FSK

Business Context and Reporting Period

Company: FS Investment Corporation (FSIC)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2016
Business Overview: FSIC is an externally managed, non-diversified, closed-end management investment company regulated as a Business Development Company (BDC). Its investment objective is to generate current income and, to a lesser extent, long-term capital appreciation by investing primarily in senior secured loans, second lien secured loans, and subordinated debt of private U.S. middle-market companies. The company also holds equity interests and collateralized securities.

Key Financial Metrics

Note: All figures in thousands except per share data.

Material Changes vs. Prior Comparable Period

• Operating Performance: For the nine months ended September 30, 2016, the net increase in net assets resulting from operations was $242.4 million ($1.00 per share), a significant improvement compared to $116.9 million ($0.48 per share) in the same period of 2015. This improvement was driven by a net change in unrealized appreciation of $106.7 million in 2016, compared to a depreciation of $51.9 million in 2015.
• Investment Income: Total investment income decreased to $313.8 million for the nine months ended September 30, 2016, from $360.0 million in 2015. This decline was primarily due to reduced leverage, prepayments of higher-yielding assets, and an increase in equity holdings.
• Expense Structure: Total operating expenses increased to $158.1 million in 2016 from $151.1 million in 2015. A key factor in the 2015 expense reduction was the reversal of capital gains incentive fees of $18.4 million, which did not occur in 2016. Conversely, 2016 included $938,000 in breakage fees associated with the partial paydown of the JPM Facility.
• Portfolio Composition: The portfolio fair value decreased slightly to $3.94 billion from $4.03 billion at year-end 2015. The percentage of the portfolio in Senior Secured Loans (First Lien) decreased from 54% to 52%, while Equity/Other increased from 12% to 15%.

Guidance, Outlook, and Risks

• Management Commentary: Management attributes the improvement in unrealized gains to improvements in high-yield markets, a general tightening of credit spreads, and increased valuations of Caesars Entertainment Operating Co., Inc. loans following positive restructuring developments. The gross portfolio yield prior to leverage was 9.2% as of September 30, 2016.
• Financing Changes: On November 1, 2016 (subsequent to the reporting period), the company entered into a new $625 million term loan facility with JPMorgan Chase and terminated its existing JPM repurchase facility. This indicates a strategic shift in leverage management.
• Distributions: The company declared a quarterly cash distribution of $0.22275 per share on November 2, 2016. For the nine months ended September 30, 2016, 100% of distributions were funded by net investment income.
• Risks and Contingencies:
  • Interest Rate Risk: 65.2% of the portfolio pays variable interest rates. A rise in rates could increase interest income but also increase interest expense on floating-rate debt.
  • Valuation Risk: 99.9% of investments are classified as Level 3 (unobservable inputs), requiring significant management judgment and reliance on independent valuation firms.
  • Asset Quality: As of September 30, 2016, 1% of the portfolio was rated "5" (underperforming with expected loss of principal) and 0.7% was on non-accrual status.

Key Facts for Investor Verification

• NAV vs. Market Price: Verify the current trading price of FSIC shares relative to the reported NAV of $9.42 to assess the premium or discount.
• Debt Maturities: Review the maturity schedule of the $1.73 billion in debt, specifically the $650 million JPM Facility (repurchase agreement) which was terminated in November 2016 and replaced by a term loan.
• Unfunded Commitments: Confirm the company's liquidity position against $137.2 million in unfunded debt commitments as of September 30, 2016.
• Incentive Fee Accruals: Monitor the subordinated income incentive fee payable to the advisor, which was $12.25 million as of period end, and the methodology for capital gains incentive fees which are accrued on unrealized gains but only payable upon realization.
• Portfolio Concentration: Assess the impact of the top holdings, particularly the 21% allocation to Capital Goods and 12% to Energy, on overall portfolio performance.