By Lisa M. Goetz
Leonard Tannenbaum, CEO of Fifth Street Finance, decided to take a calculated gamble after a discussion with his poker buddy — converting his third private fund into a business development company (BDC) in 2008. That friend, David Einhorn, founder and president of Greenlight Capital Inc., told Tannenbaum he would be successful as long as he stuck to three tenets: transparency, discipline and marking the book appropriately.
Tannenbaum, on this year’s Forbes list of “America’s 20 Most Powerful CEOs 40 and Under,” founded his first private investment firm in 1998. That firm eventually became Fifth Street Finance, a specialty finance company that lends to and invests in small- and mid-sized companies, primarily in connection with investments by private equity sponsors. Prior to launching Fifth Street, Tannenbaum gained small company experience as an equity analyst for Merrill Lynch.
“In 1998, we raised a small fund of about $30 million that made investments until 2004. In January 2005, Fifth Street Mezzanine Partners II was launched — our second fund that reached $157 million and included institutional investors like DuPont, Sumitomo Bank and WP Global, along with numerous high net worth individuals and family offices. That fund basically finished investing in March 2007, when we began raising a third fund,” Tannenbaum says.
Then came the conversation with Einhorn, during which Tannenbaum asked about the drawbacks of starting a business development company. “David essentially told me that it would be more difficult to fundraise. As CEO of a public company, I would be subject to far more scrutiny, but he said I could handle it. Sure enough, it was more difficult, but we raised $173 million through great investors like Genworth, RGA, Westfield and numerous high net worth families that again came to invest. And, typical to my fashion, I put all of my own assets into Fund III, and I bought $10 million of pre-IPO stock. We had Goldman Sachs as a lead underwriter, and they had not been an underwriter for another BDC in about 12 years. We had Wachovia and UBS as bookrunners and Stiefel Nicholas as a co-manager rounding out a very strong cover,” he explains.
“In addition, this new public entity to be called Fifth Street Finance Corp. was all set up and ready to go public. Despite a very turbulent economic climate, we approached the SEC in January 2008 — and then the world collapsed. We actually went public in June 2008. There were only two financial services firms that went public that year — Fifth Street Finance and Visa,” Tannenbaum adds.
When asked how becoming a CEO of a publicly traded company has changed his life, he reveals that the role is a natural fit for him because he enjoys marketing, planning for the future and asking people for their opinions. “I like discussing things. Because I like marketing and talking to people, we ensure compliance with U.S. Securities law through transparency. We disclose more information and more often than our peers. What I really like about being public is that I’m a planner. I like planning three to five years out for the company, and we have a detailed plan that I adapt every year and present to the board of directors and senior partners.”
As the leader of a public company, Tannenbaum especially appreciates that Fifth Street has its own capital because it allows him to plan for growth with more certainty. “What I love about being public is this permanent capital allows us to not worry about what happens when this fund concludes, when we should start marketing the next fund, where our contacts are now or how they are thinking about investing,” he explains.
Fifth Street’s clients are private equity firms that invest in companies with between $3 million and $50 million in EBITDA. These companies are in industries such as healthcare, manufacturing, business services, education services, retail and consumer, construction and engineering, food and restaurants, and media and advertising. Fifth Street has the ability to underwrite up to $100 million. “Our typical deal is still a lower middle-market or middle-market deal where the company earns an average of $10 million in EBITDA. A transaction of $35 million is about our average size, with a price somewhere between 10% and 11%,” Tannenbaum notes.
He describes the company’s structure as “very simple,” with 42 employees of Fifth Street affiliates based in White Plains, NY, Greenwich, CT, Chicago and Los Angeles. “Our primary job is to manage the public entity, which is Fifth Street Finance Corp. Fifth Street’s adviser is a partnership made up of several members. I value this structure and the combined effort here, and we all care about our overall performance,” he adds.
Fundamentals for Success
In April 2012, Fifth Street announced that it had joined a select group of business development companies with two investment grade debt ratings, after having received BBB- ratings from both Standard & Poor’s and Fitch. Moreover, in September 2011, the company announced the closing of a seven-year, $200 million credit facility, with an interest rate of LIBOR+2.25% per year and includes an option for a one-year extension, with its long-term partner, Sumitomo Mitsui Banking Corporation.
“Within the past six months, one of our biggest accomplishments has been building on our Sumitomo relationship by getting a $200 million line and being one of two companies in our industry to get that line. I plan on continuing to build on the relationship with our Japanese partners. More recently, S&P assigned us an investment grade rating of BBB- and Fitch reaffirmed the investment grade rating they granted us in April 2011,” Tannenbaum relates.
A third recent accomplishment was adding Alexander Frank to the Fifth Street team as chief financial officer. Frank previously served as CFO of Chilton Investment Company and spent more than 22 years at Morgan Stanley, serving a portion of the time as CFO and ultimately as head of global operations. “He’s such a terrific personality and has helped us to continue institutionalizing the platform so nicely,” Tannenbaum says.
As for the overall success of Fifth Street’s venture into the public realm, Tannenbaum points toward Einhorn’s three fundamentals. “The keys to Fifth Street’s success story, while so many in our industry group went from very big market caps to very small market caps, is following the three basic tenets that David laid out in that conversation: 1.) Transparency; we’re known as one of the most transparent companies in the industry, if not the most transparent; 2.) Discipline; we generally don’t deviate from our investment strategy; and 3.) Marking our book appropriately. Those three things, as well as time.”
He adds, “With 95% of our deals being sourced through private equity sponsors, we continue to build our sponsor relationships and deliver to our clients year in and year out with a sense of enthusiasm and caring. That is what starts to build brand and reputation. And surrounding yourself with smart people to continue to build that culture and amplify that strategy,” he divulges.
A self-proclaimed planning enthusiast, Tannenbaum does so with variability in mind. “For example, first, we have to understand what the base case is. Treasuries can be manipulated and because of that, the whole scale can be manipulated. When is that going to change and how is that going to change? I believe that given the current economic and political climate the Federal Reserve will not take up interest rates until the end of 2013. I believe the Federal Reserve will start telegraphing the increase in interest rates in early 2013. And I believe that inflation is already starting to heat up, which is a plan that the Federal Reserve has to bail itself out Fannie and Freddie and a big debt country like us it inherently attacks on the population. I’m not criticizing the Federal Reserve at all; I think it may be the only way out. Bernanke knows that, and he’s very smart.”
He continues, “In that context, we have $1.2 billion of assets, and we have $700 million of available of borrowing as a corporate borrower. Because we’re a BBB- credit, I get to change our liability and asset structure. I don’t have much time to do this. I only have eight more months before Bernanke suddenly signals a rise to combat inflationary targets that are exceeding the range that the Federal Reserve is comfortable with, and I expect the whole curve is going to shift.”
M&A and Middle-Market Lending
As part of Tannenbaum’s planning for variability, he forecasts middle-market lending and M&A activity to heat up in 2012, despite a slow start, with the trend peaking by the end of the year. To support his prediction, he cites, among other factors, the rebounding U.S. economy this year and concern about capital gains and healthcare tax increases in 2013.
“With a recovering economy, better earnings, good lending environment, artificially low interests rates and a tax rate expected to go up next year, the whole formula is really built for mergers and acquisitions activity. So, why wasn’t the first quarter very good? There was much more supply of capital than demand for capital. My only answer is, and I saw this in 2010, that America is full of ‘holiday shoppers.’ They all shop at the last minute, even though they know the holidays are coming, they shop right around the holidays. So, it’s a similar phenomenon. Everyone is trying to wait. However, in talking to the investment banks and watching our field back above $2 billion, we’re seeing early stages of very robust M&A. I told my team we need to be staffed and ready and productive for at least a doubling of the pipeline by the end of the year. I expect this last quarter will be the biggest quarter for M&A in history by far,” Tannenbaum posits.
He also says that the loan supply/demand balance is slowly tilting in the issuers’ favor, as evidenced by widening spreads, especially in the higher credits, which, he says, soon will reach the middle market. Tannenbaum offers as examples two recent Fifth Street deals: “One of the deals was an okay security that we underwrote with a B rating, and second lien loans were priced at 10.25% or at least that was the price that was told to us. I told my team that for the risk of a B, I wasn’t thrilled with 10.25%. We deserved more than that and we should pass. And then the sponsor’s all upset, and the bank’s all upset. And they came back to us and said ‘We’re wrong about the price. What price would you like?’ So we came in at 11% or 11.5%, and ultimately closed the deal around that price, so we’re already seeing spreads widen.”
He continues, “And with the other deal, I actually liked the credit a lot. We really understood the industry. We did a robust amount of work and we committed to $15 million and we were told pricing there went up a half a percent. So, with the same $15 million, we’ll earn more money. And the first lien went wide, too, so we might get a bit of the first lien loan as well. The upper market is a great indicator of what is going to go on in the middle and lower markets. In a few weeks we’ll see pricing widen in the middle market, then we’ll see if pricing widens in the lower market.”
Transforming the BDC Industry
The business development company industry plays an important role in filling the gap between the banks and private equity sponsors, according to Tannenbaum, particularly when the BDC fills the hole in transactions to make sure M&A has the “grease” it needs to let the deal happen. As for the future of the BDC industry, he is encouraged that Basel III continues to constrain banks’ capital, leverage and ability to make what he calls “silly stretch loans” into the cash flows of companies. This constraint on banks will create more opportunities for alternative lenders, he says.
“I’m really enthusiastic about the role the industry is playing and the amount of capital the industry can put to work. And a perfect demonstration of that is two very credible private equity firms, TPG Capital and The Carlyle Group, which are both going to raise and issue BDCs in the next 12 to 18 months. The only thing that is missing from the industry is the big credible players to validate the strategy and to validate the BDC industry to the institutional community. Bringing in Carlysle and TPG will continue to transform the perception of our industry positively,” Tannenbaum concludes.
Lisa M. Goetz is an associate editor of the ABF Journal.