Fifth Street faces securities violations lawsuit

The firm is alleged to have inflated value of assets at its largest BDC and delayed write-downs ahead of taking the management company public.

The management of Fifth Street Finance Corp (FSC) and its parent company inflated the assets and income of the firm’s largest BDC ahead of a flotation, a lawsuit claims.

FSC, its parent Fifth Street Asset Management (FSAM), the firm’s founder Len Tannenbaum and other company executives have been accused of securities violations in a class action suit filed in the Southern District Court of New York.

A spokesman for Fifth Street said the firm intended to “vigorously defend” the action. “We believe that the claim was filed without merit,” he said.

The suit was filed on behalf of shareholders who purchased FSC common stock between July 7, 2014 and February 6 this year. As of last June, FSC accounted for 90 percent of the management company’s assets and was its main revenue driver. 

“During the class period, defendants engaged in a fraudulent scheme and course of business designed to artificially inflate FSC’s asset and investment income in order to increase FSAM’s revenue,” the suit claims. “FSAM, acting as the investment manager for FSC, caused FSC to dramatically expand its investment portfolio throughout 2014.” 

The vehicle increased its total assets by 28 percent to $2.7 billion year-on-year to September 30, 2014. Management fees grew by 40 percent in the same period to $86 million. Defendants highlighted this income growth in FSAM IPO materials.

The claim argues that the growth was fueled by increasingly speculative investments at unsustainable leverage levels and that the firm, without the knowledge of investors, delayed writing down impairments to inflate FSAM revenues. 

“Given that FSAM’s future expected cash flows are tied directly to the long-term viability of FSC and its business, defendants sought to maintain the illusion of sustainable performance in FSC’s investment portfolio until after they could cash out in the FSAM IPO,” the filing said. 

The plaintiffs argue that Fifth Street management masked the poor credit quality of some of FSC’s underlying assets as well as delayed write-downs and losses until the asset manager had been floated. Tannenbaum and other FSAM owners cashed out “for tens of millions of dollars” via the initial public offering which raised about $100 million in gross cash proceeds, the filing claimed.