OFS Capital Corporation — Q2 2022 Form 10-Q Summary
Business context and reporting period
OFS Capital Corporation is an externally managed, non-diversified business development company and regulated investment company. Its objective is to generate current income and capital appreciation primarily through debt investments, with additional equity investments and structured finance notes. This filing covers the unaudited quarter and six months ended June 30, 2022, compared primarily with the quarter ended March 31, 2022 and the six months ended June 30, 2021.
Financial performance and key metrics
| Metric | Q2 2022 | Q2 2021 | Six months 2022 | Six months 2021 |
|---|---|---|---|---|
| Total investment income | $10.4 million | $11.4 million | $21.4 million | $21.9 million |
| Net investment income | $6.2 million | $3.2 million | $9.3 million | $5.8 million |
| Net investment income per share | $0.47 | $0.24 | $0.69 | $0.43 |
| Net increase or decrease in net assets from operations | $(8.8) million | $22.4 million | $(0.5) million | $26.6 million |
| Net increase or decrease per share | $(0.66) | $1.67 | $(0.03) | $1.98 |
| Distributions declared per share | $0.29 | $0.22 | $0.57 | $0.42 |
Net investment income represented approximately 59.9% of quarterly investment income in Q2 2022, compared with approximately 28.3% in Q2 2021. The improvement primarily reflected lower interest expense, no income incentive fee, and a $3.0 million reversal of previously accrued capital gains incentive fees. Adjusted net investment income, excluding the capital gains fee effect, was $0.24 per share in Q2 2022 versus $0.30 per share in Q1 2022.
- Net asset value declined to $195.7 million, or $14.57 per share, from $203.7 million, or $15.18 per share, at December 31, 2021 and from $15.52 per share at March 31, 2022.
- Q2 net investment losses of $15.1 million were primarily caused by unrealized depreciation in structured finance notes and broadly syndicated loans as liquid credit spreads widened.
- Cash flow used in operating activities was $34.7 million for the six months ended June 30, 2022, compared with $2.2 million used in the prior-year period. Cash declined to $14.8 million from $43.0 million at year-end 2021.
- Portfolio investment purchases and originations totaled $122.6 million, while principal repayments, sales and structured finance distributions generated $77.9 million of proceeds during the first six months.
- Weighted-average realized yield on the total portfolio was 8.2% in both Q2 2022 and Q1 2022. Weighted-average performing income yield increased to 9.1% from 9.0%.
Portfolio, debt and liquidity
- Total investments at fair value were $547.7 million, up from $507.1 million at December 31, 2021. The portfolio included $356.0 million of debt investments, $101.8 million of equity investments and $89.9 million of structured finance notes.
- Approximately 98% of the loan portfolio at fair value consisted of senior secured loans. Manufacturing, health care and social assistance, and professional, scientific and technical services represented approximately 51.9% of portfolio company investments by fair value.
- Pfanstiehl Holdings represented 15.2% of the total portfolio and 42.5% of consolidated net assets at fair value. Its valuation increased by $17.4 million during the first six months, creating significant concentration and valuation risk.
- Total debt carrying value was $360.5 million, consisting primarily of $134.1 million under the BNP Facility, $180.0 million of unsecured notes and $50.6 million of SBA debentures.
- Approximately 63% of outstanding debt was fixed rate, and all outstanding debt contractually matured in 2025 or later. Asset coverage was 162%, above the 150% statutory requirement.
- Available commitments were $35.0 million under the PWB Credit Facility and $15.9 million under the BNP Facility, subject to borrowing-base and covenant requirements.
- Unfunded commitments to portfolio companies totaled $37.3 million. Cash available for distribution to the parent was approximately $3.5 million from SBIC I LP and none from OFSCC-FS.
Material changes versus prior comparable periods
- Q2 2022 results shifted from substantial investment gains in Q2 2021 to an $8.8 million net loss, primarily because of market-driven unrealized depreciation.
- Six-month net investment income increased 60.0% to $9.3 million, while total investment income decreased 2.4% to $21.4 million.
- Interest expense declined to $7.6 million from $9.1 million for the first six months, aided by lower average effective borrowing costs and the redemption of debt. Management fees increased to $4.1 million from $3.7 million as average portfolio fair value increased.
- Non-accrual loans increased to four loans with $17.8 million of fair value, or 3.3% of total investments, from two loans with $7.7 million of fair value, or 1.4%, at December 31, 2021. Eblens Holdings and an Envocore second-lien loan were placed on non-accrual during Q2.
- SBIC I LP redeemed $19.0 million of SBA debentures during the first quarter, reducing outstanding SBA debentures from approximately $69.9 million at year-end 2021 to $50.9 million.
- The BNP Facility was amended in June 2022 to extend its reinvestment period to June 2025 and maturity to June 2027, convert its benchmark from LIBOR to SOFR, and increase applicable margins and the rate floor. The PWB facility was amended in April 2022 to increase capacity to $35.0 million and extend maturity to February 2024.
Guidance, outlook, management commentary and risks
Management stated that it believes liquidity is sufficient to support existing portfolio companies and selectively deploy capital. The board declared a $0.29 per-share distribution for the third quarter of 2022, payable September 30, 2022 to stockholders of record September 23, 2022.
- Approximately 93% of debt investments at fair value bore floating rates, and approximately 83% of those floating-rate investments were LIBOR-based. Management expects the LIBOR-to-SOFR transition to have a minimal impact but noted that the outcome remains uncertain.
- Rising interest rates may increase investment income but also increase borrowing costs and pressure portfolio-company performance. Inflation, supply-chain disruptions, the Russia-Ukraine conflict and residual COVID-19 effects may impair borrowers and valuations.
- Approximately 91% of investments were classified as Level 3 or otherwise valued using significant judgment and unobservable inputs. Fair values may differ materially from amounts ultimately realized.
- Structured finance notes experienced a $9.3 million Q2 loss and remain exposed to underlying loan defaults, credit-spread volatility and uncertain cash distributions.
- The company relies on distributions from SBIC I LP and OFSCC-FS, which are restricted by SBA rules and financing agreements. It also faces conflicts-of-interest risks because OFS Advisor manages affiliated funds, CLOs and other accounts.
- The company reported no material pending legal proceedings, no material changes to previously disclosed risk factors, and effective disclosure controls as of June 30, 2022.
Investor verification checklist
- Verify the sustainability of recurring net investment income excluding the one-time $3.0 million capital gains fee reversal.
- Monitor Pfanstiehl Holdings’ operating performance and valuation because it represents 42.5% of net assets.
- Track the four non-accrual loans, particularly Eblens and Envocore, and related recovery assumptions.
- Reconcile available liquidity with $37.3 million of unfunded portfolio commitments and restrictions on subsidiary cash distributions.
- Review the effect of higher SOFR and LIBOR transition terms on both portfolio income and BNP Facility borrowing costs.
- Assess the sensitivity of NAV to Level 3 valuation assumptions, widening credit spreads, structured finance performance and further market volatility.