January 25, 2013
Interviewed by: David Snow
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Alternative Finance in the Middle Market

The strength of publicly traded business development companies, or BDCs, is their ability to lend up and down the capital structure, filling a void when more traditional avenues of finance are unavailable, says Leonard Tannenbaum, CEO of Fifth Street Finance.  In this candid interview, the outspoken Tannenbaum discusses the flexibility of the BDC structure, its benefits for borrowers, and how to optimize a lending portfolio for a BDC’s own investors.

The strength of publicly traded business development companies, or BDCs, is their ability to lend up and down the capital structure, filling a void when more traditional avenues of finance are unavailable, says Leonard Tannenbaum, CEO of Fifth Street Finance.  In this candid interview, the outspoken Tannenbaum discusses the flexibility of the BDC structure, its benefits for borrowers, and how to optimize a lending portfolio for a BDC’s own investors.

Privcap: How would you characterize the middle market and its appetite for alternative sources of capital?

Leonard Tannenbaum, Fifth Street Finance: There’s three segments, basically, in the middle market. So there’s the lower market– let’s call it $5 million less than EBITDA . There’s the $5 million to $10 million transactions, which is really the lower-middle market. The middle-middle market, or the true middle market, as some people characterize it, is $10 to $20, $25 million. And the upper-middle market is probably $25 million to $75 million.

And everybody likes to say they’re in the middle market. But really, they’re in all different categories. A smaller company that’s selling really doesn’t have any competition from– I mean, in the lower-middle market, it doesn’t really have any competition from CLOs.

Banks really aren’t aggressive. They probably don’t have a lot of saleable assets. Probably have more cash flow. They don’t have the infrastructure. Therefore, when we do those deals, we probably the highest yields. However, put the least money to work, and it takes them most time to do them.

The upper-middle market, as we talked about, really has a lot of different capital sources that are hitting it, because it’s more stable. They have good financial resources. In fact, they’re probably even shadow-rated, to an extent. Probably shadow-rated B. And so that, even high-yield buyers are starting to dip down into that market.

So really, dependent on the type of market– depends on the risk-averse players versus the more risky players. Of course, you get paid for risk. But most of the money is more risk-averse, and therefore trends towards the higher end of the market, creating a supply-and-demand imbalance.

Privcap: What do you expect to drive growth in alternative lending and BDCs in the years ahead?

Tannenbaum: One of the reasons alternative finance sources, like business development companies, should continue to grow, and you’ll see our industry continue to gain capital, is because of the role that we’re playing in the middle market, upper-middle market, lower-middle market, in terms of filling the gap for private equity sponsors that want to finance companies, and companies that just want to finance. For example, we had a $100 million deal, and we actually recently lost, with one of our key private equity sponsors. We lost $100 million, but we won a second lien piece for $25 million

Why? We pledged the whole $100 million at 8 and 1/2%. But they were able to finance the first $75 million, first lien, with a bank– and the banks, as we talked about earlier, were being very aggressive– at Libor 450. So we fell into the second lien at 13%, still blending to 7 and 1/2%.

And that ability to move up, down the structure– first lien, last out, first lien, second lien, mezz equity– that’s the whole point of alternative lending, or business development companies, is we can be flexible lenders. And that flexible lending, when the banks pull back, we take more of the first lien, the banks get aggressive, you take more of the second lien– you can do whatever you need to do to win the deal for your sponsor.

Privcap: What makes Fifth Street and attractive partner for a potential borrower?

Tannenbaum: The reason why Fifth Street is able to finance all different parts of the structure is because we have such efficient borrowing today. And a billion market cap, and a billion four of assets, triple-B-minus with S&P, triple-B-minus with Fitch, as an investment-grade company, we’re able to borrow cheaper and have multiple buckets of borrowers.

So for example, Wells Fargo lends to us. We have a $150 million line with them. Seven banks– Key Bank, ING, UBS, and others, lent to us in another working capital facility.

We have the SBA license. We have two, actually. Actually, two SBA licenses, where we have very low-cost financing. We have a line with Sumitomo Bank, which is one of the largest banks in the world, at Libor 225 for seven-year money, for a certain type of asset.

All of these different buckets are necessary. And of course, we just issued, last week, an unsecured bond offering for 12 years at 5 and 7/8. So all of these different types of buckets allow us to finance efficiently, finance different parts of the structure, and put them in the right buckets. But you have to almost be our size to have that much flexibility.

Privcap: Where do you see the greatest risks to your portfolio?

Tannenbaum: Look, the biggest thing– right now, we’re very diversified. We have 67, almost 70 assets. Forgot about the ones that closed today. And the largest asset’s 3.4% of assets. No big industry concentration. Maybe health care.

So underwriting teams– we’ve hired from BMO, from GE. We have terrific underwriting teams. And we underwrite with such consistent methodology, the underwriting process is not really where the risk is.

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