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, 2013

Business Overview: The Company is an externally managed, non-diversified, closed-end management investment company regulated as a Business Development Company (BDC) and taxed as a Regulated Investment Company (RIC). Its investment objective is to generate current income and, to a lesser extent, long-term capital appreciation by investing primarily in senior secured loans, second lien secured loans, and subordinated debt of private U.S. companies.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total investment income increased significantly to $110,044 from $50,535 in the prior year quarter, driven primarily by portfolio growth following the closing of the continuous public offering in May 2012.
• Expense Increases: Total operating expenses rose to $59,315 from $35,643. This increase is attributed to higher management fees ($22,206 vs. $12,204) and the accrual of a subordinated income incentive fee of $14,228 (none in Q1 2012). Interest expense also increased to $12,136 from $5,181 due to higher leverage utilization.
• Realized Gains: The Company recorded a net realized gain on investments of $14,171, compared to a net realized loss of $3,102 in Q1 2012. The prior year included gains from a terminated total return swap which is no longer active.
• Unrealized Appreciation: Net change in unrealized appreciation on investments was $17,518, a decrease from $61,017 in Q1 2012, reflecting a tightening of credit spreads in the current period compared to the strengthening credit markets of the prior period.
• Portfolio Composition: As of March 31, 2013, 63% of the portfolio (by fair value) consisted of non-broadly syndicated investments (proprietary, anchor orders, event-driven, opportunistic, and collateralized securities), up from 58% at year-end 2012.

Guidance, Outlook, and Risks

• Financing Arrangements: The Company maintains four primary financing facilities. On April 23, 2013 (subsequent to period end), the Company amended its JPM Facility to increase available debt financing from $700,000 to $950,000 and extended the final repurchase date to April 15, 2017.
• Distributions: The Company declared a regular monthly cash distribution of $0.0675 per share for April and May 2013. Distributions are funded from net investment income and capital gains proceeds. No portion of distributions in Q1 2013 represented a return of capital for tax purposes.
• Expense Reimbursement: Franklin Square Holdings has an agreement to reimburse expenses to ensure distributions are not paid from offering proceeds or borrowings. No reimbursements were required in Q1 2013.
• Risk Factors:
  • Interest Rate Risk: 69.6% of the portfolio pays variable interest rates. A rise in rates increases interest income but also increases interest expense on floating-rate debt.
  • Valuation Risk: All investments are classified as Level 3 (unobservable inputs). Valuations are determined in good faith by the Board of Directors using third-party pricing services and independent valuation firms.
  • Liquidity: The Company relies on borrowings and asset sales to fund distributions and operations. It maintains a share repurchase program, having repurchased 883,047 shares in Q1 2013.

Investor Verification Checklist

• Debt Maturities: Verify the maturity dates of the Broad Street Credit Facility (Dec 22, 2013) and Arch Street Credit Facility (Aug 29, 2015) to assess near-term refinancing needs.
• Incentive Fee Accruals: Confirm the portion of capital gains incentive fees ($35,168 accrued) that is based on unrealized gains ($27,960) versus realized gains ($858), as fees on unrealized gains are not payable until realized.
• Portfolio Yield: Review the estimated gross annual portfolio yield of 10.4% (prior to leverage) and monitor for changes in credit spreads affecting the 69.6% variable-rate portion of the portfolio.
• Qualifying Assets: Ensure the Company maintains at least 70% of total assets in qualifying assets to retain BDC status (83.8% as of March 31, 2013).
• Subsequent Financing: Review the impact of the April 2013 amendment to the JPM Facility on leverage ratios and interest expense going forward.