OFS Capital Corporation 10-Q Summary
Business Context and Reporting Period
OFS Capital Corporation is an externally managed, non-diversified business development company and regulated investment company focused primarily on debt investments, with a smaller allocation to equity investments and structured finance securities. This unaudited Form 10-Q covers the three and nine months ended September 30, 2022, with comparisons to the prior quarter, the comparable nine-month period, and December 31, 2021.
Key Financial Metrics
| Metric | Three months ended September 30, 2022 | Nine months ended September 30, 2022 |
|---|---|---|
| Total investment income | $13.4 million | $34.7 million |
| Total expenses | $9.0 million | $21.1 million |
| Net investment income | $4.4 million, or $0.33 per share | $13.6 million, or $1.01 per share |
| Net realized and unrealized gain (loss) on investments | $(13.9) million | $(23.5) million |
| Net increase (decrease) in net assets from operations | $(9.6) million, or $(0.71) per share | $(10.0) million, or $(0.75) per share |
| Distributions declared per share | $0.29 | $0.86 |
- Net investment income represented approximately 32.7% of quarterly investment income and 39.2% for the nine-month period.
- Net asset value was $182.1 million, or $13.58 per share, at September 30, 2022, compared with $203.7 million, or $15.18 per share, at December 31, 2021.
- Total investments at fair value were $516.6 million, up from $507.1 million at December 31, 2021, while total assets declined to $538.2 million from $569.0 million.
- Cash was $13.1 million at quarter-end. Cash used in operating activities was $21.2 million and cash used in financing activities was $8.8 million for the nine months, resulting in a $30.0 million decrease in cash.
- Debt carrying value was $349.7 million, consisting principally of $121.4 million under the BNP Facility, $50.9 million of SBA debentures, $180.0 million of unsecured notes and $1.5 million under the PWB Credit Facility.
- Asset coverage was 160%, above the 150% statutory minimum. Approximately 99% of outstanding debt matured in 2025 or later, 63% was fixed-rate and 49% was unsecured.
Material Changes Versus Prior Periods
- Quarterly investment income increased to $13.4 million from $10.4 million in the preceding quarter, principally from higher interest income as floating-rate investments benefited from rising rates and from higher fee income.
- Weighted-average performing income yield increased to 11.6% from 9.1% in the preceding quarter. Approximately 94% of the loan portfolio at fair value was floating-rate.
- Quarterly net investment income declined to $4.4 million from $6.2 million in the preceding quarter, primarily because interest expense increased and the prior quarter included a $3.0 million reversal of accrued capital gains incentive fees.
- Net asset value per share declined 6.8% from $14.57 at June 30, 2022 to $13.58 at September 30, 2022, primarily because of $13.9 million of net investment losses.
- Nine-month net investment income increased to $13.6 million from $9.0 million in the comparable 2021 period, while total investment gains reversed from a $33.3 million gain to a $23.5 million loss.
- Interest expense decreased year over year for the nine-month period because of the 2021 refinancing of unsecured notes, although quarterly borrowing costs increased as SOFR rose.
- The investment portfolio shifted toward structured finance securities and senior secured debt. Structured finance securities at fair value increased to $89.9 million from $75.2 million at year-end 2021.
Portfolio, Credit Quality and Unusual Items
- The portfolio included debt investments in 57 portfolio companies, equity investments in 17 companies and 23 structured finance securities. Approximately 99% of loans at fair value were senior secured.
- Four loans were on non-accrual status at September 30, 2022, with fair value of $12.2 million, or 2.4% of total investments. No new loans were placed on non-accrual during the quarter, but non-accrual loans increased from $7.7 million of fair value at December 31, 2021.
- A post-secondary, for-profit education equity investment was significantly impaired following an unexpected U.S. Department of Education decision affecting a significant revenue source. The investment’s equity appreciation right was valued at zero and contributed $7.2 million of quarterly unrealized depreciation.
- Two non-accrual loan investments generated approximately $5.2 million of quarterly unrealized depreciation. The filing identifies Eblens Holdings and Envocore as significant contributors.
- Pfanstiehl Holdings represented $82.3 million, or 15.9% of the total portfolio at fair value and 45.2% of net assets. Its fair value increased by $16.5 million during the nine months, substantially consisting of unrealized appreciation.
- Debt investments were concentrated in manufacturing, health care and social assistance, and professional, scientific and technical services, which together represented approximately 53.8% of portfolio company investments at fair value.
Liquidity, Capital Resources and Outlook
- Unused commitments were $33.5 million under the PWB Credit Facility and $28.6 million under the BNP Facility, subject to borrowing-base requirements and covenants. The Company stated that it could access these commitments while remaining within asset coverage requirements.
- Unfunded commitments to portfolio companies totaled $38.3 million at September 30, 2022.
- The PWB facility was amended to increase maximum availability to $35.0 million and extend maturity to February 2024. The BNP Facility was amended to extend its reinvestment period to June 2025, extend maturity to June 2027, convert its benchmark from LIBOR to SOFR and increase applicable margins and the interest-rate floor.
- SBIC I LP repaid $19.0 million of SBA debentures during the nine months. Management expects SBIC I LP to continue repaying debentures over time and to make only follow-on investments in its existing portfolio companies.
- Management stated that liquidity was sufficient to support existing portfolio companies and selectively deploy capital, but noted that distributions from SBIC I LP and OFSCC-FS are subject to regulatory and facility restrictions.
- On November 1, 2022, the Board declared a fourth-quarter distribution of $0.30 per share, payable December 30, 2022 to stockholders of record as of December 23, 2022.
Risks, Contingencies and Governance Matters
- Portfolio valuations are primarily based on Level 3 inputs and significant management judgment. On September 7, 2022, the Board designated OFS Advisor as valuation designee under SEC Rule 2a-5, creating a potential conflict because management fees are partly based on asset values.
- Rising interest rates may increase investment income because most loans are floating-rate, but also increase borrowing costs and may reduce portfolio company cash flow and fair values.
- The portfolio is exposed to inflation, recession risk, credit-spread widening, supply-chain disruption, the continuing effects of COVID-19, the Russia-Ukraine war and the transition from LIBOR to SOFR.
- Approximately 69% of variable-rate debt investments were LIBOR-based at quarter-end. Management expects the LIBOR transition to have a minimal impact but states that the ultimate effect cannot be predicted.
- Fair value sensitivity analysis indicated a total portfolio range of approximately $502.3 million to $531.4 million versus reported fair value of $516.6 million.
- The Company reported no material pending legal proceedings and no material changes to previously disclosed risk factors other than the valuation-designee conflict risk.
Investor Verification Items
- Verify the sustainability of the $0.33 quarterly net investment income per share against the $0.29 distribution, including the effect of higher SOFR and potential increases in funding costs.
- Review the four non-accrual loans, particularly Eblens Holdings and Envocore, and assess recovery assumptions and further NAV downside.
- Assess the valuation and concentration risk associated with Pfanstiehl Holdings, whose fair value substantially exceeds cost and represents 45.2% of net assets.
- Confirm the financial and regulatory effects of the post-secondary education investment impairment and the related zero valuation of the equity appreciation right.
- Monitor asset coverage, borrowing-base availability, covenant compliance and the $38.3 million of unfunded portfolio commitments.
- Reconcile reported GAAP net investment income with non-GAAP Adjusted NII, which was $0.33 per share for the quarter and $0.87 per share for the nine months after excluding capital gains incentive fee effects.