497 1 d417858d497.htm FINAL PROSPECTUS SUPPLEMENT FINAL PROSPECTUS SUPPLEMENT
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Filed Pursuant to Rule 497
File No. 333-180267

 

PROSPECTUS SUPPLEMENT

(to Prospectus dated July 27, 2012)

Fifth Street Finance Corp.

$75,000,000

5.875% Senior Notes due 2024

We are a specialty finance company that lends to and invests in small and mid-sized companies, primarily in connection with investments by private equity sponsors. We invest in securities that are rated below investment grade by rating agencies or that would be rated below investment grade if they were rated. Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity investments.

We are an externally managed, closed-end, non-diversified management investment company that has elected to be treated as a business development company under the Investment Company Act of 1940. We are managed by Fifth Street Management LLC.

We are offering $75,000,000 in aggregate principal amount of 5.875% senior notes due 2024, or the “Notes.” The Notes will mature on October 30, 2024. We will pay interest on the Notes on January 30, April 30, July 30 and October 30 of each year, beginning on January 30, 2013. We may redeem the Notes in whole or in part at any time or from time to time on or after October 30, 2017, at the redemption price set forth under “Specific Terms of the Notes and the Offering—Optional redemption” in this prospectus supplement. The Notes will be issued in minimum denominations of $25 and integral multiples of $25 in excess thereof.

The Notes will be our direct senior unsecured obligations and rank pari passu with all outstanding and future unsecured unsubordinated indebtedness issued by Fifth Street Finance Corp.

We intend to apply to list the Notes on the New York Stock Exchange, or NYSE, and, if the application is approved, we expect trading in the Notes on the NYSE to begin within 30 days of the original issue date under the symbol “FSCE.” The Notes are expected to trade “flat,” which means that purchasers will not pay, and sellers will not receive, any accrued and unpaid interest on the Notes that is not reflected in the trading price. Currently, there is no public market for the Notes.

An investment in the Notes involves a high degree of risk and should be considered highly speculative. See “Supplementary Risk Factors” beginning on page S-9 in this prospectus supplement and “Risk Factors” beginning on page 15 of the accompanying prospectus to read about factors you should consider, including the risk of leverage, before investing in our Notes.

This prospectus supplement and the accompanying prospectus contain important information about us that a prospective investor should know before investing in the Notes. Please read this prospectus supplement and the accompanying prospectus before investing and keep them for future reference. We file periodic reports, current reports, proxy statements and other information with the Securities and Exchange Commission. This information is available free of charge by contacting us at 10 Bank Street, 12th Floor, White Plains, New York 10606 or by telephone at (914) 286-6800 or on our website at www.fifthstreetfinance.com. Information contained on our website is not incorporated by reference into this prospectus supplement or the accompanying prospectus, and you should not consider that information to be part of this prospectus supplement or the accompanying prospectus. The Securities and Exchange Commission also maintains a website at www.sec.gov that contains information about us.

 

     Per Note     Total  

Public offering price

     100.0   $ 75,000,000   

Sales load (underwriting discount)

     3.0   $ 2,250,000   

Proceeds, before expenses, to us(1)

     97.0   $ 72,750,000   

 

(1) We estimate that we will incur approximately $300,000 of expenses relating to this offering, resulting in net proceeds, after sales load (underwriting discount) and expenses, to us of approximately $72.45 million.

The public offering price set forth above does not include accrued interest, if any. Interest on the Notes will accrue from October 18, 2012 and must be paid by the purchaser if the Notes are delivered after October 18, 2012.

THE NOTES ARE NOT DEPOSITS OR OTHER OBLIGATIONS OF A BANK AND ARE NOT INSURED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION OR ANY OTHER GOVERNMENT AGENCY.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus supplement or the accompanying prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

Delivery of the Notes in book-entry form only through The Depository Trust Company will be made on or about October 18, 2012.

Joint Book-Running Managers

 

UBS Investment Bank   Raymond James   RBC Capital Markets   Stifel Nicolaus Weisel

Co-Managers

 

Credit Suisse   Deutsche Bank Securities   Janney Montgomery Scott   Maxim Group LLC

The date of this prospectus supplement is October 11, 2012.


Table of Contents

TABLE OF CONTENTS

PROSPECTUS SUPPLEMENT

 

ABOUT THIS PROSPECTUS SUPPLEMENT

     S-iii   

PROSPECTUS SUPPLEMENT SUMMARY

     S-1   

SPECIFIC TERMS OF THE NOTES AND THE OFFERING

     S-4   

SUPPLEMENTARY RISK FACTORS

     S-9   

USE OF PROCEEDS

     S-12   

CAPITALIZATION

     S-13   

SELECTED FINANCIAL AND OTHER DATA

     S-14   

RATIOS OF EARNINGS TO FIXED CHARGES

     S-15   

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     S-16   

UNDERWRITING

     S-47   

MATERIAL U.S. FEDERAL INCOME TAX CONSIDERATIONS

     S-43   

LEGAL MATTERS

     S-50   

INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

     S-50   

CHANGE IN INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

     S-50   

AVAILABLE INFORMATION

     S-50   

CONSOLIDATED FINANCIAL STATEMENTS

     S-51   

 

PROSPECTUS

 

  

PROSPECTUS SUMMARY

     1   

THE OFFERING

     7   

FEES AND EXPENSES

     12   

SELECTED FINANCIAL AND OTHER DATA

     14   

RISK FACTORS

     15   

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

     34   

USE OF PROCEEDS

     35   

PRICE RANGE OF COMMON STOCK AND DISTRIBUTIONS

     36   

RATIOS OF EARNINGS TO FIXED CHARGES

     38   

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     39   

SENIOR SECURITIES

     70   

BUSINESS

     71   

PORTFOLIO COMPANIES

     83   

MANAGEMENT

     89   

PORTFOLIO MANAGEMENT

     98   

INVESTMENT ADVISORY AGREEMENT

     100   

ADMINISTRATION AGREEMENT

     107   

LICENSE AGREEMENT

     107   

CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

     108   

CONTROL PERSONS AND PRINCIPAL STOCKHOLDERS

     109   

DIVIDEND REINVESTMENT PLAN

     111   

DESCRIPTION OF OUR CAPITAL STOCK

     112   

DESCRIPTION OF OUR DEBT SECURITIES

     115   

DESCRIPTION OF OUR WARRANTS

     127   

MATERIAL U.S. FEDERAL INCOME TAX CONSIDERATIONS

     129   

REGULATION

     137   

 

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PLAN OF DISTRIBUTION

     142   

CUSTODIAN, TRANSFER AND DISTRIBUTION PAYING AGENT AND REGISTRAR

     144   

BROKERAGE ALLOCATION AND OTHER PRACTICES

     144   

LEGAL MATTERS

     144   

INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

     144   

CHANGE IN INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

     144   

AVAILABLE INFORMATION

     145   

PRIVACY NOTICE

     145   

INDEX TO FINANCIAL STATEMENTS

     F-1   

 

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ABOUT THIS PROSPECTUS SUPPLEMENT

You should rely only on the information contained in this prospectus supplement and the accompanying prospectus. Neither we nor the underwriters have authorized any other person to provide you with different information from that contained in this prospectus supplement or the accompanying prospectus. If anyone provides you with different or inconsistent information, you should not rely on it. Neither this prospectus supplement nor the accompanying prospectus constitutes an offer to sell, or a solicitation of an offer to buy, the Notes by any person in any jurisdiction where it is unlawful for that person to make such an offer or solicitation or to any person in any jurisdiction to whom it is unlawful to make such an offer or solicitation. The information contained in this prospectus supplement and the accompanying prospectus is complete and accurate only as of their respective dates, regardless of the time of their delivery or sale of the Notes. Our financial condition, results of operations and prospects may have changed since those dates. To the extent required by law, we will amend or supplement the information contained in this prospectus supplement and the accompanying prospectus to reflect any material changes to such information subsequent to the date of this prospectus supplement and the accompanying prospectus and prior to the completion of any offering pursuant to this prospectus supplement and the accompanying prospectus.

This document is in two parts. The first part is this prospectus supplement, which describes the terms of the Notes and this offering and also adds to and updates information contained in the accompanying prospectus. The second part is the accompanying prospectus, which gives more general information and disclosure. To the extent the information contained in this prospectus supplement differs from or is additional to the information contained in the accompanying prospectus, you should rely only on the information contained in this prospectus supplement. You should read this prospectus supplement and the accompanying prospectus together with the additional information described under the heading “Available Information” before investing in the Notes.

Forward-Looking Statements

Information contained in this prospectus supplement and the accompanying prospectus may contain forward-looking statements. In addition, forward-looking statements can generally be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “anticipate,” “estimate,” or “continue” or the negative thereof or other variations thereon or comparable terminology. The matters described in “Supplementary Risk Factors” in this prospectus supplement, and in “Risk Factors” in the accompanying prospectus, and certain other factors noted throughout this prospectus supplement and the accompanying prospectus constitute cautionary statements identifying important factors with respect to any such forward-looking statements, including certain risks and uncertainties that could cause actual results to differ materially from those in such forward-looking statements. The forward-looking statements contained in this prospectus supplement and the accompanying prospectus are excluded from the safe harbor protection provided by Section 27A of the Securities Act of 1933, or the Securities Act. For a list of factors that could affect these forward-looking statements, see “Supplementary Risk Factors” in this prospectus supplement, and “Risk Factors” and “Special Note Regarding Forward-Looking Statements” in the accompanying prospectus.

 

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PROSPECTUS SUPPLEMENT SUMMARY

This summary highlights some of the information in this prospectus supplement and the accompanying prospectus. It is not complete and may not contain all of the information that is important to you. To understand the terms of the Notes offered pursuant to this prospectus supplement and the accompanying prospectus, you should read the entire prospectus supplement and the accompanying prospectus carefully. Together, these documents describe the specific terms of the Notes we are offering.

We commenced operations on February 15, 2007 as Fifth Street Mezzanine Partners III, L.P., a Delaware limited partnership. Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp., a Delaware corporation. Unless otherwise noted, the terms “we,” “us,” “our,” the “Company” and “Fifth Street” refer to Fifth Street Mezzanine Partners III, L.P. prior to the merger date and Fifth Street Finance Corp. on and after the merger date. In addition, the terms “Fifth Street Management” and “investment adviser” refer to Fifth Street Management LLC, our external investment adviser.

Fifth Street Finance Corp.

We are a specialty finance company that lends to and invests in small and mid-sized companies, primarily in connection with investments by private equity sponsors. We define small and mid-sized companies as those with annual revenues between $25 million and $250 million. Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity investments. We are externally managed and advised by Fifth Street Management. Fifth Street Management is an affiliate of Fifth Street Capital LLC, a private investment firm founded and managed by our chief executive officer, and Fifth Street Management’s managing partner, Leonard M. Tannenbaum, who has led the investment of over $2.2 billion in small and mid-sized companies, including the investments made by Fifth Street, since 1998.

Our investments generally range in size from $5 million to $75 million and are principally in the form of first and second lien debt investments, which may also include an equity component. We invest in securities that are rated below investment grade by rating agencies or that would be rated below investment grade if they were rated. Below investment grade securities, which are often referred to as “high yield” or “junk,” have predominantly speculative characteristics with respect to the issuer’s capacity to pay interest and repay principal. Although our focus could change we are currently focusing our origination efforts on a prudent mix of first lien, second lien and subordinated loans which we believe will provide superior risk-adjusted returns while maintaining adequate credit protection.

We are an externally managed, closed-end, non-diversified management investment company that has elected to be treated as a business development company under the Investment Company Act of 1940, or the 1940 Act. As a business development company, we are required to comply with regulatory requirements, including limitations on our use of debt. We are permitted to, and expect to, finance our investments through borrowings. However, as a business development company, we are only generally allowed to borrow amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowing. The amount of leverage that we employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing, such as the maturity, covenant package and rate structure of the proposed borrowings, our ability to raise funds through the issuance of shares of our common stock and the risks of such borrowings within the context of our investment outlook. Ultimately, we only intend to use leverage if the expected returns from borrowing to make investments will exceed the cost of such borrowing. We are currently targeting a debt to equity ratio (excluding SBA debentures) of 0.6x (i.e., we aim to have one dollar of equity for each $0.60 of non-SBA debt outstanding). As of June 30, 2012, we had a debt to equity ratio (excluding SBA debentures) of 0.42x.

 

 

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We have also elected to be treated for federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code, or the Code. As a RIC, we generally will not have to pay corporate-level federal income taxes on any net ordinary income or realized net capital gains that we distribute to our stockholders if we meet certain source-of-income, distribution and asset diversification requirements.

In addition, we maintain two wholly-owned subsidiaries that are licensed as small business investment companies, or SBICs, and regulated by the Small Business Administration, or the SBA. The SBIC licenses allow us, through our wholly-owned subsidiaries, to issue SBA-guaranteed debentures. We received exemptive relief from the Securities and Exchange Commission, or SEC, to permit us to exclude the debt of our SBIC subsidiaries guaranteed by the SBA from the definition of senior securities in the 200% asset coverage ratio we are required to maintain under the 1940 Act.

The following diagram depicts our organizational structure:

 

LOGO

Our Corporate Information

Our principal executive offices are located at 10 Bank Street, 12th Floor, White Plains, NY 10606 and our telephone number is (914) 286-6800. We maintain a website on the Internet at www.fifthstreetfinance.com. Information contained on our website is not incorporated by reference into this prospectus supplement or the accompanying prospectus and you should not consider information contained on our website to be part of this prospectus supplement or the accompanying prospectus.

 

 

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Recent Developments

On May 10, 2012, our wholly-owned subsidiary, Fifth Street Mezzanine Partners V, L.P., received an SBIC license. This is the second SBIC license granted to us through our SBIC subsidiaries and expands our SBIC lending capacity from $150 million to $225 million.

During the quarter ended September 30, 2012, we had estimated gross deal originations of approximately $129.0 million, of which $117.0 million were funded at close. We also received estimated cash payments of approximately $28.3 million in connection with the exits of certain portfolio companies.

On September 14, 2012, we completed a follow-on public offering of 8,451,486 shares of our common stock, which included a partial exercise of the underwriters’ overallotment option, at an offering price of $10.79 per share. The gross proceeds totaled $91.2 million.

As of October 10, 2012, we had $60.3 million of outstanding borrowings under our $150 million secured credit facility, or the Wells Fargo facility, with Wells Fargo Bank, National Association, successor to Wachovia Bank, N.A.; $101.0 million of outstanding borrowings under our $230 million secured syndicated revolving credit facility, or the ING facility, with certain lenders party thereto from time to time and ING Capital LLC, as administrative agent; and $45.0 million of outstanding borrowings under our $200 million secured credit facility with Sumitomo Mitsui Banking Corporation, or the Sumitomo facility.

The preliminary financial data included in this prospectus supplement has been prepared by, and is the sole responsibility of, Fifth Street’s management. PricewaterhouseCoopers LLP has not audited, reviewed, compiled or performed any procedures with respect to the accompanying preliminary financial data. Accordingly, PricewaterhouseCoopers LLP does not express an opinion or any other form of assurance with respect thereto.

 

 

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SPECIFIC TERMS OF THE NOTES AND THE OFFERING

This prospectus supplement sets forth certain terms of the Notes that we are offering pursuant to this prospectus supplement and supplements the accompanying prospectus that is attached to the back of this prospectus supplement. This section outlines the specific legal and financial terms of the Notes. You should read this section together with the more general description of the Notes in the accompanying prospectus under the heading “Description of Our Debt Securities” before investing in the Notes. Capitalized terms used in this prospectus supplement and not otherwise defined shall have the meanings ascribed to them in the accompanying prospectus or in the indenture governing the Notes.

 

Issuer

Fifth Street Finance Corp.

 

Title of the securities

5.875% Senior Notes due 2024

 

Aggregate principal amount being offered

$75,000,000

 

 

Initial public offering price

100% of the aggregate principal amount.

 

Principal payable at maturity

100% of the aggregate principal amount; the principal amount of each Note will be payable on its stated maturity date at the office of the Paying Agent, Registrar and Transfer Agent for the Notes or at such other office in The City of New York as we may designate.

 

Type of Note

Fixed rate note

 

Listing

We intend to list the Notes on the New York Stock Exchange within 30 days of the original issue date under the symbol “FSCE.”

 

Interest rate

5.875% per year

 

Day count basis

360-day year of twelve 30-day months

 

Original issue date

October 18, 2012

 

Stated maturity date

October 30, 2024

 

Date interest starts accruing

October 18, 2012

 

Interest payment dates

Each January 30, April 30, July 30, and October 30, commencing January 30, 2013. If an interest payment date falls on a non-business day, the applicable interest payment will be made on the next business day and no additional interest will accrue as a result of such delayed payment.

 

Interest periods

The initial interest period will be the period from and including October 18, 2012, to, but excluding, the initial interest payment date, and the subsequent interest periods will be the periods from and including an interest payment date to, but excluding, the next interest payment date or the stated maturity date, as the case may be.

 

 

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Regular record dates for interest

Each January 15, April 15, July 15 and October 15.

 

Specified currency

U.S. Dollars

 

Place of payment

New York City

 

Ranking of Notes

The Notes will be our direct unsecured obligations and will rank:

 

   

pari passu with our other outstanding and future senior unsecured indebtedness, including without limitation, the $115.0 million 5.375% Convertible Senior Notes due 2016 (the “Convertible Notes”) outstanding as of October 10, 2012;

 

   

senior to any of our future indebtedness that expressly provides it is subordinated to the Notes;

 

   

effectively subordinated to all our existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness, including without limitation, the $206.3 million of borrowings under our credit facilities outstanding as of October 10, 2012; and

 

   

structurally subordinated to all existing and future indebtedness and other obligations of any of our subsidiaries, including without limitation, the indebtedness of Fifth Street Funding, LLC, Fifth Street Funding II, LLC and our SBIC subsidiaries.

 

Denominations

We will issue the Notes in denominations of $25 and integral multiples of $25 in excess thereof.

 

Business day

Each Monday, Tuesday, Wednesday, Thursday and Friday that is not a day on which banking institutions in New York City are authorized or required by law or executive order to close.

 

Optional redemption

The Notes may be redeemed in whole or in part at any time or from time to time at our option on or after October 30, 2017, upon not less than 30 days nor more than 60 days written notice by mail prior to the date fixed for redemption thereof, at a redemption price of 100% of the outstanding principal amount thereof plus accrued and unpaid interest payments otherwise payable for the then-current quarterly interest period accrued to but not including the date fixed for redemption.

 

  You may be prevented from exchanging or transferring the Notes when they are subject to redemption. In case any Notes are to be redeemed in part only, the redemption notice will provide that, upon surrender of such Note, you will receive, without a charge, a new Note or Notes of authorized denominations representing the principal amount of your remaining unredeemed Notes.

 

 

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  Any exercise of our option to redeem the Notes will be done in compliance with the Investment Company Act of 1940, as amended, and the rules, regulations and interpretations promulgated thereunder, which we collectively refer to as the 1940 Act, to the extent applicable.

 

  If we redeem only some of the Notes, the Trustee or DTC, as applicable, will determine the method for selection of the particular Notes to be redeemed, in accordance with the indenture governing the Notes, and in accordance with the rules of any national securities exchange or quotation system on which the Notes are listed. Unless we default in payment of the redemption price, on and after the date of redemption, interest will cease to accrue on the Notes called for redemption.

 

  Under the ING facility, we currently would not be permitted to exercise our optional redemption right without complying with certain repurchase conditions specified in the facility.

 

Sinking fund

The Notes will not be subject to any sinking fund.

 

Repayment at option of Holders

Holders will not have the option to have the Notes repaid prior to the stated maturity date.

 

Defeasance and covenant defeasance

The Notes are subject to defeasance by us.

 

  The Notes are subject to covenant defeasance by us.

 

  Under the ING facility, we currently would be prohibited from defeasing the Notes or effecting covenant defeasance under the Notes.

 

Form of Notes

The Notes will be represented by global securities that will be deposited and registered in the name of The Depository Trust Company, or DTC, or its nominee. Except in limited circumstances, you will not receive certificates for the Notes. Beneficial interests in the Notes will be represented through book-entry accounts of financial institutions acting on behalf of beneficial owners as direct and indirect participants in DTC. Investors may elect to hold interests in the Notes through either DTC, if they are a participant, or indirectly through organizations which are participants in DTC.

 

Trustee, Paying Agent, Registrar and Transfer Agent

Deutsche Bank Trust Company Americas

 

 

Other covenants

In addition to the covenants described in the prospectus attached to this prospectus supplement, the following covenants shall apply to the Notes:

 

   

We agree that for the period of time during which the Notes are outstanding, we will not violate Section 18(a)(1)(A) as modified by

 

 

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Section 61(a)(1) of the 1940 Act or any successor provisions, whether or not we continue to be subject to such provisions of the 1940 Act, but giving effect, in either case, to any exemptive relief granted to us by the U.S. Securities and Exchange Commission (the “SEC”). These provisions generally prohibit us from making additional borrowings, including through the issuance of additional debt or the sale of additional debt securities, unless our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowings.

 

   

We agree that for the period of time during which the Notes are outstanding, we will not violate Section 18(a)(1)(B) as modified by Section 61(a)(1) of the 1940 Act or any successor provisions, giving effect to any exemptive relief granted to us by the SEC. These provisions generally prohibit us from declaring any cash dividend or distribution upon any class of our capital stock, or purchasing any such capital stock if our asset coverage, as defined in the 1940 Act, is below 200% at the time of the declaration of the dividend or distribution or the purchase and after deducting the amount of such dividend, distribution or purchase.

 

   

If, at any time, we are not subject to the reporting requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934 to file any periodic reports with the SEC, we agree to furnish to holders of the Notes and the Trustee, for the period of time during which the Notes are outstanding, our audited annual consolidated financial statements, within 90 days of our fiscal year end, and unaudited interim consolidated financial statements, within 45 days of our fiscal quarter end (other than our fourth fiscal quarter). All such financial statements will be prepared, in all material respects, in accordance with applicable United States generally accepted accounting principles.

 

Global Clearance and Settlement Procedures

Interests in the Notes will trade in DTC’s Same Day Funds Settlement System, and any permitted secondary market trading activity in such Notes will, therefore, be required by DTC to be settled in immediately available funds. None of the issuer, the Trustee or the paying agent will have any responsibility for the performance by DTC or its participants or indirect participants of their respective obligations under the rules and procedures governing their operations.

 

Use of Proceeds

We estimate that the net proceeds we receive from the sale of the $75.00 million aggregate principal amount of Notes in this offering will be approximately $72.45 million, after deducting the underwriting discounts and commissions of $2.25 million payable by us and estimated offering expenses of approximately $300,000 payable by us.

 

 

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  We intend to use the net proceeds from this offering to repay debt outstanding under our Wells Fargo facility and ING facility, and for general corporate purposes, including working capital requirements. However, through reborrowing under our credit facilities, we intend to make investments in small and mid-sized companies (including investments made through our SBIC subsidiaries) in accordance with our investment objective and strategies described in this prospectus supplement and the accompanying prospectus. We will invest any idle funds primarily in high quality, short-term debt securities, consistent with our business development company election and our election to be taxed as a RIC, at yields significantly below those we expect to earn on investments in small and mid-sized companies. See “Use of Proceeds.”

 

 

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SUPPLEMENTARY RISK FACTORS

Investing in the Notes involves a high degree of risk. In addition to the other information contained in this prospectus supplement and the accompanying prospectus, you should carefully consider the following supplementary risk factors together with the risk factors set forth in the accompanying prospectus before making an investment in the Notes. The risks set out below and in the accompanying prospectus are not the only risks we face. Additional risks and uncertainties not presently known to us might also impair our operations and performance. If any of the events described herein or in the accompanying prospectus occur, our business, financial condition and results of operations could be materially and adversely affected. In such case, our net asset value and the market price of the Notes could decline, and you may lose part or all of your investment.

The Notes will be unsecured and therefore will be effectively subordinated to any secured indebtedness we have currently incurred or may incur in the future.

The Notes will not be secured by any of our assets or any of the assets of our subsidiaries. As a result, the Notes are effectively subordinated to any secured indebtedness we or our subsidiaries have currently incurred and may incur in the future (or any indebtedness that is initially unsecured to which we subsequently grant security) to the extent of the value of the assets securing such indebtedness. In any liquidation, dissolution, bankruptcy or other similar proceeding, the holders of any of our existing or future secured indebtedness and the secured indebtedness of our subsidiaries may assert rights against the assets pledged to secure that indebtedness in order to receive full payment of their indebtedness before the assets may be used to pay other creditors, including the holders of the Notes. As of October 10, 2012, we had $60.3 million of outstanding borrowings under our Wells Fargo facility, $101.0 million of outstanding borrowings under our ING facility and $45.0 million of outstanding borrowings under our Sumitomo facility.

The Notes will be structurally subordinated to the indebtedness and other liabilities of our subsidiaries.

The Notes are obligations exclusively of Fifth Street Finance Corp. and not of any of our subsidiaries. None of our subsidiaries is a guarantor of the Notes and the Notes are not required to be guaranteed by any subsidiaries we may acquire or create in the future. A portion of the indebtedness required to be consolidated on our balance sheet is held through our SBIC subsidiaries. The assets of such subsidiaries are not directly available to satisfy the claims of our creditors, including holders of the Notes. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition, Liquidity and Capital Resources” in this prospectus supplement and in the accompanying prospectus for more detail on the SBA-guaranteed debentures.

Except to the extent we are a creditor with recognized claims against our subsidiaries, all claims of creditors (including trade creditors) and holders of preferred stock, if any, of our subsidiaries will have priority over our equity interests in such subsidiaries (and therefore the claims of our creditors, including holders of the Notes) with respect to the assets of such subsidiaries. Even if we are recognized as a creditor of one or more of our subsidiaries, our claims would still be effectively subordinated to any security interests in the assets of any such subsidiary and to any indebtedness or other liabilities of any such subsidiary senior to our claims. Consequently, the Notes will be structurally subordinated to all indebtedness and other liabilities (including trade payables) of any of our subsidiaries and any subsidiaries that we may in the future acquire or establish as financing vehicles or otherwise. As of October 10, 2012, we had $60.3 million borrowings outstanding under our Wells Fargo facility, $45.0 million of borrowings outstanding under our Sumitomo facility and $150.0 million of indebtedness outstanding incurred by our SBIC subsidiaries. All of such indebtedness would be structurally senior to the Notes. In addition, our subsidiaries may incur substantial additional indebtedness in the future, all of which would be structurally senior to the Notes.

 

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The indenture under which the Notes will be issued will contain limited protection for holders of the Notes.

The indenture under which the Notes will be issued offers limited protection to holders of the Notes. The terms of the indenture and the Notes do not restrict our or any of our subsidiaries’ ability to engage in, or otherwise be a party to, a variety of corporate transactions, circumstances or events that could have a material adverse impact on your investment in the Notes. In particular, the terms of the indenture and the Notes will not place any restrictions on our or our subsidiaries’ ability to:

 

   

issue securities or otherwise incur additional indebtedness or other obligations, including (1) any indebtedness or other obligations that would be equal in right of payment to the Notes, (2) any indebtedness or other obligations that would be secured and therefore rank effectively senior in right of payment to the Notes to the extent of the values of the assets securing such debt, (3) indebtedness of ours that is guaranteed by one or more of our subsidiaries and which therefore is structurally senior to the Notes and (4) securities, indebtedness or obligations issued or incurred by our subsidiaries that would be senior to our equity interests in our subsidiaries and therefore rank structurally senior to the Notes with respect to the assets of our subsidiaries, in each case other than an incurrence of indebtedness or other obligation that would cause a violation of Section 18(a)(1)(A) as modified by Section 61(a)(1) of the 1940 Act or any successor provisions, whether or not we continue to be subject to such provisions of the 1940 Act, but giving effect, in either case, to any exemptive relief granted to us by the SEC (these provisions generally prohibit us from making additional borrowings, including through the issuance of additional debt or the sale of additional debt securities, unless our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowings);

 

   

pay dividends on, or purchase or redeem or make any payments in respect of, capital stock or other securities ranking junior in right of payment to the Notes, including subordinated indebtedness, in each case other than dividends, purchases, redemptions or payments that would cause a violation of Section 18(a)(1)(B) as modified by Section 61(a)(1) of the 1940 Act or any successor provisions giving effect to any exemptive relief granted to us by the SEC (these provisions generally prohibit us from declaring any cash dividend or distribution upon any class of our capital stock, or purchasing any such capital stock if our asset coverage, as defined in the 1940 Act, is below 200% at the time of the declaration of the dividend or distribution or the purchase and after deducting the amount of such dividend, distribution or purchase);

 

   

sell assets (other than certain limited restrictions on our ability to consolidate, merge or sell all or substantially all of our assets);

 

   

enter into transactions with affiliates;

 

   

create liens (including liens on the shares of our subsidiaries) or enter into sale and leaseback transactions;

 

   

make investments; or

 

   

create restrictions on the payment of dividends or other amounts to us from our subsidiaries.

In addition, the indenture will not require us to offer to purchase the Notes in connection with a change of control or any other event.

Furthermore, the terms of the indenture and the Notes do not protect holders of the Notes in the event that we experience changes (including significant adverse changes) in our financial condition, results of operations or credit ratings, as they do not require that we or our subsidiaries adhere to any financial tests or ratios or specified levels of net worth, revenues, income, cash flow, or liquidity.

Our ability to recapitalize, incur additional debt and take a number of other actions that are not limited by the terms of the Notes may have important consequences for you as a holder of the Notes, including making it more difficult for us to satisfy our obligations with respect to the Notes or negatively affecting the trading value of the Notes.

Certain of our current debt instruments include more protections for their holders than the indenture and the Notes. See “Risk Factors — Risks Relating to Our Business and Structure — Substantially all of our assets are

 

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subject to security interests under secured credit facilities or claims of the SBA with respect to our SBA-guaranteed debentures and if we default on our obligations thereunder, we may suffer adverse consequences, including the lenders and/or the SBA foreclosing on our assets” in the accompanying prospectus. In addition, other debt we issue or incur in the future could contain more protections for its holders than the indenture and the Notes, including additional covenants and events of default. The issuance or incurrence of any such debt with incremental protections could affect the market for and trading levels and prices of the Notes.

There is no existing trading market for the Notes and, even if the NYSE approves the listing of the Notes, an active trading market for the Notes may not develop, which could limit your ability to sell the Notes or the market price of the Notes.

The Notes will be a new issue of debt securities for which there initially will not be a trading market. We intend to list the Notes on the NYSE within 30 days of the original issue date under the symbol ‘‘FSCE.’’ However, there is no assurance that the Notes will be approved for listing on the NYSE. Moreover, even if the listing of the Notes is approved, we cannot provide any assurances that an active trading market will develop for the Notes or that you will be able to sell your Notes. If the Notes are traded after their initial issuance, they may trade at a discount from their initial offering price depending on prevailing interest rates, the market for similar securities, our credit ratings, if any, general economic conditions, our financial condition, performance and prospects and other factors. The underwriters have advised us that they may make a market in the Notes, but they are not obligated to do so. The underwriters may discontinue any market-making in the Notes at any time at their sole discretion. Accordingly, we cannot assure you that the Notes will be approved for listing on the NYSE, that a liquid trading market will develop for the Notes, that you will be able to sell your Notes at a particular time or that the price you receive when you sell will be favorable. To the extent an active trading market does not develop, the liquidity and trading price for the Notes may be harmed. Accordingly, you may be required to bear the financial risk of an investment in the Notes for an indefinite period of time.

If we default on our obligations to pay our other indebtedness, we may not be able to make payments on the Notes.

Any default under the agreements governing our indebtedness, including a default under the Wells Fargo facility, the ING facility, the Sumitomo facility, and our Convertible Notes or other indebtedness to which we may be a party that is not waived by the required lenders or holders, and the remedies sought by the holders of such indebtedness could make us unable to pay principal, premium, if any, and interest on the Notes and substantially decrease the market value of the Notes. If we are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our indebtedness, we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest, the lenders under the Wells Fargo facility, the ING facility, the Sumitomo facility or other debt we may incur in the future could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to seek to obtain waivers from the required lenders under the Wells Fargo facility, the ING facility, or the Sumitomo facility or the required holders of our Convertible Notes or other debt that we may incur in the future to avoid being in default. If we breach our covenants under the Wells Fargo facility, the ING facility, the Sumitomo facility, or our Convertible Notes or other debt and seek a waiver, we may not be able to obtain a waiver from the required lenders or holders. If this occurs, we would be in default and our lenders or debt holders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation. If we are unable to repay debt, lenders having secured obligations, including the lenders under the Wells Fargo facility, the ING facility, or the Sumitomo facility, could proceed against the collateral securing the debt. Because the Wells Fargo facility, the ING facility, the Sumitomo facility, and our Convertible Notes have, and any future credit facilities will likely have, customary cross-default provisions, if the indebtedness thereunder or under any future credit facility is accelerated, we may be unable to repay or finance the amounts due. See “Description of Our Debt Securities” in the accompanying prospectus.

 

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USE OF PROCEEDS

The net proceeds from our sale of the $75.00 million aggregate principal amount of Notes in this offering are estimated to be approximately $72.45 million, after deducting the underwriting discounts and commissions of approximately $2.25 million payable by us and estimated offering expenses of approximately $300,000 payable by us.

We intend to use the net proceeds from this offering to repay debt outstanding under our Wells Fargo facility and ING facility, and for general corporate purposes, including working capital requirements. However, through reborrowing under our credit facilities, we intend to make investments in small and mid-sized companies (including investments made through our SBIC subsidiaries) in accordance with our investment objective and strategies described in this prospectus supplement and the accompanying prospectus. As of October 10, 2012, we had $60.3 million outstanding under the Wells Fargo facility. The Wells Fargo facility has a maturity date of April 25, 2016 and bears interest at a rate of LIBOR (1-month) plus 2.75% per annum with no LIBOR floor. As of October 10, 2012, we had $101.0 million outstanding under the ING facility. The ING facility has a maturity date of February 29, 2016 and bears interest at a rate of LIBOR (1, 2, 3 or 6-month, at our option) plus 3.25% per annum with no LIBOR floor, or, when the facility is drawn more than 35%, LIBOR plus 3.0% per annum with no LIBOR floor. We anticipate that substantially all of the net proceeds from this offering will be used as described above within three months. We will invest any idle funds primarily in high quality, short-term debt securities, consistent with our business development company election and our election to be taxed as a RIC, at yields significantly below those we expect to earn on investments in small and mid-sized companies. The management fee payable by us to our investment adviser will not be reduced while our assets are invested in these securities unless such securities constitute cash and cash equivalents (as defined in the notes to our Consolidated Financial Statements). Our ability to achieve our investment objective may be limited to the extent that the net proceeds from this offering, pending full investment, are held in lower-yielding interest-bearing deposits or other short-term instruments.

 

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CAPITALIZATION

The following table sets forth our capitalization as of June 30, 2012:

 

   

on an actual basis; and

 

   

on an as adjusted basis to reflect the sale of $75.00 million aggregate principal amount of Notes in this offering, after deducting the underwriting discounts and commissions of $2.25 million payable by us and estimated offering expenses of approximately $300,000 payable by us.

 

     As of June 30, 2012
(unaudited)
 
         Actual             As Adjusted      

Cash and cash equivalents

   $ 105,694,423      $ 105,694,423   
  

 

 

   

 

 

 

Long-term debt, including current maturities:

    

Credit facilities payable

   $ 228,540,580      $ 156,090,580 (1) 

Convertible senior notes payable

     115,000,000        115,000,000   

SBA debentures payable

     150,000,000       
150,000,000
  

Notes offered hereby

     —          75,000,000   
  

 

 

   

 

 

 

Total long-term debt

     493,540,580        496,090,580   

Net assets:

    

Common stock, $0.01 par value (150,000,000 shares authorized; 82,462,402 shares outstanding)

     824,624        824,624 (2) 

Additional paid-in-capital

     930,189,578        930,189,578 (2) 

Net unrealized depreciation on investments and interest rate swap

     (21,916,421     (21,916,421

Net realized loss on investments and interest rate swap

     (90,904,347     (90,904,347

Accumulated overdistributed net investment income

     (6,122,309     (6,122,309
  

 

 

   

 

 

 

Total net assets

     812,071,125        812,071,125   
  

 

 

   

 

 

 

Total capitalization

   $ 1,305,611,705      $ 1,308,161,705   
  

 

 

   

 

 

 

 

(1) We intend to use the net proceeds from this offering to repay debt outstanding under our Wells Fargo facility and ING facility. As of October 10, 2012, we had credit facilities payable in the amount of $206.3 million due to net repayments under our credit facilities in the amount of $22.2 million subsequent to June 30, 2012. This table has not been adjusted to reflect such net repayments.
(2) This amount does not reflect the 8,451,486 shares of our common stock we issued on September 14, 2012 at an offering price of $10.79 per share. The gross proceeds from such offering totaled $91.2 million.

 

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SELECTED FINANCIAL AND OTHER DATA

The following selected financial data should be read together with our consolidated financial statements and the related notes and the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this prospectus supplement and the accompanying prospectus. Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp. The financial information as of and for the period from inception (February 15, 2007) to September 30, 2007 and for the fiscal years ended September 30, 2008, 2009, 2010, and 2011, set forth below was derived from the audited consolidated financial statements and related notes for Fifth Street Mezzanine Partners III, L.P. and Fifth Street Finance Corp., respectively. The financial information at and for the nine months ended June 30, 2012 and 2011 was derived from our unaudited financial statements and related notes. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements for the interim periods, have been included. The historical financial information below may not be indicative of our future performance. Our results for the interim period may not be indicative of our results for the full year.

 

    At and for the
Nine Months Ended
    At and for the Year Ended     At September 30,
2007 and for the
period February 15,
2007 through
September 30,

2007
 

(dollars in thousands, except
per share amounts)

  June 30,
2012
    June 30,
2011
    September 30,
2011
    September 30,
2010
    September 30,
2009
    September 30,
2008
   

Statement of Operations data:

             

Total investment income

  $ 122,583      $ 87,478      $ 125,165      $ 70,538      $ 49,828      $ 33,219      $ 4,296   

Base management fee, net

    17,226        13,946        19,656        9,275        5,889        4,258        1,564   

Incentive fee

    16,422        11,785        16,782        10,756        7,841        4,118        —     

All other expenses

    24,817        14,609        23,080        7,483        4,736        4,699        1,773   

Gain on extinguishment of convertible senior notes

    1,571        —          1,480        —          —          —          —     

Net investment income

    65,689        47,138        67,127        43,024        31,362        20,144        959   

Unrealized appreciation (depreciation) on interest rate swap

    —          51        773        (773     —          —          —     

Realized loss on interest rate swap

    —          —          (1,335     —          —          —          —     

Unrealized appreciation (depreciation) on investments

    14,060        34,871        (7,299     (1,054     (10,795     (16,948     123   

Realized gain (loss) on investments

    (27,420     (28,109     (29,059     (18,781     (14,373     62        —     

Net increase in partners’ capital/net assets resulting from operations

    52,329        53,951        30,207        22,416        6,194        3,258        1,082   

Per share data:

             

Net asset value per common share at period end

  $ 9.85      $ 10.72      $ 10.07      $ 10.43      $ 10.84      $ 13.02      $ N/A   

Market price at period end

    9.98        11.60        9.32        11.14        10.93        10.05        N/A   

Net investment income

    0.84        0.77        1.05        0.95        1.27        1.29        N/A   

Net realized and unrealized loss on investments and interest rate swap

    (0.17     0.11        (0.58     (0.46     (1.02     (1.08     N/A   

Net increase in partners’ capital/net assets resulting from operations

    0.67        0.88        0.47        0.49        0.25        0.21        N/A   

Dividends paid per share

    0.89        0.94        1.28        0.99        1.20        0.61        N/A   

Balance Sheet data at period end:

             

Total investments at fair value

  $ 1,198,097      $ 1,053,479      $ 1,119,837      $ 563,821      $ 299,611      $ 273,759      $ 88,391   

Cash and cash equivalents

    105,694        17,606        67,644        76,765        113,205        22,906        17,654   

Other assets

    20,700        22,683        22,236        11,340        3,071        2,484        1,285   

Total assets

    1,324,491        1,093,768        1,209,717        651,926        415,887        299,149        107,330   

Total liabilities

    512,420        318,119        481,090        82,754        5,331        4,813        514   

Total net assets

    812,071        775,649        728,627        569,172        410,556        294,336        106,816   

Other data:

             

Weighted average yield on debt investments(1)

    12.13     12.64     12.4     14.0     15.7     16.2     16.8

Number of investments at period end

    76        60        65        38        28        24        10   

(1) Weighted average yield is calculated based upon our debt investments at the end of the period.

 

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RATIOS OF EARNINGS TO FIXED CHARGES

The following table contains our ratio of earnings to fixed charges for the periods indicated, computed as set forth below. You should read these ratios of earnings to fixed charges in connection with our consolidated financial statements, including the notes to those statements, included in this prospectus. Although our earnings have generally increased in recent periods, our ratio of earnings to fixed charges has decreased due to greater levels of borrowing.

 

     For The Nine
Months Ended
June 30,

2012
     For The  Year
Ended

September 30,
2011
     For The Year
Ended
September 30,
2010
     For The Year
Ended
September 30,
2009
     For The Year
Ended
September 30,
2008
     For The Period
February 15,
2007 through
September  30,
2007
 

Earnings to Fixed Charges(1)

     4.09         3.00         12.65         10.74         4.55         3.07   

 

(1) Earnings include net realized and unrealized gains or losses. Net realized and unrealized gains or losses can vary substantially from period to period.

For purposes of computing the ratios of earnings to fixed charges, earnings represent net increase in net assets resulting from operations plus (or minus) income tax expense (benefit) including excise tax expense plus fixed charges. Fixed charges include interest and credit facility fees and amortization of debt issuance costs.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in connection with our Consolidated Financial Statements and the notes thereto included in this prospectus supplement.

The information in this section contains forward-looking statements that involve risks and uncertainties. Please see “Supplementary Risk Factors” in this prospectus supplement and “Risk Factors” and “Special Note Regarding Forward-Looking Statements” in the accompanying prospectus for a discussion of the uncertainties, risks and assumptions associated with these statements.

Overview

We are a specialty finance company that lends to and invests in small and mid-sized companies primarily in connection with investments by private equity sponsors. Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity investments.

We were formed as a Delaware limited partnership (Fifth Street Mezzanine Partners III, L.P.) on February 15, 2007. Effective as of January 2, 2008, Fifth Street Mezzanine Partners III, L.P. merged with and into Fifth Street Finance Corp. At the time of the merger, all outstanding partnership interests in Fifth Street Mezzanine Partners III, L.P. were exchanged for 12,480,972 shares of common stock in Fifth Street Finance Corp.

On June 17, 2008, we completed an initial public offering of 10,000,000 shares of our common stock at the offering price of $14.12 per share. Our stock was listed on the New York Stock Exchange until November 28, 2011 when the Company transferred the listing to the NASDAQ Global Select Market, where it continues to trade under the symbol “FSC.”

Critical Accounting Policies

Basis of Presentation

The preparation of financial statements in accordance with GAAP requires management to make certain estimates and assumptions affecting amounts reported in the Consolidated Financial Statements. We have identified investment valuation and revenue recognition as our most critical accounting estimates. We continuously evaluate our estimates, including those related to the matters described below. These estimates are based on the information that is currently available to us and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from those estimates under different assumptions or conditions. A discussion of our critical accounting policies follows.

Investment Valuation

We are required to report our investments that are not publicly traded or for which current market values are not readily available at fair value. The fair value is deemed to be the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Under the bond yield approach, we use bond yield models to determine the present value of the future cash flow streams of our debt investments. We review various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assess the information in the valuation process.

Under the market approach, we estimate the enterprise value of the portfolio companies in which we invest. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise

 

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value is best expressed as a range of fair values from which we derive a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, we analyze various factors, including the portfolio company’s historical and projected financial results. Typically, private companies are valued based on multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), cash flows, net income, revenues, or in limited cases, book value. We generally require portfolio companies to provide annual audited and quarterly and monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year.

Under the income approach, we generally prepare and analyze discounted cash flow models based on our projections of the future free cash flows of the business.

Our Board of Directors undertakes a multi-step valuation process each quarter in connection with determining the fair value of our investments:

 

   

Our quarterly valuation process begins with each portfolio company or investment being initially valued by our finance department;

 

   

Preliminary valuations are then reviewed and discussed with the principals of our investment adviser;

 

   

Separately, independent valuation firms engaged by our Board of Directors prepare preliminary valuations on a selected basis and submit reports to us;

 

   

Our finance department compares and contrasts its preliminary valuations to the preliminary valuations of the independent valuation firms;

 

   

Our finance department prepares a valuation report for the Valuation Committee of our Board of Directors;

 

   

The Valuation Committee of our Board of Directors is apprised of the preliminary valuations of the independent valuation firms;

 

   

The Valuation Committee of our Board of Directors reviews the preliminary valuations, and our finance department responds and supplements the preliminary valuations to reflect any comments provided by the Valuation Committee;

 

   

The Valuation Committee of our Board of Directors makes a recommendation to the Board of Directors; and

 

   

Our Board of Directors discusses valuations and determines the fair value of each investment in our portfolio in good faith.

The fair value of all of our investments at June 30, 2012 and September 30, 2011 was determined by our Board of Directors. Our Board of Directors is solely responsible for the valuation of our portfolio investments at fair value as determined in good faith pursuant to our valuation policy and our consistently applied valuation process.

Our Board of Directors has authorized the engagement of independent valuation firms to provide us with valuation assistance. Upon completion of their processes each quarter, the independent valuation firms provide us with written reports regarding the preliminary valuations of selected portfolio securities as of the close of such quarter. We will continue to engage independent valuation firms to provide us with assistance regarding our determination of the fair value of selected portfolio securities each quarter; however, our Board of Directors is ultimately and solely responsible for determining the fair value of our investments in good faith. We intend to have a portion of the portfolio valued by an independent third party on a quarterly basis, with a substantial portion being valued on an annual basis.

 

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The portions of our portfolio valued, as a percentage of the portfolio at fair value, by independent valuation firms by period were as follows:

 

For the quarter ended December 31, 2007

     91.9

For the quarter ended March 31, 2008

     92.1

For the quarter ended June 30, 2008

     91.7

For the quarter ended September 30, 2008

     92.8

For the quarter ended December 31, 2008

     100.0

For the quarter ended March 31, 2009

     88.7 %(1) 

For the quarter ended June 30, 2009

     92.1

For the quarter ended September 30, 2009

     28.1

For the quarter ended December 31, 2009

     17.2 %(2) 

For the quarter ended March 31, 2010

     26.9

For the quarter ended June 30, 2010

     53.1

For the quarter ended September 30, 2010

     61.8

For the quarter ended December 31, 2010

     73.9

For the quarter ended March 31, 2011

     82.0

For the quarter ended June 30, 2011

     82.9

For the quarter ended September 30, 2011

     91.2

For the quarter ended December 31, 2011

     89.1

For the quarter ended March 31, 2012

     87.3

For the quarter ended June 30, 2012

     84.3

 

(1) 96.0% excluding our investment in IZI Medical Products, Inc., which closed on March 31, 2009, and therefore was not part of the independent valuation process
(2) 24.8% excluding four investments that closed in December 2009 and therefore were not part of the independent valuation process

As of June 30, 2012 and September 30, 2011, approximately 90.5% and 92.6%, respectively, of our total assets represented investments in portfolio companies valued at fair value.

Revenue Recognition

Interest and Dividend Income

Interest income, adjusted for accretion of original issue discount, is recorded on the accrual basis to the extent that such amounts are expected to be collected. We stop accruing interest on investments when it is determined that interest is no longer collectible. Distributions from portfolio companies are recorded as dividend income when the distribution is received.

Fee Income

We receive a variety of fees in the ordinary course of business. Certain fees, such as some origination fees, are capitalized and amortized in accordance with ASC 310-20 Nonrefundable Fees and Other Costs. In accordance with ASC 820, the net unearned fee income balance is netted against the cost and fair value of the respective investments. Other fees, such as servicing fees, are classified as fee income and recognized as they are earned on a monthly basis.

We have also structured exit fees across certain of our portfolio investments to be received upon the future exit of those investments. Exit fees are payable upon the exit of a debt security. These fees are to be paid to us upon the sooner to occur of (i) a sale of the borrower or substantially all of the assets of the borrower, (ii) the maturity date of the loan or (iii) the date when full prepayment of the loan occurs. The receipt of such fees is

 

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contingent upon the occurrence of one of the events listed above for each of the investments. A percentage of these fees is included in net investment income over the life of the loan. As of June 30, 2012, we had structured $6.8 million in aggregate exit fees across nine portfolio investments upon the future exit of those investments.

Payment-in-Kind (PIK) Interest

Our loans typically contain contractual PIK interest provisions. The PIK interest, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term, is generally recorded on the accrual basis to the extent such amounts are expected to be collected. We generally cease accruing PIK interest if there is insufficient value to support the accrual or if we do not expect the portfolio company to be able to pay all principal and interest due. Our decision to cease accruing PIK interest involves subjective judgments and determinations based on available information about a particular portfolio company, including whether the portfolio company is current with respect to its payment of principal and interest on its loans and debt securities; monthly and quarterly financial statements and financial projections for the portfolio company; our assessment of the portfolio company’s business development success, including product development, profitability and the portfolio company’s overall adherence to its business plan; information obtained by us in connection with periodic formal update interviews with the portfolio company’s management and, if appropriate, the private equity sponsor; and information about the general economic and market conditions in which the portfolio company operates. Based on this and other information, we determine whether to cease accruing PIK interest on a loan or debt security. Our determination to cease accruing PIK interest on a loan or debt security is generally made substantially before our full write-down of such loan or debt security.

For a discussion of risks we are subject to as a result of our use of PIK interest in connection with our investments, see “Risk Factors — Risks Relating to Our Business and Structure — We may have difficulty paying our required distributions if we recognize income before or without receiving cash representing such income,” “— We may in the future choose to pay dividends in our own stock, in which case you may be required to pay tax in excess of the cash you receive” and “— Our incentive fee may induce our investment adviser to make speculative investments” in our annual report on Form 10-K for the year ended September 30, 2011. In addition, if it is subsequently determined that we will not be able to collect any previously accrued PIK interest, the fair value of our loans or debt securities would decline by the amount of such previously accrued, but uncollectible, PIK interest. The accrual of PIK interest on our debt investments increases the recorded cost basis of these investments in our consolidated financial statements and, as a result, increases the cost basis of these investments for purposes of computing the capital gains incentive fee payable by us to our investment adviser.

To maintain our status as a RIC, PIK income must be paid out to our stockholders in the form of dividends even though we have not yet collected the cash and may never collect the cash relating to the PIK interest. Accumulated PIK interest was $27.9 million and represented 2.3% of the fair value of our portfolio of investments as of June 30, 2012 and $22.7 million or 2.0% as of September 30, 2011. The net increase in loan balances as a result of contracted PIK arrangements are separately identified in our Consolidated Statements of Cash Flows.

Portfolio Composition

Our investments principally consist of loans, purchased equity investments and equity grants in privately-held companies. Our loans are typically secured by either a first or second lien on the assets of the portfolio company and generally have terms of up to six years (but an expected average life of between three and four years). We are currently focusing our origination efforts on a prudent mix of first lien, second lien and subordinated loans which we believe will provide superior risk-adjusted returns while maintaining adequate credit protection. The mix may change over time based on market conditions and management’s view of where the best risk adjusted returns are available.

 

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A summary of the composition of our investment portfolio at cost and fair value as a percentage of total investments is shown in the following tables:

 

     June 30, 2012     September 30, 2011  

Cost:

    

First lien debt

     69.45     77.05

Second lien debt

     11.54     13.97

Subordinated debt

     16.88     7.40

Purchased equity

     1.49     0.97

Equity grants

     0.45     0.53

Limited partnership interests

     0.19     0.08
  

 

 

   

 

 

 

Total

     100.00     100.00
  

 

 

   

 

 

 
     June 30, 2012     September 30, 2011  

Fair value:

    

First lien debt

     69.43     78.14

Second lien debt

     11.08     12.80

Subordinated debt

     16.98     7.25

Purchased equity

     1.81     1.12

Equity grants

     0.50     0.60

Limited partnership interests

     0.20     0.09
  

 

 

   

 

 

 

Total

     100.00     100.00
  

 

 

   

 

 

 

The industry composition of our portfolio at cost and fair value as a percentage of total investments were as follows:

 

     June 30,
2012
    September 30,
2011
 

Cost:

    

Healthcare services

     12.00     19.65

Education services

     7.55     2.57

Healthcare equipment

     6.82     6.16

Internet software & services

     6.05     3.79

Diversified support services

     5.98     4.80

Oil & gas equipment services

     5.02     7.11

Leisure products

     4.56     1.17

Construction and engineering

     4.01     3.74

Advertising

     3.40     1.72

Pharmaceuticals

     3.30     2.36

Apparel, accessories & luxury goods

     3.18     2.68

Diversified financial services

     3.17     1.15

Electronic equipment & instruments

     2.94     3.01

Specialty stores

     2.72     2.99

Integrated telecommunication services

     2.63     2.25

Leisure facilities

     2.47     3.29

Household products

     2.46     2.70

Home improvement retail

     2.29     2.42

IT consulting & other services

     2.09     4.23

Restaurants

     1.92     1.21

Industrial machinery

     1.71     0.90

Electronic manufacturing services

     1.69     1.75

Human resources & employment services

     1.61     1.77

Auto parts & equipment

     1.57     1.63

Environmental & facilities services

     1.56     1.41

 

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     June 30,
2012
    September 30,
2011
 

Distributors

     1.56     1.61

Air freight & logistics

     1.52     1.56

Food distributors

     1.44     1.80

Research & consulting services

     1.15     0.00

Construction materials

     0.57     0.58

Housewares & specialties

     0.44     0.46

Building products

     0.41     0.58

Multi-sector holdings

     0.19     0.09

Movies & entertainment

     0.02     0.02

Fertilizers & agricultural chemicals

     0.00     2.49

Healthcare technology

     0.00     1.77

Trucking

     0.00     1.48

Data processing & outsourced services

     0.00     1.10
  

 

 

   

 

 

 

Total

     100.00     100.00
  

 

 

   

 

 

 
     June 30,
2012
    September 30,
2011
 

Fair Value:

    

Healthcare services

     12.59     20.67

Education services

     7.69     2.69

Healthcare equipment

     6.98     6.42

Internet software & services

     6.35     3.91

Diversified support services

     6.21     5.02

Oil & gas equipment services

     5.20     7.38

Leisure products

     4.67     1.22

Advertising

     3.49     1.80

Pharmaceuticals

     3.41     2.46

Apparel, accessories & luxury goods

     3.35     3.00

Diversified financial services

     3.29     1.19

Electronic equipment & instruments

     2.99     3.11

Specialty stores

     2.85     3.14

Construction and engineering

     2.75     3.20

Integrated telecommunication services

     2.70     2.36

Leisure facilities

     2.57     3.43

Household products

     2.52     2.67

IT consulting & other services

     2.17     4.42

Home improvement retail

     2.09     2.46

Environmental & facilities services

     1.93     1.78

Industrial machinery

     1.81     0.97

Auto parts & equipment

     1.72     1.70

Restaurants

     1.71     1.06

Human resources & employment services

     1.70     1.87

Distributors

     1.64     1.69

Food distributors

     1.49     1.88

Research & consulting services

     1.20     0.00

Air freight & logistics

     1.19     1.54

Electronic manufacturing services

     0.70     0.77

Construction materials

     0.59     0.61

Multi-sector holdings

     0.19     0.11

Building products

     0.18     0.43

Housewares & specialties

     0.06     0.23

Movies & entertainment

     0.02     0.02

Fertilizers & agricultural chemicals

     0.00     2.61

Healthcare technology

     0.00     1.87

Data processing & outsourced services

     0.00     0.31
  

 

 

   

 

 

 

Total

     100.00     100.00
  

 

 

   

 

 

 

 

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Portfolio Asset Quality

We employ a ranking system to assess and monitor the credit risk of our investment portfolio. We rank all investments on a scale from 1 to 5. The system is intended to reflect the performance of the borrower’s business, the collateral coverage of the loan, and other factors considered relevant to making a credit judgment. We have determined that there should be an individual ranking assigned to each tranche of securities in the same portfolio company where appropriate. This may arise when the perceived risk of loss on the investment varies significantly between tranches due to their respective seniority in the capital structure.

 

   

Investment Ranking 1 is used for investments that are performing above expectations and/or a capital gain is expected.

 

   

Investment Ranking 2 is used for investments that are performing substantially within our expectations, and whose risks remain neutral or favorable compared to the potential risk at the time of the original investment. All new investments are initially ranked 2.

 

   

Investment Ranking 3 is used for investments that are performing below our expectations and that require closer monitoring, but where we expect no loss of investment return (interest and/or dividends) or principal. Companies with a ranking of 3 may be out of compliance with financial covenants.

 

   

Investment Ranking 4 is used for investments that are performing below our expectations and for which risk has increased materially since the original investment. We expect some loss of investment return, but no loss of principal.

 

   

Investment Ranking 5 is used for investments that are performing substantially below our expectations and whose risks have increased substantially since the original investment. Investments with a ranking of 5 are those for which some loss of principal is expected.

The following table shows the distribution of our investments on the 1 to 5 investment ranking scale at fair value, as of June 30, 2012 and September 30, 2011:

 

     June 30, 2012      September 30, 2011  
   Fair Value      Percentage of
Total Portfolio
    Leverage
Ratio
     Fair Value      Percentage of
Total Portfolio
    Leverage
Ratio
 

1

   $ 44,925         3.75     2.07       $ 81,335         7.26     3.16   

2

     1,133,015         94.57     3.89         1,021,990         91.26     3.87   

3

     3,549         0.30     NM(1)         8,660         0.77     NM(1)   

4

     11,518         0.96     NM(1)                 0.00       

5

     5,090         0.42     NM(1)         7,852         0.71     NM(1)   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 1,198,097         100.00     3.83       $ 1,119,837         100.00     3.82   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) Due to operating performance this ratio is not measurable and, as a result, is excluded from the total portfolio calculation.

We may from time to time modify the payment terms of our investments, either in response to current economic conditions and their impact on certain of our portfolio companies or in accordance with tier pricing provisions in certain loan agreements. As of June 30, 2012, we had modified the payment terms of our investments in 14 portfolio companies. Such modified terms may include increased PIK interest provisions and reduced cash interest rates. These modifications, and any future modifications to our loan agreements, may limit the amount of interest income that we recognize from the modified investments, which may, in turn, limit our ability to make distributions to our stockholders.

 

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Loans and Debt Securities on Non-Accrual Status

As of June 30, 2012, we had stopped accruing cash and/or PIK interest and original issue discount (“OID”) on four investments, three of which had not paid all of their scheduled cash interest payments for the period ended June 30, 2012. As of June 30, 2011, we had stopped accruing cash interest, PIK interest and OID on two investments that had not paid all of their scheduled cash interest payments for the period ended June 30, 2011.

Cash non-accrual status is inclusive of PIK and other noncash income, where applicable. The percentages of our portfolio investments at cost and fair value by accrual status as of June 30, 2012, September 30, 2011 and June 30, 2011 were as follows:

 

    June 30, 2012     September 30, 2011     June 30, 2011  
    Cost     % of
Portfolio
    Fair
Value
    % of
Portfolio
    Cost     % of
Portfolio
    Fair
Value
    % of
Portfolio
    Cost     % of
Portfolio
    Fair
Value
    % of
Portfolio
 

Accrual

  $ 1,168,495        95.75   $ 1,181,490        98.61   $ 1,116,762        96.60   $ 1,111,986        99.30   $ 1,025,169        97.86   $ 1,046,526        99.34

PIK non-accrual

    15,637        1.28     3,454        0.29            0.00            0.00            0.00            0.00

Cash non-accrual

    36,260        2.97     13,153        1.10     39,320        3.40     7,851        0.70     22,383        2.14     6,953        0.66
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 1,220,392        100.00   $ 1,198,097        100.00   $ 1,156,082        100.00   $ 1,119,837        100.00   $ 1,047,552        100.00   $ 1,053,479        100.00
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The non-accrual status of our portfolio investments as of June 30, 2012, September 30, 2011 and June 30, 2011 was as follows:

 

     June 30, 2012      September 30, 2011      June 30, 2011  

Lighting by Gregory, LLC

     Cash non-accrual         Cash non-accrual         Cash non-accrual   

O’Currance, Inc.(1)

             Cash non-accrual           

Premier Trailer Leasing, Inc.(1)

             Cash non-accrual         Cash non-accrual   

Repechage Investments Limited

     Cash non-accrual         Cash non-accrual           

Rail Acquisition Corp.

     PIK non-accrual                   

Traffic Control & Safety Corp. — Second Lien and Subordinated Debt

     Cash non-accrual                   

 

(1) We no longer hold this investment. See “— Discussion and Analysis of Results and Operations — Comparison of the three and nine months ended June 30, 2012 and June 30, 2011 — Realized Gain (Loss) on Investments and Interest Rate Swaps” for a discussion of our recent realization events.

Income non-accrual amounts related to the above investments for the three and nine months ended June 30, 2012 and June 30, 2011 were as follows:

 

     Three months ended
June 30, 2012
     Three months ended
June 30, 2011
     Nine months ended
June 30, 2012
     Nine months ended
June 30, 2011
 

Cash interest income

   $ 524       $ 917       $ 2,681       $ 4,484   

PIK interest income

     1,033         155         3,078         541   

OID income

                     95         60   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,557       $ 1,072       $ 5,854       $ 5,085   
  

 

 

    

 

 

    

 

 

    

 

 

 

Discussion and Analysis of Results and Operations

Results of Operations

The principal measure of our financial performance is the net increase (decrease) in net assets resulting from operations, which includes net investment income (loss), net realized gain (loss) and net unrealized appreciation (depreciation). Net investment income is the difference between our income from interest, dividends, fees, and other investment income and total expenses. Net realized gain (loss) on investments is the difference between the

 

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proceeds received from dispositions of portfolio investments and their stated costs. Net unrealized appreciation (depreciation) is the net change in the fair value of our investment portfolio and interest rate swap.

Comparison of the three and nine months ended June 30, 2012 and June 30, 2011

Total Investment Income

Total investment income includes interest and dividend income on our investments, fee income and other investment income. Fee income consists principally of loan and arrangement fees, administrative fees, unused fees, amendment fees, equity structuring fees, exit fees, prepayment fees and waiver fees. Other investment income consists primarily of dividend income received from certain of our equity investments.

Total investment income for the three months ended June 30, 2012 and June 30, 2011 was $41.0 million and $32.4 million, respectively. For the three months ended June 30, 2012, this amount primarily consisted of $32.6 million of interest income from portfolio investments (which included $3.9 million of PIK interest) and $8.3 million of fee income. For the three months ended June 30, 2011, this amount primarily consisted of $29.0 million of interest income from portfolio investments (which included $3.6 million of PIK interest) and $3.3 million of fee income.

Total investment income for the nine months ended June 30, 2012 and June 30, 2011 was $122.6 million and $87.5 million, respectively. For the nine months ended June 30, 2012, this amount primarily consisted of $98.1 million of interest income from portfolio investments (which included $10.2 million of PIK interest) and $24.4 million of fee income. For the nine months ended June 30, 2011, this amount primarily consisted of $75.6 million of interest income from portfolio investments (which included $10.2 million of PIK interest) and $11.7 million of fee income.

The increase in our total investment income for the three and nine months ended June 30, 2012 as compared to the three and nine months ended June 30, 2011 was primarily attributable to a higher average level of outstanding debt investments, which was principally due to a net increase of 10 debt investments in our portfolio and fee income related to debt payoffs, partially offset by amortization payments received on our debt investments and a decrease in the weighted average yield on our debt investments from 12.64% to 12.13% during the year-over-year period.

Expenses

Expenses for the three months ended June 30, 2012 and June 30, 2011 were $19.3 million and $15.9 million, respectively. Expenses increased for the three months ended June 30, 2012 as compared to the three months ended June 30, 2011 by $3.4 million. This was due primarily to increases in:

 

   

Base management fee, which was attributable to a 13.7% increase in the fair value of the investment portfolio due to an increase in net investment fundings in the year-over-year period;

 

   

Incentive fee, which was attributable to a 32.6% increase in pre-incentive fee net investment income for the year-over-year period; and

 

   

Interest expense, which was attributable to a 26.1% increase in weighted average debt outstanding for the year-over-year period.

Expenses for the nine months ended June 30, 2012 and June 30, 2011 were $58.5 million and $40.3 million, respectively. Expenses increased for the nine months ended June 30, 2012 as compared to the nine months ended June 30, 2011 by $18.2 million. This was due primarily to increases in:

 

   

Base management fee, which was attributable to the increase in the fair value of the investment portfolio discussed above;

 

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Incentive fee, which was attributable to a 39.4% increase in pre-incentive fee net investment income for the year-over-year period; and

 

   

Interest expense, which was attributable to a 97.9% increase in weighted average debt outstanding for the year-over-year period. The significant increase in debt outstanding for the three and nine months ended June 30, 2012 as compared to the three and nine months ended June 30, 2011 is attributable to our ability to obtain attractively priced debt to finance our investment operations.

Gain on Extinguishment of Convertible Senior Notes

During the three and nine months ended June 30, 2012, we repurchased $9.0 million and $20.0 million in principal amount, respectively, of our unsecured convertible notes (“Convertible Notes”) in the open market and surrendered them to the Trustee for cancellation. The aggregate purchase price of these Convertible Notes was $17.9 million because they were trading at a discount due to what we believe were volatile market conditions. As such we recorded a gain in the amount of the difference between the reacquisition price and the net carrying amount of these Convertible Notes, net of the proportionate amount of unamortized debt issuance costs. The net gain on extinguishment of debt recorded for the three and nine months ended June 30, 2012 was $0.2 million and $1.6 million, respectively. Because this net gain was included in the amount that must be distributed to our stockholders in order for us to maintain our RIC status and is classified as a component of net investment income in our Consolidated Statements of Operations, such net gain was included in “Pre-Incentive Fee Net Investment Income” for purposes of the payment of the income incentive fee to the investment adviser under our investment advisory agreement. Paying an incentive fee on this type of net gain is permissible under our investment advisory agreement, but because such a fee was not specifically detailed in the investment advisory agreement, we obtained the approval of our Board of Directors to pay such a fee in the future and ratify the payment of such fees we have already paid. This type of net gain, and corresponding income incentive fee, may occur again in the future.

Net Investment Income

As a result of the $8.6 million increase in total investment income and the $0.2 million gain on extinguishment of debt, as compared to the $3.4 million increase in total expenses, net investment income for the three months ended June 30, 2012 reflected a $5.4 million, or 32.6%, increase compared to the three months ended June 30, 2011.

As a result of the $35.1 million increase in total investment income and the $1.6 million gain on extinguishment of debt, as compared to the $18.2 million increase in total expenses, net investment income for the nine months ended June 30, 2012 reflected a $18.5 million, or 39.4%, increase compared to the nine months ended June 30, 2011.

Realized Gain (Loss) on Investments and Interest Rate Swap

Realized gain (loss) is the difference between the proceeds received from dispositions of portfolio investments and interest rate swaps and their stated costs. Realized losses may also be recorded in connection with our determination that certain investments are considered worthless securities and/or meet the conditions for loss recognition per the applicable tax rules.

During the nine months ended June 30, 2012, we recorded investment realization events, including the following:

 

   

In November 2011, we recorded a realized loss in the amount of $18.1 million as a result of a Delaware bankruptcy court judge ruling which confirmed a Chapter 11 plan of reorganization that provided no recovery on our investment in Premier Trailer Leasing, Inc.;

 

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In November 2011, we received a cash payment of $20.2 million from IZI Medical Products, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and we received an additional $1.3 million proceeds from our equity investment, realizing a gain of $0.8 million;

 

   

In December 2011, we received a cash payment of $23.0 million from ADAPCO, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and no realized gain or loss was recorded on this transaction;

 

   

In December 2011, we received a cash payment of $2.0 million from Best Vinyl Fence & Deck, LLC in full satisfaction of all obligations related to the Term Loan A under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction;

 

   

In December 2011, we received a cash payment of $9.2 million from Actient Pharmaceuticals LLC in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction;

 

   

In January 2012, we received a cash payment of $18.5 million from IOS Acquisitions, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and no realized gain or loss was recorded on this transaction;

 

   

In February 2012, we received a cash payment of $2.1 million from O’Currance, Inc. The debt investment was exited below par and we recorded a realized loss in the amount of $10.7 million on this transaction;

 

   

In February 2012, we received a cash payment of $25.0 million from Ernest Health, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and no realized gain or loss was recorded on this transaction;

 

   

In March 2012, we received a cash payment of $47.7 million from CRGT, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and no realized gain or loss was recorded on this transaction;

 

   

In March 2012, we received a cash payment of $24.5 million from Epic Acquisition, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and no realized gain or loss was recorded on this transaction;

 

   

In March 2012, we received a cash payment of $48.8 million from Dominion Diagnostics, LLC in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and no realized gain or loss was recorded on this transaction;

 

   

In March 2012, we received a cash payment of $5.0 million from Genoa Healthcare Holdings, LLC in full satisfaction of all obligations under the senior loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction;

 

   

In May 2012, we received a cash payment of $28.9 million from JTC Education, Inc. in full satisfaction of all obligations under the first lien loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction;

 

   

In May 2012, we received a cash payment of $6.1 million from Fitness Edge, LLC in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction; and

 

   

In June 2012, we received a cash payment of $20.2 million from Caregiver Services, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and no realized gain or loss was recorded on this transaction.

 

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During the nine months ended June 30, 2011, we recorded investment realization events, including the following:

 

   

In October 2010, we received a cash payment of $8.7 million from Goldco, Inc. in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and no realized gain or loss was recorded on this transaction;

 

   

In November 2010, we received a cash payment of $11.0 million from TBA Global, LLC in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par and no realized gain or loss was recorded on this transaction;

 

   

In November 2010, we restructured our investment in Vanguard Vinyl, Inc. The restructuring resulted in a material modification of the terms of the loan agreement. As such, we recorded a realized loss in the amount of $1.7 million in accordance with ASC 470-50;

 

   

In December 2010, we restructured our investment in Nicos Polymers & Grinding, Inc. The restructuring resulted in a material modification of the terms of the loan agreement. As such, we recorded a realized loss in the amount of $3.9 million in accordance with ASC 470-50;

 

   

In December 2010, we received a cash payment of $25.3 million from Boot Barn in full satisfaction of all obligations under the loan agreement. The debt investment was exited at par (plus additional fees) and no realized gain or loss was recorded on this transaction;

 

   

In December 2010, we received a cash payment of $11.7 million from Western Emulsions, Inc. in partial satisfaction of the obligations under the loan agreement. No realized gain or loss was recorded on this transaction;

 

   

In December 2010, we restructured our investment in Lighting by Gregory, LLC. The restructuring resulted in a material modification of the terms of the loan agreement. As such, we recorded a realized loss in the amount of $7.8 million in accordance with ASC 470-50;

 

   

In March 2011, we received a cash payment of $5.0 million from AmBath/ReBath Holdings, Inc. as part of a restructuring of the loan agreement. The restructuring resulted in a material modification of the terms of the loan agreement. As such, we recorded a realized loss in the amount of $0.3 million in accordance with ASC 470-50; and

 

   

In March and April 2011, we received cash payments totaling $1.1 million from MK Network, LLC as part of a settlement of the loan agreement. In April 2011, we recorded a realized loss on this investment in the amount of $14.1 million.

Net Unrealized Appreciation or Depreciation on Investments and Interest Rate Swap

Net unrealized appreciation or depreciation is the net change in the fair value of our investments and interest rate swap during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.

During the three months ended June 30, 2012, we recorded net unrealized appreciation of $0.2 million. This consisted of $0.1 million of net unrealized appreciation on debt investments and $0.1 million of net unrealized appreciation on equity investments. During the three months ended June 30, 2011, we recorded net unrealized appreciation of $18.5 million. This consisted of $14.0 million of net reclassifications to realized losses and $7.1 million of net unrealized appreciation on equity investments, offset by $1.7 million of net unrealized depreciation on debt investments and $0.9 million of net unrealized depreciation on our interest rate swap.

During the nine months ended June 30, 2012, we recorded net unrealized appreciation of $14.1 million. This consisted of $1.9 million of net unrealized appreciation on equity investments and $27.7 million of net reclassifications to realized losses, offset by $15.5 million of net unrealized depreciation on debt investments.

 

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        During the nine months ended June 30, 2011, we recorded net unrealized appreciation of $34.9 million. This consisted of $24.9 million of net reclassifications to realized losses, $4.0 million of net unrealized appreciation on debt investments and $6.0 million of net unrealized appreciation on equity investments.

Financial Condition, Liquidity and Capital Resources

Cash Flows

We have a number of alternatives available to fund the growth of our investment portfolio and our operations, including, but not limited to, raising equity, increasing debt and funding from operational cash flow. Additionally, we may reduce investment size by syndicating a portion of any given transaction. We intend to fund our future distribution obligations through operating cash flow or with funds obtained through future equity and debt offerings or credit facilities, as we deem appropriate.

For the nine months ended June 30, 2012, we experienced a net increase in cash and cash equivalents of $38.1 million. During that period, we used $22.4 million of cash in operating activities, primarily for the funding of $407.9 million of investments and net revolvers, partially offset by $333.3 million of principal payments, PIK payments received and investment sale proceeds received and $65.7 million of net investment income. During the same period, cash provided by financing activities was $60.4 million, primarily consisting of $50.5 million of net borrowings under our credit facilities and $100.7 million of proceeds from the issuance of our common stock, partially offset by $68.7 million of cash dividends paid, $17.9 million of net repurchases of our convertible senior notes and $3.3 million of deferred financing costs paid.

For the nine months ended June 30, 2011, we experienced a net decrease in cash and cash equivalents of $59.2 million. During that period, we used $431.5 million of cash in operating activities, primarily for the funding of $566.8 million of investments and net revolvers, partially offset by $89.0 million of principal payments and PIK payments received and $47.1 million of net investment income. During the same period, cash provided by financing activities was $372.3 million, primarily consisting of $77.0 million of SBA borrowings, $206.8 million of proceeds from the issuance of our common stock and $152.0 million of proceeds from the issuance of our convertible senior notes, partially offset by $53.6 million of cash dividends paid and $9.2 million of deferred financing costs paid.

As of June 30, 2012, we had $105.7 million in cash and cash equivalents, portfolio investments (at fair value) of $1.20 billion, $5.9 million of interest and fees receivable, $150.0 million of SBA debentures payable, $228.5 million of borrowings outstanding under our credit facilities, $115.0 million of convertible senior notes payable and unfunded commitments of $96.0 million.

As of September 30, 2011, we had $67.6 million in cash and cash equivalents, portfolio investments (at fair value) of $1.12 billion, $6.8 million of interest and fees receivable, $150.0 million of SBA debentures payable, $178.0 million of borrowings outstanding under our credit facilities, $135.0 million of convertible senior notes payable and unfunded commitments of $108.8 million.

Other Sources of Liquidity

We intend to continue to generate cash primarily from cash flows from operations, including interest earned, future borrowings and future offerings of securities. In the future, we may also securitize a portion of our investments in first and second lien senior loans or unsecured debt or other assets. To securitize loans, we would likely create a wholly-owned subsidiary and contribute a pool of loans to the subsidiary. We would then sell interests in the subsidiary on a non-recourse basis to purchasers and we would retain all or a portion of the equity in the subsidiary. Our primary use of funds is investments in our targeted asset classes and cash distributions to holders of our common stock.

 

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Although we expect to fund the growth of our investment portfolio through the net proceeds from equity offerings, including our dividend reinvestment plan, and issuances of senior securities or future borrowings, to the extent permitted by the 1940 Act, our plans to raise capital may not be successful. In this regard, because our common stock has at times traded at a price below our then-current net asset value per share and we are limited in our ability to sell our common stock at a price below net asset value per share, we may be limited in our ability to raise equity capital.

In addition, we intend to distribute between 90% and 100% of our taxable income to our stockholders in order to satisfy the requirements applicable to RICs under Subchapter M of the Code. See “Regulated Investment Company Status and Distributions” below. Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio companies or to repay borrowings. In addition, the illiquidity of our portfolio investments may make it difficult for us to sell these investments when desired and, if we are required to sell these investments, we may realize significantly less than their recorded value.

Also, as a business development company, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, to total senior securities, which include all of our borrowings and any outstanding preferred stock, of at least 200%. This requirement limits the amount that we may borrow. As of June 30, 2012, we were in compliance with this requirement. The amount of leverage that we employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing, such as the maturity, covenant package and rate structure of the proposed borrowings, our ability to raise funds through the issuance of shares of our common stock and the risks of such borrowings within the context of our investment outlook. Ultimately, we only intend to use leverage if the expected returns from borrowing to make investments will exceed the cost of such borrowing. To fund growth in our investment portfolio in the future, we anticipate needing to raise additional capital from various sources, including the equity markets and the securitization or other debt-related markets, which may or may not be available on favorable terms, if at all.

Finally, through wholly-owned subsidiaries, we sought and obtained licenses from the SBA to operate SBIC subsidiaries. In this regard, on February 3, 2010, our wholly-owned subsidiary, Fifth Street Mezzanine Partners IV, L.P. (“FSMP IV”), received a license, effective February 1, 2010, from the SBA to operate as an SBIC under Section 301(c) of the Small Business Investment Act of 1958. On May 15, 2012, our wholly-owned subsidiary, Fifth Street Mezzanine Partners V, L.P. (“FSMP V”), received a license, effective May 10, 2012, from the SBA to operate as an SBIC. SBICs are designated to stimulate the flow of private equity capital to eligible small businesses. Under SBA regulations, SBICs may make loans to eligible small businesses and invest in the equity securities of small businesses.

The SBIC licenses allow our SBIC subsidiaries to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and other customary procedures. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and have a ten year maturity. The principal amount of SBA-guaranteed debentures is not required to be paid prior to maturity but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed at the time of issuance at a market-driven spread over U.S. Treasury Notes with 10-year maturities.

 

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SBA regulations currently limit the amount that an SBIC subsidiary may borrow to a maximum of $150 million when it has at least $75 million in regulatory capital. Affiliated SBICs are permitted to issue up to a combined maximum amount of $225 million when it has at least $112.5 million in regulatory capital. As of June 30, 2012, FSMP IV had $75 million in regulatory capital and $150 million in SBA-guaranteed debentures outstanding, which had a fair value of $126.2 million. These debentures bear interest at a weighted average interest rate of 3.567% (excluding the SBA annual charge), as follows:

 

Rate Fix Date

   Debenture
Amount
     Fixed
Interest
Rate
    SBA
Annual
Charge
 

September 2010

   $ 73,000         3.215 %     0.285 %

March 2011

     65,300         4.084 %     0.285 %

September 2011

     11,700         2.877 %     0.285 %

As of June 30, 2012, FSMP V had $37.5 million in regulatory capital, but did not yet have any SBA-guaranteed debentures outstanding.

We have received exemptive relief from the Securities and Exchange Commission (“SEC”) to permit us to exclude the debt of our SBIC subsidiaries guaranteed by the SBA from the definition of senior securities in the 200% asset coverage test under the 1940 Act. This allows us increased flexibility under the 200% asset coverage test by permitting us to borrow up to $225 million more than we would otherwise be able to absent the receipt of this exemptive relief.

Significant capital transactions that occurred since October 1, 2010

The following table reflects the dividend distributions per share that our Board of Directors has declared and we have paid, including shares issued under our DRIP, on our common stock since October 1, 2010:

 

Date Declared

 

Record Date

   

Payment Date

    Amount per
Share
    Cash
Distribution
    DRIP Shares
Issued
    DRIP Shares
Value
 

November 30, 2010

    January 4, 2011        January 31, 2011      $ 0.1066      $ 5.4 million        36,038      $ 0.5 million   

November 30, 2010

    February 1, 2011        February 28, 2011        0.1066        5.4 million        29,072        0.4 million   

November 30, 2010

    March 1, 2011        March 31, 2011        0.1066        6.5 million        43,766        0.6 million   

January 30, 2011

    April 1, 2011        April 29, 2011        0.1066        6.5 million        45,193        0.6 million   

January 30, 2011

    May 2, 2011        May 31, 2011        0.1066        6.5 million        48,870        0.6 million   

January 30, 2011

    June 1, 2011        June 30, 2011        0.1066        6.5 million        55,367        0.6 million   

May 2, 2011

    July 1, 2011        July 29, 2011        0.1066        7.1 million        58,829        0.6 million   

May 2, 2011

    August 1, 2011        August 31, 2011        0.1066        7.1 million        64,431        0.6 million   

May 2, 2011

    September 1, 2011        September 30, 2011        0.1066        7.2 million        52,487        0.5 million   

August 1, 2011

    October 14, 2011        October 31, 2011        0.1066        7.3 million        40,388 (1)     0.4 million   

August 1, 2011

    November 15, 2011        November 30, 2011        0.1066        7.3 million        43,034 (1)      0.4 million   

August 1, 2011

    December 13, 2011        December 23, 2011        0.1066        7.3 million        43,531 (1)     0.4 million   

November 10, 2011

    January 13, 2012        January 31, 2012        0.0958        6.6 million        29,902 (1)     0.3 million   

November 10, 2011

    February 15, 2012        February 29, 2012        0.0958        7.4 million        45,071        0.4 million   

November 10, 2011

    March 15, 2012        March 30, 2012        0.0958        7.5 million        41,807 (1)      0.4 million   

February 7, 2012

    April 13, 2012        April 30, 2012        0.0958        7.4 million        48,328 (1)     0.5 million   

February 7, 2012

    May 15, 2012        May 31, 2012        0.0958        7.4 million        47,877 (1)     0.5 million   

February 7, 2012

    June 15, 2012        June 29, 2012        0.0958        7.5 million        41,499        0.4 million   

May 7, 2012

    July 13, 2012        July 31, 2012        0.0958        7.4 million        49,217        0.5 million  

May 7, 2012

    August 15, 2012        August 31, 2012        0.0958        7.5 million        41,359        0.4 million   

 

(1) Shares were purchased on the open market and distributed.

 

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The following table reflects share transactions that occurred from October 1, 2010 through June 30, 2012:

 

Date

  

Transaction

  Shares      Share Price     Gross Proceeds  

December 2010

   At-the-market offering     429,110       $ 11.87 (3)   $ 5.1 million   

February 4, 2011

   Public offering(1)     11,500,000         12.65        145.5 million   

June 24, 2011

   Public offering(2)     5,558,469         11.72        65.1 million   

January 26, 2012

   Public offering     10,000,000         10.07        100.7 million   

 

(1) Includes the underwriters’ full exercise of their over-allotment option
(2) Includes the underwriters’ partial exercise of their over-allotment option
(3) Average offering price

Borrowings

On November 16, 2009, we and Fifth Street Funding, LLC, a consolidated wholly-owned bankruptcy remote special purpose subsidiary (“Funding”), entered into a Loan and Servicing Agreement (“Wells Agreement”) with respect to a three-year credit facility (“Wells Fargo facility”) with Wells Fargo Bank, National Association (“Wells Fargo”), as successor to Wachovia Bank, National Association (“Wachovia”), Wells Fargo Securities, LLC, as administrative agent, each of the additional institutional and conduit lenders party thereto from time to time, and each of the lender agents party thereto from time to time, in the amount of $50 million, with an accordion feature which allowed for potential future expansion of the facility up to $100 million. The facility bore interest at LIBOR plus 4.0% per annum and had a maturity date of November 16, 2012.

On May 26, 2010, we amended the Wells Fargo facility to expand the borrowing capacity under that facility. Pursuant to the amendment, we received an additional $50 million commitment, thereby increasing the size of the facility from $50 million to $100 million, with an accordion feature that allows for potential future expansion of that facility from a total of $100 million up to a total of $150 million. In addition, the interest rate of the Wells Fargo facility was reduced from LIBOR plus 4% per annum to LIBOR plus 3.5% per annum, with no LIBOR floor, and the maturity date of the facility was extended from November 16, 2012 to May 26, 2013.

On November 5, 2010, we amended the Wells Fargo facility to, among other things, provide for the issuance from time to time of letters of credit for the benefit of our portfolio companies. The letters of credit are subject to certain restrictions, including a borrowing base limitation and an aggregate sublimit of $15.0 million.

On February 28, 2011, we amended the Wells Fargo facility to, among other things, (i) reduce the interest rate to LIBOR plus 3.0% per annum, with no LIBOR floor, (ii) extend the period during which we may make new borrowings under the facility to February 25, 2013 and (iii) extend the maturity date of the facility to February 25, 2014. The facility may be extended for up to two additional years upon the mutual consent of Wells Fargo and each of the lender parties thereto.

On November 30, 2011, we amended the Wells Fargo facility to, among other things, reduce the interest rate to LIBOR plus 2.75% per annum, with no LIBOR floor.

On April 23, 2012, we amended the Wells Fargo facility to, among other things, expand the borrowing capacity under the facility. Pursuant to the amendment, we received an additional $50 million commitment, thereby increasing the size of the facility to $150 million, with an accordion feature which allows for future expansion of the facility up to a total of $250 million. In addition, the period during which we may make and reinvest borrowings under the facility was extended to April 23, 2014 and the maturity date of the facility was extended to April 25, 2016.

In connection with the Wells Fargo facility, we concurrently entered into (i) a Purchase and Sale Agreement with Funding, pursuant to which we will sell to Funding certain loan assets we have originated or acquired, or will originate or acquire and (ii) a Pledge Agreement with Wells Fargo, pursuant to which we pledged all of our

 

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equity interests in Funding as security for the payment of Funding’s obligations under the Wells Agreement and other documents entered into in connection with the Wells Fargo facility. Funding was formed for the sole purpose of entering into the Wells Fargo facility and has no other operations.

The Wells Agreement and related agreements governing the Wells Fargo facility required both Funding and us to, among other things (i) make representations and warranties regarding the collateral as well as each of our businesses, (ii) agree to certain indemnification obligations and (iii) comply with various covenants, servicing procedures, limitations on acquiring and disposing of assets, reporting requirements and other customary requirements for similar credit facilities. The Wells Fargo facility agreements also include usual and customary default provisions such as the failure to make timely payments under the facility, a change in control of Funding, and the failure by Funding or us to materially perform under the Wells Agreement and related agreements governing the facility, which, if not complied with, could accelerate repayment under the facility, thereby materially and adversely affecting our liquidity, financial condition and results of operations.

The Wells Fargo facility is secured by all of the assets of Funding, and all of our equity interest in Funding. We use the Wells Fargo facility to fund a portion of our loan origination activities and for general corporate purposes. Each loan origination under the facility is subject to the satisfaction of certain conditions. We cannot be assured that Funding will be able to borrow funds under the Wells Fargo facility at any particular time or at all. As of June 30, 2012, we had $26.0 million of borrowings outstanding under the Wells Fargo facility that had a fair value of $26.0 million. Our borrowings under the Wells Fargo facility bore interest at a weighted average interest rate of 3.120% during the nine months ended June 30, 2012. For the three and nine months ended June 30, 2012, we recorded interest expense of $0.7 million and $2.0 million, respectively, related to the Wells Fargo facility.

On May 27, 2010, we entered into a three-year secured syndicated revolving credit facility (“ING facility”) pursuant to a Senior Secured Revolving Credit Agreement (“ING Credit Agreement”) with certain lenders party thereto from time to time and ING Capital LLC, as administrative agent. The ING facility allowed for us to borrow money at a rate of either (i) LIBOR plus 3.5% per annum or (ii) 2.5% per annum plus an alternate base rate based on the greatest of the Prime Rate, Federal Funds Rate plus 0.5% per annum or LIBOR plus 1% per annum, and had a maturity date of May 27, 2013. The ING facility also allowed us to request letters of credit from ING Capital LLC, as the issuing bank. The initial commitment under the ING facility was $90 million, and the ING facility included an accordion feature that allowed for potential future expansion of the facility up to a total of $150 million. The ING facility is secured by substantially all of our assets, as well as the assets of our wholly-owned subsidiary, FSFC Holdings, Inc., and our indirect wholly-owned subsidiary, Fifth Street Fund of Funds LLC, subject to certain exclusions for, among other things, equity interests in our SBIC subsidiaries and equity interests in Funding and Fifth Street Funding II, LLC as further set forth in a Guarantee, Pledge and Security Agreement (“ING Security Agreement”) entered into in connection with the ING Credit Agreement, among FSFC Holdings, Inc., ING Capital LLC, as collateral agent, and us. Fifth Street Fund of Funds LLC and FSFC Holdings, Inc. were formed to hold certain of our portfolio companies for tax purposes and have no other operations. None of our SBIC subsidiaries, Funding or Fifth Street Funding II, LLC is party to the ING facility and their respective assets have not been pledged in connection therewith. The ING facility provides that we may use the proceeds and letters of credit under the facility for general corporate purposes, including acquiring and funding leveraged loans, mezzanine loans, high-yield securities, convertible securities, preferred stock, common stock and other investments.

On February 22, 2011, we amended the ING facility to, among other things, expand the borrowing capacity to $215 million. In addition, the ING facility’s accordion feature was increased to allow for potential future expansion up to a total of $300 million and the maturity date was extended to February 22, 2014.

On July 8, 2011, we amended the ING facility to, among other things, expand the borrowing capacity to $230 million and increase the accordion feature to allow for potential future expansion up to a total of

 

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$350 million. In addition, the ING facility’s interest rate was reduced to LIBOR plus 3.0% per annum, with no LIBOR floor, when the facility is drawn more than 35%. Otherwise, the interest rate will be LIBOR plus 3.25% per annum, with no LIBOR floor.

On February 29, 2012, we amended the ING facility to, among other things, (i) extend the period during which we may make and repay borrowings under the ING facility to February 27, 2015, (ii) extend the maturity date to February 29, 2016 and (iii) increase the accordion feature to allow for potential future expansion up to a total of $450 million.

Pursuant to the ING Security Agreement, FSFC Holdings, Inc. and Fifth Street Fund of Funds LLC guaranteed the obligations under the ING Security Agreement, including our obligations to the lenders and the administrative agent under the ING Credit Agreement. Additionally, we pledged our entire equity interest in FSFC Holdings, Inc. and FSFC Holdings, Inc. pledged its entire equity interest in Fifth Street Fund of Funds LLC to the collateral agent pursuant to the terms of the ING Security Agreement.

The ING Credit Agreement and related agreements governing the ING facility required FSFC Holdings, Inc., Fifth Street Fund of Funds LLC and us to, among other things, (i) make representations and warranties regarding the collateral as well as each of our businesses, (ii) agree to certain indemnification obligations and (iii) agree to comply with various affirmative and negative covenants and other customary requirements for similar credit facilities. The ING facility documents also include usual and customary default provisions such as the failure to make timely payments under the facility, the occurrence of a change in control, and the failure by us to materially perform under the ING Credit Agreement and related agreements governing the facility, which, if not complied with, could accelerate repayment under the facility, thereby materially and adversely affecting our liquidity, financial condition and results of operations.

Each loan or letter of credit originated under the ING facility is subject to the satisfaction of certain conditions. We cannot be assured that we will be able to borrow funds under the ING facility at any particular time or at all.

As of June 30, 2012, we had $151.5 million of borrowings outstanding under the ING facility that had a fair value of $151.5 million. Our borrowings under the ING facility bore interest at a weighted average interest rate of 3.390% during the nine months ended June 30, 2012. For the three and nine months ended June 30, 2012, we recorded interest expense of $1.3 million and $4.1 million, respectively, related to the ING facility.

On September 16, 2011, Fifth Street Funding II, LLC, a consolidated wholly-owned bankruptcy remote, special purpose subsidiary (“Funding II”), entered into a Loan and Servicing Agreement (“Sumitomo Agreement”) with respect to a seven-year credit facility (“Sumitomo facility”) with Sumitomo Mitsui Banking Corporation (“SMBC”), an affiliate of Sumitomo Mitsui Financial Group, Inc., as administrative agent, and each of the lenders from time to time party thereto, in the amount of $200 million. The Sumitomo facility bears interest at a rate of LIBOR plus 2.25% per annum with no LIBOR floor, permits us to make new borrowings until September 16, 2014, matures on September 16, 2018 and includes an option for a one-year extension.

In connection with the Sumitomo facility, we concurrently entered into a Purchase and Sale Agreement with Funding II, pursuant to which we will sell to Funding II certain loan assets we have originated or acquired, or will originate or acquire.

The Sumitomo Agreement and related agreements governing the Sumitomo facility required both Funding II and us to, among other things (i) make representations and warranties regarding the collateral as well as each of our businesses, (ii) agree to certain indemnification obligations and (iii) comply with various covenants, servicing procedures, limitations on acquiring and disposing of assets, reporting requirements and other customary requirements for similar credit facilities. The Sumitomo facility agreements also include usual and customary default provisions such as the failure to make timely payments under the facility, a change in control of Funding II, and the failure by Funding II or us to materially perform under the Sumitomo Agreement and related agreements governing the Sumitomo facility, which, if not complied with, could accelerate repayment under the facility, thereby materially and adversely affecting our liquidity, financial condition and results of operations. Funding II was formed for the sole purpose of entering into the Sumitomo facility and has no other operations.

 

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The Sumitomo facility is secured by all of the assets of Funding II. Each loan origination under the facility is subject to the satisfaction of certain conditions. We cannot be assured that Funding II will be able to borrow funds under the Sumitomo facility at any particular time or at all. As of June 30, 2012, we had $51.0 million of borrowings outstanding under the Sumitomo facility that had a fair value of $51.0 million. Our borrowings under the Sumitomo facility bore interest at a weighted average interest rate of 2.885% during the nine months ended June 30, 2012. For the three and nine months ended June 30, 2012, we recorded interest expense of $0.3 million and $0.7 million, respectively, related to the Sumitomo facility.

As of June 30, 2012, except for assets that were funded through our SBIC subsidiaries, substantially all of our assets were pledged as collateral under the Wells Fargo facility, ING facility or the Sumitomo facility. With respect to the assets funded through our SBIC subsidiaries, the SBA, as a creditor, will have a superior claim to the SBIC subsidiaries’ assets over our stockholders.

Interest expense for the three and nine months ended June 30, 2012 was $5.6 million and $16.9 million, respectively. Interest expense for the three and nine months ended June 30, 2011 was $5.0 million and $9.6 million, respectively.

The following table describes significant financial covenants with which we must comply under each of our credit facilities on a quarterly basis. The Sumitomo facility does not require us to comply with significant financial covenants.

 

Facility

  

Financial Covenant

 

Description

  Target Value    Reported Value(1)

Wells Fargo facility

   Minimum shareholders’ equity (inclusive of affiliates)   Net assets shall not be less than $510 million plus 50% of the aggregate net proceeds of all sales of equity interests after February 25, 2011   $592 million    $812 million
   Minimum shareholders’ equity (exclusive of affiliates)   Net assets exclusive of affiliates other than Funding shall not be less than $250 million   $250 million    $619 million
   Asset coverage ratio   Asset coverage ratio shall not be less than 2.00:1   2.00:1    4.85:1

ING facility

  

Minimum

shareholders’ equity

  Net assets shall not be less than the greater of (a) 55% of total assets; and (b) $510 million plus 50% of the aggregate net proceeds of all sales of equity interests after February 22, 2011   $592 million    $812 million
   Asset coverage ratio   Asset coverage ratio shall not be less than 2.25:1   2.25:1    4.85:1
   Interest coverage ratio   Interest coverage ratio shall not be less than 2.50:1   2.50:1    6.67:1
   Eligible portfolio investments test   Aggregate value of (a) Cash and cash equivalents and (b) Portfolio investments ranked 1, 2 or 3 shall not be less than $175 million   $175 million    $626 million

 

(1) As contractually required, we report financial covenants based on the last filed quarterly or annual report, in this case our Form 10-Q for the quarter ended March 31, 2012. We were also in compliance with all financial covenants under these credit facilities based on the financial information contained in our Form 10-Q for the quarter ended June 30, 2012.

 

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We and our SBIC subsidiaries are also subject to certain regulatory requirements relating to our borrowings. For a discussion of such requirements, see “Item 1. Business — Regulation — Business Development Company Regulations” and “— Small Business Investment Company Regulations” in our Annual Report on Form 10-K for the year ended September 30, 2011.

The following table reflects material credit facility and SBA debenture transactions that have occurred since October 1, 2009. Amounts available and drawn are as of June 30, 2012:

 

Facility

  Date  

Transaction

  Total
Facility
Amount
    Upfront
fee Paid
    Total
Facility
Availability
    Amount
Drawn
    Remaining
Availability
   

Interest Rate

Wells Fargo facility

  11/16/2009   Entered into credit facility   $ 50 million      $ 0.8 million            LIBOR + 4.00%
  5/26/2010   Expanded credit facility     100 million        0.9 million            LIBOR + 3.50%
  2/28/2011   Amended credit facility     100 million        0.4 million            LIBOR + 3.00%
  11/30/2011   Amended credit facility     100 million                   LIBOR + 2.75%
  4/23/2012   Amended credit facility     150 million        1.2 million      $ 26 million (1)   $ 26 million             LIBOR + 2.75%

ING facility

  5/27/ 2010   Entered into credit facility     90 million        0.8 million            LIBOR + 3.50%
  2/22/ 2011   Expanded credit facility     215 million        1.6 million            LIBOR + 3.50%
  7/8/ 2011   Expanded credit facility     230 million        0.4 million            LIBOR + 3.00%/3.25%(2)
  2/29/2012   Amended credit facility     230 million        1.5 million        230 million        152 million      $ 78 million      LIBOR + 3.00%/3.25%(2)

SBA

  2/16/ 2010   Received capital commitment     75 million        0.8 million           
  9/21/ 2010   Received capital commitment     150 million        0.8 million        150 million        150 million             3.567%(3)
  7/23/2012   Received capital commitment     75 million        0.8 million        75 million               75 million     

Sumitomo facility

  9/16/2011   Entered into credit facility     200 million        2.5 million        51 million (1)      51 million       

  
  LIBOR + 2.25%

 

(1) Availability to increase upon our decision to further collateralize the facility.
(2) LIBOR plus 3.0% when the facility is drawn more than 35%. Otherwise, LIBOR plus 3.25%.
(3) Weighted average interest rate of 3.567% (excludes the SBA annual charge of 0.285%).

On April 12, 2011, we issued $152 million of our Convertible Notes, including $2 million issued to Leonard M. Tannenbaum, our Chief Executive Officer. The Convertible Notes were issued pursuant to an Indenture, dated April 12, 2011 (the “Indenture”), between us and Deutsche Bank Trust Company Americas, as trustee (the “Trustee”).

The Convertible Notes mature on April 1, 2016 (the “Maturity Date”), unless previously converted or repurchased in accordance with their terms. The Convertible Notes bear interest at a rate of 5.375% per year payable semiannually in arrears on April 1 and October 1 of each year, commencing on October 1, 2011. The Convertible Notes are our senior unsecured obligations and rank senior in right of payment to our existing and future indebtedness that is expressly subordinated in right of payment to the Convertible Notes; equal in right of payment to our existing and future unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of our secured indebtedness (including existing unsecured indebtedness that we later secure) to the extent of the value of the assets securing such indebtedness; and structurally junior to all existing and future indebtedness (including trade payables) incurred by our subsidiaries or financing vehicles.

Prior to the close of business on the business day immediately preceding January 1, 2016, holders may convert their Convertible Notes only under certain circumstances set forth in the Indenture, such as during specified periods when our shares of common stock trade at more than 110% of the then applicable conversion price or the Convertible Notes trade at less than 98% of their conversion value. On or after January 1, 2016 until the close of business on the business day immediately preceding the Maturity Date, holders may convert their Convertible Notes at any time. Upon conversion, we will deliver shares of our common stock. The conversion rate was initially, and currently is, 67.7415 shares of common stock per $1,000 principal amount of Convertible

 

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Notes (equivalent to a conversion price of approximately $14.76 per share of common stock). The conversion rate is subject to customary anti-dilution adjustments, including for any cash dividends or distributions paid on shares of our common stock in excess of a monthly dividend of $0.1066 per share, but will not be adjusted for any accrued and unpaid interest. In addition, if certain corporate events occur prior to the Maturity Date, the conversion rate will be increased for converting holders. Based on the current conversion rate, the maximum number of shares of common stock that would be issued upon conversion of the $115.0 million Convertible Notes outstanding at June 30, 2012 is 7,790,273. If we deliver shares of common stock upon a conversion at the time our net asset value per share exceeds the conversion price in effect at such time, our stockholders may incur dilution. In addition, our stockholders will experience dilution in their ownership percentage of our common stock upon our issuance of common stock in connection with the conversion of our Convertible Notes and any dividends paid on our common stock will also be paid on shares issued in connection with such conversion after such issuance. The shares of common stock issued upon a conversion are not subject to registration rights.

We may not redeem the Convertible Notes prior to maturity. No sinking fund is provided for the Convertible Notes. In addition, if certain corporate events occur in respect to us, holders of the Convertible Notes may require us to repurchase for cash all or part of their Convertible Notes at a repurchase price equal to 100% of the principal amount of the Convertible Notes to be repurchased, plus accrued and unpaid interest through, but excluding, the required repurchase date.

The Indenture contains certain covenants, including covenants requiring us to provide financial information to the holders of the Convertible Notes and the Trustee if we cease to be subject to the reporting requirements of the Securities Exchange Act of 1934. These covenants are subject to limitations and exceptions that are described in the Indenture.

For the three and nine months ended June 30, 2012, we recorded interest expense of $1.7 million and $5.4 million, respectively, related to the Convertible Notes.

We may repurchase the Convertible Notes in accordance with the 1940 Act and the rules promulgated thereunder. Any Convertible Notes repurchased by us may, at our option, be surrendered to the Trustee for cancellation, but may not be reissued or resold by us. Any Convertible Notes surrendered for cancellation will be promptly cancelled and no longer outstanding under the Indenture. During the three and nine months ended June 30, 2012, we repurchased $9.0 million and $20.0 million in principal amount, respectively, of the Convertible Notes in the open market for an aggregate purchase price of $17.9 million and surrendered them to the Trustee for cancellation.

As of June 30, 2012, there were $115.0 million Convertible Notes outstanding, which had a fair value of $109.4 million.

Off-Balance Sheet Arrangements

We may be a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our portfolio companies. As of June 30, 2012, our only off-balance sheet arrangements consisted of $96.0 million of unfunded commitments, which was comprised of $87.3 million to provide debt financing to certain of our portfolio companies and $8.7 million related to unfunded limited partnership interests. As of September 30, 2011, our only off-balance sheet arrangements consisted of $108.8 million, which was comprised of $102.7 million to provide debt financing to certain of our portfolio companies and $6.1 million related to unfunded limited partnership interests. Such commitments are subject to our portfolio companies’ satisfaction of certain financial and nonfinancial covenants and involve, to varying degrees, elements of credit risk in excess of the amount recognized in the Statement of Assets and Liabilities and are not reflected on our Consolidated Statement of Assets and Liabilities.

 

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A summary of the composition of unfunded commitments (consisting of revolvers, term loans and limited partnership interests) as of June 30, 2012 and September 30, 2011 is shown in the table below:

 

     June 30, 2012      September 30, 2011  

Welocalize, Inc.

   $ 10,000       $ 750   

Yeti Acquisition, LLC

     7,500           

Charter Brokerage, LLC

     6,471         6,176   

Refac Optical Group

     5,500         5,500   

Rail Acquisition Corp.

     5,042         5,446   

I Drive Safely, LLC

     5,000           

Traffic Control & Safety Corporation

     4,876         3,014   

Enhanced Recovery Company, LLC

     4,000         4,000   

Drugtest, Inc.

     4,000         4,000   

World 50, Inc.

     4,000           

Phoenix Brands Merger Sub LLC

     3,857         3,000   

Miche Bag, LLC

     3,500         5,000   

Titan Fitness, LLC

     3,500         2,957   

Cardon Healthcare Network, LLC

     3,000         2,000   

Tegra Medical, LLC

     3,000         1,500   

Discovery Practice Management, Inc.

     2,600         3,000   

Mansell Group, Inc.

     2,000         2,000   

Physicians Pharmacy Alliance, Inc.

     2,000         2,000   

Riverside Fund V, LP (limited partnership interest)

     2,000           

Specialty Bakers, LLC

     1,500         2,000   

Eagle Hospital Physicians, Inc.

     1,400         2,500   

Milestone Partners IV, LP (limited partnership interest)

     1,343         2,000   

Ansira Partners, Inc.

     1,190           

Psilos Group Partners IV, LP (limited partnership interest)

     1,000         1,000   

CPASS Acquisition Company

     1,000           

ACON Equity Partners III, LP (limited partnership interest)

     986           

Bunker Hill Capital II (QP), LP (limited partnership interest)

     934         960   

BMC Acquisition, Inc.

     900           

Riverlake Equity Partners II, LP (limited partnership interest)

     760         878   

HealthDrive Corporation

     750         2,000   

RCP Direct, LP (limited partnership interest)

     652           

Baird Capital Partners V, LP (limited partnership interest)

     615         701   

Riverside Fund IV, LP (limited partnership interest)

     402         555   

Advanced Pain Management

     400         267   

Saddleback Fence and Vinyl Products, Inc.

     300         400   

JTC Education, Inc.

             14,000   

CRGT, Inc.

             12,500   

Dominion Diagnostics, LLC

             5,000   

ADAPCO, Inc.

             4,250   

Epic Acquisition, Inc.

             3,000   

IZI Medical Products, Inc.

             2,500   

Flatout, Inc.

             1,500   

IOS Acquisitions, Inc.

             1,250   

Best Vinyl Fence & Deck, LLC

             1,000   

Trans-Trade, Inc.

             200   
  

 

 

    

 

 

 

Total

   $ 95,978       $ 108,804   
  

 

 

    

 

 

 

 

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Contractual Obligations

The following table reflects information pertaining to debt outstanding under the SBA debentures payable, the Wells Fargo facility, the ING facility, the Sumitomo facility and our Convertible Notes:

 

      Debt Outstanding
as of September 30,
2011
     Debt Outstanding
as of June 30,
2012
     Weighted average debt
outstanding for the
nine months ended
June 30, 2012
     Maximum debt
outstanding for
the nine months
ended
June 30,
2012
 

SBA debentures payable

   $ 150,000       $ 150,000       $ 150,000       $ 150,000   

Wells Fargo facility

     39,524         26,041         29,651       $ 48,269   

ING facility

     133,500         151,500         96,084       $ 151,500   

Sumitomo facility

     5,000         51,000         11,183       $ 51,000   

Convertible Notes

     135,000         115,000         122,336       $ 135,000   
  

 

 

    

 

 

    

 

 

    

Total debt

   $ 463,024       $ 493,541       $ 409,254       $ 493,541   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table reflects our contractual obligations arising from the SBA debentures payable, the Wells Fargo facility, the ING facility, the Sumitomo facility, and our Convertible Notes:

 

     Payments due by period as of June 30, 2012  
     Total      < 1 year      1-3 years      3-5 years      > 5 years  

SBA debentures payable

   $ 150,000       $       $       $       $ 150,000   

Interest due on SBA debentures

     50,953         5,778         11,556         11,572         22,047   

Wells Fargo facility

     26,041                         26,041           

Interest due on Wells Fargo facility

     2,982         780         1,560         642           

ING facility

     151,500                         151,500           

Interest due on ING facility

     18,063         4,924         9,848         3,291           

Sumitomo facility

     51,000                                 51,000   

Interest due on Sumitomo facility

     7,894         1,270         2,540         2,540         1,544   

Convertible senior notes payable

     115,000                         115,000           

Interest due on convertible senior notes

     23,218         6,181         12,363         4,674           
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 596,651       $ 18,933       $ 37,867       $ 315,260       $ 224,591   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Regulated Investment Company Status and Distributions

We elected, effective as of January 2, 2008, to be treated as a RIC under Subchapter M of the Code. As long as we qualify as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders on a timely basis.

Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation until realized. Dividends declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital.

To maintain RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any). As a RIC, we are also subject

 

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to a federal excise tax, based on distribution requirements of our taxable income on a calendar year basis (e.g., calendar year 2012). We anticipate timely distribution of our taxable income within the tax rules; however, we incurred a de minimis U.S. federal excise tax for calendar years 2008, 2009 and 2010. We did not incur a federal excise tax for calendar year 2011 and do not expect to incur a federal excise tax for calendar year 2012. We intend to distribute to our stockholders between 90% and 100% of our annual taxable income (which includes our taxable interest and fee income). However, we are partially dependent on our SBIC subsidiaries for cash distributions to enable us to meet the RIC distribution requirements. Our SBIC subsidiaries may be limited by the Small Business Investment Act of 1958, and SBA regulations governing SBICs, from making certain distributions to us that may be necessary to enable us to maintain our status as a RIC. We may have to request a waiver of the SBA’s restrictions for our SBIC subsidiaries to make certain distributions to maintain our RIC status. We cannot assure you that the SBA will grant such waiver. Also, the covenants under the Wells Fargo facility and Sumitomo facility could, under certain circumstances, restrict Funding and Funding II, respectively, from making distributions to us and, as a result, hinder our ability to satisfy the distribution requirement. Similarly, the covenants contained in the ING facility may prohibit us from making distributions to our stockholders, and, as a result, could hinder our ability to satisfy the distribution requirement. In addition, we may retain for investment some or all of our net taxable capital gains (i.e., realized net long-term capital gains in excess of realized net short-term capital losses) and treat such amounts as deemed distributions to our stockholders. If we do this, our stockholders will be treated as if they received actual distributions of the capital gains we retained and then reinvested the net after-tax proceeds in our common stock. Our stockholders also may be eligible to claim tax credits (or, in certain circumstances, tax refunds) equal to their allocable share of the tax we paid on the capital gains deemed distributed to them. To the extent our taxable earnings for a fiscal taxable year fall below the total amount of our dividends for that fiscal year, a portion of those dividend distributions may be deemed a return of capital to our stockholders.

We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a business development company under the 1940 Act and due to provisions in our credit facilities. If we do not distribute a certain percentage of our taxable income annually, we will suffer adverse tax consequences, including possible loss of our status as a RIC. We cannot assure stockholders that they will receive any distributions or distributions at a particular level.

In accordance with certain applicable Treasury regulations and private letter rulings issued by the Internal Revenue Service, a RIC may treat a distribution of its own stock as fulfilling its RIC distribution requirements if each stockholder may elect to receive his or her entire distribution in either cash or stock of the RIC, subject to a limitation that the aggregate amount of cash to be distributed to all stockholders must be at least 20% of the aggregate declared distribution. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a pro rata amount of cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive less than 20% of his or her entire distribution in cash. If these and certain other requirements are met, for U.S federal income tax purposes, the amount of the dividend paid in stock will be equal to the amount of cash that could have been received instead of stock. We have no current intention of paying dividends in shares of our stock in accordance with these Treasury regulations or private letter rulings.

Related Party Transactions

We have entered into an investment advisory agreement with Fifth Street Management LLC, our investment adviser. Fifth Street Management is controlled by Leonard M. Tannenbaum, its managing member and the chairman of our Board of Directors and our chief executive officer. Pursuant to the investment advisory agreement, fees payable to our investment adviser will be equal to (a) a base management fee of 2.0% of the value of our gross assets, which includes any borrowings for investment purposes and excludes cash and cash equivalents, and (b) an incentive fee based on our performance. The incentive fee consists of two parts. The first

 

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part is calculated and payable quarterly in arrears and equals 20% of our “Pre-Incentive Fee Net Investment Income” for the immediately preceding quarter, subject to a preferred return, or “hurdle,” and a “catch up” feature. The second part is determined and payable in arrears as of the end of each fiscal year (or upon termination of the investment advisory agreement) and equals 20% of our “Incentive Fee Capital Gains,” which equals our realized capital gains on a cumulative basis from inception through the end of the year, if any, computed net of all realized capital losses and unrealized capital depreciation on a cumulative basis, less the aggregate amount of any previously paid capital gain incentive fee.

The investment advisory agreement may be terminated by either party without penalty upon no fewer than 60 days’ written notice to the other. During the three and nine months ended June 30, 2012, we incurred fees that are due to our investment adviser of $11.6 million and $33.6 million, respectively, under the investment advisory agreement.

Pursuant to the administration agreement with FSC, Inc., which is controlled by Mr. Tannenbaum, FSC, Inc. will furnish us with the facilities and administrative services necessary to conduct our day-to-day operations, including equipment, clerical, bookkeeping and recordkeeping services at such facilities. In addition, FSC, Inc. will assist us in connection with the determination and publishing of our net asset value, the preparation and filing of tax returns and the printing and dissemination of reports to our stockholders. We will reimburse FSC, Inc. the allocable portion of overhead and other expenses incurred by it in performing its obligations under the administration agreement, including a portion of the rent and the compensation of our chief financial officer and chief compliance officer and their respective staffs. Such reimbursement is at cost with no profit to, or markup by, FSC, Inc. FSC, Inc. has voluntarily determined to forgo receiving reimbursement for the services performed for us by our chief compliance officer. Although FSC, Inc. currently intends to forgo its right to receive such reimbursement, it is under no obligation to do so and may cease to do so at any time in the future. The administration agreement may be terminated by either party without penalty upon no fewer than 60 days’ written notice to the other. During the three and nine months ended June 30, 2012, we have incurred expenses that are due to FSC, Inc. of $1.0 million and $3.2 million, respectively, under the administration agreement.

We have also entered into a license agreement with Fifth Street Capital LLC pursuant to which Fifth Street Capital LLC has agreed to grant us a non-exclusive, royalty-free license to use the name “Fifth Street.” Under this agreement, we will have a right to use the “Fifth Street” name, for so long as Fifth Street Management LLC or one of its affiliates remains our investment adviser. Other than with respect to this limited license, we will have no legal right to the “Fifth Street” name. Fifth Street Capital LLC is controlled by Mr. Tannenbaum, its managing member.

Recent Developments

On August 6, 2012, our Board of Directors declared the following dividends:

 

   

$0.0958 per share, payable on October 31, 2012 to stockholders of record on October 15, 2012;

 

   

$0.0958 per share, payable on November 30, 2012 to stockholders of record on November 15, 2012;

 

   

$0.0958 per share, payable on December 28, 2012 to stockholders of record on December 14, 2012;

 

   

$0.0958 per share, payable on January 31, 2013 to stockholders of record on January 15, 2013; and

 

   

$0.0958 per share, payable on February 28, 2013 to stockholders of record on February 15, 2013.

Recently Issued Accounting Standards

See Note 2 to the Consolidated Financial Statements for a description of recent accounting pronouncements, including the expected dates of adoption and the anticipated impact on the Consolidated Financial Statements.

 

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Quantitative and Qualitative Disclosure about Market Risk

We are subject to financial market risks, including changes in interest rates. Changes in interest rates may affect both our cost of funding and our interest income from portfolio investments, cash and cash equivalents and idle funds investments. Our risk management systems and procedures are designed to identify and analyze our risk, to set appropriate policies and limits and to continually monitor these risks and limits by means of reliable administrative and information systems and other policies and programs. Our investment income will be affected by changes in various interest rates, including LIBOR and prime rates, to the extent our debt investments include floating interest rates. In addition, our investments are carried at fair value as determined in good faith by our Board of Directors in accordance with the 1940 Act (See “— Critical Accounting Policies — Investment Valuation”). Our valuation methodology utilizes discount rates in part in valuing our investments, and changes in those discount rates may have an impact on the valuation of our investments.

As of June 30, 2012, 68.1% of our debt investment portfolio (at fair value) and 65.6% of our debt investment portfolio (at cost) bore interest at floating rates. The composition of our floating rate debt investments by cash interest rate floor (excluding PIK) as of June 30, 2012 and September 30, 2011 was as follows:

 

     June 30, 2012     September 30, 2011  
     Fair Value      % of Floating
Rate Portfolio
    Fair Value      % of Floating
Rate Portfolio
 

Under 1%

   $ 96,203         12.10   $ 125,453         16.96

1% to under 2%

     455,180         57.23     261,878         35.40

2% to under 3%

     111,185         13.98     168,928         22.83

3% to under 4%

     132,763         16.69     176,976         23.92

4% to under 5%

             0.00     757         0.10

5% and over

             0.00     5,843         0.79
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 795,331         100.00   $ 739,835         100.00
  

 

 

    

 

 

   

 

 

    

 

 

 

Based on our Consolidated Statement of Assets and Liabilities as of June 30, 2012, the following table shows the approximate annualized increase (decrease) in components of net assets resulting from operations of hypothetical base rate changes in interest rates, assuming no changes in our investment and capital structure.

 

Basis point increase(1)

   Interest
income
     Interest
expense
    Net
increase (decrease)
 

100

   $ 1,000       $ (2,300   $ (1,300

200

     5,000         (4,600     400   

300

     12,400         (6,900     5,500   

400

     20,700         (9,100     11,600   

500

     28,900         (11,400     17,500   

 

(1) A decline in interest rates would not have a material impact on our Consolidated Financial Statements.

 

 

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We regularly measure exposure to interest rate risk. We assess interest rate risk and manage our interest rate exposure on an ongoing basis by comparing our interest rate sensitive assets to our interest rate sensitive liabilities. Based on this review, we determine whether or not any hedging transactions are necessary to mitigate exposure to changes in interest rates. The following table shows a comparison of the interest rate base for our interest-bearing cash and outstanding investments, at principal, and our outstanding borrowings as of June 30, 2012 and September 30, 2011:

 

     June 30, 2012      September 30, 2011  
     Interest Bearing
Cash and
Investments
     Borrowings
     Interest Bearing
Cash and
Investments
     Borrowings
 

Money market rate

   $ 105,694       $       $ 67,644       $   

Prime rate

     22,931         74,000         38,890         53,000   

LIBOR

           

30 day

     54,440         154,541         51,368         125,024   

90 day

     717,403                 654,932           

Fixed rate

     421,489         265,000         418,981         285,000   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,321,957       $ 493,541       $ 1,231,815       $ 463,024   
  

 

 

    

 

 

    

 

 

    

 

 

 

On August 16, 2010, we entered into an interest rate swap agreement that was scheduled to expire on August 15, 2013, for a total notional amount of $100 million, for the purposes of hedging the interest rate risk related to the Wells facility and the ING facility. Under the interest rate swap agreement, we paid a fixed interest rate of 0.99% and received a floating rate based on the prevailing one-month LIBOR. In August 2011, we terminated our interest rate swap agreement and realized a loss of $1.3 million, which included a reclassification of $0.8 million of prior unrealized depreciation. As of June 30, 2012, we were no longer party to any interest rate swap agreements.

 

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MATERIAL U.S. FEDERAL INCOME TAX CONSIDERATIONS

The following discussion is a general summary of the material United States federal income tax considerations (and, in the case of a non-U.S. holder (as defined below), the material United States federal estate tax consequences) applicable to an investment in the Notes. This summary does not purport to be a complete description of the income and estate tax considerations applicable to such an investment. The discussion is based upon the Internal Revenue Code of 1986, as amended (the “Code”), Treasury Regulations, and administrative and judicial interpretations, each as of the date of this prospectus supplement and all of which are subject to change, potentially with retroactive effect. You should consult your own tax advisor with respect to tax considerations that pertain to your purchase of our Notes.

This discussion deals only with Notes held as capital assets within the meaning of Section 1221 of the Code and does not purport to deal with persons in special tax situations, such as financial institutions, insurance companies, controlled foreign corporations, passive foreign investment companies and regulated investment companies (and shareholders of such corporations), dealers in securities or currencies, traders in securities, former citizens of the United States, persons holding the Notes as a hedge against currency risks or as a position in a “straddle,” “hedge,” “constructive sale transaction” or “conversion transaction” for tax purposes, entities that are tax-exempt for United States federal income tax purposes, retirement plans, individual retirement accounts, tax-deferred accounts, persons subject to the alternative minimum tax, pass-through entities (including partnerships and entities and arrangements classified as partnerships for United States federal income tax purposes) and beneficial owners of pass-through entities, or persons whose functional currency is not the U.S. dollar. It also does not deal with beneficial owners of the Notes other than original purchasers of the Notes who acquire the Notes in this offering for a price equal to their original issue price (i.e., the first price at which a substantial amount of the Notes is sold other than to bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters, placement agents or wholesalers). If you are considering purchasing the Notes, you should consult your own tax advisor concerning the application of the United States federal tax laws to you in light of your particular situation, as well as any consequences to you of purchasing, owning and disposing of the Notes under the laws of any other taxing jurisdiction.

For purposes of this discussion, the term “U.S. holder” means a beneficial owner of a Note that is, for United States federal income tax purposes, (i) an individual citizen or resident of the United States, (ii) a corporation or other entity treated as a corporation for United States federal income tax purposes, created or organized in or under the laws of the United States or of any political subdivision thereof, (iii) a trust (a) subject to the control of one or more United States persons and the primary supervision of a court in the United States, or (b) that existed on August 20, 1996 and has made a valid election (under applicable Treasury Regulations) to be treated as a domestic trust, or (iv) an estate the income of which is subject to United States federal income taxation regardless of its source. The term “non-U.S. holder” means a beneficial owner of a Note that is neither a U.S. holder nor a partnership (including an entity or arrangement treated as a partnership for U.S. federal income tax purposes). An individual may, subject to exceptions, be deemed to be a resident alien, as opposed to a non-resident alien, by, among other ways, being present in the United States (i) on at least 31 days in the calendar year, and (ii) for an aggregate of at least 183 days during a three-year period ending in the current calendar year, counting for such purposes all of the days present in the current year, one-third of the days present in the immediately preceding year, and one-sixth of the days present in the second preceding year. Resident aliens are subject to United States federal income tax as if they were United States citizens.

If a partnership (including an entity or arrangement treated as a partnership for U.S. federal income tax purposes) holds any Notes, the United States federal income tax treatment of a partner of the partnership generally will depend upon the status of the partner, the activities of the partnership and certain determinations made at the partner level. Partners of partnerships holding Notes should consult their own tax advisors.

Taxation of Note Holders

Under present law, we are of the opinion that the Notes will constitute indebtedness of us for United States federal income tax purposes, which the below discussion assumes. We intend to treat all payments made with respect to the Notes consistent with this characterization.

 

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Payments or accruals of interest on a Note generally will be taxable to a U.S. holder as ordinary interest income at the time they are received (actually or constructively) or accrued, in accordance with the U.S. holder’s regular method of tax accounting.

Upon the sale, exchange, redemption, retirement or other taxable disposition of a Note, a U.S. holder generally will recognize capital gain or loss equal to the difference between the amount realized on the sale, exchange, redemption, retirement or other taxable disposition (excluding amounts representing accrued and unpaid interest, which are treated as ordinary income) and the U.S. holder’s adjusted tax basis in the Note. A U.S. holder’s adjusted tax basis in a Note generally will equal the U.S. holder’s initial investment in the Note. Capital gain or loss generally will be long-term capital gain or loss if the Note was held for more than one year. Long-term capital gains recognized by individuals and certain other non-corporate U.S. holders generally are eligible for reduced rates of taxation. The distinction between capital gain or loss and ordinary income or loss is also important in other contexts; for example, for purposes of the limitations on a U.S. holder’s ability to offset capital losses against ordinary income.

After December 31, 2012, a tax of 3.8 percent will be imposed on the amount of “net investment income,” in the case of an individual, or undistributed “net investment income,” in the case of an estate or trust (other than a charitable trust), which exceeds certain threshold amounts. “Net investment income” as defined for United States federal Medicare contribution purposes generally includes interest payments and gain recognized from the sale or other disposition of the Notes. Qualified pension trusts, which are not subject to income taxes generally, and non-U.S. individuals will not be subject to this tax. U.S. holders should consult their own tax advisors regarding the effect, if any, of this tax on their ownership and disposition of the Notes.

Taxation of Non-U.S. Holders.    A non-U.S. holder generally will not be subject to United States federal income or withholding taxes on payments of principal or interest on a Note provided that (i) income on the Note is not effectively connected with the conduct by the non-U.S. holder of a trade or business within the United States, (ii) the non-U.S. holder is not a controlled foreign corporation related to the Company through stock ownership, (iii) in the case of interest income, the recipient is not a bank receiving interest described in Section 881(c)(3)(A) of the Code, (iv) the non-U.S. holder does not own (actually or constructively) 10% or more of the total combined voting power of all classes of stock of the Company, and (v) the non-U.S. holder provides a statement in the year in which a payment occurs or in the preceding 3 years, on an Internal Revenue Service (IRS) Form W-8BEN (or other applicable form) signed under penalties of perjury that includes its name and address and certifies that the non-U.S. holder is the beneficial owner and is not a United States person in compliance with applicable requirements, or satisfies documentary evidence requirements for establishing that it is a non-U.S. holder.

A non-U.S. holder that is not exempt from tax under these rules generally will be subject to United States federal income tax withholding on payments of interest on the Notes at a rate of 30% unless (i) the income is effectively connected with the conduct of a United States trade or business, so long as the non-U.S. holder has provided an IRS Form W-8ECI or substantially similar substitute form stating that the interest on the Notes is effectively connected with the non-U.S. holder’s conduct of a trade or business in the U.S. in which case the interest will be subject to United States federal income tax on a net income basis as applicable to U.S. holders generally (unless an applicable income tax treaty provides otherwise), or (ii) an applicable income tax treaty provides for a lower rate of, or exemption from, withholding tax.

In the case of a non-U.S. holder that is a corporation and that receives income that is effectively connected with the conduct of a United States trade or business, such income may also be subject to a branch profits tax (which is generally imposed on a non-U.S. corporation on the actual or deemed repatriation from the United States of earnings and profits attributable to a United States trade or business) at a 30% rate. The branch profits tax may not apply (or may apply at a reduced rate) if the non-U.S. holder is a qualified resident of a country with which the United States has an income tax treaty.

 

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To claim the benefit of an income tax treaty or to claim exemption from withholding because income is effectively connected with a United States trade or business, the non-U.S. holder must timely provide the appropriate, properly executed IRS forms. The non-U.S. holder must inform the recipient of any changes on these forms within 30 days of such change. These forms may be required to be periodically updated. Also, a non-U.S. holder who is claiming the benefits of a treaty may be required to obtain a United States taxpayer identification number and to provide certain documentary evidence issued by foreign governmental authorities to prove residence in the foreign country.

Generally, a non-U.S. holder will not be subject to United States federal income or withholding taxes on any amount that constitutes capital gain upon the sale, exchange, redemption, retirement or other taxable disposition of a Note, provided that (i) the gain is not effectively connected with the conduct of a trade or business in the United States by the non-U.S. holder (and, if required by an applicable income tax treaty, is not attributable to a United States “permanent establishment” maintained by the non-U.S. holder) and (ii) that the non-U.S. holder is not an individual who is present in the U.S. for 183 days or more in the taxable year of the sale, exchange, or other taxable disposition and meets certain other conditions (unless such holder is eligible for relief under an applicable income tax treaty). Certain other exceptions may be applicable, and a non-U.S. holder should consult its tax advisor in this regard.

A Note that is held by an individual who, at the time of death, is not a citizen or resident of the United States (as specially defined for United States federal estate tax purposes) generally will not be subject to the United States federal estate tax, unless, at the time of death, (i) such individual directly or indirectly, actually or constructively, owns ten percent or more of the total combined voting power of all classes of our stock entitled to vote within the meaning of Section 871(h)(3) of the Code and the Treasury Regulations thereunder or (ii) such individual’s interest in the Notes is effectively connected with the individual’s conduct of a United States trade or business.

Information Reporting and Backup Withholding.    A U.S. holder (other than an “exempt recipient,” including a corporation and certain other persons who, when required, demonstrate their exempt status) may be subject to backup withholding at a rate of 28% (which rate currently is scheduled to increase to 31% for taxable years beginning on or after January 1, 2013) on, and to information reporting requirements with respect to, payments of principal and interest on, and proceeds from the sale, exchange, redemption or retirement of, the Notes. In general, if a non-corporate U.S. holder subject to information reporting fails to furnish a correct taxpayer identification number or otherwise fails to comply with applicable backup withholding requirements, backup withholding at the applicable rate may apply.

The amount of interest we pay to a non-U.S. holder on the Notes will be reported to such non-U.S. Holder and to the IRS annually on an IRS Form 1042-S even if the non-U.S. holder is exempt from the 30% withholding tax described above. Copies of the information returns reporting those payments and the amounts withheld may also be made available to the tax authorities in the country where the non-U.S. holder is resident under provisions of an applicable income tax treaty or agreement.

In addition, backup withholding tax and certain other information reporting requirements apply to payments of principal and interest on, and proceeds from the sale, exchange, redemption or retirement of, the Notes held by a non-U.S. holder, unless an exemption applies. Backup withholding and information reporting will not apply to payments we make to a non-U.S. holder if such non-U.S. holder has provided to the applicable withholding agent under penalties of perjury the required certification of their non-U.S. person status as discussed above (and the applicable withholding agent does not have actual knowledge or reason to know that they are a U.S. person) or if the non-U.S. holder is an exempt recipient.

If a non-U.S. holder sells or redeems a Note through a U.S. broker or the U.S. office of a foreign broker, the proceeds from such sale or redemption will be subject to information reporting and backup withholding unless such non-U.S. holder provides a withholding certificate or other appropriate documentary evidence establishing

 

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that such non-U.S. holder is not a United States person to the broker and such broker does not have actual knowledge or reason to know that such non-U.S. holder is a United States person, or the non-U.S. holder is an exempt recipient eligible for an exemption from information reporting and backup withholding. If a non-U.S. holder sells or redeems a Note through the foreign office of a broker who is a United States person or has certain enumerated connections with the U.S., the proceeds from such sale or redemption will be subject to information reporting unless the non-U.S. holder provides to such broker a withholding certificate or other documentary evidence establishing that the non-U.S. holder is not a United States person and such broker does not have actual knowledge or reason to know that such evidence is false, or the non-U.S. holder is an exempt recipient eligible for an exemption from information reporting. In circumstances where information reporting by the foreign office of such a broker is required, backup withholding will be required only if the broker has actual knowledge that the non-U.S. holder is a United States person.

You should consult your tax advisor regarding the qualification for an exemption from backup withholding and information reporting and the procedures for obtaining such an exemption, if applicable. Any amounts withheld under the backup withholding rules from a payment to a beneficial owner generally would be allowed as a refund or a credit against such beneficial owner’s United States federal income tax provided the required information is timely furnished to the IRS.

Foreign Account Tax Compliance Act

Legislation enacted in 2010 imposes a withholding tax of 30% on payments of interest or gross proceeds from the disposition of a debt instrument paid after December 31, 2012 to certain non-U.S. entities, including certain non-U.S. financial institutions and investment funds, unless such non-U.S. entity complies with certain reporting requirements regarding its United States account holders and its United States owners. The date for implementation of these rules generally was extended by the IRS to January 1, 2014 for payments of fixed or determinable annual or periodic (FDAP) income, including interest, and to January 1, 2015 for other “withholdable payments,” including payments of gross proceeds. After these dates, payments of interest on, or gross proceeds from the sale or redemption of, the Notes made to a non-U.S. entity generally will be subject to the new information reporting regime; however, the new withholding obligations will only apply to obligations issued after March 18, 2012, and proposed Treasury regulations would extend this grandfathering provision to obligations that are outstanding on January 1, 2013. Congress delegated broad authority to the U.S. Treasury Department to promulgate regulations to implement the new withholding and reporting regime. It cannot be predicted whether or how these proposed Treasury regulations (if finalized) or any regulations promulgated by the U.S. Treasury Department pursuant to this broad delegation of regulatory authority will affect holders of the Notes. Prospective purchasers of the Notes should consult their own tax advisors regarding the new withholding and reporting provisions.

You should consult your own tax advisor with respect to the particular tax consequences to you of an investment in the Notes, including the possible effect of any pending legislation or proposed regulations.

 

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UNDERWRITING

UBS Securities LLC, Raymond James & Associates, Inc., RBC Capital Markets, LLC and Stifel, Nicolaus & Company, Incorporated are acting as joint book-running managers of the offering and UBS Securities LLC is acting as representative of the underwriters named below. Subject to the terms and conditions stated in the underwriting agreement dated October 11, 2012, each underwriter named below severally agrees to purchase aggregate principal amount of Notes indicated in the following table:

 

Underwriters

   Principal
Amount
 

UBS Securities LLC

   $ 15,000,000   

Raymond James & Associates, Inc.

     15,000,000   

RBC Capital Markets, LLC

     15,000,000   

Stifel, Nicolaus & Company, Incorporated

     15,000,000   

Credit Suisse Securities (USA) LLC

     3,750,000   
Deutsche Bank Securities Inc.      3,750,000   
Janney Montgomery Scott LLC      3,750,000   
Maxim Group LLC      3,750,000   
  

 

 

 

Total

   $ 75,000,000   
  

 

 

 

The underwriters are committed to take and pay for all of the Notes being offered, if any are purchased.

Commissions and Discounts

The following table shows the per Note and total underwriting discounts and commissions to be paid by us to the underwriters.

 

Paid by Fifth Street

   Discounts
and
Commissions
 

Per Note

     3.0

Total

   $ 2,250,000   

Notes sold by the underwriters to the public will initially be offered at the public offering price set forth on the cover of this prospectus supplement and to certain dealers at a price less a concession not in excess of 1.60% of the aggregate principal amount of Notes. The underwriters may allow, and the dealers may reallow, a discount from the concession not in excess of 1.40% of the aggregate principal amount of the Notes to certain broker dealers. If all the Notes are not sold at the public offering price, the representative may change the offering price and the other selling terms. The offering of the Notes by the underwriters is subject to receipt and acceptance and subject to the underwriters’ right to reject any order in whole or in part.

We estimate that our share of the total expenses of the offering, excluding underwriting discounts, will be approximately $300,000.

We have agreed to indemnify the several underwriters against certain liabilities, including liabilities under the Securities Act.

Lock-up Agreement

We have agreed not to directly or indirectly sell, offer to sell, enter into any agreement to sell, or otherwise dispose of, any debt securities issued by the Company which are substantially similar to the Notes or securities convertible into such debt securities which are substantially similar to the Notes for a period of 30 days after the date of this prospectus supplement without first obtaining the prior written consent of UBS Securities LLC.

 

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The 30-day restricted period described in the preceding paragraph will be automatically extended if: (1) during the last 17 days of the 30-day restricted period we issue an earnings release or announce material news or a material event; or (2) prior to the expiration of the 30-day restricted period, we announce that we will release earnings results during the 15-day period following the last day of the 30-day restricted period, in which case the restrictions described in the preceding paragraph will continue to apply until the expiration of the 18-day period beginning on the issuance of the earnings release of the announcement of the material news or material event.

Listing

The Notes are a new issue of securities with no established trading market. We intend to apply to list the Notes on the NYSE and, if the application is approved, we expect trading in the Notes on the NYSE to begin within 30 days after the original issue date under the symbol “FSCE.” Currently there is no public market for the Notes and we can provide no assurance that the Notes will be approved for listing on the NYSE or that an active trading market will develop for the Notes.

We have been advised by the underwriters that they presently intend to make a market in the Notes after completion of the offering as permitted by applicable laws and regulations. The underwriters are not obligated, however, to make a market in the Notes and any such market-making may be discontinued at any time in the sole discretion of the underwriters without any notice. Accordingly, no assurance can be given as to the liquidity of, or development of a public trading market for, the Notes. If an active public trading market for the Notes does not develop, the market price and liquidity of the Notes may be adversely affected.

Price Stabilizations and Short Positions

In connection with the offering, UBS Securities LLC, on behalf of the underwriters, may purchase and sell Notes in the open market. These transactions may include short sales, stabilizing transactions and purchases to cover positions created by short sales. Short sales involve the sale by the underwriters of a greater number of Notes than they are required to purchase in the offering. The underwriters must close out any naked short position by purchasing Notes in the open market. A naked short position is more likely to be created if the underwriters are concerned that there may be downward pressure on the price of the Notes in the open market after pricing that could adversely affect investors who purchase in the offering. Stabilizing transactions consist of various bids for or purchases of Notes made by the underwriters in the open market prior to the completion of the offering.

The underwriters may also impose a penalty bid. This occurs when a particular underwriter repays to the underwriters a portion of the underwriting discount received by it because the representative has repurchased Notes sold by or for the account of such underwriter in stabilizing or short covering transactions.

Purchases to cover a short position and stabilizing transactions, as well as other purchases by the underwriters for their own accounts, may have the effect of preventing or retarding a decline in the market price of our Notes, and together with the imposition of the penalty bid, may stabilize, maintain or otherwise affect the market price of our Notes. As a result, the price of the Notes may be higher than the price that otherwise might exist in the open market. If these activities are commenced, they may be discontinued at any time. These transactions may be effected on the NYSE, in the over-the-counter market or otherwise.

 

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Additional Underwriter Compensation

The underwriters and their respective affiliates are full service financial institutions engaged in various activities, which may include securities trading, commercial and investment banking, financial advisory, investment management, investment research, principal investment, hedging, financing and brokerage activities. Certain of the underwriters and their respective affiliates have, from time to time, performed, and may in the future perform, various financial advisory and investment banking services for the issuer, for which they received or will receive customary fees and expenses, including acting as underwriters for our securities offerings. The underwriters and their respective affiliates may also make investment recommendations and/or publish or express independent research views in respect of such securities or instruments and may at any time hold, or recommend to clients that they acquire, long and/or short positions in such securities and instruments. Affiliates of UBS Securities, LLC, RBC Capital Markets, LLC and Deutsche Bank Securities Inc. are lenders under the syndicated ING facility and may receive payments from the Company in connection therewith. In addition, an affiliate of Deutsche Bank Securities Inc. serves as trustee under the indentures governing the Notes and our Convertible Notes and may receive payments from the Company in connection therewith.

Settlement

We expect that delivery of the Notes will be made against payment therefor on or about October 18, 2012, which will be the fifth business day following the date of the pricing of the Notes (such settlement being herein referred to as “T+5”). Under Rule 15c6-1 under the Securities Exchange Act of 1934, as amended, trades in the secondary market generally are required to settle in three business days, unless the parties to any such trade expressly agree otherwise. Accordingly, purchasers who wish to trade the Notes prior to the date of delivery hereunder will be required, by virtue of the fact that the Notes initially will settle in T+5 business days, to specify an alternate settlement arrangement at the time of any such trade to prevent a failed settlement.

Other Jurisdictions

Other than in the United States, no action has been taken by us or the underwriters that would permit a public offering of the Notes offered by this prospectus supplement in any jurisdiction where action for that purpose is required. The Notes offered by this prospectus supplement may not be offered or sold, directly or indirectly, nor may this prospectus supplement or any other offering material or advertisements in connection with the offer and sale of any such Notes be distributed or published in any jurisdiction, except under circumstances that will result in compliance with the applicable rules and regulations of that jurisdiction. Persons into whose possession this prospectus supplement comes are advised to inform themselves about and to observe any restriction relating to the offering and the distribution of this prospectus supplement. This prospectus supplement and the accompanying prospectus do not constitute an offer to sell or a solicitation of an offer to buy the Notes offered by this prospectus supplement and the accompanying prospectus in any jurisdiction in which such an offer or a solicitation is unlawful.

The addresses of the underwriters are: UBS Securities LLC, 677 Washington Boulevard, Stamford, CT 06901; Raymond James & Associates, Inc., 880 Carillon Parkway, St. Petersburg, Florida 33716; RBC Capital Markets, LLC, 200 Vesey Street, New York, New York 10281; and Stifel, Nicolaus & Company, Incorporated, 501 N. Broadway, St. Louis, Missouri 63102.

 

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LEGAL MATTERS

The validity of the Notes offered by this prospectus supplement and certain other legal matters will be passed upon for us by Sutherland Asbill & Brennan LLP, Washington D.C. Certain legal matters related to the offering will be passed upon for the underwriters by Fried, Frank, Harris, Shriver & Jacobson LLP, New York, New York.

INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The financial statements as of September 30, 2011 and 2010 and for each of the two years in the period ended September 30, 2011, included in the accompanying prospectus, have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report appearing therein.

The consolidated financial statements as of September 30, 2009 (not included herein), and for the year ended September 30, 2009, included in the accompanying prospectus, have been audited by Grant Thornton LLP, our former independent registered public accounting firm, as stated in their report appearing therein.

CHANGE IN INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

On February 11, 2010, we dismissed Grant Thornton LLP as our independent registered public accounting firm. During the fiscal years ended September 30, 2008 and 2009 and through February 11, 2010, there were no disagreements between us and Grant Thornton LLP with respect to any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Grant Thornton LLP, would have caused it to make reference to the subject matter of such disagreements in its reports on the financial statements for such years.

On February 11, 2010, we engaged PricewaterhouseCoopers LLP as our new independent registered public accounting firm to audit our Consolidated Financial Statements for the fiscal year ended September 30, 2010.

AVAILABLE INFORMATION

We have filed with the SEC a registration statement on Form N-2, together with all amendments and related exhibits, under the Securities Act, with respect to the Notes offered by this prospectus supplement. The registration statement contains additional information about us and the Notes being offered by this prospectus supplement.

We file with or furnish to the SEC annual, quarterly and current reports, proxy statements and other information meeting the informational requirements of the Securities Exchange Act of 1934. You may inspect and copy these reports, proxy statements and other information, as well as the registration statement and related exhibits and schedules, at the Public Reference Room of the SEC at 100 F Street, N.E., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information filed electronically by us with the SEC, which are available on the SEC’s website at www.sec.gov. Copies of these reports, proxy and information statements and other information may be obtained, after paying a duplicating fee, by electronic request at the following e-mail address: publicinfo@sec.gov, or by writing the SEC’s Public Reference Section, 100 F Street, N.E., Washington, D.C. 20549.

 

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CONSOLIDATED FINANCIAL STATEMENTS

Fifth Street Finance Corp.

Consolidated Statements of Assets and Liabilities

(in thousands, except per share data)

(unaudited)

 

     June 30,
2012
    September 30,
2011
 
ASSETS   

Investments at fair value:

    

Control investments (cost June 30, 2012: $15,542; cost September 30, 2011: $13,726)

   $ 14,916      $ 14,500   

Affiliate investments (cost June 30, 2012: $1,080; cost September 30, 2011: $34,182)

     2,444        25,897   

Non-control/Non-affiliate investments (cost June 30, 2012: $1,203,770; cost September 30, 2011: $1,108,174)

     1,180,737        1,079,440   
  

 

 

   

 

 

 

Total investments at fair value (cost June 30, 2012: $1,220,392; cost September 30, 2011: $1,156,082)

     1,198,097        1,119,837   

Cash and cash equivalents

     105,694        67,644   

Interest and fees receivable

     5,922        6,752   

Due from portfolio company

     449        552   

Deferred financing costs

     14,216        14,668   

Collateral posted to bank and other assets

     113        264   
  

 

 

   

 

 

 

Total assets

   $ 1,324,491      $ 1,209,717   
  

 

 

   

 

 

 
LIABILITIES AND NET ASSETS   

Liabilities:

    

Accounts payable, accrued expenses and other liabilities

   $ 1,146      $ 1,175   

Base management fee payable

     6,094        5,710   

Incentive fee payable

     5,477        4,997   

Due to FSC, Inc.

     2,152        1,480   

Interest payable

     3,965        4,669   

Payments received in advance from portfolio companies

     36        35   

Offering costs payable

     9          

Credit facilities payable

     228,541        178,024   

SBA debentures payable

     150,000        150,000   

Convertible senior notes payable

     115,000        135,000   
  

 

 

   

 

 

 

Total liabilities

     512,420        481,090   
  

 

 

   

 

 

 

Net assets:

    

Common stock, $0.01 par value, 150,000 shares authorized, 82,462 and 72,376 shares issued and outstanding at June 30, 2012 and September 30, 2011

     825        724   

Additional paid-in-capital

     930,188        829,620   

Net unrealized depreciation on investments and interest rate swap

     (21,916     (35,976

Net realized loss on investments and interest rate swap

     (90,904     (63,485

Accumulated overdistributed net investment income

     (6,122     (2,256
  

 

 

   

 

 

 

Total net assets (equivalent to $9.85 and $10.07 per common share at June 30, 2012 and September 30, 2011) (Note 12)

     812,071        728,627   
  

 

 

   

 

 

 

Total liabilities and net assets

   $ 1,324,491      $ 1,209,717   
  

 

 

   

 

 

 

See notes to Consolidated Financial Statements.

 

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Fifth Street Finance Corp.

Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)

 

     Three  months
ended

June 30,
2012
    Three months
ended
June 30,
2011
    Nine months
ended
June 30,
2012
    Nine months
ended
June 30,
2011
 

Interest income:

        

Control investments

   $ 2      $ 40      $ 434      $ 54   

Affiliate investments

     835        1,126        2,229        3,416   

Non-control/Non-affiliate investments

     27,822        24,271        85,131        61,963   

Interest on cash and cash equivalents

     11        4        29        17   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total interest income

     28,670        25,441        87,823        65,450   
  

 

 

   

 

 

   

 

 

   

 

 

 

PIK interest income:

        

Control investments

     211        105        249        239   

Affiliate investments

     158        278        467        835   

Non-control/Non-affiliate investments

     3,557        3,179        9,516        9,103   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total PIK interest income

     3,926        3,562        10,232        10,177   
  

 

 

   

 

 

   

 

 

   

 

 

 

Fee income:

        

Control investments

                          127   

Affiliate investments

     377        283        630        550   

Non-control/Non-affiliate investments

     7,954        2,992        23,744        11,000   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total fee income

     8,331        3,275        24,374        11,677   
  

 

 

   

 

 

   

 

 

   

 

 

 

Dividend and other income:

        

Non-control/Non-affiliate investments

     81        164        154        174   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total dividend and other income

     81        164        154        174   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total investment income

     41,008        32,442        122,583        87,478   
  

 

 

   

 

 

   

 

 

   

 

 

 

Expenses:

        

Base management fee

     6,094        5,381        17,226        13,946   

Incentive fee

     5,477        4,132        16,422        11,785   

Professional fees

     619        456        2,310        1,654   

Board of Directors fees

     30        46        156        132   

Interest expense

     5,611        4,977        16,936        9,640   

Administrator expense

     690        395        2,214        1,140   

General and administrative expenses

     807        529        3,201        2,043   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total expenses

     19,328        15,916        58,465        40,340   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gain on extinguishment of convertible senior notes

     230               1,571          
  

 

 

   

 

 

   

 

 

   

 

 

 

Net investment income

     21,910        16,526        65,689        47,138   
  

 

 

   

 

 

   

 

 

   

 

 

 

Unrealized appreciation (depreciation) on interest rate swap

            (919            51   

Unrealized appreciation (depreciation) on investments:

        

Control investments

     (2,493     5,225        (1,404 )     12,538   

Affiliate investments

     322        13,931        9,649        3,760   

Non-control/Non-affiliate investments

     2,350        215        5,815        18,573   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net unrealized appreciation on investments

     179        19,371        14,060        34,871   
  

 

 

   

 

 

   

 

 

   

 

 

 

Realized loss on investments:

        

Control investments

                          (7,806

Affiliate investments

            (14,146     (10,620     (14,146 )

Non-control/Non-affiliate investments

                   (16,800 )     (6,157
  

 

 

   

 

 

   

 

 

   

 

 

 

Net realized loss on investments

            (14,146     (27,420 )     (28,109 )
  

 

 

   

 

 

   

 

 

   

 

 

 

Net increase in net assets resulting from operations

   $ 22,089      $ 20,832      $ 52,329      $ 53,951   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net investment income per common share — basic

   $ 0.27      $ 0.25      $ 0.84      $ 0.77   

Earnings per common share — basic

   $ 0.27      $ 0.31      $ 0.67      $ 0.88   

Weighted average common shares outstanding — basic

     82,421        67,081        78,089        61,254   

Net investment income per common share — diluted

   $ 0.26      $ 0.24      $ 0.80      $ 0.76   

Earnings per common share — diluted

   $ 0.26      $ 0.30      $ 0.64      $ 0.87   

Weighted average common shares outstanding — diluted

     90,279        76,020        86,325        64,233   

See notes to Consolidated Financial Statements.

 

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Table of Contents

Fifth Street Finance Corp.

Consolidated Statements of Changes in Net Assets

(in thousands, except per share data)

(unaudited)

 

     Nine months ended
June 30,

2012
    Nine months ended
June 30,

2011
 

Operations:

    

Net investment income

   $ 65,689      $ 47,138   

Net unrealized appreciation on investments and interest rate swap

     14,060        34,922   

Net realized loss on investments

     (27,420     (28,109
  

 

 

   

 

 

 

Net increase in net assets from operations

     52,329        53,951   

Stockholder transactions:

    

Distributions to stockholders

     (69,555     (57,644
  

 

 

   

 

 

 

Net decrease in net assets from stockholder transactions

     (69,555 )      (57,644 ) 

Capital share transactions:

    

Issuance of common stock, net

     99,815        206,079   

Issuance of common stock under dividend reinvestment plan

     855        4,091   
  

 

 

   

 

 

 

Net increase in net assets from capital share transactions

     100,670        210,170   
  

 

 

   

 

 

 

Total increase in net assets

     83,444        206,477   
  

 

 

   

 

 

 

Net assets at beginning of period

     728,627        569,172   
  

 

 

   

 

 

 

Net assets at end of period

   $ 812,071      $ 775,649   
  

 

 

   

 

 

 

Net asset value per common share

   $ 9.85      $ 10.72   
  

 

 

   

 

 

 

Common shares outstanding at end of period

     82,462        72,376   

 

 

 

See notes to Consolidated Financial Statements.

 

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Table of Contents

Fifth Street Finance Corp.

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

 

     Nine months
ended
June 30,
2012
    Nine months
ended
June 30,
2011
 

Cash flows from operating activities:

    

Net increase in net assets resulting from operations

   $ 52,329      $ 53,951   

Adjustments to reconcile net increase in net assets resulting from operations to net cash provided (used) by operating activities:

    

Gain on extinguishment of convertible senior notes

     (1,571       

Net unrealized appreciation on investments and interest rate swap

     (14,060     (34,922

Net realized losses on investments and interest rate swap

     27,420        28,109   

PIK interest income

     (10,232     (10,177

Recognition of fee income

     (24,374     (11,677

Accretion of original issue discount on investments

     (1,367     (1,239

Amortization of deferred financing costs

     3,241        1,816   

Change in operating assets and liabilities:

    

Fee income received

     19,336        16,866   

(Increase) decrease in interest and fees receivable

     385        (2,252

(Increase) decrease in due from portfolio company

     103        (329 )

(Increase) decrease in collateral posted to bank and other assets

     151        (218 )

Increase (decrease) in accounts payable, accrued expenses and other liabilities

     (29 )     262   

Increase in base management fee payable

     384        2,505   

Increase in incentive fee payable

     480        1,272   

Increase (decrease) in due to FSC, Inc.

     672        (263

Increase (decrease) in interest payable

     (704     3,185   

Decrease in payments received in advance from portfolio companies

     (1     (545

Purchases of investments and net revolver activity, net of syndications

     (407,854     (566,835 )

Principal payments received on investments (scheduled payments)

     32,795        19,559   

Principal payments received on investments (payoffs)

     283,966        62,447   

PIK interest income received in cash

     5,007        7,030   

Proceeds from the sale of investments

     11,549          
  

 

 

   

 

 

 

Net cash used by operating activities

     (22,374 )     (431,455
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Dividends paid in cash

     (68,699     (53,553

Borrowings under SBA debentures payable

            77,000   

Borrowings under credit facilities

     409,297        406,000   

Repayments of borrowings under credit facilities

     (358,780     (406,000

Proceeds from the issuance of convertible senior notes

            152,000   

Repurchases of convertible senior notes

     (17,939       

Proceeds from the issuance of common stock

     100,700        206,788   

Deferred financing costs paid

     (3,279     (9,230

Offering costs paid

     (876     (709
  

 

 

   

 

 

 

Net cash provided by financing activities

     60,424        372,296   
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     38,050        (59,159

Cash and cash equivalents, beginning of period

     67,644        76,765   
  

 

 

   

 

 

 

Cash and cash equivalents, end of period

   $ 105,694      $ 17,606   
  

 

 

   

 

 

 

Supplemental Information:

    

Cash paid for interest

   $ 14,720      $ 4,639   

Non-cash financing activities:

    

Issuance of shares of common stock under dividend reinvestment plan

   $ 855      $ 4,091   

See notes to Consolidated Financial Statements.

 

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Table of Contents

Fifth Street Finance Corp.

Consolidated Schedule of Investments

June 30, 2012

(dollar amounts in thousands)

(unaudited)

 

Portfolio Company/Type of Investment(1)(2)(5)

  

Industry

   Principal(8)      Cost      Fair Value  

Control Investments(3)

           

Lighting By Gregory, LLC(9)(13)(14)

   Housewares & specialties         

First Lien Term Loan A, 9.75% PIK due 2/28/2013

      $ 4,700       $ 3,996       $ 737   

First Lien Bridge Loan, 8% PIK due 3/31/2012(16)

        113         113           

97.38% membership interest

           1,210           
        

 

 

    

 

 

 
           5,319         737   

Coll Materials Group LLC(9)

   Environmental & facilities services         

Second Lien Term Loan, 12% cash due 11/1/2014

        7,096         7,096         7,071   

50% Membership interest in CD Holdco, LLC

           3,127         7,108   
        

 

 

    

 

 

 
           10,223         14,179   
        

 

 

    

 

 

 

Total Control Investments (1.8% of net assets)

         $ 15,542       $ 14,916   
        

 

 

    

 

 

 

Affiliate Investments(4)

           

Caregiver Services, Inc.

   Healthcare services         

1,080,399 shares of Series A Preferred Stock

         $ 1,080       $ 2,444   
        

 

 

    

 

 

 
           1,080         2,444   
        

 

 

    

 

 

 

Total Affiliate Investments (0.3% of net assets)

         $ 1,080       $ 2,444   
        

 

 

    

 

 

 

Non-Control/Non-Affiliate Investments(7)

           

Repechage Investments Limited(13)(14)

   Restaurants         

First Lien Term Loan, 12.75% cash 2.75% PIK due 10/16/2011(16)

      $ 3,632       $ 3,412       $ 898   

7,500 shares of Series A Preferred Stock of Elephant & Castle, Inc.

           750           
        

 

 

    

 

 

 
           4,162         898   

Traffic Control & Safety Corporation(9)(14)(16)

   Construction & engineering         

Senior Debtor-in-Possession Loan, LIBOR+12% cash due 10/20/2012

        7,899         7,899         7,899   

Senior Term Loan A, LIBOR+9% cash due 6/29/2012

        5,000         5,000         5,000   

Senior Revolver, LIBOR+9% cash due 6/29/2012

        8,587         8,587         8,587   

Second Lien Term Loan, 12% cash 3% PIK due 5/28/2015(13)

        22,595         21,247         11,518   

Subordinated Term Loan, 15% PIK due 5/28/2015

        6,024         5,531           

24,750 shares of Series B Preferred Stock

           248           

43,494 shares of Series D Preferred Stock

           435           

25,000 shares of Common Stock

           3           
        

 

 

    

 

 

 
           48,950         33,004   

TBA Global, LLC

   Advertising         

53,994 Senior Preferred Shares

           216         326   

191,977 Shares A Shares

           192           
        

 

 

    

 

 

 
           408         326   

Fitness Edge, LLC

   Leisure facilities         

1,000 Common Units(6)

           43         201   
        

 

 

    

 

 

 
           43         201   

Capital Equipment Group, Inc.(9)

   Industrial machinery         

Second Lien Term Loan, 12% cash 2.75% PIK due 7/10/2013

        10,436         10.350         10,516   

33,463 shares of Common Stock

           345         593   
        

 

 

    

 

 

 
           10,695         11,109   

Rail Acquisition Corp.(14)

   Electronic manufacturing services         

First Lien Term Loan, 12% PIK due 9/1/2013

        20,167         15,637