary from those shown in this example.


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(1) As illustrated in Year 3 of Alternative 1 above, if Fifth Street were to be wound up on a date other than its fiscal year end of any year, Fifth Street may have paid aggregate capital gains incentive fees that are more than the amount of such fees that would be payable if Fifth Street had been wound up on its fiscal year end of such year.
 
(2) As noted above, it is possible that the cumulative aggregate capital gains fee received by our investment adviser ($6.4 million) is effectively greater than $5 million (20% of cumulative aggregate realized capital gains less net realized capital losses or net unrealized depreciation ($25 million)).
 
Payment of Our Expenses
 
Our primary operating expenses are the payment of a base management fee and any incentive fees under the investment advisory agreement and the allocable portion of overhead and other expenses incurred by FSC, Inc. in performing its obligations under the administration agreement. Our investment management fee compensates our investment adviser for its work in identifying, evaluating, negotiating, executing and servicing our investments. We bear all other expenses of our operations and transactions, including (without limitation) fees and expenses relating to:
 
  •  offering expenses;
 
  •  the investigation and monitoring of our investments;
 
  •  the cost of calculating our net asset value;
 
  •  the cost of effecting sales and repurchases of shares of our common stock and other securities;
 
  •  management and incentive fees payable pursuant to the investment advisory agreement;
 
  •  fees payable to third parties relating to, or associated with, making investments and valuing investments (including third-party valuation firms);
 
  •  transfer agent and custodial fees;
 
  •  fees and expenses associated with marketing efforts (including attendance at investment conferences and similar events);
 
  •  federal and state registration fees;
 
  •  any exchange listing fees;
 
  •  federal, state and local taxes;
 
  •  independent directors’ fees and expenses;
 
  •  brokerage commissions;
 
  •  costs of proxy statements, stockholders’ reports and notices;
 
  •  costs of preparing government filings, including periodic and current reports with the SEC;
 
  •  fidelity bond, liability insurance and other insurance premiums; and
 
  •  printing, mailing, independent accountants and outside legal costs and all other direct expenses incurred by either our investment adviser or us in connection with administering our business, including payments under the administration agreement that will be based upon our allocable portion of overhead and other expenses incurred by FSC, Inc. in performing its obligations under the administration agreement and the compensation of our chief financial officer and chief compliance officer, and their staff. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us by our chief compliance officer, Bernard D. Berman, given his compensation arrangement with our investment adviser. However, although FSC, Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future.


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Duration and Termination
 
The investment advisory agreement was first approved by our Board of Directors on December 13, 2007 and by a majority of the limited partners of Fifth Street Mezzanine Partners III, L.P. through a written consent first solicited on December 14, 2007. On March 14, 2008, our Board of Directors, including all of the directors who are not “interested persons” as defined in the 1940 Act, approved an amendment to the investment advisory agreement that revised the investment advisory agreement to clarify the calculation of the base management fee. Such amendment was also approved by a majority of our outstanding voting securities through a written consent first solicited on April 7, 2008. Unless earlier terminated as described below, the investment advisory agreement, as amended, will remain in effect for a period of two years from the date it was approved by the Board of Directors and will remain in effect from year-to-year thereafter if approved annually by the Board of Directors or by the affirmative vote of the holders of a majority of our outstanding voting securities, including, in either case, approval by a majority of our directors who are not interested persons. The investment advisory agreement will automatically terminate in the event of its assignment. The investment advisory agreement may be terminated by either party without penalty upon not more than 60 days’ written notice to the other. The investment advisory agreement may also be terminated, without penalty, upon the vote of a majority of our outstanding voting securities.
 
Indemnification
 
The investment advisory agreement provides that, absent willful misfeasance, bad faith or gross negligence in the performance of their respective duties or by reason of the reckless disregard of their respective duties and obligations, our investment adviser and its officers, managers, agents, employees, controlling persons, members (or their owners) and any other person or entity affiliated with it, are entitled to indemnification from us for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of our investment adviser’s services under the investment advisory agreement or otherwise as our investment adviser.
 
Organization of our Investment Adviser
 
Our investment adviser is a Delaware limited liability company that registered as an investment adviser under the Advisers Act. The principal address of our investment adviser is 10 Bank Street, 12th Floor, White Plains, NY 10606.
 
Board Approval of the Investment Advisory Agreement
 
At a meeting of our Board of Directors held on February 24, 2010, our Board of Directors unanimously voted to approve the investment advisory agreement. In reaching a decision to approve the investment advisory agreement, the Board of Directors reviewed a significant amount of information and considered, among other things:
 
  •  the nature, quality and extent of the advisory and other services to be provided to us by Fifth Street Management;
 
  •  the fee structures of comparable externally managed business development companies that engage in similar investing activities;
 
  •  our projected operating expenses and expense ratio compared to business development companies with similar investment objectives;
 
  •  any existing and potential sources of indirect income to Fifth Street Management from its relationship with us and the profitability of that relationship, including through the investment advisory agreement;
 
  •  information about the services to be performed and the personnel performing such services under the investment advisory agreement;


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  •  the organizational capability and financial condition of Fifth Street Management and its affiliates; and
 
  •  various other matters.
 
Based on the information reviewed and the discussions detailed above, the Board of Directors, including all of the directors who are not “interested persons” as defined in the 1940 Act, concluded that the investment advisory fee rates and terms are reasonable in relation to the services provided and approved the investment advisory agreement and the administration agreement as being in the best interests of our stockholders.
 
Administration Agreement
 
We have also entered into an administration agreement with FSC, Inc. under which FSC, Inc. provides administrative services for us, including office facilities and equipment and clerical, bookkeeping and recordkeeping services at such facilities. Under the administration agreement, FSC, Inc. also performs, or oversees the performance of, our required administrative services, which includes being responsible for the financial records which we are required to maintain and preparing reports to our stockholders and reports filed with the SEC. In addition, FSC, Inc. assists us in determining and publishing our net asset value, overseeing the preparation and filing of our tax returns and the printing and dissemination of reports to our stockholders, and generally overseeing the payment of our expenses and the performance of administrative and professional services rendered to us by others. For providing these services, facilities and personnel, we reimburse FSC, Inc. the allocable portion of overhead and other expenses incurred by FSC, Inc. in performing its obligations under the administration agreement, including rent and our allocable portion of the costs of compensation and related expenses of our chief financial officer and chief compliance officer, and their staff. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us by our chief compliance officer, Bernard D. Berman, given his compensation arrangement with our investment adviser. However, although FSC, Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future. FSC, Inc. may also provide on our behalf managerial assistance to our portfolio companies. The administration agreement may be terminated by either party without penalty upon 60 days’ written notice to the other party.
 
The administration agreement provides that, absent willful misfeasance, bad faith or gross negligence in the performance of their respective duties or by reason of the reckless disregard of their respective duties and obligations, FSC, Inc. and its officers, managers, agents, employees, controlling persons, members and any other person or entity affiliated with it are entitled to indemnification from us for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of services under the administration agreement or otherwise as administrator for us.
 
License Agreement
 
We have also entered into a license agreement with Fifth Street Capital LLC pursuant to which Fifth Street Capital LLC has agreed to grant us a non-exclusive, royalty-free license to use the name “Fifth Street.” Under this agreement, we will have a right to use the “Fifth Street” name, for so long as Fifth Street Management or one of its affiliates remains our investment adviser. Other than with respect to this limited license, we will have no legal right to the “Fifth Street” name.
 
Exchange Act Reports
 
We maintain a website at www.fifthstreetfinance.com. The information on our website is not incorporated by reference in this annual report on Form 10-K.
 
We make available on or through our website certain reports and amendments to those reports that we file with or furnish to the SEC in accordance with the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These include our annual reports on Form 10-K, our quarterly reports on Form 10-Q and our current reports on Form 8-K. We make this information available on our website free of charge as soon as reasonably practicable after we electronically file the information with, or furnish it to, the SEC.


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Regulation
 
Business Development Company Regulations
 
We have elected to be regulated as a business development company under the 1940 Act. The 1940 Act contains prohibitions and restrictions relating to transactions between business development companies and their affiliates, principal underwriters and affiliates of those affiliates or underwriters. The 1940 Act requires that a majority of the directors be persons other than “interested persons,” as that term is defined in the 1940 Act. In addition, the 1940 Act provides that we may not change the nature of our business so as to cease to be, or to withdraw our election as, a business development company unless approved by a majority of our outstanding voting securities.
 
The 1940 Act defines “a majority of the outstanding voting securities” as the lesser of (i) 67% or more of the voting securities present at a meeting if the holders of more than 50% of our outstanding voting securities are present or represented by proxy or (ii) more than 50% of our outstanding voting securities.
 
As a business development company, we will not generally be permitted to invest in any portfolio company in which our investment adviser or any of its affiliates currently have an investment or to make any co-investments with our investment adviser or its affiliates without an exemptive order from the SEC. We currently do not intend to apply for an exemptive order that would permit us to co-invest with vehicles managed by our investment adviser or its affiliates.
 
Qualifying Assets
 
Under the 1940 Act, a business development company may not acquire any asset other than assets of the type listed in Section 55(a) of the 1940 Act, which are referred to as qualifying assets, unless, at the time the acquisition is made, qualifying assets represent at least 70% of the company’s total assets. The principal categories of qualifying assets relevant to our business are any of the following:
 
(1) Securities purchased in transactions not involving any public offering from the issuer of such securities, which issuer (subject to certain limited exceptions) is an eligible portfolio company, or from any person who is, or has been during the preceding 13 months, an affiliated person of an eligible portfolio company, or from any other person, subject to such rules as may be prescribed by the SEC. An eligible portfolio company is defined in the 1940 Act as any issuer which:
 
(a) is organized under the laws of, and has its principal place of business in, the United States;
 
(b) is not an investment company (other than a small business investment company wholly owned by the business development company) or a company that would be an investment company but for certain exclusions under the 1940 Act; and
 
(c) satisfies any of the following:
 
(i) does not have any class of securities that is traded on a national securities exchange;
 
(ii) has a class of securities listed on a national securities exchange, but has an aggregate market value of outstanding voting and non-voting common equity of less than $250 million;
 
(iii) is controlled by a business development company or a group of companies including a business development company and the business development company has an affiliated person who is a director of the eligible portfolio company; or
 
(iv) is a small and solvent company having total assets of not more than $4 million and capital and surplus of not less than $2 million;
 
(2) Securities of any eligible portfolio company that we control;
 
(3) Securities purchased in a private transaction from a U.S. issuer that is not an investment company or from an affiliated person of the issuer, or in transactions incident thereto, if the issuer is in bankruptcy and subject to reorganization or if the issuer, immediately prior to the purchase of its


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securities was unable to meet its obligations as they came due without material assistance other than conventional lending or financing arrangements;
 
(4) Securities of an eligible portfolio company purchased from any person in a private transaction if there is no ready market for such securities and we already own 60% of the outstanding equity of the eligible portfolio company;
 
(5) Securities received in exchange for or distributed on or with respect to securities described in (1) through (4) above, or pursuant to the exercise of warrants or rights relating to such securities; or
 
(6) Cash, cash equivalents, U.S. government securities or high-quality debt securities maturing in one year or less from the time of investment.
 
In addition, a business development company must be operated for the purpose of making investments in the types of securities described in (1), (2) or (3) above.
 
Managerial Assistance to Portfolio Companies
 
In order to count portfolio securities as qualifying assets for the purpose of the 70% test, we must either control the issuer of the securities or must offer to make available to the issuer of the securities (other than small and solvent companies described above) significant managerial assistance; except that, where we purchase such securities in conjunction with one or more other persons acting together, one of the other persons in the group may make available such managerial assistance. Making available managerial assistance means, among other things, any arrangement whereby the business development company, through its directors, officers or employees, offers to provide, and, if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company.
 
Temporary Investments
 
Pending investment in other types of “qualifying assets,” as described above, our investments may consist of cash, cash equivalents, U.S. government securities or high-quality debt securities maturing in one year or less from the time of investment, which we refer to, collectively, as temporary investments, so that 70% of our assets are qualifying assets. Typically, we will invest in U.S. Treasury bills or in repurchase agreements, provided that such agreements are fully collateralized by cash or securities issued by the U.S. government or its agencies. A repurchase agreement (which is substantially similar to a secured loan) involves the purchase by an investor, such as us, of a specified security and the simultaneous agreement by the seller to repurchase it at an agreed-upon future date and at a price that is greater than the purchase price by an amount that reflects an agreed-upon interest rate. There is no percentage restriction on the proportion of our assets that may be invested in such repurchase agreements. However, if more than 25% of our total assets constitute repurchase agreements from a single counterparty, we would not meet the diversification tests in order to qualify as a RIC for U.S. federal income tax purposes. Thus, we do not intend to enter into repurchase agreements with a single counterparty in excess of this limit. Our investment adviser will monitor the creditworthiness of the counterparties with which we enter into repurchase agreement transactions.
 
Senior Securities
 
We are permitted, under specified conditions, to issue multiple classes of debt and one class of stock senior to our common stock if our asset coverage, as defined in the 1940 Act, is at least equal to 200% immediately after each such issuance. In addition, while any senior securities remain outstanding, we may be prohibited from making distribution to our stockholders or repurchasing such securities or shares unless we meet the applicable asset coverage ratios at the time of the distribution or repurchase. We may also borrow amounts up to 5% of the value of our total assets for temporary or emergency purposes without regard to asset coverage. For a discussion of the risks associated with leverage, see “Risk Factors — Risks Relating to Our Business and Structure — Regulations governing our operation as a business development company and RIC affect our ability to raise, and the way in which we raise, additional capital or borrow for investment purposes,


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which may have a negative effect on our growth” and “— Because we borrow money, the potential for loss on amounts invested in us will be magnified and may increase the risk of investing in us.”
 
Common Stock
 
We are not generally able to issue and sell our common stock at a price below net asset value per share. We may, however, sell our common stock, warrants, options or rights to acquire our common stock, at a price below the current net asset value of the common stock if our Board of Directors determines that such sale is in our best interests and that of our stockholders, and our stockholders approve such sale. In any such case, the price at which our securities are to be issued and sold may not be less than a price which, in the determination of our Board of Directors, closely approximates the market value of such securities (less any distributing commission or discount). We may also make rights offerings to our stockholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act. See “Risk Factors — Risks Relating to Our Business and Structure — Regulations governing our operation as a business development company affect our ability to raise, and the way in which we raise, additional capital or borrow for investment purposes, which may have a negative effect on our growth.”
 
Code of Ethics
 
We have adopted a code of ethics pursuant to Rule 17j-1 under the 1940 Act and we have also approved the investment adviser’s code of ethics that was adopted by it under Rule 17j-1 under the 1940 Act and Rule 204A-1 of the Advisers Act. These codes establish procedures for personal investments and restrict certain personal securities transactions. Personnel subject to the code may invest in securities for their personal investment accounts, including securities that may be purchased or held by us, so long as such investments are made in accordance with the code’s requirements. You may also read and copy the codes of ethics at the SEC’s Public Reference Room located at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the codes of ethics are available on the EDGAR Database on the SEC’s Internet site at http://www.sec.gov.
 
Compliance Policies and Procedures
 
We and our investment adviser have adopted and implemented written policies and procedures reasonably designed to prevent violation of the federal securities laws and are required to review these compliance policies and procedures annually for their adequacy and the effectiveness of their implementation. Our chief compliance officer is responsible for administering these policies and procedures.
 
Proxy Voting Policies and Procedures
 
We have delegated our proxy voting responsibility to our investment adviser. The proxy voting policies and procedures of our investment adviser are set forth below. The guidelines are reviewed periodically by our investment adviser and our non-interested directors, and, accordingly, are subject to change.
 
Introduction
 
As an investment adviser registered under the Advisers Act, our investment adviser has a fiduciary duty to act solely in the best interests of its clients. As part of this duty, it recognizes that it must vote client securities in a timely manner free of conflicts of interest and in the best interests of its clients.
 
These policies and procedures for voting proxies for the investment advisory clients of our investment adviser are intended to comply with Section 206 of, and Rule 206(4)-6 under, the Advisers Act.
 
Proxy policies
 
Our investment adviser will vote proxies relating to our securities in the best interest of our stockholders. It will review on a case-by-case basis each proposal submitted for a stockholder vote to determine its impact


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on the portfolio securities held by us. Although our investment adviser will generally vote against proposals that may have a negative impact on our portfolio securities, it may vote for such a proposal if there exists compelling long-term reasons to do so.
 
The proxy voting decisions of our investment adviser are made by the senior officers who are responsible for monitoring each of our investments. To ensure that its vote is not the product of a conflict of interest, it will require that: (a) anyone involved in the decision making process disclose to its chief compliance officer any potential conflict that he or she is aware of and any contact that he or she has had with any interested party regarding a proxy vote; and (b) employees involved in the decision making process or vote administration are prohibited from revealing how our investment adviser intends to vote on a proposal in order to reduce any attempted influence from interested parties.
 
Proxy voting records
 
You may obtain information, without charge, regarding how we voted proxies with respect to our portfolio securities by making a written request for proxy voting information to: Chief Compliance Officer, 10 Bank Street, 12th Floor, White Plains, NY 10606.
 
Other
 
We will be subject to periodic examination by the SEC for compliance with the 1940 Act.
 
We are required to provide and maintain a bond issued by a reputable fidelity insurance company to protect us against larceny and embezzlement. Furthermore, as a business development company, we are prohibited from protecting any director or officer against any liability to us or our stockholders arising from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office.
 
Exchange Act and Sarbanes-Oxley Act Compliance
 
We are subject to the reporting and disclosure requirements of the Exchange Act, including the filing of quarterly, annual and current reports, proxy statements and other required items. In addition, we are subject to the Sarbanes-Oxley Act, which imposes a wide variety of regulatory requirements on publicly-held companies and their insiders. For example:
 
  •  pursuant to Rule 13a-14 of the Exchange Act, our chief executive officer and chief financial officer are required to certify the accuracy of the financial statements contained in our periodic reports;
 
  •  pursuant to Item 307 of Regulation S-K, our periodic reports are required to disclose our conclusions about the effectiveness of our disclosure controls and procedures; and
 
  •  pursuant to Rule 13a-15 of the Exchange Act, our management is required to prepare a report regarding its assessment of our internal control over financial reporting. Our independent registered public accounting firm is required to audit our internal control over financial reporting.
 
The Sarbanes-Oxley Act requires us to review our current policies and procedures to determine whether we comply with the Sarbanes-Oxley Act and the regulations promulgated thereunder. We intend to monitor our compliance with all regulations that are adopted under the Sarbanes-Oxley Act and will take actions necessary to ensure that we are in compliance therewith.
 
Small Business Investment Company Regulations
 
In August 2009, we formed Fifth Street Mezzanine Partners IV, L.P., a wholly-owned subsidiary of ours. In February 2010, Fifth Street Mezzanine Partners IV, L.P. received final approval to be licensed by the United States Small Business Administration, or SBA, as a small business investment company, or SBIC.


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The SBIC license allows our SBIC subsidiary to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and other customary procedures. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and have a ten year maturity. The principal amount of SBA-guaranteed debentures is not required to be paid prior to maturity but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed on a semi-annual basis at a market-driven spread over U.S. Treasury Notes with 10-year maturities.
 
SBICs are designed to stimulate the flow of private equity capital to eligible small businesses. Under SBA regulations, SBICs may make loans to eligible small businesses and invest in the equity securities of small businesses. Under present SBA regulations, eligible small businesses include businesses that have a tangible net worth not exceeding $18 million and have average annual fully taxed net income not exceeding $6 million for the two most recent fiscal years. In addition, an SBIC must devote 25% of its investment activity to “smaller” concerns as defined by the SBA. A smaller concern is one that has a tangible net worth not exceeding $6 million and has average annual fully taxed net income not exceeding $2 million for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services.
 
SBA regulations currently limit the amount that our SBIC subsidiary may borrow up to a maximum of $150 million when it has at least $75 million in regulatory capital, receives a capital commitment from the SBA and has been through an examination by the SBA subsequent to licensing. As of September 30, 2010, our SBIC subsidiary had $75 million in regulatory capital and the SBA had issued a capital commitment to our SBIC subsidiary in the amount of $150 million.
 
The SBA restricts the ability of SBICs to repurchase their capital stock. SBA regulations also include restrictions on a “change of control” or transfer of an SBIC and require that SBICs invest idle funds in accordance with SBA regulations. In addition, our SBIC subsidiary may also be limited in its ability to make distributions to us if it does not have sufficient capital, in accordance with SBA regulations.
 
Our SBIC subsidiary is subject to regulation and oversight by the SBA, including requirements with respect to maintaining certain minimum financial ratios and other covenants. Receipt of an SBIC license does not assure that our SBIC subsidiary will receive SBA guaranteed debenture funding, which is dependent upon our SBIC subsidiary continuing to be in compliance with SBA regulations and policies. The SBA, as a creditor, will have a superior claim to our SBIC subsidiary’s assets over our stockholders in the event we liquidate our SBIC subsidiary or the SBA exercises its remedies under the SBA-guaranteed debentures issued by our SBIC subsidiary upon an event of default.
 
The New York Stock Exchange Corporate Governance Regulations
 
The New York Stock Exchange has adopted corporate governance regulations that listed companies must comply with. We are in compliance with such corporate governance listing standards applicable to business development companies.
 
Taxation as a Regulated Investment Company
 
As a business development company, we have elected to be treated, and intend to qualify annually, as a RIC under Subchapter M of the Code, beginning with our 2008 taxable year. As a RIC, we generally will not have to pay corporate-level U.S. federal income taxes on any income that we distribute to our stockholders as dividends. To continue to qualify as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements (as described below). In addition, to qualify for RIC tax treatment we must distribute to our stockholders, for each taxable year, at least 90% of our “investment company taxable income,” which is generally our ordinary income plus the excess of our realized net short-term capital gains over our realized net long-term capital losses (the “Annual Distribution Requirement”).


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If we:
 
  •  qualify as a RIC; and
 
  •  satisfy the Annual Distribution Requirement,
 
then we will not be subject to U.S. federal income tax on the portion of our income we distribute (or are deemed to distribute) to stockholders. We will be subject to U.S. federal income tax at the regular corporate rates on any income or capital gains not distributed (or deemed distributed) to our stockholders.
 
We will be subject to a 4% nondeductible U.S. federal excise tax on certain undistributed income unless we distribute in a timely manner an amount at least equal to the sum of (1) 98% of our net ordinary income for each calendar year, (2) 98% of our capital gain net income for the one-year period ending October 31 in that calendar year and (3) any income recognized, but not distributed, in preceding years (the “Excise Tax Avoidance Requirement”). We generally will endeavor in each taxable year to make sufficient distributions to our stockholders to avoid any U.S. federal excise tax on our earnings.
 
In order to qualify as a RIC for U.S. federal income tax purposes, we must, among other things:
 
  •  continue to qualify as a business development company under the 1940 Act at all times during each taxable year;
 
  •  derive in each taxable year at least 90% of our gross income from dividends, interest, payments with respect to loans of certain securities, gains from the sale of stock or other securities, net income from certain “qualified publicly traded partnerships,” or other income derived with respect to our business of investing in such stock or securities (the “90% Income Test”); and
 
  •  diversify our holdings so that at the end of each quarter of the taxable year:
 
  •  at least 50% of the value of our assets consists of cash, cash equivalents, U.S. Government securities, securities of other RICs, and other securities if such other securities of any one issuer do not represent more than 5% of the value of our assets or more than 10% of the outstanding voting securities of the issuer; and
 
  •  no more than 25% of the value of our assets is invested in the securities, other than U.S. government securities or securities of other RICs, of one issuer, of two or more issuers that are controlled, as determined under applicable Code rules, by us and that are engaged in the same or similar or related trades or businesses or of certain “qualified publicly traded partnerships” (the “Diversification Tests”).
 
We may be required to recognize taxable income in circumstances in which we do not receive cash. For example, if we hold debt obligations that are treated under applicable tax rules as having original issue discount (such as debt instruments with PIK interest or, in certain cases, increasing interest rates or issued with warrants), we must include in income each year a portion of the original issue discount that accrues over the life of the obligation, regardless of whether cash representing such income is received by us in the same taxable year. We may also have to include in income other amounts that we have not yet received in cash, such as PIK interest and deferred loan origination fees that are paid after origination of the loan or are paid in non-cash compensation such as warrants or stock. Because any original issue discount or other amounts accrued will be included in our investment company taxable income for the year of accrual, we may be required to make a distribution to our stockholders in order to satisfy the Annual Distribution Requirement, even though we will not have received any corresponding cash amount.
 
Although we do not presently expect to do so, we are authorized to borrow funds and to sell assets in order to satisfy distribution requirements. However, under the 1940 Act, we are not permitted in certain circumstances to make distributions to our stockholders while our debt obligations and other senior securities are outstanding unless certain “asset coverage” tests are met. Moreover, our ability to dispose of assets to meet our distribution requirements may be limited by (1) the illiquid nature of our portfolio and/or (2) other requirements relating to our status as a RIC, including the Diversification Tests. If we dispose of assets in


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order to meet the Annual Distribution Requirement or the Excise Tax Avoidance Requirement, we may make such dispositions at times that, from an investment standpoint, are not advantageous.
 
Pursuant to a recent revenue procedure (Revenue Procedure 2010-12) issued by the Internal Revenue Service, or IRS, the IRS has indicated that it will treat distributions from certain publicly traded RICs (including business development companies) that are paid part in cash and part in stock as dividends that would satisfy the RIC’s annual distribution requirements and qualify for the dividends paid deduction for federal income tax purposes. In order to qualify for such treatment, the revenue procedure requires that at least 10% of the total distribution be payable in cash and that each stockholder have a right to elect to receive its entire distribution in cash. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a proportionate share of the cash to be distributed (although no stockholder electing to receive cash may receive less than 10% of such stockholder’s distribution in cash). This revenue procedure applies to distributions declared on or before December 31, 2012 with respect to taxable years ending on or before December 31, 2011. We do not currently intend to pay dividends in shares of our common stock pursuant to the revenue procedure any time in the near future.
 
Item 1A.   Risk Factors
 
RISK FACTORS
 
Investing in our common stock involves a number of significant risks. In addition to the other information contained in this annual report on Form 10-K, you should consider carefully the following information before making an investment in our common stock. The risks set out below are not the only risks we face. Additional risks and uncertainties not presently known to us or not presently deemed material by us might also impair our operations and performance. If any of the following events occur, our business, financial condition and results of operations could be materially and adversely affected. In such case, our net asset value and the trading price of our common stock could decline, and you may lose part or all of your investment.
 
Risks Relating to Economic Conditions
 
The current state of the economy and financial markets increases the likelihood of adverse effects on our financial position and results of operations.
 
The U.S. capital markets experienced extreme volatility and disruption over the past several years, leading to recessionary conditions and depressed levels of consumer and commercial spending. Disruptions in the capital markets increased the spread between the yields realized on risk-free and higher risk securities, resulting in illiquidity in parts of the capital markets. While recent indicators suggest improvement in the capital markets, we cannot provide any assurance that these conditions will not worsen. If these conditions continue or worsen, the prolonged period of market illiquidity may have an adverse effect on our business, financial condition, and results of operations. Unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us. These events could limit our investment originations, limit our ability to grow and negatively impact our operating results.
 
In addition, to the extent that recessionary conditions continue or worsen, the financial results of small to mid-sized companies, like those in which we invest, will continue to experience deterioration, which could ultimately lead to difficulty in meeting debt service requirements and an increase in defaults. Additionally, the end markets for certain of our portfolio companies’ products and services have experienced, and continue to experience, negative economic trends. The performances of certain of our portfolio companies have been, and may continue to be, negatively impacted by these economic or other conditions, which may ultimately result in our receipt of a reduced level of interest income from our portfolio companies and/or losses or charge offs related to our investments, and, in turn, may adversely affect distributable income.


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Economic recessions or downturns could impair the ability of our portfolio companies to repay loans, which, in turn, could increase our non-performing assets, decrease the value of our portfolio, reduce our volume of new loans and harm our operating results, which would have an adverse effect on our results of operations.
 
Many of our portfolio companies are and may be susceptible to economic slowdowns or recessions and may be unable to repay our loans during such periods. Therefore, our non-performing assets are likely to increase and the value of our portfolio is likely to decrease during such periods. Adverse economic conditions also may decrease the value of collateral securing some of our loans and the value of our equity investments. In this regard, as a result of recent economic conditions and their impact on certain of our portfolio companies, we have agreed to modify the payment terms of our investments in eleven of our portfolio companies as of September 30, 2010. Such modified terms include changes in payment-in-kind interest provisions and/or cash interest rates. These modifications, and any future modifications to our loan agreements as a result of the recent economic conditions or otherwise, may limit the amount of interest income that we recognize from the modified investments, which may, in turn, limit our ability to make distributions to our stockholders and have an adverse effect on our results of operations.
 
Risks Relating to Our Business and Structure
 
Changes in interest rates may affect our cost of capital and net investment income.
 
Because we may borrow to fund our investments, a portion of our net investment income may be dependent upon the difference between the interest rate at which we borrow funds and the interest rate at which we invest these funds. A portion of our investments will have fixed interest rates, while a portion of our borrowings will likely have floating interest rates. As a result, a significant change in market interest rates could have a material adverse effect on our net investment income. In periods of rising interest rates, our cost of funds could increase, which would reduce our net investment income. We may hedge against such interest rate fluctuations by using standard hedging instruments such as interest rate swap agreements, futures, options and forward contracts, subject to applicable legal requirements, including without limitation, all necessary registrations (or exemptions from registration) with the Commodity Futures Trading Commission. These activities may limit our ability to participate in the benefits of lower interest rates with respect to the hedged borrowings. Adverse developments resulting from changes in interest rates or hedging transactions could have a material adverse effect on our business, financial condition and results of operations.
 
We have a limited operating history.
 
Fifth Street Mezzanine Partners III, L.P. commenced operations on February 15, 2007. On January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp., a Delaware corporation. As a result, we are subject to all of the business risks and uncertainties associated with any new business, including the risk that we will not achieve our investment objective and that the value of our common stock could decline substantially.
 
We currently have a limited number of investments in our investment portfolio. As a result, a loss on one or more of those investments would have a more adverse effect on our company than the effect such a loss would have on a company with a larger and more diverse investment portfolio.
 
As a company with a limited operating history, we have not had the opportunity to invest in a large number of portfolio companies. As a result, until we have increased the number of investments in our investment portfolio, a loss on one or more of our investments would affect us more adversely than such loss would affect a company with a larger and more diverse investment portfolio.


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A significant portion of our investment portfolio is and will continue to be recorded at fair value as determined in good faith by our Board of Directors and, as a result, there is and will continue to be uncertainty as to the value of our portfolio investments.
 
Under the 1940 Act, we are required to carry our portfolio investments at market value or, if there is no readily available market value, at fair value as determined by our Board of Directors. Typically, there is not a public market for the securities of the privately held companies in which we have invested and will generally continue to invest. As a result, we value these securities quarterly at fair value as determined in good faith by our Board of Directors.
 
Certain factors that may be considered in determining the fair value of our investments include the nature and realizable value of any collateral, the portfolio company’s earnings and its ability to make payments on its indebtedness, the markets in which the portfolio company does business, comparison to comparable publicly-traded companies, discounted cash flow and other relevant factors. Because such valuations, and particularly valuations of private securities and private companies, are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. Due to this uncertainty, our fair value determinations may cause our net asset value on a given date to materially understate or overstate the value that we may ultimately realize upon the sale of one or more of our investments. As a result, investors purchasing our common stock based on an overstated net asset value would pay a higher price than the realizable value of our investments might warrant.
 
Our ability to achieve our investment objective depends on our investment adviser’s ability to support our investment process; if our investment adviser were to lose any of its principals, our ability to achieve our investment objective could be significantly harmed.
 
As discussed above, we were organized on February 15, 2007. We have no employees and, as a result, we depend on the investment expertise, skill and network of business contacts of the principals of our investment adviser. The principals of our investment adviser evaluate, negotiate, structure, execute, monitor and service our investments. Our future success will depend to a significant extent on the continued service and coordination of the principals of our investment adviser. The departure of any of these individuals could have a material adverse effect on our ability to achieve our investment objective.
 
Our ability to achieve our investment objective depends on our investment adviser’s ability to identify, analyze, invest in, finance and monitor companies that meet our investment criteria. Our investment adviser’s capabilities in structuring the investment process, providing competent, attentive and efficient services to us, and facilitating access to financing on acceptable terms depend on the employment of investment professionals in adequate number and of adequate sophistication to match the corresponding flow of transactions. To achieve our investment objective, our investment adviser may need to hire, train, supervise and manage new investment professionals to participate in our investment selection and monitoring process. Our investment adviser may not be able to find investment professionals in a timely manner or at all. Failure to support our investment process could have a material adverse effect on our business, financial condition and results of operations.
 
Our investment adviser has no prior experience managing a business development company or a RIC.
 
The 1940 Act and the Code impose numerous constraints on the operations of business development companies and RICs that do not apply to the other investment vehicles previously managed by the principals of our investment adviser. For example, under the 1940 Act, business development companies are required to invest at least 70% of their total assets primarily in securities of qualifying U.S. private or thinly traded companies. Moreover, qualification for taxation as a RIC under subchapter M of the Code requires satisfaction of source-of-income and diversification requirements and our ability to avoid corporate-level taxes on our income and gains depends on our satisfaction of distribution requirements. The failure to comply with these provisions in a timely manner could prevent us from qualifying as a business development company or RIC or could force us to pay unexpected taxes and penalties, which could be material. Our investment adviser does


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not have any prior experience managing a business development company or RIC. Its lack of experience in managing a portfolio of assets under such constraints may hinder its ability to take advantage of attractive investment opportunities and, as a result, achieve our investment objective.
 
Our business model depends to a significant extent upon strong referral relationships with private equity sponsors, and the inability of the principals of our investment adviser to maintain or develop these relationships, or the failure of these relationships to generate investment opportunities, could adversely affect our business.
 
We expect that the principals of our investment adviser will maintain and develop their relationships with private equity sponsors, and we will rely to a significant extent upon these relationships to provide us with potential investment opportunities. If the principals of our investment adviser fail to maintain their existing relationships or develop new relationships with other sponsors or sources of investment opportunities, we will not be able to grow our investment portfolio. In addition, individuals with whom the principals of our investment adviser have relationships are not obligated to provide us with investment opportunities, and, therefore, there is no assurance that such relationships will generate investment opportunities for us.
 
We may face increasing competition for investment opportunities, which could reduce returns and result in losses.
 
We compete for investments with other business development companies and investment funds (including private equity funds and mezzanine funds), as well as traditional financial services companies such as commercial banks and other sources of funding. Many of our competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, some competitors may have a lower cost of capital and access to funding sources that are not available to us. In addition, some of our competitors may have higher risk tolerances or different risk assessments than we have. These characteristics could allow our competitors to consider a wider variety of investments, establish more relationships and offer better pricing and more flexible structuring than we are able to do. We may lose investment opportunities if we do not match our competitors’ pricing, terms and structure. If we are forced to match our competitors’ pricing, terms and structure, we may not be able to achieve acceptable returns on our investments or may bear substantial risk of capital loss. A significant part of our competitive advantage stems from the fact that the market for investments in small and mid-sized companies is underserved by traditional commercial banks and other financial sources. A significant increase in the number and/or the size of our competitors in this target market could force us to accept less attractive investment terms. Furthermore, many of our competitors have greater experience operating under, or are not subject to, the regulatory restrictions that the 1940 Act imposes on us as a business development company.
 
Our incentive fee may induce our investment adviser to make speculative investments.
 
The incentive fee payable by us to our investment adviser may create an incentive for it to make investments on our behalf that are risky or more speculative than would be the case in the absence of such compensation arrangement, which could result in higher investment losses, particularly during cyclical economic downturns. The way in which the incentive fee payable to our investment adviser is determined, which is calculated separately in two components as a percentage of the income (subject to a hurdle rate) and as a percentage of the realized gain on invested capital, may encourage our investment adviser to use leverage to increase the return on our investments or otherwise manipulate our income so as to recognize income in quarters where the hurdle rate is exceeded. Under certain circumstances, the use of leverage may increase the likelihood of default, which would disfavor the holders of our common stock.
 
The incentive fee payable by us to our investment adviser also may create an incentive for our investment adviser to invest on our behalf in instruments that have a deferred interest feature. Under these investments, we would accrue the interest over the life of the investment but would not receive the cash income from the investment until the end of the investment’s term, if at all. Our net investment income used to calculate the income portion of our incentive fee, however, includes accrued interest. Thus, a portion of the incentive fee would be based on income that we have not yet received in cash and may never receive in cash if the portfolio


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company is unable to satisfy such interest payment obligation to us. Consequently, while we may make incentive fee payments on income accruals that we may not collect in the future and with respect to which we do not have a formal “claw back” right against our investment adviser per se, the amount of accrued income written off in any period will reduce the income in the period in which such write-off was taken and thereby reduce such period’s incentive fee payment.
 
In addition, our investment adviser receives the incentive fee based, in part, upon net capital gains realized on our investments. Unlike the portion of the incentive fee based on income, there is no performance threshold applicable to the portion of the incentive fee based on net capital gains. As a result, our investment adviser may have a tendency to invest more in investments that are likely to result in capital gains as compared to income producing securities. Such a practice could result in our investing in more speculative securities than would otherwise be the case, which could result in higher investment losses, particularly during economic downturns.
 
Given the subjective nature of the investment decisions made by our investment adviser on our behalf, we will be unable to monitor these potential conflicts of interest between us and our investment adviser.
 
Our base management fee may induce our investment adviser to incur leverage.
 
The fact that our base management fee is payable based upon our gross assets, which would include any borrowings for investment purposes, may encourage our investment adviser to use leverage to make additional investments. Under certain circumstances, the use of increased leverage may increase the likelihood of default, which would disfavor holders of our common stock. Given the subjective nature of the investment decisions made by our investment adviser on our behalf, we will not be able to monitor this potential conflict of interest.
 
Because we borrow money, the potential for loss on amounts invested in us will be magnified and may increase the risk of investing in us.
 
Borrowings, also known as leverage, magnify the potential for loss on invested equity capital. If we continue to use leverage to partially finance our investments, through borrowings from banks and other lenders, you will experience increased risks of investing in our common stock. If the value of our assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged. Similarly, any decrease in our income would cause net income to decline more sharply than it would have had we not borrowed. Such a decline could negatively affect our ability to make common stock distribution payments. Leverage is generally considered a speculative investment technique.
 
Substantially all of our assets are subject to security interests under secured credit facilities and if we default on our obligations under the facilities, we may suffer adverse consequences, including the lenders foreclosing on our assets.
 
As of September 30, 2010, except for assets that were funded through our SBIC subsidiary, substantially all of our assets were pledged as collateral under our credit facilities. If we default on our obligations under these facilities, the lenders may have the right to foreclose upon and sell, or otherwise transfer, the collateral subject to their security interests. In such event, we may be forced to sell our investments to raise funds to repay our outstanding borrowings in order to avoid foreclosure and these forced sales may be at times and at prices we would not consider advantageous. Moreover, such deleveraging of our company could significantly impair our ability to effectively operate our business in the manner in which we have historically operated. As a result, we could be forced to curtail or cease new investment activities and lower or eliminate the dividends that we have historically paid to our stockholders.
 
In addition, if the lenders exercise their right to sell the assets pledged under our credit facilities, such sales may be completed at distressed sale prices, thereby diminishing or potentially eliminating the amount of cash available to us after repayment of the amounts outstanding under the credit facilities.


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Because we intend to distribute between 90% and 100% of our income to our stockholders in connection with our election to be treated as a RIC, we will continue to need additional capital to finance our growth. If additional funds are unavailable or not available on favorable terms, our ability to grow will be impaired.
 
In order to qualify for the tax benefits available to RICs and to minimize corporate-level taxes, we intend to distribute to our stockholders between 90% and 100% of our annual taxable income, except that we may retain certain net capital gains for investment, and treat such amounts as deemed distributions to our stockholders. If we elect to treat any amounts as deemed distributions, we must pay income taxes at the corporate rate on such deemed distributions on behalf of our stockholders. As a result of these requirements, we will likely need to raise capital from other sources to grow our business. As a business development company, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, to total senior securities, which includes all of our borrowings and any outstanding preferred stock, of at least 200%. These requirements limit the amount that we may borrow. Because we will continue to need capital to grow our investment portfolio, these limitations may prevent us from incurring debt and require us to raise additional equity at a time when it may be disadvantageous to do so.
 
While we expect to be able to borrow and to issue additional debt and equity securities, we cannot assure you that debt and equity financing will be available to us on favorable terms, or at all. Also, as a business development company, we generally are not permitted to issue equity securities priced below net asset value without stockholder approval. If additional funds are not available to us, we could be forced to curtail or cease new investment activities, and our net asset value and share price could decline.
 
Our ability to enter into transactions with our affiliates is restricted.
 
We are prohibited under the 1940 Act from participating in certain transactions with certain of our affiliates without the prior approval of the members of our independent directors and, in some cases, the SEC. Any person that owns, directly or indirectly, 5% or more of our outstanding voting securities is our affiliate for purposes of the 1940 Act and we are generally prohibited from buying or selling any securities (other than our securities) from or to such affiliate, absent the prior approval of our independent directors. The 1940 Act also prohibits certain “joint” transactions with certain of our affiliates, which could include investments in the same portfolio company (whether at the same or different times), without prior approval of our independent directors and, in some cases, the SEC. If a person acquires more than 25% of our voting securities, we are prohibited from buying or selling any security (other than any security of which we are the issuer) from or to such person or certain of that person’s affiliates, or entering into prohibited joint transactions with such person, absent the prior approval of the SEC. Similar restrictions limit our ability to transact business with our officers or directors or their affiliates. As a result of these restrictions, we may be prohibited from buying or selling any security (other than any security of which we are the issuer) from or to any portfolio company of a private equity fund managed by our investment adviser without the prior approval of the SEC, which may limit the scope of investment opportunities that would otherwise be available to us.
 
There are significant potential conflicts of interest which could adversely impact our investment returns.
 
Our executive officers and directors, and certain members of our investment adviser, serve or may serve as officers, directors or principals of entities that operate in the same or a related line of business as we do or of investment funds managed by our affiliates. Accordingly, they may have obligations to investors in those entities, the fulfillment of which might not be in the best interests of us or our stockholders. For example, Mr. Tannenbaum, our chief executive officer and managing partner of our investment adviser, is the managing partner of Fifth Street Capital LLC, a private investment firm. Although the other investment funds managed by Fifth Street Capital LLC and its affiliates generally are fully committed and, other than follow-on investments in existing portfolio companies, are no longer making investments, in the future, the principals of our investment adviser may manage other funds which may from time to time have overlapping investment objectives with those of us and accordingly invest in, whether principally or secondarily, asset classes similar to those targeted by us. If this should occur, the principals of our investment adviser would face conflicts of


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interest in the allocation of investment opportunities to us and such other funds. Although our investment professionals will endeavor to allocate investment opportunities in a fair and equitable manner, we and our common stockholders could be adversely affected in the event investment opportunities are allocated among us and other investment vehicles managed or sponsored by, or affiliated with, our executive officers, directors, and members of our investment adviser.
 
The incentive fee we pay to our investment adviser relating to capital gains may be effectively greater than 20%.
 
As a result of the operation of the cumulative method of calculating the capital gains portion of the incentive fee we pay to our investment adviser, the cumulative aggregate capital gains fee received by our investment adviser could be effectively greater than 20%, depending on the timing and extent of subsequent net realized capital losses or net unrealized depreciation. For additional information on this calculation, see the disclosure in footnote 2 to Example 2 under the caption “Item 1. Business — Investment Advisory Agreement — Management Fee — Incentive Fee.” We cannot predict whether, or to what extent, this payment calculation would affect your investment in our stock.
 
The involvement of our investment adviser’s investment professionals in our valuation process may create conflicts of interest.
 
Our portfolio investments are generally not in publicly traded securities. As a result, the values of these securities are not readily available. We value these securities at fair value as determined in good faith by our Board of Directors based upon the recommendation of the Valuation Committee of our Board of Directors. In connection with that determination, investment professionals from our investment adviser prepare portfolio company valuations based upon the most recent portfolio company financial statements available and projected financial results of each portfolio company. The participation of our investment adviser’s investment professionals in our valuation process could result in a conflict of interest as our investment adviser’s management fee is based, in part, on our gross assets.
 
A failure on our part to maintain our qualification as a business development company would significantly reduce our operating flexibility.
 
If we fail to continuously qualify as a business development company, we might be subject to regulation as a registered closed-end investment company under the 1940 Act, which would significantly decrease our operating flexibility. In addition, failure to comply with the requirements imposed on business development companies by the 1940 Act could cause the SEC to bring an enforcement action against us. For additional information on the qualification requirements of a business development company, see the disclosure under the caption “Item 1. Business — Regulation — Business Development Company Regulations.”
 
Regulations governing our operation as a business development company and RIC affect our ability to raise, and the way in which we raise, additional capital or borrow for investment purposes, which may have a negative effect on our growth.
 
As a result of the annual distribution requirement to qualify for tax free treatment at the corporate level on income and gains distributed to stockholders, we need to periodically access the capital markets to raise cash to fund new investments. We generally are not able to issue or sell our common stock at a price below net asset value per share, which may be a disadvantage as compared with other public companies or private investment funds. We may, however, sell our common stock, or warrants, options or rights to acquire our common stock, at a price below the current net asset value of the common stock if our Board of Directors and independent directors determine that such sale is in our best interests and the best interests of our stockholders, and our stockholders as well as those stockholders that are not affiliated with us approve such sale. In any such case, the price at which our securities are to be issued and sold may not be less than a price that, in the determination of our Board of Directors, closely approximates the market value of such securities (less any underwriting commission or discount). If our common stock trades at a discount to net asset value, this restriction could adversely affect our ability to raise capital.


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We also may make rights offerings to our stockholders at prices less than net asset value, subject to applicable requirements of the 1940 Act. If we raise additional funds by issuing more shares of our common stock or issuing senior securities convertible into, or exchangeable for, our common stock, the percentage ownership of our stockholders may decline at that time and such stockholders may experience dilution. Moreover, we can offer no assurance that we will be able to issue and sell additional equity securities in the future, on terms favorable to us or at all.
 
In addition, we may issue “senior securities,” including borrowing money from banks or other financial institutions only in amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such incurrence or issuance. Our ability to issue different types of securities is also limited. Compliance with these requirements may unfavorably limit our investment opportunities and reduce our ability in comparison to other companies to profit from favorable spreads between the rates at which we can borrow and the rates at which we can lend. As a business development company, therefore, we may need to issue equity more frequently than our privately owned competitors, which may lead to greater stockholder dilution.
 
We expect to continue to borrow for investment purposes. If the value of our assets declines, we may be unable to satisfy the asset coverage test, which could prohibit us from paying dividends and could prevent us from qualifying as a RIC. If we cannot satisfy the asset coverage test, we may be required to sell a portion of our investments and, depending on the nature of our debt financing, repay a portion of our indebtedness at a time when such sales may be disadvantageous.
 
In addition, we may in the future seek to securitize our portfolio securities to generate cash for funding new investments. To securitize loans, we would likely create a wholly-owned subsidiary and contribute a pool of loans to the subsidiary. We would then sell interests in the subsidiary on a non-recourse basis to purchasers and we would retain all or a portion of the equity in the subsidiary. An inability to successfully securitize our loan portfolio could limit our ability to grow our business or fully execute our business strategy and may decrease our earnings, if any. The securitization market is subject to changing market conditions and we may not be able to access this market when we would otherwise deem appropriate. Moreover, the successful securitization of our portfolio might expose us to losses as the residual investments in which we do not sell interests will tend to be those that are riskier and more apt to generate losses. The 1940 Act also may impose restrictions on the structure of any securitization.
 
Our SBIC subsidiary’s investment adviser has no prior experience managing an SBIC and any failure to comply with SBA regulations, resulting from our SBIC subsidiary’s investment adviser’s lack of experience or otherwise, could have an adverse effect on our operations.
 
On February 3, 2010, our wholly-owned subsidiary, Fifth Street Mezzanine Partners IV, L.P., received a license, effective February 1, 2010, from the SBA to operate as an SBIC under Section 301(c) of the Small Business Investment Act of 1958 and is regulated by the SBA. The SBIC license allows our SBIC subsidiary to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and other customary procedures. The SBA places certain limitations on the financing terms of investments by SBICs in portfolio companies and prohibits SBICs from providing funds for certain purposes or to businesses in a few prohibited industries. Compliance with SBIC requirements may cause our SBIC subsidiary to forego attractive investment opportunities that are not permitted under SBA regulations.
 
Further, SBA regulations require that an SBIC be periodically examined and audited by the SBA to determine its compliance with the relevant SBA regulations. The SBA prohibits, without prior SBA approval, a “change of control” of an SBIC or transfers that would result in any person (or a group of persons acting in concert) owning 10% or more of a class of capital stock of an SBIC. If our SBIC subsidiary fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit its use of debentures, declare outstanding debentures immediately due and payable, and/or limit it from making new investments. In addition, the SBA can revoke or suspend a license for willful or repeated violation of, or willful or repeated failure to observe, any provision of the Small Business Investment Act of 1958 or any rule or regulation promulgated thereunder. These actions by the SBA would, in turn, negatively affect us because our SBIC subsidiary is our wholly-owned subsidiary. Our SBIC subsidiary’s investment adviser does


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not have any prior experience managing an SBIC. Its lack of experience in complying with SBA regulations may hinder its ability to take advantage of our SBIC subsidiary’s access to SBA-guaranteed debentures.
 
Any failure to comply with SBA regulations could have an adverse effect on our operations.
 
We may experience fluctuations in our quarterly results.
 
We could experience fluctuations in our quarterly operating results due to a number of factors, including our ability or inability to make investments in companies that meet our investment criteria, the interest rate payable on the debt securities we acquire, the level of our expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our market and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods.
 
Our Board of Directors may change our investment objective, operating policies and strategies without prior notice or stockholder approval, the effects of which may be adverse.
 
Our Board of Directors has the authority to modify or waive our current investment objective, operating policies and strategies without prior notice and without stockholder approval. We cannot predict the effect any changes to our current investment objective, operating policies and strategies would have on our business, net asset value, operating results and value of our stock. However, the effects might be adverse, which could negatively impact our ability to pay you distributions and cause you to lose part or all of your investment.
 
We will be subject to corporate-level income tax if we are unable to maintain our qualification as a RIC under Subchapter M of the Code or do not satisfy the annual distribution requirement.
 
To maintain RIC status and be relieved of federal taxes on income and gains distributed to our stockholders, we must meet the following annual distribution, income source and asset diversification requirements.
 
  •  The annual distribution requirement for a RIC will be satisfied if we distribute to our stockholders on an annual basis at least 90% of our net ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any. Because we may use debt financing, we are subject to an asset coverage ratio requirement under the 1940 Act and we may be subject to certain financial covenants under our debt arrangements that could, under certain circumstances, restrict us from making distributions necessary to satisfy the distribution requirement. If we are unable to obtain cash from other sources, we could fail to qualify for RIC tax treatment and thus become subject to corporate-level income tax.
 
  •  The income source requirement will be satisfied if we obtain at least 90% of our income for each year from dividends, interest, gains from the sale of stock or securities or similar sources.
 
  •  The asset diversification requirement will be satisfied if we meet certain asset diversification requirements at the end of each quarter of our taxable year. To satisfy this requirement, at least 50% of the value of our assets must consist of cash, cash equivalents, U.S. government securities, securities of other RICs, and other acceptable securities; and no more than 25% of the value of our assets can be invested in the securities, other than U.S. government securities or securities of other RICs, of one issuer, of two or more issuers that are controlled, as determined under applicable Code rules, by us and that are engaged in the same or similar or related trades or businesses or of certain “qualified publicly traded partnerships.” Failure to meet these requirements may result in our having to dispose of certain investments quickly in order to prevent the loss of RIC status. Because most of our investments will be in private companies, and therefore will be relatively illiquid, any such dispositions could be made at disadvantageous prices and could result in substantial losses.


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If we fail to qualify for or maintain RIC status or to meet the annual distribution requirement for any reason and are subject to corporate income tax, the resulting corporate taxes could substantially reduce our net assets, the amount of income available for distribution and the amount of our distributions.
 
We may not be able to pay you distributions, our distributions may not grow over time and a portion of our distributions may be a return of capital.
 
We intend to pay distributions to our stockholders out of assets legally available for distribution. We cannot assure you that we will achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions. Our ability to pay distributions might be adversely affected by, among other things, the impact of one or more of the risk factors described in this annual report on Form 10-K. In addition, the inability to satisfy the asset coverage test applicable to us as a business development company can limit our ability to pay distributions. All distributions will be paid at the discretion of our Board of Directors and will depend on our earnings, our financial condition, maintenance of our RIC status, compliance with applicable business development company regulations and such other factors as our Board of Directors may deem relevant from time to time. We cannot assure you that we will pay distributions to our stockholders in the future.
 
When we make distributions, we will be required to determine the extent to which such distributions are paid out of current or accumulated earnings and profits. Distributions in excess of current and accumulated earnings and profits will be treated as a non-taxable return of capital to the extent of an investor’s basis in our stock and, assuming that an investor holds our stock as a capital asset, thereafter as a capital gain.
 
We may have difficulty paying our required distributions if we recognize income before or without receiving cash representing such income.
 
For federal income tax purposes, we include in income certain amounts that we have not yet received in cash, such as original issue discount or accruals on a contingent payment debt instrument, which may occur if we receive warrants in connection with the origination of a loan or possibly in other circumstances. Such original issue discount is included in income before we receive any corresponding cash payments. We also may be required to include in income certain other amounts that we do not receive in cash.
 
Since, in certain cases, we may recognize income before or without receiving cash representing such income, we may have difficulty meeting the annual distribution requirement necessary to be relieved of federal taxes on income and gains distributed to our stockholders. Accordingly, we may have to sell some of our investments at times and/or at prices we would not consider advantageous, raise additional debt or equity capital or forgo new investment opportunities for this purpose. If we are not able to obtain cash from other sources, we may fail to satisfy the annual distribution requirement and thus become subject to corporate-level income tax.
 
We may in the future choose to pay dividends in our own stock, in which case you may be required to pay tax in excess of the cash you receive.
 
We may distribute taxable dividends that are payable in part in our stock. Taxable stockholders receiving such dividends will be required to include the full amount of the dividend as ordinary income (or as long-term capital gain to the extent such distribution is properly designated as a capital gain dividend) to the extent of our current and accumulated earnings and profits for United States federal income tax purposes. As a result, a U.S. stockholder may be required to pay tax with respect to such dividends in excess of any cash received. If a U.S. stockholder sells the stock it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of our stock at the time of the sale. Furthermore, with respect to non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of our stockholders determine to sell shares of our stock in order to pay taxes owed on dividends, it may put downward pressure on the trading price of our stock.


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In addition, as discussed elsewhere in this annual report on Form 10-K, our loans typically contain a payment-in-kind (“PIK”) interest provision. The PIK interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To avoid the imposition of corporate-level tax on us, this non-cash source of income needs to be paid out to stockholders in cash distributions or, in the event that we determine to do so, in shares of our common stock, even though we have not yet collected and may never collect the cash relating to the PIK interest. As a result, if we distribute taxable dividends in the form of our common stock, we may have to distribute a stock dividend to account for PIK interest even though we have not yet collected the cash.
 
Our wholly-owned SBIC subsidiary may be unable to make distributions to us that will enable us to maintain RIC status, which could result in the imposition of an entity-level tax.
 
In order for us to continue to qualify for RIC tax treatment and to minimize corporate-level taxes, we are required to distribute substantially all of our net ordinary income and net capital gain income, including income from certain of our subsidiaries, which includes the income from our SBIC subsidiary. We are partially dependent on our SBIC subsidiary for cash distributions to enable us to meet the RIC distribution requirements. Our SBIC subsidiary may be limited by the Small Business Investment Act of 1958, and SBA regulations governing SBICs, from making certain distributions to us that may be necessary to maintain our status as a RIC. We may have to request a waiver of the SBA’s restrictions for our SBIC subsidiary to make certain distributions to maintain our RIC status. We cannot assure you that the SBA will grant such waiver and if our SBIC subsidiary is unable to obtain a waiver, compliance with the SBA regulations may result in loss of RIC tax treatment and a consequent imposition of an entity-level tax on us.
 
Changes in laws or regulations governing our operations may adversely affect our business or cause us to alter our business strategy.
 
We and our portfolio companies are subject to regulation at the local, state and federal level. New legislation may be enacted or new interpretations, rulings or regulations could be adopted, including those governing the types of investments we are permitted to make or that impose limits on our ability to pledge a significant amount of our assets to secure loans, any of which could harm us and our stockholders, potentially with retroactive effect.
 
Additionally, any changes to the laws and regulations governing our operations relating to permitted investments may cause us to alter our investment strategy in order to avail ourselves of new or different opportunities. Such changes could result in material differences to the strategies and plans set forth in this annual report on Form 10-K and may result in our investment focus shifting from the areas of expertise of our investment adviser to other types of investments in which our investment adviser may have less expertise or little or no experience. Thus, any such changes, if they occur, could have a material adverse effect on our results of operations and the value of your investment.
 
We have identified deficiencies in our internal control over financial reporting from time to time. Future control deficiencies could prevent us from accurately and timely reporting our financial results.
 
We have identified deficiencies in our internal control over financial reporting from time to time, including significant deficiencies and material weaknesses. A “significant deficiency” is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of a company’s financial reporting. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis.
 
Our failure to identify deficiencies in our internal control over financial reporting in a timely manner or remediate any deficiencies, or the identification of material weaknesses or significant deficiencies in the future could prevent us from accurately and timely reporting our financial results.


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Risks Relating to Our Investments
 
Our investments in portfolio companies may be risky, and we could lose all or part of our investment.
 
Investing in small and mid-sized companies involves a number of significant risks. Among other things, these companies:
 
  •  may have limited financial resources and may be unable to meet their obligations under their debt instruments that we hold, which may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of us realizing any guarantees from subsidiaries or affiliates of our portfolio companies that we may have obtained in connection with our investments, as well as a corresponding decrease in the value of the equity components of our investments;
 
  •  may have shorter operating histories, narrower product lines, smaller market shares and/or significant customer concentrations than larger businesses, which tend to render them more vulnerable to competitors’ actions and market conditions, as well as general economic downturns;
 
  •  are more likely to depend on the management talents and efforts of a small group of persons; therefore, the death, disability, resignation or termination of one or more of these persons could have a material adverse impact on our portfolio company and, in turn, on us;
 
  •  generally have less predictable operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, and may require substantial additional capital to support their operations, finance expansion or maintain their competitive position; and
 
  •  generally have less publicly available information about their businesses, operations and financial condition. If we are unable to uncover all material information about these companies, we may not make a fully informed investment decision, and as a result may lose part or all of our investment.
 
In addition, in the course of providing significant managerial assistance to certain of our portfolio companies, certain of our officers and directors may serve as directors on the boards of such companies. To the extent that litigation arises out of our investments in these companies, our officers and directors may be named as defendants in such litigation, which could result in an expenditure of funds (through our indemnification of such officers and directors) and the diversion of management time and resources.
 
An investment strategy focused primarily on privately held companies presents certain challenges, including the lack of available information about these companies.
 
We invest primarily in privately held companies. Generally, little public information exists about these companies, including typically a lack of audited financial statements and ratings by third parties. We must therefore rely on the ability of our investment adviser to obtain adequate information to evaluate the potential risks of investing in these companies. These companies and their financial information may not be subject to the Sarbanes-Oxley Act and other rules that govern public companies. If we are unable to uncover all material information about these companies, we may not make a fully informed investment decision, and we may lose money on our investments. These factors could affect our investment returns.
 
If we make unsecured debt investments, we may lack adequate protection in the event our portfolio companies become distressed or insolvent and will likely experience a lower recovery than more senior debtholders in the event our portfolio companies defaults on their indebtedness.
 
We may make unsecured debt investments in portfolio companies in the future. Unsecured debt investments are unsecured and junior to other indebtedness of the portfolio company. As a consequence, the holder of an unsecured debt investment may lack adequate protection in the event the portfolio company becomes distressed or insolvent and will likely experience a lower recovery than more senior debtholders in the event the portfolio company defaults on its indebtedness. In addition, unsecured debt investments of small and mid-sized companies are often highly illiquid and in adverse market conditions may experience steep declines in valuation even if they are fully performing.


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If we invest in the securities and obligations of distressed or bankrupt companies, such investments may be subject to significant risks, including lack of income, extraordinary expenses, uncertainty with respect to satisfaction of debt, lower-than expected investment values or income potentials and resale restrictions.
 
We are authorized to invest in the securities and other obligations of distressed or bankrupt companies. At times, distressed debt obligations may not produce income and may require us to bear certain extraordinary expenses (including legal, accounting, valuation and transaction expenses) in order to protect and recover our investment. Therefore, to the extent we invest in distressed debt, our ability to achieve current income for our stockholders may be diminished.
 
We also will be subject to significant uncertainty as to when and in what manner and for what value the distressed debt we invest in will eventually be satisfied (e.g., through a liquidation of the obligor’s assets, an exchange offer or plan of reorganization involving the distressed debt securities or a payment of some amount in satisfaction of the obligation). In addition, even if an exchange offer is made or plan of reorganization is adopted with respect to distressed debt held by us, there can be no assurance that the securities or other assets received by us in connection with such exchange offer or plan of reorganization will not have a lower value or income potential than may have been anticipated when the investment was made.
 
Moreover, any securities received by us upon completion of an exchange offer or plan of reorganization may be restricted as to resale. As a result of our participation in negotiations with respect to any exchange offer or plan of reorganization with respect to an issuer of distressed debt, we may be restricted from disposing of such securities.
 
The lack of liquidity in our investments may adversely affect our business.
 
We invest, and will continue to invest, in companies whose securities are not publicly traded, and whose securities will be subject to legal and other restrictions on resale or will otherwise be less liquid than publicly traded securities. In fact, all of our assets may be invested in illiquid securities. The illiquidity of these investments may make it difficult for us to sell these investments when desired. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we had previously recorded these investments. Our investments are usually subject to contractual or legal restrictions on resale or are otherwise illiquid because there is usually no established trading market for such investments. The illiquidity of most of our investments may make it difficult for us to dispose of them at a favorable price, and, as a result, we may suffer losses.
 
We may not have the funds or ability to make additional investments in our portfolio companies.
 
After our initial investment in a portfolio company, we may be called upon from time to time to provide additional funds to such company or have the opportunity to increase our investment through the exercise of a warrant to purchase common stock. There is no assurance that we will make, or will have sufficient funds to make, follow-on investments. Any decisions not to make a follow-on investment or any inability on our part to make such an investment may have a negative impact on a portfolio company in need of such an investment, may result in a missed opportunity for us to increase our participation in a successful operation or may reduce the expected yield on the investment.
 
Our portfolio companies may incur debt that ranks equally with, or senior to, our investments in such companies.
 
We invest primarily in first and second lien debt issued by small and mid-sized companies. Our portfolio companies may have, or may be permitted to incur, other debt that ranks equally with, or senior to, the debt in which we invest. By their terms, such debt instruments may entitle the holders to receive payments of interest or principal on or before the dates on which we are entitled to receive payments with respect to the debt instruments in which we invest. Also, in the event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company, holders of debt instruments ranking senior to our investment in that portfolio company would typically be entitled to receive payment in full before we receive any distribution. After repaying such senior creditors, such portfolio company may not have any remaining assets to use for


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repaying its obligation to us. In the case of debt ranking equally with debt instruments in which we invest, we would have to share on an equal basis any distributions with other creditors holding such debt in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy of the relevant portfolio company.
 
The disposition of our investments may result in contingent liabilities.
 
Most of our investments will involve private securities. In connection with the disposition of an investment in private securities, we may be required to make representations about the business and financial affairs of the portfolio company typical of those made in connection with the sale of a business. We may also be required to indemnify the purchasers of such investment to the extent that any such representations turn out to be inaccurate or with respect to certain potential liabilities. These arrangements may result in contingent liabilities that ultimately yield funding obligations that must be satisfied through our return of certain distributions previously made to us.
 
There may be circumstances where our debt investments could be subordinated to claims of other creditors or we could be subject to lender liability claims.
 
Even though we have structured some of our investments as senior loans, if one of our portfolio companies were to go bankrupt, depending on the facts and circumstances, including the extent to which we actually provided managerial assistance to that portfolio company, a bankruptcy court might recharacterize our debt investment and subordinate all or a portion of our claim to that of other creditors. We may also be subject to lender liability claims for actions taken by us with respect to a borrower’s business or instances where we exercise control over the borrower. It is possible that we could become subject to a lender’s liability claim, including as a result of actions taken in rendering significant managerial assistance.
 
Second priority liens on collateral securing loans that we make to our portfolio companies may be subject to control by senior creditors with first priority liens. If there is a default, the value of the collateral may not be sufficient to repay in full both the first priority creditors and us.
 
Certain loans that we make to portfolio companies will be secured on a second priority basis by the same collateral securing senior secured debt of such companies. The first priority liens on the collateral will secure the portfolio company’s obligations under any outstanding senior debt and may secure certain other future debt that may be permitted to be incurred by the company under the agreements governing the loans. The holders of obligations secured by the first priority liens on the collateral will generally control the liquidation of and be entitled to receive proceeds from any realization of the collateral to repay their obligations in full before us. In addition, the value of the collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. There can be no assurance that the proceeds, if any, from the sale or sales of all of the collateral would be sufficient to satisfy the loan obligations secured by the second priority liens after payment in full of all obligations secured by the first priority liens on the collateral. If such proceeds are not sufficient to repay amounts outstanding under the loan obligations secured by the second priority liens, then we, to the extent not repaid from the proceeds of the sale of the collateral, will only have an unsecured claim against the company’s remaining assets, if any.
 
The rights we may have with respect to the collateral securing the loans we make to our portfolio companies with senior debt outstanding may also be limited pursuant to the terms of one or more intercreditor agreements that we enter into with the holders of senior debt. Under such an intercreditor agreement, at any time that obligations that have the benefit of the first priority liens are outstanding, any of the following actions that may be taken with respect to the collateral will be at the direction of the holders of the obligations secured by the first priority liens: the ability to cause the commencement of enforcement proceedings against the collateral; the ability to control the conduct of such proceedings; the approval of amendments to collateral documents; releases of liens on the collateral; and waivers of past defaults under collateral documents. We may not have the ability to control or direct such actions, even if our rights are adversely affected.


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We generally do not and will not control our portfolio companies.
 
We do not, and do not expect to, control most of our portfolio companies, even though we may have board representation or board observation rights, and our debt agreements may contain certain restrictive covenants. As a result, we are subject to the risk that a portfolio company in which we invest may make business decisions with which we disagree and the management of such company, as representatives of the holders of their common equity, may take risks or otherwise act in ways that do not serve our interests as a debt investor. Due to the lack of liquidity for our investments in non-traded companies, we may not be able to dispose of our interests in our portfolio companies as readily as we would like or at an appropriate valuation. As a result, a portfolio company may make decisions that could decrease the value of our portfolio holdings.
 
Defaults by our portfolio companies would harm our operating results.
 
A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, termination of its loans and foreclosure on its secured assets, which could trigger cross-defaults under other agreements and jeopardize a portfolio company’s ability to meet its obligations under the debt or equity securities that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms, which may include the waiver of certain financial covenants, with a defaulting portfolio company.
 
We may not realize gains from our equity investments.
 
Certain investments that we have made in the past and may make in the future include warrants or other equity securities. In addition, we have made in the past and may make in the future direct equity investments in companies. Our goal is ultimately to realize gains upon our disposition of such equity interests. However, the equity interests we receive may not appreciate in value and, in fact, may decline in value. Accordingly, we may not be able to realize gains from our equity interests, and any gains that we do realize on the disposition of any equity interests may not be sufficient to offset any other losses we experience. We also may be unable to realize any value if a portfolio company does not have a liquidity event, such as a sale of the business, recapitalization or public offering, which would allow us to sell the underlying equity interests. We often seek puts or similar rights to give us the right to sell our equity securities back to the portfolio company issuer. We may be unable to exercise these puts rights for the consideration provided in our investment documents if the issuer is in financial distress.
 
We are subject to certain risks associated with foreign investments.
 
We may make investments in foreign companies. Investing in foreign companies may expose us to additional risks not typically associated with investing in U.S. companies. These risks include changes in foreign exchange rates, exchange control regulations, political and social instability, expropriation, imposition of foreign taxes, less liquid markets and less available information than is generally the case in the U.S., higher transaction costs, less government supervision of exchanges, brokers and issuers, less developed bankruptcy laws, difficulty in enforcing contractual obligations, lack of uniform accounting and auditing standards and greater price volatility.
 
Our success will depend, in part, on our ability to anticipate and effectively manage these and other risks. We cannot assure you that these and other factors will not have a material adverse effect on our business as a whole.
 
We may expose ourselves to risks if we engage in hedging transactions.
 
We have and may in the future enter into hedging transactions, which may expose us to risks associated with such transactions. We may utilize instruments such as forward contracts and interest rate swaps, caps, collars and floors to seek to hedge against fluctuations in the relative values of our portfolio positions and amounts due under our credit facilities from changes in market interest rates. Use of these hedging instruments may include counterparty credit risk. Utilizing such hedging instruments does not eliminate the possibility of fluctuations in the values of such positions and amounts due under our credit facilities or prevent losses if the


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values of such positions decline. However, such hedging can establish other positions designed to gain from those same developments, thereby offsetting the decline in the value of such portfolio positions. Such hedging transactions may also limit the opportunity for gain if the values of the underlying portfolio positions should increase. Moreover, it may not be possible to hedge against an interest rate fluctuation that is so generally anticipated that we are not able to enter into a hedging transaction at an acceptable price.
 
The success of our hedging transactions will depend on our ability to correctly predict movements and interest rates. Therefore, while we may enter into such transactions to seek to reduce interest rate risks, unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a hedging strategy and price movements in the portfolio positions being hedged may vary. Moreover, for a variety of reasons, we may not seek to establish a perfect correlation between such hedging instruments and the portfolio holdings or credit facilities being hedged. Any such imperfect correlation may prevent us from achieving the intended hedge and expose us to risk of loss. See also “— Changes in interest rates may affect our cost of capital and net investment income.”
 
Risks Relating to Our Common Stock
 
Shares of closed-end investment companies, including business development companies, may trade at a discount to their net asset value.
 
Shares of closed-end investment companies, including business development companies, may trade at a discount from net asset value. This characteristic of closed-end investment companies and business development companies is separate and distinct from the risk that our net asset value per share may decline. We cannot predict whether our common stock will trade at, above or below net asset value.
 
Investing in our common stock may involve an above average degree of risk.
 
The investments we make in accordance with our investment objective may result in a higher amount of risk than alternative investment options and a higher risk of volatility or loss of principal. Our investments in portfolio companies involve higher levels of risk, and therefore, an investment in our shares may not be suitable for someone with lower risk tolerance.
 
The market price of our common stock may fluctuate significantly.
 
The market price and liquidity of the market for shares of our common stock may be significantly affected by numerous factors, some of which are beyond our control and may not be directly related to our operating performance. These factors include:
 
  •  significant volatility in the market price and trading volume of securities of business development companies or other companies in our sector, which are not necessarily related to the operating performance of these companies;
 
  •  inability to obtain any exemptive relief that may be required by us from the SEC;
 
  •  changes in regulatory policies, accounting pronouncements or tax guidelines, particularly with respect to RICs, business development companies and SBICs;
 
  •  loss of our BDC or RIC status or our SBIC subsidiary’s status as an SBIC;
 
  •  changes in earnings or variations in operating results;
 
  •  changes in the value of our portfolio of investments;
 
  •  any shortfall in revenue or net income or any increase in losses from levels expected by investors or securities analysts;
 
  •  departure of our investment adviser’s key personnel; and
 
  •  general economic trends and other external factors.


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Certain provisions of our restated certificate of incorporation and amended and restated bylaws as well as the Delaware General Corporation Law could deter takeover attempts and have an adverse impact on the price of our common stock.
 
Our restated certificate of incorporation and our amended and restated bylaws as well as the Delaware General Corporation Law contain provisions that may have the effect of discouraging a third party from making an acquisition proposal for us. These anti-takeover provisions may inhibit a change in control in circumstances that could give the holders of our common stock the opportunity to realize a premium over the market price for our common stock.
 
Item 1B.   Unresolved Staff Comments
 
None.
 
Item 2.   Properties
 
We do not own any real estate or other physical properties materially important to our operations; however, we lease office space for our principal executive office at 10 Bank Street, 12th floor, White Plains, NY 10606. Our investment adviser also maintains additional office space at 500 W. Putnam Ave., Suite 400, Greenwich, CT 06830. We may from time to time lease satellite office space elsewhere, but these leases are generally not material to our operations. We believe that our current office facilities are adequate for our business as we intend to conduct it.
 
Item 3.   Legal Proceedings
 
Although we may, from time to time, be involved in litigation arising out of our operations in the normal course of business or otherwise, we are currently not a party to any pending material legal proceedings.


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PART II
 
Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Price Range of Common Stock
 
Our common stock is traded on the New York Stock Exchange under the symbol “FSC.” The following table sets forth, for each fiscal quarter during the two most recently completed fiscal years, the range of high and low sales prices of our common stock as reported on the New York Stock Exchange:
 
                 
    High   Low
 
Fiscal year ended September 30, 2009
               
First quarter
  $ 10.24     $ 5.02  
Second quarter
  $ 8.48     $ 5.80  
Third quarter
  $ 11.14     $ 6.92  
Fourth quarter
  $ 11.36     $ 9.02  
Fiscal year ended September 30, 2010
               
First quarter
  $ 10.99     $ 9.35  
Second quarter
  $ 12.13     $ 10.45  
Third quarter
  $ 13.64     $ 10.49  
Fourth quarter
  $ 11.30     $ 9.79  
 
The last reported price for our common stock on November 23, 2010 was $11.67 per share. As of November 23, 2010, we had 13 stockholders of record, which did not include stockholders for whom shares are held in nominee or “street” name.
 
Sales of Unregistered Securities
 
While we did not engage in any sales of unregistered securities during the fiscal year ended September 30, 2010, we issued a total of 170,803 shares of common stock under our dividend reinvestment plan (“DRIP”). This issuance was not subject to the registration requirements of the Securities Act of 1933, as amended. The aggregate value the shares of our common stock issued under our DRIP was approximately $2.0 million.
 
Distributions
 
Our dividends, if any, are determined by our Board of Directors. We have elected to be treated for federal income tax purposes as a RIC under Subchapter M of the Code. As long as we qualify as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders on a timely basis.
 
To maintain RIC tax treatment, we must, among other things, distribute at least 90% of our net ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any. Depending on the level of taxable income earned in a tax year, we may choose to carry forward taxable income in excess of current year distributions into the next tax year and pay a 4% excise tax on such income. Any such carryover taxable income must be distributed through a dividend declared prior to filing the final tax return related to the year in which such taxable income was generated. We may, in the future, make actual distributions to our stockholders of our net capital gains. We can offer no assurance that we will achieve


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results that will permit the payment of any cash distributions and, if we issue senior securities, we may be prohibited from making distributions if doing so causes us to fail to maintain the asset coverage ratios stipulated by the 1940 Act or if distributions are limited by the terms of any of our borrowings. See “Item 1. Business — Regulation — Taxation as a Regulated Investment Company.”
 
We have adopted an “opt out” dividend reinvestment plan for our common stockholders. As a result, if we make a cash distribution, then stockholders’ cash distributions will be automatically reinvested in additional shares of our common stock, unless they specifically “opt out” of the dividend reinvestment plan so as to receive cash distributions.
 
Pursuant to a recent revenue procedure (Revenue Procedure 2010-12) issued by the Internal Revenue Service, or IRS, the IRS has indicated that it will treat distributions from certain publicly traded RICs (including business development companies) that are paid part in cash and part in stock as dividends that would satisfy the RIC’s annual distribution requirements and qualify for the dividends paid deduction for federal income tax purposes. In order to qualify for such treatment, the revenue procedure requires that at least 10% of the total distribution be payable in cash and that each stockholder have a right to elect to receive its entire distribution in cash. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a proportionate share of the cash to be distributed (although no stockholder electing to receive cash may receive less than 10% of such stockholder’s distribution in cash). This revenue procedure applies to distributions declared on or before December 31, 2012 with respect to taxable years ending on or before December 31, 2011. We do not currently intend to pay dividends in shares of our common stock pursuant to the revenue procedure any time in the near future.
 
The following table reflects the dividend distributions per share that our Board of Directors has declared and we have paid, including shares issued under our DRIP, on our common stock from October 1, 2008 through September 30, 2010:
 
                                                     
            Amount
      DRIP Shares
  DRIP Shares
Date Declared
 
Record Date
 
Payment Date
  per Share   Cash Distribution   Issued   Value
 
 
December 9, 2008
      December 19, 2008       December 29, 2008     $ 0.32     $ 6.4 million       105,326     $ 0.8 million  
 
December 9, 2008
      December 30, 2008       January 29, 2009       0.33       6.6 million       139,995       0.8 million  
 
December 18, 2008
      December 30, 2008       January 29, 2009       0.05       1.0 million       21,211       0.1 million  
 
April 14, 2009
      May 26, 2009       June 25, 2009       0.25       5.6 million       11,776       0.1 million  
 
August 3, 2009
      September 8, 2009       September 25, 2009       0.25       7.5 million       56,890       0.6 million  
 
November 12, 2009
      December 10, 2009       December 29, 2009       0.27       9.7 million       44,420       0.5 million  
 
January 12, 2010
      March 3, 2010       March 30, 2010       0.30       12.9 million       58,689       0.7 million  
 
May 3, 2010
      May 20, 2010       June 30, 2010       0.32       14.0 million       42,269       0.5 million  
 
August 2, 2010
      September 1, 2010       September 29, 2010       0.10       5.2 million       25,425       0.3 million  


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Stock Performance Graph
 
The following graph compares the cumulative 27-month total return to shareholders on Fifth Street Finance Corp.’s common stock relative to the cumulative total returns of the NYSE Composite index, the NASDAQ Financial index and a customized peer group of six companies that includes the following investment companies, which have elected to be regulated as business development companies under the 1940 Act: Apollo Investment Corp., Ares Capital Corp., Blackrock Kelso Capital Corp., Gladstone Capital Corp., MCG Capital Corp. and MVC Capital Inc. The graph assumes that the value of the investment in the common stock of each company, in each index, and in the peer group was $100 on June 12, 2008 (the date our common stock began to trade on the NYSE Stock Market in connection with our initial public offering), assumes the reinvestment of all cash dividends prior to any tax effect, and tracks the investment through to September 30, 2010. The comparisons in the graph below are based on historical data and are not intended to forecast the possible future performance of our common stock.
 
Comparison of 27 Month Cumulative Total Stockholder Return*
Among Fifth Street Finance Corp., the NYSE Composite Index,
the NASDAQ Financial Index and a Peer Group
 
(LINE GRAPH)
 
* $100 invested on June 12, 2008 in stock or May 31, 2008 in index, including reinvestment of dividends.
 
                                                                                         
    June 12, 2008   Jun-08   Sep-08   Dec-08   Mar-09   Jun-09   Sep-09   Dec-09   Mar-10   Jun-10   Sep-10
 
Fifth Street Finance Corp
    100.00       84.90       85.31       69.97       71.73       95.66       106.87       107.87       119.76       116.79       119.14  
NYSE Composite
    100.00       92.29       80.76       79.80       54.23       64.87       76.35       79.80       83.17       72.73       82.31  
NASDAQ Financial
    100.00       86.46       94.51       76.87       61.86       68.85       75.77       76.87       83.57       74.69       75.75  
Peer Group
    100.00       85.96       97.79       61.85       36.79       59.04       85.19       93.78       120.34       102.39       122.41  
 
Open Market Stock Repurchase Program
 
In October 2008, our Board of Directors authorized a stock repurchase program to acquire up to $8 million of our outstanding common stock. Stock repurchases under this program were made through the open market at times and were in such amounts as our management deemed appropriate. The stock repurchase program expired December 2009.


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In October 2010, our Board of Directors authorized a stock repurchase program to acquire up to $20 million of our outstanding common stock. Stock repurchases under this program are to be made through the open market at times and in such amounts as our management deems appropriate, provided it is below the most recently published net asset value per share. The stock repurchase program expires December 31, 2011 and may be limited or terminated by the Board of Directors at any time without prior notice.
 
Item 6.   Selected Financial Data
 
The following selected financial data should be read together with our financial statements and the related notes and the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” which is included elsewhere in this annual report on Form 10-K. Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp. The financial information as of and for the period from inception (February 15, 2007) to September 30, 2007, and for the fiscal years ended September 30, 2008, 2009, and 2010 set forth below was derived from our audited financial statements and related notes for Fifth Street Mezzanine Partners III, L.P. and Fifth Street Finance Corp., respectively.
 
                                 
    At and for the
    At and for the
    At and for the
    At September 30, 2007
 
    Year Ended
    Year Ended
    Year Ended
    and for the period
 
    September 30,
    September 30,
    September 30,
    February 15, 2007
 
    2010     2009     2008     through September 30, 2007  
    (In thousands, except per share amounts)  
 
Statement of Operations data:
                               
Total investment income
  $ 70,538     $ 49,828     $ 33,219     $ 4,296  
Base management fee, net
    9,275       5,889       4,258       1,564  
Incentive fee
    10,756       7,841       4,118        
All other expenses
    7,483       4,736       4,699       1,773  
Net investment income
    43,024       31,362       20,144       959  
Unrealized depreciation on interest rate swap
    (773 )                  
Unrealized appreciation (depreciation) on investments
    (1,055 )     (10,795 )     (16,948 )     123  
Realized gain (loss) on investments
    (18,780 )     (14,373 )     62        
Net increase in partners’ capital/net assets resulting from operations
    22,416       6,194       3,258       1,082  
Per share data:
                               
Net asset value per common share at period end
  $ 10.43     $ 10.84     $ 13.02     $ N/A  
Market price at period end
    11.14       10.93       10.05       N/A  
Net investment income
    0.95       1.27       1.29       N/A  
Net realized and unrealized loss on investments and interest rate swap
    (0.46 )     (1.02 )     (1.08 )     N/A  
Net increase in partners’ capital/net assets resulting from operations
    0.49       0.25       0.21       N/A  
Dividends paid
    0.99       1.20       0.61       N/A  
Balance Sheet data at period end:
                               
Total investments at fair value
  $ 563,821     $ 299,611     $ 273,759     $ 88,391  
Cash and cash equivalents
    76,765       113,205       22,906       17,654  
Other assets
    11,340       3,071       2,484       1,285  
Total assets
    651,926       415,887       299,149       107,330  
Total liabilities
    82,754       5,331       4,813       514  
Total net assets
    569,172       410,556       294,336       106,816  
Other data:
                               
Weighted average annual yield on debt investments(1)
    14.0 %     15.7 %     16.2 %     16.8 %
Number of investments at period end
    38       28       24       10  
 
 
(1) Weighted average annual yield is calculated based upon our debt investments at the end of the period.


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Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion should be read in connection with our Consolidated Financial Statements and the notes thereto included elsewhere in this annual report on Form 10-K.
 
Some of the statements in this annual report on Form 10-K constitute forward-looking statements because they relate to future events or our future performance or financial condition. The forward-looking statements contained in this annual report on Form 10-K may include statements as to:
 
  •  our future operating results and dividend projections;
 
  •  our business prospects and the prospects of our portfolio companies;
 
  •  the impact of the investments that we expect to make;
 
  •  the ability of our portfolio companies to achieve their objectives;
 
  •  our expected financings and investments;
 
  •  the adequacy of our cash resources and working capital; and
 
  •  the timing of cash flows, if any, from the operations of our portfolio companies.
 
In addition, words such as “anticipate,” “believe,” “expect,” “project” and “intend” indicate a forward-looking statement, although not all forward-looking statements include these words. The forward-looking statements contained in this annual report on Form 10-K involve risks and uncertainties. Our actual results could differ materially from those implied or expressed in the forward-looking statements for any reason, including the factors set forth in “Item 1A. Risk Factors” and elsewhere in this annual report on Form 10-K. Other factors that could cause actual results to differ materially include but are not limited to:
 
  •  changes in the economy and the financial markets;
 
  •  risks associated with possible disruption in our operations or the economy generally due to terrorism or natural disasters;
 
  •  future changes in laws or regulations (including the interpretation of these laws and regulations by regulatory authorities) and conditions in our operating areas, particularly with respect to BDCs, SBICs or RICs; and
 
  •  other considerations that may be disclosed from time to time in our publicly disseminated documents and filings.
 
We have based the forward-looking statements included in this annual report on Form 10-K on information available to us on the date of this annual report, and we assume no obligation to update any such forward-looking statements. Although we undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that we may make directly to you or through reports that we in the future may file with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.
 
Overview
 
We are a specialty finance company that lends to and invests in small and mid-sized companies in connection with investments by private equity sponsors. Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity investments.
 
We were formed as a Delaware limited partnership (Fifth Street Mezzanine Partners III, L.P.) on February 15, 2007. Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp. At the time of the merger, all outstanding partnership interests in Fifth Street


46


 

Mezzanine Partners III, L.P. were exchanged for 12,480,972 shares of common stock in Fifth Street Finance Corp.
 
Our Consolidated Financial Statements prior to January 2, 2008 reflect our operations as a Delaware limited partnership (Fifth Street Mezzanine Partners III, L.P.) prior to our merger with and into a corporation (Fifth Street Finance Corp.).
 
On June 17, 2008, we completed an initial public offering of 10,000,000 shares of our common stock at the offering price of $14.12 per share. Our shares are listed on the New York Stock Exchange under the symbol “FSC.”
 
On July 21, 2009, we completed a follow-on public offering of 9,487,500 shares of our common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $9.25 per share.
 
On September 25, 2009, we completed a follow-on public offering of 5,520,000 shares of our common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $10.50 per share.
 
On January 27, 2010, we completed a follow-on public offering of 7,000,000 shares of our common stock, which did not include the underwriters’ exercise of their over-allotment option, at the offering price of $11.20 per share. On February 25, 2010, we sold 300,500 shares of our common stock at the offering price of $11.20 per share upon the underwriters’ exercise of their over-allotment option in connection with this offering.
 
On June 21, 2010, we completed a follow-on public offering of 9,200,000 shares of our common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $11.50 per share.
 
Current Market Conditions
 
Since mid-2007, the global financial markets have been in a great deal of turmoil, experiencing stress, volatility, illiquidity, and disruption. This turmoil appears to have peaked in the fall of 2008, resulting in several major financial institutions becoming insolvent, being acquired, or receiving government assistance. While the turmoil in the financial markets appears to have abated somewhat, the global economy continues to experience economic uncertainty. Economic uncertainty impacts our business in many ways, including changing spreads, structures, and purchase multiples as well as the overall supply of investment capital.
 
Despite the economic uncertainty, our deal pipeline remains robust, with high quality transactions backed by private equity sponsors in small to mid-sized companies. As always, we remain cautious in selecting new investment opportunities, and will only deploy capital in deals which are consistent with our disciplined philosophy of pursuing superior risk-adjusted returns.
 
As evidenced by our recent investment activities, we expect to grow the business in part by increasing the average investment size when and where appropriate. At the same time, we expect to focus more on first lien transactions. We also expect to invest in more floating rate facilities, with rate floors, to protect against interest rate decreases.
 
Although we believe that we currently have sufficient capital available to fund investments, a prolonged period of market disruptions may cause us to reduce the volume of loans we originate and/or fund, which could have an adverse effect on our business, financial condition, and results of operations. In this regard, because our common stock has at times traded at a price below our then current net asset value per share and we are limited in our ability to sell our common stock at a price below net asset value per share, we may be limited in our ability to raise equity capital.


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Critical Accounting Policies
 
FASB Accounting Standards Codification
 
The issuance of FASB Accounting Standards Codificationtm (the “Codification”) on July 1, 2009 (effective for interim or annual reporting periods ending after September 15, 2009), changes the way that U.S. generally accepted accounting principles (“GAAP”) are referenced. Beginning on that date, the Codification officially became the single source of authoritative nongovernmental GAAP; however, SEC registrants must also consider rules, regulations, and interpretive guidance issued by the SEC or its staff. The switch affects the way companies refer to GAAP in financial statements and in their accounting policies. References to standards will consist solely of the number used in the Codification’s structural organization.
 
Consistent with the effective date of the Codification, financial statements for periods ending after September 15, 2009, refer to the Codification structure, not pre-Codification historical GAAP.
 
Basis of Presentation
 
Effective January 2, 2008, Fifth Street Mezzanine Partners III, L.P. (the “Partnership”), a Delaware limited partnership organized on February 15, 2007, merged with and into Fifth Street Finance Corp. The merger involved the exchange of shares between companies under common control. In accordance with the guidance on exchanges of shares between entities under common control, our results of operations and cash flows for the fiscal year ended September 30, 2008 are presented as if the merger had occurred as of October 1, 2007. Accordingly, no adjustments were made to the carrying value of assets and liabilities (or the cost basis of investments) as a result of the merger. Prior to January 2, 2008, references to Fifth Street are to the Partnership. After January 2, 2008, references to Fifth Street, FSC, “we” or “our” are to Fifth Street Finance Corp., unless the context otherwise requires. Fifth Street’s financial results for the fiscal year ended September 30, 2007 refer to the Partnership.
 
The preparation of financial statements in accordance with GAAP requires management to make certain estimates and assumptions affecting amounts reported in the Consolidated Financial Statements. We have identified investment valuation and revenue recognition as our most critical accounting estimates. We continuously evaluate our estimates, including those related to the matters described below. These estimates are based on the information that is currently available to us and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from those estimates under different assumptions or conditions. A discussion of our critical accounting policies follows.
 
Investment Valuation
 
We are required to report our investments that are not publicly traded or for which current market values are not readily available at fair value. The fair value is deemed to be the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
 
Under Accounting Standards Codification 820, Fair Value Measurements and Disclosures (“ASC 820”), which we adopted effective October 1, 2008, we perform detailed valuations of our debt and equity investments on an individual basis, using market based, income based, and bond yield approaches as appropriate. In general, we utilize a bond yield method for the majority of our investments, as long as it is appropriate. If, in our judgment, the bond yield approach is not appropriate, we may use the enterprise value approach, or, in certain cases, an alternative methodology potentially including an asset liquidation or expected recovery model.
 
Under the market approach, we estimate the enterprise value of the portfolio companies in which we invest. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise value is best expressed as a range of fair values, from which we derive a single estimate of


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enterprise value. To estimate the enterprise value of a portfolio company, we analyze various factors, including the portfolio company’s historical and projected financial results. Typically, private companies are valued based on multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), cash flows, net income, revenues, or in limited cases, book value. We generally require portfolio companies to provide annual audited and quarterly and monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year.
 
Under the income approach, we generally prepare and analyze discounted cash flow models based on our projections of the future free cash flows of the business. Under the bond yield approach, we use bond yield models to determine the present value of the future cash flow streams of our debt investments. We review various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assess the information in the valuation process.
 
Under the bond yield approach, we use bond yield models to determine the present value of the future cash flow streams of our debt investments. We review various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assess the information in the valuation process.
 
Our Board of Directors undertakes a multi-step valuation process each quarter in connection with determining the fair value of our investments:
 
  •  Our quarterly valuation process begins with each portfolio company or investment being initially valued by the deal team within our investment adviser responsible for the portfolio investment;
 
  •  Preliminary valuations are then reviewed and discussed with the principals of our investment adviser;
 
  •  Separately, independent valuation firms engaged by our Board of Directors prepare preliminary valuations on a selected basis and submit reports to us;
 
  •  The deal team compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms;
 
  •  The deal team prepares a valuation report for the Valuation Committee of our Board of Directors;
 
  •  The Valuation Committee of our Board of Directors is apprised of the preliminary valuations of the independent valuation firms;
 
  •  The Valuation Committee of our Board of Directors reviews the preliminary valuations, and the deal team responds and supplements the preliminary valuations to reflect any comments provided by the Valuation Committee;
 
  •  The Valuation Committee of our Board of Directors makes a recommendation to the Board of Directors; and
 
  •  Our Board of Directors discusses valuations and determines the fair value of each investment in our portfolio in good faith.
 
The fair value of all of our investments at September 30, 2010, and September 30, 2009, was determined by our Board of Directors. Our Board of Directors is solely responsible for the valuation of our portfolio investments at fair value as determined in good faith pursuant to our valuation policy and our consistently applied valuation process.
 
Our Board of Directors has engaged independent valuation firms to provide us with valuation assistance. Upon completion of its process each quarter, the independent valuation firms provides us with a written report regarding the preliminary valuations of selected portfolio securities as of the close of such quarter. We will continue to engage independent valuation firms to provide us with assistance regarding our determination of


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the fair value of selected portfolio securities each quarter; however, our Board of Directors is ultimately and solely responsible for determining the fair value of our investments in good faith.
 
The portions of our portfolio valued, as a percentage of the portfolio at fair value, by independent valuation firms by period were as follows:
 
         
For the quarter ending December 31, 2007
    91.9 %
For the quarter ending March 31, 2008
    92.1 %
For the quarter ending June 30, 2008
    91.7 %
For the quarter ending September 30, 2008
    92.8 %
For the quarter ending December 31, 2008
    100.0 %
For the quarter ending March 31, 2009
    88.7 %(1)
For the quarter ending June 30, 2009
    92.1 %
For the quarter ending September 30, 2009
    28.1 %
For the quarter ending December 31, 2009
    17.2 %(2)
For the quarter ending March 31, 2010
    26.9 %
For the quarter ending June 30, 2010
    53.1 %
For the quarter ending September 30, 2010
    61.8 %
 
 
(1) 96.0% excluding our investment in IZI Medical Products, Inc., which closed on June 30, 2009 and therefore was not part of the independent valuation process
 
(2) 24.8% excluding four investments that closed in December 2009 and therefore were not part of the independent valuation process
 
Our $50 million credit facility with Bank of Montreal was terminated effective September 16, 2009. The facility required independent valuations for at least 90% of the portfolio on a quarterly basis. With the termination of this facility, this valuation test is no longer required. However, we still intend to have a portion of the portfolio valued by an independent third party on an quarterly basis, with a substantial portion being valued on an annual basis.
 
As of September 30, 2010 and September 30, 2009, approximately 86.5% and 72.0%, respectively, of our total assets represented investments in portfolio companies valued at fair value.
 
Revenue Recognition
 
Interest and Dividend Income
 
Interest income, adjusted for amortization of premium and accretion of original issue discount, is recorded on the accrual basis to the extent that such amounts are expected to be collected. We stop accruing interest on investments when it is determined that interest is no longer collectible. Distributions from portfolio companies are recorded as dividend income when the distribution is received.
 
Fee Income
 
We receive a variety of fees in the ordinary course of business. Certain fees, such as origination fees, are capitalized and amortized in accordance with ASC 310-20 Nonrefundable Fees and Other Costs. In accordance with ASC 820, the net unearned fee income balance is netted against the cost and fair value of the respective investments. Other fees, such as servicing fees, are classified as fee income and recognized as they are earned on a monthly basis.
 
We have also structured exit fees across certain of our portfolio investments to be received upon the future exit of those investments. These fees are to be paid to us upon the sooner to occur of (i) a sale of the borrower or substantially all of the assets of the borrower, (ii) the maturity date of the loan, or (iii) the date when full prepayment of the loan occurs. Exit fees are fees which are earned and payable upon the exit of a debt security and, similar to a prepayment penalty, are not accrued or otherwise included in net


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investment income until received. The receipt of such fees as well as the timing of our receipt of such fees are contingent upon a successful exit event for each of the investments.
 
Payment-in-Kind (PIK) Interest
 
Our loans typically contain a contractual PIK interest provision. The PIK interest, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term, is generally recorded on the accrual basis to the extent such amounts are expected to be collected. We generally cease accruing PIK interest if there is insufficient value to support the accrual or if we do not expect the portfolio company to be able to pay all principal and interest due. Our decision to cease accruing PIK interest involves subjective judgments and determinations based on available information about a particular portfolio company, including whether the portfolio company is current with respect to its payment of principal and interest on its loans and debt securities; monthly and quarterly financial statements and financial projections for the portfolio company; our assessment of the portfolio company’s business development success, including product development, profitability and the portfolio company’s overall adherence to its business plan; information obtained by us in connection with periodic formal update interviews with the portfolio company’s management and, if appropriate, the private equity sponsor; and information about the general economic and market conditions in which the portfolio company operates. Based on this and other information, we determine whether to cease accruing PIK interest on a loan or debt security. Our determination to cease accruing PIK interest on a loan or debt security is generally made well before our full write-down of such loan or debt security. In addition, if it is subsequently determined that we will not be able to collect any previously accrued PIK interest, the fair value of our loans or debt securities would decline by the amount of such previously accrued, but uncollectible, PIK interest.
 
For a discussion of risks we are subject to as a result of our use of PIK interest in connection with our investments, see “Item 1A. Risk Factors — Risks Relating to Our Business and Structure — We may have difficulty paying our required distributions if we recognize income before or without receiving cash representing such income,” “— We may in the future choose to pay dividends in our own stock, in which case you may be required to pay tax in excess of the cash you receive” and “— Our incentive fee may induce our investment adviser to make speculative investments.” In addition, if it is subsequently determined that we will not be able to collect any previously accrued PIK interest, the fair value of our loans or debt securities would decline by the amount of such previously accrued, but uncollectible, PIK interest.
 
To maintain our status as a RIC, PIK income must be paid out to our stockholders in the form of dividends even though we have not yet collected the cash and may never collect the cash relating to the PIK interest. Accumulated PIK interest was $19.3 million and represented 3.4% of the fair value of our portfolio of investments as of September 30, 2010 and $12.1 million or 4.0% as of September 30, 2009. The net increase in loan balances as a result of contracted PIK arrangements are separately identified in our Consolidated Statements of Cash Flows.
 
Portfolio Composition
 
Our investments principally consist of loans, purchased equity investments and equity grants in privately-held companies. Our loans are typically secured by either a first or second lien on the assets of the portfolio company, generally have terms of up to six years (but an expected average life of between three and four years) and typically bear interest at fixed rates and, to a lesser extent, at floating rates. We are currently focusing our new debt origination efforts on first lien loans. We believe that the risk-adjusted returns from these loans are superior to second lien investments at this time and offer superior credit quality. However, we may choose to originate second lien and unsecured loans in the future.


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A summary of the composition of our investment portfolio at cost and fair value as a percentage of total investments is shown in the following tables:
 
                 
    September 30,
    September 30,
 
    2010     2009  
 
Cost:
               
First lien debt
    72.61 %     46.82 %
Second lien debt
    25.42 %     50.08 %
Subordinated debt
    0.80 %     0.00 %
Purchased equity
    0.39 %     1.27 %
Equity grants
    0.75 %     1.83 %
Limited partnership interests
    0.03 %     0.00 %
                 
Total
    100.00 %     100.00 %
                 
 
                 
    September 30,
  September 30,
    2010   2009
 
Fair value:
               
First lien debt
    73.84 %     47.40 %
Second lien debt
    24.45 %     51.37 %
Subordinated debt
    0.78 %     0.00 %
Purchased equity
    0.11 %     0.17 %
Equity grants
    0.79 %     1.06 %
Limited partnership interests
    0.03 %     0.00 %
                 
Total
    100.00 %     100.00 %
                 
 
The industry composition of our portfolio at cost and fair value as a percentage of total investments were as follows:
 
                 
    September 30,
  September 30,
    2010   2009
 
Cost:
               
Healthcare services
    14.76 %     15.53 %
Healthcare equipment
    13.61 %     0.00 %
Education services
    7.58 %     0.00 %
Home improvement retail
    5.51 %     0.00 %
Food distributors
    5.13 %     2.73 %
Fertilizers and agricultural chemicals
    4.51 %     0.00 %
Diversified support services
    4.43 %     0.00 %
Construction and engineering
    4.22 %     5.89 %
Footwear and apparel
    3.97 %     6.85 %
Healthcare technology
    3.63 %     11.37 %
Media — advertising
    3.35 %     4.10 %
Food retail
    3.31 %     0.00 %
Manufacturing — mechanical products
    3.16 %     4.71 %
Emulsions manufacturing
    2.95 %     3.59 %
Trailer leasing services
    2.88 %     5.21 %
Air freight and logistics
    2.36 %     3.29 %
Merchandise display
    2.25 %     3.98 %
Data processing and outsourced services
    2.21 %     4.12 %


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    September 30,
  September 30,
    2010   2009
 
Restaurants
    2.11 %     6.20 %
Housewares and specialties
    2.06 %     3.68 %
Capital goods
    1.71 %     3.05 %
Environmental and facilities services
    1.51 %     2.73 %
Building products
    1.40 %     2.14 %
Leisure facilities
    1.16 %     2.20 %
Household products/specialty chemicals
    0.18 %     2.38 %
Entertainment — theaters
    0.03 %     2.32 %
Multi-sector holdings
    0.02 %     0.00 %
Home furnishing retail
    0.00 %     3.93 %
                 
Total
    100.00 %     100.00 %
                 
Fair value:
               
Healthcare services
    15.83 %     17.21 %
Healthcare equipment
    14.40 %     0.00 %
Education services
    7.47 %     0.00 %
Home improvement retail
    5.76 %     0.00 %
Food distributors
    5.38 %     3.00 %
Fertilizers and agricultural chemicals
    4.76 %     0.00 %
Diversified support services
    4.66 %     0.00 %
Construction and engineering
    4.23 %     5.96 %
Footwear and apparel
    4.18 %     7.37 %
Healthcare technology
    3.93 %     12.27 %
Media — advertising
    3.52 %     4.37 %
Food retail
    3.50 %     0.00 %
Manufacturing — mechanical products
    3.20 %     5.03 %
Emulsions manufacturing
    3.02 %     4.05 %
Air freight and logistics
    2.49 %     3.60 %
Merchandise display
    2.35 %     4.36 %
Data processing and outsourced services
    2.26 %     4.44 %
Restaurants
    2.15 %     5.94 %
Capital goods
    1.81 %     3.26 %
Leisure facilities
    1.25 %     2.38 %
Building products
    1.21 %     2.06 %
Environmental and facilities services
    0.91 %     2.04 %
Trailer leasing services
    0.82 %     3.29 %
Housewares and specialties
    0.66 %     1.90 %
Household products/specialty chemicals
    0.19 %     1.50 %
Entertainment — theaters
    0.05 %     2.52 %
Multi-sector holdings
    0.01 %     0.00 %
Home furnishing retail
    0.00 %     3.45 %
                 
Total
    100.00 %     100.00 %
                 

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Portfolio Asset Quality
 
We employ a grading system to assess and monitor the credit risk of our investment portfolio. We rate all investments on a scale from 1 to 5. The system is intended to reflect the performance of the borrower’s business, the collateral coverage of the loan, and other factors considered relevant to making a credit judgment.
 
  •  Investment Rating 1 is used for investments that are performing above expectations and/or a capital gain is expected.
 
  •  Investment Rating 2 is used for investments that are performing substantially within our expectations, and whose risks remain neutral or favorable compared to the potential risk at the time of the original investment. All new loans are initially rated 2.
 
  •  Investment Rating 3 is used for investments that are performing below our expectations and that require closer monitoring, but where we expect no loss of investment return (interest and/or dividends) or principal. Companies with a rating of 3 may be out of compliance with financial covenants.
 
  •  Investment Rating 4 is used for investments that are performing below our expectations and for which risk has increased materially since the original investment. We expect some loss of investment return, but no loss of principal.
 
  •  Investment Rating 5 is used for investments that are performing substantially below our expectations and whose risks have increased substantially since the original investment. Investments with a rating of 5 are those for which some loss of principal is expected.
 
The following table shows the distribution of our investments on the 1 to 5 investment rating scale at fair value, as of September 30, 2010 and September 30, 2009:
 
                                                 
Investment
  September 30, 2010     September 30, 2009  
Rating
  Fair Value     % of Portfolio     Leverage Ratio     Fair Value     % of Portfolio     Leverage Ratio  
 
1
  $ 89,150,457       15.81 %     2.97     $ 22,913,497       7.65 %     1.70  
2
    424,494,799       75.29 %     4.31       248,506,393       82.94 %     4.34  
3
    18,055,528       3.20 %     13.25       6,122,236       2.04 %     10.04  
4
    23,823,120       4.23 %     8.13       16,377,904       5.47 %     8.31  
5
    8,297,412       1.47 %     NM (1)     5,691,107       1.90 %     NM (1)
                                                 
Total
  $ 563,821,316       100.00 %     4.53     $ 299,611,137       100.00 %     4.42  
                                                 
 
 
(1) Due to operating performance this ratio is not measurable and, as a result, is excluded from the total portfolio calculation.
 
As a result of current economic conditions and their impact on certain of our portfolio companies, we have agreed to modify the payment terms of our investments in eleven of our portfolio companies as of September 30, 2010. Such modified terms include increased payment-in-kind interest provisions and/or reduced cash interest rates. These modifications, and any future modifications to our loan agreements as a result of the current economic conditions or otherwise, may limit the amount of interest income that we recognize from the modified investments, which may, in turn, limit our ability to make distributions to our stockholders.
 
Loans and Debt Securities on Non-Accrual Status
 
Five investments did not pay all of their scheduled monthly cash interest payments for the year ended September 30, 2010. As of September 30, 2010, we had also stopped accruing PIK interest and original issue discount (“OID”) on these five investments. As of September 30, 2009, we had stopped accruing PIK interest and OID on five investments, including two investments that had not paid their scheduled monthly cash interest payments. As of September 30, 2008, no investments were on non-accrual status.


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The non-accrual status of our portfolio investments as of September 30, 2010, September 30, 2009 and September 30, 2008 was as follows:
 
             
    September 30, 2010   September 30, 2009   September 30, 2008
 
Lighting by Gregory, LLC
  Cash non-accrual   Cash non-accrual  
CPAC, Inc. 
    PIK non-accrual  
MK Network, LLC
  Cash non-accrual    
Martini Park, LLC
    PIK non-accrual  
Vanguard Vinyl, Inc. 
  Cash non-accrual    
Nicos Polymers & Grinding, Inc. 
  Cash non-accrual   PIK non-accrual  
Premier Trailer Leasing, Inc. 
  Cash non-accrual   Cash non-accrual  
 
Non-accrual interest amounts related to the above investments for the years ended September 30, 2010 September 30, 2009 and September 30, 2008 were as follows:
 
                         
    September 30, 2010     September 30, 2009     September 30, 2008  
 
Cash interest income
  $ 5,804,101     $ 2,938,190     $  
PIK interest income
    1,903,005       1,398,347        
OID income
    328,792       402,522        
                         
Total
  $ 8,035,898     $ 4,739,059     $  
                         
 
Discussion and Analysis of Results and Operations
 
Results of Operations
 
The principal measure of our financial performance is the net income (loss) which includes net investment income (loss), net realized gain (loss) and net unrealized appreciation (depreciation). Net investment income is the difference between our income from interest, dividends, fees, and other investment income and total expenses. Net realized gain (loss) on investments is the difference between the proceeds received from dispositions of portfolio investments and their stated costs. Net unrealized appreciation (depreciation) is the net change in the fair value of our investment portfolio and derivative instruments.
 
Comparison of years ended September 30, 2010 and September 30, 2009
 
Total Investment Income
 
Total investment income for the years ended September 30, 2010 and September 30, 2009 was $70.5 million and $49.8 million, respectively. For the year ended September 30, 2010, this amount primarily consisted of $63.9 million of interest income from portfolio investments (which included $10.0 million of PIK interest), and $6.0 million of fee income. For the year ended September 30, 2009, this amount primarily consisted of $46.0 million of interest income from portfolio investments (which included $7.4 million of PIK interest), and $3.5 million of fee income.
 
The increase in our total investment income for the year ended September 30, 2010 as compared to the year ended September 30, 2009 was primarily attributable to a net increase of eight debt investments in our portfolio in the year-over-year period, partially offset by scheduled amortization repayments received and other debt payoffs during the same period.
 
Expenses
 
Expenses (net of the permanently waived portion of the base management fee) for the years ended September 30, 2010 and September 30, 2009 were $27.5 million and $18.4 million, respectively. Expenses


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increased for the year ended September 30, 2010 as compared to the year ended September 30, 2009 by $9.1 million, primarily as a result of increases in the base management fee, the incentive fee, interest expense, administrator expense, and other general and administrative expenses.
 
The increase in base management and incentive fees resulted from an increase in our total assets as reflected in the growth of the investment portfolio, offset partially by our investment adviser’s unilateral decision to waive $727,000 and $172,000 of the base management fee for the years ended September 30, 2010 and September 30, 2009, respectively.
 
Net Investment Income
 
As a result of the $20.7 million increase in total investment income as compared to the $9.1 million increase in total expenses, net investment income for the year ended September 30, 2010 reflected a $11.6 million, or 37.2%, increase compared to the year ended September 30, 2009.
 
Realized Gain (Loss) on Investments
 
Net realized gain (loss) on investments is the difference between the proceeds received from dispositions of portfolio investments and their stated costs. Realized losses may also be recorded in connection with our determination that certain investments are considered worthless securities and/or meet the conditions for loss recognition per the applicable tax rules.
 
During the year ended September 30, 2010, we recorded the following investment realization events:
 
  •  In October 2009, we received a cash payment in the amount of $0.1 million representing a payment in full of all amounts due in connection with the cancellation of our loan agreement with American Hardwoods Industries, LLC. We recorded a $0.1 million reduction to the previously recorded $10.4 million realized loss on the investment in American Hardwoods;
 
  •  In March 2010, we recorded a realized loss in the amount of $2.9 million in connection with the sale of a portion of our interest in CPAC, Inc.;
 
  •  In August 2010, we received a cash payment of $7.6 million from Storyteller Theaters Corporation in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction;
 
  •  In September 2010, we restructured our investment in Rail Acquisition Corp. Although the full amount owed under the loan agreement remained intact, the restructuring resulted in a material modification of the terms of the loan agreement. As such, we recorded a realized loss in the amount of $2.6 million in accordance with EITF Abstract Issue No. 96-19;
 
  •  In September 2010, we sold our investment in Martini Park, LLC and received a cash payment in the amount of $0.1 million. We recorded a realized loss on this investment in the amount of $4.0 million; and
 
  •  In September 2010, we exited our investment in Rose Tarlow, Inc. and received a cash payment in the amount of $3.6 million in full settlement of the debt investment. We recorded a realized loss on this investment in the amount of $9.3 million.
 
During the year ended September 30, 2009, we exited our investment in American Hardwoods Industries, LLC and recorded a realized loss of $10.4 million, and recorded a $4.0 million realized loss on our investment in CPAC, Inc. in connection with our determination that the investment was permanently impaired based on, among other things, our analysis of changes in the portfolio company’s business operations and prospects.
 
Net Change in Unrealized Appreciation or Depreciation
 
Net unrealized appreciation or depreciation is the net change in the fair value of our investment portfolio during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.


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During the year ended September 30, 2010, we recorded net unrealized depreciation of $1.8 million. This consisted of $19.1 million of net unrealized depreciation on debt investments and $0.8 million of net unrealized depreciation on interest rate swaps, offset by $17.6 million of reclassifications to realized losses and $0.5 million of net unrealized appreciation on equity investments. During the year ended September 30, 2009, we recorded net unrealized depreciation of $10.8 million. This consisted of $23.1 million of net unrealized depreciation on debt investments and $2.0 million of net unrealized depreciation on equity investments, offset by $14.3 million of reclassifications to realized losses.
 
Comparison of years ended September 30, 2009 and September 30, 2008
 
Total Investment Income
 
Total investment income for the years ended September 30, 2009 and September 30, 2008 was $49.8 million and $33.2 million, respectively. For the year ended September 30, 2009, this amount primarily consisted of $46.0 million of interest income from portfolio investments (which included $7.4 million of PIK interest), and $3.5 million of fee income. For the year ended September 30, 2008, this amount primarily consisted of $30.5 million of interest income from portfolio investments (which included $4.9 million of PIK interest), and $1.8 million of fee income.
 
The increase in our total investment income for the year ended September 30, 2009 as compared to the year ended September 30, 2008 was primarily attributable to a net increase of two debt investments in our portfolio in the year-over-year period, partially offset by debt repayments received during the same period.
 
Expenses
 
Expenses (net of the permanently waived portion of the base management fee) for the years ended September 30, 2009 and September 30, 2008 were $18.4 million and $13.1 million, respectively. Expenses increased for the year ended September 30, 2009 as compared to the year ended September 30, 2008 by $5.3 million, primarily as a result of increases in base management fee, incentive fees and other general and administrative expenses.
 
The increase in base management fee resulted from an increase in our total assets as reflected in the growth of the investment portfolio offset partially by our investment adviser’s unilateral decision to waive $172,000 of the base management fee for the year ended September 30, 2009. Incentive fees were implemented effective January 2, 2008 when Fifth Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp., and reflect the growth of our net investment income before such fees.
 
Net Investment Income
 
As a result of the $16.6 million increase in total investment income as compared to the $5.3 million increase in total expenses, net investment income for the year ended September 30, 2009 reflected a $11.3 million, or 55.7%, increase compared to the year ended September 30, 2008.
 
Realized Gain (Loss) on Investments
 
Net realized gain (loss) on investments is the difference between the proceeds received from dispositions of portfolio investments and their stated costs. During the year ended September 30, 2009, we exited our investment in American Hardwoods Industries, LLC and recorded a realized loss of $10.4 million, and recorded a $4.0 million realized loss on our investment in CPAC, Inc. in connection with our determination that the investment was permanently impaired based on, among other things, our analysis of changes in the portfolio company’s business operations and prospects. During the year ended September 30, 2008, we sold our equity investment in Filet of Chicken and realized a gain of $62,000.
 
Net Change in Unrealized Appreciation or Depreciation
 
Net unrealized appreciation or depreciation is the net change in the fair value of our investment portfolio during the reporting period, including the reversal of previously recorded unrealized appreciation or


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depreciation when gains or losses are realized. During the year ended September 30, 2009, we recorded net unrealized depreciation of $10.8 million. This consisted of $23.1 million of net unrealized depreciation on debt investments and $2.0 million of net unrealized depreciation on equity investments, offset by $14.3 million of reclassifications to realized losses. During the year ended September 30, 2008, we recorded net unrealized depreciation of $16.9 million. This consisted of $12.1 million of net unrealized depreciation on debt investments and $4.8 million of net unrealized depreciation on equity investments.
 
Financial Condition, Liquidity and Capital Resources
 
Cash Flows
 
We have a number of alternatives available to fund the growth of our investment portfolio and our operations, including, but not limited to, raising equity, increasing debt, or funding from operational cash flow. Additionally, we may reduce investment size by syndicating a portion of any given transaction.
 
For the year ended September 30, 2010, we experienced a net decrease in cash and cash equivalents of $36.4 million. During that period, we used $239.2 million of cash in operating activities, primarily for the funding of $325.5 million of investments, partially offset by $44.5 million of principal payments received and $43.0 million of net investment income. During the same period cash provided by financing activities was $202.7 million, primarily consisting of $179.1 million of proceeds from issuances of our common stock and $73.0 million of SBA borrowings, partially offset by $41.8 million of cash dividends paid, $1.3 million of offering costs paid and $6.3 million of deferred financing costs paid. We intend to fund our future distribution obligations through operating cash flow or with funds obtained through future equity offerings or credit facilities, as we deem appropriate.
 
For the year ended September 30, 2009, we experienced a net increase in cash and cash equivalents of $90.3 million. During that period, we used $19.7 million of cash in operating activities, primarily for the funding of $62.0 million of investments, partially offset by $18.3 million of principal payments received and $31.4 million of net investment income. During the same period cash provided by financing activities was $110.0 million, primarily consisting of $138.6 million of proceeds from issuance of our common stock, partially offset by $27.1 million of cash dividends paid, $1.0 million of offering costs paid and $0.5 million paid to repurchase shares of our common stock on the open market.
 
For the year ended September 30, 2008, we experienced a net increase in cash and equivalents of $5.3 million. During that period, we used $179.4 million of cash in operating activities primarily for the funding of $202.4 million of investments, partially offset by $2.2 million of principal payments received and $20.1 million of net investment income. During the same period cash provided by financing activities was $184.6 million, primarily consisting of $131.3 million of proceeds from issuance of our common stock, partially offset by $8.9 million of cash dividends paid and $1.5 million of offering costs paid.
 
As of September 30, 2010, we had $76.8 million in cash and cash equivalents, portfolio investments (at fair value) of $563.8 million, $3.8 million of interest and fees receivable, $73.0 million of SBA debentures payable, no borrowings outstanding under our credit facilities, and unfunded commitments of $49.5 million.
 
As of September 30, 2009, we had $113.2 million in cash and cash equivalents, portfolio investments (at fair value) of $299.6 million, $2.9 million of interest receivable, no borrowings outstanding and unfunded commitments of $9.8 million.
 
As of September 30, 2008, we had $22.9 million in cash and cash equivalents, portfolio investments (at fair value) of $273.8 million, $2.4 million of interest receivable, no borrowings outstanding under our secured revolving credit facility and unfunded commitments of $24.7 million.
 
Other Sources of Liquidity
 
We intend to continue to generate cash primarily from cash flows from operations, including interest earned from the temporary investment of cash in U.S. government securities and other high-quality debt investments that mature in one year or less, future borrowings and future offerings of securities. In the future,


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we may also securitize a portion of our investments in first and second lien senior loans or unsecured debt or other assets. To securitize loans, we would likely create a wholly-owned subsidiary and contribute a pool of loans to the subsidiary. We would then sell interests in the subsidiary on a non-recourse basis to purchasers and we would retain all or a portion of the equity in the subsidiary. Our primary use of funds is investments in our targeted asset classes and cash distributions to holders of our common stock.
 
Although we expect to fund the growth of our investment portfolio through the net proceeds from future equity offerings, including our dividend reinvestment plan, and issuances of senior securities or future borrowings, to the extent permitted by the 1940 Act, our plans to raise capital may not be successful. In this regard, because our common stock has at times traded at a price below our then-current net asset value per share and we are limited in our ability to sell our common stock at a price below net asset value per share, we may be limited in our ability to raise equity capital.
 
In addition, we intend to distribute between 90% and 100% of our taxable income to our stockholders in order to satisfy the requirements applicable to RICs under Subchapter M of the Code. See “Regulated Investment Company Status and Distributions” below. Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio companies or to repay borrowings. In addition, the illiquidity of our portfolio investments may make it difficult for us to sell these investments when desired and, if we are required to sell these investments, we may realize significantly less than their recorded value.
 
Also, as a business development company, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, to total senior securities, which include all of our borrowings and any outstanding preferred stock, of at least 200%. This requirement limits the amount that we may borrow. As of September 30, 2010, we were in compliance with this requirement. To fund growth in our investment portfolio in the future, we anticipate needing to raise additional capital from various sources, including the equity markets and the securitization or other debt-related markets, which may or may not be available on favorable terms, if at all.
 
Finally, in light of the conditions in the financial markets and the U.S. economy overall, we, through a wholly-owned subsidiary, sought and obtained a license from the SBA to operate an SBIC.
 
In this regard, on February 3, 2010, our wholly-owned subsidiary, Fifth Street Mezzanine Partners IV, L.P., received a license, effective February 1, 2010, from the SBA to operate as an SBIC under Section 301(c) of the Small Business Investment Act of 1958. SBICs are designated to stimulate the flow of private equity capital to eligible small businesses. Under SBA regulations, SBICs may make loans to eligible small businesses and invest in the equity securities of small businesses.
 
The SBIC license allows our SBIC subsidiary to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and other customary procedures. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and have a ten year maturity. The principal amount of SBA-guaranteed debentures is not required to be paid prior to maturity but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed on a semi-annual basis at a market-driven spread over U.S. Treasury Notes with 10-year maturities.
 
SBA regulations currently limit the amount that our SBIC subsidiary may borrow to a maximum of $150 million when it has at least $75 million in regulatory capital, receives a capital commitment from the SBA and has been through an examination by the SBA subsequent to licensing. As of September 30, 2010, our SBIC subsidiary had $75 million in regulatory capital. The SBA has issued a capital commitment to our SBIC subsidiary in the amount of $150 million, and $73 million of SBA debentures were outstanding as of September 30, 2010 that bore an interest rate of 3.50%, including the SBA annual charge of 0.285%.
 
We applied for exemptive relief from the SEC on September 9, 2009 and filed an amended application on February 8, 2010 to permit us to exclude the debt of our SBIC subsidiary guaranteed by the SBA from our 200% asset coverage test under the 1940 Act. If we receive an exemption for this SBA debt, we would have increased flexibility under the 200% asset coverage test.


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Significant capital transactions that occurred from October 1, 2008 through September 30, 2010
 
The following table reflects the dividend distributions per share that our Board of Directors has declared and we have paid, including shares issued under our DRIP, on our common stock from October 1, 2008 through September 30, 2010:
 
                                         
            Amount
  Cash
  DRIP Shares
  DRIP Shares
Date Declared
 
Record Date
 
Payment Date
  per Share   Distribution   Issued   Value
 
December 9, 2008
  December 19, 2008   December 29, 2008   $ 0.32     $ 6.4 million       105,326     $ 0.8 million  
December 9, 2008
  December 30, 2008   January 29, 2009     0.33       6.6 million       139,995       0.8 million  
December 18, 2008
  December 30, 2008   January 29, 2009     0.05       1.0 million       21,211       0.1 million  
April 14, 2009
  May 26, 2009   June 25, 2009     0.25       5.6 million       11,776       0.1 million  
August 3, 2009
  September 8, 2009   September 25, 2009     0.25       7.5 million       56,890       0.6 million  
November 12, 2009
  December 10, 2009   December 29, 2009     0.27       9.7 million       44,420       0.5 million  
January 12, 2010
  March 3, 2010   March 30, 2010     0.30       12.9 million       58,689       0.7 million  
May 3, 2010
  May 20, 2010   June 30, 2010     0.32       14.0 million       42,269       0.5 million  
August 2, 2010
  September 1, 2010   September 29, 2010     0.10       5.2 million       25,425       0.3 million  
 
The following table reflects shareholder transactions that occurred from October 1, 2008 through September 30, 2010:
 
                             
                Gross
                Proceeds
Date
 
Transaction
  Shares   Share Price   (Uses)
 
October 27, 2008
  Repurchase shares     39,000     $ 5.96     $ (0.2 million )
October 28, 2008
  Repurchase shares     39,000       5.89       (0.2 million )
July 21, 2009
  Public offering(1)     9,487,500       9.25       87.8 million  
September 25, 2009
  Public offering(1)     5,520,000       10.50       58.0 million  
January 27, 2010
  Public offering     7,000,000       11.20       78.4 million  
February 25, 2010
  Underwriters’ exercise of
over-allotment
    300,500       11.20       3.4 million  
June 21, 2010
  Public offering(1)     9,200,000       11.50       105.8 million  
 
 
(1) Includes the underwriters’ full exercise of their over-allotment option
 
Borrowings
 
On November 16, 2009, Fifth Street Funding, LLC, a consolidated wholly-owned bankruptcy remote, special purpose subsidiary (“Funding”), and we entered into a Loan and Servicing Agreement (“Agreement”), with respect to a three-year credit facility (“Wells Fargo facility”) with Wells Fargo Bank, National Association (“Wells Fargo”), as successor to Wachovia Bank, National Association (“Wachovia”), Wells Fargo Securities, LLC, as administrative agent, each of the additional institutional and conduit lenders party thereto from time to time, and each of the lender agents party thereto from time to time, in the amount of $50 million, with an accordion feature which allowed for potential future expansion of the facility up to $100 million. The facility bore interest at LIBOR plus 4.0% per annum and had a maturity date of November 16, 2012.
 
On May 26, 2010, we amended the Wells Fargo facility to expand the borrowing capacity under that facility. Pursuant to the amendment, we received an additional $50 million commitment, thereby increasing the size of the facility from $50 million to $100 million, with an accordion feature that allows for potential future expansion of that facility from a total of $100 million up to a total of $150 million. In addition, the interest rate of the Wells Fargo facility was reduced from LIBOR plus 4% per annum to LIBOR plus 3.5% per annum, with no LIBOR floor, and the maturity date of the facility was extended from November 16, 2012 to May 26, 2013. The facility may be extended for up to two additional years upon the mutual consent of Wells Fargo and each of the lender parties thereto.


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In connection with the Wells Fargo facility, we concurrently entered into (i) a Purchase and Sale Agreement with Funding, pursuant to which we will sell to Funding certain loan assets we have originated or acquired, or will originate or acquire and (ii) a Pledge Agreement with Wells Fargo, pursuant to which we pledged all of our equity interests in Funding as security for the payment of Funding’s obligations under the Agreement and other documents entered into in connection with the Wells Fargo facility.
 
The Agreement and related agreements governing the Wells Fargo facility required both Funding and us to, among other things (i) make representations and warranties regarding the collateral as well as each of our businesses, (ii) agree to certain indemnification obligations, and (iii) comply with various covenants, servicing procedures, limitations on acquiring and disposing of assets, reporting requirements and other customary requirements for similar credit facilities. The Wells Fargo facility agreements also include usual and customary default provisions such as the failure to make timely payments under the facility, a change in control of Funding, and the failure by Funding or us to materially perform under the Agreement and related agreements governing the facility, which, if not complied with, could accelerate repayment under the facility, thereby materially and adversely affecting our liquidity, financial condition and results of operations.
 
The Wells Fargo facility is secured by all of the assets of Funding, and all of our equity interest in Funding. We intend to use the net proceeds of the Wells Fargo facility to fund a portion of our loan origination activities and for general corporate purposes. Each loan origination under the facility is subject to the satisfaction of certain conditions. We cannot be assured that Funding will be able to borrow funds under the Wells Fargo facility at any particular time or at all. As of September 30, 2010, we had no borrowings outstanding under the Wells Fargo facility.
 
On May 27, 2010, we entered into a three-year secured syndicated revolving credit facility (“ING facility”) pursuant to a Senior Secured Revolving Credit Agreement (“ING Credit Agreement”) with certain lenders party thereto from time to time and ING Capital LLC, as administrative agent. The ING facility allows for us to borrow money at a rate of either (i) LIBOR plus 3.5% per annum or (ii) 2.5% per annum plus an alternate base rate based on the greatest of the Prime Rate, Federal Funds Rate plus 0.5% per annum or LIBOR plus 1% per annum, and has a maturity date of May 27, 2013. The ING facility also allows us to request letters of credit from ING Capital LLC, as the issuing bank. The initial commitment under the ING facility is $90 million, and the ING facility includes an accordion feature that allows for potential future expansion of the facility up to a total of $150 million. The ING facility is secured by substantially all of our assets, as well as the assets of two of our wholly-owned subsidiaries, FSFC Holdings, Inc. and FSF/MP Holdings, Inc., subject to certain exclusions for, among other things, equity interests in our SBIC subsidiary and equity interests in Funding as further set forth in a Guarantee, Pledge and Security Agreement (“ING Security Agreement”) entered into in connection with the ING Credit Agreement, among FSFC Holdings, Inc., FSF/MP Holdings, Inc., ING Capital LLC, as collateral agent, and us. Neither our SBIC subsidiary nor Funding is party to the ING facility and their respective assets have not been pledged in connection therewith. The ING facility provides that we may use the proceeds and letters of credit under the facility for general corporate purposes, including acquiring and funding leveraged loans, mezzanine loans, high-yield securities, convertible securities, preferred stock, common stock and other investments.
 
Pursuant to the ING Security Agreement, FSFC Holdings, Inc. and FSF/MP Holdings, Inc. guaranteed the obligations under the ING Security Agreement, including our obligations to the lenders and the administrative agent under the ING Credit Agreement. Additionally, we pledged our entire equity interests in FSFC Holdings, Inc. and FSF/MP Holdings, Inc. to the collateral agent pursuant to the terms of the ING Security Agreement.
 
The ING Credit Agreement and related agreements governing the ING facility required FSFC Holdings, Inc., FSF/MP Holdings, Inc. and us to, among other things (i) make representations and warranties regarding the collateral as well as each of our businesses, (ii) agree to certain indemnification obligations, and (iii) agree to comply with various affirmative and negative covenants and other customary requirements for similar credit facilities. The ING facility documents also include usual and customary default provisions such as the failure to make timely payments under the facility, the occurrence of a change in control, and the failure by us to materially perform under the ING Credit Agreement and related agreements governing the facility, which, if


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not complied with, could accelerate repayment under the facility, thereby materially and adversely affecting our liquidity, financial condition and results of operations.
 
Each loan or letter of credit originated under the ING facility is subject to the satisfaction of certain conditions. We cannot be assured that we will be able to borrow funds under the ING facility at any particular time or at all.
 
Through September 30, 2010, there had been no borrowings or repayments on the ING facility.
 
As of September 30, 2010, except for assets that were funded through our SBIC subsidiary, substantially all of our assets were pledged as collateral under the Wells Fargo facility or the ING facility.
 
Interest expense for the years ended September 30, 2010, 2009 and 2008 was $1.9 million, $0.6 million, and $0.9 million, respectively.
 
The following table describes significant financial covenants with which we must comply under each of our credit facilities on a quarterly basis:
 
                 
Facility
 
Financial Covenant
 
Description
  Target Value   Reported Value (1)
 
Wells Fargo facility
  Minimum shareholders’ equity (inclusive of affiliates)   Net assets shall not be less than $200 million plus the aggregate net proceeds of all sales of equity interests after November 16, 2009   $334 million   $569 million
    Minimum shareholders’ equity (exclusive of affiliates)   Net assets exclusive of affiliates other than Funding shall not be less than $250 million   $250 million   $494 million
    Asset coverage ratio   Asset coverage ratio shall not be less than 2.00:1   2.00:1   8.37:1
                 
ING facility
  Minimum shareholders’ equity   Net assets shall not be less than the greater of (a) 55% of total assets; and (b) $385 million plus the aggregate net proceeds of all sales of equity interests after February 24, 2010   $436 million   $569 million
    Asset coverage ratio   Asset coverage ratio shall not be less than 2.25:1   2.25:1   17.26:1
    Interest coverage ratio   Interest coverage ratio shall not be less than 2.50:1   2.50:1   73.94:1
    Eligible portfolio investments test   Aggregate value of (a) Cash and cash equivalents and (b) Portfolio investments rated 1, 2 or 3 shall not be less than $175 million   $175 million   $289 million
 
 
(1) As contractually required, we report financial covenants based on the last filed quarterly or annual report, in this case our Form 10-Q for the quarter ended June 30, 2010. We were also in compliance with all financial covenants under these credit facilities based on the financial information filed in this Form 10-K for the year ended September 30, 2010.


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We and our SBIC subsidiary are also subject to certain regulatory requirements relating to our borrowings. For a discussion of such requirements, see “Item 1. Business — Regulation — Business Development Company Regulations” and “— Small Business Investment Company Regulations.”
 
The following table reflects credit facility and debenture transactions that occurred from October 1, 2008 through September 30, 2010. Amounts available and drawn are as of September 30, 2010.
 
                                     
            Total
               
            Facility
  Upfront
      Amount
  Interest
            Amount   fee Paid   Availability   Drawn   Rate
 
Bank of Montreal
  December 30, 2008   Renewed credit facility   $50 million   $0.3 million   $     $     LIBOR + 3.25%
    September 16, 2009   Terminated credit facility                            
Wells Fargo facility
  November 16, 2009   Entered into credit facility   50 million   $0.8 million                   LIBOR + 4.00%
    May 26, 2010   Expanded credit facility   100 million   $0.9 million     42 million (1 )         LIBOR + 3.50%
ING facility
  May 27, 2010   Entered into credit facility   90 million   $0.8 million     90 million           LIBOR + 3.50%
SBA
  February 16, 2010   Received capital commitment   75 million   $0.8 million                    
    September 21, 2010   Received capital commitment   150 million   $0.8 million     150 million       73 million     3.50% (2)
 
 
(1) Availability to increase upon our decision to further collateralize the facility.
 
(2) Includes the SBA annual charge of 0.285%.
 
Off-Balance Sheet Arrangements
 
We may be a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our portfolio companies. As of September 30, 2010, our only off-balance sheet arrangements consisted of $49.5 million of unfunded commitments, which was comprised of $46.7 million to provide debt financing to certain of our portfolio companies and $2.8 million related to unfunded limited partnership interests. As of September 30, 2009, our only off-balance sheet arrangements consisted of $9.8 million, which was comprised of $7.8 million to provide debt financing to certain of our portfolio companies and $2.0 million related to unfunded limited partnership interests. Such commitments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the Statement of Assets and Liabilities and are not reflected on our Consolidated Statement of Assets and Liabilities.
 
Contractual Obligations
 
On February 3, 2010, our SBIC subsidiary received a license, effective February 1, 2010, from the SBA to operate as an SBIC. The SBIC license allows our SBIC subsidiary to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and other customary procedures. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and have a ten year maturity. The principal amount of SBA-guaranteed debentures is not required to be paid prior to maturity but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed on a semi-annual basis at a market-driven spread over U.S. Treasury Notes with 10-year maturities. As of September 30, 2010, we had $73 million of SBA debentures payable that bore an interest rate of 3.50%, including the SBA annual charge of 0.285%.
 
On November 16, 2009, we entered into the Wells Fargo facility in the amount of $50 million with an accordion feature, which allowed for potential future expansion of the Wells Fargo facility up to $100 million. The Wells Fargo facility bore interest at LIBOR plus 4% per annum and had a maturity date of November 26, 2012. On May 26, 2010, we amended the Wells Fargo facility to expand our borrowing capacity under that facility. Pursuant to the amendment, we received an additional $50 million commitment, thereby increasing the size of the Wells Fargo facility from $50 million to $100 million, with an accordion feature that allows for potential future expansion of that facility from a total of $100 million up to a total of $150 million. In addition, the interest rate of the Wells Fargo facility was reduced from LIBOR plus 4% per annum to LIBOR plus 3.5% per annum, with no LIBOR floor, and the maturity date of the facility was extended from November 16, 2012 to May 26, 2013.


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On May 27, 2010, we entered into the ING facility, which allows for us to borrow money at a rate of either (i) LIBOR plus 3.5% per annum or (ii) 2.5% per annum plus an alternate base rate based on the greatest of the Prime Rate, Federal Funds Rate plus 0.5% per annum or LIBOR plus 1% per annum, and has a maturity date of May 27, 2013. The ING facility also allows us to request letters of credit from ING Capital LLC, as the issuing bank. The initial commitment under the ING facility is $90 million, and the ING facility includes an accordion feature that allows for potential future expansion of the facility up to a total of $150 million.
 
As of September 30, 2010, we had no borrowings outstanding under either the Wells Fargo facility or the ING facility.
 
The following table reflects our contractual obligations arising from the SBA debentures payable, the Wells Fargo Facility and the ING Facility:
 
                                         
    Payments Due by Period as of September 30, 2010
    Total   < 1 year   1-3 years   3-5 years   > 5 years
 
SBA debentures payable
  $ 73,000,000     $     $     $     $ 73,000,000  
Interest due on SBA debentures
    25,423,995       2,407,998       5,116,999       5,110,000       12,788,998  
Wells fargo facility
                             
ING facility
                             
Total
  $ 98,423,995     $ 2,407,998     $ 5,116,999     $ 5,110,000     $ 85,788,998  
 
A summary of the composition of unfunded commitments (consisting of revolvers, term loans and limited partnership interests) as of September 30, 2010 and September 30, 2009 is shown in the table below:
 
                 
    September 30,
    September 30,
 
    2010     2009  
 
Storyteller Theaters Corporation
  $     $ 1,750,000  
HealthDrive Corporation
    1,500,000       1,500,000  
IZI Medical Products, Inc. 
    2,500,000       2,500,000  
Trans-Trade, Inc. 
    500,000       2,000,000  
Riverlake Equity Partners II, LP (limited partnership interest)
    966,360       1,000,000  
Riverside Fund IV, LP (limited partnership interest)
    864,175       1,000,000  
ADAPCO, Inc. 
    5,750,000        
AmBath/ReBath Holdings, Inc. 
    1,500,000        
JTC Education, Inc. 
    9,062,453        
Tegra Medical, LLC
    4,000,000        
Vanguard Vinyl, Inc. 
    1,250,000        
Flatout, Inc. 
    1,500,000        
Psilos Group Partners IV, LP (limited partnership interest)
    1,000,000        
Mansell Group, Inc. 
    2,000,000        
NDSSI Holdings, Inc. 
    1,500,000        
Eagle Hospital Physicians, Inc. 
    2,500,000        
Enhanced Recovery Company, LLC
    3,623,148        
Epic Acquisition, Inc. 
    2,700,000        
Specialty Bakers, LLC
    2,000,000        
Rail Acquisition Corp. 
    4,798,897        
                 
Total
  $ 49,515,033     $ 9,750,000  
                 
 
We have entered into two contracts under which we have material future commitments, the investment advisory agreement, pursuant to which Fifth Street Management LLC has agreed to serve as our investment


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adviser, and the administration agreement, pursuant to which FSC, Inc. has agreed to furnish us with the facilities and administrative services necessary to conduct our day-to-day operations.
 
Regulated Investment Company Status and Dividends
 
Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp., which has elected to be treated as a business development company under the 1940 Act. We elected, effective as of January 2, 2008, to be treated as a RIC under Subchapter M of the Code. As long as we qualify as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders on a timely basis.
 
Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation until realized. Dividends declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital.
 
To maintain RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any). As a RIC, we are also subject to a federal excise tax, based on distributive requirements of our taxable income on a calendar year basis (e.g., calendar year 2010). We anticipate timely distribution of our taxable income within the tax rules; however, we may incur a U.S. federal excise tax for the calendar year 2010. We intend to distribute to our stockholders between 90% and 100% of our annual taxable income (which includes our taxable interest and fee income). However, in future periods, we will be partially dependent on our SBIC subsidiary for cash distributions to enable us to meet the RIC distribution requirements. Our SBIC subsidiary may be limited by the Small Business Investment Act of 1958, and SBA regulations governing SBICs, from making certain distributions to us that may be necessary to enable us to maintain our status as a RIC. We may have to request a waiver of the SBA’s restrictions for our SBIC subsidiary to make certain distributions to maintain our RIC status. We cannot assure you that the SBA will grant such waiver. Also, the financial covenants under the Wells Fargo facility could, under certain circumstances, restrict Fifth Street Funding, LLC from making distributions to us and, as a result, hinder our ability to satisfy the distribution requirement. In addition, we may retain for investment some or all of our net taxable capital gains (i.e., realized net long-term capital gains in excess of realized net short-term capital losses) and treat such amounts as deemed distributions to our stockholders. If we do this, our stockholders will be treated as if they received actual distributions of the capital gains we retained and then reinvested the net after-tax proceeds in our common stock. Our stockholders also may be eligible to claim tax credits (or, in certain circumstances, tax refunds) equal to their allocable share of the tax we paid on the capital gains deemed distributed to them. To the extent our taxable earnings for a fiscal taxable year fall below the total amount of our dividends for that fiscal year, a portion of those dividend distributions may be deemed a return of capital to our stockholders.
 
We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a business development company under the 1940 Act and due to provisions in our credit facilities. If we do not distribute a certain percentage of our taxable income annually, we will suffer adverse tax consequences, including possible loss of our status as a RIC. We cannot assure stockholders that they will receive any distributions or distributions at a particular level.
 
Pursuant to a recent revenue procedure (Revenue Procedure 2010-12), or the Revenue Procedure, issued by the Internal Revenue Service, or IRS, the IRS has indicated that it will treat distributions from certain publicly traded RICs (including BDCs) that are paid part in cash and part in stock as dividends that would satisfy the RIC’s annual distribution requirements and qualify for the dividends paid deduction for federal


65


 

income tax purposes. In order to qualify for such treatment, the Revenue Procedure requires that at least 10% of the total distribution be payable in cash and that each stockholder have a right to elect to receive its entire distribution in cash. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a proportionate share of the cash to be distributed (although no stockholder electing to receive cash may receive less than 10% of such stockholder’s distribution in cash). This Revenue Procedure applies to distributions declared on or before December 31, 2012 with respect to taxable years ending on or before December 31, 2011. We have no current intention of paying dividends in shares of our stock.
 
Related Party Transactions
 
We have entered into an investment advisory agreement with Fifth Street Management LLC, our investment adviser. Fifth Street Management is controlled by Leonard M. Tannenbaum, its managing member and the chairman of our Board of Directors and our chief executive officer. Pursuant to the investment advisory agreement, fees payable to our investment adviser will be equal to (a) a base management fee of 2.0% of the value of our gross assets, which includes any borrowings for investment purposes, and (b) an incentive fee based on our performance. Our investment adviser agreed to permanently waive that portion of its base management fee attributable to our assets held in the form of cash and cash equivalents as of the end of each quarter beginning March 31, 2010. The incentive fee consists of two parts. The first part is calculated and payable quarterly in arrears and equals 20% of our “Pre-Incentive Fee Net Investment Income” for the immediately preceding quarter, subject to a preferred return, or “hurdle,” and a “catch up” feature. The second part is determined and payable in arrears as of the end of each fiscal year (or upon termination of the investment advisory agreement) and equals 20% of our “Incentive Fee Capital Gains,” which equals our realized capital gains on a cumulative basis from inception through the end of the year, if any, computed net of all realized capital losses and unrealized capital depreciation on a cumulative basis, less the aggregate amount of any previously paid capital gain incentive fee.
 
The investment advisory agreement may be terminated by either party without penalty upon no fewer than 60 days’ written notice to the other. Since we entered into the investment advisory agreement in December 2007, we have paid our investment adviser $8.4 million, $13.7 million and $20.0 million for the fiscal years ended September 30, 2008, September 30, 2009, and September 30, 2010, respectively, under the investment advisory agreement.
 
Pursuant to the administration agreement with FSC, Inc., which is controlled by Mr. Tannenbaum, FSC, Inc. will furnish us with the facilities and administrative services necessary to conduct our day-to-day operations, including equipment, clerical, bookkeeping and recordkeeping services at such facilities. In addition, FSC, Inc. will assist us in connection with the determination and publishing of our net asset value, the preparation and filing of tax returns and the printing and dissemination of reports to our stockholders. We will pay FSC, Inc. our allocable portion of overhead and other expenses incurred by it in performing its obligations under the administration agreement, including a portion of the rent and the compensation of our chief financial officer and chief compliance officer and their respective staffs. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us by our chief compliance officer, Bernard D. Berman, given his compensation arrangement with our investment adviser. Although FSC, Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future. The administration agreement may be terminated by either party without penalty upon no fewer than 60 days’ written notice to the other. Since we entered into the administration agreement in December 2007, we have paid FSC, Inc. approximately $1.6 million, $1.3 million and $2.0 million for the fiscal years ended September 30, 2008, September 30, 2009 and September 30, 2010, respectively, under the administration agreement.
 
We have also entered into a license agreement with Fifth Street Capital LLC pursuant to which Fifth Street Capital LLC has agreed to grant us a non-exclusive, royalty-free license to use the name “Fifth Street.” Under this agreement, we will have a right to use the “Fifth Street” name, for so long as Fifth Street Management LLC or one of its affiliates remains our investment adviser. Other than with respect to this limited license, we will have no legal right to the “Fifth Street” name. Fifth Street Capital LLC is controlled by Mr. Tannenbaum, its managing member.


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Recent Developments
 
On October 1, 2010, we closed a $63.5 million senior secured debt facility to support the acquisition of a provider of technology solutions. The investment is backed by a private equity sponsor and $51.0 million was funded at closing. The terms of this investment include a $12.5 million revolver at an interest rate of LIBOR + 7.5% per annum, a $29.0 million Term Loan A at an interest rate of LIBOR + 7.5% per annum and a $22.0 million Term Loan B at an interest rate of 12.5% per annum. This is a first lien facility with a scheduled maturity of five years.
 
On October 1, 2010, we received a cash payment of $8.6 million from Goldco, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par.
 
On October 13, 2010, Nicos Polymers & Grinding, Inc., an existing portfolio company, filed for Chapter 11 bankruptcy as part of a restructuring of that investment. The bankruptcy was subsequently moved to a court mandated mediation process. On November 15, 2010, we and the major shareholder of Nicos Polymers & Grinding, Inc. agreed to a binding term sheet to settle the restructuring via an out of court foreclosure process. The restructuring will result in Nicos Polymers & Grinding retaining $10.0 million of senior term debt at an interest rate of 8.0% with a scheduled maturity of seven years, along with a $1.0 million to $3.0 million expandable revolving line of credit.
 
On October 22, 2010, our Board of Directors authorized a stock repurchase program to acquire up to $20 million of our outstanding common stock. Stock repurchases under this program are to be made through the open market at times and in such amounts as our management deems appropriate, provided that the price is below the most recently published net asset value per share. The stock repurchase program expires December 31, 2011 and may be limited or terminated by the Board of Directors at any time without prior notice.
 
On October 22, 2010, our Board of Directors approved an amendment to our DRIP to allow for a 5% discount on newly issued shares purchased through the DRIP, provided the shares will not be issued at a price below the most recently published net asset value per share.
 
On October 27, 2010, we paid a dividend in the amount of $0.10 per share to stockholders of record on October 6, 2010.
 
On November 4, 2010, we held a foreclosure auction of the assets of Vanguard Vinyl, Inc., an existing portfolio company, as part of a loan restructuring. The restructuring broke up Vanguard Vinyl, Inc. into two operating companies. One operating company, located in California will maintain $0.8 million of senior secured term debt at an interest rate of 8.0%, along with a $0.4 million revolving line of credit; both loans have a scheduled maturity of three years. The other operating company will manage operations in Utah with $2.0 million of senior secured term debt at an interest rate of 8.0%, along with a $1.0 million revolving line of credit; both loans have a scheduled maturity of three years. The Hawaii operations will maintain $3.8 million of senior secured term debt at an interest rate of 8% with a scheduled maturity of six months.
 
On November 5, 2010, we amended the Wells Fargo facility to, among other things, provide for the issuance from time to time of letters of credit for the benefit of our portfolio companies. The letters of credit are subject to certain restrictions, including a borrowing base limitation and an aggregate sublimit of $15.0 million.
 
On November 15, 2010, our SBIC subsidiary drew $6.0 million from its SBA commitment to use to fund future investments.
 
On November 16, 2010, we received a cash payment of $11.0 million from TBA Global, LLC in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par.
 
On November 16, 2010, we drew $10.0 million on the Wells Fargo facility.
 
On November 19, 2010, we closed a $45.5 million senior secured debt facility to support the acquisition of a provider of technology-based services. The investment is backed by a private equity sponsor and $39.5 million was funded at closing. The terms of this investment include a $6.0 million revolver at an interest


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rate of LIBOR + 7.0% per annum with a 2% LIBOR floor, a $16.4 million Term Loan A at an interest rate of LIBOR + 8.0% per annum with a 2% LIBOR floor, a $21.0 million Term Loan B at an interest rate of LIBOR + 10.25% per annum with a 2% LIBOR floor, and a $2.1 million membership interest. This is a first lien facility with a scheduled maturity of five years.
 
On November 24, 2010, we paid a dividend in the amount of $0.11 per share to stockholders of record on November 3, 2010.
 
On November 30, 2010, our Board of Directors declared the following monthly dividends:
 
  •  $0.1066 per share, payable on January 31, 2011 to stockholders of record on January 4, 2011;
 
  •  $0.1066 per share, payable on February 28, 2011 to stockholders of record on February 1, 2011; and
 
  •  $0.1066 per share, payable on March 31, 2011 to stockholders of record on March 1, 2011.
 
Recently Issued Accounting Standards
 
See Note 2 to the Consolidated Financial Statements for a description of recent accounting pronouncements, including the expected dates of adoption and the anticipated impact on the Consolidated Financial Statements.
 
Item 7A.   Quantitative and Qualitative Disclosures about Market Risk
 
We are subject to financial market risks, including changes in interest rates. Changes in interest rates may affect both our cost of funding and our interest income from portfolio investments, cash and cash equivalents and idle funds investments. Our risk management systems and procedures are designed to identify and analyze our risk, to set appropriate policies and limits and to continually monitor these risks and limits by means of reliable administrative and information systems and other policies and programs. Our investment income will be affected by changes in various interest rates, including LIBOR and prime rates, to the extent any of our debt investments include floating interest rates. The significant majority of our debt investments are made with fixed interest rates for the term of the investment. However, as of September 30, 2010, 32.8% of our debt investment portfolio (at fair value) and 31.4% of our debt investment portfolio (at cost) bore interest at floating rates. As of September 30, 2010, based on our applicable levels of floating-rate debt investments, a 1.0% change in interest rates would not have a material effect on our level of interest income from debt investments.
 
Based on our review of interest rate risk, we determine whether or not any hedging transactions are necessary to mitigate exposure to changes in interest rates. On August 16, 2010, we entered into an interest rate swap agreement that expires on August 15, 2013, for a total notional amount of $100 million, for the purposes of hedging the interest rate risk related to the Wells facility and the ING facility. Under the interest rate swap agreement, we will pay a fixed interest rate of 0.99% and receive a floating rate based on the prevailing one-month LIBOR.
 
Our investments are carried at fair value as determined in good faith by our Board of Directors in accordance with the 1940 Act (See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies — Investment Valuation”). Our valuation methodology utilizes discount rates in part in valuing our investments, and changes in those discount rates may have an impact on the valuation of our investments. Assuming no changes in our investment and capital structure, a hypothetical increase or decrease in discount rates of 100 basis points would increase or decrease our net assets resulting from operations by $12 million.


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Stockholders of
Fifth Street Finance Corp.:
 
In our opinion, the accompanying consolidated statement of assets and liabilities, including the consolidated schedule of investments, and the related consolidated statements of operations, changes in net assets and cash flows, present fairly, in all material respects, the financial position of Fifth Street Finance Corp. (“the Company”) at September 30, 2010, and the results of its operations, the changes in its net assets and its cash flows for the year ended September 30, 2010, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing on page 119 of the annual report to stockholders. Our responsibility is to express an opinion on these financial statements and on the Company’s internal control over financial reporting based on our integrated audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
/s/  PricewaterhouseCoopers LLP
New York, New York
December 1, 2010


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
Board of Directors and Stockholders of
  Fifth Street Finance Corp.
 
We have audited the accompanying consolidated statement of assets and liabilities, including the consolidated schedule of investments, of Fifth Street Finance Corp. (a Delaware corporation) (the “Company”) as of September 30, 2009, and the related consolidated statements of operations, changes in net assets, and cash flows and the financial highlights (included in Note 12) for the years ended September 30, 2009 and 2008. Our audits of the basic financial statements included the Schedule of Investments In and Advances to Affiliates. These financial statements, financial highlights and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our procedures included physical inspection or confirmation of securities owned as of September 30, 2009. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Fifth Street Finance Corp. as of September 30, 2009, and the results of its operations, changes in net assets and its cash flows and financial highlights for the years ended September 30, 2009 and 2008 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
 
/s/  GRANT THORNTON LLP
New York, New York
December 9, 2009


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Fifth Street Finance Corp.
 
 
                 
    September 30,
    September 30,
 
    2010     2009  
 
ASSETS
Investments at Fair Value:
               
Control investments (cost September 30, 2010: $12,195,029; cost September 30, 2009: $12,045,029)
  $ 3,700,000     $ 5,691,107  
Affiliate investments (cost September 30, 2010: $50,133,521; cost September 30, 2009: $71,212,035)
    47,222,059       64,748,560  
Non-control/Non-affiliate investments (cost September 30, 2010: $530,168,045; cost September 30, 2009: $243,975,221)
    512,899,257       229,171,470  
                 
Total Investments at Fair Value (cost September 30, 2010: $592,496,595; cost September 30, 2009: $327,232,285)
    563,821,316       299,611,137  
Cash and cash equivalents
    76,765,254       113,205,287  
Interest and fees receivable
    3,813,757       2,866,991  
Due from portfolio company
    103,426       154,324  
Deferred financing costs
    5,465,964        
Collateral posted to bank and other assets
    1,956,013       49,609  
                 
Total Assets
  $ 651,925,730     $ 415,887,348  
                 
 
LIABILITIES AND NET ASSETS
Liabilities:
               
Accounts payable, accrued expenses and other liabilities
  $ 1,322,282     $ 723,856  
Base management fee payable
    2,875,802       1,552,160  
Incentive fee payable
    2,859,139       1,944,263  
Due to FSC, Inc. 
    1,083,038       703,900  
Interest payable
    282,640        
Payments received in advance from portfolio companies
    1,330,724       190,378  
Offering costs payable
          216,720  
SBA debentures payable
    73,000,000        
                 
Total Liabilities
    82,753,625       5,331,277  
                 
Net Assets:
               
Common stock, $0.01 par value, 150,000,000 shares authorized, 54,550,290 and 37,878,987 shares issued and outstanding at September 30, 2010 and September 30, 2009
    545,503       378,790  
Additional paid-in-capital
    619,759,984       439,989,597  
Net unrealized depreciation on investments and interest rate swap
    (29,448,713 )     (27,621,147 )
Net realized loss on investments
    (33,090,961 )     (14,310,713 )
Accumulated undistributed net investment income
    11,406,292       12,119,544  
                 
Total Net Assets
    569,172,105       410,556,071  
                 
Total Liabilities and Net Assets
  $ 651,925,730     $ 415,887,348  
                 
 
See notes to Consolidated Financial Statements.


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Fifth Street Finance Corp.
 
 
                         
    Year
    Year
    Year
 
    Ended
    Ended
    Ended
 
    September 30,
    September 30,
    September 30,
 
    2010     2009     2008  
Interest income:
                       
Control investments
  $ 182,827     $     $  
Affiliate investments
    7,619,018       10,632,844       8,804,543  
Non-control/Non-affiliate investments
    46,089,945       27,931,097       16,800,945  
Interest on cash and cash equivalents
    237,557       208,824       750,605  
                         
Total interest income
    54,129,347       38,772,765       26,356,093  
                         
PIK interest income:
                       
Control investments
                 
Affiliate investments
    1,227,133       1,634,116       1,539,934  
Non-control/Non-affiliate investments
    8,776,935       5,821,173       3,357,464  
                         
Total PIK interest income
    10,004,068       7,455,289       4,897,398  
                         
Fee income:
                       
Control investments
                 
Affiliate investments
    1,433,206       1,101,656       702,463  
Non-control/Non-affiliate investments
    4,537,837       2,440,538       1,105,576  
                         
Total fee income
    5,971,043       3,542,194       1,808,039  
                         
Dividend and other income:
                       
Control investments
                 
Affiliate investments
                26,740  
Non-control/Non-affiliate investments
    433,317       22,791       130,971  
Other income
          35,396        
                         
Total dividend and other income
    433,317       58,187       157,711  
                         
Total investment income
    70,537,775       49,828,435       33,219,241  
                         
Expenses:
                       
Base management fee
    10,002,326       6,060,690       4,258,334  
Incentive fee
    10,756,040       7,840,579       4,117,554  
Professional fees
    1,348,908       1,492,554       1,389,541  
Board of Directors fees
    278,418       310,250       249,000  
Organizational costs
                200,747  
Interest expense
    1,929,389       636,901       917,043  
Administrator expense
    1,321,546       796,898       978,387  
Line of credit guarantee expense
                83,333  
Transaction fees
                206,726  
General and administrative expenses
    2,604,051       1,500,197       674,360  
                         
Total expenses
    28,240,678       18,638,069       13,075,025  
Base management fee waived
    (727,067 )     (171,948 )      
                         
Net expenses
    27,513,611       18,466,121       13,075,025  
                         
Net investment income
    43,024,164       31,362,314       20,144,216  
Unrealized depreciation on interest rate swap
    (773,435 )            
                         
Unrealized appreciation (depreciation) on investments:
                       
Control investments
    (2,141,107 )     (1,792,015 )      
Affiliate investments
    3,294,482       286,190       (10,570,012 )
Non-control/Non-affiliate investments
    (2,207,506 )     (9,289,492 )     (6,378,755 )
                         
Net unrealized depreciation on investments
    (1,054,131 )     (10,795,317 )     (16,948,767 )
                         
Realized gain (loss) on investments:
                       
Control investments
                 
Affiliate investments
    (6,937,100 )     (4,000,000 )      
Non-control/Non-affiliate investments
    (11,843,148 )     (10,373,200 )     62,487  
                         
Total realized gain (loss) on investments
    (18,780,248 )     (14,373,200 )     62,487  
                         
Net increase in net assets resulting from operations
  $ 22,416,350     $ 6,193,797     $ 3,257,936  
                         
Net Investment Income per common share — basic and diluted(1)
  $ 0.95     $ 1.27     $ 1.29  
                         
Earnings per common share — basic and diluted(1)
  $ 0.49     $ 0.25     $ 0.21  
                         
Weighted average common shares — basic and diluted
    45,440,584       24,654,325       15,557,469  
 
 
(1) The earnings and net investment income per share calculations for the year ended September 30, 2008 are based on the assumption that if the number of shares issued at the time of the merger on January 2, 2008 (12,480,972 shares of common stock) had been issued at the beginning of the fiscal year on October 1, 2007, the Company’s earnings and net investment income per share would have been $0.21 and $1.29 per share, respectively.
 
See notes to Consolidated Financial Statements.


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Fifth Street Finance Corp.
 
 
                         
    Year Ended
    Year Ended
    Year Ended
 
    September 30,
    September 30,
    September 30,
 
    2010     2009     2008  
 
Operations:
                       
Net investment income
  $ 43,024,164     $ 31,362,314     $ 20,144,216  
Net unrealized depreciation on investments and interest rate swap
    (1,827,566 )     (10,795,317 )     (16,948,767 )
Net realized gain (loss) on investments
    (18,780,248 )     (14,373,200 )     62,487  
                         
Net increase in net assets resulting from operations
    22,416,350       6,193,797       3,257,936  
                         
Stockholder transactions:
                       
Distributions to stockholders from net investment income
    (43,737,416 )     (29,591,657 )     (10,754,721 )
                         
Net decrease in net assets from stockholder transactions
    (43,737,416 )     (29,591,657 )     (10,754,721 )
                         
Capital share transactions:
                       
Issuance of preferred stock
                15,000,000  
Issuance of common stock, net
    178,017,945       137,625,075       129,448,456  
Issuance of common stock under dividend reinvestment plan
    1,919,155       2,455,499       1,882,200  
Redemption of preferred stock
                (15,000,000 )
Repurchases of common stock
          (462,482 )      
Issuance of common stock upon conversion of partnership interests
                169,420,000  
Redemption of partnership interest for common stock
                (169,420,000 )
Fractional shares paid to partners from conversion
                (358 )
Capital contributions from partners
                66,497,000  
Capital withdrawals by partners
                (2,810,369 )
                         
Net increase in net assets from capital share transactions
    179,937,100       139,618,092       195,016,929  
                         
Total increase in net assets
    158,616,034       116,220,232       187,520,144  
Net assets at beginning of period
    410,556,071       294,335,839       106,815,695  
                         
Net assets at end of period
  $ 569,172,105     $ 410,556,071     $ 294,335,839  
                         
Net asset value per common share
  $ 10.43     $ 10.84     $ 13.02  
                         
Common shares outstanding at end of period
    54,550,290       37,878,987       22,614,289  
 
See notes to Consolidated Financial Statements.


74


 

Fifth Street Finance Corp.
 
 
                         
    Year Ended
    Year Ended
    Year Ended
 
    September 30,
    September 30,
    September 30,
 
    2010     2009     2008  
 
Cash flows from operating activities:
                       
Net increase in net assets resulting from operations
  $ 22,416,350     $ 6,193,797     $ 3,257,936  
Net unrealized depreciation on investments and interest rate swap
    1,827,566       10,795,317       16,948,767  
Net realized (gains) losses on investments
    18,780,248       14,373,200       (62,487 )
PIK interest income
    (10,004,068 )     (7,455,289 )     (4,897,398 )
Recognition of fee income
    (5,971,043 )     (3,542,194 )     (1,808,039 )
Accretion of original issue discount on investments
    (893,077 )     (842,623 )     (954,436 )
Amortization of deferred financing costs
    798,492              
Other income
          (35,396 )      
Changes in operating assets and liabilities:
                       
PIK interest income received in cash
    1,618,762       428,140       114,412  
Fee income received
    11,882,094       3,895,559       5,478,011  
Increase in interest receivable
    (946,766 )     (499,185 )     (1,613,183 )
(Increase) decrease in due from portfolio company
    50,898       (73,561 )     46,952  
Decrease in prepaid management fees
                252,586  
Increase in collateral posted to bank and other assets
    (1,906,404 )     (14,903 )     (34,706 )
Increase (decrease) in accounts payable, accrued expenses and other liabilities
    (176,705 )     156,170       150,584  
Increase in base management fee payable
    1,323,642       170,948       1,381,212  
Increase in incentive fee payable
    914,876       130,250       1,814,013  
Increase in due to FSC, Inc. 
    379,138       129,798       574,102  
Increase (decrease) in interest payable
    282,640       (38,750 )     28,816  
Increase in payments received in advance from portfolio companies
    1,140,346       56,641       133,737  
Purchase of investments
    (325,527,419 )     (61,950,000 )     (202,402,611 )
Proceeds from the sale of investments
    306,178       144,000       62,487  
Principal payments received on investments (scheduled repayments and revolver paydowns)
    21,776,331       6,951,902       2,152,992  
Principal payments received on investments (payoffs)
    22,767,681       11,350,000        
                         
Net cash used in operating activities
    (239,160,240 )     (19,676,179 )     (179,376,253 )
                         
Cash flows from financing activities:
                       
Dividends paid in cash
    (41,818,261 )     (27,136,158 )     (8,872,521 )
Repurchases of common stock
          (462,482 )      
Capital contributions
                66,497,000  
Capital withdrawals
                (2,810,369 )
Borrowings under SBA debentures payable
    73,000,000              
Borrowings under credit facilities
    43,000,000       29,500,000       79,250,000  
Repayments of borrowings under credit facilities
    (43,000,000 )     (29,500,000 )     (79,250,000 )
Proceeds from the issuance of common stock
    179,125,148       138,578,307       131,316,000  
Proceeds from the issuance of manditorily redeemable preferred stock
                15,000,000  
Redemption of preferred stock
                (15,000,000 )
Deferred financing costs paid
    (6,264,457 )            
Offering costs paid
    (1,322,223 )     (1,004,577 )     (1,501,179 )
Redemption of partnership interests for cash
                (358 )
                         
Net cash provided by financing activities
    202,720,207       109,975,090       184,628,573  
                         
Net increase (decrease) in cash and cash equivalents
    (36,440,033 )     90,298,911       5,252,320  
Cash and cash equivalents, beginning of period
    113,205,287       22,906,376       17,654,056  
                         
Cash and cash equivalents, end of period
  $ 76,765,254     $ 113,205,287     $ 22,906,376  
                         
Supplemental Information:
                       
Cash paid for interest
  $ 848,257     $ 425,651     $ 888,227  
Non-cash financing activities:
                       
Issuance of shares of common stock under dividend reinvestment plan
  $ 1,919,155     $ 2,455,499     $ 1,882,200  
Reinvested shares of common stock under dividend reinvestment plan
  $     $     $ (1,882,200 )
Redemption of partnership interests
  $     $     $ (173,699,632 )
Issuance of shares of common stock in exchange for partnership interests
  $     $     $ 173,699,632  
 
See notes to Consolidated Financial Statements.


75


 

Fifth Street Finance Corp.
 
 
                             
Portfolio Company/Type of Investment(1)(2)(5)
 
Industry
  Principal(8)     Cost     Fair Value  
 
Control Investments(3)
                           
Lighting By Gregory, LLC(13)(14)
  Housewares &
Specialties
                       
First Lien Term Loan A, 9.75% due 2/28/2013
      $ 5,419,495     $ 4,728,589     $ 1,503,716  
First Lien Term Loan B, 14.5% due 2/28/2013
        8,575,783       6,906,440       2,196,284  
First Lien Bridge Loan, 8% due 10/15/2010
        152,312       150,000        
97.38% membership interest
                410,000        
                             
                  12,195,029       3,700,000  
                             
Total Control Investments
              $ 12,195,029     $ 3,700,000  
                             
Affiliate Investments(4)
                           
O’Currance, Inc. 
  Data Processing
& Outsourced
Services
                       
First Lien Term Loan A, 16.875% due 3/21/2012
        10,961,448     $ 10,869,262     $ 10,805,775  
First Lien Term Loan B, 16.875%, 3/21/2012
        1,853,976       1,828,494       1,896,645  
1.75% Preferred Membership interest in O’Currance Holding Co., LLC
                130,413       38,592  
3.3% Membership Interest in O’Currance Holding Co., LLC
                250,000        
                             
                  13,078,169       12,741,012  
MK Network, LLC(13)(14)
  Education
services
                       
First Lien Term Loan A, 13.5% due 6/1/2012
        9,740,358       9,539,188       7,913,140  
First Lien Term Loan B, 17.5% due 6/1/2012
        4,926,187       4,748,004       3,938,660  
First Lien Revolver, Prime + 1.5% (10% floor), due 6/1/2010(10)
                     
11,030 Membership Units(6)
                771,575        
                             
                  15,058,767       11,851,800  
Caregiver Services, Inc. 
  Healthcare
services
                       
Second Lien Term Loan A, LIBOR+6.85% (12% floor) due 2/25/2013
        7,141,190       6,813,431       7,113,622  
Second Lien Term Loan B, 16.5% due 2/25/2013
        14,692,015       14,102,756       14,179,626  
1,080,399 shares of Series A Preferred Stock
                1,080,398       1,335,999  
                             
                  21,996,585       22,629,247  
                             
Total Affiliate Investments
              $ 50,133,521     $ 47,222,059  
                             
Non-Control/Non-Affiliate Investments(7)
                           
CPAC, Inc.
  Household
Products
                       
Subordinated Term Loan, 12.5% due 6/1/2012
        1,064,910     $ 1,064,910     $ 1,064,910  
                             
                  1,064,910       1,064,910  
Vanguard Vinyl, Inc.(9)(13)(14)
  Building
Products
                       
First Lien Term Loan, 12% due 3/30/2013
        7,000,000       6,827,373       5,812,199  
First Lien Revolver, LIBOR+7% (10% floor) due 3/30/2013
        1,250,000       1,207,895       1,029,268  
25,641 Shares of Series A Preferred Stock
                253,846        
25,641 Shares of Common Stock
                2,564        
                             
                  8,291,678       6,841,467  
Repechage Investments Limited
  Restaurants                        
First Lien Term Loan, 15.5% due 10/16/2011
        3,708,971       3,475,906       3,486,342  
7,500 shares of Series A Preferred Stock of Elephant & Castle, Inc. 
                750,000       354,114  
                             
                  4,225,906       3,840,456  


76


 

 
Fifth Street Finance Corp.
 
Consolidated Schedule of Investments
September 30, 2010
 
                             
Portfolio Company/Type of Investment(1)(2)(5)
 
Industry
  Principal(8)     Cost     Fair Value  
 
Traffic Control & Safety Corporation(9)
  Construction and
Engineering
                       
Second Lien Term Loan, 15% due 5/28/2015
        19,969,524       19,724,493       19,440,090  
Subordinated Loan, 15% due 5/28/2015
        4,577,800       4,577,800       4,404,746  
24,750 shares of Series B Preferred Stock
                247,500        
43,494 shares of Series D Preferred Stock(6)
                434,937        
25,000 shares of Common Stock
                2,500        
                             
                  24,987,230       23,844,836  
Nicos Polymers & Grinding Inc.(9)(13)(14)
  Environmental
& facilities
services
                       
First Lien Term Loan A, LIBOR+5% (10% floor), due 7/17/2012
        3,154,876       3,040,465       1,782,181  
First Lien Term Loan B, 13.5% due 7/17/2012
        6,180,185       5,713,125       3,347,672  
3.32% Interest in Crownbrook Acquisition I LLC
                168,086        
                             
                  8,921,676       5,129,853  
TBA Global, LLC(9)
  Advertising                        
Second Lien Term Loan B, 14.5% due 8/3/2012
        10,840,081       10,594,939       10,625,867  
53,994 Senior Preferred Shares
                215,975       215,975  
191,977 Shares A Shares
                191,977       179,240  
                             
                  11,002,891       11,021,082  
Fitness Edge, LLC
  Leisure
Facilities
                       
First Lien Term Loan A, LIBOR+5.25% (10% floor), due 8/8/2012
        1,250,000       1,245,136       1,247,418  
First Lien Term Loan B, 15% due 8/8/2012
        5,631,547       5,575,477       5,674,493  
1,000 Common Units
                42,908       118,132  
                             
                  6,863,521       7,040,043  
Filet of Chicken(9)
  Food
Distributors
                       
Second Lien Term Loan, 14.5% due 7/31/2012
        9,316,518       9,063,155       8,964,766  
                             
                  9,063,155       8,964,766  
Boot Barn(9)
  Apparel,
accessories &
luxury goods and
Footwear
                       
Second Lien Term Loan, 14.5% due 10/3/2013
        23,545,479       23,288,566       23,477,539  
247.06 shares of Series A Preferred Stock
                247,060       71,394  
1,308 shares of Common Stock
                131        
                             
                  23,535,757       23,548,933  
Premier Trailer Leasing, Inc.(9)(13)(14)
  Trucking                        
Second Lien Term Loan, 16.5% due 10/23/2012
        18,452,952       17,063,645       4,597,412  
285 shares of Common Stock
                1,140        
                             
                  17,064,785       4,597,412  
Pacific Press Technologies, Inc.(9)
                           
Second Lien Term Loan, 14.75% due 7/10/2013
  Industrial
machinery
    10,071,866       9,798,901       9,829,869  
33,786 shares of Common Stock
                344,513       402,894  
                             
                  10,143,414       10,232,763  
Goldco, LLC
                           
Second Lien Term Loan, 17.5% due 1/31/2013
  Restaurants     8,355,688       8,259,479       8,259,479  
                             
                  8,259,479       8,259,479  
Rail Acquisition Corp.(9)
  Electronic
manufacturing
services
                       
First Lien Term Loan, 17% due 9/1/2013
        16,315,866       13,536,969       12,854,425  
First Lien Revolver, 7.85% due 9/1/2013
        5,201,103       5,201,103       5,201,103  
                             
                  18,738,072       18,055,528  

77


 

 
Fifth Street Finance Corp.
 
Consolidated Schedule of Investments
September 30, 2010