OCSL

Business Context and Reporting Period

Company: Fifth Street Finance Corp. (Note: The input metadata references "Oaktree Specialty Lending Corp," but the filing text explicitly identifies the registrant as Fifth Street Finance Corp.)
Filing Type: Form 10-K (Annual Report)
Period Ended: September 30, 2009
Business Overview: The Company is an externally managed, closed-end, non-diversified management investment company regulated as a Business Development Company (BDC) under the Investment Company Act of 1940. It invests in debt and equity securities of small and mid-sized companies (revenues $25M–$250M), primarily in connection with private equity sponsors. The portfolio consists of first and second lien debt investments and equity grants.

Key Financial Metrics

Liquidity and Debt: As of September 30, 2009, the Company had no borrowings outstanding. A $50 million credit facility with Bank of Montreal was terminated on September 16, 2009. Subsequently, on November 16, 2009, the Company entered into a new $50 million credit facility with Wachovia Bank (expandable to $100 million).

Material Changes vs. Prior Period

• Income Growth: Total investment income increased 50% to $49.8 million, driven by higher average levels of outstanding debt investments and increased fee income.
• Realized Losses: The Company recorded a net realized loss of $14.4 million in 2009, compared to a gain of $0.1 million in 2008. This was primarily due to a $10.4 million loss on the exit of American Hardwoods Industries, LLC, and a $4.0 million impairment charge on CPAC, Inc.
• Portfolio Quality: The percentage of the portfolio rated "Investment Rating 5" (expecting loss of principal) increased to 1.90% ($5.7 million) from 0% in 2008. Five investments were placed on non-accrual status.
• Cash Position: Cash and cash equivalents surged from $22.9 million to $113.2 million, largely due to two follow-on equity offerings in 2009 raising approximately $145.8 million in gross proceeds.
• NAV Decline: NAV per share decreased from $13.02 to $10.84, reflecting unrealized depreciation and realized losses offset by capital raises.

Guidance, Outlook, and Risks

Management Commentary: Management notes a robust deal pipeline despite market disruptions. The Company intends to focus on first lien transactions and floating rate facilities with rate floors. It plans to deploy capital from its significant cash balance ($113.2 million) into new investments.

Outlook: The Company expects to grow its business by increasing average investment sizes. It is pursuing a Small Business Investment Company (SBIC) license to access SBA-guaranteed debentures, which could provide lower-cost capital.

Risks and Contingencies:

• Economic Conditions: Recessionary conditions may impair portfolio companies' ability to repay loans, increasing defaults and non-performing assets.
• Valuation Uncertainty: A significant portion of the portfolio is valued at fair value by the Board of Directors in the absence of a ready market, introducing subjectivity.
• Liquidity Constraints: As a RIC, the Company must distribute at least 90% of taxable income, limiting retained earnings for growth and necessitating frequent capital raises.
• Below-NAV Issuances: Stockholders approved the issuance of shares below NAV (up to 15% dilution) to facilitate capital raising, which has already resulted in 9.1% dilution.

Investor Verification Checklist

• Realized Losses: Verify the specific details and recovery potential regarding the $10.4 million loss on American Hardwoods Industries and the $4.0 million impairment on CPAC, Inc.
• Non-Accrual Status: Review the financial health of the five investments placed on non-accrual status and the likelihood of future write-downs.
• Capital Deployment: Monitor the rate at which the $113.2 million cash balance is deployed into new investments to ensure it generates sufficient yield to cover expenses and dividends.
• SBIC Licensing: Confirm the status of the SBIC subsidiary application and the potential impact on the Company's cost of capital and leverage capacity.
• Dividend Sustainability: Assess whether net investment income ($31.4 million) is sufficient to cover the dividend payout requirements ($29.6 million paid in 2009) without eroding NAV further.