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OFS Capital: Analyzing The New Debt Offering

BDCs:
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NEWS

On April 11, 2017 OFS Capital (“OFS”) issued a registered public offering of $43.75mn Unsecured Notes.

If and when the underwriters exercise their over-allotment, total proceeds should be around $50mn.

The maturity of the offering is April 2025, and may be redeemed from April 2020.

The yield on the Unsecured Notes is 6.375%, payable quarterly.

Egan-Jones is expected to give the rating an A.

The ticker of the new issue is OFSL.

The financing is expected to close on April 16, 2018.

The proceeds of the offering will initially be used to pay down the BDC’s Revolver, which has $38.2mn outstanding.

See the press release above.


ANALYSIS

Introduction

We seek to use the opportunity of this new debt offering to analyze the likely impact on the BDC’s balance sheet, leverage and earnings and ask whether this development is positive for the shareholders and soon to be minted debt holders.

Highlights

At December 31, 2017 OFS had $277mn in investment assets at fair market value.

That was financed by $147mn of SBIC debentures and $17mn in Revolver debt.

Net Assets were $188mn.

In addition, flush from a 2017 equity raise and repayments, OFS had $73mn in cash.

The weighted average cost of the SBIC debentures was 3.18%.

Not Cheap

However, the interest expense on the Revolver – provided by Pacific Western Bank – is much higher.

The lender charges a floor rate of 5.25%, and a rate of Prime + 0.75%.

There is also a 0.5% unused commitment fee.

According to the latest filing, the “effective interest rate” (which includes amortization of deferred debt issuance costs”) was 5.74%.

We’re not certain if this includes unused line fees.

With a higher floor negotiated in March 2018 , when the Revolver was increased from $35mn to $50mn, the current effective rate is probably close to 6.0% or higher.

Flat Yield Curve

As a result, we expect the swapping of secured for unsecured debt will have little impact on interest expense and thus earnings.

If OFS’s underwriters exercise their right to over-allotments of the Baby Bonds, total proceeds will exceed $50mn.

Net of the $38.2mn in Revolver debt outstanding, this suggests total cash resources at OFS will exceed $84mn.

How High ?

Thanks to the new BDC rules, and the exemptive relief from counting SBIC debentures as debt from a regulatory point of view, OFS could increase assets to well over $0.5bn before needing new equity capital.

The assets would be split roughly 50/50 between SBIC debt held at a subsidiary  and on  balance sheet secured and unsecured debt.

Here And Now

However, in the short run, our analysis focuses on what might happen to the BDC’s balance sheet based on current resources.

We estimate that if all cash gets deployed into investments and the entire $50mn Revolver which OFS has contracted for is drawn, total investment assets could reach $342mn.

(More likely, if some cash is retained and some Revolver availability, total portfolio assets will be closer to $320mn, or a 15% increase over year end 2017).

On a pro-forma basis non-SBIC assets, used as collateral for the secured Revolver and supporting the repayment of the Unsecured Notes, would reach $183mn from $27mn at year-end 2017.

Those assets would be financed $50mn with secured Revolver debt and $50mn with the new Baby Bond.

Accretion Analysis. Or “Are We Going To Make Any Money Out Of All This ?”

As has been the case on almost every occasion when we undertake any in-depth analysis of the economics of leveraging up a BDC’s balance sheet, incremental earnings realized should be minimal.

Here’s our math for all to see and agree or disagree with:

The average yield on OFS investment assets is 10.4%.

As we’ve seen, the cost of secured and unsecured debt ranges between 6.0% and 6.5%.

For our purposes we’ve assumed 6.25% all-in.

Then there’s the incremental Management Fee on assets purchased of 1.75%.

Incremental Operating Expenses run about 1.0% of investment assets.

That means Net Investment Income Before Incentive Fee is likely to be 1.4%.

After the Incentive Fee, the net contribution to Net Investment Income Per Share is likely to be 1.1%.

If we figure that some of the income is likely to be Pay-In-Kind (not unusual in the higher risk loans in the lower middle market) the actual cash contribution to recurring earnings will probably be minimal or flat.

Loans Do Occasionally Go Bad You Know

Finally – and inescapably – if we make a provision for eventual bad debts (even after adjusting for some Realized Gains from equity investments along the way), the return to shareholders is likely to be negative.

Thankfully – despite investing in the lower tranches of borrowers balance sheet – OFS has a good credit record.

Credit Rundown

Here’s a brief run-down of the overall performance since coming public and the current situation:

In fact, the BDC still boasts $3.9mn in net Realized Gains over its history.

However, a number of troubled credits has pushed up Unrealized Depreciation by ($14.8mn) in 2017, despite booking Realized Losses of ($8mn) in the year.

For our purposes, we assume OFS will write-off 1%-2% per annum of investment assets, both in the SBIC subsidiary and on its own balance sheet.

Of course – as ever is the case with lending and investing – those losses will be lumpy.

Current Troubles

Judging by the BDC’s own Portfolio Risk Categorization credit outlook is looking up at the end of 2017 versus 2016.

On the 7 point scale OFS uses, $20.5mn is in the bottom 4 categories, and none in the lowest level (7-Loss) and only $1.2mn in Category 6- Doubtful.

See page 60 of the 10-K.

As mentioned above, that’s partly due to absorbing some Realized Losses during the past year and from positive movement in the outlook for some portfolio companies.

Not So Fast

However, we would advise investors to keep an eye on what happens to just-restructured (debt for equity) Jobson Healthcare Information, LLC.

Then there are the two non-accrual loans to Community Intervention Services and Southern Technical Institute.

Most of the damage is already done there with no income being recognized and a fair value of just $1.2mn.

The cost of those two investments is $11.1mn, which highlights how much of what OFS does is provide junior capital which can be largely wiped out when pushing comes to shoving.

We also have our eyes on another restructured deal which we wrote about several months ago: My Alarm Center, LLC.

That Oaktree Capital owned company is still valued at $2.8mn, but does not generate any cash income.

From the little we can surmise, this restructured investment could yet go either way.

Also on our Watch List is Master Cutlery, LLC.

OFS has stopped recognizing even PIK income on the investment which has been written down.

The same non accruing of PIK income is true at Stancor and TRS Services.

Also worrisome.

Doing Our Sums

The value of all our Watch List names adds up to $37.6mn, or about twice what OFS has in its Categories 4 through 7.

On the other hand, the BDC does have a couple of equity upsides on its books worth over $6mn that might offset any credit losses.


VIEWS

Common Stock

From a shareholder’s standpoint, the issuance of the Baby Bond is unlikely to provide much Net Investment Income benefit in the short or long term.

The IIQ 2018 results will be weighted down by the cost of raising the new Unsecured Notes and the slight difference in interest rates between secured and unsecured.

Undrawn Revolver fees will temporarily grow.

Down the road – given the high cost of the debt and of the Investment Advisor’s compensation, not to mention ineluctable (BDC Reporter’s Word of The Day) credit hits – incremental earnings per share will be hard to find.

They Say. We Say.

Management would probably argue for the benefit of greater portfolio diversification.

The BDC Reporter would mention the greater risk of a credit trip-up and higher potential losses to shareholder capital.

Wishes

Much better for OFS would be to increase its SBIC debenture borrowing which could cut debt service costs by almost a half.

That option does not seem currently available.

Perhaps the larger portfolio will allow for a lower cost of secured borrowing down the road, but that’s just a hypothetical.

Also helpful would be either a partial  waiver or reduction of the Management Fee and/or the Incentive Fee.

Neither seems likely.

Fixed Income

There’s a reason OFS has arrived so late in the Unsecured Note world.

With the bulk of its assets funded by the SBA/SBIC, the BDC had little in way of investments to support on balance sheet lending.

At the end of 2016 total Revolver borrowings were $10mn, funding less than 4% of the portfolio.

At year end 2017, the Revolver balance was still only $18mn, or 6% of investment assets.

However, thanks to cash on the balance sheet resulting from what seemed to some as a surprising equity raise in 2017 and a small number of non-SBIC pledged loans, OFS is branching out.

If our numbers are right (see above) gross asset coverage of non-SBIC borrowings should be 183% on a pro-forma basis.

Trust But Verify

In our BDC Reporter Stress Test we assume for a BDC with the kind of risk profile OFS has a 30% haircut in value during a Crisis/Recession.

That would leave $129mn in pro-forma value in those non-SBIC assets.

Net of $50mn of Revolver debt to be repaid that leaves $79mn of assets with which to repay the $50mn in Baby Bonds raised.

On our internal rating system of A to F, that’s a D.

A passing grade, but not by much.

(By comparison an A rated Baby Bond has 400% of net asset coverage, even after all the haircuts we take to reflect what happens to credit assets when conditions are at their worst).

Bigger Context

Unfortunately, thanks to the new BDC rules and the inability of most BDCs to Just Say No to extra leverage just when they should be, we expect our internal ratings on BDC Fixed Income issues to drop to similar levels in the quarters ahead.

OFS itself has not even adopted the new lower asset coverage rules.

Maybe that’s a tactical move while in the midst of raising unsecured debt.

It’s possible that OFS will join many of its peers, which would allow even more pro-forma borrowing capacity, as we mentioned above.

Even without that, though, our numbers suggest that OFS will shortly have asset coverage of all debt BELOW 150% in any case.

Thank the SEC exemptive relief from having to count its SBIC debt.

If OFS goes ahead and adopts the new BDC rules that coverage could drop even lower.

Sadly that will neither benefit shareholders or debt holders.


INVESTMENT DISCLOSURE

Common Stock

We have a position in OFS common stock that we’ve held for some time and have been dollar-cost averaging down as the stock price drops.

Following our analysis we’re unlikely to add to our position and will seek an eventual exit if the opportunity arises.

On a Total Return basis our position is in the red, but dividends received has offset 60% of our price loss.

We remain relatively confident in the Investment Advisor’s ability to work itself out of most of its credit problems.

However, the economics of the BDC suggest that earnings per share are more likely to deteriorate than improve over the long term.

Fixed Income

We have an order in with our broker at MS Howells to purchase the new Baby Bond when available, but have decided to cancel the prospective investment.

While we don’t envisage any loss of principal even in a worst case, the 6.375% yield does not adequately compensate for the current risk or the potential for even more leverage being added to the balance sheet in the future.

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