Fitch Places Fifth Street Finance Corp.'s 'BBB-' Rating on Negative Watch

  Fitch Places Fifth Street Finance Corp.'s 'BBB-' Rating on Negative Watch

Business Wire

NEW YORK -- July 31, 2014

Fitch Ratings has placed the Fifth Street Finance Corp.'s (FSC) 'BBB-' Issuer
Default Rating and senior unsecured debt rating on Rating Watch Negative. A
complete list of affected ratings is included at the end of this release.

KEY RATING DRIVERS

The Rating Watch Negative reflects an inconsistent dividend policy, increasing
leverage, material portfolio growth and expansion into new business verticals.
While certain of these individual concerns are also present at other Business
Development Companies (BDCs), Fitch believes the combined presence of these
factors at FSC increases the company's risk profile.

FSC recently announced a dividend increase, beginning in September 2014, which
follows a dividend cut in December 2013. The revised dividend is above current
run-rate core earnings, and suggests the potential need for increased leverage
and/or additional portfolio growth in a challenging credit environment.

FSC's dividend coverage (defined as net investment income (NII) divided by
dividends) had been consistently running below 100% when management announced
a decrease in its monthly dividend in November 2013; a move deemed prudent by
Fitch, particularly given the low-yield environment. NII has since been
in-line with the lowered dividend.

Fitch believes the announced dividend increase reflects an expectation for
incremental revenue provided by the ramp-up of FSC's senior loan fund (SLF),
which could provide increased returns. However, Fitch believes the higher
dividend level is aggressive in the face of a still challenging yield spread
environment and unsustainable non-accrual levels, and does not leave much room
for error. As a result, the higher dividend target could encourage outsized
risk taking which could include looser underwriting and/or higher sustained
leverage.

FSC's leverage has recently exceeded its articulated target of 0.6x to 0.7x
debt-to-equity, excluding SBA debt, which is exempt from regulatory asset
coverage calculations. Leverage amounted to 0.84x at March 31, 2014, or 0.97x
times including SBA debt, which Fitch views as high, even with the senior loan
focus, and compares to 0.63x average leverage for investment grade peers.
While Fitch believes leverage has likely declined since quarter-end, given the
recent $131.8 million equity raise, leverage may need to run above target in
order to sustain earnings at the new dividend level, given the tight yield
spread environment.

Fitch believes asset quality at FSC, and in the BDC sector more generally, is
at unsustainably strong levels, and the company may not have a cushion to
cover the dividend if credit quality issues arise. FSC has also been a
frequent issuer of common equity, which Fitch expects to continue, and
believes this could further pressure dividend coverage, as the distribution
burden continues to rise.

FSC has also grown the portfolio rapidly, at 50% in calendar year 2013 and 13%
in the first quarter of 2014, which compares to average growth for investment
grade peers of 18% and 3%, respectively. Fitch remains cautious about outsized
portfolio growth in the current credit environment. Vintage concentrations in
the portfolio could yield asset quality deterioration down the road, and thus,
weaken dividend coverage.

Beginning in 2013, FSC also modestly expanded into new business verticals
including venture lending and aircraft leasing which accounted for
approximately 2.9% and 3% of the portfolio at fair value, respectively, as of
March 31, 2014. FSC's underwriting acumen in these verticals is unproven,
although the company has added additional staff with relevant experience. The
ultimate performance of these verticals will take some time to observe.

RATING SENSITIVITIES

Resolution of the Rating Watch Negative will be driven by an assessment of
near-term dividend coverage, leverage, and portfolio risk. Failure to fund the
higher dividend level with core NII over the next two to three quarters would
likely result in a one notch rating downgrade, as it would speak to poor
financial planning. While ability to cover the dividend over the next two to
three quarters would be viewed positively, this on its own may not result in
the Rating Outlook being returned to Stable. Rather, a Negative Rating Outlook
may follow resolution of the Rating Watch Negative in order to reflect the
longer term concerns with respect to leverage levels, growth, new business
verticals and the broader industry competitive dynamics.

Conversely, a return to a Stable Outlook would be dependent upon a track
record of consistent dividend coverage, at the new level, the maintenance of
leverage within the targeted range, and an observation of portfolio credit
performance, given the outsized growth, relative to peers, in recent quarters,
and expansion into new product verticals and structures (SLF). The portfolio
risk profile will be analyzed in the context of portfolio mix and diversity
and underlying portfolio company leverage and yields. Fitch believes this
assessment could take 12-24 months to observe.

Additionally, Fitch sees a number of emerging industry challenges that could
pressure ratings for the industry more broadly or at least increase rating
differentiation amongst BDCs over a longer-term horizon. These challenges
include a potential increase in regulatory leverage limits and increased
competition, which are yielding tighter market spreads and looser underwriting
terms, including higher underlying portfolio company leverage and weaker
covenant packages. Should competition continue to intensify, market yields
could decline further, which would reduce earnings generation and pressure
dividend coverage for the space.

Headquartered in Greenwich, CT, FSC is an externally managed BDC, formed in
2007 with an objective to generate both current income and capital
appreciation through debt and equity investments. As of March 31, 2014, the
company had investments in 124 portfolio companies amounting to approximately
$2.7 billion at fair value.

Fitch has placed the following ratings on Rating Watch Negative:

Fifth Street Finance Corp.

--Long-term IDR 'BBB-';

--Secured debt 'BBB-';

--Unsecured debt 'BBB-'.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Global Financial Institutions Criteria' (January 2014);

--'Investment Manager and Alternative Funds Criteria' (December 2013).

Applicable Criteria and Related Research:

Global Financial Institutions Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=732397

Investment Manager and Alternative Funds Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=725057

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=843276

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Contact:

Fitch Ratings
Primary Analyst
Meghan Neenan, CFA, +1 212-908-9121
Senior Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Johann Juan, +1 312-368-3339
Director
or
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Managing Director
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