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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2011
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from:                     to                    
Commission File Number: 01-33901
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, White Plains, NY   10606
     
(Address of principal executive office)   (Zip Code)
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 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 (§232.405 of this chapter) 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 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   Smaller reporting company o
        (Do not check if a smaller reporting company)    
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 registrant had 72,375,832 shares of common stock outstanding as of July 28, 2011.
 
 

 


 

FIFTH STREET FINANCE CORP.
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2011
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2


 

PART I — FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Fifth Street Finance Corp.
Consolidated Statements of Assets and Liabilities
(in thousands, except per share data)
(unaudited)
                 
    June 30, 2011     September 30, 2010  
Assets
               
 
               
Investments at fair value:
               
Control investments (cost at June 30, 2011: $13,615; cost at September 30, 2010: $12,195)
  $ 17,490     $ 3,700  
Affiliate investments (cost at June 30, 2011: $34,325; cost at September 30, 2010: $50,134)
    35,174       47,222  
Non-control/Non-affiliate investments (cost at June 30, 2011: $999,612; cost at September 30, 2010: $530,168)
    1,000,815       512,899  
 
               
Total investments at fair value (cost at June 30, 2011: $1,047,552; cost at September 30, 2010: $592,497)
    1,053,479       563,821  
 
               
Cash and cash equivalents
    17,606       76,765  
Interest and fees receivable
    7,198       3,814  
Due from portfolio company
    432       103  
Deferred financing costs
    12,880       5,466  
Collateral posted to bank and other assets
    2,173       1,957  
 
               
Total Assets
  $ 1,093,768     $ 651,926  
 
               
Liabilities and Net Assets
               
 
               
Liabilities:
               
Accounts payable, accrued expenses and other liabilities
  $ 1,532     $ 1,322  
Base management fee payable
    5,381       2,876  
Incentive fee payable
    4,132       2,859  
Due to FSC, Inc.
    820       1,083  
Interest payable
    3,468       283  
Payments received in advance from portfolio companies
    786       1,331  
SBA debentures payable
    150,000       73,000  
Convertible senior notes payable
    152,000        
Total Liabilities
    318,119       82,754  
 
               
Net Assets:
               
Common stock, $0.01 par value, 150,000 shares authorized, 72,376 and 54,550 shares issued and outstanding at June 30, 2011 and September 30, 2010
    724       546  
Additional paid-in-capital
    829,752       619,760  
Net unrealized appreciation (depreciation) on investments and interest rate swap
    5,473       (29,449 )
Net realized loss on investments
    (61,200 )     (33,091 )
Accumulated undistributed net investment income
    900       11,406  
Total Net Assets (equivalent to $10.72 and $10.43 per common share at June 30, 2011 and September 30, 2010) (Note 12)
    775,649       569,172  
 
               
Total Liabilities and Net Assets
  $ 1,093,768     $ 651,926  
See notes to Consolidated Financial Statements.

3


 

Fifth Street Finance Corp.
Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)
                                 
    Three months     Three months     Nine months     Nine months  
    ended June 30,     ended June 30,     ended June 30,     ended June 30,  
    2011     2010     2011     2010  
Interest income:
                               
Control investments
  $ 40     $     $ 54     $ 183  
Affiliate investments
    1,126       1,749       3,416       6,266  
Non-control/Non-affiliate investments
    24,271       13,201       61,963       32,749  
Interest on cash and cash equivalents
    4       7       17       208  
Total interest income
    25,441       14,957       65,450       39,406  
 
                               
PIK interest income:
                               
Control investments
    105             239        
Affiliate investments
    278       293       835       948  
Non-control/Non-affiliate investments
    3,179       2,118       9,103       5,730  
Total PIK interest income
    3,562       2,411       10,177       6,678  
 
                               
Fee income:
                               
Control investments
                127        
Affiliate investments
    283       537       550       1,216  
Non-control/Non-affiliate investments
    2,992       1,117       11,000       2,797  
Total fee income
    3,275       1,654       11,677       4,013  
 
                               
Dividend and other income:
                               
Control investments
                       
Affiliate investments
                       
Non-control/Non-affiliate investments
    164       385       174       408  
Total dividend and other income
    164       385       174       408  
 
                               
Total Investment Income
    32,442       19,407       87,478       50,505  
 
                               
Expenses:
                               
Base management fee
    5,381       2,523       13,946       7,127  
Incentive fee
    4,132       3,008       11,785       7,897  
Professional fees
    456       174       1,654       805  
Board of Directors fees
    46       31       132       112  
Interest expense
    4,977       493       9,640       845  
Administrator expense
    395       357       1,140       928  
General and administrative expenses
    529       789       2,043       1,930  
Total expenses
    15,916       7,375       40,340       19,644  
Base management fee waived
                      (727 )
Net expenses
    15,916       7,375       40,340       18,917  
 
                               
Net Investment Income
    16,526       12,032       47,138       31,588  
Unrealized appreciation (depreciation) on interest rate swap
    (919 )           51        
 
                               
Unrealized appreciation (depreciation) on investments:
                               
Control investments
    5,225       (4,171 )     12,538       (1,691 )
Affiliate investments
    13,931       (2,422 )     3,760       1,306  
Non-control/Non-affiliate investments
    215       (7,328 )     18,573       (11,360 )
Net unrealized appreciation (depreciation) on investments
    19,371       (13,921 )     34,871       (11,745 )
 
                               
Realized gain (loss) on investments:
                               
Control investments
                (7,806 )      
Affiliate investments
    (14,146 )           (14,146 )     (2,908 )
Non-control/Non-affiliate investments
                (6,157 )     106  
Net realized loss on investments
    (14,146 )           (28,109 )     (2,802 )
 
                               
Net increase (decrease) in net assets resulting from operations
  $ 20,832     $ (1,889 )   $ 53,951     $ 17,041  
 
                               
Net investment income per common share — basic
  $ 0.25     $ 0.26     $ 0.77     $ 0.75  
Earnings per common share — basic
  $ 0.31     $ (0.04 )   $ 0.88     $ 0.40  
Weighted average common shares outstanding — basic
    67,081       46,294       61,254       42,379  
 
                               
Net investment income per common share —diluted
  $ 0.24     $ 0.26     $ 0.76     $ 0.75  
Earnings per common share —diluted
  $ 0.30     $ (0.04 )   $ 0.87     $ 0.40  
Weighted average common shares outstanding — diluted
    76,020       46,294       64,233       42,379  
See notes to Consolidated Financial Statements.

4


 

Fifth Street Finance Corp.
Consolidated Statements of Changes in Net Assets
(in thousands, except per share data)
(unaudited)
                 
    Nine months ended     Nine months ended  
    June 30, 2011     June 30, 2010  
Operations:
               
Net investment income
  $ 47,138     $ 31,588  
Net unrealized appreciation (depreciation) on investments and interest rate swap
    34,922       (11,745 )
Net realized loss on investments
    (28,109 )     (2,802 )
 
               
Net increase in net assets from operations
    53,951       17,041  
 
               
Stockholder transactions:
               
Distributions to stockholders
    (57,644 )     (38,285 )
 
               
Net decrease in net assets from stockholder transactions
    (57,644 )     (38,285 )
 
               
Capital share transactions:
               
Issuance of common stock, net
    206,079       178,015  
Issuance of common stock under dividend reinvestment plan
    4,091       1,635  
 
               
Net increase in net assets from capital share transactions
    210,170       179,650  
Total increase in net assets
    206,477       158,406  
Net assets at beginning of period
    569,172       410,556  
Net assets at end of period
  $ 775,649     $ 568,962  
 
               
Net asset value per common share
  $ 10.72     $ 10.43  
 
               
Common shares outstanding at end of period
    72,376       54,525  
See notes to Consolidated Financial Statements.

5


 

Fifth Street Finance Corp.
Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
                 
    Nine months ended     Nine months ended  
    June 30, 2011     June 30, 2010  
Cash flows from operating activities:
               
Net increase in net assets resulting from operations
  $ 53,951     $ 17,041  
Adjustments to reconcile net increase in net assets resulting from operations to net cash used by operating activities:
               
Net unrealized (appreciation) depreciation on investments and interest rate swap
    (34,922 )     11,745  
Net realized losses on investments
    28,109       2,802  
PIK interest income
    (10,177 )     (6,678 )
Recognition of fee income
    (11,677 )     (4,013 )
Accretion of original issue discount on investments
    (1,239 )     (692 )
Amortization of deferred financing costs
    1,816       430  
Change in operating assets and liabilities:
               
Fee income received
    16,866       8,134  
Increase in interest and fees receivable
    (2,252 )     (1,867 )
(Increase) decrease in due from portfolio company
    (329 )     58  
Increase in collateral posted to bank and other assets
    (218 )     (45 )
Increase (decrease) in accounts payable, accrued expenses and other liabilities
    262       (391 )
Increase in base management fee payable
    2,505       970  
Increase in incentive fee payable
    1,272       1,064  
Increase (decrease) in due to FSC, Inc.
    (263 )     160  
Increase in interest payable
    3,185       140  
Decrease in payments received in advance from portfolio companies
    (545 )     (152 )
Purchases of investments and net revolver activity, net of syndications
    (566,835 )     (226,502 )
Principal payments received on investments (scheduled payments)
    19,559       8,242  
Principal payments received on investments (payoffs)
    62,447       6,783  
PIK interest income received in cash
    7,030       782  
Proceeds from the sale of investments
          4,192  
Net cash used by operating activities
    (431,455 )     (177,797 )
Cash flows from financing activities:
               
Dividends paid in cash
    (53,553 )     (36,650 )
Borrowings under SBA debentures payable
    77,000       35,000  
Borrowings under credit facilities
    406,000       43,000  
Repayments of borrowings under credit facilities
    (406,000 )     (43,000 )
Deferred financing costs paid
    (9,230 )     (5,217 )
Proceeds from the issuance of convertible senior notes
    152,000        
Proceeds from the issuance of common stock
    206,788       179,125  
Offering costs paid
    (709 )     (989 )
Net cash provided by financing activities
    372,296       171,269  
Net decrease in cash and cash equivalents
    (59,159 )     (6,528 )
Cash and cash equivalents, beginning of period
    76,765       113,205  
Cash and cash equivalents, end of period
  $ 17,606     $ 106,677  
 
               
Supplemental Information:
               
Cash paid for interest
  $ 4,639     $ 351  
Non-cash financing activities:
               
Issuance of shares of common stock under dividend reinvestment plan
  $ 4,091     $ 1,635  
See notes to Consolidated Financial Statements.

6


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
June 30, 2011
(dollar amounts in thousands)
(unaudited)
                                 
Portfolio Company/Type of Investment (1)(2)(5)   Industry     Principal (8)     Cost     Fair Value  
 
 
                               
Control Investments (3)
                               
Lighting By Gregory, LLC (9)(13)(14)
  Housewares & Specialties                        
 
                               
First Lien Term Loan A, 9.75% due 2/28/2013
          $ 4,259     $ 3,996     $ 3,056  
First Lien Bridge Loan, 6% due 3/31/2012
            113       113        
97.38% membership interest
                    1,210        
                     
 
                               
 
                    5,319       3,056  
 
                               
Nicos Polymers & Grinding Inc.
  Environmental & facilities services                        
First Lien Term Loan, 8% due 12/4/2017
            5,239       5,169       5,298  
First Lien Revolver, 8% due 12/4/2017
            1,500       1,500       1,544  
50% Membership Interest in CD Holdco, LLC
                    1,627       7,592  
                     
 
                               
 
                    8,296       14,434  
                     
 
                               
Total Control Investments
                  $ 13,615     $ 17,490  
                     
 
                               
Affiliate Investments (4)
                               
O’Currance, Inc.
  Data Processing & Outsourced Services                        
 
                               
First Lien Term Loan A, 16.875% due 3/21/2012
            11,298     $ 11,254     $ 11,371  
First Lien Term Loan B, 16.875%, due 3/21/2012
            1,153       1,140       1,200  
1.75% Preferred Membership interest in O’Currance Holding Co., LLC
                    131        
3.3% Membership Interest in O’Currance Holding Co., LLC
                    250        
                     
 
                               
 
                    12,775       12,571  
 
                               
Caregiver Services, Inc.
  Healthcare services                        
Second Lien Term Loan A, LIBOR+6.85% (12% floor) due 2/25/2013
            6,069       5,849       6,225  
Second Lien Term Loan B, 16.5% due 2/25/2013
            15,040       14,621       14,994  
1,080,399 shares of Series A Preferred Stock
                    1,080       1,384  
                     
 
                               
 
                    21,550       22,603  
                     
 
                               
Total Affiliate Investments
                  $ 34,325     $ 35,174  
                     
 
                               
Non-Control/Non-Affiliate Investments (7)
                               
 
                               
CPAC, Inc.
  Household Products                        
 
                               
Subordinated Term Loan, 12.5% due 6/1/2012
            1,169     $ 1,169     $ 1,169  
                     
 
                               
 
                    1,169       1,169  
Repechage Investments Limited
  Restaurants                        
First Lien Term Loan, 15.5% due 10/16/2011
            3,533       3,412       2,840  
7,500 shares of Series A Preferred Stock of Elephant & Castle, Inc.
                    750        
 
                               
                     
 
                               
 
                    4,162       2,840  

7


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
June 30, 2011
(dollar amounts in thousands)
(unaudited)
                                 
Portfolio Company/Type of Investment (1)(2)(5)   Industry     Principal (8)     Cost     Fair Value  
 
 
                               
Traffic Control & Safety Corporation (9)
  Construction and Engineering                        
Senior Term Loan, LIBOR+9% due 6/29/2012
            5,000       4,826       4,798  
Senior Revolver, LIBOR+9% due 6/29/2012
            11,486       11,176       11,143  
Second Lien Term Loan, 12% due 5/28/2015
            20,584       20,378       19,544  
Subordinated Loan, 15% due 5/28/2015
            5,126       5,126       3,263  
24,750 shares of Series B Preferred Stock
                    248        
43,494 shares of Series D Preferred Stock (6)
                    435        
25,000 shares of Common Stock
                    3        
                     
 
                               
 
                    42,192       38,748  
 
                               
TBA Global, LLC
  Advertising                        
53,994 Senior Preferred Shares
                    216       216  
191,977 Shares A Shares
                    192       179  
                     
 
                               
 
                    408       395  
 
                               
Fitness Edge, LLC
  Leisure facilities                        
First Lien Term Loan A, LIBOR+5.25% (10% floor), due 8/8/2012
            875       873       887  
First Lien Term Loan B, 15% due 8/8/2012
            5,739       5,706       5,821  
1,000 Common Units (6)
                    43       153  
                     
 
                               
 
                    6,622       6,861  
 
                               
Filet of Chicken (9)
  Food Distributors                        
Second Lien Term Loan, 14.5% due 7/31/2012
            7,306       7,163       7,379  
                     
 
                               
 
                    7,163       7,379  
 
                               
Boot Barn
  Apparel, accessories & luxury goods                        
247.06 shares of Series A Preferred Stock
                    247       71  
1,308 shares of Common Stock
                    9       9  
                     
 
                               
 
                    256       80  
 
                               
Premier Trailer Leasing, Inc. (9)(13)(14)
  Trucking                        
Second Lien Term Loan, 16.5% due 10/23/2012
            18,913       17,064       3,897  
285 shares of Common Stock
                    1        
                     
 
                               
 
                    17,065       3,897  
Pacific Press Technologies, Inc. (9)
                               
Second Lien Term Loan, 14.75% due 7/10/2013
  Industrial machinery     10,226       10,033       10,265  
33,463 shares of Common Stock
                    345       694  
                     
 
                               
 
                    10,378       10,959  
 
                               
Rail Acquisition Corp.
  Electronic manufacturing services                        
First Lien Term Loan, 17% due 9/1/2013
            17,862       15,083       9,547  
First Lien Revolver, 7.85% due 9/1/2013
            4,470       4,470       4,469  
                     
 
                               
 
                    19,553       14,016  
Western Emulsions, Inc. (9)
  Construction materials                        
Second Lien Term Loan, 15% due 6/30/2014
            6,800       6,682       6,811  
                     
 
                               
 
                    6,682       6,811  
 
                               
Storyteller Theaters Corporation
  Movies & entertainment                        
1,692 shares of Common Stock
                          62  
20,000 shares of Preferred Stock
                    200       200  
                     
 
                               
 
                    200       262  

8


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
June 30, 2011
(dollar amounts in thousands)
(unaudited)
                                 
Portfolio Company/Type of Investment (1)(2)(5)   Industry     Principal (8)     Cost     Fair Value  
 
 
                               
HealthDrive Corporation (9)
  Healthcare services                        
First Lien Term Loan A, 10% due 7/17/2013
            6,363       6,117       6,467  
First Lien Term Loan B, 13% due 7/17/2013
            10,256       10,176       10,519  
First Lien Revolver, 12% due 7/17/2013 (11)
                  (7 )      
                     
 
                               
 
                    16,286       16,986  
 
                               
idX Corporation
  Distributors                        
Second Lien Term Loan, 14.5% due 7/1/2014
            18,799       18,511       18,908  
                     
 
                               
 
                    18,511       18,908  
 
                               
Cenegenics, LLC
  Healthcare services                        
First Lien Term Loan, 17% due 10/27/2014
            19,183       18,431       19,313  
414,419 Common Units (6)
                    599       1,270  
                     
 
                               
 
                    19,030       20,583  
 
                               
IZI Medical Products, Inc.
  Healthcare technology                        
First Lien Term Loan A, 12% due 3/31/2014
            3,536       3,502       3,555  
First Lien Term Loan B, 16% due 3/31/2014
            17,258       16,821       17,245  
First Lien Revolver, 10% due 3/31/2014 (11)
                  (28 )      
453,755 Preferred units of IZI Holdings, LLC (6)
                    454       612  
                     
 
                               
 
                    20,749       21,412  
 
                               
Trans-Trade, Inc.
  Air freight & logistics                        
First Lien Term Loan, 15.5% due 9/10/2014
            12,443       12,188       11,673  
First Lien Revolver, 12% due 9/10/2014
            5,800       5,695       5,447  
                     
 
                               
 
                    17,883       17,120  
 
                               
Riverlake Equity Partners II,LP
  Multi-sector holdings                        
1.89% limited partnership interest
                    122       122  
                     
 
                               
 
                    122       122  
 
                               
Riverside Fund IV, LP
  Multi-sector holdings                        
0.25% limited partnership interest
                    445       445  
                     
 
                               
 
                    445       445  
 
                               
ADAPCO, Inc.
  Fertilizers & agricultural chemicals                        
First Lien Term Loan A, 10% due 12/17/2014
            7,500       7,396       7,580  
First Lien Term Loan B, 14% due 12/17/2014
            14,443       14,251       14,562  
First Lien Revolver, 10% due 12/17/2014
            4,750       4,614       4,838  
                     
 
                               
 
                    26,261       26,980  
 
                               
Ambath/Rebath Holdings, Inc.
  Home improvement retail                        
First Lien Term Loan A, LIBOR+7% (10% floor) due 12/30/2014
            3,750       3,750       3,778  
First Lien Term Loan B, 15% due 12/30/2014
            22,852       22,852       22,833  
First Lien Revolver, LIBOR+6.5% (9.5% floor) due 12/30/2014 (10)
            1,500       1,500       1,508  
                     
 
                               
 
                    28,102       28,119  
JTC Education, Inc.
  Education services                        
 
                               
First Lien Term Loan, LIBOR+9.5% (12.5% floor) due 12/31/2014
            28,299       27,625       28,367  
First Lien Revolver, LIBOR+9.5% (12.75% floor) due 12/31/2014 (11)
                  (329 )      
                     
 
                               
 
                    27,296       28,367  

9


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
June 30, 2011
(dollar amounts in thousands)
(unaudited)
                                 
Portfolio Company/Type of Investment (1)(2)(5)   Industry     Principal (8)     Cost     Fair Value  
 
Tegra Medical, LLC
  Healthcare equipment                        
First Lien Term Loan A, LIBOR+7% (10% floor) due 12/31/2014
            23,590       23,258       23,753  
First Lien Term Loan B, 14% due 12/31/2014
            22,436       22,133       22,411  
First Lien Revolver, LIBOR+7% (10% floor) due 12/31/2014
            1,500       1,445       1,525  
                     
 
                               
 
                    46,836       47,689  
 
                               
Flatout, Inc.
  Food retail                        
First Lien Term Loan A, 10% due 12/31/2014
            6,425       6,296       6,475  
First Lien Term Loan B, 15% due 12/31/2014
            13,025       12,761       13,077  
First Lien Revolver, 10% due 12/31/2014 (11)
                  (32 )      
                     
 
                               
 
                    19,025       19,552  
 
                               
Psilos Group Partners IV, LP
  Multi-sector holdings                        
2.52% limited partnership interest (12)
                           
                     
 
                               
 
                           
Mansell Group, Inc.
  Advertising                        
First Lien Term Loan A, LIBOR+7% (10% floor) due 4/30/2015
            9,750       9,593       9,805  
First Lien Term Loan B, LIBOR+9% (13.5% floor) due 4/30/2015
            8,107       7,976       8,117  
First Lien Revolver, LIBOR+6% (9% floor) due 4/30/2015
            1,000       970       1,015  
                     
 
                               
 
                    18,539       18,937  
 
                               
NDSSI Holdings, Inc.
  Electronic equipment
& instruments
                       
First Lien Term Loan, LIBOR+9.75% (12.75% floor) due 4/30/2015
            29,712       29,247       29,194  
First Lien Revolver, LIBOR+7% (10% floor) due 4/30/2015
            3,500       3,427       3,414  
                     
 
                               
 
                    32,674       32,608  
 
                               
Eagle Hospital Physicians, Inc.
  Healthcare services                        
First Lien Term Loan, LIBOR+8.75% (11.75% floor) due 8/11/2015
            7,700       7,570       7,773  
First Lien Revolver, LIBOR+5.75% (8.75% floor) due 8/11/2015 (11)
                  (41 )      
                     
 
                               
 
                    7,529       7,773  
 
                               
Enhanced Recovery Company, LLC
  Diversified support services                        
First Lien Term Loan A, LIBOR+7% (9% floor) due 8/13/2015
            14,863       14,619       14,925  
First Lien Term Loan B, LIBOR+10% (13% floor) due 8/13/2015
            11,070       10,889       11,089  
First Lien Revolver, LIBOR+7% (9% floor) due 8/13/2015 (11)
                  (66 )      
                     
 
                               
 
                    25,442       26,014  
 
                               
Epic Acquisition, Inc.
  Healthcare services                        
First Lien Term Loan A, LIBOR+8% (11% floor) due 8/13/2015
            8,813       8,669       8,878  
First Lien Term Loan B, 15.25% due 8/13/2015
            17,246       16,964       17,420  
First Lien Revolver, LIBOR+6.5% (9.5% floor) due 8/13/2015 (11)
                  (49 )      
                     
 
                               
 
                    25,584       26,298  
 
                               
Specialty Bakers LLC
  Food distributors                        
First Lien Term Loan A, LIBOR+8.5% due 9/15/2015
            8,550       8,362       8,580  
First Lien Term Loan B, LIBOR+11% (13.5% floor) due 9/15/2015
            11,000       10,763       11,000  
First Lien Revolver, LIBOR+8.5% due 9/15/2015 (11)
                  (87 )      
                     
 
                               
 
                    19,038       19,580  

10


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
June 30, 2011
(dollar amounts in thousands)
(unaudited)
                                 
Portfolio Company/Type of Investment (1)(2)(5)   Industry     Principal (8)     Cost     Fair Value  
 
CRGT, Inc.
  IT consulting & other services                        
First Lien Term Loan A, LIBOR+7.5% due 10/1/2015
            29,000       28,542       29,148  
First Lien Term Loan B, 12.5% due 10/1/2015
            22,000       21,626       22,115  
First Lien Revolver, LIBOR+7.5% due 10/1/2015 (11)
                  (213 )      
                     
 
                               
 
                    49,955       51,263  
 
                               
Welocalize, Inc.
  Internet software & services                        
First Lien Term Loan A, LIBOR+8% (10% floor) due 11/19/2015
            16,195       15,908       16,290  
First Lien Term Loan B, LIBOR+9% (12.25% floor) due 11/19/2015
            21,163       20,799       21,130  
First Lien Revolver, LIBOR+7% (9% floor) due 11/19/2015
            4,250       4,146       4,282  
2,086,163 Common Units in RPWL Holdings, LLC
                    2,086       2,127  
                     
 
                               
 
                    42,939       43,829  
Miche Bag, LLC
  Apparel,accessories & luxury goods                        
First Lien Term Loan A, LIBOR+9% (12% floor) due 12/7/2013
            15,000       14,696       15,151  
First Lien Term Loan B, LIBOR+10% (16% floor) due 12/7/2015
            17,293       14,704       17,399  
First Lien Revolver, LIBOR+7% (10% floor) due 12/7/2015 (11)
                  (112 )      
10,371 Preferred Equity units in Miche Holdings, LLC (6)
                    1,037       1,421  
146,289 Series D Common Equity units in Miche Holdings, LLC (6)
                    1,463       2,004  
                     
 
                               
 
                    31,788       35,975  
 
                               
Bunker Hill Capital II (QP), L.P.
  Multi-sector holdings                        
0.50% limited partnership interest
                    40       40  
                     
 
                               
 
                    40       40  
Dominion Diagnostics, LLC (9)
  Healthcare services                        
First Lien Term Loan A, LIBOR+7% (9.5% floor) due 12/17/2015
            29,950       29,400       30,266  
First Lien Term Loan B, LIBOR+10.5% (14% floor) due 12/17/2015
            20,008       19,655       20,103  
First Lien Revolver, LIBOR+6.5% (9% floor) due 12/17/2015 (11)
                  (89 )      
                     
 
                    48,966       50,369  
Advanced Pain Management
  Healthcare services                        
First Lien Term Loan, LIBOR+5% (6.75% floor) due 12/22/2015
            8,098       7,968       8,105  
First Lien Revolver, LIBOR+5% (6.75% floor) due 12/22/2015
            200       194       210  
                     
 
                    8,162       8,315  
DISA, Inc.
  Human resources & employment services                        
First Lien Term Loan A, LIBOR+7.5% (8.25% floor) due 12/30/2015
            12,730       12,503       12,861  
First Lien Term Loan B, LIBOR+11.5% (12.5% floor) due 12/30/2015
            8,363       8,219       8,429  
First Lien Revolver, LIBOR+6% (7% floor) due 12/30/2015 (11)
                  (70 )      
                     
 
                    20,652       21,290  
Saddleback Fence and Vinyl Products, Inc.
  Building
products
                       
First Lien Term Loan, 8% due 11/30/2013
            773       773       773  
First Lien Revolver, 8% due 11/30/2011
                         
                     
 
                               
 
                    773       773  
Best Vinyl Fence & Deck, LLC
  Building
Products
                       
First Lien Term Loan A, 8% due 11/30/2013
            2,061       1,947       2,061  
First Lien Term Loan B, 8% due 5/31/2011
            3,943       3,942       3,942  
First Lien Revolver, 8% due 11/30/2011
                         
                     
 
                               
 
                    5,889       6,003  

11


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
June 30, 2011
(dollar amounts in thousands)
(unaudited)
                                 
Portfolio Company/Type of Investment (1)(2)(5)   Industry     Principal (8)     Cost     Fair Value  
 
Physicians Pharmacy Alliance, Inc.
  Healthcare services                        
First Lien Term Loan, LIBOR+10.5% due 1/4/2016
            16,913       16,579       17,027  
First Lien Revolver, LIBOR+6% due 1/4/2016 (11)
                  (39 )      
                     
 
                               
 
                    16,540       17,027  
Cardon Healthcare Network, LLC
  Diversified support services                        
First Lien Term Loan, LIBOR+10% (11.75% floor) due 1/6/2016
            11,700       11,478       11,761  
First Lien Revolver, LIBOR+6.5% (8.25% floor) due 1/6/2016 (11)
                  (38 )      
                     
 
                    11,440       11,761  
U.S. Retirement Partners, Inc.
  Diversified financial services                        
First Lien Term Loan, LIBOR+9.5% (11.5% floor) due 1/6/2016
            12,700       12,385       12,775  
                     
 
                    12,385       12,775  
IOS Acquisitions, Inc.
  Oil & gas equipment & services                        
First Lien Term Loan A, LIBOR+8% (10% floor) due 1/14/2016
            9,035       8,890       9,036  
First Lien Term Loan B, LIBOR+12% (14% floor) due 1/14/2016
            10,564       10,393       10,536  
First Lien Revolver, LIBOR+8% (10% floor) due 1/14/2016 (11)
                  (38 )      
                     
 
                    19,245       19,572  
Actient Pharmaceuticals LLC
  Healthcare services                        
First Lien Term Loan, LIBOR+6.25% (8.25% floor) due 7/29/2015
            9,754       9,578       9,897  
                     
 
                    9,578       9,897  
Phoenix Brands Merger Sub LLC
  Household products                        
Senior Term Loan, LIBOR+5% (6.5% floor) due 1/31/2016
            8,304       8,131       8,379  
Subordinated Term Loan, LIBOR+13.875% due 2/1/2017
            20,193       19,821       20,245  
First Lien Revolver, LIBOR+5% (6.5% floor) due 1/31/2016
            4,286       4,153       4,282  
                     
 
                    32,105       32,906  
U.S. Collections, Inc.
  Diversified support services                        
First Lien Term Loan, LIBOR+5.25% (7% floor) due 3/31/2016
            10,985       10,775       10,985  
                     
 
                    10,775       10,985  
CCCG, LLC
  Oil & gas equipment & services                        
First Lien Term Loan, LIBOR+9% (10.75% floor) due 7/29/2015
            34,825       34,166       34,862  
                     
 
                    34,166       34,862  
Maverick Healthcare Group, LLC
  Healthcare equipment                        
First Lien Term Loan, LIBOR+9% (10.75% floor) due 12/31/2016
            24,875       24,335       25,016  
                     
 
                    24,335       25,016  

12


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
June 30, 2011
(dollar amounts in thousands)
(unaudited)
                                 
Portfolio Company/Type of Investment (1)(2)(5)   Industry     Principal (8)     Cost     Fair Value  
 
Refac Optical Group
  Specialty Stores                        
First Lien Term Loan A, LIBOR+7.5% due 3/23/2016
            14,365       14,036       14,409  
First Lien Term Loan B, LIBOR+10.25% due 3/23/2016
            20,122       19,663       20,235  
First Lien Revolver, LIBOR+7.5% due 3/23/2016 (11)
                  (123 )      
1,000 Shares of Common Stock in Refac Holdings, Inc.
                    1       1  
1,000 Shares of Preferred Stock in Refac Holdings, Inc.
                    999       992  
                     
 
                               
 
                    34,576       35,637  
 
                               
Pacific Architects & Engineers, Inc.
  Diversified support services                        
First Lien Term Loan A, LIBOR+5% (6.5% floor) due 4/4/2017
            4,500       4,433       4,500  
First Lien Term Loan B, LIBOR+7% (8.5% floor) due 4/4/2017
            5,000       4,926       5,000  
                     
 
                               
 
                    9,359       9,500  
 
                               
Ernest Health, Inc.
  Healthcare services                        
Second Lien Term Loan, LIBOR+8.5% (10.25% floor) due 5/13/2017
            25,000       24,638       25,000  
 
                               
                     
 
                               
 
                    24,638       25,000  
Securus Technologies, Inc.
  Integrated telecommunication services                        
Second Lien Term Loan, LIBOR+8.25% (10% floor) due 5/31/2018
            26,500       25,976       26,500  
 
                               
                     
 
                               
 
                    25,976       26,500  
Gundle/SLT Environmental, Inc.
  Environmental & facilities services                        
First Lien Term Loan, LIBOR+5.5% (7% floor) due 5/27/2016
            8,000       7,921       8,000  
                     
 
                    7,921       8,000  
Titan Fitness, LLC
  Leisure facilities                        
First Lien Term Loan A, LIBOR+8.75% (10% floor) due 6/30/2016
            17,500       17,298       17,500  
First Lien Term Loan B, LIBOR+10.75% (13.5% floor) due 6/30/2016
            11,500       11,369       11,500  
First Lien Term Loan C, 18% due 6/30/2016
            2,600       2,570       2,600  
First Lien Revolver, LIBOR+8.75% (10% floor) due 6/30/2016
            1,008       970       1,010  
                     
 
                    32,207       32,610  
Baird Capital Partners V, LP
  Multi-sector holdings                        
0.4% limited partnership interest (12)
                           
                     
 
                               
0.4% limited partnership interest (12)
                           
 
                  $ 999,612     $ 1,000,815  
                     
 
                               
Total Portfolio Investments
                  $ 1,047,552     $ 1,053,479  
                     

13


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
June 30, 2011
(unaudited)
 
(1)   All debt investments are income producing unless otherwise noted in (13) or (14) below. Interest rates and floors may contain fixed rate PIK provisions. Equity is non-income producing unless otherwise noted.
 
(2)   See Note 3 to the Consolidated Financial Statements for portfolio composition by geographic region.
 
(3)   Control Investments are defined by the Investment Company Act of 1940 (“1940 Act”) as investments in companies in which the Company owns more than 25% of the voting securities or maintains greater than 50% of the board representation.
 
(4)   Affiliate Investments are defined by the 1940 Act as investments in companies in which the Company owns between 5% and 25% of the voting securities.
 
(5)   Equity ownership may be held in shares or units of companies related to the portfolio companies.
 
(6)   Income producing through payment of dividends or distributions.
 
(7)   Non-Control/Non-Affiliate Investments are defined by the 1940 Act as investments that are neither Control Investments nor Affiliate Investments.
 
(8)   Principal includes accumulated PIK interest and is net of repayments.
 
(9)   Interest rates have been adjusted on certain term loans and revolvers. These rate adjustments are temporary in nature due to financial or payment covenant violations in the original credit agreements, or permanent in nature per loan amendment or waiver documents. The table below summarizes these rate adjustments by portfolio company:
                 
Portfolio Company   Effective date   Cash interest   PIK interest   Reason
Filet of Chicken
  April 1, 2011   + 1.0% on Term Loan       Tier pricing per waiver
agreement
Dominion Diagnostics, LLC
  April 1, 2011   - 0.5% on Term Loan A   - 1.0% on Term Loan B   Tier pricing per credit
agreement
Lighting by Gregory, LLC
  March 11, 2011   - 2.0% on Bridge Loan       Per loan amendment
Western Emulsions, Inc.
  September 30, 2010       + 3.0% on Term Loan   Per loan agreement
Pacific Press Technologies, Inc.
  July 1, 2010   - 2.0% on Term Loan   - 0.75% on Term Loan   Per waiver agreement
Traffic Control & Safety Corp.
  May 28, 2010   - 4.0% on Second Lien Term Loan   + 1.0% on Second Lien Term Loan   Per restructuring agreement
Premier Trailer Leasing, Inc.
  August 4, 2009   + 4.0% on Term Loan       Default interest per credit
agreement
HealthDrive Corporation
  April 30, 2009   + 2.0% on Term Loan A       Per waiver agreement
 
(10)   Revolving credit line has been suspended and is deemed unlikely to be renewed in the future.
 
(11)   Cost amounts represent unearned income related to undrawn commitments.
 
(12)   Represents an unfunded commitment to fund a limited partnership interest.
 
(13)   Investment was on cash non-accrual status as of June 30, 2011.
 
(14)   Investment was on PIK non-accrual status as of June 30, 2011.
See notes to Consolidated Financial Statements.

14


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
(dollar amounts in thousands)
September 30, 2010
                                 
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     $ 4,729     $ 1,504  
First Lien Term Loan B, 14.5% due 2/28/2013
            8,576       6,906       2,196  
First Lien Bridge Loan, 8% due 10/15/2010
            152       150        
97.38% membership interest
                    410        
 
                           
 
                    12,195       3,700  
 
                           
Total Control Investments
                  $ 12,195     $ 3,700  
 
                           
Affiliate Investments(4)
                               
O’Currance, Inc.
  Data Processing & Outsourced Services                        
First Lien Term Loan A, 16.875% due 3/21/2012
            10,961     $ 10,869     $ 10,806  
First Lien Term Loan B, 16.875%, due 3/21/2012
            1,854       1,828       1,897  
1.75% Preferred Membership interest in O’Currance Holding Co., LLC
                    130       38  
3.3% Membership Interest in O’Currance Holding Co., LLC
                    251        
 
                           
 
                    13,078       12,741  
MK Network, LLC(13)(14)
  Education services                        
First Lien Term Loan A, 13.5% due 6/1/2012
            9,740       9,539       7,913  
First Lien Term Loan B, 17.5% due 6/1/2012
            4,926       4,748       3,939  
First Lien Revolver, Prime + 1.5% (10% floor), due 6/1/2010(10)
                         
11,030 Membership Units(6)
                    772        
 
                           
 
                    15,059       11,852  
Caregiver Services, Inc.
  Healthcare services                        
Second Lien Term Loan A, LIBOR+6.85% (12% floor) due 2/25/2013
            7,141       6,813       7,114  
Second Lien Term Loan B, 16.5% due 2/25/2013
            14,692       14,103       14,180  
1,080,399 shares of Series A Preferred Stock
                    1,081       1,335  
 
                           
 
                    21,997       22,629  
 
                           
Total Affiliate Investments
                  $ 50,134     $ 47,222  
 
                           
Non-Control/Non-Affiliate Investments(7)
                               
CPAC, Inc.
  Household Products                        
Subordinated Term Loan, 12.5% due 6/1/2012
            1,065     $ 1,065     $ 1,065  
 
                           
 
                    1,065       1,065  
Vanguard Vinyl, Inc.(9)(13)(14)
  Building Products                        
First Lien Term Loan, 12% due 3/30/2013
            7,000       6,827       5,812  
First Lien Revolver, LIBOR+7% (10% floor) due 3/30/2013
            1,250       1,208       1,029  
25,641 Shares of Series A Preferred Stock
                    254        
25,641 Shares of Common Stock
                    3        
 
                           
 
                    8,292       6,841  
Repechage Investments Limited
  Restaurants                        
First Lien Term Loan, 15.5% due 10/16/2011
            3,709       3,476       3,486  
7,500 shares of Series A Preferred Stock of Elephant & Castle, Inc.
                    750       354  
 
                           
 
                    4,226       3,840  

15


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
(dollar amounts in thousands)
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
            19,970       19,724       19,440  
Subordinated Loan, 15% due 5/28/2015
            4,578       4,578       4,405  
24,750 shares of Series B Preferred Stock
                    248        
43,494 shares of Series D Preferred Stock(6)
                    435        
25,000 shares of Common Stock
                    2        
 
                           
 
                    24,987       23,845  
Nicos Polymers & Grinding Inc.(9)(13)(14)
  Environmental & facilities services                        
First Lien Term Loan A, LIBOR+5% (10% floor), due 7/17/2012
            3,155       3,040       1,782  
First Lien Term Loan B, 13.5% due 7/17/2012
            6,180       5,713       3,348  
3.32% Interest in Crownbrook Acquisition I LLC
                    169        
 
                           
 
                    8,922       5,130  
TBA Global, LLC(9)
  Advertising                        
Second Lien Term Loan B, 14.5% due 8/3/2012
            10,840       10,595       10,626  
53,994 Senior Preferred Shares
                    216       216  
191,977 Shares A Shares
                    192       179  
 
                           
 
                    11,003       11,021  
Fitness Edge, LLC
  Leisure Facilities                        
First Lien Term Loan A, LIBOR+5.25% (10% floor), due 8/8/2012
            1,250       1,245       1,247  
First Lien Term Loan B, 15% due 8/8/2012
            5,632       5,575       5,674  
1,000 Common Units (6)
                    44       119  
 
                           
 
                    6,864       7,040  
Filet of Chicken(9)
  Food Distributors                        
Second Lien Term Loan, 14.5% due 7/31/2012
            9,317       9,063       8,965  
 
                           
 
                    9,063       8,965  
Boot Barn(9)
  Apparel, accessories & luxury goods                        
Second Lien Term Loan, 14.5% due 10/3/2013
            23,545       23,289       23,478  
247.06 shares of Series A Preferred Stock
                    247       71  
1,308 shares of Common Stock
                           
 
                           
 
                    23,536       23,549  
Premier Trailer Leasing, Inc.(9)(13)(14)
  Trucking                        
Second Lien Term Loan, 16.5% due 10/23/2012
            18,453       17,064       4,597  
285 shares of Common Stock
                    1        
 
                           
 
                    17,065       4,597  
Pacific Press Technologies, Inc.(9)
                               
Second Lien Term Loan, 14.75% due 7/10/2013
  Industrial machinery     10,072       9,799       9,830  
33,786 shares of Common Stock
                    344       403  
 
                           
 
                    10,143       10,233  
Goldco, LLC
                               
Second Lien Term Loan, 17.5% due 1/31/2013
  Restaurants     8,356       8,259       8,259  
 
                           
 
                    8,259       8,259  
Rail Acquisition Corp.(9)
  Electronic manufacturing services                        
First Lien Term Loan, 17% due 9/1/2013
            16,316       13,537       12,854  
First Lien Revolver, 7.85% due 9/1/2013
            5,201       5,201       5,202  
 
                           
 
                    18,738       18,056  

16


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
(dollar amounts in thousands)
September 30, 2010
                                 
Portfolio Company/Type                        
of Investment(1)(2)(5)   Industry     Principal(8)     Cost     Fair Value  
Western Emulsions, Inc.(9)
  Construction materials                        
Second Lien Term Loan, 15% due 6/30/2014
            17,865       17,476       17,040  
 
                           
 
                    17,476       17,040  
Storyteller Theaters Corporation
  Movies & entertainment                        
1,692 shares of Common Stock
                          62  
20,000 shares of Preferred Stock
                    200       200  
 
                           
 
                    200       262  
HealthDrive Corporation(9)
  Healthcare services                        
First Lien Term Loan A, 10% due 7/17/2013
            6,663       6,324       6,489  
First Lien Term Loan B, 13% due 7/17/2013
            10,179       10,069       9,962  
First Lien Revolver, 12% due 7/17/2013
            500       489       509  
 
                           
 
                    16,882       16,960  
idX Corporation
  Distributors                        
Second Lien Term Loan, 14.5% due 7/1/2014
            13,589       13,351       13,258  
 
                           
 
                    13,351       13,258  
Cenegenics, LLC
  Healthcare services                        
First Lien Term Loan, 17% due 10/27/2014
            20,172       19,257       19,545  
414,419 Common Units(6)
                    598       1,417  
 
                           
 
                    19,855       20,962  
IZI Medical Products, Inc.
  Healthcare technology                        
First Lien Term Loan A, 12% due 3/31/2014
            4,450       4,388       4,407  
First Lien Term Loan B, 16% due 3/31/2014
            17,258       16,702       17,093  
First Lien Revolver, 10% due 3/31/2014(11)
                  (35 )     (35 )
453,755 Preferred units of IZI Holdings, LLC (6)
                    454       676  
 
                           
 
                    21,509       22,141  
Trans-Trade, Inc.
  Air freight & logistics                        
First Lien Term Loan, 15.5% due 9/10/2014
            12,751       12,536       12,549  
First Lien Revolver, 12% due 9/10/2014
            1,500       1,469       1,492  
 
                           
 
                    14,005       14,041  
Riverlake Equity Partners II, LP
  Multi-sector holdings                        
1.87% limited partnership interest
                    34       34  
 
                           
 
                    34       34  
Riverside Fund IV, LP
  Multi-sector holdings                        
0.33% limited partnership interest
                    136       136  
 
                           
 
                    136       136  
ADAPCO, Inc.
  Fertilizers & agricultural chemicals                        
First Lien Term Loan A, 10% due 12/17/2014
            9,000       8,789       8,807  
First Lien Term Loan B, 14% due 12/17/2014
            14,226       13,893       13,898  
First Lien Term Revolver, 10% due 12/17/2014
            4,250       4,013       4,107  
 
                           
 
                    26,695       26,812  

17


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
(dollar amounts in thousands)
September 30, 2010
                                 
Portfolio Company/Type                        
of Investment(1)(2)(5)   Industry     Principal(8)     Cost     Fair Value  
Ambath/Rebath Holdings, Inc.
  Home improvement retail                        
First Lien Term Loan A, LIBOR+7% (10% floor) due 12/30/2014
            9,500       9,278       9,128  
First Lien Term Loan B, 15% due 12/30/2014
            22,424       21,920       21,913  
First Lien Term Revolver, LIBOR+6.5% (9.5% floor) due 12/30/2014
            1,500       1,433       1,443  
 
                           
 
                    32,631       32,484  
JTC Education, Inc.
  Education services                        
First Lien Term Loan, LIBOR+9.5% (12.5% floor) due 12/31/2014
            31,055       30,244       30,660  
First Lien Revolver, LIBOR+9.5% (12.75% floor) due 12/31/2014(11)
                  (401 )     (401 )
 
                           
 
                    29,843       30,259  
Tegra Medical, LLC
  Healthcare equipment                        
First Lien Term Loan A, LIBOR+7% (10% floor) due 12/31/2014
            26,320       25,877       26,250  
First Lien Term Loan B, 14% due 12/31/2014
            22,099       21,729       22,114  
First Lien Revolver, LIBOR+7% (10% floor) due 12/31/2014(11)
                  (66 )     (66 )
 
                           
 
                    47,540       48,298  
Flatout, Inc.
  Food retail                        
First Lien Term Loan A, 10% due 12/31/2014
            7,300       7,121       7,144  
First Lien Term Loan B, 15% due 12/31/2014
            12,863       12,540       12,644  
First Lien Revolver, 10% due 12/31/2014(11)
                  (39 )     (38 )
 
                           
 
                    19,622       19,750  
Psilos Group Partners IV, LP
  Multi-sector holdings                        
2.53% limited partnership interest(12)
                           
 
                           
2.53% limited partnership interest(12)
                           
 
                           
Mansell Group, Inc.
  Advertising                        
First Lien Term Loan A, LIBOR+7% (10% floor) due 4/30/2015
            5,000       4,910       4,916  
First Lien Term Loan B, LIBOR+9% (13.5% floor) due 4/30/2015
            4,026       3,952       3,947  
First Lien Revolver, LIBOR+6% (9% floor) due 4/30/2015(11)
                  (37 )     (37 )
 
                           
 
                    8,825       8,826  
NDSSI Holdings, Inc.
  Electronic equipment & instruments                        
First Lien Term Loan, LIBOR+9.75% (13.75% floor) due 9/10/2014
            30,246       29,685       29,409  
First Lien Revolver, LIBOR+7% (10% floor) due 9/10/2014
            3,500       3,409       3,479  
 
                           
 
                    33,094       32,888  
Eagle Hospital Physicians, Inc.
  Healthcare services                        
First Lien Term Loan, LIBOR+8.75% (11.75% floor) due 8/11/2015
            8,000       7,784       7,784  
First Lien Revolver, LIBOR+5.75% (8.75% floor) due 8/11/2015
                  (65 )     (65 )
 
                           
 
                    7,719       7,719  
Enhanced Recovery Company, LLC
  Diversified support services                        
First Lien Term Loan A, LIBOR+7% (9% floor) due 8/13/2015
            15,500       15,172       15,172  
First Lien Term Loan B, LIBOR+10% (13% floor) due 8/13/2015
            11,015       10,782       10,782  
First Lien Revolver, LIBOR+7% (9% floor) due 8/13/2015
            377       292       292  
 
                           
 
                    26,246       26,246  

18


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
(dollar amounts in thousands)
September 30, 2010
                                 
Portfolio Company/Type                        
of Investment(1)(2)(5)   Industry     Principal(8)     Cost     Fair Value  
Epic Acquisition, Inc.
  Healthcare services                        
First Lien Term Loan A, LIBOR+8% (11% floor) due 8/13/2015
            7,750       7,555       7,555  
First Lien Term Loan B, 15.25% due 8/13/2015
            13,555       13,212       13,212  
First Lien Revolver, LIBOR+6.5% (9.5% floor) due 8/13/2015
            300       223       223  
 
                           
 
                    20,990       20,990  
Specialty Bakers LLC
  Food distributors                        
First Lien Term Loan A, LIBOR+8.5% due 9/15/2015
            9,000       8,756       8,756  
First Lien Term Loan B, LIBOR+11% (13.5% floor) due 9/15/2015
            11,000       10,704       10,704  
First Lien Revolver, LIBOR+8.5% due 9/15/2015
            2,000       1,892       1,892  
 
                           
 
                    21,352       21,352  
 
                           
Total Non-Control/Non-Affiliate Investments
                  $ 530,168     $ 512,899  
 
                           
Total Portfolio Investments
                  $ 592,497     $ 563,821  
 
                           
 
(1)   All debt investments are income producing unless otherwise noted in (13) or (14) below. Interest rates and floors may contain fixed rate PIK provisions. Equity is non-income producing unless otherwise noted.
 
(2)   See Note 3 to the Consolidated Financial Statements for portfolio composition by geographic region.
 
(3)   Control Investments are defined by the Investment Company Act of 1940 (“1940 Act”) as investments in companies in which the Company owns more than 25% of the voting securities or maintains greater than 50% of the board representation.
 
(4)   Affiliate Investments are defined by the 1940 Act as investments in companies in which the Company owns between 5% and 25% of the voting securities.
 
(5)   Equity ownership may be held in shares or units of companies related to the portfolio companies.
 
(6)   Income producing through payment of dividends or distributions.
 
(7)   Non-Control/Non-Affiliate Investments are defined by the 1940 Act as investments that are neither Control Investments nor Affiliate Investments.
 
(8)   Principal includes accumulated PIK interest and is net of repayments.

19


 

Fifth Street Finance Corp.
Consolidated Schedule of Investments
September 30, 2010
 
(9)   Interest rates have been adjusted on certain term loans and revolvers. These rate adjustments are temporary in nature due to financial or payment covenant violations in the original credit agreements, or permanent in nature per loan amendment or waiver documents. The table below summarizes these rate adjustments by portfolio company:
                 
Portfolio Company   Effective date   Cash interest   PIK interest   Reason
Nicos Polymers & Grinding, Inc.
  February 10, 2008       + 2.0% on Term Loan A & B   Per waiver agreement
TBA Global, LLC
  February 15, 2008       + 2.0% on Term Loan B   Per waiver agreement
Vanguard Vinyl, Inc.
  April 1, 2008   + 0.5% on Term Loan       Per loan amendment
Filet of Chicken
  January 1, 2009   + 1.0% on Term Loan       Tier pricing per waiver agreement
Boot Barn
  January 1, 2009   + 1.0% on Term Loan   + 2.5% on Term Loan   Tier pricing per waiver agreement
HealthDrive Corporation
  April 30, 2009   + 2.0% on Term Loan A       Per waiver agreement
Premier Trailer Leasing, Inc.
  August 4, 2009   + 4.0% on Term Loan       Default interest per credit agreement
Rail Acquisition Corp.
  May 1, 2010   - 4.5% on Term Loan   - 0.5% on Term Loan   Per restructuring agreement
Traffic Control & Safety Corp.
  May 28, 2010   - 4.0% on Term Loan   + 1.0% on Term Loan   Per restructuring agreement
Pacific Press Technologies, Inc.
  July 1, 2010   - 2.0% on Term Loan   - 0.75% on Term Loan   Per waiver agreement
Western Emulsions, Inc.
  September 30, 2010       + 3.0% on Term Loan   Per loan agreement
 
(10)   Revolving credit line has been suspended and is deemed unlikely to be renewed in the future.
 
(11)   Amounts represent unearned income related to undrawn commitments.
 
(12)   Represents an unfunded commitment to fund a limited partnership interest.
 
(13)   Investment was on cash non-accrual status as of September 30, 2010.
 
(14)   Investment was on PIK non-accrual status as of September 30, 2010.

20


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
Note 1. Organization
     Fifth Street Mezzanine Partners III, L.P. (the “Partnership”), a Delaware limited partnership, was organized on February 15, 2007 to primarily invest in debt securities of small and middle market companies. FSMPIII GP, LLC was the Partnership’s general partner (the “General Partner”). The Partnership’s investments were managed by Fifth Street Management LLC (the “Investment Adviser”). The General Partner and Investment Adviser were under common ownership.
     Effective January 2, 2008, the Partnership merged with and into Fifth Street Finance Corp. (the “Company”), an externally managed, closed-end, non-diversified management investment company that has elected to be treated as a business development company under the Investment Company Act of 1940 (the “1940 Act”). Fifth Street Finance Corp. is managed by the Investment Adviser. Prior to January 2, 2008, references to the Company are to the Partnership. Since January 2, 2008, references to the “Company”, “FSC”, “we” or “our” are to Fifth Street Finance Corp., unless the context otherwise requires.
     The Company also has certain wholly-owned subsidiaries, including subsidiaries that are not consolidated for income tax purposes, which hold certain portfolio investments of the Company. The subsidiaries are consolidated with the Company for accounting purposes, and the portfolio investments held by the subsidiaries are included in the Company’s Consolidated Financial Statements. All significant intercompany balances and transactions have been eliminated.
     The Company’s shares are listed on the New York Stock Exchange under the symbol “FSC.” The following table reflects common stock offerings that have occurred since inception:
                             
                Offering        
Date   Transaction   Shares     price     Gross proceeds
June 17, 2008
  Initial public offering     10,000,000     $ 14.12     $ 141.2 million
July 21, 2009
  Follow-on public offering (including underwriters’exercise of over-allotment option)     9,487,500     $ 9.25     $ 87.8 million
September 25, 2009
  Follow-on public offering (including underwriters’ exercise of over-allotment option)     5,520,000     $ 10.50     $ 58.0 million
January 27, 2010
  Follow-on public offering     7,000,000     $ 11.20     $ 78.4 million
February 25, 2010
  Underwriters’ exercise of over-allotment option     300,500     $ 11.20     $ 3.4 million
June 21, 2010
  Follow-on public offering (including underwriters’exercise of over-allotment option)     9,200,000     $ 11.50     $ 105.8 million
December 2010
  At-the-Market offering     429,110     $ 11.87 (1)   $ 5.1 million
February 4, 2011
  Follow-on public offering (including underwriters’ exercise of over-allotment option)     11,500,000     $ 12.65     $ 145.5 million
June 24, 2011
  Follow-on public offering (including underwriters’ exercise of over-allotment option)     5,558,469     $ 11.72     $ 65.1 million
 
(1)   Average offering price
     On February 3, 2010, the Company’s consolidated wholly-owned subsidiary, Fifth Street Mezzanine Partners IV, L.P., received a license, effective February 1, 2010, from the United States Small Business Administration, or SBA, to operate as a small business investment company, or 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 the Company’s 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

21


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
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 the Company’s 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 June 30, 2011, the Company’s SBIC subsidiary had $75 million in regulatory capital. The SBA has issued a capital commitment to the Company’s SBIC subsidiary in the amount of $150 million, and $150.0 million of SBA debentures were outstanding as of June 30, 2011. $73.0 million of these debentures bear interest at a rate of 3.50% per annum, including the SBA annual charge of 0.285%, $65.3 million of these debentures bear interest at a rate of 4.369% per annum, including the SBA annual charge of 0.285%, and the remainder do not yet have a locked interest rate.
     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, the Company’s SBIC subsidiary may also be limited in its ability to make distributions to the Company if it does not have sufficient capital, in accordance with SBA regulations.
     The Company’s 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 the SBIC subsidiary will receive SBA-guaranteed debenture funding and is dependent upon the SBIC subsidiary continuing to be in compliance with SBA regulations and policies.
     The SBA, as a creditor, will have a superior claim to the SBIC subsidiary’s assets over the Company’s stockholders in the event the Company liquidates the SBIC subsidiary or the SBA exercises its remedies under the SBA-guaranteed debentures issued by the SBIC subsidiary upon an event of default.
     The Company has received exemptive relief from the Securities and Exchange Commission (“SEC”) to permit it to exclude the debt of the SBIC subsidiary guaranteed by the SBA from the definition of senior securities in the Company’s 200% asset coverage test under the 1940 Act. This allows the Company increased flexibility under the 200% asset coverage test by permitting it to borrow up to $150 million more than it would otherwise be able to under the 1940 Act absent the receipt of this exemptive relief.
Note 2. Significant Accounting Policies
Basis of Presentation and Liquidity:
     The Consolidated Financial Statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and Regulation S-X. In the opinion of management, all adjustments of a normal recurring nature considered necessary for the fair presentation of the Consolidated Financial Statements have been made. The financial results of the Company’s portfolio investments are not consolidated in the Company’s Consolidated Financial Statements.
     Although the Company expects to fund the growth of its investment portfolio through the net proceeds from the recent and future debt and equity offerings, the Company’s dividend reinvestment plan, and issuances of senior securities or future borrowings, to the extent permitted by the 1940 Act, the Company cannot assure that its plans to raise capital will be successful. In addition, the Company intends to distribute to its stockholders between 90% and 100% of its taxable income each year in order to satisfy the requirements applicable to Regulated Investment Companies (“RICs”) under Subchapter M of the Internal Revenue Code (“Code”). Consequently, the Company may not have the funds or the ability to fund new investments, to make additional investments in its portfolio companies, to fund its unfunded commitments to portfolio companies or to repay borrowings. In addition, the illiquidity of its portfolio investments may make it difficult for the Company to sell these investments when desired and, if the Company is required to sell these investments, it may realize significantly less than their recorded value.
Use of Estimates:
     The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions affecting amounts reported in the financial statements and accompanying notes. These estimates are based on the information that is currently available to the Company and on various other assumptions that the Company believes to be reasonable under the circumstances. Actual results could differ materially from those estimates under different assumptions and conditions. The most significant estimates inherent in the preparation of the Company’s Consolidated Financial Statements are the valuation of investments and revenue recognition.
     The Consolidated Financial Statements include portfolio investments at fair value of $1.05 billion and $563.8 million at June 30, 2011 and September 30, 2010, respectively. The portfolio investments represent 135.8% and 99.1% of net assets at June 30, 2011 and September 30, 2010, respectively, and their fair values have been determined by the Company’s Board of Directors in good faith in the absence of readily available market values. Because of the inherent uncertainty of valuation, the determined values may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.
     The Company classifies its investments in accordance with the requirements of the 1940 Act. Under the 1940 Act, “Control Investments” are defined as investments in companies in which the Company owns more than 25% of the voting securities or has rights to maintain greater than 50% of the board representation; “Affiliate Investments” are defined as investments in companies in which the Company owns between 5% and 25% of the voting securities; and “Non-Control/Non-Affiliate Investments” are defined as investments that are neither Control Investments nor Affiliate Investments.

22


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
Fair Value Measurements:
     The Financial Accounting Standards Board Accounting Standards Codification (“ASC”) Topic 820 Fair Value Measurements and Disclosures (“ASC 820”) defines fair value as the amount 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. A liability’s fair value is defined as the amount that would be paid to transfer the liability to a new obligor, not the amount that would be paid to settle the liability with the creditor. 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.
     Assets recorded at fair value in the Company’s Consolidated Financial Statements are categorized based upon the level of judgment associated with the inputs used to measure their fair value.
     Hierarchical levels, defined by ASC 820 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:
    Level 1 — Unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.
 
    Level 2 — Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data at the measurement date for substantially the full term of the assets or liabilities.
 
    Level 3 — Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.
     Under ASC 820, the Company performs detailed valuations of its debt and equity investments on an individual basis, using market, income and bond yield approaches as appropriate. In general, the Company utilizes the bond yield method in determining the fair value of its investments, as long as it is appropriate. If, in the Company’s judgment, the bond yield approach is not appropriate, it may use the enterprise value approach in determining the fair value of the Company’s investment in the portfolio company. If there is deterioration in the credit quality of the portfolio company or an investment is in workout status, the Company may use alternative methodologies, including an asset liquidation or expected recovery model.
     Under the market approach, the Company estimates the enterprise value of the portfolio companies in which it invests. 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 the Company derives a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, the Company analyzes 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. The Company generally requires 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, the Company generally prepares and analyzes discounted cash flow models based on projections of the future free cash flows of the business.
     Under the bond yield approach, the Company uses bond yield models to determine the present value of the future cash flow streams of its debt investments. The Company reviews various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assesses the information in the valuation process.
     The Company’s Board of Directors undertakes a multi-step valuation process each quarter in connection with determining the fair value of the Company’s 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;

23


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
    Preliminary valuations are then reviewed and discussed with the principals of the Investment Adviser;
 
    Separately, independent valuation firms engaged by the Board of Directors prepare preliminary valuations on a selected basis and submit the reports to the Company;
 
    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 the Board of Directors;
 
    The Valuation Committee of the Board of Directors is apprised of the preliminary valuations of the independent valuation firms;
 
    The Valuation Committee of the 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 the Board of Directors makes a recommendation to the Board of Directors; and
 
    The Board of Directors discusses valuations and determines the fair value of each investment in the Company’s portfolio in good faith.
     The fair value of all of the Company’s investments at June 30, 2011 and September 30, 2010 was determined by the Board of Directors. The Board of Directors is solely responsible for the valuation of the portfolio investments at fair value as determined in good faith pursuant to the Company’s valuation policy and a consistently applied valuation process.
     The Board of Directors has engaged independent valuation firms to provide valuation assistance. Upon completion of their processes each quarter, the independent valuation firms provide the Company with written reports regarding the preliminary valuations of selected portfolio securities as of the close of such quarter. The Company will continue to engage independent valuation firms to provide assistance regarding the determination of the fair value of selected portfolio securities each quarter; however, the Board of Directors is ultimately and solely responsible for determining the fair value of the Company’s investments in good faith.
     Realized gain or loss on the sale of 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 the Company’s determination that certain investments are considered worthless securities and/or meet the conditions for loss recognition per the applicable tax rules.

24


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
Investment Income:
     Interest income, adjusted for amortization of premium and accretion of original issue discount, is recorded on an accrual basis to the extent that such amounts are expected to be collected. The Company stops accruing interest on investments when it is determined that interest is no longer collectible. In connection with its investment, the Company sometimes receives nominal cost equity that is valued as part of the negotiation process with the particular portfolio company. When the Company receives nominal cost equity, the Company allocates its cost basis in its investment between its debt securities and its nominal cost equity at the time of origination. Any resulting discount from recording the loan is accreted into interest income over the life of the loan.
     Distributions of earnings from portfolio companies are recorded as dividend income when the distribution is received.
     The Company has investments in debt securities which contain a payment-in-kind or “PIK” interest provision. PIK interest is computed at the contractual rate specified in each investment agreement and added to the principal balance of the investment and recorded as income.
     Fee income consists of the monthly collateral management fees that the Company receives in connection with its debt investments and the accreted portion of the debt origination fees. The Company capitalizes a portion of the upfront loan origination fees received in connection with investments. The unearned fee income from such fees is accreted into fee income, based on the straight line method or effective interest method as applicable, over the life of the investment.
     The Company has also structured exit fees across certain of its portfolio investments to be received upon the future exit of those investments. These fees are to be paid to the Company 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 payable upon the exit of a debt security, and a percentage of these fees are included in net investment income over the life of the loan. The receipt of such fees is contingent upon a successful exit event for each of the investments.
Cash and Cash Equivalents:
     Cash and cash equivalents consist of demand deposits and highly liquid investments with maturities of three months or less, when acquired. The Company places its cash and cash equivalents with financial institutions and, at times, cash held in bank accounts may exceed the Federal Deposit Insurance Corporation insured limit. Included in cash and cash equivalents is $0.6 million that is held at Wells Fargo Bank, National Association (“Wells Fargo”) in connection with the Company’s three-year credit facility. The Company is restricted in terms of access to this cash until such time as the Company submits its required monthly reporting schedules and Wells Fargo verifies the Company’s compliance per the terms of the credit agreement.
Deferred Financing Costs:
     Deferred financing costs consist of fees and expenses paid in connection with the closing of credit facilities and are capitalized at the time of payment. Deferred financing costs are amortized using the straight line method over the terms of the respective credit facilities. This amortization expense is included in interest expense in the Company’s Consolidated Statement of Operations.
Collateral Posted to Bank:
     Collateral posted to bank consists of cash posted as collateral with respect to the Company’s interest rate swap. The Company is restricted in terms of access to this collateral until such swap is terminated or the swap agreement expires. Cash collateral posted is held in an account at Wells Fargo.

25


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
Interest Rate Swap:
     The Company does not utilize hedge accounting and marks its interest rate swap to fair value on a quarterly basis through its Consolidated Statement of Operations.
Offering Costs:
     Offering costs consist of fees and expenses incurred in connection with the public offer and sale of the Company’s common stock, including legal, accounting, and printing fees. $0.7 million of offering costs have been charged to capital during the nine months ended June 30, 2011.
Income Taxes:
     As a RIC, the Company is not subject to federal income tax on the portion of its taxable income and gains distributed currently to its stockholders as a dividend. The Company intends to distribute between 90% and 100% of its taxable income and gains, within the Subchapter M rules, and thus the Company anticipates that it will not incur any federal income tax at the RIC level. As a RIC, the Company is also subject to a federal excise tax based on distributive requirements of its taxable income on a calendar year basis (e.g., calendar year 2011). The Company anticipates timely distribution of its taxable income within the tax rules; however, the Company incurred a de minimis federal excise tax for calendar years 2008, 2009 and 2010. In addition, the Company may incur a federal excise tax in future years.
     The purpose of the Company’s taxable subsidiaries is to permit the Company to hold equity investments in portfolio companies which are “pass through” entities for federal tax purposes in order to comply with the “source income” requirements contained in the RIC tax requirements. The taxable subsidiaries are not consolidated with the Company for income tax purposes and may generate income tax expense as a result of their ownership of certain portfolio investments. This income tax expense, if any, would be reflected in the Company’s Consolidated Statements of Operations. The Company uses the asset and liability method to account for its taxable subsidiaries’ income taxes. Using this method, the Company recognizes deferred tax assets and liabilities for the estimated future tax effects attributable to temporary differences between financial reporting and tax bases of assets and liabilities. In addition, the Company recognizes deferred tax benefits associated with net operating carry forwards that it may use to offset future tax obligations. The Company measures deferred tax assets and liabilities using the enacted tax rates expected to apply to taxable income in the years in which it expects to recover or settle those temporary differences.
     ASC 740 Accounting for Uncertainty in Income Taxes (“ASC 740”) provides guidance for how uncertain tax positions should be recognized, measured, presented, and disclosed in the Company’s Consolidated Financial Statements. ASC 740 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s tax returns to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authority. Tax positions not deemed to meet the more-likely-than-not threshold are recorded as a tax benefit or expense in the current year. Management’s determinations regarding ASC 740 may be subject to review and adjustment at a later date based upon factors including, but not limited to, an ongoing analysis of tax laws, regulations and interpretations thereof. The Company recognizes the tax benefits of uncertain tax positions only where the position is “more likely than not” to be sustained assuming examination by tax authorities. Management has analyzed the Company’s tax positions, and has concluded that no liability for unrecognized tax benefits should be recorded related to uncertain tax positions taken on returns filed for open tax years 2008, 2009 or 2010. The Company identifies its major tax jurisdictions as U.S. Federal and New York State, and the Company is not aware of any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will change materially in the next 12 months.
Recent Accounting Pronouncements
     In January 2010, the FASB issued Accounting Standards Update No. 2010-06, Fair Value Measurements and Improving Disclosures About Fair Value Measurements (Topic 820), which provides for improving disclosures about fair value measurements, primarily significant transfers in and out of Levels 1 and 2, and activity in Level 3 fair value measurements. The disclosures and clarifications of existing disclosures are effective for the interim and annual reporting periods beginning after December 15, 2009, while the disclosures about the purchases, sales, issuances, and settlements in the roll forward activity in Level 3 fair value measurements are effective for fiscal years after December 15, 2010 and for the interim periods within those fiscal years. Except for certain detailed Level 3 disclosures, which are effective for fiscal years after December 15, 2010 and interim periods within those years, the new guidance became effective for the Company’s fiscal 2010 second quarter. The adoption of this disclosure-only guidance is included in Note 3 — Portfolio Investments and did not have an impact on the Company’s consolidated financial results.
     In May 2011, the FASB issued Accounting Standards Update No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”). ASU 2011-04 amends ASC 820, which will require entities to change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. ASU 2011-04 clarifies the application of existing fair value measurement and disclosure requirements related to the application of the highest and best use and valuation premise concepts for financial and nonfinancial instruments, measuring the fair value of an instrument classified in shareholders’ equity, and disclosures about fair value measurements. ASU 2011-04 changes the measurement of the fair value of financial instruments that are managed within a portfolio and the application of premiums and discounts in a fair value measurement related to size as a characteristic of the reporting entity’s holding rather than a characteristic of the asset or liability. ASU 2011-04 requires additional disclosures about fair value measurements categorized within Level 3 of the fair value hierarchy including the valuation processes used by the reporting entity, the sensitivity of the fair value to changes in unobservable inputs, and the interrelationships between those unobservable inputs, if any. All the amendments to ASC 820 made by ASU 2011-04 are effective for interim and annual periods beginning after December 15, 2011. The adoption of ASU 2011-04 is not expected to have a material impact on the Company’s consolidated financial statements, except it will enhance the disclosures around fair value of investments.

26


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
Note 3. Portfolio Investments
     At June 30, 2011, 135.8% of net assets or $1.05 billion was invested in 60 long-term portfolio investments and 2.3% of net assets or $17.6 million was invested in cash and cash equivalents. In comparison, at September 30, 2010, 99.1% of net assets or $563.8 million was invested in 38 long-term portfolio investments and 13.5% of net assets or $76.8 million was invested in cash and cash equivalents. As of June 30, 2011, primarily all of the Company’s debt investments were secured by first or second priority liens on the assets of the portfolio companies. Moreover, the Company held equity investments in certain of its portfolio companies consisting of common stock, preferred stock, limited partnership interests or limited liability company interests. These instruments generally do not produce a current return, but are held for potential investment appreciation and capital gain.
     During the three and nine months ended June 30, 2011, the Company recorded net realized losses on investments of $14.1 million and $28.1 million, respectively. During the three and nine months ended June 30, 2010, the Company recorded net realized losses on investments of $0 and $2.8 million, respectively. During the three and nine months ended June 30, 2011, the Company recorded net unrealized appreciation of $19.4 million and $34.9 million, respectively. During the three and nine months ended June 30, 2010, the Company recorded net unrealized depreciation of $13.9 million and $11.7 million, respectively.
     The composition of the Company’s investments as of June 30, 2011 and September 30, 2010 at cost and fair value was as follows:
                                 
    June 30, 2011     September 30, 2010  
    Cost     Fair Value     Cost     Fair Value  
Investments in debt securities
  $ 1,033,320     $ 1,033,883     $ 585,529     $ 558,580  
Investments in equity securities
    14,232       19,596       6,968       5,241  
 
                       
 
                               
Total
  $ 1,047,552     $ 1,053,479     $ 592,497     $ 563,821  
 
                       
 
     The composition of the Company’s debt investments as of June 30, 2011 and September 30, 2010 at fixed rates and floating rates was as follows:
 
    June 30, 2011     September 30, 2010  
    Fair Value     % of Portfolio     Fair Value     % of Portfolio  
Fixed rate debt securities
  $ 366,528       35.45 %   $ 375,584       67.24 %
Floating rate debt securities
    667,355       64.55 %     182,996       32.76 %
 
                       
 
                               
Total
  $ 1,033,883       100.00 %   $ 558,580       100.00 %
 
                       
     The following table presents the financial instruments carried at fair value as of June 30, 2011, by caption on the Company’s Consolidated Statement of Assets and Liabilities for each of the three levels of hierarchy established by ASC 820.
                                 
    Level 1     Level 2     Level 3     Total  
Investments in debt securities (first lien)
  $     $     $ 869,683     $ 869,683  
Investments in debt securities (second lien)
                139,524       139,524  
Investments in debt securities (subordinated)
                24,676       24,676  
Investments in equity securities (preferred)
                4,896       4,896  
Investments in equity securities (common)
                14,700       14,700  
 
                       
Total investments at fair value
  $     $     $ 1,053,479     $ 1,053,479  
Interest rate swap
          722             722  
 
                       
 
                               
Total liabilities at fair value
  $     $ 722     $     $ 722  
 
                       
     The following table presents the financial instruments carried at fair value as of September 30, 2010, by caption on the Company’s Consolidated Statement of Assets and Liabilities for each of the three levels of hierarchy established by ASC 820.
                                 
    Level 1     Level 2     Level 3     Total  
Investments in debt securities (first lien)
  $     $     $ 416,324     $ 416,324  
Investments in debt securities (second lien)
                137,851       137,851  
Investments in debt securities (subordinated)
                4,405       4,405  
Investments in equity securities (preferred)
                2,892       2,892  
Investments in equity securities (common)
                2,349       2,349  
 
                       
Total investments at fair value
  $     $     $ 563,821     $ 563,821  
Interest rate swap
          773             773  
 
                       
 
                               
Total liabilities at fair value
  $     $ 773     $     $ 773  
 
                       
     When a determination is made to classify a financial instrument within Level 3 of the valuation hierarchy, the determination is based upon the fact that the unobservable factors are the most significant to the overall fair value measurement. However, Level 3 financial instruments typically include, in addition to the unobservable or Level 3 components, observable components (that is, components that are actively quoted and can be validated by external sources). Accordingly, the appreciation (depreciation) in the tables below includes changes in fair value due in part to observable factors that are part of the valuation methodology.

27


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     The following table provides a roll-forward in the changes in fair value from March 31, 2011 to June 30, 2011 for all investments for which the Company determines fair value using unobservable (Level 3) factors.
                                                 
    First     Second     Subordinated     Preferred     Common        
    Lien Debt     Lien Debt     Debt     Equity     Equity     Total  
Fair value as of March 31, 2011
  $ 821,885     $ 82,586     $ 24,347     $ 4,560     $ 6,372     $ 939,750  
New investments & net revolver activity
    56,107       56,500                   1,569       114,176  
Redemptions/repayments
    (9,299 )     (458 )                       (9,757 )
Net accrual of PIK interest income
    2,212       612       419                   3,243  
Accretion of original issue discount
    348       82                         430  
Net change in unearned income
    1,129       (875 )     17                   271  
Net unrealized appreciation (depreciation)
    10,534       1,077       (107 )     336       7,531       19,371  
Net change from unrealized to realized
    (13,233 )                       (772 )     (14,005 )
Transfer into (out of) Level 3
                                   
 
                                   
 
                                               
Fair value as of June 30, 2011
  $ 869,683     $ 139,524     $ 24,676     $ 4,896     $ 14,700     $ 1,053,479  
 
                                   
 
                                               
Net unrealized appreciation (depreciation) relating to Level 3 assets still held at June 30, 2011 and reported within net unrealized appreciation (depreciation) on investments in the Consolidated Statement of Operations for the three months ended June 30, 2011
  $ (2,699 )   $ 1,077     $ (107 )   $ 336     $ 6,759     $ 5,366  
     The following table provides a roll-forward in the changes in fair value from March 31, 2010 to June 30, 2010, for all investments for which the Company determines fair value using unobservable (Level 3) factors.
                                                 
    First     Second     Subordinated     Preferred     Common        
    Lien Debt     Lien Debt     Debt     Equity     Equity     Total  
Fair value as of March 31, 2010
  $ 317,722     $ 137,947     $     $ 2,662     $ 2,535     $ 460,866  
New investments & net revolver activity
    44,999             5,344       435       53       50,831  
Redemptions/repayments
    (3,608 )     (1,849 )                       (5,457 )
Net accrual of PIK interest income
    1,216       955       94                   2,265  
Accretion of original issue discount
    141       103                         244  
Net change in unearned income
    (140 )     126                         (14 )
Net unrealized appreciation (depreciation)
    (12,254 )     (781 )     (278 )     (159 )     (449 )     (13,921 )
Net change from unrealized to realized
                                   
Transfer into (out of) Level 3
                                   
 
                                   
 
                                               
Fair value as of June 30, 2010
  $ 348,076     $ 136,501     $ 5,160     $ 2,938     $ 2,139     $ 494,814  
 
                                   
 
                                               
Net unrealized depreciation relating to Level 3 assets still held at June 30, 2010 and reported within net unrealized appreciation (depreciation) on investments in the Consolidated Statement of Operations for the three months ended June 30, 2010
  $ (12,254 )   $ (781 )   $ (278 )   $ (159 )   $ (449 )   $ (13,921 )
     The following table provides a roll-forward in the changes in fair value from September 30, 2010 to June 30, 2011 for all investments for which the Company determines fair value using unobservable (Level 3) factors.
                                                 
    First     Second     Subordinated     Preferred     Common        
    Lien Debt     Lien Debt     Debt     Equity     Equity     Total  
Fair value as of September 30, 2010
  $ 416,324     $ 137,851     $ 4,405     $ 2,892     $ 2,349     $ 563,821  
New investments & net revolver activity
    482,057       56,500       21,065       2,036       6,297       567,955  
Redemptions/repayments
    (30,187 )     (53,025 )                       (83,212 )
Net accrual of PIK interest income
    5,903       (3,601 )     845                   3,147  
Accretion of original issue discount
    842       397                         1,239  
Net change in unearned income
    (5,992 )     43       (373 )                 (6,322 )
Net unrealized appreciation (depreciation)
    27,687       1,359       (1,266 )     222       6,869       34,871  
Net change from unrealized to realized
    (26,951 )                 (254 )     (815 )     (28,020 )
Transfer into (out of) Level 3
                                   
 
                                   
 
                                               
Fair value as of June 30, 2011
  $ 869,683     $ 139,524     $ 24,676     $ 4,896     $ 14,700     $ 1,053,479  
 
                                   
 
                                               

28


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
                                                 
    First     Second     Subordinated     Preferred     Common        
    Lien Debt     Lien Debt     Debt     Equity     Equity     Total  
Net unrealized appreciation (depreciation) relating to Level 3 assets still held at June 30, 2011 and reported within net unrealized appreciation (depreciation) on investments in the Consolidated Statement of Operations for the nine months ended June 30, 2011
  $ 3,927     $ 1,579     $ (1,266 )   $ (32 )   $ 6,054     $ 10,262  
The following table provides a roll-forward in the changes in fair value from September 30, 2009 to June 30, 2010, for all investments for which the Company determines fair value using unobservable (Level 3) factors.
                                                 
    First     Second     Subordinated     Preferred     Common        
    Lien Debt     Lien Debt     Debt     Equity     Equity     Total  
Fair value as of September 30, 2009
  $ 142,018     $ 153,904     $     $ 2,889     $ 800     $ 299,611  
New investments & net revolver activity
    215,031       6,000       5,344       435       689       227,499  
Redemptions/repayments
    3,100       (23,139 )                 (71 )     (20,110 )
Net accrual of PIK interest income
    3,277       2,525       94                   5,896  
Accretion of original issue discount
    373       319                         692  
Net change in unearned income
    (4,705 )     584                         (4,121 )
 
                                               
Net unrealized appreciation (depreciation)
    (11,018 )     (3,081 )     (278 )     (386 )     3,018       (11,745 )
Net change from unrealized to realized
          (611 )                 (2,297 )     (2,908 )
Transfer into (out of) Level 3
                                   
 
                                   
 
                                               
Fair value as of June 30, 2010
  $ 348,076     $ 136,501     $ 5,160     $ 2,938     $ 2,139     $ 494,814  
 
                                   
 
                                               
Net unrealized appreciation (depreciation) relating to Level 3 assets still held at June 30, 2010 and reported within net unrealized appreciation (depreciation) on investments in the Consolidated Statement of Operations for the nine months ended June 30, 2010
  $ (10,776 )   $ (4,380 )   $ (278 )   $ (386 )   $ 721     $ (15,099 )

29


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     Concurrent with its adoption of ASC 820, effective October 1, 2008, the Company augmented the valuation techniques it uses to estimate the fair value of its debt investments where there is not a readily available market value (Level 3). Prior to October 1, 2008, the Company estimated the fair value of its Level 3 debt investments by first estimating the enterprise value of the portfolio company which issued the debt investment. To estimate the enterprise value of a portfolio company, the Company analyzed various factors, including the portfolio companies historical and projected financial results. Typically, private companies are valued based on multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), cash flow, net income, revenues or, in limited instances, book value.
     In estimating a multiple to use for valuation purposes, the Company looked to private merger and acquisition statistics, discounted public trading multiples or industry practices. In some cases, the best valuation methodology may have been a discounted cash flow analysis based on future projections. If a portfolio company was distressed, a liquidation analysis may have provided the best indication of enterprise value.
     If there was adequate enterprise value to support the repayment of the Company’s debt, the fair value of the Level 3 loan or debt security normally corresponded to cost plus the amortized original issue discount unless the borrower’s condition or other factors lead to a determination of fair value at a different amount.
     Beginning on October 1, 2008, the Company also introduced a bond yield model to value these investments based on the present value of expected cash flows. The significant inputs into the model are market interest rates for debt with similar characteristics and an adjustment for the portfolio company’s credit risk. The credit risk component of the valuation considers several factors including financial performance, business outlook, debt priority and collateral position.
     The Company’s off-balance sheet arrangements consisted of $95.0 million and $49.5 million of unfunded commitments to provide debt financing to its portfolio companies or to fund limited partnership interests as of June 30, 2011 and September 30, 2010, respectively. 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 the Company’s Consolidated Statements of Assets and Liabilities.

30


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     A summary of the composition of the unfunded commitments (consisting of revolvers, term loans and limited partnership interests) as of June 30, 2011 and September 30, 2010 is shown in the table below:
                 
    June 30, 2011     September 30, 2010  
     
Traffic Control & Safety Corporation
  $ 3,514     $  
HealthDrive Corporation
    2,000       1,500  
IZI Medical Products, Inc.
    2,500       2,500  
Trans-Trade, Inc.
    200       500  
Riverlake Equity Partners II, LP (limited partnership interest)
    878       966  
Riverside Fund IV, LP (limited partnership interest)
    555       864  
ADAPCO, Inc.
    5,250       5,750  
AmBath/ReBath Holdings, Inc.
          1,500  
JTC Education, Inc.
    6,409       9,062  
Tegra Medical, LLC
    2,500       4,000  
Vanguard Vinyl, Inc.
          1,250  
Flatout, Inc.
    1,500       1,500  
Psilos Group Partners IV, LP (limited partnership interest)
    1,000       1,000  
Mansell Group, Inc.
    1,000       2,000  
NDSSI Holdings, Inc.
    1,500       1,500  
Eagle Hospital Physicians, Inc.
    2,500       2,500  
Enhanced Recovery Company, LLC
    4,000       3,623  
Epic Acquisition, Inc.
    3,000       2,700  
Specialty Bakers, LLC
    4,000       2,000  
Rail Acquisition Corp.
    5,530       4,799  
Bunker Hill Capital II (QP), L.P. (limited partnership interest)
    960        
CRGT, Inc.
    12,500        
Welocalize, Inc.
    1,750        
Miche Bag, LLC
    5,000        
Dominion Diagnostics, LLC
    5,000        
Advanced Pain Management
    200        
DISA, Inc.
    4,000        
Saddleback Fence and Vinyl Products, Inc.
    400        
Best Vinyl Fence & Deck, LLC
    1,000        
Physicians Pharmacy Alliance, Inc.
    2,000        
Cardon Healthcare Network, LLC
    2,000        
IOS Acquisitions, Inc.
    2,000        
Phoenix Brands Merger Sub LLC
    2,143        
Refac Optical Group
    5,500        
Titan Fitness, LLC
    1,727        
Baird Capital Partners V, LP (limited partnership interest)
    1,000        
     
 
Total
  $ 95,016     $ 49,514  
     
     Summaries of the composition of the Company’s investment portfolio at cost and fair value as a percentage of total investments are shown in the following tables:
                                 
    June 30, 2011     September 30, 2010  
     
Cost:
                               
First lien debt
  $ 856,290       81.74 %   $ 430,201       72.61 %
Second lien debt
    150,915       14.41 %     150,601       25.42 %
Subordinated debt
    26,116       2.49 %     4,728       0.80 %
Purchased equity
    7,466       0.71 %     2,330       0.39 %
Equity grants
    6,158       0.59 %     4,468       0.75 %
Limited partnership interests
    607       0.06 %     169       0.03 %
     
 
                               
Total
  $ 1,047,552       100.00 %   $ 592,497       100.00 %
     

31


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
                                 
    June 30, 2011     September 30, 2010  
     
Fair value:
                               
First lien debt
  $ 869,683       82.55 %   $ 416,324       73.84 %
Second lien debt
    139,524       13.24 %     137,851       24.45 %
Subordinated debt
    24,676       2.34 %     4,405       0.78 %
Purchased equity
    11,559       1.10 %     625       0.11 %
Equity grants
    7,429       0.71 %     4,447       0.79 %
Limited partnership interests
    608       0.06 %     169       0.03 %
     
 
                               
Total
  $ 1,053,479       100.00 %   $ 563,821       100.00 %
     
     The Company invests in portfolio companies located in the United States. The following tables show the portfolio composition by geographic region at cost and fair value as a percentage of total investments. The geographic composition is determined by the location of the corporate headquarters of the portfolio company, which may not be indicative of the primary source of the portfolio company’s business.
                                 
    June 30, 2011     September 30, 2010  
Cost:
                               
Northeast
  $ 318,960       30.45 %   $ 175,371       29.60 %
Southwest
    264,197       25.23 %     121,104       20.44 %
Southeast
    233,788       22.32 %     108,805       18.36 %
West
    145,907       13.93 %     133,879       22.60 %
Midwest
    84,700       8.07 %     53,338       9.00 %
     
 
                               
Total
  $ 1,047,552       100.00 %   $ 592,497       100.00 %
     
                                 
    June 30, 2011     September 30, 2010  
Fair value:
                               
Northeast
  $ 329,582       31.29 %   $ 161,264       28.60 %
Southwest
    248,952       23.63 %     107,469       19.07 %
Southeast
    239,656       22.75 %     109,457       19.41 %
West
    147,859       14.04 %     131,881       23.39 %
Midwest
    87,430       8.29 %     53,750       9.53 %
 
                               
     
Total
  $ 1,053,479       100.00 %   $ 563,821       100.00 %
     

32


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     The composition of the Company’s portfolio by industry at cost and fair value as of June 30, 2011 and September 30, 2010 were as follows:
                                 
    June 30, 2011     September 30, 2010  
Cost:
                               
Healthcare services
  $ 197,862       18.89 %   $ 87,444       14.76 %
Healthcare equipment
    71,172       6.79 %     47,540       8.02 %
Diversified support services
    57,016       5.44 %     26,246       4.43 %
Oil & gas equipment & services
    53,411       5.10 %           0.00 %
IT consulting & other services
    49,955       4.77 %           0.00 %
Internet software & services
    42,939       4.10 %           0.00 %
Construction and engineering
    42,192       4.03 %     24,987       4.22 %
Leisure facilities
    38,828       3.71 %     6,864       1.16 %
Specialty stores
    34,576       3.30 %           0.00 %
Household products
    33,274       3.18 %     1,065       0.18 %
Electronic equipment & instruments
    32,674       3.12 %     33,094       5.59 %
Apparel, accessories & luxury goods
    32,044       3.06 %     23,536       3.97 %
Home improvement retail
    28,102       2.68 %     32,631       5.51 %
Education services
    27,296       2.61 %     44,902       7.58 %
Fertilizers & agricultural chemicals
    26,261       2.51 %     26,695       4.51 %
Food distributors
    26,201       2.50 %     30,415       5.13 %
Integrated telecommunication services
    25,976       2.48 %           0.00 %
Healthcare technology
    20,749       1.98 %     21,509       3.63 %
Human resources & employment services
    20,652       1.97 %           0.00 %
Electronic manufacturing services
    19,553       1.87 %     18,738       3.16 %
Food retail
    19,025       1.82 %     19,622       3.31 %
Advertising
    18,946       1.81 %     19,828       3.35 %
Distributors
    18,511       1.77 %     13,351       2.25 %
Air freight and logistics
    17,883       1.71 %     14,005       2.36 %
Trucking
    17,065       1.63 %     17,065       2.88 %
Environmental & facilities services
    16,217       1.55 %     8,922       1.51 %
Data processing and outsourced services
    12,775       1.22 %     13,078       2.21 %
Other diversified financial services
    12,385       1.18 %           0.00 %
Industrial machinery
    10,378       0.99 %     10,143       1.71 %
Construction materials
    6,682       0.64 %     17,476       2.95 %
Building products
    6,662       0.64 %     8,292       1.40 %
Housewares & specialties
    5,319       0.51 %     12,195       2.06 %
Restaurants
    4,162       0.40 %     12,485       2.11 %
Multi-sector holdings
    608       0.02 %     169       0.02 %
Movies & entertainment
    201       0.02 %     200       0.03 %
     
 
                               
Total
  $ 1,047,552       100.00 %   $ 592,497       100.00 %
     
                                 
    June 30, 2011     September 30, 2010  
Fair Value:
                               
Healthcare services
  $ 204,851       19.45 %   $ 89,262       15.83 %
Healthcare equipment
    72,705       6.90 %     48,298       8.57 %
Diversified support services
    58,260       5.53 %     26,246       4.66 %
Oil & gas equipment & services
    54,433       5.17 %           0.00 %
IT consulting & other services
    51,263       4.87 %           0.00 %
Internet software & services
    43,829       4.16 %           0.00 %
Leisure facilities
    39,469       3.75 %     7,040       1.25 %
Construction and engineering
    38,748       3.68 %     23,845       4.23 %
Apparel, accessories & luxury goods
    36,056       3.42 %     23,549       4.18 %
Specialty stores
    35,637       3.38 %           0.00 %
Household products
    34,075       3.23 %     1,065       0.19 %
Electronic equipment & instruments
    32,608       3.10 %     32,888       5.83 %
Education services
    28,367       2.69 %     42,111       7.47 %
Home improvement retail
    28,119       2.67 %     32,484       5.76 %
Fertilizers & agricultural chemicals
    26,980       2.56 %     26,812       4.76 %
Food distributors
    26,959       2.56 %     3,317       5.38 %
Integrated telecommunication services
    26,500       2.52 %           0.00 %
Environmental & facilities services
    22,435       2.13 %     5,130       0.91 %
Healthcare technology
    21,412       2.03 %     22,141       3.93 %
Human resources & employment services
    21,290       2.02 %           0.00 %
Food retail
    19,552       1.86 %     19,750       3.50 %
Advertising
    19,332       1.84 %     19,847       3.52 %
Distributors
    18,908       1.79 %     13,258       2.35 %
Air freight and logistics
    17,120       1.63 %     14,041       2.49 %
Electronic manufacturing services
    14,016       1.33 %     18,056       3.20 %
Other diversified financial services
    12,775       1.21 %           0.00 %
Data processing and outsourced services
    12,571       1.19 %     12,741       2.26 %
Industrial machinery
    10,959       1.04 %     10,233       1.81 %
Construction materials
    6,811       0.65 %     17,040       3.02 %
Building products
    6,776       0.64 %     6,841       1.21 %
Trucking
    3,897       0.37 %     4,597       0.82 %
Housewares & specialties
    3,056       0.29 %     3,700       0.66 %
Restaurants
    2,840       0.27 %     12,100       2.15 %
Multi-sector holdings
    608       0.06 %     169       0.01 %
Movies & entertainment
    262       0.01 %     260       0.05 %
     
 
Total
  $ 1,053,479       100.00 %   $ 563,821       100.00 %
     

33


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     The Company’s investments are generally in small and mid-sized companies in a variety of industries. At June 30, 2011 and September 30, 2010, the Company had no single investment that represented greater than 10% of the total investment portfolio at fair value. Income, consisting of interest, dividends, fees, other investment income, and realization of gains or losses, can fluctuate upon repayment or sale of an investment and in any given year can be highly concentrated among several investments. For the three months ended June 30, 2011 and June 30, 2010, no individual investment produced income that exceeded 10% of investment income.
Note 4. Fee Income
     The Company receives a variety of fees in the ordinary course of business. Certain fees, such as some 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 of the respective investments. Other fees, such as servicing and collateral management fees, are classified as fee income and recognized as they are earned on a monthly basis.
     Accumulated unearned fee income activity for the nine months ended June 30, 2011 and June 30, 2010 was as follows:
                 
    Nine months     Nine months  
    ended June 30,     ended June 30,  
    2011     2010  
Beginning unearned fee income balance
  $ 11,901     $ 5,590  
Net fees received
    13,311       8,099  
Unearned fee income recognized
    (6,989 )     (3,613 )
     
 
               
Ending unearned fee income balance
  $ 18,223     $ 10,076  
     
     As of June 30, 2011, the Company had structured $7.7 million in aggregate exit fees across 10 portfolio investments upon the future exit of those investments. These fees are to be paid to the Company 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 payable upon the exit of a debt investment and a portion of these fees is included in net investment income over the period of the loan. The receipt of such fees is contingent upon a successful exit event for each of the investments.

34


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
Note 5. Share Data
     Effective January 2, 2008, the Partnership merged with and into the Company. At the time of the merger, all outstanding partnership interests in the Partnership were exchanged for 12,480,972 shares of common stock of the Company. An additional 26 fractional shares were payable to the stockholders in cash.
     On June 17, 2008, the Company completed an initial public offering of 10,000,000 shares of its common stock at the offering price of $14.12 per share. The net proceeds totaled $129.5 million after deducting investment banking commissions of $9.9 million and offering costs of $1.8 million.
     On July 21, 2009, the Company completed a follow-on public offering of 9,487,500 shares of its common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $9.25 per share. The net proceeds totaled $82.7 million after deducting investment banking commissions of $4.4 million and offering costs of $0.7 million.
     On September 25, 2009, the Company completed a follow-on public offering of 5,520,000 shares of its common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $10.50 per share. The net proceeds totaled $54.9 million after deducting investment banking commissions of $2.8 million and offering costs of $0.3 million.
     On January 27, 2010, the Company completed a follow-on public offering of 7,000,000 shares of its common stock at the offering price of $11.20 per share, with 300,500 additional shares being sold as part of the underwriters’ partial exercise of their over-allotment option on February 25, 2010. The net proceeds totaled $77.5 million after deducting investment banking commissions of $3.7 million and offering costs of $0.5 million.
     On April 20, 2010, at the Company’s 2010 Annual Meeting, the Company’s stockholders approved, among other things, amendments to the Company’s restated certificate of incorporation to increase the number of authorized shares of common stock from 49,800,000 shares to 150,000,000 shares and to remove the Company’s authority to issue shares of Series A Preferred Stock.
     On June 21, 2010, the Company completed a follow-on public offering of 9,200,000 shares of its common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $11.50 per share. The net proceeds totaled $100.5 million after deducting investment banking commissions of $4.8 million and offering costs of $0.5 million.
     On December 7, 2010, the Company entered into an at-the-market equity offering sales agreement relating to shares of its common stock. Throughout the month of December 2010, the Company sold 429,110 shares of its common stock at an average offering price of $11.87 per share. The net proceeds totaled $5.0 million after deducting fees and commissions of $0.1 million. The Company terminated the at-the-market equity offering sales agreement effective January 20, 2011 and did not sell any shares of the Company’s common stock pursuant thereto subsequent to December 31, 2010.
     On February 4, 2011, the Company completed a follow-on public offering of 11,500,000 shares of its common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $12.65 per share. The net proceeds totaled $138.6 million after deducting investment banking commissions of $6.5 million and offering costs of $0.3 million.
     On June 24, 2011, the Company completed a follow-on public offering of 5,558,469 shares of its common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $11.72 per share. The net proceeds totaled $62.7 million after deducting investment banking commissions of $2.3 million and offering costs of $0.2 million.
     The following table sets forth the computation of basic and diluted earnings per share, pursuant to ASC 260-10 Earnings per Share, for the three and nine months ended June 30, 2011 and June 30, 2010:
                                 
    Three months     Three months     Nine months     Nine months  
    ended June 30,     ended June 30,     ended June 30,     ended June 30,  
    2011     2010     2011     2010  
Earnings per common share — basic:
                               
Net increase (decrease) in net assets
  $ 20,832     $ (1,889 )   $ 53,951     $ 17,041  
Weighted average common shares outstanding — basic
    67,081       46,294       61,254       42,379  
Earnings per common share — basic
  $ 0.31     $ (0.04 )   $ 0.88     $ 0.40  
 
                               
Earnings per common share — diluted:
                               
Net increase (decrease) in net assets, before adjustments
  $ 20,832     $ (1,889 )   $ 53,951     $ 17,041  
Adjustments for interest on convertible senior notes and for base management and incentive fees
    1,636             1,636        
 
                       
Net increase (decrease) in net assets, as adjusted
  $ 22,468     $ (1,889 )   $ 55,587     $ 17,041  
Weighted average common shares outstanding — basic
    67,081       46,294       61,254       42,379  
Adjustments for dilutive effect of convertible notes
    8,939             2,980        
 
                       
Weighted average common shares outstanding — diluted
    76,020       46,294       64,234       42,379  
Earnings per common share — diluted
  $ 0.30     $ (0.04 )   $ 0.87     $ 0.40  

35


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     The following table reflects the dividend distributions per share that the Board of Directors of the Company has declared and the Company has paid, including shares issued under the dividend reinvestment plan (“DRIP”), on its common stock from inception to June 30, 2011:
                                                 
    Record     Payment     Amount     Cash     DRIP Shares     DRIP Shares  
Date Declared   Date     Date     per Share     Distribution     Issued     Value  
 
5/1/2008
    5/19/2008       6/3/2008     $ 0.30     $1.9 million     133,317     $1.9 million
8/6/2008
    9/10/2008       9/26/2008       0.31     5.1 million     196,786 (1)   1.9 million
12/9/2008
    12/19/2008       12/29/2008       0.32     6.4 million     105,326     0.8 million
12/9/2008
    12/30/2008       1/29/2009       0.33     6.6 million     139,995     0.8 million
12/18/2008
    12/30/2008       1/29/2009       0.05     1.0 million     21,211     0.1 million
4/14/2009
    5/26/2009       6/25/2009       0.25     5.6 million     11,776     0.1 million
8/3/2009
    9/8/2009       9/25/2009       0.25     7.5 million     56,890     0.6 million
11/12/2009
    12/10/2009       12/29/2009       0.27     9.7 million     44,420     0.5 million
1/12/2010
    3/3/2010       3/30/2010       0.30     12.9 million     58,689     0.7 million
5/3/2010
    5/20/2010       6/30/2010       0.32     14.0 million     42,269     0.5 million
8/2/2010
    9/1/2010       9/29/2010       0.10     5.2 million     25,425     0.3 million
8/2/2010
    10/6/2010       10/27/2010       0.10     5.2 million     24,850     0.3 million
8/2/2010
    11/3/2010       11/24/2010       0.11     5.7 million     26,569     0.3 million
8/2/2010
    12/1/2010       12/29/2010       0.11     5.7 million     28,238     0.3 million
11/30/2010
    1/4/2011       1/31/2011       0.1066     5.4 million     36,038     0.5 million
11/30/2010
    2/1/2011       2/28/2011       0.1066     5.5 million     29,072     0.4 million
11/30/2010
    3/1/2011       3/31/2011       0.1066     6.5 million     43,766     0.6 million
1/30/2011
    4/1/2011       4/29/2011       0.1066     6.5 million     45,193     0.6 million
1/30/2011
    5/2/2011       5/31/2011       0.1066     6.5 million     48,870     0.6 million
1/30/2011
    6/1/2011       6/30/2011       0.1066     6.5 million     55,367     0.6 million
 
(1)   Shares were purchased on the open market and distributed.
     In October 2008, the Company’s Board of Directors authorized a stock repurchase program to acquire up to $8 million of the Company’s outstanding common stock. Stock repurchases under this program were made through the open market at times and in such amounts as Company management deemed appropriate. The stock repurchase program expired December 2009. In October 2008, the Company repurchased 78,000 shares of common stock on the open market as part of its share repurchase program.
     In October 2010, the Company’s Board of Directors authorized a stock repurchase program to acquire up to $20 million of the Company’s outstanding common stock. Stock repurchases under this program are to be made through the open market at times and in such amounts as the Company’s 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.
Note 6. Lines of Credit
     On November 16, 2009, Fifth Street Funding, LLC, a consolidated wholly-owned bankruptcy remote, special purpose subsidiary (“Funding”), and the Company entered into a Loan and Servicing Agreement (“Wells Agreement”), with respect to a three-year credit facility (“Wells Fargo facility”) with Wells Fargo, as successor to Wachovia Bank, National Association, 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, the Company amended the Wells Fargo facility to expand the borrowing capacity under that facility. Pursuant to the amendment, the Company 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.
     On November 5, 2010, the Company 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 the Company’s 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 February 28, 2011, the Company amended the Wells Fargo facility to, among other things, reduce the interest rate to LIBOR plus 3.0% per annum, with no LIBOR floor, and extend the maturity date of the facility to February 25, 2014.

36


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     In connection with the Wells Fargo facility, the Company concurrently entered into (i) a Purchase and Sale Agreement with Funding, pursuant to which the Company will sell to Funding certain loan assets it has originated or acquired, or will originate or acquire and (ii) a Pledge Agreement with Wells Fargo, pursuant to which the Company pledged all of its equity interests in Funding as security for the payment of Funding’s obligations under the Wells Agreement and other documents entered into in connection with the Wells Fargo facility.
     The Wells Agreement and related agreements governing the Wells Fargo facility required both Funding and the Company to, among other things (i) make representations and warranties regarding the collateral as well as each of their 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 the Company to materially perform under the Wells Agreement and related agreements governing the facility, which, if not complied with, could accelerate repayment under the facility, thereby materially and adversely affecting the Company’s liquidity, financial condition and results of operations. The Company is currently in compliance with all financial covenants under the Wells Fargo facility.
     The Wells Fargo facility is secured by all of the assets of Funding, and all of the Company’s equity interest in Funding. The Company intends to use the net proceeds of the Wells Fargo facility to fund a portion of its loan origination activities and for general corporate purposes. Each loan origination under the facility is subject to the satisfaction of certain conditions. The Company 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 June 30, 2011, the Company had no borrowings outstanding under the Wells Fargo facility.
     On May 27, 2010, the Company 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 the Company 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 had a maturity date of May 27, 2013. The ING facility also allows the Company to request letters of credit from ING Capital LLC, as the issuing bank. The initial commitment under the ING facility was $90 million, and the ING facility included an accordion feature that allowed for potential future expansion of the facility up to a total of $150 million. The ING facility is secured by substantially all of the Company’s assets, as well as the assets of two of the Company’s wholly-owned subsidiaries, FSFC Holdings, Inc. and FSF/MP Holdings, Inc., subject to certain exclusions for, among other things, equity interests in the Company’s 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 the Company. Neither the Company’s 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 the Company 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.
     On February 22, 2011, the Company amended the ING facility to, among other things, expand the borrowing capacity to $215 million. In addition, the ING facility’s accordion feature was increased to allow for potential future expansion up to a total of $300 million and the maturity date was extended to February 22, 2014.

37


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     Pursuant to the ING Security Agreement, FSFC Holdings, Inc. and FSF/MP Holdings, Inc. guaranteed the obligations under the ING Security Agreement, including the Company’s obligations to the lenders and the administrative agent under the ING Credit Agreement. Additionally, the Company pledged its 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 the Company to, among other things (i) make representations and warranties regarding the collateral as well as each of the Company’s 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 the Company to materially perform under the ING Credit Agreement and related agreements governing the facility, which, if not complied with, could accelerate repayment under the facility, thereby materially and adversely affecting the Company’s liquidity, financial condition and results of operations. The Company is currently in compliance with all financial covenants under the ING facility.
     Each loan or letter of credit originated under the ING facility is subject to the satisfaction of certain conditions. The Company cannot be assured that it will be able to borrow funds under the ING facility at any particular time or at all.
     As of June 30, 2011, the Company had no borrowings outstanding under the ING facility.
     As of June 30, 2011, except for assets that were funded through the Company’s SBIC subsidiary, substantially all of the Company’s assets were pledged as collateral under the Wells Fargo facility or the ING facility.
     Interest expense for the three and nine months ended June 30, 2011 was $5.0 million and $9.6 million, respectively. Interest expense for the three and nine months ended June 30, 2010 was $0.5 million and $0.8 million, respectively.
Note 7. Interest and Dividend Income
     Interest income is recorded on an accrual basis to the extent that such amounts are expected to be collected. In accordance with the Company’s policy, accrued interest is evaluated periodically for collectability. The Company stops 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.
     The Company holds debt in its portfolio that contains a 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. The Company generally ceases accruing PIK interest if there is insufficient value to support the accrual or if the Company does not expect the portfolio company to be able to pay all principal and interest due. The Company’s 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; the Company’s 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 the Company 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, the Company determines whether to cease accruing PIK interest on a loan or debt security. The Company’s determination to cease accruing PIK interest on a loan or debt security is generally made well before the Company’s full write-down of such loan or debt security.

38


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     Accumulated PIK interest activity for the nine months ended June 30, 2011 and June 30, 2010 was as follows:
                 
    Nine months ended     Nine months ended  
    June 30, 2011     June 30, 2010  
     
PIK balance at beginning of period
  $ 19,301     $ 12,059  
Gross PIK interest accrued
    10,718       8,117  
PIK income reserves
    (541 )     (1,439 )
PIK interest received in cash
    (7,030 )     (782 )
Adjustments due to loan exits
    (317 )     (1,143 )
     
 
PIK balance at end of period
  $ 22,131     $ 16,812  
     
     As of June 30, 2011, the Company had stopped accruing cash interest, PIK interest and original issue discount (“OID”) on two investments that did not pay all of their scheduled cash interest payments for the period ended June 30, 2011. As of June 30, 2010, the Company had stopped accruing PIK interest and OID on six investments, including three investments that had not paid all of their scheduled cash interest payments.
     Cash non-accrual status is inclusive of PIK and other noncash income, where applicable. The percentage of the Company’s portfolio investments at cost and fair value by accrual status for the periods ended June 30, 2011 and June 30, 2010 was as follows:
                                                                                                 
    June 30, 2011     September 30, 2010     June 30, 2010  
            % of             % of             % of             % of             % of             % of  
    Cost     Portfolio     Fair Value     Portfolio     Cost     Portfolio     Fair Value     Portfolio     Cost     Portfolio     Fair Value     Portfolio  
             
Accrual
  $ 1,025,169       97.86 %   $ 1,046,526       99.34 %   $ 530,965       89.61 %   $ 531,701       94.30 %   $ 464,112       86.88 %   $ 463,221       93.61 %
PIK non-accrual
          0.00 %           0.00 %           0.00 %           0.00 %     36,901       6.91 %     22,873       4.62 %
Cash non-accrual
    22,383       2.14 %     6,953       0.66 %     61,532       10.39 %     32,120       5.70 %     33,168       6.21 %     8,721       1.77 %
             
Total
  $ 1,047,552       100.00 %   $ 1,053,479       100.00 %   $ 592,497       100.00 %   $ 563,821       100.00 %   $ 534,181       100.00 %   $ 494,815       100.00 %
             
     The non-accrual status of the Company’s portfolio investments as of June 30, 2011, September 30, 2010 and June 30, 2010 was as follows:
                         
    June 30, 2011     September 30, 2010     June 30, 2010  
     
Lighting by Gregory, LLC
  Cash non-accrual   Cash non-accrual   Cash non-accrual
Martini Park, LLC
              Cash non-accrual
Nicos Polymers & Grinding, Inc.
        Cash non-accrual   PIK non-accrual
MK Network, LLC
        Cash non-accrual      
Premier Trailer Leasing, Inc.
  Cash non-accrual   Cash non-accrual   Cash non-accrual
Rose Tarlow, Inc.
              PIK non-accrual
Rail Acquisition Corp.
              PIK non-accrual
Vanguard Vinyl, Inc.
        Cash non-accrual      
     Income non-accrual amounts for the three and nine months ended June 30, 2011 and June 30, 2010 were as follows:
                                 
    Three months ended     Three months ended     Nine months ended     Nine months ended  
    June 30, 2011     June 30, 2010     June 30, 2011     June 30, 2010  
     
Cash interest income
  $ 917     $ 1,349     $ 4,484     $ 3,794  
PIK interest income
    155       519       541       1,439  
OID income
          38       60       247  
     
 
                               
Total
  $ 1,072     $ 1,906     $ 5,085     $ 5,480  
     
Note 8. Taxable/Distributable Income and Dividend Distributions
     Taxable income differs from net increase (decrease) in net assets resulting from operations primarily due to: (1) unrealized appreciation (depreciation) on investments, as investment gains and losses are not included in taxable income until they are realized; (2) origination fees received in connection with investments in portfolio companies, which are amortized into interest income over the life of the investment for book purposes, are treated as taxable income upon receipt; (3) organizational and deferred offering costs; (4) recognition of interest income on certain loans; and (5) income or loss recognition on exited investments.
     At September 30, 2010, the Company had a net loss carryforward of $1.5 million to offset net capital gains, to the extent provided by federal tax law. The capital loss carryforward will expire in the Company’s tax year ending September 30, 2017. During the year ended September 30, 2010, the Company realized capital losses from the sale of investments after October 31 and prior to year end (“post-October capital losses”) of $10.3 million, which for tax purposes are treated as arising on the first day of the following year.

39


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     Listed below is a reconciliation of “net increase in net assets resulting from operations” to taxable income for the three and nine months ended June 30, 2011:
                 
    Three months ended     Nine months ended  
    June 30, 2011     June 30, 2011  
     
Net increase in net assets resulting from operations
  $ 20,832     $ 53,951  
Net change in unrealized (appreciation) depreciation
    (18,452 )     (34,922 )
Book/tax difference due to deferred loan origination fees, net
    (271 )     6,322  
Book/tax difference due to organizational and deferred offering costs
    (22 )     (65 )
Book/tax difference due to interest income on certain loans
          1,726  
Book/tax difference due to capital losses not recognized
    14,146       28,109  
Other book-tax differences
    (163 )     (43 )
     
 
               
Taxable/Distributable Income (1)
  $ 16,070     $ 55,078  
     
 
(1)   The Company’s taxable income for 2011 is an estimate and will not be finally determined until the Company files its tax return for the fiscal year ended September 30, 2011. Therefore, the final taxable income may be different than the estimate.
     Distributions to stockholders are recorded on the record date. The Company is required to distribute annually to its stockholders at least 90% of its net ordinary income and net realized short-term capital gains in excess of net realized long-term capital losses for each taxable year in order to be eligible for the tax benefits allowed to a RIC under Subchapter M of the Code. The Company anticipates paying out as a dividend all or substantially all of those amounts. The amount to be paid out as a dividend is determined by the Board of Directors and is based on management’s estimate of the Company’s annual taxable income. The Company maintains an “opt out” dividend reinvestment plan for its stockholders.

40


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
To date, the Company’s Board of Directors declared the following distributions:
                                 
Dividend Type   Date Declared     Record Date     Payment Date     Amount per Share  
Quarterly
    5/1/2008       5/19/2008       6/3/2008     $ 0.30  
Quarterly
    8/6/2008       9/10/2008       9/26/2008     $ 0.31  
Quarterly
    12/9/2008       12/19/2008       12/29/2008     $ 0.32  
Quarterly
    12/9/2008       12/30/2008       1/29/2009     $ 0.33  
Special
    12/18/2008       12/30/2008       1/29/2009     $ 0.05  
Quarterly
    4/14/2009       5/26/2009       6/25/2009     $ 0.25  
Quarterly
    8/3/2009       9/8/2009       9/25/2009     $ 0.25  
Quarterly
    11/12/2009       12/10/2009       12/29/2009     $ 0.27  
Quarterly
    1/12/2010       3/3/2010       3/30/2010     $ 0.30  
Quarterly
    5/3/2010       5/20/2010       6/30/2010     $ 0.32  
Quarterly
    8/2/2010       9/1/2010       9/29/2010     $ 0.10  
Monthly
    8/2/2010       10/6/2010       10/27/2010     $ 0.10  
Monthly
    8/2/2010       11/3/2010       11/24/2010     $ 0.11  
Monthly
    8/2/2010       12/1/2010       12/29/2010     $ 0.11  
Monthly
    11/30/2010       1/4/2011       1/31/2011     $ 0.1066  
Monthly
    11/30/2010       2/1/2011       2/28/2011     $ 0.1066  
Monthly
    11/30/2010       3/1/2011       3/31/2011     $ 0.1066  
Monthly
    1/30/2011       4/1/2011       4/29/2011     $ 0.1066  
Monthly
    1/30/2011       5/2/2011       5/31/2011     $ 0.1066  
Monthly
    1/30/2011       6/1/2011       6/30/2011     $ 0.1066  
Monthly
    5/2/2011       7/1/2011       7/29/2011     $ 0.1066  
Monthly
    5/2/2011       8/1/2011       8/31/2011     $ 0.1066  
Monthly
    5/2/2011       9/2/2011       9/30/2011     $ 0.1066  
     For income tax purposes, the Company estimates that its distributions will be composed entirely of ordinary income, and will be reflected as such on the Form 1099-DIV for the calendar year 2011. The Company anticipates declaring further distributions to its stockholders to meet the RIC distribution requirements.
     As a RIC, the Company is also subject to a federal excise tax based on distributive requirements of its taxable income on a calendar year basis. Because the Company did not satisfy these distribution requirements for calendar years 2008, 2009 and 2010, the Company incurred a de minimis federal excise tax for those calendar years.
Note 9. Realized Gains or Losses from Investments and Net Change in Unrealized Appreciation or Depreciation from Investments
     Realized gains or losses are measured by the difference between the net proceeds from the sale or redemption and the cost basis of the investment without regard to unrealized appreciation or depreciation previously recognized, and includes investments written-off during the period, net of recoveries. Realized losses may also be recorded in connection with the Company’s determination that certain investments are considered worthless securities and/or meet the conditions for loss recognition per the applicable tax rules. Net change in unrealized appreciation or depreciation from investments reflects the net change in the valuation of the portfolio pursuant to the Company’s valuation guidelines and the reclassification of any prior period unrealized appreciation or depreciation on exited investments.
     During the nine months ended June 30, 2011, the Company recorded investment realization events, including the following:
    In October 2010, the Company received a cash payment of $8.7 million from Goldco, Inc. 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 November 2010, the Company 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 and no realized gain or loss was recorded on this transaction;
 
    In November 2010, the Company restructured its investment in Vanguard Vinyl, Inc. The restructuring resulted in a material modification of the terms of the loan agreement. As such, the Company recorded a realized loss in the amount of $1.7 million in accordance with ASC 470-50;

41


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
    In December 2010, the Company restructured its investment in Nicos Polymers & Grinding, Inc. The restructuring resulted in a material modification of the terms of the loan agreement. As such, the Company recorded a realized loss in the amount of $3.9 million in accordance with ASC 470-50;
 
    In December 2010, the Company received a cash payment of $25.3 million from Boot Barn 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 December 2010, the Company received a cash payment of $11.7 million from Western Emulsions, Inc. in partial satisfaction of the obligations under the loan agreement. No realized gain or loss was recorded on this transaction;
 
    In December 2010, the Company restructured its investment in Lighting by Gregory, LLC. The restructuring resulted in a material modification of the terms of the loan agreement. As such, the Company recorded a realized loss in the amount of $7.8 million in accordance with ASC 470-50;
 
    In March 2011, the Company received a cash payment of $5.0 million from AmBath/ReBath Holdings, Inc. as part of a restructuring of the loan agreement. The restructuring resulted in a material modification of the terms of the loan agreement. As such, the Company recorded a realized loss in the amount of $0.3 million in accordance with ASC 470-50; and
 
    In March and April 2011, the Company received cash payments totaling $1.1 million from MK Network, LLC as part of a settlement of the loan agreement. In April 2011, the Company recorded a realized loss on this investment in the amount of $14.1 million.
     During the nine months ended June 30, 2010, the Company recorded investment realization events, including the following:
    In October 2009, the Company 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 its loan agreement with American Hardwoods Industries, LLC. The Company recorded a $0.1 million reduction to the previously recorded $10.4 million realized loss on the investment in American Hardwoods;
 
    In October 2009, the Company received a cash payment of $3.9 million from Elephant & Castle, Inc. in partial satisfaction of the obligations under the loan agreement. No realized gain or loss was recorded on this transaction; and
 
    In March 2010, the Company recorded a realized loss in the amount of $2.9 million in connection with the sale of a portion of its investment in CPAC, Inc.
Note 10. Concentration of Credit Risks
     The Company places its cash in financial institutions and at times such balances may be in excess of the FDIC insured limit. The Company limits its exposure to credit loss by depositing its cash with high credit quality financial institutions and monitoring their financial stability.
Note 11. Related Party Transactions
     The Company has entered into an investment advisory agreement with the Investment Adviser. Under the investment advisory agreement, the Company pays the Investment Adviser a fee for its services under the investment advisory agreement consisting of two components — a base management fee and an incentive fee.
Base management Fee
     The base management fee is calculated at an annual rate of 2% of the Company’s gross assets, which includes any borrowings for investment purposes. The base management fee is payable quarterly in arrears, and will be calculated based on the value of the Company’s 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 prorated.

42


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
     On January 6, 2010, the Company announced that the Investment Adviser had voluntarily agreed to take the following actions:
    To waive the portion of its base management fee for the quarter ended December 31, 2009 attributable to four new portfolio investments, as well as cash and cash equivalents. The amount of the management fee waived was $0.7 million; and
 
    To permanently waive that portion of its base management fee attributable to the Company’s assets held in the form of cash and cash equivalents as of the end of each quarter beginning March 31, 2010.
     For purposes of the waiver, cash and cash equivalents is as defined in the notes to the Company’s Consolidated Financial Statements.
     For the three and nine months ended June 30, 2011, the net base management fees were $5.4 million and $13.9 million, respectively. For the three and nine months ended June 30, 2010, the net base management fees were $2.5 million and $6.4 million, respectively. At June 30, 2011, the Company had a liability on its Consolidated Statement of Assets and Liabilities in the amount of $5.4 million reflecting the unpaid portion of the base management fee payable to the Investment Adviser.
Incentive Fee
     The incentive fee portion of the investment advisory agreement has two parts. The first part is calculated and payable quarterly in arrears based on the Company’s “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 the Company receives from portfolio companies) accrued during the fiscal quarter, minus the Company’s operating expenses for the quarter (including the base management fee, expenses payable under the Company’s administration agreement with FSC, Inc., and any interest expense and dividends paid on any issued and outstanding indebtedness or 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 the Company has 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 the Company’s 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. The Company’s net investment income used to calculate this part of the incentive fee is also included in the amount of its gross assets used to calculate the 2% base management fee. The operation of the incentive fee with respect to the Company’s 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 the Company’s Pre-Incentive Fee Net Investment Income does not exceed the hurdle rate of 2% (the “preferred return” or “hurdle”);
 
    100% of the Company’s 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. The Company refers to this portion of its 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 the Investment Adviser with an incentive fee of 20% on all of the Company’s Pre-Incentive Fee Net Investment Income as if a hurdle rate did not apply when the Company’s Pre-Incentive Fee Net Investment Income exceeds 2.5% in any fiscal quarter; and

43


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
    20% of the amount of the Company’s 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 (20% of all Pre-Incentive Fee Net Investment Income thereafter is allocated to the Investment Adviser).
     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), commencing on September 30, 2008, and equals 20% of the Company’s 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.
     GAAP requires the Company to accrue for the theoretical capital gains incentive fee that would be payable after giving effect to the net realized and unrealized capital appreciation and depreciation. It should be noted that a fee so calculated and accrued would not necessarily be payable under the investment advisory agreement, and may never be paid based upon the computation of capital gains incentive fees in subsequent periods. Amounts ultimately paid under the investment advisory agreement will be consistent with the formula reflected in the investment advisory agreement.
     The Company does not currently accrue for capital gains incentive fees due to the accumulated realized and unrealized losses in the portfolio.
     For the three and nine months ended June 30, 2011, incentive fees were $4.1 million and $11.8 million, respectively. For the three and nine months ended June 30, 2010, incentive fees were $3.0 million and $7.9 million, respectively, and were comprised solely of incentive fees related to the Company’s Pre-Incentive Fee Net Investment Income. At June 30, 2011, the Company had a liability on its Consolidated Statement of Assets and Liabilities in the amount of $4.1 million reflecting the unpaid portion of the incentive fee payable to the Investment Adviser.
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, the Company’s 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 the Company for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of the Investment Adviser’s services under the investment advisory agreement or otherwise as the Company’s Investment Adviser.
Administration Agreement
     The Company has also entered into an administration agreement with FSC, Inc. under which FSC, Inc. provides administrative services for the Company, 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 the Company’s required administrative services, which includes being responsible for the financial records which the Company is required to maintain and preparing reports to the Company’s stockholders and reports filed with the SEC. In addition, FSC, Inc. assists the Company in determining and publishing the Company’s net asset value, overseeing the preparation and filing of the Company’s tax returns and the printing and dissemination of reports to the Company’s stockholders, and generally overseeing the payment of the Company’s expenses and the performance of administrative and professional services rendered to the Company by others. For providing these services, facilities and personnel, the Company reimburses 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 the Company’s allocable portion of the costs of compensation and related expenses of the Company’s chief financial officer and chief compliance officer and their staffs. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for the Company by its chief compliance officer. 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 the Company’s behalf, managerial assistance to the Company’s portfolio companies. The administration agreement may be terminated by either party without penalty upon 60 days’ written notice to the other party.
     For the three and nine months ended June 30, 2011, the Company accrued administration expenses of $0.6 million, including $0.2 million of general and administrative expenses, and $1.9 million, including $0.8 million of general and administrative expenses, that are due to FSC, Inc., respectively. At June 30, 2011, $0.8 million was included in Due to FSC, Inc. in the Consolidated Statement of Assets and Liabilities.

44


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
Note 12. Financial Highlights
                                 
    Three     Three     Nine     Nine  
    months ended     months ended     months ended     months ended  
    June 30, 2011     June 30, 2010     June 30, 2011     June 30, 2010  
Net asset value at beginning of period
  $ 10.68     $ 10.70     $ 10.43     $ 10.84  
Net investment income
    0.25       0.26       0.77       0.75  
Net unrealized appreciation (depreciation) on investments and interest rate swap
    0.28       (0.30 )     0.57       (0.28 )
Net realized loss on investments
    (0.21 )           (0.46 )     (0.07 )
Dividends declared
    (0.32 )     (0.32 )     (0.94 )     (0.89 )
Issuance of common stock
    0.04       0.09       0.35       0.08  
Net asset value at end of period
  $ 10.72     $ 10.43     $ 10.72     $ 10.43  
 
                               
Per share market value at beginning of period
  $ 13.35     $ 11.61     $ 11.14     $ 10.93  
Per share market value at end of period
  $ 11.60     $ 11.03     $ 11.60     $ 11.03  
Total return (1)
    (10.85 )%     (2.24 )%     12.32 %     11.55 %
Common shares outstanding at beginning of period
    66,668       45,283       54,550       37,879  
Common shares outstanding at end of period
    72,376       54,525       72,376       54,525  
 
                               
Net assets at beginning of period
  $ 711,748     $ 484,397     $ 569,172     $ 410,556  
Net assets at end of period
  $ 775,649     $ 568,962     $ 775,649     $ 568,962  
Average net assets (2)
  $ 718,704     $ 481,979     $ 650,881     $ 449,540  
Ratio of net investment income to average net assets (3)
    9.22 %     10.01 %     9.68 %     9.39 %
Ratio of total expenses to average net assets (3)
    8.88 %     6.14 %     8.29 %     5.63 %
Ratio of portfolio turnover to average investments at fair value
    0.00 %     0.00 %     1.75 %     1.13 %
Weighted average outstanding debt (4)
  $ 294,542     $ 23,269     $ 206,797     $ 11,857  
Average debt per share
  $ 4.39     $ 0.50     $ 3.38     $ 0.28  
 
(1)   Total return equals the increase or decrease of ending market value over beginning market value, plus distributions, divided by the beginning market value, assuming dividend reinvestment prices obtained under the Company’s dividend reinvestment plan. Total return is not annualized.
 
(2)   Calculated based upon the daily weighted average net assets for the period.
 
(3)   Interim periods are annualized.
 
(4)   Calculated based upon the daily weighted average of loans payable for the period.

45


 

FIFTH STREET FINANCE CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(in thousands, except share and per share amounts, percentages and as otherwise indicated)
Note 13. Preferred Stock
     The Company’s restated certificate of incorporation had not authorized any shares of preferred stock. However, on April 4, 2008, the Company’s Board of Directors approved a certificate of amendment to its restated certificate of incorporation reclassifying 200,000 shares of its common stock as shares of non-convertible, non-participating preferred stock, with a par value of $0.01 and a liquidation preference of $500 per share (“Series A Preferred Stock”) and authorizing the issuance of up to 200,000 shares of Series A Preferred Stock. A certificate of amendment was also approved by the holders of a majority of the shares of the Company’s outstanding common stock through a written consent first solicited on April 7, 2008.
     On April 20, 2010, at the Company’s 2010 Annual Meeting, the Company’s stockholders approved an amendment to the Company’s restated certificate of incorporation to remove the Company’s authority to issue shares of Series A Preferred Stock.
Note 14. Interest Rate Swaps
     In August 2010, the Company entered into a three-year interest rate swap agreement to mitigate its exposure to adverse fluctuations in interest rates for a total notional amount of $100.0 million. Under the interest rate swap agreement, the Company will pay a fixed interest rate of 0.99% and receive a floating rate based on the prevailing one-month LIBOR, which as of June 30, 2011 was 0.19%. For the three and nine months ended June 30, 2011, the Company recorded unrealized depreciation of $0.9 million and unrealized appreciation of $0.1 million, respectively, related to this swap agreement. As of June 30, 2011, this swap agreement had a fair value of ($0.7) million which is included in “accounts payable, accrued expenses and other liabilities” in the Company’s Consolidated Statements of Assets and Liabilities.
     As of June 30, 2011, the Company posted $2.1 million of cash as collateral with respect to the interest rate swap. The Company is restricted in terms of access to this collateral until such swap is terminated or the swap agreement expires. Cash collateral posted is held in an account at Wells Fargo.
     Swaps contain varying degrees of off-balance sheet risk which could result from changes in the market values of underlying assets, indices or interest rates and similar items. As a result, the amounts recognized in the Consolidated Statement of Assets and Liabilities at any given date may not reflect the total amount of potential losses that the Company could ultimately incur.
Note 15. Convertible Senior Notes
     On April 12, 2011, the Company issued $152 million unsecured convertible senior notes (“Convertible Notes”), including $2 million issued to Leonard M. Tannenbaum, the Company’s Chief Executive Officer. The Convertible Notes were issued pursuant to an Indenture, dated April 12, 2011 (the “Indenture”), between the Company and Deutsche Bank Trust Company Americas, as trustee (the “Trustee”).
      The Convertible Notes mature on April 1, 2016 (the “Maturity Date”), unless previously converted or repurchased in accordance with their terms. The Convertible Notes bear interest at a rate of 5.375% per year payable semiannually in arrears on April 1 and October 1 of each year, commencing on October 1, 2011. The Convertible Notes are the Company’s senior unsecured obligations and rank senior in right of payment to the Company’s existing and future indebtedness that is expressly subordinated in right of payment to the Convertible Notes; equal in right of payment to the Company’s existing and future unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of the Company’s secured indebtedness (including existing unsecured indebtedness that the Company later secures) to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness (including trade payables) incurred by the Company’s subsidiaries or financing vehicles.
     Prior to the close of business on the business day immediately preceding January 1, 2016, holders may convert their Convertible Notes only under certain circumstances set forth in the Indenture, such as during specified periods when the Company’s shares of common stock trade at more than 110% of the then applicable conversion price or the Convertible Notes trade at less than 98% of their conversion value. On or after January 1, 2016 until the close of business on the business day immediately preceding the Maturity Date, holders may convert their Convertible Notes at any time. Upon conversion, the Company will deliver shares of its common stock. The conversion rate was initially, and currently is, 67.7415 shares of common stock per $1,000 principal amount of Convertible Notes (equivalent to a conversion price of approximately $14.76 per share of common stock). The conversion rate is subject to customary anti-dilution adjustments, including for any cash dividends or distributions paid on shares of the Company’s common stock in excess of the monthly dividend of $0.1066 the Company is currently paying, but will not be adjusted for any accrued and unpaid interest. In addition, if certain corporate events occur prior to the Maturity Date, the conversion rate will be increased for converting holders.
     The Company may not redeem the Convertible Notes prior to maturity. No sinking fund is provided for the Convertible Notes. In addition, if certain corporate events occur in respect of the Company, holders of the Convertible Notes may require the Company to repurchase for cash all or part of their Convertible Notes at a repurchase price equal to 100% of the principal amount of the Convertible Notes to be repurchased, plus accrued and unpaid interest through, but excluding, the required repurchase date.
     The Indenture contains certain covenants, including covenants requiring the Company to provide financial information to the holders of the Convertible Notes, and the Trustee if the Company ceases to be subject to the reporting requirements of the Securities Exchange Act of 1934. These covenants are subject to limitations and exceptions that are described in the Indenture.
      For the three months ended June 30, 2011, the Company recorded interest expense of $2.0 million related to the Convertible Notes.

46


 

Item 2. 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 quarterly report on Form 10-Q.
     Some of the statements in this quarterly report on Form 10-Q constitute forward-looking statements because they relate to future events or our future performance or financial condition. The forward-looking statements contained in this quarterly report on Form 10-Q 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 forward-looking statements, although not all forward-looking statements include these words. The forward-looking statements contained in this quarterly report on Form 10-Q 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 “Risk Factors” in our annual report on Form 10-K for the year ended September 30, 2010 and our quarterly report on Form 10-Q for the quarter ended March 31, 2011. Other factors that could cause actual results to differ materially include:
    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 business development companies, small business investment companies, or SBICs, and regulated investment companies, 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 quarterly report on Form 10-Q on information available to us on the date of this quarterly 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 Securities and Exchange Commission, or the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.
     Except as otherwise specified, references to the “Company,” “we,” “us,” and “our,” refer to Fifth Street Finance Corp.
     All amounts are in thousands, except share and per share amounts, percentages and as otherwise indicated.

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Overview
     We are a specialty finance company that lends to and invests in small and mid-sized companies primarily 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 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.
     On December 7, 2010, we entered into an at-the-market equity offering sales agreement relating to shares of our common stock. Throughout the month of December 2010, we sold 429,110 shares of our common stock at an average offering price of $11.87 per share. We terminated the at-the-market equity offering sales agreement effective January 20, 2011 and did not sell any shares of our common stock pursuant thereto subsequent to December 31, 2010.
     On February 4, 2011, we completed a follow-on public offering of 11,500,000 shares of our common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $12.65 per share.
      On April 12, 2011, we issued $152 million unsecured convertible senior notes (“Convertible Notes”) which are convertible into shares of our common stock at the initial rate of 67.7415 shares of common stock per $1,000 principal amount of Convertible Notes (equivalent to a conversion price of approximately $14.76 per share of common stock).
     On June 24, 2011, we completed a follow-on public offering of 5,558,469 shares of our common stock, which included the underwriters’ exercise of their over-allotment option, at the offering price of $11.72 per share.
Current Market Conditions
     Since mid-2007, the global financial markets have experienced 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. 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.

48


 

Critical Accounting Policies
FASB Accounting Standards Codification
     The issuance of FASB Accounting Standards Codification tm (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
     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, income, and bond yield approaches as appropriate. In general, we utilize the bond yield method in determining the fair value 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 in determining the fair value of our investment in the portfolio company. If there is deterioration in the credit quality of the portfolio company or an investment is in workout status, we may use alternative methodologies 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 (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.
     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;

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    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 June 30, 2011, and September 30, 2010, 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 their processes each quarter, the independent valuation firms provide us with written reports 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.
     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 %
For the quarter ending December 31, 2010
    73.9 %
For the quarter ending March 31, 2011
    82.0 %
For the quarter ending June 30, 2011
    82.9 %
(1)   96.0% excluding our investment in IZI Medical Products, Inc., which closed on December 31, 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 a quarterly basis, with a substantial portion being valued on an annual basis.
     As of June 30, 2011 and September 30, 2010, approximately 96.3% and 86.5%, 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.

50


 

Fee Income
     We receive a variety of fees in the ordinary course of business. Certain fees, such as some 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 payable upon the exit of a debt security and a portion of these fees are included in net investment income over the life of the loan. The receipt of such fees is 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 “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 our annual report on Form 10-K for the year ended September 30, 2010. 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. The accrual of PIK interest on our debt investments increases the recorded cost basis of these investments in our consolidated financial statements and, as a result, increases the cost basis of these investments for purposes of computing the capital gains incentive fee payable by us to our investment adviser.
     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 $22.1 million and represented 2.1% of the fair value of our portfolio of investments as of June 30, 2011 and $19.3 million or 3.4% as of September 30, 2010. 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 and generally have terms of up to six years (but an expected average life of between three and four years). We are currently focusing our new debt origination efforts on first lien loans because we believe that the risk-adjusted returns from these loans are superior to second lien and unsecured loans 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:
                 
    June 30, 2011     September 30, 2010  
Cost:
               
First lien debt
    81.74 %     72.61 %
Second lien debt
    14.41 %     25.42 %
Subordinated debt
    2.49 %     0.80 %
Purchased equity
    0.71 %     0.39 %
Equity grants
    0.59 %     0.75 %
Limited partnership interests
    0.06 %     0.03 %
 
           
 
               
Total
    100.00 %     100.00 %
 
           
 
               
 
    June 30, 2011       September 30, 2010  
 
           
Fair value:
               
First lien debt
    82.55 %     73.84 %
Second lien debt
    13.24 %     24.45 %
Subordinated debt
    2.34 %     0.78 %
Purchased equity
    1.10 %     0.11 %
Equity grants
    0.71 %     0.79 %
Limited partnership interests
    0.06 %     0.03 %
 
           
 
               
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:
 
    June 30, 2011     September 30, 2010  
Cost:
               
Healthcare services
    18.89 %     14.76 %
Healthcare equipment
    6.79 %     8.02 %
Diversified support services
    5.44 %     4.43 %
Oil & gas equipment & services
    5.10 %     0.00 %
IT consulting & other services
    4.77 %     0.00 %
Internet software & services
    4.10 %     0.00 %
Construction and engineering
    4.03 %     4.22 %
Leisure facilities
    3.71 %     1.16 %
Specialty stores
    3.30 %     0.00 %
Household products
    3.18 %     0.18 %
Electronic equipment & instruments
    3.12 %     5.59 %
Apparel, accessories & luxury goods
    3.06 %     3.97 %
Home improvement retail
    2.68 %     5.51 %
Education services
    2.61 %     7.58 %
Fertilizers & agricultural chemicals
    2.51 %     4.51 %
Food distributors
    2.50 %     5.13 %
Integrated telecommunication services
    2.48 %     0.00 %
Healthcare technology
    1.98 %     3.63 %
Human resources & employment services
    1.97 %     0.00 %
Electronic manufacturing services
    1.87 %     3.16 %
Food retail
    1.82 %     3.31 %
Advertising
    1.81 %     3.35 %
Distributors
    1.77 %     2.25 %
Air freight and logistics
    1.71 %     2.36 %
Trucking
    1.63 %     2.88 %
Environmental & facilities services
    1.55 %     1.51 %
Data processing and outsourced services
    1.22 %     2.21 %
Other diversified financial services
    1.18 %     0.00 %
Industrial machinery
    0.99 %     1.71 %
Construction materials
    0.64 %     2.95 %
Building products
    0.64 %     1.40 %
Housewares & specialties
    0.51 %     2.06 %
Restaurants
    0.40 %     2.11 %
Multi-sector holdings
    0.02 %     0.02 %
Movies & entertainment
    0.02 %     0.03 %
     
 
               
Total
    100.00 %     100.00 %
     

52


 

                 
    June 30, 2011     September 30, 2010  
Fair Value:
               
Healthcare services
    19.45 %     15.83 %
Healthcare equipment
    6.90 %     8.57 %
Diversified support services
    5.53 %     4.66 %
Oil & gas equipment & services
    5.17 %     0.00 %
IT consulting & other services
    4.87 %     0.00 %
Internet software & services
    4.16 %     0.00 %
Leisure facilities
    3.75 %     1.25 %
Construction and engineering
    3.68 %     4.23 %
Apparel, accessories & luxury goods
    3.42 %     4.18 %
Specialty stores
    3.38 %     0.00 %
Household products
    3.23 %     0.19 %
Electronic equipment & instruments
    3.10 %     5.83 %
Education services
    2.69 %     7.47 %
Home improvement retail
    2.67 %     5.76 %
Fertilizers & agricultural chemicals
    2.56 %     4.76 %
Food distributors
    2.56 %     5.38 %
Integrated telecommunication services
    2.52 %     0.00 %
Environmental & facilities services
    2.13 %     0.91 %
Healthcare technology
    2.03 %     3.93 %
Human resources & employment services
    2.02 %     0.00 %
Food retail
    1.86 %     3.50 %
Advertising
    1.84 %     3.52 %
Distributors
    1.79 %     2.35 %
Air freight and logistics
    1.63 %     2.49 %
Electronic manufacturing services
    1.33 %     3.20 %
Other diversified financial services
    1.21 %     0.00 %
Data processing and outsourced services
    1.19 %     2.26 %
Industrial machinery
    1.04 %     1.81 %
Construction materials
    0.65 %     3.02 %
Building products
    0.64 %     1.21 %
Trucking
    0.37 %     0.82 %
Housewares & specialties
    0.29 %     0.66 %
Restaurants
    0.27 %     2.15 %
Multi-sector holdings
    0.06 %     0.01 %
Movies & entertainment
    0.01 %     0.05 %
     
 
               
Total
    100.00 %     100.00 %
     

53


 

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 investments 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 June 30, 2011 and September 30, 2010:
                                                 
    June 30, 2011     September 30, 2010  
            Percentage of     Leverage             Percentage of     Leverage  
    Fair Value     Total Portfolio     Ratio     Fair Value     Total Portfolio     Ratio  
1
  $ 99,826       9.48 %     3.06     $ 89,150       15.81 %     2.97  
2
    929,843       88.26 %     3.47       424,495       75.29 %     4.31  
3
    14,016       1.33 %   NM (1)     18,056       3.20 %     13.25  
4
    2,840       0.27 %   NM (1)     23,823       4.23 %     8.13  
5
    6,954       0.66 %   NM (1)     8,297       1.47 %   NM (1)
     
 
                                               
Total
  $ 1,053,479       100.00 %     3.35     $ 563,821       100.00 %     4.53  
     
 
(1)   Due to operating performance this ratio is not measurable and, as a result, is excluded from the total portfolio calculation.
     We may from time to time modify the payment terms of our investments, either in response to current economic conditions and their impact on certain of our portfolio companies or in accordance with tier pricing provisions in certain loan agreements. As of June 30, 2011, we had modified the payment terms of our investments in eight portfolio companies. Such modified terms may include increased PIK interest provisions and reduced cash interest rates. These modifications, and any future modifications to our loan agreements, 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
     As of June 30, 2011, we had stopped accruing cash interest, PIK interest and original issue discount (“OID”) on two investments that did not pay all of their scheduled cash interest payments for the period ended June 30, 2011. As of June 30, 2010, we had stopped accruing PIK interest and OID on six investments, including three investments that had not paid all of their scheduled cash interest payments.

54


 

      Cash non-accrual status is inclusive of PIK and other noncash income, where applicable. The percentage of our portfolio investments at cost and fair value by accrual status for the periods ended June 30, 2011 and June 30, 2010 was as follows:
                                                                                                 
    June 30, 2011     September 30, 2010     June 30, 2010  
            % of             % of             % of             % of             % of             % of  
    Cost     Portfolio     Fair Value     Portfolio     Cost     Portfolio     Fair Value     Portfolio     Cost     Portfolio     Fair Value     Portfolio  
             
Accrual
  $ 1,025,169       97.86 %   $ 1,046,526       99.34 %   $ 530,965       89.61 %   $ 531,701       94.30 %   $ 464,112       86.88 %   $ 463,221       93.61 %
PIK non-accrual
          0.00 %           0.00 %           0.00 %           0.00 %     36,901       6.91 %     22,873       4.62 %
Cash non-accrual
    22,383       2.14 %     6,953       0.66 %     61,532       10.39 %     32,120       5.70 %     33,168       6.21 %     8,721       1.77 %
             
Total
  $ 1,047,552       100.00 %   $ 1,053,479       100.00 %   $ 592,497       100.00 %   $ 563,821       100.00 %   $ 534,181       100.00 %   $ 494,815       100.00 %
             
The non-accrual status of our portfolio investments as of June 30, 2011, September 30, 2010 and June 30, 2010 was as follows:
                         
    June 30, 2011     September 30, 2010     June 30, 2010  
     
Lighting by Gregory, LLC
  Cash non-accrual   Cash non-accrual   Cash non-accrual
Martini Park, LLC
              Cash non-accrual
Nicos Polymers & Grinding, Inc.
        Cash non-accrual   PIK non-accrual
MK Network, LLC
        Cash non-accrual      
Premier Trailer Leasing, Inc.
  Cash non-accrual   Cash non-accrual   Cash non-accrual
Rose Tarlow, Inc.
              PIK non-accrual
Rail Acquisition Corp.
              PIK non-accrual
Vanguard Vinyl, Inc.
        Cash non-accrual      
Income non-accrual amounts for the three and nine months ended June 30, 2011 and June 30, 2010 were as follows:
                                 
    Three months ended     Three months ended     Nine months ended     Nine months ended  
    June 30, 2011     June 30, 2010     June 30, 2011     June 30, 2010  
     
Cash interest income
  $ 917     $ 1,349     $ 4,484     $ 3,794  
PIK interest income
    155       519       541       1,439  
OID income
          38       60       247  
     
 
                               
Total
  $ 1,072     $ 1,906     $ 5,085     $ 5,480  
     

55


 

Discussion and Analysis of Results and Operations
Results of Operations
     The principal measure of our financial performance is net increase (decrease) in net assets resulting from operations, 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 the three and nine months ended June 30, 2011 and June 30, 2010
Total Investment Income
     Total investment income includes interest and dividend income on our investments, fee income and other investment income. Fee income consists principally of loan and arrangement fees, administrative fees, unused fees, amendment fees, equity structuring fees, exit fees, prepayment fees and waiver fees. Other investment income consists primarily of dividend income received from certain of our equity investments.
     Total investment income for the three months ended June 30, 2011 and June 30, 2010 was $32.4 million and $19.4 million, respectively. For the three months ended June 30, 2011, this amount primarily consisted of $29.0 million of interest income from portfolio investments (which included $3.6 million of PIK interest), and $3.3 million of fee income. For the three months ended June 30, 2010, total investment income primarily consisted of $17.4 million of interest income from portfolio investments (which included $2.4 million of PIK interest), and $1.7 million of fee income.
     Total investment income for the nine months ended June 30, 2011 and June 30, 2010 was $87.5 million and $50.5 million, respectively. For the nine months ended June 30, 2011, this amount primarily consisted of $75.6 million of interest income from portfolio investments (which included $10.2 million of PIK interest), and $11.7 million of fee income. For the nine months ended June 30, 2010, this amount primarily consisted of $45.9 million of interest income from portfolio investments (which included $6.7 million of PIK interest) and $4.0 million of fee income.
     The increase in our total investment income for the three and nine months ended June 30, 2011 as compared to the three and nine months ended June 30, 2010 was primarily attributable to higher average levels of outstanding debt investments, which was principally due to an increase of 24 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 three months ended June 30, 2011 and June 30, 2010 were $15.9 million and $7.4 million, respectively. Expenses increased for the three months ended June 30, 2011 as compared to the three months ended June 30, 2010 by $8.5 million, primarily as a result of increases in the base management fee, the incentive fee, interest expense and professional fees.
     Expenses (net of the permanently waived portion of the base management fee) for the nine months ended June 30, 2011 and June 30, 2010 were $40.3 million and $18.9 million, respectively. Expenses increased for the nine months ended June 30, 2011 as compared to the nine months ended June 30, 2010 by $21.4 million, primarily as a result of increases in the base management fee, the incentive fee, interest expense, professional fees, and other general and administrative expenses.
Net Investment Income
     As a result of the $13.0 million increase in total investment income as compared to the $8.5 million increase in net expenses, net investment income for the three months ended June 30, 2011 reflected a $4.5 million, or 37.4%, increase compared to the three months ended June 30, 2010.
     As a result of the $37.0 million increase in total investment income as compared to the $21.4 million increase in net expenses, net investment income for the nine months ended June 30, 2011 reflected a $15.6 million, or 49.2%, increase compared to the nine months ended June 30, 2010.
Realized Gain (Loss) on Sale of 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 nine months ended June 30, 2011, we recorded investment realization events, including the following:

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    In October 2010, we received a cash payment of $8.7 million from Goldco, Inc. 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 November 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 and no realized gain or loss was recorded on this transaction;
 
    In November 2010, we restructured our investment in Vanguard Vinyl, Inc. 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 $1.7 million in accordance with ASC 470-50;
 
    In December 2010, we restructured our investment in Nicos Polymers & Grinding, Inc. 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 $3.9 million in accordance with ASC 470-50;
 
    In December 2010, we received a cash payment of $25.3 million from Boot Barn 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 December 2010, we received a cash payment of $11.7 million from Western Emulsions, Inc. in partial satisfaction of the obligations under the loan agreement. No realized gain or loss was recorded on this transaction;
 
    In December 2010, we restructured our investment in Lighting by Gregory, LLC. 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 $7.8 million in accordance with ASC 470-50;
 
    In March 2011, we received a cash payment of $5.0 million from AmBath/ReBath Holdings, Inc. as part of a restructuring of the loan agreement. 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 $0.3 million in accordance with ASC 470-50; and
 
    In March and April 2011, we received cash payments totaling $1.1 million from MK Network, LLC as part of a settlement of the loan agreement. In April 2011, we recorded a realized loss on this investment in the amount of $14.1 million.
     During the nine months ended June 30, 2010, we recorded investment realization events, including the following:
    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 October 2009, we received a cash payment of $3.9 million from Elephant & Castle, Inc. in partial satisfaction of the obligations under the loan agreement. No realized gain or loss was recorded on this transaction; and
 
    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 investment in CPAC, Inc.
Net Unrealized Appreciation or Depreciation on Investments and Interest Rate Swap
          Net unrealized appreciation or depreciation is the net change in the fair value of our investment portfolio and our interest rate swap during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.
          During the three months ended June 30, 2011, we recorded net unrealized appreciation of $18.5 million. This consisted of $14.0 million of net reclassifications to realized losses and $7.1 million of net unrealized appreciation on equity investments, offset by $1.7 million of net unrealized depreciation on debt investments and $0.9 million of net unrealized depreciation on our interest rate swap. During the three months ended June 30, 2010, we recorded net unrealized depreciation of $13.9 million. This consisted of $13.3 million of net unrealized depreciation on debt investments and $0.6 million of net unrealized depreciation on equity investments.
          During the nine months ended June 30, 2011, we recorded net unrealized appreciation of $34.9 million. This consisted of $24.9 million of net reclassifications to realized losses, $4.0 million of net unrealized appreciation on debt investments and $6.0 million of net unrealized appreciation on equity investments. During the nine months ended June 30, 2010, we recorded net unrealized depreciation of $11.7 million. This consisted of $15.3 million of net unrealized depreciation on debt investments, partially offset by $0.3 million of net unrealized appreciation on equity investments and $3.3 million of reclassifications to realized losses.
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. We intend to fund our future distribution obligations through operating cash flow or with funds obtained through future equity and debt offerings or credit facilities, as we deem appropriate.
          For the nine months ended June 30, 2011, we experienced a net decrease in cash and cash equivalents of $59.2 million. During that period, we used $431.5 million of cash in operating activities, primarily for the funding of $566.8 million of investments, partially offset by $89.0 million of principal and PIK payments received and $47.1 million of net investment income. During the same period, cash provided by financing activities was $372.3 million, primarily consisting of $77.0 million of SBA borrowings, $206.8 million of proceeds from the issuance of our common stock, and $152.0 million of proceeds from the issuance of our convertible senior notes, partially offset by $53.6 million of cash dividends paid and $9.2 million of deferred financing costs paid.
          For the nine months ended June 30, 2010, we experienced a net decrease in cash and cash equivalents of $6.5 million. During that period, we used $177.8 million of cash in operating activities, primarily for the funding of $226.5 million of investments, partially offset by $4.2 million of cash proceeds from the sale of investments, $15.8 million of principal and PIK payments received and $31.6 million of net investment income. During the same period cash provided by financing activities was $171.3 million, primarily consisting of $179.1 million of proceeds from the issuance of our common stock, partially offset by $36.7 million of cash dividends paid and $5.2 million of deferred financing costs paid.
          As of June 30, 2011, we had $17.6 million in cash and cash equivalents, portfolio investments (at fair value) of $1.05 billion, $7.2 million of interest and fees receivable, $150.0 million of SBA debentures payable, $152.0 million of convertible senior notes payable, and unfunded commitments of $95.0 million.

57


 

     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 and unfunded commitments of $49.5 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, future borrowings and future offerings of securities. In the future, 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 June 30, 2011, 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, through a wholly-owned subsidiary, we 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 June 30, 2011, 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 $150.0 million of SBA debentures were outstanding as of June 30, 2011. $73.0 million of these debentures bear interest at a rate of 3.50% per annum, including the SBA annual charge of 0.285%, $65.3 million of these debentures bear interest at a rate of 4.369% per annum, including the SBA annual charge of 0.285%, and the remainder do not yet have a locked interest rate.
     We have received exemptive relief from the Securities and Exchange Commission (“SEC”) to permit us to exclude the debt of the SBIC subsidiary guaranteed by the SBA from the definition of senior securities in the 200% asset coverage test under the 1940 Act. This allows us increased flexibility under the 200% asset coverage test by permitting us to borrow up to $150 million more than we would otherwise be able to absent the receipt of this exemptive relief.
     We have also submitted an application to the SBA for a second SBIC license. On May 27, 2011, we received a letter from the Investment Division of the SBA that invited us to continue moving forward with this application. If approved, this license would provide us with the capability to issue an additional $75 million of SBA-guaranteed debentures beyond the $150 million of SBA-guaranteed debentures we, through our wholly-owned subsidiary, currently have the ability to issue. However, there are no assurances that we will be successful in obtaining a second SBIC license from the SBA.
Significant capital transactions that occurred from October 1, 2009 through June 30, 2011

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     The following table reflects the dividend distributions per share that our Board of Directors has declared on our common stock from October 1, 2009 through June 30, 2011:
                                         
Date   Record   Payment   Amount     Cash   DRIP Shares     DRIP Shares
Declared   Date   Date   per Share     Distribution   Issued     Value
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
August 2, 2010
  October 6, 2010   October 27, 2010     0.10     5.2 million     24,850     0.3 million
August 2, 2010
  November 3, 2010   November 24, 2010     0.11     5.7 million     26,569     0.3 million
August 2, 2010
  December 1, 2010   December 29, 2010     0.11     5.7 million     28,238     0.3 million
November 30, 2010
  January 4, 2011   January 31, 2011     0.1066     5.4 million     36,038     0.5 million
November 30, 2010
  February 1, 2011   February 28, 2011     0.1066     5.5 million     29,072     0.4 million
November 30, 2010
  March 1, 2011   March 31, 2011     0.1066     6.5 million     43,766     0.6 million
January 30, 2011
  April 1, 2011   April 29, 2011     0.1066     6.5 million     45,193     0.6 million
January 30, 2011
  May 2, 2011   May 31, 2011     0.1066     6.5 million     48,870     0.6 million
January 30, 2011
  June 1, 2011   June 30, 2011     0.1066     6.5 million     55,367     0.6 million
May 2, 2011
  July 1, 2011   July 29, 2011     0.1066     7.1 million     58,829     0.6 million
May 2, 2011
  August 1, 2011   August 31, 2011     0.1066                    
May 2, 2011
  September 1, 2011   September 30, 2011     0.1066                    
The following table reflects share transactions that occurred from October 1, 2009 through June 30, 2011:
                             
Date   Transaction   Shares     Share Price     Gross Proceeds (Uses)
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
December 2010
  At-the-market offering     429,110       11.87 (2)   5.1 million
February 4, 2011
  Public offering (1)     11,500,000       12.65     145.5 million
June 24, 2011
  Public offering (1)     5,558,469       11.72     65.1 million
 
(1)   Includes the underwriters’ full or partial exercise of their over-allotment option
 
(2)   Average offering price
Borrowings
     On November 16, 2009, we and Fifth Street Funding, LLC, a consolidated wholly-owned bankruptcy remote, special purpose subsidiary (“Funding”), entered into a Loan and Servicing Agreement (“Wells 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, 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

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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 could be extended for up to two additional years upon the mutual consent of Wells Fargo and each of the lender parties thereto.
     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 February 28, 2011, we amended the Wells Fargo facility to, among other things, reduce the interest rate to LIBOR plus 3.0% per annum, with no LIBOR floor, and extend the maturity date of the facility to February 25, 2014.
     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 Wells Agreement and other documents entered into in connection with the Wells Fargo facility.
     The Wells 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 Wells 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 June 30, 2011, 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 had a maturity date of May 27, 2013. The ING facility also allowed us to request letters of credit from ING Capital LLC, as the issuing bank. The initial commitment under the ING facility was $90 million, and the ING facility included 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 Fifth Street Funding, LLC (the special purpose subsidiary established pursuant to the Wells Fargo facility) 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 Fifth Street Funding, LLC 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.
     On February 22, 2011, we amended the ING facility to, among other things, expand the borrowing capacity to $215 million. In addition, the ING facility’s accordion feature was increased to allow for potential future expansion up to a total of $300 million and the maturity date was extended to February 22, 2014.

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     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 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.
     As of June 30, 2011, we had no borrowings outstanding under the ING facility.
     As of June 30, 2011, 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 three and nine months ended June 30, 2011 was $5.0 million and