OXSQ

Business Context and Reporting Period

Company: Oxford Square Capital Corp. (OXSQ)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2018
Business Model: OXSQ is a closed-end, non-diversified management investment company regulated as a Business Development Company (BDC) and taxed as a Regulated Investment Company (RIC). Its primary objective is to maximize total return by investing in corporate debt securities and Collateralized Loan Obligation (CLO) structured finance investments. The company utilizes leverage to enhance returns.

Key Financial Metrics

Portfolio Composition (Fair Value): Senior Secured Notes (63.5%), CLO Equity (33.0%), Equity and Other (3.3%), CLO Debt (0.2%).

Material Changes vs. Prior Period

• Operating Results: The company reported a net decrease in net assets from operations of $9.2 million in 2018, a significant reversal from the $43.6 million increase in 2017. This was primarily driven by a net change in unrealized depreciation of $39.3 million, largely due to market volatility in the fourth quarter of 2018 affecting CLO equity valuations.
• Investment Income: Total investment income decreased by $5.1 million (8.3%) to $56.3 million, primarily due to a decline in income from securitization vehicles and investments ($5.4 million decrease) resulting from lower average cost bases and yields on CLO equity.
• Expenses: Total operating expenses decreased by $7.9 million to $22.8 million. This reduction was driven by lower interest expense ($5.7 million decrease) and professional fees, partially offset by higher net investment income incentive fees.
• Leverage: Total debt principal increased significantly from $64.4 million in 2017 to $150.0 million in 2018. This increase was due to the establishment of a new $125.0 million credit facility (OXSQ Facility) with Citibank, N.A., of which $85.7 million was outstanding at year-end.
• Share Repurchases: The company repurchased 3,828,450 shares of common stock for approximately $25.0 million during 2018, reducing the share count and impacting net assets.

Guidance, Outlook, and Risks

Management Commentary: Management views the market opportunity as strong despite the challenging fourth quarter of 2018. They believe the decline in U.S. loan prices allows for the acquisition of performing assets at discounts, which may build CLO asset value over time. The company maintains a focus on smaller broadly-syndicated loans and club deals to maintain liquidity.

Regulatory Changes: The Small Business Credit Availability Act (SBCAA) allows BDCs to reduce their asset coverage requirement from 200% to 150%. OXSQ's Board approved this change, effective April 6, 2019, which may allow for increased leverage in the future.

Risks and Contingencies:

• Market Volatility: The company is exposed to significant market risk, particularly in CLO equity investments, which are highly sensitive to interest rate changes and credit spreads. The 2018 unrealized losses highlight this sensitivity.
• Leverage Risk: Borrowings magnify potential gains and losses. The company's asset coverage ratio was 309% as of December 31, 2018.
• Regulatory Compliance: As a BDC, the company must maintain at least 70% of assets in "qualifying assets." As of year-end, qualifying assets represented 68.3% of total assets; no non-qualifying assets were acquired during periods when the ratio was below 70%.
• Tax Status: The company must distribute at least 90% of its investment company taxable income to maintain RIC status. In 2018, distributions included a tax return of capital of approximately $0.07 per share.

Key Facts for Investor Verification

• Unrealized Depreciation: Verify the magnitude of the $39.3 million unrealized depreciation and its specific impact on CLO equity valuations versus direct corporate debt holdings.
• Debt Facility Terms: Review the covenants and mandatory amortization schedule of the new $125.0 million OXSQ Facility maturing in June 2020.
• Asset Coverage Ratio: Monitor the asset coverage ratio post-April 2019 as the regulatory threshold drops to 150% and the company potentially increases leverage.
• Distribution Sustainability: Assess the sustainability of the $0.80 per share distribution rate given the net decrease in net assets from operations and the portion of distributions classified as a return of capital.
• Portfolio Grading: Review the credit grading of the debt portfolio (weighted average grade of 2.1) to assess credit quality relative to the market downturn.