FSK

Business Context and Reporting Period

Company: FS Investment Corporation (FS KKR Capital Corp)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: March 31, 2009
Business Overview: The Company is an externally managed, non-diversified closed-end investment company regulated as a Business Development Company (BDC). It formally commenced operations on January 2, 2009, following the completion of its initial public offering. The investment objective is to generate current income and, to a lesser extent, long-term capital appreciation, primarily through senior secured and second lien loans to private U.S. companies.

Key Financial Metrics

Material Changes vs. Prior Period

The Company commenced operations on January 2, 2009. Consequently, the three months ended March 31, 2009, represent the first full quarter of active investment operations. Comparisons to the three months ended March 31, 2008, are limited as the Company was in the organization phase during the prior period.

• Operations: In Q1 2009, the Company generated a net increase in net assets of $293, compared to a net decrease of $240 in Q1 2008 (which consisted primarily of organization costs).
• Portfolio Deployment: The Company invested $11,157 in 21 portfolio companies during Q1 2009. As of March 31, 2009, the portfolio consisted of 18 companies with a fair value of $9,919. There were no investments held as of December 31, 2008.
• Capital Raised: During the quarter, the Company sold 914,781 shares (adjusted for stock distributions) for gross proceeds of $8,330. Cumulative gross proceeds raised since inception totaled $20,101.
• Expense Structure: Total operating expenses were $268 in Q1 2009. This included $124 in expense reimbursements from the sponsor (Franklin Square Holdings), which reduced net expenses to $144. In Q1 2008, expenses were $243, consisting entirely of organization costs.

Outlook, Management Commentary, and Risks

Management Commentary:

• Market Conditions: Management notes that while global credit markets have suffered stress and volatility, the disruption has created attractive pricing levels for debt securities, presenting significant investment opportunities for new capital.
• Portfolio Quality: As of March 31, 2009, 93% of the portfolio was rated "2" (performing investment executing in accordance with business plan) and 7% was rated "1" (exceeding expectations). No investments were rated 3, 4, or 5.
• Yield and Ratings: The estimated gross annual portfolio yield was 14.4%, with a weighted average credit rating of B2 (Moody's scale).
• Expense Reimbursement: The sponsor, Franklin Square Holdings, agreed to reimburse expenses to ensure net investment income covers distributions. This arrangement is expected to continue through June 2009 and potentially thereafter until the Company achieves economies of scale.

Risks and Contingencies:

• Market Risk: The Company is subject to interest rate risk. All current portfolio investments pay variable interest rates. Rising rates could increase borrowing costs if the Company utilizes leverage in the future.
• Valuation Risk: All investments are classified as Level 3 under SFAS 157 (significant unobservable inputs), relying on third-party pricing services and internal models due to the private nature of the market.
• Liquidity: The Company relies on its continuous public offering and cash flows from investments for liquidity. It currently has no off-balance sheet arrangements.

Investor Verification Checklist

• Sponsor Support: Verify the duration and terms of the expense reimbursement agreement with Franklin Square Holdings, as current profitability relies heavily on this support ($124k reimbursement vs. $14k net investment income).
• Valuation Methodology: Review the specific inputs used for Level 3 fair value measurements, as 100% of the portfolio ($9,919) relies on unobservable inputs.
• Capital Deployment: Monitor the pace of capital deployment from the continuous offering ($8.3M raised in Q1) to ensure efficient investment of cash balances.
• Distribution Sustainability: Confirm that future distributions can be maintained from net investment income once the sponsor's expense reimbursement arrangement expires.
• Portfolio Concentration: Assess industry concentration risks, noting that Telecommunications (19.2%) and Business Information Services (17.9%) represent the largest sectors.