OCSL

Business Context and Reporting Period

Company: Fifth Street Finance Corp. (Note: Input metadata referenced "Oaktree," but the filing text identifies the registrant as Fifth Street Finance Corp.)
Filing Type: Form 10-K (Annual Report)
Period Ended: September 30, 2015
Business Overview: A closed-end, non-diversified business development company (BDC) and regulated investment company (RIC) that lends to and invests in small and mid-sized companies, primarily in connection with private equity sponsors. The company is externally managed by Fifth Street Management LLC.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Decline: Total investment income decreased by approximately 9.7% to $265.5 million from $294.0 million in 2014, primarily due to a decrease in fee income earned on new investments.
• Net Income Drop: Net investment income fell 19.4% to $114.9 million. The net increase in net assets from operations dropped significantly to $15.4 million from $112.5 million in 2014.
• Unrealized Losses: The company recorded net unrealized depreciation on investments of $71.7 million, compared to $32.2 million in the prior year. This was driven by market dislocation and volatility in loan prices during the quarter.
• Realized Losses: Net realized losses on investments totaled $28.5 million, compared to a net realized gain of $2.2 million in 2014. Significant realized losses included a $17.9 million loss on the restructuring of Miche Bag, LLC and a $7.9 million loss on the restructuring of Edmentum, Inc.
• Asset Quality: Investments on non-accrual status increased. As of September 30, 2015, four investments were on non-accrual (cash and/or PIK), compared to one in the prior year.

Guidance, Outlook, Risks, and Unusual Items

• Management Commentary: Management noted that the decline in net assets was primarily due to market movements and increased volatility in loan prices. The company continues to focus on a prudent mix of first lien, second lien, and subordinated loans.
• Fee Structure Change: On July 14, 2015, the Investment Adviser agreed to a revised base management fee arrangement effective July 1, 2015, through January 1, 2017, intended to reduce fees payable during the waiver period.
• Legal Proceedings: The company is a defendant in three putative securities class-action lawsuits alleging violations of the Securities Exchange Act of 1934. Plaintiffs allege a fraudulent scheme to artificially inflate portfolio value and income to increase the Investment Adviser's revenue. No provision for losses has been recorded.
• Internal Control Weakness: The company identified a material weakness in internal control over financial reporting related to the design and maintenance of controls to internally communicate current accounting policies and procedures.
• Proxy Contest: RiverNorth Institutional Partners, L.P. (5.9% shareholder) nominated three individuals for the Board and proposed terminating the Investment Advisory Agreement, citing fee reductions and buyback program increases.
• Risks: Significant risks include the illiquidity of portfolio investments, reliance on private equity sponsors for deal flow, interest rate fluctuations, and the potential for distributions to include a return of capital.

Investor Verification Checklist

• Portfolio Valuation: Verify the methodology used to value the $2.4 billion portfolio, particularly given the $71.7 million in unrealized depreciation and the material weakness in internal controls.
• Non-Accrual Status: Review the specific details of the four investments on non-accrual status and the likelihood of recovery.
• Legal Exposure: Monitor the status of the three class-action lawsuits and the potential financial impact of the allegations regarding portfolio valuation.
• Proxy Contest Outcome: Assess the potential impact of the RiverNorth proxy contest on the Investment Advisory Agreement and management fees.
• Liquidity and Distributions: Confirm the company's ability to meet distribution requirements given the decline in net investment income and the reliance on PIK interest.