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EX-32.2 - CERTIFICATION OF CFO PURSUANT TO SECTION 906 - Oaktree Specialty Lending Corpd247662dex322.htm
EX-31.2 - CERTIFICATION OF CFO PURSUANT TO RULE 13A-14(A) - Oaktree Specialty Lending Corpd247662dex312.htm
EX-32.1 - CERTIFICATION OF CEO PURSUANT TO SECTION 906 - Oaktree Specialty Lending Corpd247662dex321.htm
EX-31.1 - CERTIFICATION OF CEO PURSUANT TO RULE 13A-14(A) - Oaktree Specialty Lending Corpd247662dex311.htm
EX-10.15 - AMENDMENT NO. 2 TO AMENDED & RESTATED SENIOR SECURED REVOLVING CREDIT AGREEMENT - Oaktree Specialty Lending Corpd247662dex1015.htm
EX-10.19 - PURCHASE AND SALE AGREEMENT - Oaktree Specialty Lending Corpd247662dex1019.htm
EX-10.17 - WAIVER LETTER - Oaktree Specialty Lending Corpd247662dex1017.htm
EX-10.18 - LOAN AND SERVICING AGREEMENT - Oaktree Specialty Lending Corpd247662dex1018.htm
Table of Contents

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-K

(Mark One)

 

  þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
       OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended September 30, 2011

OR

 

  ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
       OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER: 1-33901

Fifth Street Finance Corp.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

 

DELAWARE   26-1219283

(State or jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

10 Bank Street, 12th Floor

White Plains, NY

 

10606

(Zip Code)

(Address of principal executive office)  

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE:

(914) 286-6800

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

Title of Each Class

 

Name of Each Exchange

on Which Registered

Common Stock, par value $0.01 per share  

The NASDAQ Global Select Market

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    YES  ¨        No  þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    YES  ¨        No  þ

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods as the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  þ        NO  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨        No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  þ           Accelerated filer  ¨   Non-accelerated filer  ¨   Smaller reporting company  ¨
    (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  ¨        NO  þ

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant as of March 31, 2011 is $868,428,327. The registrant had 72,375,832 shares of common stock outstanding as of November 28, 2011.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement relating to the registrant’s 2012 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company’s fiscal year, are incorporated by reference in Part III of this Annual Report on Form 10-K as indicated herein.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page  
   PART I   

Item 1.

  

Business

     1   

Item 1A.

  

Risk Factors

     25   

Item 1B.

  

Unresolved Staff Comments

     42   

Item 2.

  

Properties

     42   

Item 3.

  

Legal Proceedings

     42   
   PART II   

Item 5.

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      43   

Item 6.

  

Selected Financial Data

     47   

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     48   

Item 7A.

  

Quantitative and Qualitative Disclosures about Market Risk

     74   

Item 8.

  

Consolidated Financial Statements and Supplementary Data

     76   

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     135   

Item 9A.

  

Controls and Procedures

     135   

Item 9B.

  

Other Information

     136   
   PART III   

Item 10.

  

Directors, Executive Officers and Corporate Governance

     137   

Item 11.

  

Executive Compensation

     137   

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      137   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     137   

Item 14.

  

Principal Accounting Fees and Services

     137   
   PART IV   

Item 15.

  

Exhibits and Financial Statement Schedules

     138   

Signatures

     141   

Exhibit Index

  


Table of Contents

PART I

 

Item 1. Business

General

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. We define small and mid-sized companies as those with annual revenues between $25 million and $250 million. Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity investments. We are externally managed and advised by Fifth Street Management LLC, which we also refer to as our “investment adviser.”

As of September 30, 2011, we had originated $1.38 billion of funded debt and equity investments. Our portfolio totaled $1.1 billion at fair value and was comprised of 65 investments, 59 of which were in operating companies and six of which were in private equity funds. The six investments in private equity funds represented less than 1% of the fair value of our assets at September 30, 2011. The weighted average yield of our debt investments as of September 30, 2011 was approximately 12.4%, which included a cash component of 11.1%.

Our investments generally range in size from $5 million to $75 million and are principally in the form of first and second lien debt investments, which may also include an equity component. We are currently focusing our origination efforts on a prudent mix of first lien, second lien and subordinated loans which we believe will provide superior risk-adjusted returns while maintaining solid credit quality. As of September 30, 2011, 90.9% of our portfolio at fair value consisted of debt investments that were secured by first or second priority liens on the assets of our portfolio companies. Moreover, we held equity investments consisting of common stock, preferred stock or other equity interests in 27 out of our 65 portfolio companies as of September 30, 2011.

Fifth Street Mezzanine Partners III, L.P., our predecessor fund, commenced operations as a private partnership on February 15, 2007. Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into us. We were formed in late 2007 for the purpose of acquiring Fifth Street Mezzanine Partners III, L.P. and continuing its business as a public entity. We are an externally managed, closed-end, non-diversified management investment company that has elected to be regulated as a business development company under the Investment Company Act of 1940, or the 1940 Act.

As a business development company, we are required to comply with regulatory requirements, including limitations on our use of debt. We are permitted to, and expect to continue to, finance our investments through borrowings. However, as a business development company, we are only generally allowed to borrow amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowing. The amount of leverage that we employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing. See “Item 1. Business — Regulation — Business Development Company Regulations.”

We have also elected to be treated for federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code, or the Code. See “Item 1. Business — Regulation — Taxation as a Regulated Investment Company.” As a RIC, we generally will not have to pay corporate-level federal income taxes on any net ordinary income or capital gains that we distribute to our stockholders if we meet certain source-of-income, distribution and asset diversification requirements.

In addition, we maintain a wholly-owned subsidiary that is licensed as a small business investment company, or SBIC, and regulated by the Small Business Administration, or the SBA. See “Item 1. Business — Regulation — Small Business Investment Company Regulations.” The SBIC license allows us, through our wholly-owned subsidiary, to issue SBA-guaranteed debentures. We received exemptive relief from the Securities and Exchange Commission, or SEC, to permit us to exclude the debt of our SBIC subsidiary guaranteed by the SBA from the definition of senior securities in the 200% asset coverage ratio we are required to maintain under the 1940 Act. Pursuant to the 200% asset coverage ratio limitation, we are permitted to borrow one dollar for every dollar we have in assets less all liabilities and indebtedness not represented by debt securities issued by us or loans obtained by us. For example, as of September 30, 2011, we had approximately $1.0 billion in assets less

 

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all liabilities and indebtedness not represented by debt securities issued by us or loans obtained by us, which would permit us to borrow up to approximately $1.0 billion, notwithstanding other limitations on our borrowings pursuant to our credit facilities.

On May 27, 2011, we received a letter from the Investment Division of the SBA that invited us to continue moving forward with our application to obtain an SBIC license for another one of our wholly-owned subsidiaries. Although our application for this license is subject to the SBA’s approval, we remain cautiously optimistic that we will complete the licensing process. However, there can be no assurance that the SBA will approve the issuance of an SBIC license to another one of our wholly-owned subsidiaries. If we are able to successfully obtain such an additional SBIC license, we would have similar relief from the 200% asset coverage ratio limitation as described above with respect to the SBIC debt securities issued by such SBIC subsidiary.

Our principal executive office is located at 10 Bank Street, 12th floor, White Plains, New York 10606 and our telephone number is (914) 286-6800.

The Investment Adviser

Our investment adviser is affiliated with Fifth Street Capital LLC, a private investment firm founded and managed by Leonard M. Tannenbaum who has led the investment of over $1.7 billion in small and mid-sized companies, including the investments made by us, since 1998. Mr. Tannenbaum and his respective private investment firms have originated over 100 investment transactions. The other investment funds managed by these private investment firms generally are fully committed and, other than follow-on investments in existing portfolio companies, are no longer making investments.

We benefit from our investment adviser’s ability to identify attractive investment opportunities, conduct diligence on and value prospective investments, negotiate investments and manage a diversified portfolio of those investments. The principals of our investment adviser have broad investment backgrounds, with prior experience at investment funds, investment banks and other financial services companies and have developed a broad network of contacts within the private equity community. This network of contacts provides our principal source of investment opportunities.

The key principals and members of senior management of our investment adviser are Mr. Tannenbaum, our chief executive officer and our investment adviser’s managing partner, Bernard D. Berman, our president, chief compliance officer and secretary and a partner of our investment adviser, Ivelin M. Dimitrov, our chief investment officer and a partner of our investment adviser, Juan E. Alva, a partner of our investment adviser, Casey J. Zmijeski, a partner of our investment adviser and Alexander C. Frank, our chief financial officer.

Business Strategy

Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity investments. We have adopted the following business strategy to achieve our investment objective:

 

   

Capitalize on our investment adviser’s strong relationships with private equity sponsors.    Our investment adviser has developed an extensive network of relationships with private equity sponsors that invest in small and mid-sized companies. We believe that the strength of these relationships is due to a common investment philosophy, a consistent market focus, a rigorous approach to diligence and a reputation for delivering on commitments. In addition to being our principal source of originations, we believe that private equity sponsors provide significant benefits including incremental due diligence, additional monitoring capabilities and a potential source of capital and operational expertise for our portfolio companies.

 

   

Focus on established small and mid-sized companies.    We believe that there are fewer finance companies focused on transactions involving small and mid-sized companies than larger companies, and that this is one factor that allows us to negotiate favorable investment terms. Such favorable terms include higher debt yields and lower leverage levels, more significant covenant protection and greater equity grants than typical of transactions involving larger companies. We generally invest in companies with

 

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established market positions, seasoned management teams, proven products and services and strong regional or national operations. We believe that these companies possess better risk-adjusted return profiles than newer companies that are in the early stages of building management teams and/or a revenue base.

 

   

Continue our growth of direct originations.    Over the last several years, the principals of our investment adviser have developed an origination strategy that allows us to directly originate a significant portion of our investments. We believe that the benefits of direct originations include, among other things, our ability to control the structuring of investment protections and to generate origination and exit fees.

 

   

Employ disciplined underwriting policies and rigorous portfolio management.    Our investment adviser has developed an extensive underwriting process which includes a review of the prospects, competitive position, financial performance and industry dynamics of each potential portfolio company. In addition, we perform substantial diligence on potential investments, and seek to invest along side private equity sponsors who have proven capabilities in building value. As part of the monitoring process, our investment adviser will analyze monthly and quarterly financial statements versus the previous periods and year, review financial projections, meet with management, attend board meetings and review all compliance certificates and covenants.

 

   

Structure our debt investments to minimize risk of loss and achieve attractive risk-adjusted returns.    We structure our debt investments on a conservative basis with high cash yields, cash origination fees, low leverage levels and strong investment protections. As of September 30, 2011, the weighted average yield of our debt investments was approximately 12.4%, which includes a cash component of 11.1%. Our debt investments have strong protections, including default penalties, information rights, board observation rights, and affirmative, negative and financial covenants, such as lien protection and prohibitions against change of control. We believe these protections, coupled with the other features of our investments described above, should allow us to reduce our risk of capital loss and achieve attractive risk adjusted returns; however, there can be no assurance that we will be able to successfully structure our investments to minimize risk of loss and achieve attractive risk-adjusted returns.

 

   

Benefit from lower, fixed, long-term cost of capital.    The SBIC license held by our wholly-owned subsidiary allows it to issue SBA-guaranteed debentures. SBA-guaranteed debentures carry long-term fixed rates that are generally lower than rates on comparable bank and other debt. Because lower cost SBA leverage is a significant part of our capital base, our relative cost of debt capital may be lower than many of our competitors. In addition, SBIC leverage represents a stable, long-term component of our capital structure that should permit the proper matching of duration and cost compared to our portfolio investments. We are currently seeking to obtain an SBIC license for another one of our wholly-owned subsidiaries that would allow us to issue up to an additional $75 million of SBA-guaranteed debt.

 

   

Leverage the skills and experience of our investment adviser.    The principals of our investment adviser have broad investment backgrounds, with prior experience at private investment funds, investment banks and other financial services companies and they also have experience managing distressed companies. We believe that our investment adviser’s expertise in valuing, structuring, negotiating and closing transactions provides us with a competitive advantage by allowing us to provide financing solutions that meet the needs of our portfolio companies while adhering to our underwriting standards.

Investment Criteria

The principals of our investment adviser have identified the following investment criteria and guidelines for use in evaluating prospective portfolio companies and they use these criteria and guidelines in evaluating investment opportunities for us. However, not all of these criteria and guidelines were, or will be, met in connection with each of our investments.

 

   

Established companies with a history of positive operating cash flow.    We seek to invest in established companies with sound historical financial performance. We typically focus on companies with a history of profitability on an operating cash flow basis. We do not intend to invest in start-up companies or companies with speculative business plans.

 

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Ability to exert meaningful influence.    We target investment opportunities in which we will be the lead/sole investor in our tranche and in which we can add value through active participation in the direction of the company, often through advisory positions.

 

   

Private equity sponsorship.    We generally seek to invest in companies in connection with private equity sponsors who have proven capabilities in building value. We believe that a private equity sponsor can serve as a committed partner and advisor that will actively work with the company and its management team to meet company goals and create value. We assess a private equity sponsor’s commitment to a portfolio company by, among other things, the capital contribution it has made or will make in the portfolio company.

 

   

Seasoned management team.    We generally will require that our portfolio companies have a seasoned management team, with strong corporate governance. We also seek to invest in companies that have proper incentives in place, including having significant equity interests, to motivate management to act in accordance with our interests.

 

   

Defensible and sustainable business.    We seek to invest in companies with proven products and/or services and strong regional or national operations.

 

   

Exit strategy.    We generally seek to invest in companies that we believe possess attributes that will provide us with the ability to exit our investments. We expect to exit our investments typically through one of three scenarios: (i) the sale of the company resulting in repayment of all outstanding debt, (ii) the recapitalization of the company through which our loan is replaced with debt or equity from a third party or parties or (iii) the repayment of the initial or remaining principal amount of our loan then outstanding at maturity. In some investments, there may be scheduled amortization of some portion of our loan which would result in a partial exit of our investment prior to the maturity of the loan.

Deal Origination

Our deal originating efforts are focused on building relationships with private equity sponsors that are focused on investing in the small and mid-sized companies that we target. We divide the country geographically into Eastern, Central and Western regions and emphasize active, consistent sponsor coverage. The investment professionals of our investment adviser have developed an extensive network of relationships with these private equity sponsors. We estimate that there are approximately 1,300 of such private equity firms and our investment adviser has active relationships with approximately 250 of them. An active relationship is one through which our investment adviser has received at least one investment opportunity from the private equity sponsor within the last year.

Our investment adviser reviewed over 800 potential investment transactions with private equity sponsors during the year ended September 30, 2011. A significant portion of the investment transactions that we have completed to date were originated through our investment adviser’s relationships with private equity sponsors. We believe that our investment adviser has a reputation as a reliable, responsive and efficient source of funding to support private equity investments. We believe that this reputation and the relationships of our investment adviser with private equity sponsors will provide us with significant investment opportunities.

Our origination process is designed to efficiently evaluate a large number of opportunities and to identify the most attractive of such opportunities. A significant number of opportunities that clearly do not fit our investment criteria are screened by the partners of our investment adviser when they are initially identified. If an originator believes that an opportunity fits our investment criteria and merits consideration, the investment is presented to our investment adviser’s Investment Committee. This is the first stage of our origination process, the “Review” stage. During this stage, the originator gives a preliminary description of the opportunity. This is followed by preliminary due diligence, from which an investment summary is created. The opportunity may be discussed several times by the full Investment Committee of our investment adviser, or subsets of that Committee. At any point in this stage, we may reject the opportunity, and, indeed, we have historically decided not to proceed with more than 80% of the investment opportunities reviewed by our investment adviser’s Investment Committee.

 

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For the subset of opportunities that we decide to pursue, we issue preliminary term sheets and classify them in the “Term Sheet Issued” stage. This term sheet serves as a basis for negotiating the critical terms of a transaction. At this stage we begin our underwriting and investment approval process, as more fully described below. After the term sheet for a potential transaction has been fully negotiated, the transaction is presented to our investment adviser’s Investment Committee for approval. If the deal is approved, the term sheet is signed. Approximately half of the term sheets we issue result in an executed term sheet. Our underwriting and investment approval process is ongoing during this stage, during which we begin documentation of the loan. The final stage, “Closings,” culminates with the funding of an investment only after all due diligence is satisfactorily completed and all closing conditions, including the sponsor’s funding of its investment in the portfolio company, have been satisfied.

Underwriting

Underwriting Process and Investment Approval

We make our investment decisions only after consideration of a number of factors regarding the potential investment including, but not limited to: (i) historical and projected financial performance; (ii) company and industry specific characteristics, such as strengths, weaknesses, opportunities and threats; (iii) composition and experience of the management team; and (iv) track record of the private equity sponsor leading the transaction. Our investment adviser uses a proprietary scoring system that evaluates each opportunity. This methodology is employed to screen a high volume of potential investment opportunities on a consistent basis.

If an investment is deemed appropriate to pursue, a more detailed and rigorous evaluation is made along a variety of investment parameters, not all of which may be relevant or considered in evaluating a potential investment opportunity. The following outlines the general parameters and areas of evaluation and due diligence for investment decisions, although not all will necessarily be considered or given equal weighting in the evaluation process.

Management assessment

Our investment adviser makes an in-depth assessment of the management team, including evaluation along several key metrics:

 

   

The number of years in their current positions;

 

   

Track record;

 

   

Industry experience;

 

   

Management incentive, including the level of direct investment in the enterprise;

 

   

Background investigations; and

 

   

Completeness of the management team (lack of positions that need to be filled).

Industry dynamics

An evaluation of the industry is undertaken by our investment adviser that considers several factors. If considered appropriate, industry experts will be consulted or retained. The following factors are analyzed by our investment adviser:

 

   

Sensitivity to economic cycles;

 

   

Competitive environment, including number of competitors, threat of new entrants or substitutes;

 

   

Fragmentation and relative market share of industry leaders;

 

   

Growth potential; and

 

   

Regulatory and legal environment.

 

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Business model and financial assessment

Prior to making an investment decision, our investment adviser will undertake a review and analysis of the financial and strategic plans for the potential investment. There is significant evaluation of and reliance upon the due diligence performed by the private equity sponsor and third party experts including accountants and consultants. Areas of evaluation include:

 

   

Historical and projected financial performance;

 

   

Quality of earnings, including source and predictability of cash flows;

 

   

Customer and vendor interviews and assessments;

 

   

Potential exit scenarios, including probability of a liquidity event;

 

   

Internal controls and accounting systems; and

 

   

Assets, liabilities and contingent liabilities.

Private equity sponsor

Among the most critical due diligence investigations is the evaluation of the private equity sponsor making the investment. A private equity sponsor is typically the controlling shareholder upon completion of an investment and as such is considered critical to the success of the investment. The private equity sponsor is evaluated along several key criteria, including:

 

   

Investment track record;

 

   

Industry experience;

 

   

Capacity and willingness to provide additional financial support to the company through additional capital contributions, if necessary; and

 

   

Reference checks.

Investments

We target debt investments that will yield meaningful current income and provide the opportunity for capital appreciation through equity securities. We typically structure our debt investments with the maximum seniority and collateral that we can reasonably obtain while seeking to achieve our total return target. In most cases, our debt investment will be collateralized by a first or second lien on the assets of the portfolio company. As of September 30, 2011, 90.9% of our portfolio at fair value consisted of debt investments that were secured by first or second priority liens on the assets of the portfolio company.

Debt Investments

We tailor the terms of our debt investments to the facts and circumstances of the transaction and prospective portfolio company, negotiating a structure that seeks to protect our rights and manage our risk while creating incentives for the portfolio company to achieve its business plan. A substantial source of return is monthly cash interest that we collect on our debt investments. As of September 30, 2011, we directly originated a majority of our debt investments. We are currently focusing our origination efforts on a prudent mix of first lien, second lien and subordinated loans which we believe will provide superior risk-adjusted returns while maintaining solid credit quality.

 

   

First Lien Loans.    Our first lien loans generally have terms of four to six years, provide for a variable or fixed interest rate, contain prepayment penalties and are secured by a first priority security interest in all existing and future assets of the borrower. Our first lien loans may take many forms, including revolving lines of credit, term loans and acquisition lines of credit.

 

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Second Lien Loans.    Our second lien loans generally have terms of four to six years, primarily provide for a fixed interest rate, contain prepayment penalties and are secured by a second priority security interest in all existing and future assets of the borrower. Our second lien loans often include payment-in-kind, or PIK, interest, which represents contractual interest accrued and added to the principal that generally becomes due at maturity.

 

   

Unsecured Loans.    Our unsecured investments generally have terms of five to six years and provide for a fixed interest rate. We may make unsecured investments on a stand-alone basis, or in connection with a senior secured loan, a junior secured loan or a “one-stop” financing. Our unsecured investments may include payment-in-kind, or PIK, interest, which represents contractual interest accrued and added to the principal that generally becomes due at maturity, and an equity component, such as warrants to purchase common stock in the portfolio company.

We typically structure our debt investments to include covenants that seek to minimize our risk of capital loss. Our debt investments have strong protections, including default penalties, information rights, board observation rights, and affirmative, negative and financial covenants, such as lien protection and prohibitions against change of control. Our debt investments also have substantial prepayment penalties designed to extend the life of the average loan, which we believe will help to grow our portfolio.

Equity Investments

When we make a debt investment, we may be granted equity in the company in the same class of security as the sponsor receives upon funding. In addition, we may from time to time make non-control, equity co-investments in connection with private equity sponsors. We generally seek to structure our equity investments, such as direct equity co-investments, to provide us with minority rights provisions and event-driven put rights. We also seek to obtain limited registration rights in connection with these investments, which may include “piggyback” registration rights.

Private Equity Fund Investments

We make investments in the private equity funds of certain of our equity sponsors. In general, we make these investments where we have a long term relationship and are comfortable with the sponsor’s business model and investment strategy. As of September 30, 2011, we had investments in six private equity funds, which represented less than 1% of the fair value of our assets as of such date.

Portfolio Management

Active Involvement in our Portfolio Companies

As a business development company, we are obligated to offer to provide managerial assistance to our portfolio companies and to provide it if requested. In fact, we provide managerial assistance to our portfolio companies as a general practice and we seek investments where such assistance is appropriate. We monitor the financial trends of each portfolio company to assess the appropriate course of action for each company and to evaluate overall portfolio quality. We have several methods of evaluating and monitoring the performance of our investments, including but not limited to, the following:

 

   

review of monthly and quarterly financial statements and financial projections for portfolio companies;

 

   

periodic and regular contact with portfolio company management to discuss financial position requirements and accomplishments;

 

   

attendance at board meetings;

 

   

periodic formal update interviews with portfolio company management and, if appropriate, the private equity sponsor; and

 

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assessment of business development success, including product development, profitability and the portfolio company’s overall adherence to its business plan.

Rating Criteria

In addition to various risk management and monitoring tools, we use an investment rating system to characterize and monitor the credit profile and our expected level of returns on each investment in our portfolio. We use a five-level numeric rating scale. The following is a description of the conditions associated with each investment rating:

 

   

Investment Rating 1 is used for investments that are performing above expectations and/or a capital gain is expected.

 

   

Investment Rating 2 is used for investments that are performing substantially within our expectations, and whose risks remain neutral or favorable compared to the potential risk at the time of the original investment. All new loans are initially rated 2.

 

   

Investment Rating 3 is used for investments that are performing below our expectations and that require closer monitoring, but where we expect no loss of investment return (interest and/or dividends) or principal. Companies with a rating of 3 may be out of compliance with financial covenants.

 

   

Investment Rating 4 is used for investments that are performing below our expectations and for which risk has increased materially since the original investment. We expect some loss of investment return, but no loss of principal.

 

   

Investment Rating 5 is used for investments that are performing substantially below our expectations and whose risks have increased substantially since the original investment. Investments with a rating of 5 are those for which some loss of principal is expected.

In the event that we determine that an investment is underperforming, or circumstances suggest that the risk associated with a particular investment has significantly increased, we will undertake more aggressive monitoring of the effected portfolio company. While our investment rating system identifies the relative risk for each investment, the rating alone does not dictate the scope and/or frequency of any monitoring that we perform. The frequency of our monitoring of an investment is determined by a number of factors, including, but not limited to, the trends in the financial performance of the portfolio company, the investment structure and the type of collateral securing our investment, if any.

The following table shows the distribution of our investments on the 1 to 5 investment rating scale at fair value as of September 30, 2011:

 

Investment Rating

   Fair Value
(thousands)
     % of Portfolio  

1

   $ 81,335         7.26

2

     1,021,990         91.26

3

     8,660         0.77

4

             0.00

5

     7,852         0.71
  

 

 

    

 

 

 

Total

   $ 1,119,837         100.00
  

 

 

    

 

 

 

Valuation of Portfolio Investments

As a business development company, we generally invest in illiquid securities including debt and equity investments of small and mid-sized companies. All of our investments are recorded at fair value as determined in good faith by our Board of Directors.

 

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Authoritative accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available or reliable, valuation techniques are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the investments or market and the investments’ complexity.

In accordance with authoritative accounting guidance, we perform detailed valuations of our debt and equity investments on an individual basis, using market, income, and bond yield approaches as appropriate. In general, we utilize a bond yield method for the majority of our investments, as long as it is appropriate. If, in our judgment, the bond yield approach is not appropriate, we may use the market approach, or, in certain cases, an alternative methodology potentially including an asset liquidation or expected recovery model.

Under the market approach, we estimate the enterprise value of the portfolio companies in which we invest. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise value is best expressed as a range of fair values, from which we derive a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, we analyze various factors, including the portfolio company’s historical and projected financial results. Typically, private companies are valued based on multiples of earnings before interest, taxes, depreciation and amortization (EBITDA), cash flows, net income, revenues, or in limited cases, book value. We generally require portfolio companies to provide annual audited and quarterly and monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year.

Under the income approach, we generally prepare and analyze discounted cash flow models based on projections of the future free cash flows of the business.

Under the bond yield approach, we use bond yield models to determine the present value of the future cash flow streams of our debt investments. We review various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assess the information in the valuation process.

Our Board of Directors undertakes a multi-step valuation process each quarter in connection with determining the fair value of our investments:

 

   

The quarterly valuation process begins with each portfolio company or investment being initially valued by our finance department;

 

   

Preliminary valuations are then reviewed and discussed with principals of the investment adviser;

 

   

Separately, independent valuation firms engaged by our Board of Directors prepare preliminary valuations on a selected basis and submit the reports to us;

 

   

Our finance department compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms;

 

   

Our finance department 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 our finance department responds and supplements the preliminary valuations to reflect any comments provided by the Valuation Committee;

 

   

The Valuation Committee of our Board of Directors makes a recommendation to the Board of Directors regarding the fair value of the investments in our portfolio; and

 

   

Our Board of Directors discusses the valuations and determines the fair value of each investment in our portfolio in good faith.

 

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The fair value of all of our investments at September 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 a consistently applied valuation process.

Our Board of Directors has authorized the engagement of independent valuation firms to provide us with valuation assistance. Upon completion of their process each quarter, the independent valuation firms provide us with a written report regarding the preliminary valuations of selected portfolio securities as of the close of such quarter. We will continue to engage independent valuation firms to provide us with assistance regarding our determination of the fair value of selected portfolio securities each quarter; however, our Board of Directors is ultimately and solely responsible for determining the fair value of our investments in good faith.

The percentages of our portfolio at fair value for which independent valuation firms provided us with valuation assistance by period were as follows:

 

     Percentage of
Portfolio at
Fair Value
 

For the quarter ended December 31, 2007

     91.9

For the quarter ended March 31, 2008

     92.1

For the quarter ended June 30, 2008

     91.7

For the quarter ended September 30, 2008

     92.8

For the quarter ended December 31, 2008

     100.0

For the quarter ended March 31, 2009

     88.7 %(1) 

For the quarter ended June 30, 2009

     92.1

For the quarter ended September 30, 2009

     28.1

For the quarter ended December 31, 2009

     17.2 %(2) 

For the quarter ended March 31, 2010

     26.9

For the quarter ended June 30, 2010

     53.1

For the quarter ended September 30, 2010

     61.8

For the quarter ended December 31, 2010

     73.9

For the quarter ended March 31, 2011

     82.0

For the quarter ended June 30, 2011

     82.9

For the quarter ended September 30, 2011

     91.2

 

(1) 96.0% excluding our investment in IZI Medical Products, Inc., which closed on June 30, 2009 and therefore was not valued by an independent valuation firm during such period

 

(2) 24.8% excluding four investments that closed in December 2009 and therefore were not valued by an independent valuation firm during such period

We intend to have independent valuation firms provide us with valuation assistance on a portion of our portfolio on a quarterly basis and a substantial portion of our portfolio on an annual basis.

Determination of fair values involves subjective judgments and estimates. The notes to our financial statements refer to the uncertainty with respect to the possible effect of such valuations, and any change in such valuations, on our financial statements.

Competition

We compete for investments with a number of business development companies and investment funds (including private equity funds and mezzanine funds) as well as traditional financial services companies such as commercial banks and other sources of financing. Many of these entities have greater financial and managerial resources than we do. We believe we are able to be competitive with these entities primarily on the basis of the experience and contacts of our management team, our responsive and efficient investment analysis and decision-making processes, the investment terms we offer and our willingness to make smaller investments.

 

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We believe that some of our competitors make loans with interest rates and returns that are comparable to or lower than the rates and returns that we target. Therefore, we do not seek to compete solely on the interest rates that we offer to potential portfolio companies. For additional information concerning the competitive risks we face, see “Item 1A. Risk Factors — Risks Relating to Our Business and Structure — We may face increasing competition for investment opportunities, which could reduce returns and result in losses.”

Employees

We do not have any employees. Our day-to-day investment operations are managed by our investment adviser. See “Item 1. Business — Investment Advisory Agreement.” Our investment adviser employs a total of 21 investment professionals, including its principals. In addition, we reimburse our administrator, FSC, Inc., for the allocable portion of overhead and other expenses incurred by it in performing its obligations under an administration agreement, including the compensation of our chief financial officer and chief compliance officer, and their staff. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us by our chief compliance officer, Bernard D. Berman, given his compensation arrangement with our investment adviser. However, although FSC, Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future. For a more detailed discussion of the administration agreement, see “Item 1. Business — Administration Agreement.”

Investment Advisory Agreement

Overview of Our Investment Adviser

Management Services

Our investment adviser, Fifth Street Management LLC, is registered as an investment adviser under the Investment Advisers Act of 1940, or the “Advisers Act.” Our investment adviser serves pursuant to the investment advisory agreement in accordance with the 1940 Act. Subject to the overall supervision of our Board of Directors, our investment adviser manages our day-to-day operations and provides us with investment advisory services. Under the terms of the investment advisory agreement, our investment adviser:

 

   

determines the composition of our portfolio, the nature and timing of the changes to our portfolio and the manner of implementing such changes;

 

   

determines what securities we purchase, retain or sell;

 

   

identifies, evaluates and negotiates the structure of the investments we make; and

 

   

executes, monitors and services the investments we make.

Our investment adviser’s services under the investment advisory agreement may not be exclusive and it is free to furnish similar services to other entities so long as its services to us are not impaired.

Fees Paid to Our Investment Adviser

We pay our investment adviser a fee for its services under the investment advisory agreement consisting of two components — a base management fee and an incentive fee. The cost of both the base management fee payable to our investment adviser and any incentive fees earned by our investment adviser will ultimately be borne by our common stockholders.

Base Management Fee

The base management fee is calculated at an annual rate of 2% of our gross assets, which includes any borrowings for investment purposes. The base management fee is payable quarterly in arrears, and is calculated based on the value of our gross assets at the end of each fiscal quarter, and appropriately adjusted on a pro rata basis for any equity capital raises or repurchases during such quarter. The base management fee for any partial month or quarter is appropriately pro rated. Our investment adviser permanently waived the portion of the base

 

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management fee attributable to cash and cash equivalents (as defined in the notes to our Consolidated Financial Statements) as of the end of each quarter beginning March 31, 2010. As a result, our base management fee is calculated at an annual rate of 2% of our gross assets, including any investments made with borrowings, but excluding any cash and cash equivalents (as defined in the notes to our Consolidated Financial Statements) as of the end of each quarter.

Incentive Fee

The incentive fee has two parts. The first part is calculated and payable quarterly in arrears based on our “Pre-Incentive Fee Net Investment Income” for the immediately preceding fiscal quarter. For this purpose, “Pre-Incentive Fee Net Investment Income” means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence and consulting fees or other fees that we receive from portfolio companies) accrued during the fiscal quarter, minus our operating expenses for the quarter (including the base management fee, expenses payable under the administration agreement with FSC, Inc., and any interest expense and dividends paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-Incentive Fee Net Investment Income includes, in the case of investments with a deferred interest feature (such as original issue discount, debt instruments with PIK interest and zero coupon securities), accrued income that we have not yet received in cash. Pre-Incentive Fee Net Investment Income does not include any realized capital gains, realized capital losses or unrealized capital appreciation or depreciation. Pre-Incentive Fee Net Investment Income, expressed as a rate of return on the value of our net assets at the end of the immediately preceding fiscal quarter, will be compared to a “hurdle rate” of 2% per quarter (8% annualized), subject to a “catch-up” provision measured as of the end of each fiscal quarter. Our net investment income used to calculate this part of the incentive fee is also included in the amount of our gross assets used to calculate the 2% base management fee. The operation of the incentive fee with respect to our Pre-Incentive Fee Net Investment Income for each quarter is as follows:

 

   

no incentive fee is payable to the investment adviser in any fiscal quarter in which our Pre-Incentive Fee Net Investment Income does not exceed the hurdle rate of 2% (the “preferred return” or “hurdle”);

 

   

100% of our Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the hurdle rate but is less than or equal to 2.5% in any fiscal quarter (10% annualized) is payable to the investment adviser. We refer to this portion of our Pre-Incentive Fee Net Investment Income (which exceeds the hurdle rate but is less than or equal to 2.5%) as the “catch-up.” The “catch-up” provision is intended to provide our investment adviser with an incentive fee of 20% on all of our Pre-Incentive Fee Net Investment Income as if a hurdle rate did not apply when our Pre-Incentive Fee Net Investment Income exceeds 2.5% in any fiscal quarter; and

 

   

20% of the amount of our Pre-Incentive Fee Net Investment Income, if any, that exceeds 2.5% in any fiscal quarter (10% annualized) is payable to the investment adviser once the hurdle is reached and the catch-up is achieved.

The following is a graphical representation of the calculation of the income-related portion of the incentive fee:

Quarterly Incentive Fee Based on “Pre-Incentive Fee Net Investment Income”

Pre-Incentive Fee Net Investment Income

(expressed as a percentage of the value of net assets)

LOGO

 

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Percentage of Pre-Incentive Fee Net Investment Income allocated to income-related portion of incentive fee

The second part of the incentive fee is determined and payable in arrears as of the end of each fiscal year (or upon termination of the investment advisory agreement, as of the termination date) and equals 20% of our realized capital gains, if any, on a cumulative basis from inception through the end of each fiscal year, computed net of all realized capital losses and unrealized capital depreciation on a cumulative basis, less the aggregate amount of any previously paid capital gain incentive fees, provided that, the incentive fee determined as of September 30, 2008 was calculated for a period of shorter than twelve calendar months to take into account any realized capital gains computed net of all realized capital losses and unrealized capital depreciation from inception.

Example 1: Income Related Portion of Incentive Fee for Each Fiscal Quarter

Alternative 1

Assumptions

Investment income (including interest, dividends, fees, etc.) = 1.25%

Hurdle rate(1) = 2%

Management fee(2) = 0.5%

Other expenses (legal, accounting, custodian, transfer agent, etc.)(3) = 0.2%

Pre-Incentive Fee Net Investment Income

(investment income – (management fee + other expenses) = 0.55%

Pre-Incentive Fee Net Investment Income does not exceed hurdle rate, therefore there is no income-related incentive fee.

Alternative 2

Assumptions

Investment income (including interest, dividends, fees, etc.) = 2.9%

Hurdle rate(1) = 2%

Management fee(2) = 0.5%

Other expenses (legal, accounting, custodian, transfer agent, etc.)(3) = 0.2%

Pre-Incentive Fee Net Investment Income

(investment income – (management fee + other expenses) = 2.2%

 

Incentive fee

 

=

=

=

 

100% × Pre-Incentive Fee Net Investment Income (subject to “catch-up”)(4)

100% × (2.2% – 2%)

0.2%

Pre-Incentive Fee Net Investment Income exceeds the hurdle rate, but does not fully satisfy the “catch-up” provision, therefore the income related portion of the incentive fee is 0.2%.

Alternative 3

Assumptions

Investment income (including interest, dividends, fees, etc.) = 3.5%

Hurdle rate(1) = 2%

Management fee(2) = 0.5%

Other expenses (legal, accounting, custodian, transfer agent, etc.)(3) = 0.2%

Pre-Incentive Fee Net Investment Income

(investment income – (management fee + other expenses) = 2.8%

Incentive fee = 100% × Pre-Incentive Fee Net Investment Income (subject to “catch-up”)(4)

 

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Incentive fee = 100% × “catch-up” + (20% × (Pre-Incentive Fee Net Investment Income – 2.5%))

Catch up

    =      2.5% – 2%
    =      0.5%

Incentive fee

    =      (100% × 0.5%) + (20% × (2.8% – 2.5%))
    =      0.5% + (20% × 0.3%)
    =      0.5% + 0.06%
    =      0.56%

Pre-Incentive Fee Net Investment Income exceeds the hurdle rate, and fully satisfies the “catch-up” provision, therefore the income related portion of the incentive fee is 0.56%.

 

(1) Represents 8% annualized hurdle rate.

 

(2) Represents 2% annualized base management fee.

 

(3) Excludes organizational and offering expenses.

 

(4) The “catch-up” provision is intended to provide our investment adviser with an incentive fee of 20% on all Pre-Incentive Fee Net Investment Income as if a hurdle rate did not apply when our net investment income exceeds 2.5% in any fiscal quarter.

Example 2: Capital Gains Portion of Incentive Fee(*):

Alternative 1

Assumptions

Year 1: $20 million investment made in Company A (“Investment A”), and $30 million investment made in Company B (“Investment B”)

Year 2: Investment A sold for $50 million and fair market value (“FMV”) of Investment B determined to be $32 million

Year 3: FMV of Investment B determined to be $25 million

Year 4: Investment B sold for $31 million

The capital gains portion of the incentive fee would be:

Year 1: None

Year 2: Capital gains incentive fee of $6 million — ($30 million realized capital gains on sale of Investment A multiplied by 20%)

Year 3: None — $5 million (20% multiplied by ($30 million cumulative capital gains less $5 million cumulative capital depreciation)) less $6 million (previous capital gains fee paid in Year 2)

Year 4: Capital gains incentive fee of $200,000 — $6.2 million ($31 million cumulative realized capital gains multiplied by 20%) less $6 million (capital gains incentive fee taken in Year 2)

Alternative 2

Assumptions

Year 1: $20 million investment made in Company A (“Investment A”), $30 million investment made in Company B (“Investment B”) and $25 million investment made in Company C (“Investment C”)

Year 2: Investment A sold for $50 million, FMV of Investment B determined to be $25 million and FMV of Investment C determined to be $25 million

 

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Year 3: FMV of Investment B determined to be $27 million and Investment C sold for $30 million

Year 4: FMV of Investment B determined to be $24 million

Year 5: Investment B sold for $20 million

The capital gains incentive fee, if any, would be:

Year 1: None

Year 2: $5 million capital gains incentive fee — 20% multiplied by $25 million ($30 million realized capital gains on Investment A less unrealized capital depreciation on Investment B)

Year 3: $1.4 million capital gains incentive fee(1) — $6.4 million (20% multiplied by $32 million ($35 million cumulative realized capital gains less $3 million unrealized capital depreciation)) less $5 million capital gains incentive fee received in Year 2

Year 4: None

Year 5: None — $5 million (20% multiplied by $25 million (cumulative realized capital gains of $35 million less realized capital losses of $10 million)) less $6.4 million cumulative capital gains incentive fee paid in Year 2 and Year 3(2)

 

* The hypothetical amounts of returns shown are based on a percentage of our total net assets and assume no leverage. There is no guarantee that positive returns will be realized and actual returns may vary from those shown in this example.

 

(1) As illustrated in Year 3 of Alternative 1 above, if Fifth Street were to be wound up on a date other than its fiscal year end of any year, Fifth Street may have paid aggregate capital gains incentive fees that are more than the amount of such fees that would be payable if Fifth Street had been wound up on its fiscal year end of such year.

 

(2) As noted above, it is possible that the cumulative aggregate capital gains fee received by our investment adviser ($6.4 million) is effectively greater than $5 million (20% of cumulative aggregate realized capital gains less net realized capital losses or net unrealized depreciation ($25 million)).

Payment of Our Expenses

Our primary operating expenses are the payment of a base management fee and any incentive fees under the investment advisory agreement and the allocable portion of overhead and other expenses incurred by FSC, Inc. in performing its obligations under the administration agreement. Our investment management fee compensates our investment adviser for its work in identifying, evaluating, negotiating, executing and servicing our investments. We bear all other expenses of our operations and transactions, including (without limitation) fees and expenses relating to:

 

   

offering expenses;

 

   

the investigation and monitoring of our investments;

 

   

the cost of calculating our net asset value;

 

   

the cost of effecting sales and repurchases of shares of our common stock and other securities;

 

   

management and incentive fees payable pursuant to the investment advisory agreement;

 

   

fees payable to third parties relating to, or associated with, making investments and valuing investments (including third-party valuation firms);

 

   

transfer agent and custodial fees;

 

   

fees and expenses associated with marketing efforts (including attendance at investment conferences and similar events);

 

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federal and state registration fees;

 

   

any exchange listing fees;

 

   

federal, state and local taxes;

 

   

independent directors’ fees and expenses;

 

   

brokerage commissions;

 

   

costs of proxy statements, stockholders’ reports and notices;

 

   

costs of preparing government filings, including periodic and current reports with the SEC;

 

   

fidelity bond, liability insurance and other insurance premiums; and

 

   

printing, mailing, independent accountants and outside legal costs and all other direct expenses incurred by either our investment adviser or us in connection with administering our business, including payments under the administration agreement that will be based upon our allocable portion of overhead and other expenses incurred by FSC, Inc. in performing its obligations under the administration agreement and the compensation of our chief financial officer and chief compliance officer, and their staff. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us by our chief compliance officer, Bernard D. Berman, given his compensation arrangement with our investment adviser. However, although FSC, Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future.

Duration and Termination

The investment advisory agreement was first approved by our Board of Directors on December 13, 2007 and by a majority of the limited partners of Fifth Street Mezzanine Partners III, L.P. through a written consent first solicited on December 14, 2007. On March 14, 2008, our Board of Directors, including all of the directors who are not “interested persons” as defined in the 1940 Act, approved an amendment to the investment advisory agreement that revised the investment advisory agreement to clarify the calculation of the base management fee. Such amendment was also approved by a majority of our outstanding voting securities through a written consent first solicited on April 7, 2008. At a meeting of the Board of Directors held on March 1, 2011, the Board of Directors, including a majority of the independent directors, approved the annual continuation of the investment advisory agreement, and then on May 2, 2011, the investment advisory agreement was further amended, as approved by our Board of Directors, to exclude management fees on any assets held in the form of cash and cash equivalents. Unless earlier terminated as described below, the investment advisory agreement, as amended, will remain in effect from year-to-year if approved annually by the Board of Directors or by the affirmative vote of the holders of a majority of our outstanding voting securities, including, in either case, approval by a majority of our directors who are not interested persons. The investment advisory agreement will automatically terminate in the event of its assignment. The investment advisory agreement may be terminated by either party without penalty upon not more than 60 days’ written notice to the other. The investment advisory agreement may also be terminated, without penalty, upon the vote of a majority of our outstanding voting securities.

Indemnification

The investment advisory agreement provides that, absent willful misfeasance, bad faith or gross negligence in the performance of their respective duties or by reason of the reckless disregard of their respective duties and obligations, our investment adviser and its officers, managers, agents, employees, controlling persons, members (or their owners) and any other person or entity affiliated with it, are entitled to indemnification from us for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of our investment adviser’s services under the investment advisory agreement or otherwise as our investment adviser.

 

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Organization of our Investment Adviser

Our investment adviser is a Delaware limited liability company that registered as an investment adviser under the Advisers Act. The principal address of our investment adviser is 10 Bank Street, 12th Floor, White Plains, NY 10606.

Board Approval of the Investment Advisory Agreement

At a meeting of our Board of Directors held on March 1, 2011, our Board of Directors unanimously voted to approve the investment advisory agreement. In reaching a decision to approve the investment advisory agreement, the Board of Directors reviewed a significant amount of information and considered, among other things:

 

   

the nature, quality and extent of the advisory and other services to be provided to us by Fifth Street Management LLC;

 

   

the fee structures of comparable externally managed business development companies that engage in similar investing activities;

 

   

our projected operating expenses and expense ratio compared to business development companies with similar investment objectives;

 

   

any existing and potential sources of indirect income to Fifth Street Management LLC from its relationship with us and the profitability of that relationship, including through the investment advisory agreement;

 

   

information about the services to be performed and the personnel performing such services under the investment advisory agreement;

 

   

the organizational capability and financial condition of Fifth Street Management LLC and its affiliates; and

 

   

various other matters.

Based on the information reviewed and the discussions detailed above, the Board of Directors, including all of the directors who are not “interested persons” as defined in the 1940 Act, concluded that the investment advisory fee rates and terms are reasonable in relation to the services provided and approved the investment advisory agreement as being in the best interests of our stockholders.

Administration Agreement

We have also entered into an administration agreement with FSC, Inc. under which FSC, Inc. provides administrative services for us, including office facilities and equipment and clerical, bookkeeping and recordkeeping services at such facilities. Under the administration agreement, FSC, Inc. also performs, or oversees the performance of, our required administrative services, which includes being responsible for the financial records which we are required to maintain and preparing reports to our stockholders and reports filed with the SEC. In addition, FSC, Inc. assists us in determining and publishing our net asset value, overseeing the preparation and filing of our tax returns and the printing and dissemination of reports to our stockholders, and generally overseeing the payment of our expenses and the performance of administrative and professional services rendered to us by others. For providing these services, facilities and personnel, we reimburse FSC, Inc. the allocable portion of overhead and other expenses incurred by FSC, Inc. in performing its obligations under the administration agreement, including rent and our allocable portion of the costs of compensation and related expenses of our chief financial officer and chief compliance officer, and their staff. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us by our chief compliance officer, Bernard D. Berman, given his compensation arrangement with our investment adviser. However, although FSC,

 

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Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future. FSC, Inc. may also provide on our behalf managerial assistance to our portfolio companies. The administration agreement may be terminated by either party without penalty upon 60 days’ written notice to the other party.

The administration agreement provides that, absent willful misfeasance, bad faith or gross negligence in the performance of their respective duties or by reason of the reckless disregard of their respective duties and obligations, FSC, Inc. and its officers, managers, agents, employees, controlling persons, members and any other person or entity affiliated with it are entitled to indemnification from us for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of services under the administration agreement or otherwise as administrator for us.

License Agreement

We have also entered into a license agreement with Fifth Street Capital LLC pursuant to which Fifth Street Capital LLC has agreed to grant us a non-exclusive, royalty-free license to use the name “Fifth Street.” Under this agreement, we will have a right to use the “Fifth Street” name, for so long as Fifth Street Management LLC or one of its affiliates remains our investment adviser. Other than with respect to this limited license, we will have no legal right to the “Fifth Street” name.

Exchange Act Reports

We maintain a website at http://www.fifthstreetfinance.com. The information on our website is not incorporated by reference in this annual report on Form 10-K.

We make available on or through our website certain reports and amendments to those reports that we file with or furnish to the SEC in accordance with the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These include our annual reports on Form 10-K, our quarterly reports on Form 10-Q and our current reports on Form 8-K. We make this information available on our website free of charge as soon as reasonably practicable after we electronically file the information with, or furnish it to, the SEC.

Business Development Company Regulations

We have elected to be regulated as a business development company under the 1940 Act. The 1940 Act contains prohibitions and restrictions relating to transactions between business development companies and their affiliates, principal underwriters and affiliates of those affiliates or underwriters. The 1940 Act requires that a majority of the directors be persons other than “interested persons,” as that term is defined in the 1940 Act. In addition, the 1940 Act provides that we may not change the nature of our business so as to cease to be, or to withdraw our election as, a business development company unless approved by a majority of our outstanding voting securities.

The 1940 Act defines “a majority of the outstanding voting securities” as the lesser of (i) 67% or more of the voting securities present at a meeting if the holders of more than 50% of our outstanding voting securities are present or represented by proxy or (ii) more than 50% of our outstanding voting securities.

As a business development company, we will not generally be permitted to invest in any portfolio company in which our investment adviser or any of its affiliates currently have an investment or to make any co-investments with our investment adviser or its affiliates without an exemptive order from the SEC. We currently do not intend to apply for an exemptive order that would permit us to co-invest with vehicles managed by our investment adviser or its affiliates.

Qualifying Assets

Under the 1940 Act, a business development company may not acquire any asset other than assets of the type listed in Section 55(a) of the 1940 Act, which are referred to as qualifying assets, unless, at the time the

 

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acquisition is made, qualifying assets represent at least 70% of the company’s total assets. The principal categories of qualifying assets relevant to our business are any of the following:

(1) Securities purchased in transactions not involving any public offering from the issuer of such securities, which issuer (subject to certain limited exceptions) is an eligible portfolio company, or from any person who is, or has been during the preceding 13 months, an affiliated person of an eligible portfolio company, or from any other person, subject to such rules as may be prescribed by the SEC. An eligible portfolio company is defined in the 1940 Act as any issuer which:

(a) is organized under the laws of, and has its principal place of business in, the United States;

(b) is not an investment company (other than a small business investment company wholly owned by the business development company) or a company that would be an investment company but for certain exclusions under the 1940 Act; and

(c) satisfies any of the following:

(i) does not have any class of securities that is traded on a national securities exchange;

(ii) has a class of securities listed on a national securities exchange, but has an aggregate market value of outstanding voting and non-voting common equity of less than $250 million;

(iii) is controlled by a business development company or a group of companies including a business development company and the business development company has an affiliated person who is a director of the eligible portfolio company; or

(iv) is a small and solvent company having total assets of not more than $4 million and capital and surplus of not less than $2 million;

(2) Securities of any eligible portfolio company that we control;

(3) Securities purchased in a private transaction from a U.S. issuer that is not an investment company or from an affiliated person of the issuer, or in transactions incident thereto, if the issuer is in bankruptcy and subject to reorganization or if the issuer, immediately prior to the purchase of its securities was unable to meet its obligations as they came due without material assistance other than conventional lending or financing arrangements;

(4) Securities of an eligible portfolio company purchased from any person in a private transaction if there is no ready market for such securities and we already own 60% of the outstanding equity of the eligible portfolio company;

(5) Securities received in exchange for or distributed on or with respect to securities described in (1) through (4) above, or pursuant to the exercise of warrants or rights relating to such securities; or

(6) Cash, cash equivalents, U.S. government securities or high-quality debt securities maturing in one year or less from the time of investment.

In addition, a business development company must be operated for the purpose of making investments in the types of securities described in (1), (2) or (3) above.

Managerial Assistance to Portfolio Companies

In order to count portfolio securities as qualifying assets for the purpose of the 70% test, we must either control the issuer of the securities or must offer to make available to the issuer of the securities (other than small and solvent companies described above) significant managerial assistance; except that, where we purchase such

 

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securities in conjunction with one or more other persons acting together, one of the other persons in the group may make available such managerial assistance. Making available managerial assistance means, among other things, any arrangement whereby the business development company, through its directors, officers or employees, offers to provide, and, if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company.

Temporary Investments

Pending investment in other types of “qualifying assets,” as described above, our investments may consist of cash, cash equivalents, U.S. government securities or high-quality debt securities maturing in one year or less from the time of investment, which we refer to, collectively, as temporary investments, so that 70% of our assets are qualifying assets. Typically, we will invest in U.S. Treasury bills or in repurchase agreements, provided that such agreements are fully collateralized by cash or securities issued by the U.S. government or its agencies. A repurchase agreement (which is substantially similar to a secured loan) involves the purchase by an investor, such as us, of a specified security and the simultaneous agreement by the seller to repurchase it at an agreed-upon future date and at a price that is greater than the purchase price by an amount that reflects an agreed-upon interest rate. There is no percentage restriction on the proportion of our assets that may be invested in such repurchase agreements. However, if more than 25% of our total assets constitute repurchase agreements from a single counterparty, we would not meet the diversification tests in order to qualify as a RIC for U.S. federal income tax purposes. Thus, we do not intend to enter into repurchase agreements with a single counterparty in excess of this limit. Our investment adviser will monitor the creditworthiness of the counterparties with which we enter into repurchase agreement transactions.

Senior Securities

We are permitted, under specified conditions, to issue multiple classes of debt and one class of stock senior to our common stock if our asset coverage, as defined in the 1940 Act, is at least equal to 200% immediately after each such issuance. In addition, while any senior securities remain outstanding, we may be prohibited from making distributions to our stockholders or repurchasing such securities or shares unless we meet the applicable asset coverage ratios at the time of the distribution or repurchase. We may also borrow amounts up to 5% of the value of our total assets for temporary or emergency purposes without regard to asset coverage. For a discussion of the risks associated with leverage, see “Risk Factors — Risks Relating to Our Business and Structure — Regulations governing our operation as a business development company and RIC affect our ability to raise, and the way in which we raise, additional capital or borrow for investment purposes, which may have a negative effect on our growth” and “— Because we borrow money, the potential for loss on amounts invested in us will be magnified and may increase the risk of investing in us.”

We received exemptive relief from the SEC to permit us to exclude the debt of our SBIC subsidiary guaranteed by the SBA from the definition of senior securities in the 200% asset coverage ratio we are required to maintain under the 1940 Act. This provides 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 under the 1940 Act absent the receipt of this exemptive relief.

Common Stock

We are not generally able to issue and sell our common stock at a price below net asset value per share. We may, however, sell our common stock, warrants, options or rights to acquire our common stock, at a price below the current net asset value of the common stock if our Board of Directors determines that such sale is in our best interests and that of our stockholders, and our stockholders approve such sale. In any such case, the price at which our securities are to be issued and sold may not be less than a price which, in the determination of our Board of Directors, closely approximates the market value of such securities (less any distributing commission or discount). We may also make rights offerings to our stockholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act. See “Risk Factors — Risks Relating to Our

 

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Business and Structure — Regulations governing our operation as a business development company affect our ability to raise, and the way in which we raise, additional capital or borrow for investment purposes, which may have a negative effect on our growth.”

Code of Ethics

We have adopted a code of ethics pursuant to Rule 17j-1 under the 1940 Act and we have also approved the investment adviser’s code of ethics that was adopted by it under Rule 17j-1 under the 1940 Act and Rule 204A-1 of the Advisers Act. These codes establish procedures for personal investments and restrict certain personal securities transactions. Personnel subject to the code may invest in securities for their personal investment accounts, including securities that may be purchased or held by us, so long as such investments are made in accordance with the code’s requirements. You may read and copy the codes of ethics at the SEC’s Public Reference Room located at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the codes of ethics are available on the EDGAR Database on the SEC’s Internet site at http://www.sec.gov and on our website at http://www.fifthstreetfinance.com.

Compliance Policies and Procedures

We and our investment adviser have adopted and implemented written policies and procedures reasonably designed to prevent violation of the federal securities laws and are required to review these compliance policies and procedures annually for their adequacy and the effectiveness of their implementation. Our chief compliance officer is responsible for administering these policies and procedures.

Proxy Voting Policies and Procedures

We have delegated our proxy voting responsibility to our investment adviser. The proxy voting policies and procedures of our investment adviser are set forth below. The guidelines are reviewed periodically by our investment adviser and our non-interested directors, and, accordingly, are subject to change.

Introduction

As an investment adviser registered under the Advisers Act, our investment adviser has a fiduciary duty to act solely in the best interests of its client. As part of this duty, it recognizes that it must vote client securities in a timely manner free of conflicts of interest and in the best interests of its client.

These policies and procedures for voting proxies for the investment advisory clients of our investment adviser are intended to comply with Section 206 of, and Rule 206(4)-6 under, the Advisers Act.

Proxy policies

Our investment adviser will vote proxies relating to our securities in the best interest of our stockholders. It will review on a case-by-case basis each proposal submitted for a stockholder vote to determine its impact on the portfolio securities held by us. Although our investment adviser will generally vote against proposals that may have a negative impact on our portfolio securities, it may vote for such a proposal if there exists compelling long-term reasons to do so.

The proxy voting decisions of our investment adviser are made by the senior officers who are responsible for monitoring each of our investments. To ensure that its vote is not the product of a conflict of interest, it will require that: (a) anyone involved in the decision making process disclose to its chief compliance officer any potential conflict that he or she is aware of and any contact that he or she has had with any interested party regarding a proxy vote; and (b) employees involved in the decision making process or vote administration are prohibited from revealing how our investment adviser intends to vote on a proposal in order to reduce any attempted influence from interested parties.

 

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Proxy voting records

You may obtain information, without charge, regarding how we voted proxies with respect to our portfolio securities by making a written request for proxy voting information to: Chief Compliance Officer, 10 Bank Street, 12th Floor, White Plains, NY 10606.

Other

We will be subject to periodic examination by the SEC for compliance with the 1940 Act.

We are required to provide and maintain a bond issued by a reputable fidelity insurance company to protect us against larceny and embezzlement. Furthermore, as a business development company, we are prohibited from protecting any director or officer against any liability to us or our stockholders arising from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office.

Exchange Act and Sarbanes-Oxley Act Compliance

We are subject to the reporting and disclosure requirements of the Exchange Act, including the filing of quarterly, annual and current reports, proxy statements and other required items. In addition, we are subject to the Sarbanes-Oxley Act, which imposes a wide variety of regulatory requirements on publicly-held companies and their insiders. For example:

 

   

pursuant to Rule 13a-14 of the Exchange Act, our chief executive officer and chief financial officer are required to certify the accuracy of the financial statements contained in our periodic reports;

 

   

pursuant to Item 307 of Regulation S-K, our periodic reports are required to disclose our conclusions about the effectiveness of our disclosure controls and procedures; and

 

   

pursuant to Rule 13a-15 of the Exchange Act, our management is required to prepare a report regarding its assessment of our internal control over financial reporting. Our independent registered public accounting firm is required to audit our internal control over financial reporting.

The Sarbanes-Oxley Act requires us to review our current policies and procedures to determine whether we comply with the Sarbanes-Oxley Act and the regulations promulgated thereunder. We intend to monitor our compliance with all regulations that are adopted under the Sarbanes-Oxley Act and will take actions necessary to ensure that we are in compliance therewith.

Small Business Investment Company Regulations

In August 2009, we formed Fifth Street Mezzanine Partners IV, L.P., a wholly-owned subsidiary. In February 2010, Fifth Street Mezzanine Partners IV, L.P. received final approval to be licensed by the SBA as an SBIC.

The SBIC license allows our SBIC subsidiary to obtain leverage by issuing SBA-guaranteed debentures, subject to the satisfaction of certain 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 at the time of issuance at a market-driven spread over U.S. Treasury Notes with 10-year maturities.

SBICs are designed to stimulate the flow of private equity capital to eligible small businesses. Under SBA regulations, SBICs may make loans to eligible small businesses and invest in the equity securities of small businesses. Under present SBA regulations, eligible small businesses include businesses that have a tangible net worth not exceeding $18 million and have average annual fully taxed net income not exceeding $6 million for the

 

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two most recent fiscal years. In addition, an SBIC must devote 25% of its investment activity to “smaller” concerns as defined by the SBA. A smaller concern is one that has a tangible net worth not exceeding $6 million and has average annual fully taxed net income not exceeding $2 million for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services.

SBA regulations currently limit the amount of SBA-guaranteed debentures that an SBIC may issue to $150 million when it has at least $75 million in regulatory capital. Affiliated SBICs are permitted to issue up to a combined maximum amount of $225 million in SBA-guaranteed debentures when they have at least $112.5 million in combined regulatory capital. As of September 30, 2011, our SBIC subsidiary had $75 million in regulatory capital and $150 million in SBA-guaranteed debentures outstanding. On May 27, 2011, we received a letter from the Investment Division of the SBA that invited us to continue moving forward with our application to obtain an SBIC license for another one of our wholly-owned subsidiaries. Although our application for this license is subject to the SBA’s approval, we remain cautiously optimistic that we will complete the licensing process. If we ultimately receive an SBIC license for another one of our wholly-owned subsidiaries, we would be permitted to issue up to an additional $75 million of SBA-guaranteed debentures.

The SBA restricts the ability of SBICs to repurchase their capital stock. SBA regulations also include restrictions on a “change of control” or transfer of an SBIC and require that SBICs invest idle funds in accordance with SBA regulations. In addition, our SBIC subsidiary may also be limited in its ability to make distributions to us if it does not have sufficient capital, in accordance with SBA regulations.

Our SBIC subsidiary is subject to regulation and oversight by the SBA, including requirements with respect to maintaining certain minimum financial ratios and other covenants. Receipt of an SBIC license does not assure that our SBIC subsidiary will receive SBA guaranteed debenture funding, which is dependent upon our SBIC subsidiary continuing to be in compliance with SBA regulations and policies. The SBA, as a creditor, will have a superior claim to our SBIC subsidiary’s assets over our stockholders in the event we liquidate our SBIC subsidiary or the SBA exercises its remedies under the SBA-guaranteed debentures issued by our SBIC subsidiary upon an event of default.

The NASDAQ Global Select Market Corporate Governance Regulations

The NASDAQ Global Select Market has adopted corporate governance regulations that listed companies must comply with. We are in compliance with such corporate governance listing standards applicable to business development companies.

Taxation as a Regulated Investment Company

As a business development company, we have elected to be treated, and intend to continue to qualify annually, as a RIC under Subchapter M of the Code, beginning with our 2008 taxable year. As a RIC, we generally do not have to pay corporate-level U.S. federal income taxes on any income that we distribute to our stockholders as dividends. To continue to qualify as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements (as described below). In addition, to qualify for RIC tax treatment we must distribute to our stockholders, for each taxable year, at least 90% of our “investment company taxable income,” which is generally our ordinary income plus the excess of our realized net short-term capital gains over our realized net long-term capital losses (the “Annual Distribution Requirement”).

If we qualify as a RIC and satisfy the Annual Distribution Requirement, then we will not be subject to U.S. federal income tax on the portion of our income we distribute (or are deemed to distribute) to stockholders. We will be subject to U.S. federal income tax at the regular corporate rates on any income or capital gains not distributed (or deemed distributed) to our stockholders.

 

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We will be subject to a 4% nondeductible U.S. federal excise tax on certain undistributed income unless we distribute in a timely manner an amount at least equal to the sum of (1) 98% of our net ordinary income for each calendar year, (2) 98.2% of our capital gain net income for the one-year period ending October 31 in that calendar year and (3) any income recognized, but not distributed, in preceding years (the “Excise Tax Avoidance Requirement”). We generally will endeavor in each taxable year to make sufficient distributions to our stockholders to avoid any U.S. federal excise tax on our earnings.

In order to qualify as a RIC for U.S. federal income tax purposes, we must, among other things:

 

   

continue to qualify as a business development company under the 1940 Act at all times during each taxable year;

 

   

derive in each taxable year at least 90% of our gross income from dividends, interest, payments with respect to loans of certain securities, gains from the sale of stock or other securities, net income from certain “qualified publicly traded partnerships,” or other income derived with respect to our business of investing in such stock or securities (the “90% Income Test”); and

 

   

diversify our holdings so that at the end of each quarter of the taxable year:

 

   

at least 50% of the value of our assets consists of cash, cash equivalents, U.S. Government securities, securities of other RICs, and other securities if such other securities of any one issuer do not represent more than 5% of the value of our assets or more than 10% of the outstanding voting securities of the issuer; and

 

   

no more than 25% of the value of our assets is invested in the securities, other than U.S. government securities or securities of other RICs, of one issuer, of two or more issuers that are controlled, as determined under applicable Code rules, by us and that are engaged in the same or similar or related trades or businesses or of certain “qualified publicly traded partnerships” (the “Diversification Tests”).

We may be required to recognize taxable income in circumstances in which we do not receive cash. For example, if we hold debt obligations that are treated under applicable tax rules as having original issue discount (such as debt instruments with PIK interest or, in certain cases, increasing interest rates or issued with warrants), we must include in income each year a portion of the original issue discount that accrues over the life of the obligation, regardless of whether cash representing such income is received by us in the same taxable year. We may also have to include in income other amounts that we have not yet received in cash, such as PIK interest and deferred loan origination fees that are paid after origination of the loan or are paid in non-cash compensation such as warrants or stock. Because any original issue discount or other amounts accrued will be included in our investment company taxable income for the year of accrual, we may be required to make a distribution to our stockholders in order to satisfy the Annual Distribution Requirement, even though we will not have received any corresponding cash amount.

Although we do not presently expect to do so, we are authorized to borrow funds and to sell assets in order to satisfy the distribution requirements. However, under the 1940 Act, we are not permitted in certain circumstances to make distributions to our stockholders while our debt obligations and other senior securities are outstanding unless certain “asset coverage” tests are met. Moreover, our ability to dispose of assets to meet our distribution requirements may be limited by (1) the illiquid nature of our portfolio and/or (2) other requirements relating to our status as a RIC, including the Diversification Tests. If we dispose of assets in order to meet the Annual Distribution Requirement or the Excise Tax Avoidance Requirement, we may make such dispositions at times that, from an investment standpoint, are not advantageous.

Pursuant to a recent revenue procedure (Revenue Procedure 2010-12) issued by the Internal Revenue Service, or IRS, the IRS has indicated that it will treat distributions from certain publicly traded RICs (including business development companies) that are paid part in cash and part in stock as dividends that would satisfy the RIC’s annual distribution requirements and qualify for the dividends paid deduction for federal income tax purposes. In order to qualify for such treatment, the revenue procedure requires that at least 10% of the total

 

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distribution be payable in cash and that each stockholder have a right to elect to receive its entire distribution in cash. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a proportionate share of the cash to be distributed (although no stockholder electing to receive cash may receive less than 10% of such stockholder’s distribution in cash). This revenue procedure applies to distributions declared on or before December 31, 2012 with respect to taxable years ending on or before December 31, 2011. We do not currently intend to pay dividends in shares of our common stock pursuant to the revenue procedure any time in the near future.

 

Item 1A. Risk Factors

RISK FACTORS

Investing in our common stock involves a number of significant risks. In addition to the other information contained in this annual report on Form 10-K, you should consider carefully the following information before making an investment in our common stock. The risks set out below are not the only risks we face. Additional risks and uncertainties not presently known to us or not presently deemed material by us might also impair our operations and performance. If any of the following events occur, our business, financial condition and results of operations could be materially and adversely affected. In such case, our net asset value and the trading price of our common stock could decline, and you may lose part or all of your investment.

Risks Relating to Economic Conditions

The current state of the economy and financial markets increases the likelihood of adverse effects on our financial position and results of operations.

The U.S. capital markets experienced extreme volatility and disruption over the past several years, leading to recessionary conditions and depressed levels of consumer and commercial spending. Disruptions in the capital markets increased the spread between the yields realized on risk-free and higher risk securities, resulting in illiquidity in parts of the capital markets. While recent indicators suggest modest improvement in the capital markets, we cannot provide any assurance that these conditions will not worsen. If these conditions continue or worsen, the prolonged period of market illiquidity may have a material adverse effect on our business, financial condition and results of operations. Unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us. These events could limit our investment originations, limit our ability to grow and negatively impact our operating results.

In addition, to the extent that recessionary conditions return, the financial results of small to mid-sized companies, like those in which we invest, will likely experience deterioration, which could ultimately lead to difficulty in meeting debt service requirements and an increase in defaults. Additionally, the end markets for certain of our portfolio companies’ products and services have experienced, and continue to experience, negative economic trends. The performances of certain of our portfolio companies have been, and may continue to be, negatively impacted by these economic or other conditions, which may ultimately result in our receipt of a reduced level of interest income from our portfolio companies and/or losses or charge offs related to our investments, and, in turn, may adversely affect distributable income.

Economic recessions or downturns could impair the ability of our portfolio companies to repay loans, which, in turn, could increase our non-performing assets, decrease the value of our portfolio, reduce our volume of new loans and harm our operating results, which would have an adverse effect on our results of operations.

Many of our portfolio companies are and may be susceptible to economic slowdowns or recessions and may be unable to repay our loans during such periods. Therefore, our non-performing assets are likely to increase and the value of our portfolio is likely to decrease during such periods. Adverse economic conditions also may

 

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decrease the value of collateral securing some of our loans and the value of our equity investments. In this regard, as a result of recent economic conditions and their impact on certain of our portfolio companies, we have agreed to modify the payment terms of our investments in seven of our portfolio companies as of September 30, 2011. Such modified terms include changes in payment-in-kind interest provisions and/or cash interest rates. These modifications, and any future modifications to our loan agreements as a result of the recent economic conditions or otherwise, may limit the amount of interest income that we recognize from the modified investments, which may, in turn, limit our ability to make distributions to our stockholders and have a material adverse effect on our results of operations.

The recent downgrade of the U.S. credit rating and the economic crisis in Europe could negatively impact our liquidity, financial condition and earnings.

Recent U.S. debt ceiling and budget deficit concerns, together with signs of deteriorating sovereign debt conditions in Europe, have increased the possibility of additional credit-rating downgrades and economic slowdowns. Although U.S. lawmakers passed legislation to raise the federal debt ceiling, Standard & Poor’s Ratings Services lowered its long-term sovereign credit rating on the United States from “AAA” to “AA+” in August 2011. The impact of this or any further downgrades to the U.S. government’s sovereign credit rating, or its perceived creditworthiness, and the impact of the current crisis in Europe with respect to the ability of certain European Union countries to continue to service their sovereign debt obligations is inherently unpredictable and could adversely effect the U.S. and global financial markets and economic conditions. There can be no assurance that governmental or other measures to aid economic recovery will be effective. These developments, and the government’s credit concerns in general, could cause interest rates and borrowing costs to rise, which may negatively impact our ability to access the debt markets on favorable terms. In addition, the decreased credit rating could create broader financial turmoil and uncertainty, which may weigh heavily on our stock price. Continued adverse economic conditions could have a material adverse effect on our business, financial condition and results of operations.

Risks Relating to Our Business and Structure

Changes in interest rates may affect our cost of capital and net investment income.

Because we may borrow to fund our investments, a portion of our net investment income may be dependent upon the difference between the interest rate at which we borrow funds and the interest rate at which we invest these funds. A portion of our investments will have fixed interest rates, while a portion of our borrowings will likely have floating interest rates. As a result, a significant change in market interest rates could have a material adverse effect on our net investment income. In periods of rising interest rates, our cost of funds could increase, which would reduce our net investment income. We may hedge against such interest rate fluctuations by using standard hedging instruments such as interest rate swap agreements, futures, options and forward contracts, subject to applicable legal requirements, including without limitation, all necessary registrations (or exemptions from registration) with the Commodity Futures Trading Commission. These activities may limit our ability to participate in the benefits of lower interest rates with respect to the hedged borrowings. Adverse developments resulting from changes in interest rates or hedging transactions could have a material adverse effect on our business, financial condition and results of operations.

A significant portion of our investment portfolio is and will continue to be recorded at fair value as determined in good faith by our Board of Directors and, as a result, there is and will continue to be uncertainty as to the value of our portfolio investments.

Under the 1940 Act, we are required to carry our portfolio investments at market value or, if there is no readily available market value, at fair value as determined by our Board of Directors. Typically, there is not a public market for the securities of the privately held companies in which we have invested and will generally continue to invest. As a result, we value these securities quarterly at fair value as determined in good faith by our Board of Directors.

 

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Certain factors that may be considered in determining the fair value of our investments include the nature and realizable value of any collateral, the portfolio company’s earnings and its ability to make payments on its indebtedness, the markets in which the portfolio company does business, comparison to comparable publicly-traded companies, discounted cash flow and other relevant factors. Because such valuations, and particularly valuations of private securities and private companies, are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. Due to this uncertainty, our fair value determinations may cause our net asset value on a given date to materially understate or overstate the value that we may ultimately realize upon the sale of one or more of our investments. As a result, investors purchasing our common stock based on an overstated net asset value would pay a higher price than the realizable value of our investments might warrant.

Our ability to achieve our investment objective depends on our investment adviser’s ability to support our investment process; if our investment adviser were to lose any of its principals, our ability to achieve our investment objective could be significantly harmed.

We depend on the investment expertise, skill and network of business contacts of the principals of our investment adviser. The principals of our investment adviser evaluate, negotiate, structure, execute, monitor and service our investments. Our future success will depend to a significant extent on the continued service and coordination of the principals of our investment adviser. The departure of any of these individuals could have a material adverse effect on our ability to achieve our investment objective.

Our ability to achieve our investment objective depends on our investment adviser’s ability to identify, analyze, invest in, finance and monitor companies that meet our investment criteria. Our investment adviser’s capabilities in structuring the investment process, providing competent, attentive and efficient services to us, and facilitating access to financing on acceptable terms depend on the employment of investment professionals in adequate number and of adequate sophistication to match the corresponding flow of transactions. To achieve our investment objective, our investment adviser may need to hire, train, supervise and manage new investment professionals to participate in our investment selection and monitoring process. Our investment adviser may not be able to find investment professionals in a timely manner or at all. Failure to support our investment process could have a material adverse effect on our business, financial condition and results of operations.

Our business model depends to a significant extent upon strong referral relationships with private equity sponsors, and the inability of the principals of our investment adviser to maintain or develop these relationships, or the failure of these relationships to generate investment opportunities, could adversely affect our business.

We expect that the principals of our investment adviser will maintain and develop their relationships with private equity sponsors, and we will rely to a significant extent upon these relationships to provide us with potential investment opportunities. If the principals of our investment adviser fail to maintain their existing relationships or develop new relationships with other sponsors or sources of investment opportunities, we will not be able to grow our investment portfolio. In addition, individuals with whom the principals of our investment adviser have relationships are not obligated to provide us with investment opportunities, and, therefore, there is no assurance that such relationships will generate investment opportunities for us.

We may face increasing competition for investment opportunities, which could reduce returns and result in losses.

We compete for investments with other business development companies and investment funds (including private equity funds and mezzanine funds), as well as traditional financial services companies such as commercial banks and other sources of funding. Many of our competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, some competitors may have a lower cost of capital and access to funding sources that are not available to us. In addition, some of

 

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our competitors may have higher risk tolerances or different risk assessments than we have. These characteristics could allow our competitors to consider a wider variety of investments, establish more relationships and offer better pricing and more flexible structuring than we are able to do. We may lose investment opportunities if we do not match our competitors’ pricing, terms and structure. If we are forced to match our competitors’ pricing, terms and structure, we may not be able to achieve acceptable returns on our investments or may bear substantial risk of capital loss. A significant part of our competitive advantage stems from the fact that the market for investments in small and mid-sized companies is underserved by traditional commercial banks and other financial sources. A significant increase in the number and/or the size of our competitors in this target market could force us to accept less attractive investment terms. Furthermore, many of our competitors have greater experience operating under, or are not subject to, the regulatory restrictions that the 1940 Act imposes on us as a business development company.

Our incentive fee may induce our investment adviser to make speculative investments.

The incentive fee payable by us to our investment adviser may create an incentive for it to make investments on our behalf that are risky or more speculative than would be the case in the absence of such compensation arrangement, which could result in higher investment losses, particularly during cyclical economic downturns. The way in which the incentive fee payable to our investment adviser is determined, which is calculated separately in two components as a percentage of the income (subject to a hurdle rate) and as a percentage of the realized gain on invested capital, may encourage our investment adviser to use leverage to increase the return on our investments or otherwise manipulate our income so as to recognize income in quarters where the hurdle rate is exceeded. Under certain circumstances, the use of leverage may increase the likelihood of default, which would disfavor the holders of our common stock.

The incentive fee payable by us to our investment adviser also may create an incentive for our investment adviser to invest on our behalf in instruments that have a deferred interest feature. Under these investments, we would accrue the interest over the life of the investment but would not receive the cash income from the investment until the end of the investment’s term, if at all. Our net investment income used to calculate the income portion of our incentive fee, however, includes accrued interest. Thus, a portion of the incentive fee would be based on income that we have not yet received in cash and may never receive in cash if the portfolio company is unable to satisfy such interest payment obligation to us. While we may make incentive fee payments on income accruals that we may not collect in the future and with respect to which we do not have a formal “claw back” right against our investment adviser per se, the amount of accrued income written off in any period will reduce the income in the period in which such write-off was taken and thereby reduce such period’s incentive fee payment.

In addition, our investment adviser receives the incentive fee based, in part, upon net capital gains realized on our investments. Unlike the portion of the incentive fee based on income, there is no performance threshold applicable to the portion of the incentive fee based on net capital gains. As a result, our investment adviser may have a tendency to invest more in investments that are likely to result in capital gains as compared to income producing securities. Such a practice could result in our investing in more speculative securities than would otherwise be the case, which could result in higher investment losses, particularly during economic downturns.

Given the subjective nature of the investment decisions made by our investment adviser on our behalf, we will be unable to monitor these potential conflicts of interest between us and our investment adviser.

Our base management fee may induce our investment adviser to incur leverage.

The fact that our base management fee is payable based upon our gross assets, which would include any borrowings for investment purposes, may encourage our investment adviser to use leverage to make additional investments. Under certain circumstances, the use of increased leverage may increase the likelihood of default, which would disfavor holders of our common stock. Given the subjective nature of the investment decisions made by our investment adviser on our behalf, we will not be able to monitor this potential conflict of interest.

 

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Because we borrow money, the potential for loss on amounts invested in us will be magnified and may increase the risk of investing in us.

Borrowings, also known as leverage, magnify the potential for loss on invested equity capital. If we continue to use leverage to partially finance our investments, through borrowings from banks and other lenders, you will experience increased risks of investing in our common stock. If the value of our assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged. Similarly, any decrease in our income would cause net income to decline more sharply than it would have had we not borrowed. Such a decline could negatively affect our ability to make common stock distribution payments. Leverage is generally considered a speculative investment technique.

Substantially all of our assets are subject to security interests under secured credit facilities or subject to a superior claim over our stockholders by the SBA and if we default on our obligations under the facilities or with respect to our SBA-guaranteed debentures, we may suffer adverse consequences, including foreclosure on our assets.

As of September 30, 2011, substantially all of our assets were pledged as collateral under our credit facilities or subject to a superior claim over our stockholders by the SBA. If we default on our obligations under these facilities or our SBA-guaranteed debentures, the lenders and/or the SBA may have the right to foreclose upon and sell, or otherwise transfer, the collateral subject to their security interests or their superior claim. In such event, we may be forced to sell our investments to raise funds to repay our outstanding borrowings in order to avoid foreclosure and these forced sales may be at times and at prices we would not consider advantageous. Moreover, such deleveraging of our company could significantly impair our ability to effectively operate our business in the manner in which we have historically operated. As a result, we could be forced to curtail or cease new investment activities and lower or eliminate the dividends that we have historically paid to our stockholders.

In addition, if the lenders exercise their right to sell the assets pledged under our credit facilities, such sales may be completed at distressed sale prices, thereby diminishing or potentially eliminating the amount of cash available to us after repayment of the amounts outstanding under the credit facilities.

Because we intend to distribute between 90% and 100% of our income to our stockholders in connection with our election to be treated as a RIC, we will continue to need additional capital to finance our growth. If additional funds are unavailable or not available on favorable terms, our ability to grow will be impaired.

In order to qualify for the tax benefits available to RICs and to minimize corporate-level taxes, we intend to distribute to our stockholders between 90% and 100% of our annual taxable income, except that we may retain certain net capital gains for investment, and treat such amounts as deemed distributions to our stockholders. If we elect to treat any amounts as deemed distributions, we must pay income taxes at the corporate rate on such deemed distributions on behalf of our stockholders. As a result of these requirements, we will likely need to raise capital from other sources to grow our business. As a business development company, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, to total senior securities, which includes all of our borrowings and any outstanding preferred stock, of at least 200%. These requirements limit the amount that we may borrow. Because we will continue to need capital to grow our investment portfolio, these limitations may prevent us from incurring debt and require us to raise additional equity at a time when it may be disadvantageous to do so.

While we expect to be able to issue additional equity securities, we cannot assure you that equity financing will be available to us on favorable terms, or at all. Also, as a business development company, we generally are not permitted to issue equity securities priced below net asset value without stockholder approval. If additional funds are not available to us, we could be forced to curtail or cease new investment activities, and our net asset value and share price could decline.

 

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Our ability to enter into transactions with our affiliates is restricted.

We are prohibited under the 1940 Act from participating in certain transactions with certain of our affiliates without the prior approval of the members of our independent directors and, in some cases, the SEC. Any person that owns, directly or indirectly, 5% or more of our outstanding voting securities is our affiliate for purposes of the 1940 Act and we are generally prohibited from buying or selling any securities (other than our securities) from or to such affiliate, absent the prior approval of our independent directors. The 1940 Act also prohibits certain “joint” transactions with certain of our affiliates, which could include investments in the same portfolio company (whether at the same or different times), without prior approval of our independent directors and, in some cases, the SEC. If a person acquires more than 25% of our voting securities, we are prohibited from buying or selling any security (other than any security of which we are the issuer) from or to such person or certain of that person’s affiliates, or entering into prohibited joint transactions with such person, absent the prior approval of the SEC. Similar restrictions limit our ability to transact business with our officers or directors or their affiliates. As a result of these restrictions, we may be prohibited from buying or selling any security (other than any security of which we are the issuer) from or to any portfolio company of a private equity fund managed by our investment adviser without the prior approval of the SEC, which may limit the scope of investment opportunities that would otherwise be available to us.

There are significant potential conflicts of interest which could adversely impact our investment returns.

Our executive officers and directors, and certain members of our investment adviser, serve or may serve as officers, directors or principals of entities that operate in the same or a related line of business as we do or of investment funds managed by our affiliates. Accordingly, they may have obligations to investors in those entities, the fulfillment of which might not be in the best interests of us or our stockholders. For example, Mr. Tannenbaum, our chief executive officer and managing partner of our investment adviser, is the managing partner of Fifth Street Capital LLC, a private investment firm. Although the other investment funds managed by Fifth Street Capital LLC and its affiliates generally are fully committed and, other than follow-on investments in existing portfolio companies, are no longer making investments, in the future, the principals of our investment adviser may manage other funds which may from time to time have overlapping investment objectives with those of us and accordingly invest in, whether principally or secondarily, asset classes similar to those targeted by us. If this should occur, the principals of our investment adviser may face conflicts of interest in the allocation of investment opportunities to us and such other funds. Although our investment professionals will endeavor to allocate investment opportunities in a fair and equitable manner, we and our common stockholders could be adversely affected in the event investment opportunities are allocated among us and other investment vehicles managed or sponsored by, or affiliated with, our executive officers, directors and members of our investment adviser.

The incentive fee we pay to our investment adviser relating to capital gains may be effectively greater than 20%.

As a result of the operation of the cumulative method of calculating the capital gains portion of the incentive fee we pay to our investment adviser, the cumulative aggregate capital gains fee received by our investment adviser could be effectively greater than 20%, depending on the timing and extent of subsequent net realized capital losses or net unrealized depreciation. For additional information on this calculation, see the disclosure in footnote 2 to Example 2 under the caption “Item 1. Business — Investment Advisory Agreement — Fees Paid to Our Investment Adviser — Incentive Fee.” We cannot predict whether, or to what extent, this payment calculation would affect your investment in our stock.

A failure on our part to maintain our qualification as a business development company would significantly reduce our operating flexibility.

If we fail to continuously qualify as a business development company, we might be subject to regulation as a registered closed-end investment company under the 1940 Act, which would significantly decrease our

 

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operating flexibility. In addition, failure to comply with the requirements imposed on business development companies by the 1940 Act could cause the SEC to bring an enforcement action against us. For additional information on the qualification requirements of a business development company, see the disclosure under the caption “Item 1. Business — Regulation — Business Development Company Regulations.”

Regulations governing our operation as a business development company and RIC affect our ability to raise, and the way in which we raise, additional capital or borrow for investment purposes, which may have a negative effect on our growth.

As a result of the annual distribution requirement to qualify for tax free treatment at the corporate level on income and gains distributed to stockholders, we need to periodically access the capital markets to raise cash to fund new investments. We generally are not able to issue or sell our common stock at a price below net asset value per share, which may be a disadvantage as compared with other public companies or private investment funds. We may, however, sell our common stock, or warrants, options or rights to acquire our common stock, at a price below the current net asset value of the common stock if our Board of Directors and independent directors determine that such sale is in our best interests and the best interests of our stockholders, and our stockholders as well as those stockholders that are not affiliated with us approve such sale. In any such case, the price at which our securities are to be issued and sold may not be less than a price that, in the determination of our Board of Directors, closely approximates the market value of such securities (less any underwriting commission or discount). If our common stock trades at a discount to net asset value, this restriction could adversely affect our ability to raise capital.

We also may make rights offerings to our stockholders at prices less than net asset value, subject to applicable requirements of the 1940 Act. If we raise additional funds by issuing more shares of our common stock or issuing senior securities convertible into, or exchangeable for, our common stock, the percentage ownership of our stockholders may decline at that time and such stockholders may experience dilution. Moreover, we can offer no assurance that we will be able to issue and sell additional equity securities in the future, on terms favorable to us or at all.

In addition, we may issue “senior securities,” including borrowing money from banks or other financial institutions only in amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such incurrence or issuance. Our ability to issue different types of securities is also limited. Compliance with these requirements may unfavorably limit our investment opportunities and reduce our ability in comparison to other companies to profit from favorable spreads between the rates at which we can borrow and the rates at which we can lend. As a business development company, therefore, we may need to issue equity more frequently than our privately owned competitors, which may lead to greater stockholder dilution.

We expect to continue to borrow for investment purposes. If the value of our assets declines, we may be unable to satisfy the asset coverage test, which could prohibit us from paying dividends and could prevent us from qualifying as a RIC. If we cannot satisfy the asset coverage test, we may be required to sell a portion of our investments and, depending on the nature of our debt financing, repay a portion of our indebtedness at a time when such sales may be disadvantageous.

In addition, we may in the future seek to securitize our portfolio securities to generate cash for funding new investments. To securitize loans, we would likely create a wholly-owned subsidiary and contribute a pool of loans to the subsidiary. We would then sell interests in the subsidiary on a non-recourse basis to purchasers and we would retain all or a portion of the equity in the subsidiary. An inability to successfully securitize our loan portfolio could limit our ability to grow our business or fully execute our business strategy and may decrease our earnings, if any. The securitization market is subject to changing market conditions and we may not be able to access this market when we would otherwise deem appropriate. Moreover, the successful securitization of our portfolio might expose us to losses as the residual investments in which we do not sell interests will tend to be those that are riskier and more apt to generate losses. The 1940 Act also may impose restrictions on the structure of any securitization.

 

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Our SBIC subsidiary’s investment adviser has no prior experience managing an SBIC and any failure to comply with SBA regulations, resulting from our SBIC subsidiary’s investment adviser’s lack of experience or otherwise, could have an adverse effect on our operations.

On February 3, 2010, our wholly-owned subsidiary, Fifth Street Mezzanine Partners IV, L.P., received a license, effective February 1, 2010, from the SBA to operate as an SBIC under Section 301(c) of the Small Business Investment Act of 1958 and is regulated by the SBA. The SBIC license allows our SBIC subsidiary to obtain leverage by issuing SBA-guaranteed debentures. The SBA places certain limitations on the financing terms of investments by SBICs in portfolio companies and prohibits SBICs from providing funds for certain purposes or to businesses in a few prohibited industries. Compliance with SBIC requirements may cause our SBIC subsidiary to forego attractive investment opportunities that are not permitted under SBA regulations.

Further, SBA regulations require that an SBIC be periodically examined and audited by the SBA to determine its compliance with the relevant SBA regulations. The SBA prohibits, without prior SBA approval, a “change of control” of an SBIC or transfers that would result in any person (or a group of persons acting in concert) owning 10% or more of a class of capital stock of an SBIC. If our SBIC subsidiary fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit its use of debentures, declare outstanding debentures immediately due and payable, and/or limit it from making new investments. In addition, the SBA can revoke or suspend a license for willful or repeated violation of, or willful or repeated failure to observe, any provision of the Small Business Investment Act of 1958 or any rule or regulation promulgated thereunder. These actions by the SBA would, in turn, negatively affect us because our SBIC subsidiary is our wholly-owned subsidiary. Our SBIC subsidiary’s investment adviser does not have any prior experience managing an SBIC. Its lack of experience in complying with SBA regulations may hinder its ability to take advantage of our SBIC subsidiary’s access to SBA-guaranteed debentures.

Any failure to comply with SBA regulations could have an adverse effect on our operations.

We may experience fluctuations in our quarterly results.

We could experience fluctuations in our quarterly operating results due to a number of factors, including our ability or inability to make investments in companies that meet our investment criteria, the interest rate payable on the debt securities we acquire, the level of our expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our market and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods.

Our Board of Directors may change our investment objective, operating policies and strategies without prior notice or stockholder approval, the effects of which may be adverse.

Our Board of Directors has the authority to modify or waive our current investment objective, operating policies and strategies without prior notice and without stockholder approval. We cannot predict the effect any changes to our current investment objective, operating policies and strategies would have on our business, net asset value, operating results and value of our stock. However, the effects might be adverse, which could negatively impact our ability to pay you distributions and cause you to lose part or all of your investment.

We will be subject to corporate-level income tax if we are unable to maintain our qualification as a RIC under Subchapter M of the Code or do not satisfy the annual distribution requirement.

To maintain RIC status and be relieved of federal taxes on income and gains distributed to our stockholders, we must meet the following annual distribution, income source and asset diversification requirements.

 

   

The annual distribution requirement for a RIC will be satisfied if we distribute to our stockholders on an annual basis at least 90% of our net taxable income and realized net short-term capital gains in excess of

 

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realized net long-term capital losses, if any. Because we may use debt financing, we are subject to an asset coverage ratio requirement under the 1940 Act and we may be subject to certain financial covenants under our debt arrangements that could, under certain circumstances, restrict us from making distributions necessary to satisfy the distribution requirement. If we are unable to obtain cash from other sources, we could fail to qualify for RIC tax treatment and thus become subject to corporate-level income tax.

 

   

The income source requirement will be satisfied if we obtain at least 90% of our income for each year from dividends, interest, gains from the sale of stock or securities or similar sources.

 

   

The asset diversification requirement will be satisfied if we meet certain asset diversification requirements at the end of each quarter of our taxable year. To satisfy this requirement, at least 50% of the value of our assets must consist of cash, cash equivalents, U.S. government securities, securities of other RICs, and other acceptable securities; and no more than 25% of the value of our assets can be invested in the securities, other than U.S. government securities or securities of other RICs, of one issuer, of two or more issuers that are controlled, as determined under applicable Code rules, by us and that are engaged in the same or similar or related trades or businesses or of certain “qualified publicly traded partnerships.” Failure to meet these requirements may result in our having to dispose of certain investments quickly in order to prevent the loss of RIC status. Because most of our investments will be in private companies, and therefore will be relatively illiquid, any such dispositions could be made at disadvantageous prices and could result in substantial losses.

If we fail to qualify for or maintain RIC status or to meet the annual distribution requirement for any reason and are subject to corporate income tax, the resulting corporate taxes could substantially reduce our net assets, the amount of income available for distribution and the amount of our distributions.

We may not be able to pay you distributions, our distributions may not grow over time and a portion of our distributions may be a return of capital.

We intend to pay distributions to our stockholders out of assets legally available for distribution. We cannot assure you that we will achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions. Our ability to pay distributions might be adversely affected by, among other things, the impact of one or more of the risk factors described in this annual report on Form 10-K. In addition, the inability to satisfy the asset coverage test applicable to us as a business development company can limit our ability to pay distributions. All distributions will be paid at the discretion of our Board of Directors and will depend on our earnings, our financial condition, maintenance of our RIC status, compliance with applicable business development company regulations and such other factors as our Board of Directors may deem relevant from time to time. We cannot assure you that we will pay distributions to our stockholders in the future.

When we make distributions, we will be required to determine the extent to which such distributions are paid out of current or accumulated earnings and profits. Distributions in excess of current and accumulated earnings and profits will be treated as a non-taxable return of capital to the extent of an investor’s basis in our stock and, assuming that an investor holds our stock as a capital asset, thereafter as a capital gain.

We may have difficulty paying our required distributions if we recognize income before or without receiving cash representing such income.

For federal income tax purposes, we include in income certain amounts that we have not yet received in cash, such as original issue discount or accruals on a contingent payment debt instrument, which may occur if we receive warrants in connection with the origination of a loan or possibly in other circumstances. Such original issue discount is included in income before we receive any corresponding cash payments. We also may be required to include in income certain other amounts that we do not receive in cash.

Since, in certain cases, we may recognize income before or without receiving cash representing such income, we may have difficulty meeting the annual distribution requirement necessary to be relieved of federal

 

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taxes on income and gains distributed to our stockholders. Accordingly, we may have to sell some of our investments at times and/or at prices we would not consider advantageous, raise additional debt or equity capital or forgo new investment opportunities for this purpose. If we are not able to obtain cash from other sources, we may fail to satisfy the annual distribution requirement and thus become subject to corporate-level income tax.

We may in the future choose to pay dividends in our own stock, in which case you may be required to pay tax in excess of the cash you receive.

We may distribute taxable dividends that are payable in part in our stock. Taxable stockholders receiving such dividends will be required to include the full amount of the dividend as ordinary income (or as long-term capital gain to the extent such distribution is properly designated as a capital gain dividend) to the extent of our current and accumulated earnings and profits for United States federal income tax purposes. As a result, a U.S. stockholder may be required to pay tax with respect to such dividends in excess of any cash received. If a U.S. stockholder sells the stock it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of our stock at the time of the sale. Furthermore, with respect to non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of our stockholders determine to sell shares of our stock in order to pay taxes owed on dividends, it may put downward pressure on the trading price of our stock.

In addition, as discussed elsewhere in this annual report on Form 10-K, our loans typically contain payment-in-kind (“PIK”) interest provisions. The PIK interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To avoid the imposition of corporate-level tax on us, this non-cash source of income needs to be paid out to stockholders in cash distributions or, in the event that we determine to do so, in shares of our common stock, even though we have not yet collected and may never collect the cash relating to the PIK interest.

Our wholly-owned SBIC subsidiary may be unable to make distributions to us that will enable us to maintain RIC status, which could result in the imposition of an entity-level tax.

In order for us to continue to qualify for RIC tax treatment and to minimize corporate-level taxes, we are required to distribute substantially all of our net taxable income and net capital gain income, including income from certain of our subsidiaries, which includes the income from our SBIC subsidiary. We are partially dependent on our SBIC subsidiary for cash distributions to enable us to meet the RIC distribution requirements. Our SBIC subsidiary may be limited by the Small Business Investment Act of 1958, and SBA regulations governing SBICs, from making certain distributions to us that may be necessary to maintain our status as a RIC. We may have to request a waiver of the SBA’s restrictions for our SBIC subsidiary to make certain distributions to maintain our RIC status. We cannot assure you that the SBA will grant such waiver and if our SBIC subsidiary is unable to obtain a waiver, compliance with the SBA regulations may result in loss of RIC tax treatment and a consequent imposition of an entity-level tax on us.

Changes in laws or regulations governing our operations may adversely affect our business or cause us to alter our business strategy.

We and our portfolio companies are subject to regulation at the local, state and federal level. New legislation may be enacted or new interpretations, rulings or regulations could be adopted, including those governing the types of investments we are permitted to make or that impose limits on our ability to pledge a significant amount of our assets to secure loans, any of which could harm us and our stockholders, potentially with retroactive effect.

Additionally, any changes to the laws and regulations governing our operations relating to permitted investments may cause us to alter our investment strategy in order to avail ourselves of new or different opportunities. Such changes could result in material differences to the strategies and plans set forth in this annual

 

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report on Form 10-K and may result in our investment focus shifting from the areas of expertise of our investment adviser to other types of investments in which our investment adviser may have less expertise or little or no experience. Thus, any such changes, if they occur, could have a material adverse effect on our results of operations and the value of your investment.

We have identified deficiencies in our internal control over financial reporting from time to time. Future control deficiencies could prevent us from accurately and timely reporting our financial results.

We have identified deficiencies in our internal control over financial reporting from time to time, including significant deficiencies and material weaknesses. A “significant deficiency” is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of a company’s financial reporting. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis.

Our failure to identify deficiencies in our internal control over financial reporting in a timely manner or remediate any deficiencies, or the identification of material weaknesses or significant deficiencies in the future could prevent us from accurately and timely reporting our financial results.

Risks Relating to Our Investments

Our investments in portfolio companies may be risky, and we could lose all or part of our investment.

Investing in small and mid-sized companies involves a number of significant risks. Among other things, these companies:

 

   

may have limited financial resources and may be unable to meet their obligations under their debt instruments that we hold, which may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of us realizing any guarantees from subsidiaries or affiliates of our portfolio companies that we may have obtained in connection with our investments, as well as a corresponding decrease in the value of the equity components of our investments;

 

   

may have shorter operating histories, narrower product lines, smaller market shares and/or significant customer concentrations than larger businesses, which tend to render them more vulnerable to competitors’ actions and market conditions, as well as general economic downturns;

 

   

are more likely to depend on the management talents and efforts of a small group of persons; therefore, the death, disability, resignation or termination of one or more of these persons could have a material adverse impact on our portfolio company and, in turn, on us;

 

   

generally have less predictable operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, and may require substantial additional capital to support their operations, finance expansion or maintain their competitive position; and

 

   

generally have less publicly available information about their businesses, operations and financial condition. If we are unable to uncover all material information about these companies, we may not make a fully informed investment decision, and as a result may lose part or all of our investment.

In addition, in the course of providing significant managerial assistance to certain of our portfolio companies, certain of our officers and directors may serve as directors on the boards of such companies. To the extent that litigation arises out of our investments in these companies, our officers and directors may be named as defendants in such litigation, which could result in an expenditure of funds (through our indemnification of such officers and directors) and the diversion of management time and resources.

 

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An investment strategy focused primarily on privately held companies presents certain challenges, including the lack of available information about these companies.

We invest primarily in privately held companies. Generally, little public information exists about these companies, including typically a lack of audited financial statements and ratings by third parties. We must therefore rely on the ability of our investment adviser to obtain adequate information to evaluate the potential risks of investing in these companies. These companies and their financial information may not be subject to the Sarbanes-Oxley Act and other rules that govern public companies. If we are unable to uncover all material information about these companies, we may not make a fully informed investment decision, and we may lose money on our investments. These factors could affect our investment returns.

If we make unsecured debt investments, we may lack adequate protection in the event our portfolio companies become distressed or insolvent and will likely experience a lower recovery than more senior debtholders in the event our portfolio companies defaults on their indebtedness.

We have made, and may in the future make, unsecured debt investments in portfolio companies. Unsecured debt investments are unsecured and junior to other indebtedness of the portfolio company. As a consequence, the holder of an unsecured debt investment may lack adequate protection in the event the portfolio company becomes distressed or insolvent and will likely experience a lower recovery than more senior debtholders in the event the portfolio company defaults on its indebtedness. In addition, unsecured debt investments of small and mid-sized companies are often highly illiquid and in adverse market conditions may experience steep declines in valuation even if they are fully performing.

If we invest in the securities and obligations of distressed or bankrupt companies, such investments may be subject to significant risks, including lack of income, extraordinary expenses, uncertainty with respect to satisfaction of debt, lower-than expected investment values or income potentials and resale restrictions.

We are authorized to invest in the securities and other obligations of distressed or bankrupt companies. At times, distressed debt obligations may not produce income and may require us to bear certain extraordinary expenses (including legal, accounting, valuation and transaction expenses) in order to protect and recover our investment. Therefore, to the extent we invest in distressed debt, our ability to achieve current income for our stockholders may be diminished.

We also will be subject to significant uncertainty as to when and in what manner and for what value the distressed debt we invest in will eventually be satisfied (e.g., through a liquidation of the obligor’s assets, an exchange offer or plan of reorganization involving the distressed debt securities or a payment of some amount in satisfaction of the obligation). In addition, even if an exchange offer is made or plan of reorganization is adopted with respect to distressed debt held by us, there can be no assurance that the securities or other assets received by us in connection with such exchange offer or plan of reorganization will not have a lower value or income potential than may have been anticipated when the investment was made.

Moreover, any securities received by us upon completion of an exchange offer or plan of reorganization may be restricted as to resale. As a result of our participation in negotiations with respect to any exchange offer or plan of reorganization with respect to an issuer of distressed debt, we may be restricted from disposing of such securities.

The lack of liquidity in our investments may adversely affect our business.

We invest, and will continue to invest, in companies whose securities are not publicly traded, and whose securities are subject to legal and other restrictions on resale or are otherwise less liquid than publicly traded securities. In fact, all of our assets may be invested in illiquid securities. The illiquidity of these investments may make it difficult for us to sell these investments when desired. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we had previously

 

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recorded these investments. Our investments are usually subject to contractual or legal restrictions on resale or are otherwise illiquid because there is usually no established trading market for such investments. The illiquidity of most of our investments may make it difficult for us to dispose of them at a favorable price, and, as a result, we may suffer losses.

We may not have the funds or ability to make additional investments in our portfolio companies.

After our initial investment in a portfolio company, we may be called upon from time to time to provide additional funds to such company or have the opportunity to increase our investment through the exercise of a warrant to purchase common stock. There is no assurance that we will make, or will have sufficient funds to make, follow-on investments. Any decisions not to make a follow-on investment or any inability on our part to make such an investment may have a negative impact on a portfolio company in need of such an investment, may result in a missed opportunity for us to increase our participation in a successful operation or may reduce the expected yield on the investment.

Our portfolio companies may incur debt that ranks equally with, or senior to, our investments in such companies.

We invest primarily in first and second lien debt issued by small and mid-sized companies. Our portfolio companies may have, or may be permitted to incur, other debt that ranks equally with, or senior to, the debt in which we invest. By their terms, such debt instruments may entitle the holders to receive payments of interest or principal on or before the dates on which we are entitled to receive payments with respect to the debt instruments in which we invest. Also, in the event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company, holders of debt instruments ranking senior to our investment in that portfolio company would typically be entitled to receive payment in full before we receive any distribution. After repaying such senior creditors, such portfolio company may not have any remaining assets to use for repaying its obligation to us. In the case of debt ranking equally with debt instruments in which we invest, we would have to share on an equal basis any distributions with other creditors holding such debt in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy of the relevant portfolio company.

The disposition of our investments may result in contingent liabilities.

Most of our investments will involve private securities. In connection with the disposition of an investment in private securities, we may be required to make representations about the business and financial affairs of the portfolio company typical of those made in connection with the sale of a business. We may also be required to indemnify the purchasers of such investment to the extent that any such representations turn out to be inaccurate or with respect to certain potential liabilities. These arrangements may result in contingent liabilities that ultimately yield funding obligations that must be satisfied through our return of certain distributions previously made to us.

There may be circumstances where our debt investments could be subordinated to claims of other creditors or we could be subject to lender liability claims.

Even though we have structured some of our investments as senior loans, if one of our portfolio companies were to go bankrupt, depending on the facts and circumstances, including the extent to which we actually provided managerial assistance to that portfolio company, a bankruptcy court might recharacterize our debt investment and subordinate all or a portion of our claim to that of other creditors. We may also be subject to lender liability claims for actions taken by us with respect to a borrower’s business or instances where we exercise control over the borrower. It is possible that we could become subject to a lender’s liability claim, including as a result of actions taken in rendering significant managerial assistance.

 

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Second priority liens on collateral securing loans that we make to our portfolio companies may be subject to control by senior creditors with first priority liens. If there is a default, the value of the collateral may not be sufficient to repay in full both the first priority creditors and us.

Certain loans that we make to portfolio companies will be secured on a second priority basis by the same collateral securing senior secured debt of such companies. The first priority liens on the collateral will secure the portfolio company’s obligations under any outstanding senior debt and may secure certain other future debt that may be permitted to be incurred by the company under the agreements governing the loans. The holders of obligations secured by the first priority liens on the collateral will generally control the liquidation of and be entitled to receive proceeds from any realization of the collateral to repay their obligations in full before us. In addition, the value of the collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. There can be no assurance that the proceeds, if any, from the sale or sales of all of the collateral would be sufficient to satisfy the loan obligations secured by the second priority liens after payment in full of all obligations secured by the first priority liens on the collateral. If such proceeds are not sufficient to repay amounts outstanding under the loan obligations secured by the second priority liens, then we, to the extent not repaid from the proceeds of the sale of the collateral, will only have an unsecured claim against the company’s remaining assets, if any.

The rights we may have with respect to the collateral securing the loans we make to our portfolio companies with senior debt outstanding may also be limited pursuant to the terms of one or more intercreditor agreements that we enter into with the holders of senior debt. Under such an intercreditor agreement, at any time that obligations that have the benefit of the first priority liens are outstanding, any of the following actions that may be taken with respect to the collateral will be at the direction of the holders of the obligations secured by the first priority liens: the ability to cause the commencement of enforcement proceedings against the collateral; the ability to control the conduct of such proceedings; the approval of amendments to collateral documents; releases of liens on the collateral; and waivers of past defaults under collateral documents. We may not have the ability to control or direct such actions, even if our rights are adversely affected.

We generally do not and will not control our portfolio companies.

We do not, and do not expect to, control most of our portfolio companies, even though we may have board representation or board observation rights, and our debt agreements may contain certain restrictive covenants. As a result, we are subject to the risk that a portfolio company in which we invest may make business decisions with which we disagree and the management of such company, as representatives of the holders of their common equity, may take risks or otherwise act in ways that do not serve our interests as a debt investor. Due to the lack of liquidity for our investments in non-traded companies, we may not be able to dispose of our interests in our portfolio companies as readily as we would like or at an appropriate valuation. As a result, a portfolio company may make decisions that could decrease the value of our portfolio holdings.

Defaults by our portfolio companies would harm our operating results.

A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, termination of its loans and foreclosure on its secured assets, which could trigger cross-defaults under other agreements and jeopardize a portfolio company’s ability to meet its obligations under the debt or equity securities that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms, which may include the waiver of certain financial covenants, with a defaulting portfolio company.

We may not realize gains from our equity investments.

Certain investments that we have made in the past and may make in the future include warrants or other equity securities. In addition, we have made in the past and may make in the future direct equity investments in companies. Our goal is ultimately to realize gains upon our disposition of such equity interests. However, the

 

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equity interests we receive may not appreciate in value and, in fact, may decline in value. Accordingly, we may not be able to realize gains from our equity interests, and any gains that we do realize on the disposition of any equity interests may not be sufficient to offset any other losses we experience. We also may be unable to realize any value if a portfolio company does not have a liquidity event, such as a sale of the business, recapitalization or public offering, which would allow us to sell the underlying equity interests. We often seek puts or similar rights to give us the right to sell our equity securities back to the portfolio company issuer. We may be unable to exercise these puts rights for the consideration provided in our investment documents if the issuer is in financial distress.

We are subject to certain risks associated with foreign investments.

We may make investments in foreign companies. Investing in foreign companies may expose us to additional risks not typically associated with investing in U.S. companies. These risks include changes in foreign exchange rates, exchange control regulations, political and social instability, expropriation, imposition of foreign taxes, less liquid markets and less available information than is generally the case in the U.S., higher transaction costs, less government supervision of exchanges, brokers and issuers, less developed bankruptcy laws, difficulty in enforcing contractual obligations, lack of uniform accounting and auditing standards and greater price volatility.

Our success will depend, in part, on our ability to anticipate and effectively manage these and other risks. We cannot assure you that these and other factors will not have a material adverse effect on our business as a whole.

We may expose ourselves to risks if we engage in hedging transactions.

We have and may in the future enter into hedging transactions, which may expose us to risks associated with such transactions. We may utilize instruments such as forward contracts and interest rate swaps, caps, collars and floors to seek to hedge against fluctuations in the relative values of our portfolio positions and amounts due under our credit facilities from changes in market interest rates. Use of these hedging instruments may include counterparty credit risk. Utilizing such hedging instruments does not eliminate the possibility of fluctuations in the values of such positions and amounts due under our credit facilities or prevent losses if the values of such positions decline. However, such hedging can establish other positions designed to gain from those same developments, thereby offsetting the decline in the value of such portfolio positions. Such hedging transactions may also limit the opportunity for gain if the values of the underlying portfolio positions should increase. Moreover, it may not be possible to hedge against an interest rate fluctuation that is so generally anticipated that we are not able to enter into a hedging transaction at an acceptable price.

The success of our hedging transactions will depend on our ability to correctly predict movements and interest rates. Therefore, while we may enter into such transactions to seek to reduce interest rate risks, unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a hedging strategy and price movements in the portfolio positions being hedged may vary. Moreover, for a variety of reasons, we may not seek to establish a perfect correlation between such hedging instruments and the portfolio holdings or credit facilities being hedged. Any such imperfect correlation may prevent us from achieving the intended hedge and expose us to risk of loss. See also “— Changes in interest rates may affect our cost of capital and net investment income.”

Risks Relating to Our Common Stock

Shares of closed-end investment companies, including business development companies, may trade at a discount to their net asset value.

Shares of closed-end investment companies, including business development companies, may trade at a discount from net asset value. This characteristic of closed-end investment companies and business development

 

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companies is separate and distinct from the risk that our net asset value per share may decline. We cannot predict whether our common stock will trade at, above or below net asset value.

We may be unable to invest a significant portion of the net proceeds from an offering of our common stock on acceptable terms within an attractive timeframe.

Delays in investing the net proceeds raised in an offering of our common stock may cause our performance to be worse than that of other fully invested business development companies or other lenders or investors pursuing comparable investment strategies. We cannot assure you that we will be able to identify any investments that meet our investment objective or that any investment that we make will produce a positive return. We may be unable to invest the net proceeds of any offering on acceptable terms within the time period that we anticipate or at all, which could harm our financial condition and operating results.

We anticipate that, depending on market conditions, it may take us a substantial period of time to invest substantially all of the net proceeds of any offering in securities meeting our investment objective. During this period, we will invest the net proceeds of an offering primarily in cash, cash equivalents, U.S. government securities, repurchase agreements and high-quality debt instruments maturing in one year or less from the time of investment, which may produce returns that are significantly lower than the returns which we expect to achieve when our portfolio is fully invested in securities meeting our investment objective. As a result, any distributions that we pay during this period may be substantially lower than the distributions that we may be able to pay when our portfolio is fully invested in securities meeting our investment objective. In addition, until such time as the net proceeds of an offering are invested in securities meeting our investment objective, the market price for our common stock may decline. Thus, the initial return on your investment may be lower than when, if ever, our portfolio is fully invested in securities meeting our investment objective.

Investing in our common stock may involve an above average degree of risk.

The investments we make in accordance with our investment objective may result in a higher amount of risk than alternative investment options and a higher risk of volatility or loss of principal. Our investments in portfolio companies involve higher levels of risk, and therefore, an investment in our shares may not be suitable for someone with lower risk tolerance.

The market price of our common stock may fluctuate significantly.

The market price and liquidity of the market for shares of our common stock may be significantly affected by numerous factors, some of which are beyond our control and may not be directly related to our operating performance. These factors include:

 

   

significant volatility in the market price and trading volume of securities of business development companies or other companies in our sector, which are not necessarily related to the operating performance of these companies;

 

   

inability to obtain any exemptive relief that may be required by us from the SEC;

 

   

changes in regulatory policies, accounting pronouncements or tax guidelines, particularly with respect to RICs, business development companies and SBICs;

 

   

loss of our business development company or RIC status or our SBIC subsidiary’s status as an SBIC;

 

   

changes in earnings or variations in operating results;

 

   

changes in the value of our portfolio of investments;

 

   

any shortfall in revenue or net income or any increase in losses from levels expected by investors or securities analysts;

 

   

departure of our investment adviser’s key personnel; and

 

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general economic trends and other external factors.

Certain provisions of our restated certificate of incorporation and amended and restated bylaws as well as the Delaware General Corporation Law could deter takeover attempts and have an adverse impact on the price of our common stock.

Our restated certificate of incorporation and our amended and restated bylaws as well as the Delaware General Corporation Law contain provisions that may have the effect of discouraging a third party from making an acquisition proposal for us. These anti-takeover provisions may inhibit a change in control in circumstances that could give the holders of our common stock the opportunity to realize a premium over the market price for our common stock.

Risks Related to our Convertible Senior Notes

Our stockholders may experience dilution upon the conversion of our convertible senior notes.

Our convertible senior notes are convertible into shares of our common stock beginning January 1, 2016 or, under certain circumstances, earlier. Upon conversion, we must deliver shares of our common stock. The conversion rate of our convertible senior notes was initially, and currently is, 67.7415 shares of our common stock per $1,000 principal amount of our convertible senior notes (equivalent to a conversion price of approximately $14.76 per share of common stock), subject to adjustment in certain circumstances. If we deliver shares of common stock upon a conversion at the time our net asset value per share exceeds the conversion price in effect at such time, our stockholders may incur dilution. In addition, our stockholders will experience dilution in their ownership percentage of our common stock upon our issuance of common stock in connection with the conversion of our convertible senior notes and any dividends paid on our common stock will also be paid on shares issued in connection with such conversion after such issuance.

We may not have, or have the ability to raise, the funds necessary to repurchase our convertible senior notes upon a fundamental change, and our debt may contain limitations on our ability to deliver shares of our common stock upon conversion or pay cash upon repurchase of our convertible senior notes.

Holders of our convertible senior notes will have the right to require us to repurchase their notes upon the occurrence of certain significant corporate events involving us, including if our common stock ceases to trade on any national securities exchange or we consolidate or merge into another entity in certain circumstances, at a repurchase price equal to 100% of their principal amount, plus accrued and unpaid interest, if any. We refer to such a corporate event as a “fundamental change.” However, we may not have enough available cash or be able to obtain financing at the time we are required to make repurchases of convertible senior notes surrendered therefor. In addition, our ability to repurchase our convertible senior notes or deliver shares of our common stock upon conversions of the convertible senior notes may be limited by law, by regulatory authority or by agreements governing our indebtedness, including our credit facilities. In this regard, the ING facility prohibits us from repurchasing our convertible senior notes in certain circumstances upon the occurrence of a fundamental change. Our failure to repurchase the notes at a time when the repurchase is required by the indenture relating to the convertible senior notes or to deliver any shares of our common stock deliverable on future conversions of the convertible senior notes as required by the indenture would constitute a default under the indenture. A default under the indenture or the occurrence of a fundamental change itself could also lead to a default under agreements governing our indebtedness. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness and repurchase our convertible senior notes.

Provisions of our convertible senior notes could discourage an acquisition of us by a third party.

Certain provisions of our convertible senior notes could make it more difficult or more expensive for a third party to acquire us. Upon the occurrence of a fundamental change, the holders of our convertible senior notes

 

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will have the right, at their option, to require us to repurchase all or a portion of their convertible senior notes, plus accrued and unpaid interest. We may also be required to increase the conversion rate of the convertible senior notes in certain other circumstances, including in the event of certain fundamental changes. These provisions could discourage an acquisition of us by a third party.

Certain adverse consequences could result if our convertible senior notes are treated as equity interests in us for purposes of regulations under the Employee Retirement Income Security Act of 1974.

Pursuant to regulations under the Employee Retirement Income Security Act of 1974 (“ERISA”), it is possible that, due to their convertibility feature, our convertible senior notes could be treated as equity interests in us. In that event, if employee benefit plans subject to Title I of ERISA, plans that are not subject to ERISA but that are subject to Section 4975 of the Internal Revenue Code (the “Code”), such as individual retirement accounts, and entities that are deemed to hold the assets of such plans or accounts (such plans, accounts, and entities, “Benefit Plan Investors”) were to acquire 25% or more of the aggregate value of our convertible senior notes, among other consequences, we and our management would be subject to ERISA fiduciary duties, and certain transactions we might enter into, or may have entered into, in the ordinary course of our business might constitute non-exempt “prohibited transactions” under Section 406 of ERISA or Section 4975 of the Code and might have to be rescinded at significant cost to us. Moreover, if our underlying assets were deemed to be assets constituting plan assets, (i) our assets could be subject to ERISA’s reporting and disclosure requirements, (ii) a fiduciary causing a Benefit Plan Investor to make an investment in our equity interests could be deemed to have delegated its responsibility to manage the assets of the Benefit Plan Investor, and (iii) various providers of fiduciary or other services to us, and any other parties with authority or control with respect to our assets, could be deemed to be plan fiduciaries or otherwise parties in interest or disqualified persons by virtue of their provision of such services.

We do not believe that our convertible senior notes should be treated as equity interests in us for purposes of ERISA in light of the relevant regulations. No assurance can be given, however, that our convertible senior notes will not be so treated.

The accounting for convertible debt securities is complex and subject to uncertainty.

The accounting for convertible debt securities is complex and subject to frequent scrutiny by the accounting regulatory bodies and is subject to change. The issuance of our convertible senior notes may have an accounting effect on our earnings per share on a fully diluted basis. Further, we cannot predict if or when changes in the accounting for convertible debt securities could be made and whether any such change could have an adverse impact on our reported or future financial results. Any such impacts could adversely affect the market price of our common stock.

 

Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

We do not own any real estate or other physical properties materially important to our operations; however, we utilize office space that is leased by FSC, Inc. for our principal executive office at 10 Bank Street, 12th floor, White Plains, NY 10606. Our investment adviser also maintains additional office space at 2 Greenwich Office Park, 2nd floor, Greenwich, CT 06831. We may from time to time lease satellite office space elsewhere, but these leases are generally not material to our operations. We believe that our current office facilities are adequate for our business as we intend to conduct it.

 

Item 3. Legal Proceedings

Although we may, from time to time, be involved in litigation arising out of our operations in the normal course of business or otherwise, we are currently not a party to any pending material legal proceedings.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Price Range of Common Stock

Our common stock traded on the New York Stock Exchange under the symbol “FSC” until November 28, 2011. The following table sets forth, for each fiscal quarter during the two most recently completed fiscal years, the range of high and low sales prices of our common stock as reported on the New York Stock Exchange:

 

     High      Low  

Fiscal year ended September 30, 2010

     

First quarter

   $ 10.99       $ 9.35   

Second quarter

   $ 12.13       $ 10.45   

Third quarter

   $ 13.64       $ 10.49   

Fourth quarter

   $ 11.30       $ 9.79   

Fiscal year ended September 30, 2011

     

First quarter

   $ 12.35       $ 10.94   

Second quarter

   $ 13.95       $ 11.83   

Third quarter

   $ 13.45       $ 11.42   

Fourth quarter

   $ 11.84       $ 8.38   

On November 28, 2011, our common stock began trading on the NASDAQ Global Select Market, where it continues to trade under the symbol “FSC.” The last reported price for our common stock on November 28, 2011 was $9.38 per share. As of November 25, 2011, we had 70 stockholders of record, which did not include stockholders for whom shares are held in nominee or “street” name.

Sales of Unregistered Securities

While we did not engage in any sales of unregistered securities during the fiscal year ended September 30, 2011, we issued a total of 337,963 shares of common stock under our dividend reinvestment plan (“DRIP”). This issuance was not subject to the registration requirements of the Securities Act of 1933, as amended. The aggregate value the shares of our common stock issued under our DRIP was approximately $4.1 million.

Distributions

Our dividends, if any, are determined by our Board of Directors. Our dividend policy is based upon the following key principles:

 

   

Pay dividends consistent with our current and future earnings potential;

 

   

Set dividend rates that are projected to be stable and growing over time reflecting confidence in our future financial performance; and

 

   

Provide clarity that we intend to cover our dividend payout level with net investment income.

In addition, we have elected to be treated for federal income tax purposes as a RIC under Subchapter M of the Code. As long as we qualify as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders on a timely basis.

To maintain RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company net taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any). Depending on the level of

 

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taxable income earned in a tax year, we may choose to carry forward taxable income in excess of current year distributions into the next tax year and pay a 4% excise tax on such income. Any such carryover taxable income must be distributed through a dividend declared prior to filing the final tax return related to the year in which such taxable income was generated. We may, in the future, make actual distributions to our stockholders of our net capital gains. We can offer no assurance that we will achieve results that will permit the payment of any cash distributions and we may be prohibited from making distributions if doing so causes us to fail to maintain the asset coverage ratios stipulated by the 1940 Act or if distributions are limited by the terms of any of our borrowings. See “Item 1. Business — Regulation — Taxation as a Regulated Investment Company.”

We have adopted an “opt out” dividend reinvestment plan for our common stockholders. As a result, if we make a cash distribution, then stockholders’ cash distributions will be automatically reinvested in additional shares of our common stock, unless they specifically “opt out” of the dividend reinvestment plan so as to receive cash distributions.

Pursuant to a recent revenue procedure (Revenue Procedure 2010-12) issued by the Internal Revenue Service, or IRS, the IRS has indicated that it will treat distributions from certain publicly traded RICs (including business development companies) that are paid part in cash and part in stock as dividends that would satisfy the RIC’s annual distribution requirements and qualify for the dividends paid deduction for federal income tax purposes. In order to qualify for such treatment, the revenue procedure requires that at least 10% of the total distribution be payable in cash and that each stockholder have a right to elect to receive its entire distribution in cash. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a proportionate share of the cash to be distributed (although no stockholder electing to receive cash may receive less than 10% of such stockholder’s distribution in cash). This revenue procedure applies to distributions declared on or before December 31, 2012 with respect to taxable years ending on or before December 31, 2011. We do not currently intend to pay dividends in shares of our common stock pursuant to the revenue procedure any time in the near future.

The following table reflects the dividend distributions per share that our Board of Directors has declared and we have paid, including shares issued under our DRIP, on our common stock since October 1, 2009:

 

Date Declared

 

Record Date

   

Payment Date

   

Amount
per Share

   

Cash Distribution

   

DRIP Shares
Issued

   

DRIP Shares
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 (1)      0.6 million   

May 2, 2011

    August 1, 2011        August 31, 2011        0.1066        7.1 million        64,431 (1)      0.6 million   

May 2, 2011

    September 1, 2011        September 30, 2011        0.1066        7.2 million        52,487 (1)      0.5 million   

August 1, 2011

    October 14, 2011        October 31, 2011        0.1066        7.3 million        40,388 (1)      0.4 million   

 

(1) Shares were purchased on the open market and distributed.

 

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Stock Performance Graph

The following graph compares the cumulative 39-month total return to shareholders on Fifth Street Finance Corp.’s common stock relative to the cumulative total returns of the NYSE Composite index, the NASDAQ Financial index and a customized peer group of six companies that includes the following investment companies, which have elected to be regulated as business development companies under the 1940 Act: Apollo Investment Corp., Ares Capital Corp., Blackrock Kelso Capital Corp., Gladstone Capital Corp., MCG Capital Corp. and MVC Capital Inc. The graph assumes that the value of the investment in the common stock of each company, in each index, and in the peer group was $100 on June 12, 2008 (the date our common stock began to trade on the NYSE Stock Market in connection with our initial public offering), assumes the reinvestment of all cash dividends prior to any tax effect, and tracks the investment through to September 30, 2011. The comparisons in the graph below are based on historical data and are not intended to forecast the possible future performance of our common stock.

LOGO

 

* $100 invested on June 12, 2008 in stock or May 31, 2008 in index, including reinvestment of dividends.

 

     June 12, 2008      Jun-08      Sep-08      Dec-08      Mar-09      Jun-09      Sep-09      Dec-09  

Fifth Street Finance Corp

     100.00         84.90         85.31         69.97         71.73         95.66         106.87         107.87   

NYSE Composite

     100.00         92.29         80.76         62.21         54.23         64.87         76.35         79.80   

NASDAQ Financial

     100.00         86.30         94.82         76.09         62.09         68.96         76.10         77.63   

Peer Group

     100.00         85.96         97.79         61.85         36.79         59.04         85.19         93.78   
            Mar-10      Jun-10      Sep-10      Dec-10      Mar-11      Jun-11      Sep-11  

Fifth Street Finance Corp

        119.76         116.79         119.14         133.42         150.26         133.99         109.89   

NYSE Composite

        83.17         72.73         82.31         90.49         96.00         95.65         78.56   

NASDAQ Financial

        84.41         75.51         76.81         88.30         89.29         86.18         70.97   

Peer Group

        120.34         102.39         122.41         132.94         138.85         128.80         105.59   

 

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Selected unaudited quarterly financial data for Fifth Street Finance Corp. for the years ended September 30, 2011, 2010 and 2009 is below.

    For the three months ended  

(dollars in thousands,
except per share
amounts)

  September 30,
2011
    June 30,
2011
    March 31,
2011
    December 31,
2010
    September 30,
2010
    June 30,
2010
    March 31,
2010
    December 31,
2009
    September 30,
2009
    June 30,
2009
    March 31,
2009
    December 31,
2008
 

Total investment income

  $ 37,686      $ 32,442      $ 29,701      $ 25,335      $ 20,033      $ 19,407      $ 17,856      $ 13,241      $ 12,485      $ 12,839      $ 11,920      $ 12,585   

Net investment income

    19,989        16,526        16,556        14,056        11,437        12,032        11,206        8,349        7,777        7,888        7,488        8,210   

Realized and unrealized gain (loss)

    (43,733     4,306        (885     3,392        (6,062     (13,920     (1,731     1,105        (86     (1,950     (4,651     (18,482

Net increase (decrease) in net assets resulting from operations

    (23,744     20,832        15,671        17,448        5,375        (1,888     9,475        9,454        7,691        5,938        2,837        (10,272

Net assets

    728,627        775,649        711,748        574,920        569,172        568,962        484,397        410,257        410,556        272,702        272,353        268,548   

Total investment income per common share

  $ 0.52      $ 0.48      $ 0.48      $ 0.46      $ 0.37      $ 0.42      $ 0.42      $ 0.35      $ 0.41      $ 0.56      $ 0.52      $ 0.56   

Net investment income per common share

    0.28        0.25        0.27        0.26        0.21        0.26        0.26        0.22        0.26        0.35        0.33        0.36   

Earnings (loss) per common share

    (0.33     0.31        0.25        0.32        0.10        (0.04     0.22        0.25        0.25        0.26        0.12        (0.46

Net asset value per common share at period end

    10.07        10.72        10.68        10.44        10.43        10.43        10.70        10.82        10.84        11.95        11.94        11.86   

Open Market Stock Repurchase Program

In October 2008, our Board of Directors authorized a stock repurchase program to acquire up to $8 million of our outstanding common stock. Stock repurchases under this program were made through the open market at times and were in such amounts as our management deemed appropriate. The stock repurchase program expired December 2009. 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. Any 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.

 

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Item 6. Selected Financial Data

The following selected financial data should be read together with our financial statements and the related notes and the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” which is included elsewhere in this annual report on Form 10-K. Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp. The financial information as of and for the period from inception (February 15, 2007) to September 30, 2007, and for the fiscal years ended September 30, 2008, 2009, 2010 and 2011 set forth below was derived from our audited financial statements and related notes for Fifth Street Mezzanine Partners III, L.P. and Fifth Street Finance Corp., respectively.

 

(dollars in thousands, except per share amounts)

  At and for the
Year Ended
September 30,
2011
    At and for the
Year Ended
September 30,
2010
    At and for the
Year Ended
September 30,
2009
    At and for the
Year Ended
September 30,
2008
    At September 30,
2007 and for the
period
February 15,
2007 through
September 30,
2007
 

Statement of Operations data:

         

Total investment income

  $ 125,165      $ 70,538      $ 49,828      $ 33,219      $ 4,296   

Base management fee, net

    19,656        9,275        5,889        4,258        1,564   

Incentive fee

    16,782        10,756        7,841        4,118          

All other expenses

    23,080        7,483        4,736        4,699        1,773   

Gain on extinguishment of convertible senior notes

    1,480                               

Net investment income

    67,127        43,024        31,362        20,144        959   

Unrealized appreciation (depreciation) on interest rate swap

    773        (773                     

Realized loss on interest rate swap

    (1,335                            

Unrealized appreciation (depreciation) on investments

    (7,299     (1,054     (10,795     (16,948     123   

Realized gain (loss) on investments

    (29,059     (18,781     (14,373     62          

Net increase in partners’ capital/net assets resulting from operations

    30,207        22,416        6,194        3,258        1,082   

Per share data:

         

Net asset value per common share at period end

  $ 10.07      $ 10.43      $ 10.84      $ 13.02      $ N/A   

Market price at period end

    9.32        11.14        10.93        10.05        N/A   

Net investment income

    1.05        0.95        1.27        1.29        N/A   

Net realized and unrealized loss on investments and interest rate swap

    (0.58     (0.46     (1.02     (1.08     N/A   

Net increase in partners’ capital/net assets resulting from operations

    0.47        0.49        0.25        0.21        N/A   

Dividends paid per share

    1.28        0.99        1.20        0.61        N/A   

Balance Sheet data at period end:

         

Total investments at fair value

  $ 1,119,837      $ 563,821      $ 299,611      $ 273,759      $ 88,391   

Cash and cash equivalents

    67,644        76,765        113,205        22,906        17,654   

Other assets

    22,236        11,340        3,071        2,484        1,285   

Total assets

    1,209,717        651,926        415,887        299,149        107,330   

Total liabilities

    481,090        82,754        5,331        4,813        514   

Total net assets

    728,627        569,172        410,556        294,336        106,816   

Other data:

         

Weighted average yield on debt investments(1)

    12.4     14.0     15.7     16.2     16.8

Number of investments at period end

    65        38        28        24        10   

 

(1) Weighted average yield is calculated based upon our debt investments at the end of the period.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in connection with our Consolidated Financial Statements and the notes thereto included elsewhere in this annual report on Form 10-K.

Some of the statements in this annual report on Form 10-K constitute forward-looking statements because they relate to future events or our future performance or financial condition. The forward-looking statements contained in this annual report on Form 10-K may include statements as to:

 

   

our future operating results and dividend projections;

 

   

our business prospects and the prospects of our portfolio companies;

 

   

the impact of the investments that we expect to make;

 

   

the ability of our portfolio companies to achieve their objectives;

 

   

our expected financings and investments;

 

   

the adequacy of our cash resources and working capital; and

 

   

the timing of cash flows, if any, from the operations of our portfolio companies.

In addition, words such as “anticipate,” “believe,” “expect,” “project” and “intend” indicate forward-looking statements, although not all forward-looking statements include these words. The forward-looking statements contained in this annual report on Form 10-K involve risks and uncertainties. Our actual results could differ materially from those implied or expressed in the forward-looking statements for any reason, including the factors set forth in “Item 1A. Risk Factors” and elsewhere in this annual report on Form 10-K. Other factors that could cause actual results to differ materially include:

 

   

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, SBICs or RICs; and

 

   

other considerations that may be disclosed from time to time in our publicly disseminated documents and filings.

We have based the forward-looking statements included in this annual report on Form 10-K on information available to us on the date of this annual report, and we assume no obligation to update any such forward-looking statements. Although we undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that we may make directly to you or through reports that we in the future may file with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.

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.

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.

 

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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.

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 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’ partial 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.

 

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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. 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.

Critical Accounting Policies

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 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:

 

   

The quarterly valuation process begins with each portfolio company or investment being initially valued by our finance department;

 

   

Preliminary valuations are then reviewed and discussed with principals of the investment adviser;

 

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Separately, independent valuation firms engaged by our Board of Directors prepare preliminary valuations on a selected basis and submit the reports to us;

 

   

Our finance department compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms;

 

   

Our finance department 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 our finance department responds and supplements the preliminary valuations to reflect any comments provided by the Valuation Committee;

 

   

The Valuation Committee of our Board of Directors makes a recommendation to the Board of Directors regarding the fair value of the investments in our portfolio; and

 

   

Our Board of Directors discusses the valuations and determines the fair value of each investment in our portfolio in good faith.

The fair value of all of our investments at September 30, 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 a consistently applied valuation process.

Our Board of Directors has authorized the engagement of 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. We 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.

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 ended December 31, 2007

     91.9

For the quarter ended March 31, 2008

     92.1

For the quarter ended June 30, 2008

     91.7

For the quarter ended September 30, 2008

     92.8

For the quarter ended December 31, 2008

     100.0

For the quarter ended March 31, 2009

     88.7 %(1) 

For the quarter ended June 30, 2009

     92.1

For the quarter ended September 30, 2009

     28.1

For the quarter ended December 31, 2009

     17.2 %(2) 

For the quarter ended March 31, 2010

     26.9

For the quarter ended June 30, 2010

     53.1

For the quarter ended September 30, 2010

     61.8

For the quarter ended December 31, 2010

     73.9

For the quarter ended March 31, 2011

     82.0

For the quarter ended June 30, 2011

     82.9

For the quarter ended September 30, 2011

     91.2

 

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(1) 96.0% excluding our investment in IZI Medical Products, Inc., which closed on June 30, 2009 and therefore was not valued by an independent valuation firm during such period

 

(2) 24.8% excluding four investments that closed in December 2009 and therefore were not valued by an independent valuation firm during such period

As of September 30, 2011 and September 30, 2010, approximately 92.6% 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.

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. Exit fees are payable upon the exit of a debt security. 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. The receipt of such fees is contingent upon a successful exit event for each of the investments. A portion of these fees are included in net investment income over the life of the loan. As of September 30, 2011, we had structured $7.9 million in aggregate exit fees across 11 portfolio investments upon the future exit of those investments.

Payment-in-Kind (PIK) Interest

Our loans typically contain contractual PIK interest provisions. 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.

 

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For a discussion of risks we are subject to as a result of our use of PIK interest in connection with our investments, see “Item 1A. Risk Factors — Risks Relating to Our Business and Structure — We may have difficulty paying our required distributions if we recognize income before or without receiving cash representing such income,” “— We may in the future choose to pay dividends in our own stock, in which case you may be required to pay tax in excess of the cash you receive” and “— Our incentive fee may induce our investment adviser to make speculative investments.” In addition, if it is subsequently determined that we will not be able to collect any previously accrued PIK interest, the fair value of our loans or debt securities would decline by the amount of such previously accrued, but uncollectible, PIK interest. 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 $22.7 million and represented 2.0% of the fair value of our portfolio of investments as of September 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, generally have terms of up to six years (but an expected average life of between three and four years). We are currently focusing our origination efforts on a prudent mix of first lien, second lien and subordinated loans which we believe will provide superior risk-adjusted returns while maintaining solid credit quality.

A summary of the composition of our investment portfolio at cost and fair value as a percentage of total investments is shown in the following tables:

 

     September 30,
2011
    September 30,
2010
 

Cost:

    

First lien debt

     77.05     72.61

Second lien debt

     13.97     25.42

Subordinated debt

     7.40     0.80

Purchased equity

     0.97     0.39

Equity grants

     0.53     0.75

Limited partnership interests

     0.08     0.03
  

 

 

   

 

 

 

Total

     100.00     100.00
  

 

 

   

 

 

 

 

     September 30,
2011
    September 30,
2010
 

Fair value:

    

First lien debt

     78.14     73.84

Second lien debt

     12.80     24.45

Subordinated debt

     7.25     0.78

Purchased equity

     1.12     0.11

Equity grants

     0.60     0.79

Limited partnership interests

     0.09     0.03
  

 

 

   

 

 

 

Total

     100.00     100.00
  

 

 

   

 

 

 

 

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The industry composition of our portfolio at cost and fair value as a percentage of total investments were as follows:

 

     September 30,
2011
    September 30,
2010
 

Cost:

    

Healthcare services

     19.65     14.76

Oil & gas equipment services

     7.11     0.00

Healthcare equipment

     6.16     8.02

Diversified support services

     4.80     4.43

IT consulting & other services

     4.23     0.00

Internet software & services

     3.79     0.00

Construction and engineering

     3.74     4.22

Leisure facilities

     3.29     1.16

Electronic equipment & instruments

     3.01     5.59

Specialty stores

     2.99     0.00

Household products

     2.70     0.18

Apparel, accessories & luxury goods

     2.68     3.97

Education services

     2.57     7.58

Fertilizers & agricultural chemicals

     2.49     4.51

Home improvement retail

     2.42     5.51

Pharmaceuticals

     2.36     0.00

Integrated telecommunication services

     2.25     0.00

Food distributors

     1.80     5.13

Healthcare technology

     1.77     3.63

Human resources & employment services

     1.77     0.00

Electronic manufacturing services

     1.75     3.16

Advertising

     1.72     3.35

Auto parts & equipment

     1.63     0.00

Distributors

     1.61     2.25

Air freight & logistics

     1.56     2.36

Trucking

     1.48     2.88

Environmental & facilities services

     1.41     1.51

Restaurants

     1.21     2.11

Leisure products

     1.17     0.00

Diversified financial services

     1.15     0.00

Data processing & outsourced services

     1.10     2.21

Industrial machinery

     0.90     1.71

Construction materials

     0.58     2.95

Building products

     0.58     1.40

Housewares & specialties

     0.46     2.06

Multi-sector holdings

     0.09     0.02

Movies & entertainment

     0.02     0.03

Food retail

     0.00     3.31
  

 

 

   

 

 

 

Total

     100.00     100.00
  

 

 

   

 

 

 

Fair value:

    

Healthcare services

     20.67     15.83

Oil & gas equipment services

     7.38     0.00

Healthcare equipment

     6.42     8.57

Diversified support services

     5.02     4.66

IT consulting & other services

     4.42     0.00

Internet software & services

     3.91     0.00

Leisure facilities

     3.43     1.25

Construction and engineering

     3.20     4.23

Specialty stores

     3.14     0.00

Electronic equipment & instruments

     3.11     5.83

Apparel, accessories & luxury goods

     3.00     4.18

Education services

     2.69     7.47

 

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     September 30,
2011
    September 30,
2010
 

Household products

     2.67     0.19

Fertilizers & agricultural chemicals

     2.61     4.76

Home improvement retail

     2.46     5.76

Pharmaceuticals

     2.46     0.00

Integrated telecommunication services

     2.36     0.00

Food distributors

     1.88     5.38

Human resources & employment services

     1.87     0.00

Healthcare technology

     1.87     3.93

Advertising

     1.80     3.52

Environmental & facilities services

     1.78     0.91

Auto parts & equipment

     1.70     0.00

Distributors

     1.69     2.35

Air freight & logistics

     1.54     2.49

Leisure products

     1.22     0.00

Diversified financial services

     1.19     0.00

Restaurants

     1.06     2.15

Industrial machinery

     0.97     1.81

Electronic manufacturing services

     0.77     3.20

Construction materials

     0.61     3.02

Building products

     0.43     1.21

Data processing & outsourced services

     0.31     2.26

Housewares & specialties

     0.23     0.66

Multi-sector holdings

     0.11     0.01

Movies & entertainment

     0.02     0.05

Trucking

     0.00     0.82

Food retail

     0.00     3.50
  

 

 

   

 

 

 

Total

     100.00 %      100.00 % 
  

 

 

   

 

 

 

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 investment, 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.

 

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The following table shows the distribution of our investments on the 1 to 5 investment rating scale at fair value, as of September 30, 2011 and September 30, 2010:

 

Investment Rating

  

September 30, 2011

  

September 30, 2010

  

Fair Value
(thousands)

   % of Portfolio    

Leverage Ratio

  

Fair Value
(thousands)

   % of Portfolio    

Leverage Ratio

1

   $     81,335      7.26   3.16    $  89,150      15.81   2.97

2

   1,021,990      91.26   3.87    424,495      75.29   4.31

3

   8,660      0.77   NM(1)    18,056      3.20   13.25

4

        0.00      23,823      4.23   8.13

5

   7,852      0.71   NM(1)    8,297      1.47   NM(1)
  

 

  

 

 

   

 

  

 

  

 

 

   

 

Total

   $1,119,837      100.00   3.82    $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 September 30, 2011, we had modified the payment terms of our investments in seven 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 September 30, 2011, we had stopped accruing cash interest, PIK interest and original issue discount (“OID”) on four investments that had not paid all of their scheduled cash interest payments for the period ended September 30, 2011. As of September 30, 2010, we had stopped accruing cash interest, PIK interest and OID on five investments that had not paid all of their scheduled cash interest payments for the period ended September 30, 2010. As of September 30, 2009, we had stopped accruing PIK interest and OID on five investments, including two investments that had not paid all of their scheduled cash interest payments for the period ended September 30, 2009.

Cash non-accrual status is inclusive of PIK and other noncash income, where applicable. The percentages of the Company’s portfolio investments at cost and fair value by accrual status for the periods ended September 30, 2011, September 30, 2010 and September 30, 2009 were as follows:

 

    September 30, 2011     September 30, 2010     September 30, 2009  

(dollars in
thousands)

  Cost     % of
Portfolio
    Fair
Value
    % of
Portfolio
    Cost     % of
Portfolio
    Fair
Value
    % of
Portfolio
    Cost     % of
Portfolio
    Fair
Value
    % of
Portfolio
 

Accrual

  $ 1,116,762        96.60   $ 1,111,986        99.30   $ 530,965        89.61   $ 531,701        94.30   $ 277,335        84.75   $ 271,420        90.59

PIK non-accrual

           0.00            0.00            0.00            0.00     20,787        6.35     12,639        4.22

Cash non-accrual

    39,320        3.40     7,851        0.70     61,532        10.39     32,120        5.70     29,110        8.90     15,552        5.19
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 1,156,082        100.00   $ 1,119,837        100.00   $ 592,497        100.00   $ 563,821        100.00   $ 327,232        100.00   $ 299,611        100.00
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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The non-accrual status of the Company’s portfolio investments as of September 30, 2011, September 30, 2010, and September 30, 2009 was as follows:

 

     September 30, 2011      September 30, 2010      September 30, 2009  

Lighting by Gregory, LLC

     Cash non-accrual         Cash non-accrual         Cash non-accrual   

CPAC, Inc.

                     PIK non-accrual   

MK Network, LLC

             Cash non-accrual           

Martini Park, LLC

                     PIK non-accrual   

Vanguard Vinyl, Inc.

             Cash non-accrual           

Nicos Polymers & Grinding, Inc.

             Cash non-accrual         PIK non-accrual   

Premier Trailer Leasing, Inc.

     Cash non-accrual         Cash non-accrual         Cash non-accrual   

Repechage Investments Limited

     Cash non-accrual                   

O’Currance, Inc.

     Cash non-accrual                   

Income non-accrual amounts related to the above investments for the years ended September 30, 2011, September 30, 2010 and September 30, 2009 were as follows:

 

(dollars in thousands)

   Year ended
September 30,
2011
     Year ended
September 30,
2010
     Year ended
September 30,
2009
 

Cash interest income

   $ 5,815       $ 5,804       $ 2,938   

PIK interest income

     851         1,903         1,398   

OID income

     105         329         403   
  

 

 

    

 

 

    

 

 

 

Total

   $ 6,771       $ 8,036       $ 4,739   
  

 

 

    

 

 

    

 

 

 

Discussion and Analysis of Results and Operations

Results of Operations

The principal measure of our financial performance is the 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 years ended September 30, 2011 and September 30, 2010

Total Investment Income

Total investment income for the years ended September 30, 2011 and September 30, 2010 was $125.2 million and $70.5 million, respectively. For the year ended September 30, 2011, this amount primarily consisted of $108.3 million of interest income from portfolio investments (which included $13.7 million of PIK interest) and $16.7 million of fee income. For the year ended September 30, 2010, this amount primarily consisted of $63.9 million of interest income from portfolio investments (which included $10.0 million of PIK interest) and $6.0 million of fee income.

The increase in our total investment income for the year ended September 30, 2011 as compared to the year ended September 30, 2010 was primarily attributable to higher average levels of outstanding debt investments, which was principally due to a net increase of 21 debt investments in our portfolio, partially offset by scheduled amortization repayments received and other debt payoffs and a decrease in the weighted average yield of our debt investments during the year over year period.

 

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Expenses

Expenses for the years ended September 30, 2011 and September 30, 2010 were $59.5 million and $27.5 million, respectively. Expenses increased for the year ended September 30, 2011 as compared to the year ended September 30, 2010 by $32.0 million. This was due primarily to increases in:

 

   

Base management fee, which was attributable to a 98.6% increase in the fair value of the investment portfolio during the year, partially offset by our investment advisor’s decision to permanently waive the base management fee on cash and cash equivalents beginning for the quarter ended March 31, 2010;

 

   

Incentive fee, which was attributable to a 56.0% increase in pre-incentive fee net investment income for the year-over-year period; and

 

   

Interest expense, which was attributable to a 995.7% increase in weighted average debt outstanding for the year-over-year period.

Gain on Extinguishment of Convertible Senior Notes

During the year ended September 30, 2011, we repurchased $17.0 million of our Convertible Notes in the open market and surrendered them to the Trustee for cancellation. The aggregate purchase price of these Convertible Notes was $15.1 million. As such we recorded a gain in the amount of the difference between the reacquisition price and the net carrying amount of these Convertible Notes, net of the proportionate amount of unamortized debt issuance costs. The net gain on extinguishment of debt we recorded was $1.5 million.

Net Investment Income

As a result of the $54.6 million increase in total investment income as compared to the $32.0 million increase in total expenses, net investment income for the year ended September 30, 2011 reflected a $24.1 million, or 56.0%, increase compared to the year ended September 30, 2010.

Realized Gain (Loss) on Investments and Interest Rate Swap

Realized gain (loss) is the difference between the proceeds received from dispositions of portfolio investments and interest rate swaps and their stated costs. Realized losses may also be recorded in connection with our determination that certain investments are considered worthless securities and/or meet the conditions for loss recognition per the applicable tax rules.

During the year ended September 30, 2011, we recorded investment realization events, including the following:

 

   

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;

 

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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;

 

   

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;

 

   

In July 2011, we received a cash payment of $7.3 million from Filet of Chicken 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 July 2011, we received a cash payment of $19.8 million from Cenegenics, 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 August 2011, we terminated our interest rate swap agreement and realized a loss of $1.3 million, which included a reclassification of $0.8 million of prior unrealized depreciation;

 

   

In September 2011, we received a cash payment of $19.1 million from Flatout, 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; and

 

   

In September 2011, we received a cash payment of $0.1 million in connection with the sale of our investment in CPAC, Inc. We recorded a realized loss on this investment in the amount of $1.0 million.

During the year ended September 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;

 

   

In March 2010, we recorded a realized loss in the amount of $2.9 million in connection with the sale of a portion of our interest in CPAC, Inc.;

 

   

In August 2010, we received a cash payment of $7.6 million from Storyteller Theaters Corporation in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction;

 

   

In September 2010, we restructured our investment in Rail Acquisition Corp. Although the full amount owed under the loan agreement remained intact, the restructuring resulted in a material modification of the terms of the loan agreement. As such, we recorded a realized loss in the amount of $2.6 million in accordance with EITF Abstract Issue No. 96-19;

 

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In September 2010, we sold our investment in Martini Park, LLC and received a cash payment in the amount of $0.1 million. We recorded a realized loss on this investment in the amount of $4.0 million; and

 

   

In September 2010, we exited our investment in Rose Tarlow, Inc. and received a cash payment in the amount of $3.6 million in full settlement of the debt investment. We recorded a realized loss on this investment in the amount of $9.3 million.

Net Unrealized Appreciation (Depreciation) on Investments and Interest Rate Swap

Net unrealized appreciation or depreciation is the net change in the fair value of our investments and 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 year ended September 30, 2011, we recorded net unrealized depreciation of $6.5 million. This consisted of $34.6 million of net unrealized depreciation on debt investments, offset by $25.6 million of net reclassifications to realized losses on our investments and interest rate swaps (resulting in unrealized appreciation) and $2.5 million of net unrealized appreciation on equity investments. During the year ended September 30, 2010, we recorded net unrealized depreciation of $1.8 million. This consisted of $19.1 million of net unrealized depreciation on debt investments and $0.8 million of net unrealized depreciation on interest rate swaps, offset by $17.6 million of reclassifications to realized losses on our investments (resulting in unrealized appreciation) and $0.5 million of net unrealized appreciation on equity investments.

Comparison of years ended September 30, 2010 and September 30, 2009

Total Investment Income

Total investment income for the years ended September 30, 2010 and September 30, 2009 was $70.5 million and $49.8 million, respectively. For the year ended September 30, 2010, this amount primarily consisted of $63.9 million of interest income from portfolio investments (which included $10.0 million of PIK interest), and $6.0 million of fee income. For the year ended September 30, 2009, this amount primarily consisted of $46.0 million of interest income from portfolio investments (which included $7.4 million of PIK interest), and $3.5 million of fee income.

The increase in our total investment income for the year ended September 30, 2010 as compared to the year ended September 30, 2009 was primarily attributable to a net increase of eight debt investments in our portfolio in the year-over-year period, partially offset by scheduled amortization repayments received and other debt payoffs during the same period.

Expenses

Expenses (net of the permanently waived portion of the base management fee) for the years ended September 30, 2010 and September 30, 2009 were $27.5 million and $18.4 million, respectively. Expenses increased for the year ended September 30, 2010 as compared to the year ended September 30, 2009 by $9.1 million. This was due primarily to increases in:

 

   

Base management fee, which was attributable to a 88.2% increase in the fair value of the investment portfolio during the year, partially offset by our investment advisor’s decision to permanently waive the base management fee on cash and cash equivalents beginning for the quarter ended March 31, 2010;

 

   

Incentive fee, which was attributable to a 37.2% increase in pre-incentive fee net investment income for the year-over-year period; and

 

   

Interest expense, which was attributable to a 350.1% increase in weighted average debt outstanding for the year-over-year period.

 

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Net Investment Income

As a result of the $20.7 million increase in total investment income as compared to the $9.1 million increase in total expenses, net investment income for the year ended September 30, 2010 reflected a $11.6 million, or 37.2%, increase compared to the year ended September 30, 2009.

Realized Gain (Loss) on Investments and Interest Rate Swap

During the year ended September 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;

 

   

In March 2010, we recorded a realized loss in the amount of $2.9 million in connection with the sale of a portion of our interest in CPAC, Inc.;

 

   

In August 2010, we received a cash payment of $7.6 million from Storyteller Theaters Corporation in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction;

 

   

In September 2010, we restructured our investment in Rail Acquisition Corp. Although the full amount owed under the loan agreement remained intact, the restructuring resulted in a material modification of the terms of the loan agreement. As such, we recorded a realized loss in the amount of $2.6 million in accordance with EITF Abstract Issue No. 96-19;

 

   

In September 2010, we sold our investment in Martini Park, LLC and received a cash payment in the amount of $0.1 million. We recorded a realized loss on this investment in the amount of $4.0 million; and

 

   

In September 2010, we exited our investment in Rose Tarlow, Inc. and received a cash payment in the amount of $3.6 million in full settlement of the debt investment. We recorded a realized loss on this investment in the amount of $9.3 million.

During the year ended September 30, 2009, we exited our investment in American Hardwoods Industries, LLC and recorded a realized loss of $10.4 million, and recorded a $4.0 million realized loss on our investment in CPAC, Inc. in connection with our determination that the investment was permanently impaired based on, among other things, our analysis of changes in the portfolio company’s business operations and prospects.

Net Unrealized Appreciation (Depreciation) on Investments and Interest Rate Swap

During the year ended September 30, 2010, we recorded net unrealized depreciation of $1.8 million. This consisted of $19.1 million of net unrealized depreciation on debt investments and $0.8 million of net unrealized depreciation on interest rate swaps, offset by $17.6 million of reclassifications to realized losses on our investments (resulting in unrealized appreciation) and $0.5 million of net unrealized appreciation on equity investments. During the year ended September 30, 2009, we recorded net unrealized depreciation of $10.8 million. This consisted of $23.1 million of net unrealized depreciation on debt investments and $2.0 million of net unrealized depreciation on equity investments, offset by $14.3 million of reclassifications to realized losses on our investments (resulting in unrealized appreciation).

 

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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 and 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 year ended September 30, 2011, we experienced a net decrease in cash and cash equivalents of $9.1 million. During that period, we used $517.9 million of cash in operating activities, primarily for the funding of $703.5 million of investments and net revolvers, partially offset by $120.4 million of principal and PIK payments received and $67.1 million of net investment income. During the same period cash provided by financing activities was $508.8 million, primarily consisting of $206.8 million of proceeds from issuances of our common stock, $77.0 million of SBA borrowings, $136.9 million of proceeds from the issuance of our convertible senior notes (net of repurchases) and $178.0 million of net borrowings under our credit facilities, partially offset by $76.7 million of cash dividends paid, $0.8 million of offering costs paid and $12.4 million of deferred financing costs paid.

For the year ended September 30, 2010, we experienced a net decrease in cash and cash equivalents of $36.4 million. During that period, we used $239.2 million of cash in operating activities, primarily for the funding of $315.8 million of investments and net revolvers, partially offset by $36.8 million of principal and PIK payments received and $43.0 million of net investment income. During the same period cash provided by financing activities was $202.7 million, primarily consisting of $179.1 million of proceeds from issuances of our common stock and $73.0 million of SBA borrowings, partially offset by $41.8 million of cash dividends paid, $1.3 million of offering costs paid and $6.3 million of deferred financing costs paid.

As of September 30, 2011, we had $67.6 million in cash and cash equivalents, portfolio investments (at fair value) of $1.1 billion, $6.8 million of interest and fees receivable, $150.0 million of SBA debentures payable, $178.0 million of borrowings outstanding under our credit facilities, $135.0 million of convertible senior notes payable and unfunded commitments of $108.8 million.

As of September 30, 2010, we had $76.8 million in cash and cash equivalents, portfolio investments (at fair value) of $563.8 million, $3.8 million of interest and fees receivable, $73.0 million of SBA debentures payable, no borrowings outstanding under our credit facilities and unfunded commitments of $49.5 million.

Other Sources of Liquidity

We intend to continue to generate cash primarily from cash flows from operations, including interest earned, 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

 

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Company Status and Distributions” below. Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio companies or to repay borrowings. In addition, the illiquidity of our portfolio investments may make it difficult for us to sell these investments when desired and, if we are required to sell these investments, we may realize significantly less than their recorded value.

Also, as a business development company, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, to total senior securities, which include all of our borrowings and any outstanding preferred stock, of at least 200%. This requirement limits the amount that we may borrow. As of September 30, 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 at the time of issuance at a market-driven spread over U.S. Treasury Notes with 10-year maturities.

SBA regulations currently limit the amount that our SBIC subsidiary may borrow to a maximum of $150 million when it has at least $75 million in regulatory capital, receives a capital commitment from the SBA and has been through an examination by the SBA subsequent to licensing. As of September 30, 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 September 30, 2011 that had a fair value of $102.0 million. These debentures bear interest at a weighted average interest rate of 3.567% (excluding the SBA annual charge), as follows:

 

Rate Fix Date

   Debenture
Amount

(thousands)
     Fixed
Interest
Rate
    SBA
Annual
Charge
 

September 2010

   $ 73,000         3.215     0.285

March 2011

     65,300         4.084     0.285

September 2011

     11,700         2.877     0.285

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. If we are able to successfully obtain such an additional SBIC license, we would have similar relief from the 200% asset coverage ratio limitation as described above with respect to the SBIC debt securities issued by such SBIC subsidiary.

 

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Significant capital transactions that have occurred since October 1, 2009

The following table reflects the dividend distributions per share that our Board of Directors has declared and we have paid, including shares issued under our DRIP, on our common stock since October 1, 2009:

 

Date Declared

 

Record Date

   

Payment Date

    Amount
per Share
    Cash
Distribution
    DRIP Shares
Issued
    DRIP Shares
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 (1)      0.6 million   

May 2, 2011

    August 1, 2011        August 31, 2011        0.1066        7.1 million        64,431 (1)      0.6 million   

May 2, 2011

    September 1, 2011        September 30, 2011        0.1066        7.2 million        52,487 (1)      0.5 million   

August 1, 2011

    October 14, 2011        October 31, 2011        0.1066        7.3 million        40,388 (1)      0.4 million   

 

(1) Shares were purchased on the open market and distributed.

The following table reflects share transactions that occurred from October 1, 2009 through September 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 (3)      5.1 million   

February 4, 2011

   Public offering(1)     11,500,000         12.65        145.5 million   

June 24, 2011

   Public offering(2)     5,558,469         11.72        65.1 million   

 

(1) Includes the underwriters’ full exercise of their over-allotment option
(2) Includes the underwriters’ partial exercise of their over-allotment option
(3) 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 (“Wachovia”), Wells Fargo Securities, LLC, as administrative agent, each of the additional institutional and conduit lenders party thereto from time to time, and each of the lender agents party thereto from time to time, in the amount of $50 million, with an accordion feature which allowed for potential future expansion of the facility up to $100 million. The facility bore interest at LIBOR plus 4.0% per annum and had a maturity date of November 16, 2012.

 

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On May 26, 2010, we amended the Wells Fargo facility to expand the borrowing capacity under that facility. Pursuant to the amendment, we received an additional $50 million commitment, thereby increasing the size of the facility from $50 million to $100 million, with an accordion feature that allows for potential future expansion of that facility from a total of $100 million up to a total of $150 million. In addition, the interest rate of the Wells Fargo facility was reduced from LIBOR plus 4% per annum to LIBOR plus 3.5% per annum, with no LIBOR floor, and the maturity date of the facility was extended from November 16, 2012 to May 26, 2013. The facility 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 use the Wells Fargo facility to fund a portion of our loan origination activities and for general corporate purposes. Each loan origination under the facility is subject to the satisfaction of certain conditions. We cannot be assured that Funding will be able to borrow funds under the Wells Fargo facility at any particular time or at all. As of September 30, 2011, we had $39.5 million of borrowings outstanding under the Wells Fargo facility, which had a fair value of $39.5 million.

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 allowed 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 our wholly-owned subsidiary, FSFC Holdings, Inc., and our indirect wholly-owned subsidiary, Fifth Street Fund of Funds LLC, subject to certain exclusions for, among other things, equity interests in any of our SBIC subsidiaries and equity interests in Funding and Fifth Street Funding II, LLC 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., ING Capital LLC, as collateral agent, and us. None of our SBIC subsidiaries

 

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Funding, Fifth Street Funding II, 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.

On July 8, 2011, we amended the ING facility to, among other things, expand the borrowing capacity to $230 million and increase the accordion feature to allow for potential future expansion up to a total of $350 million. In addition, the ING facility’s interest rate was reduced to LIBOR plus 3.0% per annum, with no LIBOR floor, when the facility is drawn more than 35%. Otherwise, the interest rate will be LIBOR plus 3.25% per annum, with no LIBOR floor.

Pursuant to the ING Security Agreement, FSFC Holdings, Inc. and Fifth Street Fund of Funds LLC 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 interest in FSFC Holdings, Inc. and FSFC Holdings, Inc. pledged its entire equity interest in Fifth Street Fund of Funds LLC 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., Fifth Street Fund of Funds LLC 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. On November 29, 2011, we amended the ING Credit Agreement to ensure that, based on our estimate of taxable income for the fiscal year ended September 30, 2011, we would remain in compliance with the annual distribution limit provision when we finalize our taxable income amount upon the filing of our tax return in June 2012.

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 September 30, 2011, we had $133.5 million of borrowings outstanding under the ING facility, which had a fair value of $133.5 million.

On September 16, 2011, Fifth Street Funding II, LLC, a consolidated wholly-owned bankruptcy remote, special purpose subsidiary (“Funding II”), entered into a Loan and Servicing Agreement (“Sumitomo Agreement”) with respect to a seven-year credit facility (“Sumitomo facility”) with Sumitomo Mitsui Banking Corporation (“SMBC”), an affiliate of Sumitomo Mitsui Financial Group, Inc., as administrative agent, and each of the lenders from time to time party thereto, in the amount of $200 million. The Sumitomo facility bears interest at a rate of LIBOR plus 2.25% per annum with no LIBOR floor, matures on September 16, 2018 and includes an option for a one-year extension.

 

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In connection with the Sumitomo facility, we concurrently entered into a Purchase and Sale Agreement with Funding II, pursuant to which we will sell to Funding II certain loan assets we have originated or acquired, or will originate or acquire.

The Sumitomo Agreement and related agreements governing the Sumitomo facility required both Funding II 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 Sumitomo 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 II, and the failure by Funding II or us to materially perform under the Sumitomo Agreement and related agreements governing the Sumitomo 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 Sumitomo facility is secured by all of the assets of Funding II. Each loan origination under the facility is subject to the satisfaction of certain conditions. We cannot be assured that Funding II will be able to borrow funds under the Sumitomo facility at any particular time or at all. As of September 30, 2011, we had $5.0 million of borrowings outstanding under the Sumitomo facility, which had a fair value of $5.0 million.

As of September 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, ING facility or the Sumitomo facility.

Interest expense for the years ended September 30, 2011, 2010 and 2009 was $15.1 million, $1.9 million and $0.6 million, respectively.

The following table describes significant financial covenants with which we must comply under each of our credit facilities on a quarterly basis. The Sumitomo facility does not require us to comply with significant financial covenants.

 

Facility

  

Financial Covenant

 

Description

 

Target Value

  

Reported Value (1)

Wells Fargo facility

  

Minimum

shareholders’ equity (inclusive of affiliates)

  Net assets shall not be less than $510 million plus 50% of the aggregate net proceeds of all sales of equity interests after February 25, 2011   $541 million    $776 million
  

Minimum

shareholders’ equity (exclusive of affiliates)

  Net assets exclusive of affiliates other than Funding shall not be less than $250 million   $250 million    $684 million
   Asset coverage ratio   Asset coverage ratio shall not be less than 2.00:1   2.00:1    3.62:1

ING facility

  

Minimum

shareholders’ equity

  Net assets shall not be less than the greater of (a) 55% of total assets; and (b) $510 million plus 50% of the aggregate net proceeds of all sales of equity interests after February 22, 2011   $602 million    $776 million
   Asset coverage ratio   Asset coverage ratio shall not be less than 2.25:1   2.25:1    6.10:1
   Interest coverage ratio   Interest coverage ratio shall not be less than 2.50:1   2.50:1    12.42:1
   Eligible portfolio investments test   Aggregate value of (a) Cash and cash equivalents and (b) Portfolio investments rated 1, 2 or 3 shall not be less than $175 million   $175 million    $586 million

 

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(1) As contractually required, we report financial covenants based on the last filed quarterly or annual report, in this case our Form 10-Q for the quarter ended June 30, 2011. We were also in compliance with all financial covenants under these credit facilities based on the financial information contained in this Form 10-K for the year ended September 30, 2011.

We and our SBIC subsidiaries are also subject to certain regulatory requirements relating to our borrowings. For a discussion of such requirements, see “Item 1. Business — Regulation — Business Development Company Regulations” and “— Small Business Investment Company Regulations.”

The following table reflects credit facility and debenture transactions that occurred from October 1, 2009 through September 30, 2011. Amounts available are as of September 30, 2011.

 

Facility

 

Date

 

Transaction

  Total
Facility
Amount
    Upfront
fee Paid
    Total
Availability
    Remaining
Availability
    Interest Rate  

Wells Fargo facility

  November 16, 2009   Entered into credit facility   $ 50 million      $ 0.8 million            LIBOR + 4.00
  May 26, 2010   Expanded credit facility     100 million        0.9 million            LIBOR + 3.50
  February 28, 2011   Amended credit facility     100 million        0.4 million      $ 40 million (1)    $        LIBOR + 3.00

ING facility

  May 27, 2010   Entered into credit facility     90 million        0.8 million            LIBOR + 3.50
  February 22, 2011   Expanded credit facility     215 million        1.6 million            LIBOR + 3.50
  July 8, 2011   Expanded credit facility     230 million        0.4 million        230 million       96 million       

 

LIBOR +

3.00%/3.25%

  

(2) 

SBA

  February 16, 2010   Received capital commitment     75 million        0.8 million         
  September 21, 2010   Received capital commitment     150 million        0.8 million        150 million               3.567% (3)   

Sumitomo facility

  September 16, 2011   Entered into credit facility     200 million        2.5 million        10 million (1)     5 million        LIBOR + 2.25

 

(1) Availability to increase upon our decision to further collateralize the facility.
(2) LIBOR plus 3.0% when the facility is drawn more than 35%. Otherwise, LIBOR plus 3.25%.
(3) Weighted average interest rate of 3.567% (excludes the SBA annual charge of 0.285%).

On April 12, 2011, we issued $152 million unsecured convertible senior notes (“Convertible Notes”), including $2 million issued to Leonard M. Tannenbaum, our Chief Executive Officer. The Convertible Notes were issued pursuant to an Indenture, dated April 12, 2011 (the “Indenture”), between us 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 our senior unsecured obligations and rank senior in right of payment to our existing and future indebtedness that is expressly subordinated in right of payment to the Convertible Notes; equal in right of payment to our existing and future unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of our secured indebtedness (including existing unsecured indebtedness that we later secure) 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 our 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 our 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, we will deliver shares of our 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 our common stock in excess of a monthly dividend of $0.1066 per share, 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.

 

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We 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 to us, holders of the Convertible Notes may require us 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 us to provide financial information to the holders of the Convertible Notes and the Trustee if we cease 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 year ended September 30, 2011, we recorded interest expense of $4.1 million related to the Convertible Notes.

We may, to the extent permitted by law, repurchase the Convertible Notes in the open market or by tender offer at any price or by private agreement without giving prior notice to holders. Any Convertible Notes repurchased by us may, at our option, be surrendered to the Trustee for cancellation, but may not be reissued or resold by us. Any Convertible Notes surrendered for cancellation will be promptly cancelled and no longer outstanding under the indenture. During the year ended September 30, 2011, we repurchased, and surrendered to the Trustee for cancellation, Convertible Notes as follows:

 

Trade Date

   Settlement
Date
     Principal
Repurchased

(thousands)
     Purchase
Price
(thousands)
 

8/1/2011

     8/4/2011       $ 2,000       $ 1,820   

8/3/2011

     8/8/2011         5,000         4,525   

8/5/2011

     8/10/2011         10,000         8,725   
     

 

 

    

 

 

 

Total

      $ 17,000       $ 15,070   
     

 

 

    

 

 

 

As of September 30, 2011, there were $135.0 million Convertible Notes outstanding, which had a fair value of $113.4 million.

Off-Balance Sheet Arrangements

We may be a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our portfolio companies. As of September 30, 2011, our only off-balance sheet arrangements consisted of $108.8 million of unfunded commitments, which was comprised of $102.7 million to provide debt financing to certain of our portfolio companies and $6.1 million related to unfunded limited partnership interests. As of September 30, 2010, our only off-balance sheet arrangements consisted of $49.5 million, which was comprised of $46.7 million to provide debt financing to certain of our portfolio companies and $2.8 million related to unfunded limited partnership interests. Such commitments are subject to our portfolio companies’ satisfaction of certain financial and nonfinancial convenants and involve, to varying degrees, elements of credit risk in excess of the amount recognized in the Statement of Assets and Liabilities and are not reflected on our Consolidated Statement of Assets and Liabilities.

 

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Contractual Obligations

The following table reflects information pertaining to debt outstanding under the SBA debentures payable, the Wells Fargo facility, the ING facility, the Sumitomo facility and our Convertible Notes:

 

(amounts in thousands)

  Debt Outstanding
as of  September 30,
2010
    Debt Outstanding
as of  September 30,
2011
    Weighted average  debt
outstanding for the
year ended

September 30, 2011
    Maximum
debt
outstanding
for the year
ended
September 30,
2011
 

SBA debentures payable

  $ 73,000      $ 150,000      $ 125,462      $ 150,000   

Wells Fargo facility

           39,524        30,461      $ 85,000   

ING facility

           133,500        22,851      $ 133,500   

Sumitomo facility

           5,000             $ 5,000   

Convertible senior notes payable

           135,000        68,775      $ 152,000   
 

 

 

   

 

 

   

 

 

   

Total debt

  $ 73,000      $ 463,024      $ 247,549      $ 463,024   
 

 

 

   

 

 

   

 

 

   

The following table reflects our contractual obligations arising from the SBA debentures payable, the Wells Fargo facility, the ING facility, the Sumitomo facility, and our Convertible Notes:

 

     Payments due by period as of September 30, 2011  

(amounts in thousands)

   Total      < 1 year      1-3 years      3-5 years      > 5 years  

SBA debentures payable

   $ 150,000       $       $       $       $ 150,000   

Interest due on SBA debentures

     53,813         5,773         11,556         11,572         24,912   

Wells fargo facility

     39,524                 39,524                   

Interest due on Wells Fargo facility

     3,083         1,280         1,803                   

ING facility

     133,500                 133,500                   

Interest due on ING facility

     10,413         4,339         6,074                   

Sumitomo facility

     5,000                                 5,000   

Interest due on Sumitomo facility

     858         123         246         246         243   

Convertible senior notes payable

     135,000                         135,000           

Interest due on convertible senior notes

     32,703         7,256         14,513         10,934           
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 563,894       $ 18,771       $ 207,216       $ 157,752       $ 180,155   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

A summary of the composition of unfunded commitments (consisting of revolvers, term loans and limited partnership interests) as of September 30, 2011 and September 30, 2010 is shown in the table below:

 

     September 30,
2011
(thousands)
     September 30,
2010
(thousands)
 

JTC Education, Inc.

   $ 14,000       $ 9,062   

CRGT, Inc.

     12,500           

Charter Brokerage, LLC

     6,176           

Refac Optical Group

     5,500           

Rail Acquisition Corp.

     5,446         4,799   

Miche Bag, LLC

     5,000           

Dominion Diagnostics, LLC

     5,000           

ADAPCO, Inc.

     4,250         5,750   

Enhanced Recovery Company, LLC

     4,000         3,623   

DISA, Inc.

     4,000           

Traffic Control & Safety Corporation

     3,014           

Epic Acquisition, Inc.

     3,000         2,700   

Phoenix Brands Merger Sub LLC

     3,000           

 

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     September 30,
2011
(thousands)
     September 30,
2010
(thousands)
 

Discovery Practice Management, Inc.

     3,000           

Titan Fitness, LLC

     2,957           

IZI Medical Products, Inc.

     2,500         2,500   

Eagle Hospital Physicians, Inc.

     2,500         2,500   

HealthDrive Corporation

     2,000         1,500   

Mansell Group, Inc.

     2,000         2,000   

Specialty Bakers, LLC

     2,000         2,000   

Physicians Pharmacy Alliance, Inc.

     2,000           

Cardon Healthcare Network, LLC

     2,000           

Milestone Partners IV, LP (limited partnership interest)

     2,000           

Tegra Medical, LLC

     1,500         4,000   

Flatout, Inc.

     1,500         1,500   

IOS Acquisitions, Inc.

     1,250           

Psilos Group Partners IV, LP (limited partnership interest)

     1,000         1,000   

Best Vinyl Fence & Deck, LLC

     1,000           

Bunker Hill Capital II (QP), LP (limited partnership interest)

     960           

Riverlake Equity Partners II, LP (limited partnership interest)

     878         966   

Welocalize, Inc.

     750           

Baird Capital Partners V, LP (limited partnership interest)

     701           

Riverside Fund IV, LP (limited partnership interest)

     555         864   

Saddleback Fence and Vinyl Products, Inc.

     400           

Advanced Pain Management

     267           

Trans-Trade, Inc.

     200         500   

AmBath/ReBath Holdings, Inc.

             1,500   

Vanguard Vinyl, Inc.

             1,250   

NDSSI Holdings, LLC.

             1,500   
  

 

 

    

 

 

 

Total

   $ 108,804       $ 49,514   
  

 

 

    

 

 

 

Regulated Investment Company Status and Dividends

We elected, effective as of January 2, 2008, to be treated as a RIC under Subchapter M of the Code. As long as we qualify as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders on a timely basis.

Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation until realized. Dividends declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital.

To maintain RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company net taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any). As a RIC, we are also subject to a federal excise tax, based on distributive requirements of our taxable income on a calendar year basis (e.g., calendar year 2011). We anticipate timely distribution of our taxable income within the tax rules; however, we incurred a de minimis U.S. federal excise tax for calendar years 2008, 2009 and 2010. We intend to distribute to our stockholders between 90% and 100% of our annual taxable income (which includes our taxable interest and fee income). However, we are partially dependent on our SBIC subsidiary for cash distributions to enable us to

 

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meet the RIC distribution requirements. Our SBIC subsidiary may be limited by the Small Business Investment Act of 1958, and SBA regulations governing SBICs, from making certain distributions to us that may be necessary to enable us to maintain our status as a RIC. We may have to request a waiver of the SBA’s restrictions for our SBIC subsidiary to make certain distributions to maintain our RIC status. We cannot assure you that the SBA will grant such waiver. Also, the covenants under the Wells Fargo facility could, under certain circumstances, restrict Fifth Street Funding, LLC from making distributions to us and, as a result, hinder our ability to satisfy the distribution requirement. Similarly, the covenants contained in the ING facility may prohibit us from making distributions to our stockholders, and, as a result, could hinder our ability to satisfy the distribution requirement. In addition, we may retain for investment some or all of our net taxable capital gains (i.e., realized net long-term capital gains in excess of realized net short-term capital losses) and treat such amounts as deemed distributions to our stockholders. If we do this, our stockholders will be treated as if they received actual distributions of the capital gains we retained and then reinvested the net after-tax proceeds in our common stock. Our stockholders also may be eligible to claim tax credits (or, in certain circumstances, tax refunds) equal to their allocable share of the tax we paid on the capital gains deemed distributed to them. To the extent our taxable earnings for a fiscal taxable year fall below the total amount of our dividends for that fiscal year, a portion of those dividend distributions may be deemed a return of capital to our stockholders.

We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a business development company under the 1940 Act and due to provisions in our credit facilities. If we do not distribute a certain percentage of our taxable income annually, we will suffer adverse tax consequences, including possible loss of our status as a RIC. We cannot assure stockholders that they will receive any distributions or distributions at a particular level.

Pursuant to a recent revenue procedure (Revenue Procedure 2010-12), or the Revenue Procedure, issued by the Internal Revenue Service, or IRS, the IRS has indicated that it will treat distributions from certain publicly traded RICs (including BDCs) that are paid part in cash and part in stock as dividends that would satisfy the RIC’s annual distribution requirements and qualify for the dividends paid deduction for federal income tax purposes. In order to qualify for such treatment, the Revenue Procedure requires that at least 10% of the total distribution be payable in cash and that each stockholder have a right to elect to receive its entire distribution in cash. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a proportionate share of the cash to be distributed (although no stockholder electing to receive cash may receive less than 10% of such stockholder’s distribution in cash). This Revenue Procedure applies to distributions declared on or before December 31, 2012 with respect to taxable years ending on or before December 31, 2011. We have no current intention of paying dividends in shares of our stock.

Related Party Transactions

We have entered into an investment advisory agreement with Fifth Street Management LLC, our investment adviser. Fifth Street Management is controlled by Leonard M. Tannenbaum, its managing member and the chairman of our Board of Directors and our chief executive officer. Pursuant to the investment advisory agreement, fees payable to our investment adviser will be equal to (a) a base management fee of 2.0% of the value of our gross assets, which includes any borrowings for investment purposes and excludes cash and cash equivalents, and (b) an incentive fee based on our performance. The incentive fee consists of two parts. The first part is calculated and payable quarterly in arrears and equals 20% of our “Pre-Incentive Fee Net Investment Income” for the immediately preceding quarter, subject to a preferred return, or “hurdle,” and a “catch up” feature. The second part is determined and payable in arrears as of the end of each fiscal year (or upon termination of the investment advisory agreement) and equals 20% of our “Incentive Fee Capital Gains,” which equals our realized capital gains on a cumulative basis from inception through the end of the year, if any, computed net of all realized capital losses and unrealized capital depreciation on a cumulative basis, less the aggregate amount of any previously paid capital gain incentive fee.

 

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The investment advisory agreement may be terminated by either party without penalty upon no fewer than 60 days’ written notice to the other. During the years ended September 30, 2011, 2010 and 2009, we have paid our investment adviser $36.5 million, $20.0 million and $13.7 million, respectively, under the investment advisory agreement.

Pursuant to the administration agreement with FSC, Inc., which is controlled by Mr. Tannenbaum, FSC, Inc. will furnish us with the facilities and administrative services necessary to conduct our day-to-day operations, including equipment, clerical, bookkeeping and recordkeeping services at such facilities. In addition, FSC, Inc. will assist us in connection with the determination and publishing of our net asset value, the preparation and filing of tax returns and the printing and dissemination of reports to our stockholders. We will pay FSC, Inc. our allocable portion of overhead and other expenses incurred by it in performing its obligations under the administration agreement, including a portion of the rent and the compensation of our chief financial officer and chief compliance officer and their respective staffs. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us by our chief compliance officer. Although FSC, Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future. The administration agreement may be terminated by either party without penalty upon no fewer than 60 days’ written notice to the other. We have paid FSC, Inc. $2.9 million, $2.0 million and $1.3 million for the fiscal years ended September 30, 2011, September 30, 2010 and September 30, 2009, respectively, under the administration agreement.

We have also entered into a license agreement with Fifth Street Capital LLC pursuant to which Fifth Street Capital LLC has agreed to grant us a non-exclusive, royalty-free license to use the name “Fifth Street.” Under this agreement, we will have a right to use the “Fifth Street” name, for so long as Fifth Street Management LLC or one of its affiliates remains our investment adviser. Other than with respect to this limited license, we will have no legal right to the “Fifth Street” name. Fifth Street Capital LLC is controlled by Mr. Tannenbaum, its managing member.

Recent Developments

In October 2011, we repurchased $10.5 million principal of our Convertible Notes in the open market for an aggregate purchase price of $8.9 million and surrendered these Convertible Notes to the Trustee for cancellation.

On November 1, 2011, CD OPCO LLC (dba “Nicos Polymers & Grinding, Inc.”) was merged into Coll Materials Group LLC. After the merger, the owners of CD OPCO LLC hold 50% of Coll Materials Group LLC, and we hold 23.25% of Coll Materials Group LLC. Our first lien revolver and term loan were consolidated into a $13.7 million second lien term loan with a scheduled maturity of three years that bears monthly cash interest at a rate of 12.0% per annum.

On August 23, 2011, Premier Trailer Leasing, Inc. filed for Chapter 11 bankruptcy protection in Delaware. We objected to a debtor-proposed plan of reorganization, and presented our evidence in support of a competing valuation in the court. On November 10, 2011, a bankruptcy court judge confirmed a plan of reorganization for Premier Trailer Leasing, Inc. which provided no recovery for us.

On November 10, 2011, our Board of Directors declared the following monthly dividends:

 

   

$0.0958 per share, payable on January 31, 2012 to stockholders of record on January 13, 2012;

 

   

$0.0958 per share, payable on February 29, 2012 to stockholders of record on February 15, 2012; and

 

   

$0.0958 per share, payable on March 30, 2012 to stockholders of record on March 15, 2012.

On November 14, 2011, we received a cash payment of $21.6 million from IZI Medical Products, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par, and the amount received included an exit fee of $0.8 million and a prepayment fee of $0.6 million. We also received a cash payment of $1.1 million in return for our 453,755 preferred units of IZI Holdings, LLC, which were granted to us as part of the original investment funding on March 31, 2009.

 

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On November 28, 2011, we transferred the listing of our common stock from the New York Stock Exchange to the NASDAQ Global Select Market, where it continues to trade under the symbol “FSC.”

Recently Issued Accounting Standards

See Note 2 to the Consolidated Financial Statements for a description of recent accounting pronouncements, including the expected dates of adoption and the anticipated impact on the Consolidated Financial Statements.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

We are subject to financial market risks, including changes in interest rates. Changes in interest rates may affect both our cost of funding and our interest income from portfolio investments, cash and cash equivalents and idle funds investments. Our risk management systems and procedures are designed to identify and analyze our risk, to set appropriate policies and limits and to continually monitor these risks and limits by means of reliable administrative and information systems and other policies and programs. Our investment income will be affected by changes in various interest rates, including LIBOR and prime rates, to the extent our debt investments include floating interest rates. In addition, our investments are carried at fair value as determined in good faith by our Board of Directors in accordance with the 1940 Act (See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies — Investment Valuation”). Our valuation methodology utilizes discount rates in part in valuing our investments, and changes in those discount rates may have an impact on the valuation of our investments.

As of September 30, 2011, 67.3% of our debt investment portfolio (at fair value) and 64.1% of our debt investment portfolio (at cost) bore interest at floating rates. The composition of our floating rate debt investments by cash interest rate floor (excluding PIK) as of September 30, 2011 and September 30, 2010 was as follows:

 

     September 30, 2011     September 30, 2010  
     Fair Value
(thousands)
     % of Floating
Rate Portfolio
    Fair Value
(thousands)
     % of Floating
Rate Portfolio
 

Under 1%

   $ 125,453         16.96   $ 10,648         5.82

1% to under 2%

     261,878         35.40             0.00

2% to under 3%

     168,928         22.83     36,950         20.19

3% to under 4%

     176,976         23.92     125,254         68.45

4% to under 5%

     757         0.10     1,247         0.68

5% and over

     5,843         0.79     8,897         4.86
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 739,835         100.00   $ 182,996         100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

Based on our Consolidated Statement of Assets and Liabilities as of September 30, 2011, the following table shows the approximate increase (decrease) in components of net assets resulting from operations of hypothetical base rate changes in interest rates, assuming no changes in our investment and capital structure.

 

Basis point increase(1)

   Interest
income
(thousands)
     Interest
expense
(thousands)
     Net increase
(decrease)
(thousands)
 

100

   $ 1,000       $ 2,000       $ (1,000

200

     4,000         4,000           

300

     10,000         5,000         5,000   

400

     18,000         7,000         11,000   

500

     25,000         9,000         16,000   

 

(1) A hypothetical decline in interest rates would not have a material impact on our financial statements.

 

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We regularly measure exposure to interest rate risk. We assess interest rate risk and manage our interest rate exposure on an ongoing basis by comparing our interest rate sensitive assets to our interest rate sensitive liabilities. Based on this review, we determine whether or not any hedging transactions are necessary to mitigate exposure to changes in interest rates. The following table shows a comparison of the interest rate base for our interest-bearing cash and outstanding investments, at principal, and our outstanding borrowings as of September 30, 2011 and September 30, 2010:

 

     September 30, 2011      September 30, 2010  
     Interest Bearing
Cash and
Investments
(thousands)
     Borrowings
(thousands)
     Interest Bearing
Cash and
Investments
(thousands)
     Borrowings
(thousands)
 

Money market rate

   $ 67,644       $       $ 76,765       $   

Prime rate

     38,890         53,000                   

LIBOR

           

30 day

     51,368         125,024                   

90 day

     654,932                 188,884           

Fixed rate

     418,981         285,000         417,197         73,000   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,231,815       $ 463,024       $ 682,846       $ 73,000   
  

 

 

    

 

 

    

 

 

    

 

 

 

On August 16, 2010, we entered into an interest rate swap agreement that expired on August 15, 2013, for a total notional amount of $100 million, for the purposes of hedging the interest rate risk related to the Wells facility and the ING facility. Under the interest rate swap agreement, we paid a fixed interest rate of 0.99% and received a floating rate based on the prevailing one-month LIBOR. In August 2011, we terminated our interest rate swap agreement and realized a loss of $1.3 million, which included a reclassification of $0.8 million of prior unrealized depreciation. As of September 30, 2011, we were no longer party to any interest rate swap agreements.

 

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Item 8. Consolidated Financial Statements and Supplementary Data

Index to Consolidated Financial Statements

 

Reports of Independent Registered Public Accounting Firms

     77   

Consolidated Statement of Assets and Liabilities as of September 30, 2011 and 2010

     79   

Consolidated Statements of Operations for the Years Ended September 30, 2011, 2010 and 2009

     80   

Consolidated Statements of Changes in Net Assets for the Years Ended September  30, 2011, 2010 and 2009

     81   

Consolidated Statements of Cash Flows for the Years Ended September 30, 2011, 2010 and 2009

     82   

Consolidated Schedules of Investments as of September 30, 2011 and 2010

     83   

Notes to Consolidated Financial Statements

     97   

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Fifth Street Finance Corp.:

In our opinion, the accompanying consolidated statements of assets and liabilities, including the consolidated schedules of investments, and the related consolidated statements of operations, changes in net assets and cash flows, present fairly, in all material respects, the financial position of Fifth Street Finance Corp. (“the Company”) at September 30, 2011 and September 30, 2010, and the results of its operations, the changes in net assets and its cash flows for each of the two years in the period ended September 30, 2011, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2011, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing on page 135 of the annual report to the stockholders. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audits of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. Our procedures included confirmation of securities at September 30, 2011 by correspondence with the custodian, and where replies were not received, we performed other auditing procedures. We believe that our audits provide a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/    PricewaterhouseCoopers LLP

New York, New York

November 29, 2011

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders of

Fifth Street Finance Corp.

We have audited the consolidated statement of assets and liabilities, including the consolidated schedule of investments, of Fifth Street Finance Corp. (a Delaware corporation) (the “Company”) as of September 30, 2009 (not included herein), and the related consolidated statements of operations, changes in net assets, and cash flows and the financial highlights (included in Note 12), for the year ended September 30, 2009. These financial statements and financial highlights are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our procedures included physical inspection or confirmation of securities owned as of September 30, 2009. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Fifth Street Finance Corp. as of September 30, 2009, and the results of operations, changes in net assets and its cash flows and financial highlights. for the year ended September 30, 2009, in conformity with accounting principles generally accepted in the United States of America.

/s/    GRANT THORNTON LLP

New York, New York

December 9, 2009

 

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Fifth Street Finance Corp.

Consolidated Statements of Assets and Liabilities

(in thousands, except per share amounts)

 

     September 30,
2011
    September 30,
2010
 
ASSETS   

Investments at Fair Value:

    

Control investments (cost September 30, 2011: $13,726; cost September 30, 2010: $12,195)

   $ 14,500      $ 3,700   

Affiliate investments (cost September 30, 2011: $34,182; cost September 30, 2010: $50,134)

     25,897        47,222   

Non-control/Non-affiliate investments (cost September 30, 2011: $1,108,174; cost September 30, 2010: $530,168)

     1,079,440        512,899   
  

 

 

   

 

 

 

Total Investments at Fair Value (cost September 30, 2011: $1,156,082; cost September 30, 2010: $592,497)

     1,119,837        563,821   

Cash and cash equivalents

     67,644        76,765   

Interest and fees receivable

     6,752        3,814   

Due from portfolio company

     552        103   

Deferred financing costs

     14,668        5,466   

Collateral posted to bank and other assets

     264        1,957   
  

 

 

   

 

 

 

Total Assets

   $ 1,209,717      $ 651,926   
  

 

 

   

 

 

 
LIABILITIES AND NET ASSETS   

Liabilities:

    

Accounts payable, accrued expenses and other liabilities

   $ 1,175      $ 1,322   

Base management fee payable

     5,710        2,876   

Incentive fee payable

     4,997        2,859   

Due to FSC, Inc.

     1,480        1,083   

Interest payable

     4,669        283   

Payments received in advance from portfolio companies

     35        1,331   

Credit facilities payable

     178,024          

SBA debentures payable

     150,000        73,000   

Convertible senior notes payable

     135,000          
  

 

 

   

 

 

 

Total Liabilities

     481,090        82,754   
  

 

 

   

 

 

 

Net Assets:

    

Common stock, $0.01 par value, 150,000 shares authorized, 72,376 and 54,550 shares issued and outstanding at September 30, 2011 and September 30, 2010

     724        546   

Additional paid-in-capital

     829,620        619,760   

Net unrealized depreciation on investments and interest rate swap

     (35,976     (29,449

Net realized loss on investments and interest rate swap

     (63,485     (33,091

Accumulated undistributed (overdistributed) net investment income

     (2,256     11,406   
  

 

 

   

 

 

 

Total Net Assets

     728,627        569,172   
  

 

 

   

 

 

 

Total Liabilities and Net Assets

   $ 1,209,717      $ 651,926   
  

 

 

   

 

 

 

See notes to Consolidated Financial Statements.

 

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Fifth Street Finance Corp.

Consolidated Statements of Operations

(in thousands, except per share amounts)

 

    Year
Ended
September  30,
2011
    Year
Ended
September  30,
2010
    Year
Ended
September  30,
2009
 

Interest income:

     

Control investments

  $ 89      $ 183      $   

Affiliate investments

    4,265        7,619        10,633   

Non-control/Non-affiliate investments

    90,224        46,090        27,931   

Interest on cash and cash equivalents

    19        237        209   
 

 

 

   

 

 

   

 

 

 

Total interest income

    94,597        54,129        38,773   
 

 

 

   

 

 

   

 

 

 

PIK interest income:

     

Control investments

    347                 

Affiliate investments

    989        1,227        1,634   

Non-control/Non-affiliate investments

    12,339        8,777        5,821   
 

 

 

   

 

 

   

 

 

 

Total PIK interest income

    13,675        10,004        7,455   
 

 

 

   

 

 

   

 

 

 

Fee income:

     

Control investments

    127                 

Affiliate investments

    667        1,433        1,102   

Non-control/Non-affiliate investments

    15,888        4,538        2,440   
 

 

 

   

 

 

   

 

 

 

Total fee income

    16,682        5,971        3,542   
 

 

 

   

 

 

   

 

 

 

Dividend and other income:

     

Non-control/Non-affiliate investments

    211        434        23   

Other income

                  35   
 

 

 

   

 

 

   

 

 

 

Total dividend and other income

    211        434        58   
 

 

 

   

 

 

   

 

 

 

Total investment income

    125,165        70,538        49,828   
 

 

 

   

 

 

   

 

 

 

Expenses:

     

Base management fee

    19,656        10,002        6,061   

Incentive fee

    16,782        10,756        7,841   

Professional fees

    2,709        1,349        1,493   

Board of Directors fees

    452        278        310   

Interest expense

    15,137        1,929        637   

Administrator expense

    1,699        1,322        796   

General and administrative expenses

    3,083        2,605        1,500   
 

 

 

   

 

 

   

 

 

 

Total expenses

    59,518        28,241        18,638   

Base management fee waived

           (727     (172 )
 

 

 

   

 

 

   

 

 

 

Net expenses

    59,518        27,514        18,466   
 

 

 

   

 

 

   

 

 

 

Gain on extinguishment of convertible senior notes

    1,480                 
 

 

 

   

 

 

   

 

 

 

Net investment income

    67,127        43,024        31,362   

Unrealized appreciation (depreciation) on interest rate swap

    773        (773 )       

Realized loss on interest rate swap

    (1,335              

Unrealized appreciation (depreciation) on investments:

     

Control investments

    9,437        (2,141     (1,792 )

Affiliate investments

    (5,374 )     3,294        286   

Non-control/Non-affiliate investments

    (11,362     (2,207     (9,289
 

 

 

   

 

 

   

 

 

 

Net unrealized depreciation on investments

    (7,299     (1,054     (10,795
 

 

 

   

 

 

   

 

 

 

Realized loss on investments:

     

Control investments

    (7,806 )              

Affiliate investments

    (14,146     (6,937     (4,000 )

Non-control/Non-affiliate investments

    (7,107     (11,844     (10,373 )
 

 

 

   

 

 

   

 

 

 

Total realized loss on investments

    (29,059     (18,781     (14,373 )
 

 

 

   

 

 

   

 

 

 

Net increase in net assets resulting from operations

  $ 30,207      $ 22,416      $ 6,194   
 

 

 

   

 

 

   

 

 

 

Net Investment Income per common share — basic

  $ 1.05      $ 0.95      $ 1.27   

Earnings per common share — basic

  $ 0.47      $ 0.49      $ 0.25   

Weighted average common shares outstanding — basic

    64,057        45,441        24,654   

Net Investment Income per common share — diluted

  $ 1.01      $ 0.95      $ 1.27   

Earnings per common share — diluted

  $ 0.47      $ 0.49      $ 0.25   

Weighted average common shares outstanding — diluted

    68,716        45,441        24,654   

See notes to Consolidated Financial Statements.

 

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Table of Contents

Fifth Street Finance Corp.

Consolidated Statements of Changes in Net Assets

(in thousands, except per share amounts)

 

     Year Ended
September 30,
2011
    Year Ended
September 30,
2010
    Year Ended
September 30,
2009
 

Operations:

      

Net investment income

   $ 67,127      $ 43,024      $ 31,362   

Net unrealized depreciation on investments and interest rate swap

     (6,526     (1,827     (10,795

Net realized loss on investments and interest rate swap

     (30,394     (18,781     (14,373 )
  

 

 

   

 

 

   

 

 

 

Net increase in net assets resulting from operations

     30,207        22,416        6,194   
  

 

 

   

 

 

   

 

 

 

Stockholder transactions:

      

Distributions to stockholders

     (80,790     (43,737     (29,592
  

 

 

   

 

 

   

 

 

 

Net decrease in net assets from stockholder transactions

     (80,790     (43,737     (29,592
  

 

 

   

 

 

   

 

 

 

Capital share transactions:

      

Issuance of common stock, net

     205,947        178,018        137,625   

Issuance of common stock under dividend reinvestment plan

     4,091        1,919        2,455   

Repurchases of common stock

                   (462 )
  

 

 

   

 

 

   

 

 

 

Net increase in net assets from capital share transactions

     210,038        179,937        139,618   
  

 

 

   

 

 

   

 

 

 

Total increase in net assets

     159,455        158,616        116,220   

Net assets at beginning of period

     569,172        410,556        294,336   
  

 

 

   

 

 

   

 

 

 

Net assets at end of period

   $ 728,627      $ 569,172      $ 410,556   
  

 

 

   

 

 

   

 

 

 

Net asset value per common share

   $ 10.07      $ 10.43      $ 10.84   
  

 

 

   

 

 

   

 

 

 

Common shares outstanding at end of period

     72,376        54,550        37,879   

See notes to Consolidated Financial Statements.

 

81


Table of Contents

Fifth Street Finance Corp.

Consolidated Statements of Cash Flows

(in thousands, except per share amounts)

 

     Year Ended
September 30,
2011
    Year Ended
September 30,
2010
    Year Ended
September 30,
2009
 

Cash flows from operating activities:

      

Net increase in net assets resulting from operations

   $ 30,207      $ 22,416      $ 6,194   

Adjustments to reconcile net increase in net assets resulting from operations to net cash used in operating activities:

      

Gain on extinguishment of convertible senior notes

     (1,480              

Net unrealized depreciation on investments and interest rate swap

     6,526        1,827        10,795   

Net realized losses on investments and interest rate swap

     30,394        18,780        14,373   

PIK interest income

     (13,675     (10,004     (7,455

Recognition of fee income

     (16,681     (5,971     (3,542

Accretion of original issue discount on investments

     (2,063     (893     (843

Amortization of deferred financing costs

     2,747        798          

Other income

                   (35

Changes in operating assets and liabilities:

      

Fee income received

     21,890        11,882        3,896   

Increase in interest and fees receivable

     (1,715     (947     (499

(Increase) decrease in due from portfolio company

     (449 )     51        (74

(Increase) decrease in collateral posted to bank and other assets

     358        (1,906     (15

Increase (decrease) in accounts payable, accrued expenses and other liabilities

     629        (176 )     156   

Increase in base management fee payable

     2,834        1,324        171   

Increase in incentive fee payable

     2,138        915        130   

Increase in due to FSC, Inc.

     397        379        130   

Increase (decrease) in interest payable

     4,386        283        (39

Increase (decrease) in payments received in advance from portfolio companies

     (1,296     1,140        57   

Purchases of investments and net revolver activity, net of syndications

     (703,461     (315,777     (61,200

Principal payments received on investments (scheduled payments)

     31,718        12,026        6,452   

Principal payments received on investments (payoffs)

     78,635        22,768        11,100   

PIK interest income received in cash

     9,988        1,619        428   

Proceeds from the sale of investments

     50        306        144   
  

 

 

   

 

 

   

 

 

 

Net cash used in operating activities

     (517,923     (239,160     (19,676
  

 

 

   

 

 

   

 

 

 

Cash flows from financing activities:

      

Dividends paid in cash

     (76,699     (41,818     (27,136

Repurchases of common stock

                   (462 )

Borrowings under SBA debentures payable

     77,000        73,000          

Borrowings under credit facilities

     658,500        43,000        29,500   

Repayments of borrowings under credit facilities

     (480,476     (43,000     (29,500

Proceeds from the issuance of convertible senior notes

     152,000                 

Repurchases of convertible senior notes

     (15,070              

Proceeds from the issuance of common stock

     206,788        179,125        138,578   

Deferred financing costs paid

     (12,400     (6,264 )       

Offering costs paid

     (841     (1,323     (1,005
  

 

 

   

 

 

   

 

 

 

Net cash provided by financing activities

     508,802        202,720        109,975   
  

 

 

   

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     (9,121     (36,440 )     90,299   

Cash and cash equivalents, beginning of period

     76,765        113,205        22,906   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents, end of period

   $ 67,644      $ 76,765      $ 113,205   
  

 

 

   

 

 

   

 

 

 

Supplemental Information:

      

Cash paid for interest

   $ 7,553      $ 848      $ 426   

Non-cash financing activities:

      

Issuance of shares of common stock under dividend reinvestment plan

   $ 4,091      $ 1,919      $ 2,455   

 

82


Table of Contents

Fifth Street Finance Corp.

Consolidated Schedule of Investments

(dollar amounts in thousands)

September 30, 2011

 

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% PIK due 2/28/2013

      $ 4,366       $ 3,996       $ 2,526   

First Lien Bridge Loan, 8% PIK due 3/31/2012

        112         113           

97.38% membership interest

           1,210           
        

 

 

    

 

 

 
           5,319         2,526   

Nicos Polymers & Grinding, Inc.

   Environmental & facilities services         

First Lien Term Loan, 8% cash due 12/4/2017

        5,347         5,280         5,189   

First Lien Revolver, 8% cash due 12/4/2017

        1,500         1,500         1,551   

50% Membership interest in CD Holdco, LLC

           1,627         5,234   
        

 

 

    

 

 

 
           8,407         11,974   
        

 

 

    

 

 

 

Total Control Investments

         $ 13,726       $ 14,500   
        

 

 

    

 

 

 

Affiliate Investments (4)

           

O’Currance, Inc.(13)(14)

   Data Processing & Outsourced Services         

First Lien Term Loan A, 12.875% cash 4% PIK due 3/21/2012

      $ 11,414       $ 11,254       $ 3,173   

First Lien Term Loan B, 12.875% cash 4% PIK 3/21/2012

        1,164         1,140         324   

1.75% Preferred Membership interest in O’Currance Holding Co., LLC

           130           

3.3% Membership Interest in O’Currance Holding Co., LLC

           250           
        

 

 

    

 

 

 
           12,774         3,497   

Caregiver Services, Inc.

   Healthcare services         

Second Lien Term Loan A, LIBOR+6.85% (5.15% floor) cash due 2/25/2013

        5,712         5,527         5,843   

Second Lien Term Loan B, 12.5% cash 4% PIK due 2/25/2013

        15,161         14,801         15,067   

1,080,399 shares of Series A Preferred Stock

           1,080         1,490   
        

 

 

    

 

 

 
           21,408         22,400   
        

 

 

    

 

 

 

Total Affiliate Investments

         $ 34,182       $ 25,897   
        

 

 

    

 

 

 

Non-Control/Non-Affiliate Investments (7)

           

Repechage Investments Limited (13)(14)

   Restaurants         

First Lien Term Loan, 12.75% cash 2.75% PIK due 10/16/2011

      $ 3,558       $ 3,412       $ 1,829   

7,500 shares of Series A Preferred Stock of Elephant & Castle, Inc.

           750           
        

 

 

    

 

 

 
           4,162         1,829   

Traffic Control & Safety Corporation (9)

   Construction and Engineering         

Senior Term Loan, LIBOR+9% cash due 6/29/2012

        5,000         4,870         4,957   

Senior Revolver, LIBOR+9% cash due 6/29/2012

        11,986         11,754         11,966   

Second Lien Term Loan, 12% cash 3% PIK due 5/28/2015

        20,795         20,602         17,545   

Subordinated Loan, 15% PIK due 5/28/2015

        5,325         5,325         1,346   

24,750 shares of Series B Preferred Stock

           247           

43,494 shares of Series D Preferred Stock

           435           

25,000 shares of Common Stock

           3           
        

 

 

    

 

 

 
           43,236         35,814   

TBA Global, LLC

   Advertising         

53,994 Senior Preferred Shares

           216         388   

191,977 Shares A Shares

           192         74   
        

 

 

    

 

 

 
           408         462   

Fitness Edge, LLC

   Leisure Facilities         

First Lien Term Loan A, LIBOR+5.25% (4.75% floor) cash due 8/8/2012

        750         749         757   

First Lien Term Loan B, 12.5% cash 2.5% PIK due 8/8/2012

        5,776         5,750         5,814   

1,000 Common Units (6)

           43         181   
        

 

 

    

 

 

 
                 6,542      6,752  

 

83


Table of Contents

Fifth Street Finance Corp.

Consolidated Schedule of Investments

(dollar amounts in thousands)

September 30, 2011

 

Portfolio Company/Type of Investment (1)(2)(5)

  

Industry

   Principal(8)      Cost     Fair Value  

Boot Barn

   Apparel, accessories & luxury goods and footwear        

255.78 shares of Series A&B Preferred Stock

           247        71   

1,354 shares of Common Stock

           9        9   
        

 

 

   

 

 

 
           256        80   

Premier Trailer Leasing, Inc. (9)(13)(14)

   Trucking        

Second Lien Term Loan, 13.25% cash 3.25% PIK due 10/23/2012

        19,070         17,064          

285 shares of Common Stock

           1          
        

 

 

   

 

 

 
           17,065          

Capital Equipment Group, Inc. (9)

   Industrial machinery        

Second Lien Term Loan, 12% cash 2.75% PIK due 7/10/2013

        10,278         10,112        10,226   

33,463 shares of Common Stock

           345        634   
        

 

 

   

 

 

 
           10,457        10,860   

Rail Acquisition Corp.

   Electronic manufacturing services        

First Lien Term Loan, 8% cash 4% PIK due 9/1/2013

        18,415         15,636        4,106   

First Lien Revolver, 7.85% cash due 9/1/2013

        4,554         4,554        4,554   
        

 

 

   

 

 

 
           20,190        8,660   

Western Emulsions, Inc.

   Construction materials        

Second Lien Term Loan, 12.5% cash 2.5% PIK due 6/30/2014

        6,844         6,736        6,840   
        

 

 

   

 

 

 
           6,736        6,840   

Storyteller Theaters Corporation

   Movies & entertainment        

1,692 shares of Common Stock

                  62   

20,000 shares of Preferred Stock

           200        200   
        

 

 

   

 

 

 
           200        262   

HealthDrive Corporation

   Healthcare services        

First Lien Term Loan A, 10% cash due 7/17/2013

        6,263         6,049        6,352   

First Lien Term Loan B, 12% cash 1% PIK due 7/17/2013

        10,282         10,212        10,217   

First Lien Revolver, 12% cash due 7/17/2013 (11)

           (7       
        

 

 

   

 

 

 
           16,254        16,569   

idX Corporation

   Distributors        

Second Lien Term Loan, 12.5% cash 2% PIK due 7/1/2014

        18,895         18,631        18,938   
        

 

 

   

 

 

 
           18,631        18,938   

Cenegenics, LLC

   Healthcare services        

414,419 Common Units (6)

           598        1,060   
        

 

 

   

 

 

 
           598        1,060   

IZI Medical Products, Inc.

   Healthcare technology        

First Lien Term Loan A, 12% cash due 3/31/2014

        3,236         3,215        3,244   

First Lien Term Loan B, 13% cash 3% PIK due 3/31/2014

        17,258         16,861        17,061   

First Lien Revolver, 10% cash due 3/31/2014 (11)

           (25       

453,755 Preferred units of IZI Holdings, LLC

           454        642   
        

 

 

   

 

 

 
           20,505        20,947   

Trans-Trade, Inc.

   Air freight & logistics        

First Lien Term Loan, 13% cash 2.5% PIK due 9/10/2014

        12,523         12,287        11,763   

First Lien Revolver, 12% cash due 9/10/2014

        5,800         5,697        5,479   
        

 

 

   

 

 

 
           17,984        17,242   

 

84


Table of Contents

Fifth Street Finance Corp.

Consolidated Schedule of Investments

(dollar amounts in thousands)

September 30, 2011

 

Portfolio Company/Type of Investment (1)(2)(5)

  

Industry

   Principal(8)      Cost     Fair Value  

Riverlake Equity Partners II, LP

   Multi-sector holdings        

1.89% limited partnership interest (16)

           122        122   
        

 

 

   

 

 

 
           122        122   

Riverside Fund IV, LP

   Multi-sector holdings        

0.33% limited partnership interest (16)

           445        445   
        

 

 

   

 

 

 
           445        445   

ADAPCO, Inc.

   Fertilizers & agricultural chemicals        

First Lien Term Loan A, 10% cash due 12/17/2014

        8,000         7,871        8,010   

First Lien Term Loan B, 12% cash 2% PIK due 12/17/2014

        15,521         15,306        15,371   

First Lien Term Revolver, 10% cash due 12/17/2014

        5,750         5,623        5,809   
        

 

 

   

 

 

 
           28,800        29,190   

Ambath/Rebath Holdings, Inc.

   Home improvement retail        

First Lien Term Loan A, LIBOR+7% (3% floor) cash due 12/30/2014

        3,500         3,500        3,497   

First Lien Term Loan B, 12.5% cash 2.5% PIK due 12/30/2014

        22,999         22,999        22,600   

First Lien Term Revolver, LIBOR+6.5% (3% floor) cash due 12/30/2014 (10)

        1,500         1,500        1,479   
        

 

 

   

 

 

 
           27,999        27,576   

JTC Education, Inc.

   Education services        

First Lien Term Loan, LIBOR+9.5% (3% floor) cash due 12/31/2014

        30,134         29,467        29,780   

First Lien Revolver, LIBOR+9.5% (3.25% floor) cash due 12/31/2014 (11)

           (305       

17,391 Shares of Series A-1 Preferred Stock

           313        313   

17,391 Shares of Common Stock

           187        83   
        

 

 

   

 

 

 
           29,662        30,176   

Tegra Medical, LLC

   Healthcare equipment        

First Lien Term Loan A, LIBOR+7% (3% floor) cash due 12/31/2014

        22,540         22,244        22,744   

First Lien Term Loan B, 12% cash 2% PIK due 12/31/2014

        22,551         22,270        22,226   

First Lien Revolver, LIBOR+7% (3% floor) cash due 12/31/2014

        2,500         2,449        2,501   
        

 

 

   

 

 

 
           46,963        47,471   

Psilos Group Partners IV, LP

   Multi-sector holdings        

2.52% limited partnership interest (12)(16)

                    
        

 

 

   

 

 

 
                    

Mansell Group, Inc.

   Advertising        

First Lien Term Loan A, LIBOR+7% (3% floor) cash due 4/30/2015

        10,675         10,512        10,654   

First Lien Term Loan B, LIBOR+9% (3% floor) cash 1.5% PIK due 4/30/2015

        9,142         9,001        9,067   

First Lien Revolver, LIBOR+6% (3% floor) cash due 4/30/2015 (11)

           (29       
        

 

 

   

 

 

 
           19,484        19,721   

NDSSI Holdings, LLC

   Electronic equipment & instruments        

First Lien Term Loan, LIBOR+9.75% (3% floor) cash 1% PIK due 12/31/2012

        29,788         29,370        29,278   

First Lien Revolver, LIBOR+7% (3% floor) cash due 12/31/2012

        3,500         3,435        3,538   

2,000 Series D Preferred Units

           2,047        2,047   
        

 

 

   

 

 

 
           34,852        34,863   

Eagle Hospital Physicians, Inc. (9)

   Healthcare services        

First Lien Term Loan, LIBOR+8.75% (3% floor) cash due 8/11/2015

        25,400         24,907        25,246   

First Lien Revolver, LIBOR+5.75% (3% floor) cash due 8/11/2015 (11)

           (42       
        

 

 

   

 

 

 
           24,865        25,246   

 

85


Table of Contents

Fifth Street Finance Corp.

Consolidated Schedule of Investments

(dollar amounts in thousands)

September 30, 2011

 

Portfolio Company/Type of Investment (1)(2)(5)

  

Industry

   Principal(8)      Cost     Fair Value  

Enhanced Recovery Company, LLC

   Diversified support services        

First Lien Term Loan A, LIBOR+7% (2% floor) cash due 8/13/2015

        13,961         13,713        13,945   

First Lien Term Loan B, LIBOR+10% (2% floor) cash 1% PIK due 8/13/2015

        11,070         10,882        11,015   

First Lien Revolver, LIBOR+7% (2% floor) cash due 8/13/2015 (11)

           (69       
        

 

 

   

 

 

 
           24,526        24,960   

Epic Acquisition, Inc.

   Healthcare services        

First Lien Term Loan A, LIBOR+8% (3% floor) cash due 8/13/2015

        8,329         8,189        8,343   

First Lien Term Loan B, 12.25% cash 3% PIK due 8/13/2015

        17,246         16,962        17,281   

First Lien Revolver, LIBOR+6.5% (3% floor) cash due 8/13/2015(11)

           (50       
        

 

 

   

 

 

 
           25,101        25,624   

Specialty Bakers LLC

   Food distributors        

First Lien Term Loan A, LIBOR+8.5% cash due 9/15/2015

        8,325         8,148        8,220   

First Lien Term Loan B, LIBOR+11% (2.5% floor) cash due 9/15/2015

        11,000         10,770        10,756   

First Lien Revolver, LIBOR+8.5% cash due 9/15/2015

        2,000         1,916        2,029   
        

 

 

   

 

 

 
           20,834        21,005   

CRGT, Inc.

   IT consulting & other services        

First Lien Term Loan A, LIBOR+7.5% cash due 10/1/2015

        27,913         27,495        27,659   

First Lien Term Loan B, 12.5% cash 10/1/2015

        22,000         21,648        21,869   

First Lien Revolver, LIBOR+7.5% cash due 10/1/2015(11)

           (200       
        

 

 

   

 

 

 
           48,943        49,528   

Welocalize, Inc.

   Internet software & services        

First Lien Term Loan A, LIBOR+8% (2% floor) cash due 11/19/2015

        15,990         15,720        15,668   

First Lien Term Loan B, LIBOR+9% (2% floor) cash 1.25% PIK due 11/19/2015

        21,231         20,888        20,983   

First Lien Revolver, LIBOR+7% (2% floor) cash due 11/19/2015

        5,250         5,152        5,162   

2,086,163 Common Units in RPWL Holdings, LLC

           2,086        1,973   
        

 

 

   

 

 

 
           43,846        43,786   

Miche Bag, LLC

   Apparel, accessories & luxury goods        

First Lien Term Loan A, LIBOR+9% (3% floor) cash due 12/7/2013

        13,708         13,353        13,735   

First Lien Term Loan B, LIBOR+10% (3% floor) cash 3% PIK due 12/7/2015

        17,425         14,983        17,115   

First Lien Revolver, LIBOR+7% (3% floor) cash due 12/7/2015(11)

           (105       

10,371 Preferred Equity units in Miche Holdings, LLC(6)

           1,037        1,169   

146,289 Series D Common Equity units in Miche Holdings, LLC(6)

           1,463        1,496   
        

 

 

   

 

 

 
           30,731        33,515   

Bunker Hill Capital II (QP), LP

   Multi-sector holdings        

0.50% limited partnership interest(16)

           40        40   
        

 

 

   

 

 

 
           40        40   

Dominion Diagnostics, LLC(9)

   Healthcare services        

First Lien Term Loan A, LIBOR+7% (2.5% floor) cash due 12/17/2015

        29,550         29,030        29,442   

First Lien Term Loan B, LIBOR+10.5% (2.5% floor) cash 1% PIK due 12/17/2015

        20,008         19,675        19,546   

First Lien Revolver, LIBOR+6.5% (2.5% floor) cash due 12/17/2015(11)

           (83       
        

 

 

   

 

 

 
           48,622        48,988   

Advanced Pain Management

   Healthcare services        

 

86


Table of Contents

Fifth Street Finance Corp.

Consolidated Schedule of Investments

(dollar amounts in thousands)

September 30, 2011

 

Portfolio Company/Type of Investment (1)(2)(5)

  

Industry

   Principal(8)      Cost     Fair Value  

First Lien Term Loan, LIBOR+5% (1.75% floor) cash due 12/22/2015

        8,046         7,923        8,007   

First Lien Revolver, LIBOR+5% (1.75% floor) cash due 12/22/2015

        133         129        135   
        

 

 

   

 

 

 
                 8,052     8,142  

DISA, Inc.

   Human resources & employment services        

First Lien Term Loan A, LIBOR+7.5% (0.75% floor) cash due 12/30/2015

        12,460         12,256        12,542   

First Lien Term Loan B, LIBOR+10% (1% floor) cash 1.5% PIK due 12/30/2015

        8,395         8,264        8,410   

First Lien Revolver, LIBOR+6% (1% floor) cash due 12/30/2015(11)

           (63       
        

 

 

   

 

 

 
           20,457        20,952   

Saddleback Fence and Vinyl Products, Inc.

   Building products        

First Lien Term Loan, 8% cash due 11/30/2013

        773         773        773   

First Lien Revolver, 8% cash due 11/30/2013

                    
        

 

 

   

 

 

 
           773        773   

Best Vinyl Fence & Deck, LLC

   Building products        

First Lien Term Loan A, 8% cash due 11/30/2013

        2,061         1,947        2,061   

First Lien Term Loan B, 8% PIK due 7/31/2011(15)

        3,969         3,969        2,000   

First Lien Revolver, 8% cash due 11/30/2013

                    
        

 

 

   

 

 

 
           5,916        4,061   

Physicians Pharmacy Alliance, Inc.

   Healthcare services        

First Lien Term Loan, LIBOR+9% cash 1.5% PIK due 1/4/2016

        16,766         16,461        16,702   

First Lien Revolver, LIBOR+6% cash due 1/4/2016(11)

           (35       
        

 

 

   

 

 

 
           16,426        16,702   

Cardon Healthcare Network, LLC

   Diversified support services        

First Lien Term Loan, LIBOR+10% (1.75% floor) cash due 1/6/2016(9)

        11,250         11,051        11,210   

First Lien Revolver, LIBOR+6.5% (1.75% floor) cash due 1/6/2016(11)

           (35       
        

 

 

   

 

 

 
           11,016        11,210   

U.S. Retirement Partners, Inc.

   Diversified financial services        

First Lien Term Loan, LIBOR+9.5% (2% floor) cash due 1/6/2016

        13,600         13,311        13,329   
        

 

 

   

 

 

 
           13,311        13,329   

IOS Acquisitions, Inc.

   Oil & gas equipment & services        

First Lien Term Loan A, LIBOR+8% (2% floor) cash due 1/14/2016

        8,700         8,576        8,656   

First Lien Term Loan B, LIBOR+10% (2% floor) cash 2% PIK due 1/14/2016

        10,618         10,466        10,480   

First Lien Revolver, LIBOR+8% (2% floor) cash due 1/14/2016

        750         714        777   
        

 

 

   

 

 

 
           19,756        19,913   

Actient Pharmaceuticals, LLC

   Healthcare services        

First Lien Term Loan, LIBOR+6.25% (2% floor) cash due 7/29/2015

        9,180         9,018        9,169   
        

 

 

   

 

 

 
           9,018        9,169   

Phoenix Brands Merger Sub LLC

   Household products        

Senior Term Loan, LIBOR+5% (1.5% floor) cash due 1/31/2016

        8,036         7,875        7,674   

Subordinated Term Loan, 10% cash 3.875% PIK due 2/1/2017

        20,390         20,035        19,071   

First Lien Revolver, LIBOR+5% (1.5% floor) cash due 1/31/2016

        3,429         3,303        3,198   
        

 

 

   

 

 

 
           31,213        29,943   

U.S. Collections, Inc.

   Diversified support services        

 

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Table of Contents

Fifth Street Finance Corp.

Consolidated Schedule of Investments

(dollar amounts in thousands)

September 30, 2011

 

Portfolio Company/Type of Investment (1)(2)(5)

  

Industry

   Principal(8)      Cost     Fair Value  

First Lien Term Loan, LIBOR+5.25% (1.75% floor) cash due 3/31/2016

        10,847         10,649        10,828   
        

 

 

   

 

 

 
           10,649        10,828   

CCCG, LLC

   Oil & gas equipment & services        

First Lien Term Loan, LIBOR+8% (1.75% floor) cash 1% PIK due 7/29/2015

        34,738         34,115        34,152   
        

 

 

   

 

 

 
           34,115        34,152   

Maverick Healthcare Group, LLC

   Healthcare equipment        

First Lien Term Loan, LIBOR+9% (1.75% floor) cash due 12/31/2016

        24,813         24,292        24,440   
        

 

 

   

 

 

 
           24,292        24,440   

Refac Optical Group

  

Specialty

stores

       

First Lien Term Loan A, LIBOR+7.5% cash due 3/23/2016

        14,220         13,920        14,273   

First Lien Term Loan B, LIBOR+8.5% cash 1.75% PIK due 3/23/2016

        20,162         19,731        20,078   

First Lien Revolver, LIBOR+7.5% cash due 3/23/2016(11)

           (113       

1,000 Shares of Common Stock in Refac Holdings, Inc.

           1          

1,000 Shares of Preferred Stock in Refac Holdings, Inc.

           999        847   
        

 

 

   

 

 

 
           34,538        35,198   

Pacific Architects & Engineers, Inc.

  

Diversified support

services

       

First Lien Term Loan A, LIBOR+5% (1.5% floor) cash due 4/4/2017

        4,416         4,352        4,332   

First Lien Term Loan B, LIBOR+6% (1.5% floor) cash due 4/4/2017

        5,000         4,929        4,903   
        

 

 

   

 

 

 
           9,281        9,235   

Ernest Health, Inc.

   Healthcare services        

Second Lien Term Loan, LIBOR+8.5% (1.75% floor) cash due 5/13/2017

        25,000         24,656        25,049   
        

 

 

   

 

 

 
           24,656        25,049   

Securus Technologies, Inc.

   Integrated telecommunication services        

Second Lien Term Loan, LIBOR+8.25% (1.75% floor) cash due 5/31/2018

        26,500         25,995        26,374   
        

 

 

   

 

 

 
           25,995        26,374   

Gundle/SLT Environmental, Inc.

  

Environmental

& facilities services

       

First Lien Term Loan, LIBOR+5.5% (1.5% floor) cash due 5/27/2016

        7,980         7,904        7,977   
        

 

 

   

 

 

 
           7,904        7,977   

Titan Fitness, LLC

  

Leisure

facilities

       

First Lien Term Loan A, LIBOR+8.75 (1.25% floor) cash due 6/30/2016

        17,063         16,878        16,938   

First Lien Term Loan B, LIBOR+10.75% (1.25% floor) cash 1.5% PIK due 6/30/2016

        11,545         11,422        11,343   

First Lien Term Loan C, 18% PIK due 6/30/2016

        2,721         2,693        2,593   

First Lien Revolver, LIBOR+8.75% (1.25% floor) cash due 6/30/2016

        543         506        821   
        

 

 

   

 

 

 
           31,499        31,695   

Baird Capital Partners V, LP

   Multi-sector holdings        

 

88


Table of Contents

Fifth Street Finance Corp.

Consolidated Schedule of Investments

(dollar amounts in thousands)

September 30, 2011

 

Portfolio Company/Type of Investment (1)(2)(5)

  

Industry

   Principal(8)      Cost     Fair Value  

0.4% limited partnership interest(16)

           299        299   
        

 

 

   

 

 

 
           299        299   

Charter Brokerage, LLC

   Oil & gas equipment services        

Senior Term Loan, LIBOR+6.5% (1.5% floor) cash due 7/13/2016

        17,411         17,242        17,411   

Mezzanine Term Loan, 11.75% cash 2% PIK due 7/13/2016

        10,043         9,948        10,043   

Senior Revolver, LIBOR+6.5% (1.5% floor) cash due 7/13/2016

        1,176         1,107        1,177   
        

 

 

   

 

 

 
           28,297        28,631   

Stackpole Powertrain International ULC

   Auto parts & equipment        

Subordinated Term Loan, 12% cash 2% PIK due 8/1/2018

        18,059         17,883        18,059   

1,000 Common Units

           1,000        1,000   
        

 

 

   

 

 

 
           18,883        19,059   

Discovery Practice Management, Inc.

   Healthcare services        

Senior Term Loan A, LIBOR+7.5% cash due 8/8/2016

        7,027         6,942        7,027   

Senior Term Loan B, 12% cash 3% PIK due 8/8/2016

        6,248         6,174        6,248   

Senior Revolver, LIBOR+7% cash due 8/8/2016(11)

           (37       
        

 

 

   

 

 

 
           13,079        13,275   

CTM Group, Inc.

   Leisure products        

Mezzanine Term Loan A, 11% cash 2% PIK due 2/10/2017

        10,530         10,417        10,530   

Mezzanine Term Loan B, 18.4% PIK due 2/10/2017

        3,181         3,147        3,181   
        

 

 

   

 

 

 
           13,564        13,711   

Bojangles

   Restaurants        

First Lien Term Loan, LIBOR+6.5% (1.5% floor) cash due 8/17/2017

        10,000         9,803        10,000   
        

 

 

   

 

 

 
           9,803        10,000   

Milestone Partners IV, LP

   Multi-sector holdings        

3.07% limited partnership interest(12)(16)

                    
        

 

 

   

 

 

 
                    

Insight Pharmaceuticals, LLC

   Pharmaceuticals        

First Lien Term Loan, LIBOR+6% (1.5% floor) cash due 8/25/2016

        10,000         9,926        10,000   

Second Lien Term Loan, LIBOR+11.75% (1.5% floor) cash due 8/25/2017

        17,500         17,331        17,500   
        

 

 

   

 

 

 
           27,257        27,500   

National Spine and Pain Centers, LLC

   Healthcare services        

Mezzanine Term Loan, 11% cash 1.6% PIK due 9/27/2017

        19,002         18,816        19,002   

250,000 Class A Units

           250        250   
        

 

 

   

 

 

 
           19,066        19,252   
        

 

 

   

 

 

 

Total Non-Control/Non-Affiliate Investments

         $ 1,108,174      $ 1,079,440   
        

 

 

   

 

 

 

Total Portfolio Investments

         $ 1,156,082      $ 1,119,837   
        

 

 

   

 

 

 

 

(1) All debt investments are income producing. 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.

 

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Table of Contents

Fifth Street Finance Corp.

Consolidated Schedule of Investments

(dollar amounts in thousands)

September 30, 2011

 

(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

Cardon Healthcare Network, LLC

  July 1, 2011   -2.5% on Term Loan     Tier pricing per credit agreement

Eagle Hospital Physicians, Inc.

  July 1, 2011   – 0.25% on Term Loan & Revolver     Per loan 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

Capital Equipment Group, Inc.

  July 1, 2010   – 2.0% on Term Loan   – 0.75% on Term Loan   Per waiver agreement

Traffic Control & Safety Corporation

  June 1, 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

 

(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 limited partnership interest.

 

(13) Investment was on cash non-accrual status as of September 30, 2011.

 

(14) Investment was on PIK non-accrual status as of September 30, 2011.

 

(15) Best Vinyl Fence & Deck, LLC Term Loan B is under negotiation and, as such, the maturity date of the loan has been temporarily suspended.

 

(16) Investment is not a qualifying asset as defined under Section 55(a) of the 1940 Act.

 

90


Table of Contents

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% PIK due 2/28/2013

      $ 5,419       $ 4,729       $ 1,504   

First Lien Term Loan B, 14.5% PIK due 2/28/2013

        8,576         6,906         2,196   

First Lien Bridge Loan, 8% cash 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, 12.875% cash 4% PIK due 3/21/2012

        10,961       $ 10,869       $ 10,806   

First Lien Term Loan B, 12.875% cash 4% PIK 3/21/2012

        1,854         1,829         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

           250           
        

 

 

    

 

 

 
           13,078         12,741   

MK Network, LLC(13)(14)

   Education services         

First Lien Term Loan A, 13.5% cash due 6/1/2012

        9,740         9,539         7,913   

First Lien Term Loan B, 17.5% cash due 6/1/2012

        4,926         4,748         3,939   

First Lien Revolver, Prime + 1.5% (8.5% floor) cash 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% (5.15% floor) cash due 2/25/2013

        7,141         6,814         7,113   

Second Lien Term Loan B, 12.5% cash 4% PIK due 2/25/2013

        14,692         14,103         14,180   

1,080,399 shares of Series A Preferred Stock

           1,080         1,336   
        

 

 

    

 

 

 
           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% PIK 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% cash due 3/30/2013

        7,000         6,827         5,812   

First Lien Revolver, LIBOR+7% (3% floor) cash 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, 12.75% cash 2.75% PIK 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   

 

91


Table of Contents

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, 12% cash 3% PIK due 5/28/2015

        19,970         19,725         19,440   

Subordinated Loan, 15% PIK due 5/28/2015

        4,578         4,578         4,405   

24,750 shares of Series B Preferred Stock

           246           

43,494 shares of Series D Preferred Stock(6)

           435           

25,000 shares of Common Stock

           3           
        

 

 

    

 

 

 
           24,987         23,845   

Nicos Polymers & Grinding Inc.(9)(13)(14)

   Environmental
& facilities
services
        

First Lien Term Loan A, LIBOR+5% (5% floor) cash due 7/17/2012

        3,155         3,041         1,782   

First Lien Term Loan B, 12.25% cash 1.25% PIK due 7/17/2012

        6,180         5,713         3,348   

3.32% Interest in Crownbrook Acquisition I LLC

           168           
        

 

 

    

 

 

 
           8,922         5,130   

TBA Global, LLC(9)

   Advertising         

Second Lien Term Loan B, 12.5% cash 4% PIK 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% (4.75% floor) cash due 8/8/2012

        1,250         1,245         1,247   

First Lien Term Loan B, 12.5% cash 2.5% PIK due 8/8/2012

        5,632         5,575         5,675   

1,000 Common Units

           43         118   
        

 

 

    

 

 

 
           6,863         7,040   

Filet of Chicken(9)

   Food
Distributors
        

Second Lien Term Loan, 12.5% cash 2% PIK due 7/31/2012

        9,317         9,063         8,965   
        

 

 

    

 

 

 
           9,063         8,965   

Boot Barn(9)

   Apparel,
accessories &
luxury goods and
Footwear
        

Second Lien Term Loan, 12.5% cash 2% PIK 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, 13.25% cash 3.25% PIK 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, 12% cash 2.75% PIK due 7/10/2013

   Industrial
machinery
     10,072         9,799         9,830   

33,463 shares of Common Stock

           344         403   
        

 

 

    

 

 

 
           10,143         10,233   

Goldco, LLC

           

Second Lien Term Loan, 13.5% cash 4% PIK 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, 12.5% cash 4.5% PIK due 9/1/2013

        16,316         13,537         12,854   

First Lien Revolver, 7.85% cash due 9/1/2013

        5,201         5,201         5,201   
        

 

 

    

 

 

 
           18,738         18,055   

 

92


Table of Contents

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, 12.5% cash 2.5% PIK 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% cash due 7/17/2013

        6,663         6,324        6,489   

First Lien Term Loan B, 12% cash 1% PIK due 7/17/2013

        10,179         10,069        9,962   

First Lien Revolver, 12% cash due 7/17/2013

        500         489        509   
        

 

 

   

 

 

 
           16,882        16,960   

idX Corporation

   Distributors        

Second Lien Term Loan, 12.5% cash 2% PIK due 7/1/2014

        13,589         13,351        13,258   
        

 

 

   

 

 

 
           13,351        13,258   

Cenegenics, LLC

   Healthcare services        

First Lien Term Loan, 12% cash 5% PIK due 10/27/2014

        20,172         19,257        19,545   

414,419 Common Units(6)

           598        1,418   
        

 

 

   

 

 

 
           19,855        20,963   

IZI Medical Products, Inc.

   Healthcare technology        

First Lien Term Loan A, 12% cash due 3/31/2014

        4,450         4,388        4,407   

First Lien Term Loan B, 13% cash 3% PIK due 3/31/2014

        17,258         16,702        17,093   

First Lien Revolver, 10% cash 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, 13% cash 2.5% PIK due 9/10/2014

        12,751         12,536        12,549   

First Lien Revolver, 12% cash due 9/10/2014

        1,500         1,469        1,491   
        

 

 

   

 

 

 
           14,005        14,040   

Riverlake Equity Partners II, LP

   Multi-sector holdings        

1.87% limited partnership interest(15)

           34        34   
        

 

 

   

 

 

 
           34        34   

Riverside Fund IV, LP

   Multi-sector holdings        

0.33% limited partnership interest(15)

           136        136   
        

 

 

   

 

 

 
           136        136   

ADAPCO, Inc.

   Fertilizers
& agricultural chemicals
       

First Lien Term Loan A, 10% cash due 12/17/2014

        9,000         8,789        8,807   

First Lien Term Loan B, 12% cash 2% PIK due 12/17/2014

        14,226         13,893        13,898   

First Lien Term Revolver, 10% cash due 12/17/2014

        4,250         4,012        4,107   
        

 

 

   

 

 

 
           26,694        26,812   

 

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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% (3% floor) cash due 12/30/2014

        9,500         9,278        9,128   

First Lien Term Loan B, 12.5% cash 2.5% PIK due 12/30/2014

        22,424         21,920        21,913   

First Lien Term Revolver, LIBOR+6.5% (3% floor) cash 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% (3% floor) cash due 12/31/2014

        31,055         30,244        30,660   

First Lien Revolver, LIBOR+9.5% (3.25% floor) cash due 12/31/2014(11)

                (401     (401
        

 

 

   

 

 

 
           29,843        30,259   

Tegra Medical, LLC

   Healthcare
equipment
       

First Lien Term Loan A, LIBOR+7% (3% floor) cash due 12/31/2014

        26,320         25,877        26,251   

First Lien Term Loan B, 12% cash 2% PIK due 12/31/2014

        22,099         21,729        22,114   

First Lien Revolver, LIBOR+7% (3% floor) cash due 12/31/2014(11)

                (67     (67
        

 

 

   

 

 

 
           47,539        48,298   

Flatout, Inc.

   Food retail        

First Lien Term Loan A, 10% cash due 12/31/2014

        7,300         7,121        7,144   

First Lien Term Loan B, 12% cash 3% PIK due 12/31/2014

        12,863         12,540        12,644   

First Lien Revolver, 10% cash due 12/31/2014(11)

                (38     (38
        

 

 

   

 

 

 
           19,623        19,750   

Psilos Group Partners IV, LP

   Multi-sector
holdings
       

2.53% limited partnership interest(12)(15)

                    
        

 

 

   

 

 

 
                    

Mansell Group, Inc.

   Advertising        

First Lien Term Loan A, LIBOR+7% (3% floor) cash due 4/30/2015

        5,000         4,910        4,916   

First Lien Term Loan B, LIBOR+9% (3% floor) cash 1.5% PIK due 4/30/2015

        4,026         3,952        3,947   

First Lien Revolver, LIBOR+6% (3% floor) cash due 4/30/2015(11)

                (37     (37
        

 

 

   

 

 

 
           8,825        8,826   

NDSSI Holdings, LLC

   Electronic
equipment

& instruments

       

First Lien Term Loan, LIBOR+9.75% (3% floor) cash 1% PIK due 9/10/2014

        30,246         29,685        29,409   

First Lien Revolver, LIBOR+7% (3% floor) cash due 9/10/2014

        3,500         3,410        3,479   
        

 

 

   

 

 

 
           33,095        32,888   

Eagle Hospital Physicians, Inc.

   Healthcare
services
       

First Lien Term Loan, LIBOR+8.75% (3% floor) cash due 8/11/2015

        8,000         7,784        7,784   

First Lien Revolver, LIBOR+5.75% (3% floor) cash due 8/11/2015(11)

                (64     (64
        

 

 

   

 

 

 
           7,720        7,720   

Enhanced Recovery Company, LLC

   Diversified
support
services
       

First Lien Term Loan A, LIBOR+7% (2% floor) cash due 8/13/2015

        15,500         15,172        15,172   

First Lien Term Loan B, LIBOR+10% (2% floor) cash 1% PIK due 8/13/2015

        11,015         10,782        10,782   

First Lien Revolver, LIBOR+7% (2% floor) cash due 8/13/2015

        377         292        292   
        

 

 

   

 

 

 
           26,246        26,246   

 

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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% (3% floor) cash due 8/13/2015

        7,750         7,555         7,555   

First Lien Term Loan B, 12.25% cash 3% PIK due 8/13/2015

        13,555         13,211         13,211   

First Lien Revolver, LIBOR+6.5% (3% floor) cash due 8/13/2015

        300         224         224   
        

 

 

    

 

 

 
           20,990         20,990   

Specialty Bakers LLC

   Food
distributors
        

First Lien Term Loan A, LIBOR+8.5% cash due 9/15/2015

        9,000         8,756         8,756   

First Lien Term Loan B, LIBOR+11% (2.5% floor) cash due 9/15/2015

        11,000         10,704         10,704   

First Lien Revolver, LIBOR+8.5% cash 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. 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:

 

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Fifth Street Finance Corp.

Consolidated Schedule of Investments

(in thousands, except per share amounts)

September 30, 2010

 

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.

  June 1, 2010   – 4.0% on Second Lien Term Loan   + 1.0% on Second Lien 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 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.

 

(15) Investment is not a qualifying asset as defined under Section 55(a) of the 1940 Act.

 

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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.

On November 28, 2011, the Company transferred the listing of its common stock from the New York Stock Exchange to the NASDAQ Global Select Market, where it continues to trade under the symbol “FSC.” The following table reflects common stock offerings that have occurred since inception:

 

Date

 

Transaction

  Shares     Offering 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.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 satisfaction of certain 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 at the time of issuance at a market-driven spread over U.S. Treasury Notes with 10-year maturities.

SBA regulations currently limit the amount of SBA-guaranteed debentures that an SBIC may issue to $150 million when it has at least $75 million in regulatory capital. Affiliated SBICs are permitted to issue up to a combined maximum amount of $225 million in SBA-guaranteed debentures when they have at least $112.5 million in combined regulatory capital. As of September 30, 2011, the Company’s SBIC subsidiary had $75 million in regulatory capital and $150 million in SBA-guaranteed debentures outstanding, which had a fair value of $102.0 million. These debentures bear interest at a weighted average interest rate of 3.567% (excluding the SBA annual charge), as follows:

 

Rate Fix Date

   Debenture
Amount
     Fixed
Interest
Rate
    SBA
Annual
Charge
 

September 2010

   $ 73,000         3.215     0.285

March 2011

     65,300         4.084     0.285

September 2011

     11,700         2.877     0.285

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.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 pursuant to the requirements for reporting on Form 10-K 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 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 $1.1 billion and $563.8 million at September 30, 2011 and September 30, 2010, respectively. The portfolio investments represent 153.7% and 99.1% of net assets at September 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.

 

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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 market 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.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 Company’s finance department;

 

   

Preliminary valuations are then reviewed and discussed with 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 finance department compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms;

 

   

The finance department 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 finance department 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 regarding the fair value of the investments in the Company’s portfolio; 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 September 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 authorized the engagement of 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.

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

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 payment-in-kind or “PIK” interest provisions. 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. Exit fees are fees which are payable upon the exit of a debt security. 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. The receipt of such fees is contingent upon a successful exit event for each of the investments. A percentage of these fees are included in net investment income over the life of the loan.

Gain on Extinguishment of Convertible Senior Notes:

The Company may, to the extent permitted by law, repurchase its Convertible Senior Notes in the open market and may surrender these Notes to the Trustee for cancellation. If the repurchase occurs at a purchase price below par value, a gain on the extinguishment of these Notes is recorded. The amount of the gain recorded is the difference between the reacquisition price and the net carrying amount of the Notes, net of the proportionate amount of unamortized debt issuance costs.

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 $0.3 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 or amending 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.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

Collateral Posted to Bank:

Collateral posted to bank consists of cash posted as collateral with respect to the Company’s interest rate swap, which was terminated in August 2011. The Company was restricted in terms of access to this collateral until such swap was terminated or the swap agreement expired. Cash collateral posted was held in an account at Wells Fargo.

Interest Rate Swap:

The Company does not utilize hedge accounting and marks its interest rate swaps 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. $0.8 million of offering costs have been charged to capital during the year ended September 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 or state 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

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 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.

In February 2011, the FASB issued Accounting Standards Update 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring (“ASU 2011-02”). ASU 2011-02 clarifies which loan modifications constitute troubled debt restructurings. It is intended to assist creditors in determining whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. ASU 2011-02 provides guidance to clarify whether the creditor has granted a concession and whether a debtor is experiencing financial difficulties. The new guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption. The adoption of ASU 2011-02 did not have a material impact on the Company’s financial condition and results of operations.

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

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 September 2009, the FASB issued Accounting Standards Update 2009-12, Fair Value Measurements and Disclosures (Topic 820) — Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) which provides guidance on estimating the fair value of an alternative investment, amending ASC 820-10. The amendment is effective for interim and annual periods ending after December 15, 2009. The adoption of this guidance did not have a material impact on either the Company’s consolidated financial position or results of operations.

In June 2009, the FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets — an amendment of FASB Statement No. 140 (“SFAS 166”). SFAS 166 requires more information about transfers of financial assets, eliminates the qualifying special purpose entity (QSPE) concept, changes the requirements for derecognizing financial assets and requires additional disclosures. SFAS 166 is effective for the first annual reporting period that begins after November 15, 2009. The initial adoption did not have a material impact on the Company’s Consolidated Financial Statements.

In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R) which provides guidance with respect to consolidation of variable interest entities. This statement retains the scope of Interpretation 46(R) with the addition of entities previously considered qualifying special-purpose entities, as the concept of these entities was eliminated in SFAS No. 166, Accounting for Transfers of Financial Assets. This statement replaces the quantitative-based risks and rewards calculation for determining the primary beneficiary of a variable interest entity. The approach focuses on identifying which enterprise has the power to direct activities that most significantly impact the entity’s economic performance and the obligation to absorb the losses or receive the benefits from the entity. It is possible that application of this revised guidance will change an enterprise’s assessment of involvement with variable interest entities. This statement, which has been codified within ASC 810, Consolidations, was effective for the Company as of September 1, 2010. The initial adoption did not have an effect on the Company’s Consolidated Financial Statements.

 

Note 3. Portfolio Investments

At September 30, 2011, 153.7% of net assets or $1.1 billion was invested in 65 long-term portfolio investments and 9.3% of net assets or $67.6 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 September 30, 2011, 90.9% of the Company’s portfolio at fair value consisted of debt investments that 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 years ended September 30, 2011, 2010 and 2009, the Company recorded realized losses of $30.4 million, $18.8 million and $14.4 million, respectively. During the years ended September 30, 2011, 2010 and 2009, the Company recorded unrealized depreciation of $6.5 million, $1.8 million and $10.8 million, respectively.

 

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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 investments as of September 30, 2011 and September 30, 2010 at cost and fair value was as follows:

 

     September 30, 2011      September 30, 2010  
     Cost      Fair Value      Cost      Fair Value  

Investments in debt securities

   $ 1,137,754       $ 1,099,708       $ 585,529       $ 558,580   

Investments in equity securities

     18,328         20,129         6,968         5,241   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,156,082       $ 1,119,837       $ 592,497       $ 563,821   
  

 

 

    

 

 

    

 

 

    

 

 

 

The composition of the Company’s debt investments as of September 30, 2011 and September 30, 2010 at fixed rates and floating rates was as follows:

 

     September 30, 2011     September 30, 2010  
     Fair Value      % of
Portfolio
    Fair Value      % of
Portfolio
 

Fixed rate debt securities

   $ 359,873         32.72   $ 375,584         67.24 %

Floating rate debt securities

     739,835         67.28     182,996         32.76 %
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 1,099,708         100.00   $ 558,580         100.00 %
  

 

 

    

 

 

   

 

 

    

 

 

 

The following table presents the financial instruments carried at fair value as of September 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)

   $       $       $ 875,092       $ 875,092   

Investments in debt securities (second lien)

                     143,383         143,383   

Investments in debt securities (subordinated)

                     81,233         81,233   

Investments in equity securities (preferred)

                     7,167         7,167   

Investments in equity securities (common)

                     12,962         12,962   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total investments at fair value

   $       $       $     1,119,837       $     1,119,837   
  

 

 

    

 

 

    

 

 

    

 

 

 

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   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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.

The following table provides a roll-forward in the changes in fair value from September 30, 2010 to September 30, 2011, for all investments for which the Company determines fair value using unobservable (Level 3) factors.

 

    First Lien
Debt
    Second
Lien Debt
    Subordinated
Debt
    Preferred
Equity
    Common
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

    563,826        76,500        81,665        4,349        8,033        734,373   

Redemptions/repayments

    (81,382     (63,163     (1,000                   (145,545

Net accrual of PIK interest income

    5,456        (3,103     1,289        47               3,689   

Accretion of original issue discount

    1,510        553                             2,063   

Net change in unearned income

    (5,539     67        (961                   (6,433

Net unrealized appreciation (depreciation)

    (1,340     (5,322     (4,165     134        3,394        (7,299

Net change from unrealized to realized

    (23,763                   (255     (814     (24,832

Transfer into (out of) Level 3

                                         
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Fair value as of September 30, 2011

  $ 875,092      $ 143,383      $ 81,233      $ 7,167      $ 12,962      $ 1,119,837   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net unrealized appreciation (depreciation) relating to Level 3 assets still held at September 30, 2011 and reported within net unrealized appreciation (depreciation) on investments in the Consolidated Statement of Operations for the year ended September 30, 2011

  $ (15,106   $ (5,200   $ (4,165   $ (121   $ 2,580      $ (22,012

 

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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 September 30, 2009 to September 30, 2010, for all investments for which the Company determines fair value using unobservable (Level 3) factors.

 

    First Lien
Debt
    Second
Lien Debt
    Subordinated
Debt
    Preferred
Equity
    Common
Equity
    Total  

Fair value as of September 30, 2009

  $ 142,018      $ 153,904      $      $ 2,889      $ 800      $ 299,611   

New investments & net revolver activity

    304,369        7,120        4,165        435        688        316,777   

Redemptions/repayments

    (14,088     (23,168                   (71     (37,327

Net accrual of PIK interest income

    4,473        3,499        413                      8,385   

Accretion of original issue discount

    482        411                             893   

Net change in unearned income

    (6,402     491                             (5,911

Net unrealized appreciation (depreciation)

    (2,195     (3,433     (173     (432     5,179        (1,054

Net change from unrealized to realized

    (12,333     (973                   (4,247     (17,553

Transfer into (out of) Level 3

                                         
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Fair value as of September 30, 2010

  $ 416,324      $ 137,851      $ 4,405      $ 2,892      $ 2,349      $ 563,821   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net unrealized appreciation (depreciation) relating to Level 3 assets still held at September 30, 2010 and reported within net unrealized appreciation (depreciation) on investments in the Consolidated Statement of Operations for the year ended September 30, 2010

  $ (4,423   $ (4,733   $ (173   $ (432   $ 932      $ (8,829

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). The Company 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 $108.8 million and $49.5 million of unfunded commitments to provide debt financing to its portfolio companies or to fund limited partnership interests as of September 30, 2011 and September 30, 2010, respectively. Such commitments are subject to the portfolio companies’ satisfaction of certain financial and nonfinancial convenants and 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.

 

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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 September 30, 2011 and September 30, 2010 is shown in the table below:

 

     September 30, 2011      September 30, 2010  

JTC Education, Inc.

   $ 14,000       $ 9,062   

CRGT, Inc.

     12,500           

Charter Brokerage, LLC

     6,176           

Refac Optical Group

     5,500           

Rail Acquisition Corp.

     5,446         4,799   

Miche Bag, LLC

     5,000           

Dominion Diagnostics, LLC

     5,000           

ADAPCO, Inc.

     4,250         5,750   

Enhanced Recovery Company, LLC

     4,000         3,623   

DISA, Inc.

     4,000           

Traffic Control & Safety Corporation

     3,014           

Epic Acquisition, Inc.

     3,000         2,700   

Phoenix Brands Merger Sub LLC

     3,000           

Discovery Practice Management, Inc.

     3,000           

Titan Fitness, LLC

     2,957           

IZI Medical Products, Inc.

     2,500         2,500   

Eagle Hospital Physicians, Inc.

     2,500         2,500   

HealthDrive Corporation

     2,000         1,500   

Mansell Group, Inc.

     2,000         2,000   

Specialty Bakers, LLC

     2,000         2,000   

Physicians Pharmacy Alliance, Inc.

     2,000           

Cardon Healthcare Network, LLC

     2,000           

Milestone Partners IV, LP (limited partnership interest)

     2,000           

Tegra Medical, LLC

     1,500         4,000   

Flatout, Inc.

     1,500         1,500   

IOS Acquisitions, Inc.

     1,250           

Psilos Group Partners IV, LP (limited partnership interest)

     1,000         1,000   

Best Vinyl Fence & Deck, LLC

     1,000           

Bunker Hill Capital II (QP), LP (limited partnership interest)

     960           

Riverlake Equity Partners II, LP (limited partnership interest)

     878         966   

Welocalize, Inc.

     750           

Baird Capital Partners V, LP (limited partnership interest)

     701           

Riverside Fund IV, LP (limited partnership interest)

     555         864   

Saddleback Fence and Vinyl Products, Inc.

     400           

Advanced Pain Management

     267           

Trans-Trade, Inc.

     200         500   

AmBath/ReBath Holdings, Inc.

             1,500   

Vanguard Vinyl, Inc.

             1,250   

NDSSI Holdings, LLC

             1,500   
  

 

 

    

 

 

 

Total

   $ 108,804       $ 49,514   
  

 

 

    

 

 

 

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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:

 

     September 30, 2011     September 30, 2010  

Cost:

          

First lien debt

   $ 890,729         77.05   $ 430,201         72.61

Second lien debt

     161,455         13.97     150,601         25.42

Subordinated debt

     85,571         7.40     4,728         0.80

Purchased equity

     11,263         0.97     2,330         0.39

Equity grants

     6,158         0.53     4,468         0.75

Limited partnership interests

     906         0.08     169         0.03
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 1,156,082         100.00   $ 592,497         100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

Fair Value:

          

First lien debt

   $ 875,092         78.14   $ 416,324         73.84

Second lien debt

     143,383         12.80     137,851         24.45

Subordinated debt

     81,233         7.25     4,405         0.78

Purchased equity

     12,548         1.12     625         0.11

Equity grants

     6,675         0.60     4,447         0.79

Limited partnership interests

     906         0.09     169         0.03
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 1,119,837         100.00   $ 563,821         100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

The Company primarily 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.

 

     September 30, 2011     September 30, 2010  

Cost:

          

Northeast

   $ 389,185         33.66   $ 175,371         29.60

Southwest

     273,513         23.66     121,104         20.44

Southeast

     244,988         21.19     108,805         18.36

West

     142,745         12.35     133,879         22.60

Midwest

     86,768         7.51     53,338         9.00

Canada

     18,883         1.63             0.00
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 1,156,082         100.00   $ 592,497         100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

Fair Value:

          

Northeast

   $ 389,898         34.82   $ 161,264         28.60

Southeast

     248,588         22.20     109,457         19.41

Southwest

     246,358         22.00     107,469         19.07

West

     127,522         11.39     131,881         23.39

Midwest

     88,412         7.90     53,750         9.53

Canada

     19,059         1.69             0.00
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 1,119,837         100.00   $ 563,821         100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

 

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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 September 30, 2011 and September 30, 2010 were as follows:

 

     September 30, 2011     September 30, 2010  

Cost:

          

Healthcare services

   $ 227,145         19.65   $ 87,444         14.76

Oil & gas equipment & services

     82,168         7.11             0.00

Healthcare equipment

     71,254         6.16     47,540         8.02

Diversified support services

     55,472         4.80     26,246         4.43

IT consulting & other services

     48,943         4.23             0.00

Internet software & services

     43,846         3.79             0.00

Construction and engineering

     43,236         3.74     24,987         4.22

Leisure facilities

     38,041         3.29     6,864         1.16

Electronic equipment & instruments

     34,852         3.01     33,094         5.59

Specialty stores

     34,538         2.99             0.00

Household products

     31,213         2.70     1,065         0.18

Apparel, accessories & luxury goods

     30,986         2.68     23,536         3.97

Education services

     29,662         2.57     44,902         7.58

Fertilizers & agricultural chemicals

     28,800         2.49     26,695         4.51

Home improvement retail

     27,999         2.42     32,631         5.51

Pharmaceuticals

     27,257         2.36             0.00

Integrated telecommunication services

     25,995         2.25             0.00

Food distributors

     20,834         1.80     30,415         5.13

Healthcare technology

     20,505         1.77     21,509         3.63

Human resources & employment services

     20,457         1.77             0.00

Electronic manufacturing services

     20,190         1.75     18,738         3.16

Advertising

     19,892         1.72     19,828         3.35

Auto parts & equipment

     18,883         1.63             0.00

Distributors

     18,631         1.61     13,351         2.25

Air freight & logistics

     17,984         1.56     14,005         2.36

Trucking

     17,065         1.48     17,065         2.88

Environmental & facilities services

     16,311         1.41     8,922         1.51

Restaurants

     13,966         1.21     12,485         2.11

Leisure products

     13,564         1.17             0.00

Diversified financial services

     13,311         1.15             0.00

Data processing & outsourced services

     12,775         1.10     13,078         2.21

Industrial machinery

     10,457         0.90     10,143         1.71

Construction materials

     6,736         0.58     17,476         2.95

Building products

     6,689         0.58     8,292         1.40

Housewares & specialties

     5,319         0.46     12,195         2.06

Multi-sector holdings

     907         0.09     169         0.02

Movies & entertainment

     199         0.02     200         0.03

Food retail

             0.00     19,622         3.31
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 1,156,082         100.00   $ 592,497         100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

     September 30, 2011     September 30, 2010  

Fair Value:

          

Healthcare services

   $ 231,478         20.67   $ 89,262         15.83

Oil & gas equipment services

     82,696         7.38             0.00

Healthcare equipment

     71,911         6.42     48,298         8.57

Diversified support services

     56,232         5.02     26,246         4.66

IT consulting & other services

     49,528         4.42             0.00

Internet software & services

     43,786         3.91             0.00

Leisure facilities

     38,447         3.43     7,040         1.25

Construction and engineering

     35,814         3.20     23,845         4.23

Specialty stores

     35,198         3.14             0.00

Electronic equipment & instruments

     34,863         3.11     32,888         5.83

Apparel, accessories & luxury goods

     33,595         3.00     23,549         4.18

Education services

     30,176         2.69     42,111         7.47

Household products

     29,943         2.67     1,065         0.19

Fertilizers & agricultural chemicals

     29,190         2.61     26,812         4.76

Home improvement retail

     27,576         2.46     32,484         5.76

Pharmaceuticals

     27,500         2.46             0.00

Integrated telecommunication services

     26,374         2.36             0.00

Food distributors

     21,006         1.88     30,317         5.38

Human resources & employment services

     20,952         1.87             0.00

Healthcare technology

     20,947         1.87     22,141         3.93

Advertising

     20,183         1.80     19,847         3.52

Environmental & facilities services

     19,952         1.78     5,130         0.91

Auto parts & equipment

     19,059         1.70             0.00

Distributors

     18,938         1.69     13,258         2.35

Air freight & logistics

     17,243         1.54     14,041         2.49

Leisure products

     13,711         1.22             0.00

Diversified financial services

     13,329         1.19             0.00

Restaurants

     11,829         1.06     12,100         2.15

Industrial machinery

     10,860         0.97     10,233         1.81

Electronic manufacturing services

     8,660         0.77     18,056         3.20

Construction materials

     6,840         0.61     17,040         3.02

Building products

     4,833         0.43     6,841         1.21

Data processing & outsourced services

     3,497         0.31     12,741         2.26

Housewares & specialties

     2,526         0.23     3,700         0.66

Multi-sector holdings

     907         0.11     169         0.01

Movies & entertainment

     258         0.02     260         0.05

Trucking

             0.00     4,597         0.82

Food retail

             0.00     19,750         3.50
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 1,119,837         100.00   $ 563,821         100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

The Company’s investments are generally in small and mid-sized companies in a variety of industries. At September 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 years ended September 30, 2011 and September 30, 2010, no individual investment produced income that exceeded 10% of investment income.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

Note 4. Fee Income

The Company receives a variety of fees in the ordinary course of business. Certain fees, such as origination fees, are capitalized and amortized in accordance with ASC 310-20 Nonrefundable Fees and Other Costs. In accordance with ASC 820, the net unearned fee income balance is netted against the cost 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 years ended September 30, 2011 and 2010 was as follows:

 

     Year Ended
September 30, 2011
    Year Ended
September 30, 2010
 

Beginning accumulated unearned fee income balance

   $ 11,901      $ 5,590   

Net fees received

     18,160        11,806   

Unearned fee income recognized

     (11,728     (5,495
  

 

 

   

 

 

 

Ending unearned fee income balance

   $ 18,333      $ 11,901   
  

 

 

   

 

 

 

As of September 30, 2011, the Company had structured $7.9 million in aggregate exit fees across 11 portfolio investments upon the future exit of those investments. Exit fees are fees which are payable upon the exit of a debt investment. 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. The receipt of such fees is contingent upon a successful exit event for each of the investments. A portion of these fees is included in net investment income over the period of the loan.

 

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.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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’ partial 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 years ended September 30, 2011, 2010 and 2009:

 

     Year ended
September 30,
2011
     Year ended
September 30,
2010
     Year ended
September 30,
2009
 

Earnings per common share — basic:

        

Net increase in net assets resulting from operations

   $ 30,207       $ 22,416       $ 6,194   

Weighted average common shares outstanding — basic

     64,057         45,441         24,654   

Earnings per common share — basic

   $ 0.47       $ 0.49       $ 0.25   

Earnings per common share — diluted:

        

Net increase in net assets resulting from operations, before adjustments

   $ 30,207       $ 22,416       $ 6,194   

Adjustments for interest on convertible senior notes, base management fees, incentive fees and gain on extinguishment of convertible senior notes

     2,124                   
  

 

 

    

 

 

    

 

 

 

Net increase in net assets resulting from operations, as adjusted

   $ 32,331       $ 22,416       $ 6,194   

Weighted average common shares outstanding — basic

     64,057         45,441         24,654   

Adjustments for dilutive effect of senior convertible notes

     4,659                   
  

 

 

    

 

 

    

 

 

 

Weighted average common shares outstanding — diluted

     68,716         45,441         24,654   

Earnings per common share — diluted

   $ 0.47       $ 0.49       $ 0.25   

 

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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 September 30, 2011:

 

Date Declared

   Record
Date
     Payment
Date
     Amount
per Share
     Cash
Distribution
     DRIP Shares
Issued
    DRIP Shares
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   

5/2/2011

     7/1/2011         7/29/2011         0.1066         7.1 million         58,829 (1)      0.6 million   

5/2/2011

     8/1/2011         8/31/2011         0.1066         7.1 million         64,431 (1)      0.6 million   

5/2/2011

     9/1/2011         9/30/2011         0.1066         7.2 million         52,487 (1)      0.5 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

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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.

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 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 uses 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 September 30, 2011, the Company had $39.5 million of borrowings outstanding under the Wells Fargo facility, which had a fair value of $39.5 million.

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

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

lenders party thereto from time to time and ING Capital LLC, as administrative agent. The ING facility allowed 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 the Company’s wholly-owned subsidiary, FSFC Holdings, Inc., and its indirect wholly-owned subsidiary, Fifth Street Fund of Funds LLC, subject to certain exclusions for, among other things, equity interests in any of the Company’s SBIC subsidiaries, and equity interests in Funding and Funding II 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., ING Capital LLC, as collateral agent, and the Company. None of the Company’s SBIC subsidiaries, Funding or Funding II 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.

On July 8, 2011, the Company amended the ING facility to, among other things, expand the borrowing capacity to $230 million and increase the accordion feature to allow for potential future expansion up to a total of $350 million. In addition, the ING facility’s interest rate was reduced to LIBOR plus 3.0% per annum, with no LIBOR floor, when the facility is drawn more than 35%. Otherwise, the interest rate will be LIBOR plus 3.25% per annum, with no LIBOR floor.

Pursuant to the ING Security Agreement, FSFC Holdings, Inc. and Fifth Street Fund of Funds LLC 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 interest in FSFC Holdings, Inc. and FSFC Holdings, Inc. pledged its entire equity interest in Fifth Street Fund of Funds LLC 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., Fifth Street Fund of Funds LLC 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. On November 29, 2011, the Company amended the ING Credit Agreement to ensure that, based on the Company’s estimate of taxable income for the fiscal year ended September 30, 2011, the Company would remain in compliance with the annual distribution limit provision when it finalizes its taxable income amount upon the filing of its tax return in June 2012.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 September 30, 2011, the Company had $133.5 million of borrowings outstanding under the ING facility, which had a fair value of $133.5 million.

On September 16, 2011, Fifth Street Funding II, LLC, a consolidated wholly-owned bankruptcy remote, special purpose subsidiary (“Funding II”), entered into a Loan and Servicing Agreement (“Sumitomo Agreement”) with respect to a seven-year credit facility (“Sumitomo facility”) with Sumitomo Mitsui Banking Corporation (“SMBC”), an affiliate of Sumitomo Mitsui Financial Group, Inc., as administrative agent, and each of the lenders from time to time party thereto, in the amount of $200 million. The Sumitomo facility bears interest at a rate of LIBOR plus 2.25% per annum with no LIBOR floor, matures on September 16, 2018 and includes an option for a one-year extension.

In connection with the Sumitomo facility, the Company concurrently entered into a Purchase and Sale Agreement with Funding II, pursuant to which it will sell to Funding II certain loan assets the Company has originated or acquired, or will originate or acquire.

The Sumitomo Agreement and related agreements governing the Sumitomo facility required both Funding II and the Company to, among other things (i) make representations and warranties regarding the collateral as well as each of its 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 Sumitomo 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 II, and the failure by Funding II or the Company to materially perform under the Sumitomo Agreement and related agreements governing the Sumitomo 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 Sumitomo facility is secured by all of the assets of Funding II. Each loan origination under the facility is subject to the satisfaction of certain conditions. There is no assurance that Funding II will be able to borrow funds under the Sumitomo facility at any particular time or at all. As of September 30, 2011, there was $5.0 million of borrowings outstanding under the Sumitomo facility, which had a fair value of $5.0 million.

As of September 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, the ING facility or the Sumitomo facility.

Interest expense for the years ended September 30, 2011, 2010 and 2009 was $15.1 million, $1.9 million and $0.6 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.

 

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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 holds debt in its portfolio that contains PIK interest provisions. 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.

Accumulated PIK interest activity for the years ended September 30, 2011 and September 30, 2010 was as follows:

 

     Year Ended
September 30,
2011
    Year Ended
September 30,
2010
 

PIK balance at beginning of period

   $ 19,301      $ 12,059   

Gross PIK interest accrued

     14,526        11,907   

PIK income reserves

     (851     (1,903

PIK interest received in cash

     (9,988     (1,619

Loan exits

     (316     (1,143
  

 

 

   

 

 

 

PIK balance at end of period

   $ 22,672      $ 19,301   
  

 

 

   

 

 

 

As of September 30, 2011, the Company had stopped accruing cash interest, PIK interest and original issue discount (“OID”) on four investments that had not paid all of their scheduled cash interest payments for the period ended September 30, 2011. As of September 30, 2010, the Company had stopped accruing cash interest, PIK interest and OID on five investments that had not paid all of their scheduled cash interest payments for the period ended September 30, 2010. As of September 30, 2009, the Company had stopped accruing PIK interest and OID on five investments, including two investments that had not paid all of their scheduled cash interest payments for the period ended September 30, 2009.

Cash non-accrual status is inclusive of PIK and other noncash income, where applicable. The percentages of the Company’s portfolio investments at cost and fair value by accrual status for the periods ended September 30, 2011, September 30, 2010 and September 30, 2009 were as follows:

 

    September 30, 2011     September 30, 2010     September 30, 2009  
    Cost     % of
Portfolio
    Fair
Value
    % of
Portfolio
    Cost     % of
Portfolio
    Fair
Value
    % of
Portfolio
    Cost     % of
Portfolio
    Fair
Value
    % of
Portfolio
 

Accrual

  $ 1,116,762        96.60   $ 1,111,986        99.30   $ 530,965        89.61   $ 531,701        94.30   $ 277,335        84.75   $ 271,420        90.59

PIK non-accrual

           0.00            0.00            0.00            0.00     20,787        6.35     12,639        4.22

Cash non-accrual

    39,320        3.40     7,851        0.70     61,532        10.39     32,120        5.70     29,110        8.90     15,552        5.19
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 1,156,082        100.00   $ 1,119,837        100.00   $ 592,497        100.00   $ 563,821        100.00   $ 327,232        100.00   $ 299,611        100.00
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

The non-accrual status of the Company’s portfolio investments as of September 30, 2011, September 30, 2010, and September 30, 2009 was as follows:

 

     September 30, 2011      September 30, 2010      September 30, 2009  

Lighting by Gregory, LLC

     Cash non-accrual         Cash non-accrual         Cash non-accrual   

CPAC, Inc.

                     PIK non-accrual   

MK Network, LLC

             Cash non-accrual           

Martini Park, LLC

                     PIK non-accrual   

Vanguard Vinyl, Inc.

             Cash non-accrual           

Nicos Polymers & Grinding, Inc.

             Cash non-accrual         PIK non-accrual   

Premier Trailer Leasing, Inc.

     Cash non-accrual         Cash non-accrual         Cash non-accrual   

Repechage Investments Limited

     Cash non-accrual                   

O’Currance, Inc.

     Cash non-accrual                   

Income non-accrual amounts related to the above investments for the years ended September 30, 2011, September 30, 2010 and September 30, 2009 were as follows:

 

     Year ended
September 30, 2011
     Year ended
September 30, 2010
     Year ended
September 30, 2009
 

Cash interest income

   $ 5,815       $ 5,804       $ 2,938   

PIK interest income

     851         1,903         1,398   

OID income

     105         329         403   
  

 

 

    

 

 

    

 

 

 

Total

   $ 6,771       $ 8,036       $ 4,739   
  

 

 

    

 

 

    

 

 

 

 

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, 2011, the Company has net loss carryforwards of $11.8 million to offset net capital gains, to the extent provided by federal tax law. Of the capital loss carryforwards, $1.5 million will expire on September 30, 2017 and $10.3 million will expire on September 30, 2019. During the year ended September 30, 2011, the Company realized capital losses from the sale of investments after October 31, 2010 and prior to year end (“post-October capital losses”) of $29.9 million, which for tax purposes are treated as arising on the first day of the following year.

Listed below is a reconciliation of “net increase in net assets resulting from operations” to taxable income for the year ended September 30, 2011.

 

Net increase in net assets resulting from operations

   $ 30,207   

Net unrealized depreciation

     6,527   

Book/tax difference due to deferred loan origination fees, net

     6,432   

Book/tax difference due to organizational and offering costs

     (87

Book/tax difference due to interest income on certain loans

     (3,572

Book/tax difference due to capital losses not recognized

     30,394   

Other book-tax differences

     (127
  

 

 

 

Taxable/Distributable Income(1)

   $ 69,774   
  

 

 

 

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

 

(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.

As of September 30, 2011, the components of accumulated undistributed income on a tax basis were as follows:

 

Undistributed ordinary income, net (RIC status)

   $   

Realized capital losses

     (11,810

Unrealized losses, net

     (38,780

Accumulated partnership taxable income not subject to distribution

     6,236   

Other book-tax differences

     (57,363

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. The Company has recorded a deferred tax asset for the difference in the book and tax basis of certain equity investments and tax net operating losses held by its taxable subsidiaries of $1.4 million. However, this amount has been fully offset by a valuation allowance of $1.4 million, since it is more likely than not that these deferred tax assets will not be realized.

On December 22, 2010, the Regulated Investment Company Modernization Act of 2010 (the “Act”) was enacted, which changed various technical rules governing the tax treatment of regulated investment companies. The changes are generally effective for taxable years beginning after the date of enactment. Under the Act, the Company will be permitted to carryforward net capital losses incurred in taxable years beginning after the date of enactment for an unlimited period. However, any losses incurred during those future taxable years will be required to be utilized prior to the losses incurred in pre-enactment taxable years, which carry an expiration date. As a result of this ordering rule, pre-enactment net loss carryforwards may be more likely to expire unused.

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 taxable 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.

 

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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         12/29/0209       $ 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         9/1/2011         9/30/2011       $ 0.1066   

Monthly

     8/1/2011         10/14/2011         10/31/2011       $ 0.1066   

Monthly

     8/1/2011         11/15/2011         11/30/2011       $ 0.1066   

Monthly

     8/1/2011         12/13/2011         12/23/2011       $ 0.1066   

For income tax purposes, the Company estimates that its distributions will be composed primarily 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 and Net Unrealized Appreciation or Depreciation on Investments and Interest Rate Swaps

Realized gain or loss is the difference between the proceeds received from dispositions of portfolio investments or interest rate swaps 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.

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,

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 unrealized appreciation or depreciation on investments or interest rate swaps 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.

During the year ended September 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;

 

   

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;

 

   

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;

 

   

In July 2011, the Company received a cash payment of $7.3 million from Filet of Chicken 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 July 2011, the Company received a cash payment of $19.8 million from Cenegenics, 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;

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

   

In August 2011, the Company terminated its interest rate swap agreement and realized a loss of $1.3 million, which included a reclassification of $0.8 million of prior unrealized depreciation;

 

   

In September 2011, the Company received a cash payment of $19.1 million from Flatout, 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; and

 

   

In September 2011, the Company received a cash payment of $0.1 million in connection with the sale of its investment in CPAC, Inc. The Company recorded a realized loss on this investment in the amount of $1.0 million.

During the year ended September 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;

 

   

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 interest in CPAC, Inc.;

 

   

In August 2010, the Company received a cash payment of $7.6 million from Storyteller Theaters Corporation in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction;

 

   

In September 2010, the Company restructured its investment in Rail Acquisition Corp. Although the full amount owed under the loan agreement remained intact, the restructuring resulted in a material modification of the terms of the loan agreement. As such, the Company recorded a realized loss in the amount of $2.6 million in accordance with ASC 470-50;

 

   

In September 2010, the Company sold its investment in Martini Park, LLC and received a cash payment in the amount of $0.1 million. The Company recorded a realized loss on this investment in the amount of $4.0 million; and

 

   

In September 2010, the Company exited its investment in Rose Tarlow, Inc. and received a cash payment in the amount of $3.6 million in full settlement of the debt investment. The Company recorded a realized loss on this investment in the amount of $9.3 million.

During the year ended September 30, 2009, the Company exited its investment in American Hardwoods Industries, LLC and recorded a realized loss of $10.4 million, and recorded a $4.0 million realized loss on one of its portfolio company investments in connection with the determination that the investment was permanently impaired based on, among other things, analysis of changes in the portfolio company’s business operations and prospects.

During the years ended September 30, 2011, 2010 and 2009, the Company recorded net unrealized depreciation of $6.5 million, $1.8 million and $10.8 million, respectively. For the year ended September 30, 2011, the Company’s net unrealized depreciation consisted of $34.6 million of net unrealized depreciation on debt investments, offset by $25.6 million of net reclassifications to realized losses on investments and interest rate swaps (resulting in unrealized appreciation) and $2.5 million of net unrealized appreciation on equity investments.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

For the year ended September 30, 2010, the Company’s net unrealized depreciation consisted of $19.1 million of net unrealized depreciation on debt investments and $0.8 million of net unrealized depreciation on interest rate swaps, offset by $17.6 million of reclassifications to realized losses on investments (resulting in unrealized appreciation) and $0.5 million of net unrealized appreciation on equity investments.

For the year ended September 30, 2009, the Company’s net unrealized depreciation consisted of $23.1 million of net unrealized depreciation on debt investments and $2.0 million of net unrealized depreciation on equity investments, offset by $14.3 million of reclassifications to realized losses on investments (resulting in unrealized appreciation).

 

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 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.

In addition to the proration described above, for the year ended September 30, 2009, the Investment Advisor waived $0.2 million of the base management fee on a portion of the proceeds raised in connection with the equity offerings the Company completed in 2009 and which were held in cash or cash equivalents at September 30, 2009.

Also, 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 elsewhere in the notes to the Company’s Consolidated Financial Statements.

For the years ended September 30, 2011, 2010 and 2009, base management fees were $19.7 million, $9.3 million and $5.9 million, respectively. At September 30, 2011, the Company had a liability on its

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

Consolidated Statement of Assets and Liabilities in the amount of $5.7 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

 

   

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.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 years ended September 30, 2011, 2010 and 2009, incentive fees were $16.8 million, $10.8 million and $7.8 million, respectively. At September 30, 2011, the Company had a liability on its Consolidated Statement of Assets and Liabilities in the amount of $5.0 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 year ended September 30, 2011, the Company accrued administrative expenses of $2.8 million, including $1.1 million of general and administrative expenses, which are due to FSC, Inc. At September 30, 2011, $1.5 million was included in Due to FSC, Inc. in the Consolidated Statement of Assets and Liabilities.

 

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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

 

     Year Ended
September 30,
2011
    Year Ended
September 30,
2010
    Year Ended
September 30,
2009
 

Net asset value at beginning of period

   $ 10.43      $ 10.84      $ 13.02   

Net investment income

     1.05        0.95        1.27   

Net unrealized depreciation on investments and interest rate swap

     (0.10     (0.04     (0.44

Net realized loss on investments and interest rate swap

     (0.47     (0.42     (0.58

Dividends paid

     (1.26     (0.96     (1.20

Issuance of common stock

     0.42        0.06        (1.21

Repurchases of common stock

                   (0.02
  

 

 

   

 

 

   

 

 

 

Net asset value at end of period

   $ 10.07      $ 10.43      $ 10.84   
  

 

 

   

 

 

   

 

 

 

Per share market value at beginning of period

   $ 11.14      $ 10.93      $ 10.05   

Per share market value at end of period

   $ 9.32      $ 11.14      $ 10.93   

Total return(1)

     (6.76 )%      11.22     26.86

Common shares outstanding at beginning of period

     54,550        37,879        22,614   

Common shares outstanding at end of period

     72,376        54,550        37,879   

Net assets at beginning of period

   $ 569,172      $ 410,556      $ 294,336   

Net assets at end of period

   $ 728,627      $ 569,172      $ 410,556   

Average net assets(2)

   $ 677,354      $ 479,004      $ 291,401   

Ratio of net investment income to average net assets

     9.91     8.98     10.76

Ratio of total expenses to average net assets

     8.79     5.74     6.34

Ratio of portfolio turnover to average investments at fair value

     7.26     2.24     0.00

Weighted average outstanding debt(3)

   $ 247,549      $ 22,592      $ 5,019   

Average debt per share

   $ 3.86      $ 0.50      $ 0.20   

 

(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 during interim periods.

 

(2) Calculated based upon the weighted average net assets for the period.

 

(3) Calculated based upon the weighted average of loans payable for the period.

 

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.

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 paid a fixed interest rate of 0.99% and received a floating rate based on the prevailing one-month LIBOR.

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.

In August 2011, the Company terminated the swap agreement and realized a loss of $1.3 million, which includes a reclassification of $0.8 million of prior unrealized depreciation.

 

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 a monthly dividend of $0.1066 per share, 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

 

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FIFTH STREET FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

 

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 year ended September 30, 2011, the Company recorded interest expense of $4.1 million related to the Convertible Notes.

The Company may, to the extent permitted by law, repurchase the Convertible Notes in the open market or by tender offer at any price or by private agreement without giving prior notice to holders. Any Convertible Notes repurchased by the Company may, at the Company’s option, be surrendered to the Trustee for cancellation, but may not be reissued or resold by the Company. Any Convertible Notes surrendered for cancellation will be promptly cancelled and no longer outstanding under the indenture. During the year ended September 30, 2011, the Company repurchased, and surrendered to the Trustee for cancellation, Convertible Notes as follows:

 

Trade Date

   Settlement
Date
     Principal
Repurchased
     Purchase
Price
 

8/1/2011

     8/4/2011       $ 2,000       $ 1,820   

8/3/2011

     8/8/2011         5,000         4,525   

8/5/2011

     8/10/2011         10,000         8,725   
     

 

 

    

 

 

 

Total

  

   $ 17,000       $ 15,070   
     

 

 

    

 

 

 

During the year ended September 30, 2011, the Company recorded a gain on the extinguishment of these Convertible Notes in the amount of the difference between the reacquisition price and the net carrying amount, net of the proportionate amount of unamortized debt issuance costs. The net gain recorded was $1.5 million.

As of September 30, 2011, there were $135.0 million Convertible Notes outstanding, which had a fair value of $113.4 million.

 

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Schedule 12-14

Fifth Street Finance Corp.

(in thousands, except share and per share amounts, percentages and as otherwise indicated)

Schedule of Investments in and Advances to Affiliates

 

Portfolio Company/Type of Investment(1)

   Amount of
Interest,
Fees or
Dividends
Credited in
Income(2)
     Fair Value
at October 1,
2010
     Gross
Additions(3)
     Gross
Reductions(4)
    Fair Value
at September 30,
2011
 

Control Investments

             

Lighting by Gregory, LLC

             

First Lien Term Loan A, 9.75% PIK due 2/28/2013

   $ 12       $ 1,504       $ 3,296       $ (2,274   $ 2,526   

First Lien Term Loan B, 14.5% PIK due 2/28/2013

     114         2,196         4,824         (7,020       

First Lien Bridge Loan, 8% PIK due 3/31/2012

     10                 38         (38       

97.38% membership interest

                     800         (800 )       

Nicos Polymers & Grinding Inc.

             

First Lien Term Loan, 8% cash due 12/4/2017

     357                 5,486         (296 )     5,190   

First Lien Revolver, 8% cash due 12/4/2017

     69                 1,551                1,551   

50% membership interest

                     7,633         (2,400 )     5,233   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total Control Investments

   $ 562       $ 3,700       $ 23,628       $ (12,828   $ 14,500   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Affiliate Investments

             

O’Currance, Inc.

             

First Lien Term Loan A, 12.875% cash 4% PIK due 3/21/2012

     1,623         10,806         647         (8,280     3,173   

First Lien Term Loan B, 12.875% cash 4% PIK due 3/21/2012

     258         1,897         103         (1,676     324   

1.75% Preferred Membership Interest in O’Currance Holding Co., LLC

             39         27         (66       

3.3% Membership Interest in O’Currance Holding Co., LLC

                                      

MK Network, LLC

             

First Lien Term Loan A, 13.5% cash due 6/1/2012

     73         7,913         8,558         (16,471       

First Lien Term Loan B, 17.5% cash due 6/1/2012

     76         3,939         4,824         (8,763       

11,030 Membership Units

                     772         (772 )       

Caregiver Services, Inc.

             

Second Lien Term Loan A, LIBOR+6.85% (5.15% floor) cash due 2/25/2013

     903         7,112         244         (1,513     5,843   

Second Lien Term Loan B, 12.5% cash 4% PIK due 2/25/2013

     2,988         14,180         1,423         (536     15,067   

1,080,399 shares of Series A Preferred Stock

             1,336         161         (7 )     1,490   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total Affiliate Investments

   $ 5,921       $ 47,222       $ 16,759       $ (38,084   $ 25,897   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total Control & Affiliate Investments

   $ 6,483       $ 50,922       $ 40,387       $ (50,912   $ 40,397   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

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This schedule should be read in connection with the Company’s Consolidated Financial Statements, including the Consolidated Schedules of Investments and Notes to the Consolidated Financial Statements.

 

(1) The principal amount and ownership detail as shown in the Consolidated Schedules of Investments.

 

(2) Represents the total amount of interest, fees and dividends credited to income for the portion of the year an investment was included in the Control or Non-Control/Non-Affiliate categories, respectively.

 

(3) Gross additions include increases in the cost basis of investments resulting from new portfolio investments, follow-on Investments and accrued PIK interest, and the exchange of one or more existing securities for one or more new securities. Gross additions also include net increases in unrealized appreciation or net decreases in unrealized depreciation as well as the movement of an existing portfolio company into this category or out of a different category.

 

(4) Gross reductions include decreases in the cost basis of investment resulting from principal payments or sales and exchanges of one or more existing securities for one or more new securities. Gross reductions also include net increases in unrealized depreciation or net decreases in unrealized appreciation as well as the movement of an existing portfolio company out of this category and into a different category.

 

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Schedule 12-14

Fifth Street Finance Corp.

Schedule of Investments in and Advances to Affiliates

 

Portfolio Company/Type of Investment(1)

  Amount of
Interest,
Fees or
Dividends
Credited in
Income(2)
    Fair Value
at October 1,
2009
    Gross
Additions(3)
    Gross
Reductions(4)
    Fair Value
at September 30,
2010
 

Control Investments

         

Lighting by Gregory, LLC

         

First Lien Term Loan A, 9.75% PIK due 2/28/2013

  $ 83      $ 2,420      $      $ (916 )   $ 1,504   

First Lien Term Loan B, 14.5% PIK due 2/28/2013

    100        3,271               (1,075     2,196   

First Lien Bridge Loan, 8% Cash due 10/15/2010

                  150        (150       

97.38% membership interest

                                  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Control Investments

  $ 183      $ 5,691      $ 150      $ (2,141   $ 3,700   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Affiliate Investments

         

O’Currance, Inc.

         

First Lien Term Loan A, 12.875% cash 4% PIK due 3/21/2012

    1,929        10,187        899        (280     10,806   

First Lien Term Loan B, 12.875% cash 4% PIK due 3/21/2012

    421        2,919        152        (1,174     1,897   

1.75% Preferred Membership Interest in O’Currance Holding Co., LLC

           130               (91     39   

3.3% Membership Interest in O’Currance Holding Co., LLC

           54               (54       

CPAC, Inc.

         

Second Lien Term Loan, 17.5% PIK due 4/13/2012

    1,235        4,449        3,625        (8,074       

2,297 shares of Common Stock

                                  

Elephant & Castle, Inc.

         

Second Lien Term Loan, 15.5% due 4/20/2012

    68        7,312        310        (7,622       

7,500 shares of Series A Preferred Stock

           492               (492       

MK Network, LLC

         

First Lien Term Loan A, 13.5% cash due 6/1/2012

    1,460        9,034        510        (1,631     7,913   

First Lien Term Loan B, 17.5% cash due 6/1/2012

    958        5,164        335        (1,560     3,939   

First Lien Revolver, Prime +1.5% (10% floor), due 6/1/2010

                                  

11,030 Membership Units

                                  

Martini Park, LLC

         

First Lien Term Loan, 12% cash 2% PIK due 2/20/2013

    229        2,068        3,632        (5,700       

5% membership interest

                  650        (650       

Caregiver Services, Inc.

         

Second Lien Term Loan A, LIBOR+6.85% (5.15% floor) cash due 2/25/2013

    1,084        8,225        372        (1,485     7,112   

Second Lien Term Loan B, 12.5% cash 4% PIK due 2/25/2013

    2,895        13,508        1,356        (684     14,180   

1,080,399 shares of Series A Preferred Stock

           1,207        129               1,336   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Affiliate Investments

  $ 10,279      $ 64,749      $ 11,970      $ (29,497   $ 47,222   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Control & Affiliate Investments

  $ 10,462      $ 70,440      $ 12,120      $ (31,638   $ 50,922   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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This schedule should be read in connection with the Company’s Consolidated Financial Statements, including the Consolidated Schedules of Investments and Notes to the Consolidated Financial Statements.

 

(1) The principal amount and ownership detail as shown in the Consolidated Schedules of Investments.

 

(2) Represents the total amount of interest, fees and dividends credited to income for the portion of the year an investment was included in the Control or Non-Control/Non-Affiliate categories, respectively.

 

(3) Gross additions include increases in the cost basis of investments resulting from new portfolio investments, follow-on Investments and accrued PIK interest, and the exchange of one or more existing securities for one or more new securities. Gross additions also include net increases in unrealized appreciation or net decreases in unrealized depreciation as well as the movement of an existing portfolio company into this category or out of a different category.

 

(4) Gross reductions include decreases in the cost basis of investment resulting from principal payments or sales and exchanges of one or more existing securities for one or more new securities. Gross reductions also include net increases in unrealized depreciation or net decreases in unrealized appreciation as well as the movement of an existing portfolio company out of this category and into a different category.

 

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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

 

Item 9A. Controls and Procedures

 

(a)    Evaluation of Disclosure Controls and Procedures

As of September 30, 2011 (the end of the period covered by this report), management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934, as amended). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, at the end of such period, our disclosure controls and procedures were effective and provided reasonable assurance that information required to be disclosed in our periodic SEC filings is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. However, in evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of such possible controls and procedures.

 

(b)    Management’s Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rule 13a-15(f), and for performing an assessment of the effectiveness of internal control over financial reporting as of September 30, 2011. Internal control over financial reporting is a process designed by, or under the supervision of, our principal executive and principal financial officers, or persons performing similar functions, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Management performed an assessment of the effectiveness of our internal control over financial reporting as of September 30, 2011 based upon the criteria set forth in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our assessment, management determined that our internal control over financial reporting was effective as of September 30, 2011.

 

(c)    Report of the Independent Registered Public Accounting Firm

The effectiveness of our internal control over financial reporting as of September 30, 2011 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.

 

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(d)    Changes in Internal Controls Over Financial Reporting

There have been no changes in our internal control over financing reporting that occurred during the fourth fiscal quarter of 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Item 9B. Other Information

On November 29, 2011, based on our estimate of taxable income for the fiscal year ended September 30, 2011, we entered into Amendment No. 2 to Amended and Restated Senior Secured Revolving Credit Agreement, among us, FSFC Holdings, Inc., Fifth Street Fund of Funds LLC, ING Capital LLC, Key Equipment Finance, Inc. and UBS Loan Finance LLC to increase the percentage of annual taxable income that we are permitted to distribute to our stockholders under the ING Credit Agreement from 105% to 115% for the taxable year ended September 30, 2011 and 120% for the calendar year ending December 31, 2011.

The foregoing description of this amendment to the ING Credit Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of Amendment No. 2 to Amended and Restated Senior Secured Revolving Credit Agreement, filed as Exhibit 10.15 to this Form 10-K.

 

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PART III

We will file a definitive Proxy Statement for our 2012 Annual Meeting of Stockholders with the Securities and Exchange Commission, pursuant to Regulation 14A, not later than 120 days after the end of our fiscal year. Accordingly, certain information required by Part III has been omitted under General Instruction G(3) to Form 10-K. Only those sections of our definitive Proxy Statement that specifically address the items set forth herein are incorporated by reference.

 

Item 10. Directors, Executive Officers and Corporate Governance

The information required by Item 10 is hereby incorporated by reference from our definitive Proxy Statement relating to our 2012 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of our fiscal year.

 

Item 11. Executive Compensation

The information required by Item 11 is hereby incorporated by reference from our definitive Proxy Statement relating to our 2012 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of our fiscal year.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by Item 12 is hereby incorporated by reference from our definitive Proxy Statement relating to our 2012 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of our fiscal year.

 

Item 13. Certain Relationships and Related Transactions, and Director Independence

The information required by Item 13 is hereby incorporated by reference from our definitive Proxy Statement relating to our 2012 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of our fiscal year.

 

Item 14. Principal Accountant Fees and Services

The information required by Item 14 is hereby incorporated by reference from our definitive Proxy Statement relating to our 2012 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of our fiscal year.

 

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PART IV

 

Item 15. Exhibits and Financial Statement Schedules

The following documents are filed or incorporated by reference as part of this Annual Report:

 

1.   Consolidated Financial Statements

 

     Page  

Reports of Independent Registered Public Accounting Firms

     77   

Consolidated Statements of Assets and Liabilities as of September 30, 2011 and 2010

     79   

Consolidated Statements of Operations for the Years Ended September 30, 2011, 2010 and 2009

     80   

Consolidated Statements of Changes in Net Assets for the Years Ended September 30, 2011, 2010 and 2009

     81   

Consolidated Statements of Cash Flows for the Years Ended September 30, 2011, 2010 and 2009

     82   

Consolidated Schedules of Investments as of September 30, 2011 and 2010

     83   

Notes to Consolidated Financial Statements

     97   

 

2.   Financial Statement Schedule

The following financial statement schedule is filed herewith:

 

Schedule 12-14 — Investments in and advances to affiliates

     131   

 

3.   Exhibits required to be filed by Item 601 of Regulation S-K

The following exhibits are filed as part of this report or hereby incorporated by reference to exhibits previously filed with the SEC:

 

  3.1    Restated Certificate of Incorporation of the Registrant (Incorporated by reference to Exhibit 3.1 filed with Fifth Street Finance Corp.’s Form 8-A (File No. 001-33901) filed on January 2, 2008).
  3.2    Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation (Incorporated by reference to Exhibit (a)(2) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-146743) filed on June 6, 2008).
  3.3    Certificate of Correction to the Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation (Incorporated by reference to Exhibit (a)(3) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-146743) filed on June 6, 2008).
  3.4    Certificate of Amendment to Registrant’s Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.1 filed with Fifth Street Finance Corp.’s Quarterly Report on Form 10-Q (File No. 814-0075) filed on May 5, 2010).
  3.5    Amended and Restated By-laws of the Registrant (Incorporated by reference to Exhibit 3.2 filed with Fifth Street Finance Corp.’s Form 8-A (File No. 001-33901) filed on January 2, 2008).
  4.1    Form of Common Stock Certificate (Incorporated by reference to Exhibit 4.1 filed with Fifth Street Finance Corp.’s Form 8-A (File No. 001-33901) filed on January 2, 2008).
  4.2    Indenture, dated April 12, 2011, between Registrant and Deutsche Bank Trust Company Americas, as trustee (Incorporated by reference to Exhibit 4.1 filed with Fifth Street Finance Corp.’s Form 8-K (File No. 001-33901) filed on April 12, 2011).
  4.3    Form of 5.375% Convertible Senior Notes due 2016 (Incorporated by reference to Exhibit 4.2 filed with Fifth Street Finance Corp.’s Form 8-K (File No. 001-33901) filed on April 12, 2011).

 

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10.1    Amended and Restated Dividend Reinvestment Plan (Incorporated by reference to Exhibit 10.1 filed with Fifth Street Finance Corp.’s Form 8-K (File No. 001-33901) filed on October 28, 2010).
10.2    Second Amended and Restated Investment Advisory Agreement by and between Registrant and Fifth Street Management LLC (Incorporated by reference to Exhibit 10.5 filed with Fifth Street Finance Corp.’s Quarterly Report on Form 10-Q (File No. 001-33901) filed on May 4, 2011).
10.3    Custody Agreement, dated January 31, 2011, by and between Fifth Street Finance Corp. and U.S. Bank National Association (Incorporated by reference to Exhibit 10.1 filed with Fifth Street Finance Corp.’s Quarterly Report on Form 10-Q (File No. 814-00755) filed on January 31, 2011).
10.4    Amended and Restated Administration Agreement by and between Registrant and FSC, Inc. (Incorporated by reference to Exhibit 10.6 filed with Fifth Street Finance Corp.’s Quarterly Report on Form 10-Q (File No. 001-33901) filed on May 4, 2011).
10.5    Form of License Agreement by and between Registrant and Fifth Street Capital LLC (Incorporated by reference to Exhibit(k)(2) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-146743) filed on May 8, 2008).
10.6    Amended and Restated Loan and Servicing Agreement among Registrant, Fifth Street Funding, LLC, Wells Fargo Securities, LLC and Wells Fargo Bank, N.A., dated as of November 5, 2010 (Incorporated by reference to Exhibit 10.6 filed with Fifth Street Finance Corp.’s Annual Report on Form 10-K (File No. 814-00755) filed on December 2, 2010).
10.7    Amendment No. 1 to the Amended and Restated Loan and Servicing Agreement among Registrant, Fifth Street Funding, LLC, Wells Fargo Securities, LLC and Wells Fargo Bank, N.A., dated as of February 25, 2011 (Incorporated by reference to Exhibit(k)(4) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-166012) filed on March 30, 2011).
10.8    Purchase and Sale Agreement by and between Registrant and Fifth Street Funding, LLC, dated as of November 16, 2009 (Incorporated by reference to Exhibit 10.7 filed with Fifth Street Finance Corp.’s Annual Report on Form 10-K (File No. 814-00755) filed on December 9, 2009).
10.9    Pledge Agreement by and between Registrant and Wells Fargo Bank, N.A., dated as of November 16, 2009 (Incorporated by reference to Exhibit 10.8 filed with Fifth Street Finance Corp.’s Annual Report on Form 10-K (File No. 814-00755) filed on December 9, 2009).
10.10    Omnibus Amendment No. 1 relating to Registrant’s credit facility with Wells Fargo Bank, N.A., dated as of May 26, 2010 (Incorporated by reference to Exhibit(k)(6) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-166012) filed on June 4, 2010).
10.11    Amended and Restated Senior Secured Revolving Credit Agreement among Registrant, ING Capital LLC, Royal Bank of Canada, UBS Loan Finance, LLC, Morgan Stanley Bank, N.A., Key Equipment Finance Inc., Deutsche Bank Trust Company Americas and Patriot National Bank, dated as of February 22, 2011 (Incorporated by reference to Exhibit(k)(8) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-166012) filed on March 30, 2011).
10.12    Guarantee, Pledge and Security Agreement among Registrant, FSFC Holdings, Inc. and ING Capital LLC, dated as of May 27, 2010 (Incorporated by reference to Exhibit(k)(8) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-166012) filed on June 4, 2010).
10.13    Amendment and Reaffirmation Agreement among Registrant, FSFC Holdings, Inc., Fifth Street Fund of Funds LLC and ING Capital LLC, dated as of February 22, 2011 (Incorporated by reference to Exhibit(k)(10) filed with Fifth Street Finance Corp.’s Registration Statement on Form N-2 (File No. 333-166012) filed on March 30, 2011).

 

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10.14    Amendment No. 1 to Amended and Restated Senior Secured Revolving Credit Agreement and Amendment No. 2 to the Guarantee, Pledge and Security Agreement, among Registrant, FSFC Holdings, Inc., Fifth Street Fund of Funds LLC, ING Capital LLC, Royal Bank of Canada, UBS Loan Finance LLC, Morgan Stanley Bank, N.A., Key Equipment Finance, Inc., Deutsche Bank Trust Company Americas and Patriot National Bank, dated as of July 8, 2011. (Incorporated by reference to Exhibit 10.1 filed with Fifth Street Finance Corp.’s Form 8-K (File No. 001-33901) filed on July 14, 2011).
10.15*    Amendment No. 2 to Amended and Restated Senior Secured Revolving Credit Agreement among Registrant, FSFC Holdings, Inc., Fifth Street Fund of Funds LLC, ING Capital LLC, Key Equipment Finance, Inc. and UBS Loan Finance LLC, dated as of November 29, 2011.
10.16    Incremental Assumption Agreement among Registrant, FSFC Holdings, Inc., Fifth Street Fund of Funds LLC, ING Capital LLC and Royal Bank of Canada, dated as of July 8, 2011. (Incorporated by reference to Exhibit 10.2 filed with Fifth Street Finance Corp.’s Form 8-K (File No. 001-33901) filed on July 14, 2011).
10.17*    Waiver Letter among Registrant, FSFC Holdings, Inc., Fifth Street Fund of Funds LLC, ING Capital LLC, Royal Bank of Canada and Key Equipment Finance, Inc., dated as of August 3, 2011.
10.18*    Loan and Servicing Agreement among Registrant, Fifth Street Funding II, LLC and Sumitomo Mitsui Banking Corporation, dated as of September 16, 2011.
10.19*    Purchase and Sale Agreement by and between Registrant and Fifth Street Funding II, LLC, dated as of September 16, 2011.
21   

Subsidiaries of Registrant and jurisdiction of incorporation/organizations:

Fifth Street Funding, LLC — Delaware

Fifth Street Funding II, LLC — Delaware

Fifth Street Fund of Funds LLC — Delaware

Fifth Street Mezzanine Partners IV, L.P. — Delaware

Fifth Street Mezzanine Partners V, L.P. — Delaware

FSMP IV GP, LLC — Delaware

FSMP V GP, LLC — Delaware

FSFC Holdings, Inc. — Delaware

31.1*    Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
31.2*    Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934.
32.1*    Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
32.2*    Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).

 

* Filed herewith.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

FIFTH STREET FINANCE CORP.

By:

 

/s/    Leonard M. Tannenbaum

  Leonard M. Tannenbaum
  Chairman and Chief Executive Officer

By:

 

/s/    Alexander C. Frank

  Alexander C. Frank
  Chief Financial Officer

Date: November 29, 2011

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

Signature

  

Title

 

Date

/s/    LEONARD M. TANNENBAUM

Leonard M. Tannenbaum

  

Chairman and Chief Executive Officer

(principal executive officer)

  November 29, 2011

/s/    ALEXANDER C. FRANK

Alexander C. Frank

  

Chief Financial Officer

(principal financial officer and principal accounting officer)

  November 29, 2011

/s/    BERNARD D. BERMAN

Bernard D. Berman

  

President, Secretary and Chief

Compliance Officer

  November 29, 2011

/s/    BRIAN S. DUNN

Brian S. Dunn

   Director   November 29, 2011

/s/    RICHARD P. DUTKIEWICZ

Richard P. Dutkiewicz

   Director   November 29, 2011

/s/    BYRON J. HANEY

Byron J. Haney

   Director   November 29, 2011

/s/    FRANK C. MEYER

Frank C. Meyer

   Director   November 29, 2011

/s/    DOUGLAS F. RAY

Douglas F. Ray

   Director   November 29, 2011

 

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