FSK

Business Context and Reporting Period

Company: FS Investment Corporation (FSIC)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2016
Business Overview: FSIC is an externally managed, non-diversified, closed-end management investment company regulated as a Business Development Company (BDC). It invests 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

Material Changes vs. Prior Period

• Revenue Decline: Total investment income decreased by approximately 16.8% year-over-year, driven primarily by a reduction in interest and fee income due to decreased prepayment activity and the prepayment of several large investments in the prior year.
• Expense Reduction: Total operating expenses decreased to $106.5 million from $111.2 million. This was largely due to a reversal of capital gains incentive fees in 2015 and lower subordinated income incentive fees in 2016.
• Unrealized Gains: The company reported a significant net change in unrealized appreciation of $42.8 million, compared to a depreciation of $4.3 million in the prior year. Management attributed this to improvements in high-yield markets, tightening credit spreads, and specific improvements in energy investments.
• Portfolio Composition: The portfolio fair value decreased slightly to $3.93 billion. The percentage of the portfolio in Senior Secured Loans (First Lien) remained stable at 53%, while Equity/Other increased to 14% from 12%.
• Liquidity: Cash and foreign currency balances declined to $44.2 million from $82.0 million. However, the company maintained $242.1 million in available borrowings under its credit facility.

Guidance, Outlook, and Risks

• Distributions: The company declared a regular quarterly cash distribution of $0.22275 per share on August 2, 2016, payable in October 2016. Distributions for the six months ended June 30, 2016, were funded entirely by net investment income.
• Outlook: Management continues to focus on direct originations and opportunistic investments. The estimated gross portfolio yield prior to leverage was 9.3% as of June 30, 2016.
• Financing: The company utilizes leverage through a revolving credit facility (ING), a repurchase agreement (JPM), and unsecured notes. The weighted average effective interest rate on borrowings was 3.98% as of June 30, 2016.
• Risks:
  • Interest Rate Risk: 65.5% of the portfolio pays variable rates. A rise in rates could increase interest income but also increase borrowing costs on floating-rate debt.
  • Valuation Risk: The majority of investments (Level 3) are valued using unobservable inputs, requiring significant management judgment.
  • Portfolio Quality: As of June 30, 2016, 2% of the portfolio was rated as "Underperforming with expected loss of interest and some principal" (Rating 5), up from 0% in the prior year.

Investor Verification Checklist

• Asset Coverage Ratio: Verify the asset coverage per unit of 2.31x to ensure compliance with the 1940 Act requirements for BDCs.
• Unfunded Commitments: Confirm the company's ability to fund $161.1 million in unfunded debt commitments and $0.2 million in equity commitments.
• Non-Accrual Status: Review the 0.3% of investments on non-accrual status to assess credit quality deterioration.
• Incentive Fee Structure: Analyze the impact of the subordinated income incentive fee (hurdle rate of 7.5% annualized) on future net investment income.
• Debt Maturities: Note the maturity of the JPM Facility repurchase agreement on April 15, 2017, and the refinancing requirements.