OFS

OFS Capital Corp. 10-Q Summary: Period Ended September 30, 2017

Business Context and Reporting Period

OFS Capital Corporation is an externally managed, closed-end, non-diversified management investment company regulated as a Business Development Company (BDC) under the 1940 Act and taxed as a Regulated Investment Company (RIC). The company invests primarily in debt and, to a lesser extent, equity of middle-market U.S. companies. This report covers the quarterly period ended September 30, 2017. During the period, the company completed a follow-on public offering in April 2017, issuing 3,625,000 shares and raising approximately $53.7 million in net proceeds.

Key Financial Metrics

Material Changes vs. Prior Period

• Capital Raise: The company raised $53.7 million in net proceeds from a public offering in April 2017, significantly increasing cash reserves and total assets compared to the prior year.
• Investment Income Growth: Total investment income increased 24% for the three months and 10% for the nine months ended September 30, 2017, compared to the prior year periods, driven by a larger average loan balance.
• Unrealized Losses: The company reported a net loss on investments of $8.30 million for the nine months ended September 30, 2017, compared to a loss of $1.40 million in the prior year. This was primarily due to a $5.0 million realized loss on the restructuring of the My Alarm Center, LLC investment and unrealized depreciation on subordinated debt (specifically Community Intervention Services, Inc.).
• Expense Increases: Total expenses increased due to higher management fees (driven by increased assets) and interest expense from the utilization of the PWB Credit Facility, which had no borrowings in the prior year.

Guidance, Outlook, Risks, and Unusual Items

• Outlook: Management expects to continue deploying capital into middle-market companies. The weighted average yield on the debt portfolio decreased to 11.50% from 12.08% in the prior year due to the deployment of new capital into senior secured loans with lower yields.
• Unusual Items:
  • My Alarm Center Restructuring: In July 2017, a senior secured debt investment and preferred equity in My Alarm Center, LLC were restructured into common and preferred equity. This triggered the realization of a $5.2 million cumulative loss previously recorded as unrealized.
  • Non-Accrual Status: The loan to Community Intervention Services, Inc. remains on non-accrual status with a fair value of $2.04 million against an amortized cost of $7.64 million.
• Risks: Key risks include the illiquidity of portfolio investments, the impact of interest rate changes on floating-rate loans (73% of debt portfolio), and the ability to maintain RIC tax status by distributing 90% of taxable income. The company also faces regulatory risks related to its SBIC subsidiary.
• Internal Controls: Management concluded that a previously identified material weakness regarding investment valuation controls has been remediated as of September 30, 2017.

Investor Verification Checklist

• Valuation Methodology: Verify the specific EBITDA multiples and discount rates used for Level 3 fair value measurements, particularly for the $296.6 million investment portfolio.
• Non-Accrual Exposure: Review the status and recovery prospects of the Community Intervention Services, Inc. loan, which represents a significant impairment.
• Capital Deployment: Assess the pace of deploying the $53.7 million raised in the April offering and the impact on future yield.
• Debt Covenants: Confirm continued compliance with the PWB Credit Facility covenants and the 200% asset coverage ratio required for BDCs.
• Return of Capital: Note that approximately $0.27 per share of the 2017 distributions may be classified as a return of capital for tax purposes.