OFS

OFS Capital Corp. Q1 2016 Filing Summary

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended March 31, 2016. OFS Capital Corp. is an externally managed, closed-end, non-diversified management investment company operating as a Business Development Company (BDC) and a Regulated Investment Company (RIC). The company primarily invests in debt and equity of middle-market U.S. companies, utilizing leverage through SBA-guaranteed debentures via its subsidiary, OFS SBIC I LP.

Key Financial Metrics

Material Changes vs. Prior Period

• Net Income Decline: Net increase in net assets from operations decreased by approximately 30% ($0.95 million) compared to Q1 2015. This was driven by a net loss on investments of $1.38 million in Q1 2016, compared to a net gain of $0.48 million in Q1 2015.
• Investment Valuation: The company recognized a net unrealized depreciation of $3.94 million, primarily due to widening credit spreads in second-lien loan indices and interest rate market factors affecting discount rates on senior secured debt.
• Realized Gains: Despite the unrealized losses, the company recognized a net realized gain of $2.57 million, principally from the redemption of an equity investment held since 2014.
• Expense Reduction: Total expenses decreased by 14% ($0.68 million) year-over-year. Interest expense dropped $0.47 million due to the termination of the Wells Fargo Credit Facility in May 2015, partially offset by higher interest on SBA debentures. Management fees also declined due to a lower average asset base.
• Portfolio Composition: The portfolio fair value decreased to $245.4 million from $257.3 million. The number of obligors decreased from 38 to 35. Floating rate loans comprised 61% of the debt portfolio.

Guidance, Outlook, and Risks

• Correction of Error: The filing includes a correction of errors regarding the classification of net assets and distributions for prior periods (2013-2015). While this did not affect total net assets or NAV per share, it required reclassifications of accumulated undistributed income and realized gains.
• Internal Controls: Management concluded that disclosure controls and procedures were not effective as of March 31, 2016, due to a material weakness in reconciling components of distributions and net assets. Remediation efforts are underway.
• Liquidity: Cash and cash equivalents increased to $42.2 million. The company has fully drawn its $149.9 million SBA debenture commitment. A $15 million revolving credit facility with Pacific Western Bank remains undrawn.
• Distributions: The company declared a distribution of $0.34 per share for Q1 2016. Approximately 89% of the distribution is estimated to be ordinary income, with 11% as a return of capital.
• Risks: Key risks include the illiquidity of portfolio investments, reliance on SBA regulations for leverage, and the impact of widening credit spreads on fair value measurements (Level 3 assets).

Investor Verification Checklist

• Material Weakness Remediation: Verify the progress of remediation steps regarding the internal control weakness over financial reporting and distribution reconciliations.
• Valuation Sensitivity: Review the sensitivity of Level 3 asset valuations to changes in discount rates and EBITDA multiples, given the $3.9 million unrealized depreciation.
• Debt Maturity Profile: Confirm the maturity schedule of the $146.6 million in SBA debentures (maturing 2022-2025) and the company's ability to refinance or repay.
• Non-Accrual Status: Monitor the status of the single non-accrual loan (Phoenix Brands LLC), which had a fair value of $0.74 million.
• Capital Loss Carryforwards: Note that the company effectively exhausted its net capital loss carryforward in Q1 2016, which may impact future tax attributes of distributions.