Covenant Lite #26: Growth at All Costs: Lessons From Private Credit’s Fallen Stars (Part 2 of 3)

A three-part series on what can go wrong in private credit

Private credit is having its moment: steady returns, general partner confidence, and a chorus of investor enthusiasm. But market confidence often masks deeper fragilities. History teaches us—sometimes gently, often brutally—that when lending discipline falters, today's star performers can swiftly become tomorrow's cautionary tales.

In Part 1, we explored pre-financial crisis blow-ups at Allied Capital, American Capital, and Carlyle Capital. This time, we fast-forward to the post-crisis years, turning our attention to three newer implosions: Fifth Street Finance Corp., Medley Capital Corp., and Direct Lending Investments. Each story reveals how unchecked ambition and weak underwriting can quietly seed future crises.

These stories offer a reminder that when underwriting discipline slips and yield-chasing takes over, disaster is often close behind.

Meet the Fallen Stars

1. Fifth Street Finance Corp.

• Founded: Early 2000s

• Peak Assets: ~$3 billion (2014–15)

• Focus: Middle-market lending via publicly traded a BDC (Ticker: FSC), heavy emphasis on subordinated and PIK debt

• Fatal Flaw: Yield-chasing strategies, aggressive junior loans, delayed recognition of credit deterioration, and questionable valuation practices, leading to investor losses and management replacement

2. Medley Capital Corp.

• Founded: 2006

• Peak Assets: ~$1.3 billion (2014–15) in MCC; $5bn across platform

• Focus: Middle-market lending through a publicly traded BDC (Ticker: MCC), often in second-lien and mezzanine positions

• Fatal Flaw: Large sector bets (energy, media), overly concentrated loans, poor risk management, resulting in widespread non-accruals and ultimately bankruptcy

3. Direct Lending Investments (DLI)

• Founded: 2012

• Peak Assets: ~$800 million (2017–18)

• Focus: Private fund specializing in peer-to-peer and small-business loans

• Fatal Flaw: Excessive concentration risk, flawed underwriting, fraudulent performance reporting, hidden borrower stress, and inadequate transparency, resulting in a catastrophic collapse and regulatory action

Fifth Street (Ticker: FSC)

Fifth Street was founded in 1998 by Leonard M. Tannenbaum with capital from his father-in-law (Bruce Toll, co-founder of Toll Brothers). Tannenbaum had a Wharton MBA and early experience at Merrill Lynch before starting his own fund.

He cultivated ties with noted investor David Einhorn in the early 2000s (they co-invested in deals and shared poker games), from whom he learned about the BDC model. In 2008, during the credit crunch, Tannenbaum took Fifth Street Finance public as a BDC—one of very few financial IPOs that year. Einhorn’s Greenlight Capital was an early investor (owning ~9.5% post-IPO), lending credibility to the venture.

Initially, Fifth Street carved out a profitable niche in middle-market direct lending, targeting U.S. small and medium-sized enterprises with annual revenues ranging from $25 million to $500 million. The company provided senior and mezzanine loans, offering attractive yields that supported dividend distributions in the high single-digits to low teens.

Post-IPO, Fifth Street's growth trajectory was remarkable. Starting with around $135 million, the firm's portfolio quickly escalated to over $2 billion by 2014–2015. The 2010–2014 period marked aggressive asset accumulation, with portfolio assets soaring from $1.05 billion to $2.5 billion. During this rapid expansion phase, Fifth Street Asset Management (FSAM)—the external adviser led by Tannenbaum—also executed its own IPO in 2014, further intensifying the pressure to demonstrate growth.

But beneath this rapid growth lay problematic incentives. The fee structure at FSAM was based on gross assets under management. As a result, FSAM was strongly motivated to aggressively expand FSC's balance sheet to maximize fee income, even at the potential expense of credit quality. This fee structure encouraged relentless asset accumulation, placing fee generation above careful underwriting and risk assessment.

Moreover, as FSC aggressively scaled up, it failed to proportionately enhance its underwriting infrastructure or personnel. This gap meant FSC increasingly stretched underwriting standards and pursued riskier investments, transitioning from predominantly first-lien, conservative loans in the early years to higher-risk junior loans.

For several years, FSC successfully obscured its deteriorating credit quality. Investors were initially reassured by steady dividend payments and reported NAV stability, as FSC continued marking investments optimistically. But by 2014, cracks began to show publicly, as the firm announced its first significant loan write-off.

Early 2015 brought further shocks as FSC placed four additional sizable loans on non-accrual status, representing roughly 5% of its loan book at cost. This was accompanied by a dividend cut, severely undermining investor confidence and causing FSC's stock to trade at a substantial discount to NAV, reaching the mid-20% range despite NAV declining by only 5%.

Investor skepticism intensified, with shareholders filing class-action lawsuits in 2015–2016. These suits alleged deliberate mismanagement by FSAM and Tannenbaum, accusing them of inflating FSAM’s value through accelerated asset growth and delayed loss recognition, particularly ahead of FSAM’s 2014 IPO. Ultimately, FSAM and FSC settled these suits in August 2016, paying substantial penalties without admitting wrongdoing.

Simultaneously, credit deterioration deepened, with non-accrual loans surging into the low teens as a percentage of total cost—a highly problematic level for a middle-market BDC. As further impairments emerged, FSC's market valuation continued deteriorating, with shares trading at discounts exceeding 35%, eliminating the possibility of issuing new equity to stabilize finances.

Amid escalating pressure from activist investors, ongoing litigation, and SEC inquiries into valuation practices, FSC’s board finally relinquished control in July 2017. Management passed to Oaktree Capital Management, effectively ending Fifth Street’s independent existence.

Today, FSC no longer operates under its original name. Rebranded as Oaktree Specialty Lending (Ticker: OCSL), it operates as a stable entity under Oaktree’s stewardship. The original Fifth Street brand is defunct, its assets liquidated, and its stock canceled. Leonard Tannenbaum has moved on, leaving behind a cautionary tale about rapid growth, misaligned incentives, and the critical importance of transparency and disciplined underwriting in private credit.

Medley Capital Corp (Ticker: MCC)

Brook and Seth Taube, identical twins educated at Harvard, founded Medley in 2006. Parlaying backgrounds in finance—Brook at Bankers Trust and Seth in private equity—they established Medley as a credit investment firm managing institutional private funds.

In 2011, the Taubes launched their first publicly traded business development company (BDC), Medley Capital Corp. (Ticker: MCC), externally managed by Medley Management Inc., controlled by the brothers. MCC specialized in middle-market lending, providing senior secured, subordinated debt, and equity warrants to companies with revenues of $50–500M. Typical yields ranged from 8–14%, often driven by higher-risk unitranche and second-lien positions.

MCC’s total assets peaked around $1.2 billion by mid-2014, contributing to Medley's overall platform exceeding $5 billion in assets across MCC, Sierra Income (a non-traded BDC), and separate accounts. The Taubes capitalized on this growth with Medley Management Inc.’s IPO (Ticker: MDLY) in 2014, initially priced at ~$18 per share.

Similar to Fifth Street, the Taubes were incentivized through their ownership of MDLY to aggressively grow MCC's asset base, prioritizing growth in assets under management (AUM) over prudent credit underwriting. This misalignment encouraged riskier lending practices, ultimately undermining the credit quality of MCC’s portfolio.

MCC’s aggressive underwriting eventually caught up with them, leading to severe credit issues. Exposure to second-lien and equity positions peaked around 2014, coinciding with problematic sector concentrations in energy, casual dining, and special-situation tech companies. When these sectors struggled in 2015–2017, MCC’s non-accrual loans surged, and NAV per share slid sharply—from ~$12 at IPO down into single digits by 2016.

To mask the deterioration in MCC’s portfolio, the Taubes employed strategies such as extending additional credit to troubled borrowers, as well as switching their non-performing loans to payment-in-kind (PIK)—thereby delaying formal recognition of these impaired loans. Interestingly, a similar dynamic is occurring today, with many BDCs allowing their borrowers to toggle on PIK payments to reduce cash burn in the higher rate environment (Link).

These tactics temporarily boosted reported income and maintained dividend payouts, creating an illusion of stability. However, as loan defaults accelerated, the scale of unrealized losses became too large to obscure. Investor skepticism mounted, and external scrutiny intensified, ultimately validated by SEC investigations that revealed significant asset valuation discrepancies and overstated AUM figures.

MCC’s once-stable dividend ($1.48 annual) proved unsustainable, prompting cuts to $1.20 in 2016 and further reductions thereafter. NAV declines, increasing loan losses, and persistent trading discounts exceeding 50% reflected investor skepticism about Medley Management’s valuations—concerns later validated by SEC findings.

Facing declining fee income, the Taubes pursued a controversial three-way merger in 2018. The proposed deal involved MCC merging with Sierra Income, simultaneously internalizing management by acquiring Medley Management. Critics saw this as self-serving, primarily benefiting the Taubes with lucrative contracts despite poor performance.

After prolonged negotiations and investor pushback, the COVID-19 crisis in early 2020 delivered a final blow. Deteriorating credit markets severely impaired MCC’s and Sierra’s portfolios, prompting Sierra’s board to terminate the merger in May 2020. MCC’s NAV plunged, and its share price hit an all-time low (~$1–2). Medley Management, having lost advisory contracts, spiraled into insolvency and eventually entered Chapter 11 bankruptcy in 2021, wiping out equity holders.

In late 2020, MCC terminated Medley Management as advisor, rebranded as PhenixFIN Corp. (Ticker: PFX), and became internally managed under new leadership, marking a definitive split from the Taubes. Sierra Income was later acquired by Barings LLC, which merged it into Barings BDC in 2022, formally ending Medley’s saga.

Direct Lending Investments (Acronym: DLI):

Brendan Ross founded Direct Lending Investments (DLI) in 2012, positioning it as a specialized private credit fund offering exposure to high-yield loans originated via fintech platforms. Ross marketed himself prominently as a visionary in alternative credit, emphasizing his innovative approach in prominent media outlets, including favorable profiles in the Los Angeles Times. He portrayed DLI as a pioneer in fintech-based specialty lending, attracting investors intrigued by the promise of consistent, bond-like returns from the growing marketplace lending sector.

DLI’s core strategy was to purchase high-yield loans or loan portfolios from online lending platforms. Initially, it bought unsecured consumer and small business loans (whole loans) from platforms like LendingClub (Link) and Prosper (Link). Later it focused on niche areas such as short-term merchant cash advances and receivable loans.

Initially, DLI quickly grew due to steady monthly returns of approximately 0.8–1% (10–12% annually), drawing a diverse investor base that included high-net-worth individuals, family offices, and institutional allocators. From 2012 through 2018, investor materials claimed that the fund had never experienced a negative month—even during periods when broader credit markets were stressed. This “Steady Eddy” performance was a huge draw and contributed to DLI's assets under management peaking at over $1 billion in 2018.

Despite the seemingly steady returns, DLI’s situation was not as sanguine as it appeared. The unsecured consumer lending platforms like LendingClub and Prosper that it bought loans from had a significant structural flaw in the mid-2010s: lenders lacked an effective way to track borrowers’ existing obligations from other lending platforms in real-time.

This gap enabled a practice known as "loan stacking," where borrowers rapidly accumulated multiple loans from various sources without lenders being aware of the total leverage. As a result, borrowers often ended up with debt burdens far exceeding what any single lender anticipated, leading to higher and more frequent defaults.

DLI encountered these issues early but concealed them from investors. Each month the various loan-origination platforms sent Ross a raw loan-servicing file. Instead of passing these files straight to the fund administrator, Ross loaded them into his own spreadsheet macros, where he manipulated any loans showing 30- or 60-day delinquencies.

Ross would simply overwrite the delinquency code, resetting the loan to “current” or rolling forward the next‑payment‑due date. Because the administrator relied on Ross’s edited file to mark NAV, the default never showed up in the official books, and interest continued to accrue as if the borrower were paying on time.

Ross was able to cover up losses so long as the fund continued to attract new investors. It was a classic Ponzi-like dynamic: new money was used in part to pay off those who redeemed.

This dynamic worked until DLI was itself the victim of a massive fraud involving a receivables-financing facility for VOIP Guardian Partners LLC that was 25% of the fund’s NAV. VOIP claimed to advance cash to wholesale telecom carriers around the world, secured by short-dated invoices for voice-traffic termination. These invoices were supposed to turn into cash within 30-60 days as blue-chip counterparties (Vodafone, Telia, etc.) paid their phone bills.

In reality, VOIP Guardian’s largest “customers” were thin‑capitalized shell companies in Hong Kong and Dubai that never remitted a cent. For more than a year the fraud went unnoticed because VOIP Guardian rolled the facility—paying old invoices with new borrowings—while sending DLI routine interest and fee checks. Those payments, in turn, allowed Ross to keep booking double‑digit income and to show the position at full par value.

The house of cards collapsed in February 2019 when VOIP Guardian suddenly missed an interest payment due to DLI. A quick forensic review revealed that fully $160 million of receivables were fictitious; the supposed obligors either did not exist or denied ever doing business with VOIP Guardian. With no real collateral to seize, VOIP Guardian filed for Chapter 7 liquidation and Ross marked the entire position down by more than 80%.

Unlike the LendingClub and Prosper loans—where Ross could doctor loan-level data internally—the VOIP Guardian default was public, immediate, and impossible to mask. The loss wiped out years of accumulated “paper” gains, forced DLI to gate redemptions, and brought the SEC and FBI to his doorstep within weeks. The episode also exposed how Ross had violated his own diversification guidelines: investors learned only after the fact that a single counterparty accounted for one‑quarter of the fund.

Within weeks, the SEC filed charges alleging a multi-year fraud, detailing Ross’s extensive falsification of loan performance records. Ross resigned under regulatory pressure, and a court-appointed receiver took control, initiating asset liquidation.

The investigations culminated in criminal charges in 2020, leading Ross to plead guilty to securities fraud. In 2025, he was sentenced to 40 months in federal prison, permanently barred from the securities industry, and ordered to pay disgorgement and restitution.

DLI investors faced substantial losses, projected at approximately 60% of their invested capital. Although interim distributions occurred, full recovery remained unlikely due to significant asset impairments and complex legal proceedings.

Conclusion and Takeaways

The implosions at Fifth Street, Medley, and DLI highlight how rapid growth, misaligned incentives, and poor underwriting can swiftly unravel investor confidence, leaving behind painful losses.

These cautionary tales serve as essential case studies for today’s allocators. Below, we distill key lessons from these examples:

1. Fee structures drive behavior—check the alignment.

Both Fifth Street and Medley paid their external advisers a percentage of gross AUM, so the fastest way to get paid was to grow the book, not protect it. As assets ballooned, credit standards slipped and shareholders bore the losses.

2. Rapid AUM growth + yield-chasing is usually paid for later.

Stretching into junior/second-lien tranches and PIK add-ons juiced headline yields but set up a wave of non-accruals once markets cooled.

3. “Delay-and-pray” accounting turns small problems into big ones.

Whether it was FSC marking loans generously, Medley toggling borrowers to PIK, or DLI literally rewriting loan files, each manager hid early delinquencies rather than fixing them, compounding eventual losses.

4. Returns that are too smooth deserve extra skepticism.

A fund that never has a down month is probably smoothing marks, cherry-picking exits, or worse. DLI’s “Steady Eddy” 0.9 % monthly gains were exactly that.

5. Independent governance and third-party controls are non-negotiable.

DLI’s one-man data pipe, Fifth Street’s compliant board, and Medley’s conflicted committees show why investors now insist on truly independent directors, valuation agents, and auditors.

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