OFS Capital(US:OFS)2020-03-13 21:29PART I Business OFS Capital operates as an externally managed BDC, investing in U.S. middle-market companies for income and capital appreciation, and is taxed as a RIC General Overview OFS Capital operates as a BDC, aiming for current income and capital appreciation, with a $516.9 million portfolio primarily in senior secured loans, managed externally, and taxed as a RIC - The company's investment objective is to provide stockholders with both current income and capital appreciation, primarily through debt investments in U.S. middle-market companies16 Portfolio Composition at Fair Value (December 31, 2019) | Investment Type | Fair Value (in millions) | Portfolio Companies | | :--- | :--- | :--- | | Debt Investments | $451.8 | 79 | | - Senior Secured Loans | 90% of Debt Portfolio | N/A | | - Subordinated Loans | 10% of Debt Portfolio | N/A | | Equity Investments (in companies with debt) | $43.5 | 15 | | Equity-Only Investments | N/A | 6 | | Structured Finance Notes | $21.6 | 4 | - The company has reduced its required asset coverage ratio from 200% to 150%, effective May 3, 2019, allowing for increased leverage22 - The company has elected to be treated as a Regulated Investment Company (RIC), which generally eliminates corporate-level taxes on income distributed to stockholders24 Investment Strategy and Market The company targets U.S. middle-market companies, primarily investing in senior secured and subordinated loans, with a rigorous due diligence and active portfolio monitoring process - The company targets U.S. middle-market companies, typically defined as having revenues between $15 million and $300 million and annual EBITDA between $3 million and $50 million4547 - Investment types include senior secured first-lien, unitranche, second-lien, broadly syndicated, and subordinated (mezzanine) loans, along with equity securities, warrants, and Structured Finance Notes67687273 - The company employs a rigorous due diligence process focusing on prospective company characteristics, industry overview, financial analysis, and legal documentation48495051 Debt Investment Risk Ratings (December 31, 2019) | Risk Category | Fair Value (in millions) | | :--- | :--- | | 2 (Below Average Risk) | $18.0 | | 3 (Average) | $387.7 | | 4 (Special Mention) | $45.5 | | 5 (Substandard) | $0.0 | | 6 (Doubtful) | $0.7 | Management and Other Agreements OFS Capital is externally managed by OFS Advisor, subject to a base management fee of 1.75% of assets (reduced for OFSCC-FS) and a two-part incentive fee, with administrative services provided by OFS Services - The base management fee is 1.75% annually on average total assets (excluding cash, and goodwill/intangibles from the SBIC Acquisition)77 - OFS Advisor agreed to reduce its base management fee to 1.00% on assets held by the OFSCC-FS subsidiary, effective January 1, 202078 - The incentive fee has two parts: Part One is based on pre-incentive fee net investment income exceeding a 2.0% quarterly hurdle rate, and Part Two is 20% of cumulative realized capital gains net of losses and unrealized depreciation7985 Advisory Fees Paid (2017-2019) | Fee Type | 2019 | 2018 | 2017 | | :--- | :--- | :--- | :--- | | Base Management Fee | $8.3 million | $6.3 million | $5.0 million | | Incentive Fee | $4.8 million | $4.4 million | $3.0 million | - Administrative services are provided by OFS Services, an affiliate, under an Administration Agreement, with the company reimbursing for allocable overhead, including officer salaries102103 Regulation As a BDC, OFS Capital is subject to 1940 Act regulations, including a 70% qualifying asset rule and a 150% asset coverage ratio, while its SBIC subsidiary is SBA-regulated, and the company maintains RIC tax status by meeting specific income and distribution tests - As a BDC, at least 70% of the company's assets must be "qualifying assets," typically securities of private or small public U.S. companies113 - The company's applicable asset coverage ratio for senior securities was reduced from 200% to 150%, effective May 3, 2019, allowing it to borrow up to $2 for every $1 of investor equity119121 - The company's subsidiary, SBIC I LP, is licensed by the SBA and can issue up to $150 million in SBA-guaranteed debentures, subject to SBA regulations regarding eligible small business investments130131132 - To maintain its RIC status, the company must meet a 90% gross income test from qualifying sources and asset diversification tests, and distribute at least 90% of its investment company taxable income annually151154157 - The company has an SEC exemptive order permitting it to co-invest with certain funds managed by OFS Advisor, subject to approval by a required majority of independent directors111127 Risk Factors The company faces significant risks including dependence on its external advisor, conflicts of interest, leverage and financing risks, inherent credit risk in middle-market investments, regulatory compliance, market volatility, and potential trading below net asset value Risks Related to Our Business and Structure The company's success depends on OFS Advisor's professionals, with leverage magnifying gains and losses, and valuation uncertainty from illiquid assets; risks also include SBIC compliance, credit losses, maintaining RIC status, market disruptions, and cybersecurity threats - The company is dependent on the senior professionals of its external advisor, OFS Advisor, and has no internal management or employees176 - The use of borrowed money magnifies potential gains or losses; the company's asset coverage ratio was 180% as of December 31, 2019, with the Board approving a reduction to 150% effective May 3, 2019189190198 - Many portfolio investments are not publicly traded and are valued in good faith by the board, leading to uncertainty in the net asset value183184 - Failure to maintain RIC tax status would subject the company to corporate-level income tax, substantially reducing net assets and distributable income210 Risks Related to OFS Advisor and its Affiliates Conflicts of interest arise from OFS Advisor managing other funds with similar strategies, potentially leading to non-arm's length agreements and a fee structure that may incentivize higher leverage or riskier investments, while the advisor's limited liability and resignation option pose operational risks - OFS Advisor manages other entities with similar investment strategies, such as HPCI and OCCI, creating potential conflicts in allocating investment opportunities251 - The base management fee, calculated on total assets including leverage, may incentivize OFS Advisor to increase borrowings272 - The incentive fee structure may encourage OFS Advisor to make riskier or more speculative investments to generate higher returns and capital gains273275 - The Investment Advisory and Administration Agreements were negotiated between related parties and may not be as favorable as if negotiated with an unaffiliated third party264 Risks Related to Our Investments Investments in private and middle-market companies are speculative, carrying high credit risk, especially for leveraged, subordinated, and 'covenant-lite' loans, exacerbated by illiquidity, portfolio concentration, and uncertainty from the LIBOR transition - Investments in middle-market companies are speculative and involve a high degree of risk of credit loss, as these companies are susceptible to economic slowdowns291296 - The portfolio may include "covenant-lite" loans, which offer fewer protections for lenders and may lead to a greater risk of loss compared to loans with traditional financial maintenance covenants295 - The company is a non-diversified investment company, meaning its portfolio may be concentrated in a limited number of companies and industries, subjecting it to significant loss if one defaults or an industry experiences a downturn314315 - The planned phase-out of LIBOR by the end of 2021 creates uncertainty for the company's floating-rate debt securities and may adversely affect their value337338 Risks Related to Our Securities The company's common stock may trade at a significant discount to NAV, limiting equity capital raising, while Unsecured Notes are effectively subordinated to secured debt and structurally subordinated to subsidiary liabilities - Shares of BDCs, including OFS Capital, frequently trade at a discount to their net asset value (NAV); as of December 31, 2019, NAV was $12.46 per share, while the average closing price for 2019 was $11.74347 - The company's Unsecured Notes are effectively subordinated to any secured debt and structurally subordinated to all liabilities of its subsidiaries348350 - The indenture for the Unsecured Notes offers limited protection to holders and does not restrict the company from incurring additional debt or paying dividends, provided asset coverage tests are met351 Properties The company does not own any real estate; its headquarters and other offices are provided by its administrator, OFS Services, under the Administration Agreement - The company does not own or lease any material physical properties; its office facilities are provided by OFS Services under the Administration Agreement359 Legal Proceedings As of December 31, 2019, the company and its affiliates were not subject to any material pending legal proceedings, with incidental proceedings not expected to have a material effect - The company and its affiliates are not currently subject to any material pending legal proceedings360 PART II Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities This section details the company's common stock trading on Nasdaq under "OFS", including historical stock price, NAV, distributions, a stock repurchase program (no 2019 repurchases), performance comparison, fee structure, and outstanding senior securities Fiscal 2019 Quarterly Stock and Distribution Data | Quarter | NAV Per Share | High Price | Low Price | Distribution per Share | | :--- | :--- | :--- | :--- | :--- | | Q4 2019 | $12.46 | $12.01 | $10.99 | $0.34 | | Q3 2019 | $12.74 | $12.27 | $10.98 | $0.34 | | Q2 2019 | $12.95 | $12.80 | $11.85 | $0.34 | | Q1 2019 | $13.04 | $12.52 | $10.77 | $0.34 | - The Board authorized a $10.0 million stock repurchase program on May 22, 2018, with no shares repurchased during the year ended December 31, 2019366367368 Total Annual Expenses (as a % of net assets) | Expense Category | Percentage | | :--- | :--- | | Base management fees | 5.38% | | Incentive fees | 2.73% | | Interest payments on borrowed funds | 10.91% | | Other expenses | 2.76% | | Total annual expenses | 21.78% | | Base management fee reduction | (0.08)% | | Total annual expenses, net of fee waiver | 21.70% | Senior Securities Outstanding (December 31, 2019) | Security | Amount Outstanding (in thousands) | | :--- | :--- | | BNP Facility | $56,450 | | 5.95% Notes due 2026 | $54,325 | | 6.50% Notes due 2025 | $48,525 | | 6.375% Notes due 2025 | $50,000 | | PWB Credit Facility | $0 | | SBA debentures (SBIC I LP) | $149,880 | | Total Senior Securities | $359,180 | Selected Consolidated Financial Data This section summarizes five years of key financial data, showing 2019 total investment income of $52.5 million, net investment income of $19.1 million ($1.43 per share), a $9.6 million net decrease in net assets from operations due to unrealized depreciation, and growth in total investments to $516.9 million with total debt at $352.5 million Selected Financial Data (Years Ended December 31) | Metric (in thousands, except per share) | 2019 | 2018 | 2017 | | :--- | :--- | :--- | :--- | | Total investment income | $52,521 | $42,834 | $33,426 | | Net investment income | $19,098 | $18,385 | $15,877 | | Net increase in net assets from operations | $9,553 | $9,572 | $7,910 | | Net asset value per share | $12.46 | $13.10 | $14.12 | | Net investment income per share | $1.43 | $1.38 | $1.28 | | Distributions declared per share | $1.36 | $1.73 | $1.36 | | Investments, at fair value | $516,931 | $396,797 | $277,499 | | Total assets | $538,188 | $441,421 | $357,778 | | Debt | $352,478 | $254,826 | $164,823 | | Total net assets | $166,627 | $175,023 | $188,336 | - The weighted average yield on performing debt and Structured Finance Note investments decreased to 10.40% in 2019 from 11.50% in 2018392 Management's Discussion and Analysis of Financial Condition and Results of Operations Management discusses 2019 financial performance, noting investment income growth to $52.5 million driven by portfolio expansion and leverage, offset by increased expenses and a $9.5 million net loss on investments from unrealized depreciation, with the portfolio at $516.9 million and total debt at $359.2 million Portfolio Composition and Investment Activity As of December 31, 2019, the investment portfolio's fair value was $516.9 million, primarily senior secured debt, with the weighted average yield decreasing to 10.40%; new investments totaled $198.8 million, and four loans were on non-accrual status Portfolio Composition by Investment Type (Fair Value) | Investment Type | Dec 31, 2019 (in thousands) | Dec 31, 2018 (in thousands) | | :--- | :--- | :--- | | Senior secured debt | $408,724 | $319,017 | | Subordinated debt | $43,091 | $44,540 | | Preferred equity | $17,729 | $14,613 | | Common equity and warrants | $25,777 | $18,627 | | Total Direct Investments | $495,321 | $396,797 | - The weighted average yield on performing debt and Structured Finance Notes decreased from 11.5% at year-end 2018 to 10.40% at year-end 2019, primarily due to deploying capital into new, lower-yielding originations and a decrease in LIBOR426 - During 2019, the company invested $193.2 million in debt and $5.6 million in equity in new and existing portfolio companies, plus $23.4 million in Structured Finance Notes431 - At year-end 2019, four loans were on non-accrual status with an aggregate amortized cost of $22.2 million and fair value of $0.7 million428 Results of Operations For 2019, total investment income increased by $9.7 million to $52.5 million, driven by portfolio growth, while total expenses rose by $9.0 million to $33.4 million due to higher interest and management fees, resulting in $19.1 million net investment income and a $9.5 million net loss on investments from unrealized depreciation Consolidated Operating Results (in thousands) | Line Item | 2019 | 2018 | 2017 | | :--- | :--- | :--- | :--- | | Total investment income | $52,521 | $42,834 | $33,426 | | Total expenses, net | $33,423 | $24,449 | $17,549 | | Net investment income | $19,098 | $18,385 | $15,877 | | Net loss on investments | ($9,545) | ($8,813) | ($7,967) | | Net increase in net assets | $9,553 | $9,572 | $7,910 | - The increase in 2019 investment income was driven by a $103 million increase in the average outstanding loan balance445447 - The increase in 2019 expenses was primarily due to a $6.6 million rise in interest expense from increased borrowings, including the new BNP Facility and Unsecured Notes451452 - The net loss on investments in 2019 was primarily driven by a $9.0 million unrealized loss on the senior secured debt of Constellis Holdings, LLC461 Liquidity and Capital Resources As of December 31, 2019, the company had $13.4 million cash and $162.6 million in available credit facilities, with total debt outstanding at $359.2 million and an asset coverage ratio of 180%, planning future growth through equity and additional borrowings Sources of Liquidity (December 31, 2019) | Source | Amount (in millions) | | :--- | :--- | | Cash and cash equivalents | $13.4 | | PWB Credit Facility Availability | $69.0 | | BNP Facility Unused Commitment | $93.6 | Debt Outstanding (December 31, 2019) | Debt Instrument | Principal Outstanding (in thousands) | | :--- | :--- | | SBA Debentures | $149,880 | | PWB Credit Facility | $0 | | BNP Facility | $56,450 | | Unsecured Notes | $152,850 | | Total | $359,180 | - The company's asset coverage ratio was 180% as of December 31, 2019, well above the 150% regulatory requirement, with SBA debentures excluded per an SEC exemptive order475476 - The company has $4.8 million in unfunded commitments to four portfolio companies as of year-end 2019516 Quantitative and Qualitative Disclosures about Market Risk The company is primarily exposed to interest rate risk, with 93% of debt investments floating-rate (LIBOR-indexed) and a sensitivity analysis showing a $3.4 million increase in net annual income for a 100 basis point rate rise and a $2.9 million decrease for a 100 basis point fall - As of December 31, 2019, 93% of the company's debt investments at fair value were floating-rate, making its income sensitive to interest rate changes521 Annualized Impact of Hypothetical Interest Rate Changes (in thousands) | Basis Point Change | Net Increase (Decrease) in Income | | :--- | :--- | | +200 | $6,928 | | +100 | $3,368 | | -100 | ($2,861) | | -200 | ($3,005) | Financial Statements and Supplementary Data This section presents the company's audited consolidated financial statements for 2019 and prior years, including reports from independent accounting firms, statements of assets and liabilities, operations, changes in net assets, cash flows, a detailed schedule of investments, and comprehensive notes covering accounting policies, fair value, related party transactions, and debt Consolidated Statement of Assets and Liabilities (December 31, 2019) | | Amount (in thousands) | | :--- | :--- | | Assets | | | Total investments at fair value | $516,931 | | Cash and cash equivalents | $13,447 | | Total Assets | $538,188 | | Liabilities | | | Total debt (net of costs) | $352,478 | | Total Liabilities | $371,561 | | Total Net Assets | $166,627 | | Net Asset Value per share | $12.46 | - The company's independent registered public accounting firm for fiscal year 2019 was KPMG LLP, providing an unqualified opinion on financial statements and internal control effectiveness530531 - All of the company's investments are classified as Level 2 or Level 3 in the fair value hierarchy, with the vast majority ($442.3 million out of $516.9 million) classified as Level 3, indicating reliance on unobservable inputs for valuation667 Controls and Procedures Management concluded that the company's disclosure controls and internal control over financial reporting were effective as of December 31, 2019, an assessment audited by KPMG LLP with an unqualified opinion, and no material changes were reported in Q4 2019 - Management concluded that the company's disclosure controls and procedures were effective as of December 31, 2019741 - Management concluded that the company's internal control over financial reporting was effective as of December 31, 2019, an assessment audited by KPMG LLP which issued an unqualified opinion744745 PART III Directors, Executive Officers, Corporate Governance, Compensation, and Security Ownership Information for Items 10-14, covering directors, executive officers, corporate governance, compensation, security ownership, related transactions, and principal accountant fees, is incorporated by reference from the company's definitive 2020 Proxy Statement - Information regarding Directors, Executive Officers, Corporate Governance (Item 10), Executive Compensation (Item 11), Security Ownership (Item 12), Certain Relationships and Related Transactions (Item 13), and Principal Accountant Fees (Item 14) is incorporated by reference from the forthcoming 2020 Proxy Statement749750751752753 PART IV Exhibits and Financial Statement Schedules This section lists financial statements, schedules, and exhibits filed with the 10-K, including corporate governance documents, debt agreements, management agreements, and CEO/CFO certifications pursuant to the Sarbanes-Oxley Act - This section provides a comprehensive list of all documents filed with the 10-K, including corporate governance documents, debt agreements, management agreements, and required certifications755756757