When Leonard Tannenbaum set up shop in the basement of an office building in Mount Kisco, New York, his plan for his one-man investing business was about as basic as you can get. “Early on, the idea was to make money,” Tannenbaum says. “How do I make money? How do I get an edge?”
It was 1998, and he was 27 years old, a Wharton MBA with two years as an analyst at Merrill Lynch and a couple of stints at fund firms, Bloomberg Markets reports in its May issue. He even sublet out half of the 800-square-foot (74-square-meter) space. Tannenbaum asked himself: “Is there a better mousetrap to develop?”
The mousetrap Tannenbaum built almost made him a billionaire last year. When the initial public offering of Fifth Street Asset Management was being marketed at $24 to $26 a share, Tannenbaum’s stake in the company would have been worth more than $1 billion at the upper end of the initial range.
Amid market turbulence in October, though, the stock sale was pulled. Refiled, the offering priced at $17, and shares began trading on Oct. 30. “We got two-thirds of the way there,” Tannenbaum, 43, says. On April 16, the stock traded at $11.09, making his 40.2 million Class B shares worth $446 million.
Now headquartered in a 120,000-square-foot, light-filled building in Greenwich, Connecticut, Fifth Street manages more than $6 billion altogether. Its vehicles include a $70 million long-short credit hedge fund, a private senior loan fund, and a $309 million collateralized loan obligation. Most of the firm’s assets, though, are in two publicly traded business development companies: Fifth Street Finance Corp. and Fifth Street Senior Floating Rate Corp.
For retail investors, the appeal of business development companies is simple: income. The average dividend yield of the 43 BDCs in the Wells Fargo Business Development Company Index was 8.7 percent as of April 16, according to data compiled by Bloomberg. By contrast, the average dividend yield of the 42 U.S. high-yield exchange-traded funds was 4.4 percent.
BDCs are essentially closed-end funds that finance private companies. They sell stock, borrow from banks to lever up, and use the resulting pot of money to invest in middle-market companies, mostly by originating loans but also via equity stakes. Like real estate investment trusts, BDCs avoid corporate taxes by passing at least 90 percent of their net income through to investors.
Fifth Street Asset Management’s larger BDC is $2.9 billion-in-assets Fifth Street Finance Corp., whose ticker is FSC. As of April 16, it traded at a dividend yield of 10.2 percent.
That level of yield remained after a big cut in FSC’s dividend and a plunge in its stock price. In February, FSC declared that it would pay a 6 cent dividend each month through August, down from 9.17 cents. The reduction reflected slower-than-expected growth in net investment income, Todd Owens, FSC’s CEO, said on the fund’s Feb. 9 earnings call.
After FSC reduced its payout to an annual rate of 72 cents from $1.10, the stock dropped 15 percent to trade at $7.22. “Notice what it did,” Tannenbaum says. “It traded right to a 10 percent yield.”
BDCs are regulated under the Investment Company Act of 1940, which was amended by a 1980 law that created them. The act sets a number of requirements for BDCs. For one, 70 percent of their holdings must be “qualifying assets”: securities of private U.S. companies, for example. For another, BDCs’ portfolios must be diversified in specified ways.
Each quarter in regulatory filings, BDCs list their investments, marked to fair value. As of Dec. 31, FSC held investments in 137 companies. Among them was a piece of a $195 million one-stop financing facility for BeyondTrust, a Phoenix- based cybersecurity firm. FSC’s $65.2 million piece of the first-lien term loan paid a floating rate of the London interbank offered rate plus 7 percent, with a 1 percent Libor floor. FSC originated the loan in conjunction with BeyondTrust’s September acquisition by Veritas Capital, a New York–based private equity firm.
Tannenbaum says he realized early on that he could get an edge by investing alongside private equity firms because they essentially provide a credit enhancement. To raise a new fund, sponsors typically want to avoid a big loss in the previous vehicle. “So there’s a willingness and ability of a private equity firm to re-up at a problem,” he says.
Tannenbaum says that the complexity and sheer number of investments make it unlikely that busy Wall Street analysts—let alone retail investors—can analyze all of a BDC’s holdings. That provides another opportunity for an edge, he says. “Knowing your industry, knowing your assets, knowing what’s going on in the middle market—you can take advantage of that,” he says.
That’s what Tannenbaum did recently in the firm’s hedge fund, he says. Started two years ago, Fifth Street Opportunities Fund gained 11.3 percent in 2013 and 9.6 percent in 2014, according to a fund letter obtained by Bloomberg.
When FSC wrote down an investment to 40 percent of face value in February, Tannenbaum knew that a couple of other BDCs had pieces of the same loan still carried at higher values, he says. “So there’s your edge: In the hedge fund, I can trade those things knowing how retail is going to respond to them,” Tannenbaum says. “We took advantage of it by shorting some of our competitors.”
This story appears in the May 2015 issue of Bloomberg Markets magazine.
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