OFS

Business Context and Reporting Period

OFS Capital Corp (OFS Capital) is an externally managed, closed-end, non-diversified management investment company. The reporting period covers the fiscal year ended December 31, 2012. A material event during this period was the company's conversion from a limited liability company to a Delaware corporation on November 7, 2012, and its subsequent election to be regulated as a Business Development Company (BDC) under the Investment Company Act of 1940. On November 14, 2012, the company completed its Initial Public Offering (IPO), selling 6,666,667 shares at $15.00 per share, raising $100 million in gross proceeds.

The company's investment strategy focuses primarily on senior secured debt investments in U.S. middle-market companies, with a secondary focus on unitranche, second-lien, mezzanine loans, and minority equity securities.

Key Financial Metrics

Material Changes vs. Prior Period

• Structural Transformation: The company transitioned from a private LLC to a public BDC. This resulted in a change in accounting principles, specifically the shift to fair value accounting for portfolio investments effective November 7, 2012.
• Capital Raise: The IPO generated $100 million in gross proceeds. Approximately $90 million was utilized to pay down the OFS Capital WM Facility, reducing outstanding indebtedness.
• Consolidation Changes:
  • OFS Capital WM: The company consolidated the financial statements of its wholly-owned subsidiary, OFS Capital WM, effective March 30, 2012, following amendments to the credit facility that granted OFS Capital controlling financial interest.
  • Tamarix LP: The company deconsolidated Tamarix LP effective July 27, 2012, following the repayment of loans and resignation of investment professionals, shifting to equity method accounting.
• Income Growth: Total investment income increased by approximately 658% ($11.7 million) compared to 2011, primarily driven by the consolidation of OFS Capital WM's operations.
• Expense Increase: Total expenses increased by 254% ($6.7 million) compared to 2011, largely due to interest expense from the consolidated OFS Capital WM facility and increased costs associated with being a public company.

Guidance, Outlook, and Risks

Management Commentary and Outlook: Management views the current economic environment as creating attractive lending opportunities due to reduced competition from traditional banks and significant refinancing needs in the middle-market. The company intends to deploy capital into senior secured, unitranche, second-lien, and mezzanine loans. They plan to maintain a variable dividend policy, targeting distributions of 90-100% of taxable quarterly income.

Risks and Contingencies:

• Leverage: The company utilizes debt to finance investments. As of December 31, 2012, it had $99.2 million in debt. Leverage magnifies potential gains and losses and subjects the company to asset coverage tests (minimum 200%) under the 1940 Act.
• Tamarix LP Acquisition: The company intends to acquire remaining interests in Tamarix LP (an SBIC) to consolidate its financials and access SBA-guaranteed leverage. This is contingent on SBA approval and the willingness of other partners to sell.
• Valuation Uncertainty: Approximately 95% of assets are valued at fair value by the Board of Directors using unobservable inputs (Level 3), creating uncertainty regarding the realized value of investments.
• Conflicts of Interest: The company is externally managed by OFS Advisor, which receives fees based on total assets (including leveraged assets), potentially creating incentives to increase leverage.
• RIC Status: The company must distribute at least 90% of its taxable income to maintain Regulated Investment Company (RIC) status and avoid corporate-level taxes. Failure to meet this requirement could result in significant tax liabilities.

Key Facts for Investor Verification

• Asset Coverage Ratio: Verify the company's compliance with the 200% asset coverage test required for BDCs to issue senior securities or make distributions.
• Tamarix LP Consolidation Status: Monitor progress on acquiring remaining interests in Tamarix LP and obtaining necessary SBA approvals, as this impacts leverage capacity and financial reporting.
• Dividend Sustainability: Assess the company's ability to generate sufficient cash flow to meet the 90% distribution requirement for RIC status, particularly given the presence of non-cash income (e.g., PIK interest) in the portfolio.
• Portfolio Concentration: Review the concentration of the portfolio across industries and individual obligors, as the company is non-diversified under the 1940 Act.
• Management Fee Structure: Note that the base management fee is calculated on total assets (including borrowed amounts), which may incentivize leverage.