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OFS Capital : IQ 2019 Credit Review

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NEWS

We reviewed the OFS Capital (OFS) IQ 2019 earnings release, 10-Q and Conference Call.


ANALYSIS

We focused upon a company by company review of the 46 company portfolio, as well as the BDC’s own investment credit evaluation system for the period.

Based on the valuation of the OFS investments and other publicly available information, we have 11 companies on our Watch List.

Of those 3 include companies whose debt is already on non accrual, and which have been substantially written off from a valuation standpoint.

These are Community Intervention Services, Master Cutlery and Southern Technical Institute.

No recovery or income is expected from these companies in the future.

Of the remaining 8 companies on our Watch List, 6 we have given a Corporate Rating of 3 – the initial step down from “performing” status to “under performing” – and where the odds of ultimate full capital recovery is greater than loss.

Included in this category is Elgin Fasteners, whose loan expired last year without the borrower finding a new lender. Instead, OFS has extended the facility for a year and the company continues to make  interest and principal payments. Nonetheless – on a prima facie basis – an inability to get refinanced in this very liquid debt market is cause for concern. Neither this quarter nor last did management discuss this unusual situation , nor did any analyst ask a question about the status. Till we learn more, Elgin remains on our Watch List, to which the company was added in the last quarter of 2018.

The FMV of the Elgin debt is $3.4mn and the income at risk over $0.300mn per annum.

Also concerning us is Envocore Holding, aka LRI Holding. The investment, which consists of senior debt and two preferred instruments, was written down by $1.0mn in the quarter. The company was placed on our Watch List only in the prior quarter, so a further write-down in the IQ was a red flag.

New to our Watch List this quarter – and arguably not under performing very much is 3rd Rock Gaming Holdings, which has a cost of $23.8mn and an FMV of $21.5mn. Given the size of the loan- and the $1.6mn of income involved, we’ve chosen to flag the company. Readers can make their own assessment.

We also worry about TRS Services, which was written down by over $1mn this quarter, but was already on our Watch List. At FMV, the company accounts for $14.6mn and $1.8mn of investment income should anything go wrong with the debt.

The other CCR 3 credits are GGC Aerospace and PM Acquisition. 

That leaves two companies that have been rated CCR 4, where we believe the possibility of ultimate loss exceeds that of full repayment: One is printer MAI Holding, added to our Watch List for the first time. In the IVQ 2018 the $5mn loan was valued at $4.8mn. ‘This quarter the value has dropped to $3.0mn. When we see a first lien loan get written down by 40% in short order, we get concerned.

Less important- but also a CCR 4 is long standing troubled investment My Alarm Center, a former debt for equity/preferred swap, which continues to be written down since the restructuring. If we’re reading the footnotes right, OFS is not booking any income on the investment, but $2.3mn of value is still at risk.

Overall, by our methodology, $7.5mn of income is at risk if all the troubled companies on our list went on non accrual, a substantial amount for a BDC whose annualized Net Investment Income comes in just under $20mn. The total FMV value of our Watch List adds up to just under $70mn, or around 40% of the BDC’s equity capital at March 2019.

That’s a high proportion, especially in a BDC which is already highly leveraged and which has struggled to consistently out earn its dividend.

Company Ratings

Our concern is accentuated by the BDC’s own investment ratings, as shown in the 10-Q.

In the OFS seven level rating system, the value of investments deemed at above average risk has increased in just 1 quarter from $30mn to $53mn.

(The BDC does not specify which companies or investments are included in which category of credit risk).

That’s a 76% increase.

Like us, OFS admits in its footnotes that PM Acquisitions, Envocore and MAI Holdings were all downgraded in the period to their credit risk category 4.


VIEWS

In a nutshell, we have downgraded our credit outlook for OFS from OKAY to POOR.

We recognize that many of the Watch List names we’ve identified are only marginally written down. Moreover, the 3 non performers have been essentially written off and should have no material impact.

However, the point of our credit review is to alert us – and our readers – of changes in portfolio credit as early as possible.

Waiting until the negative outcome is certain and  loans are non performing – which is when most BDCs start discussing problem credits – is too late.

That’s especially the case with OFS, where poor performing investments – judging by the 3 on the books – get fully written off when things go wrong.

Every reader with an interest in OFS can decide for themselves if our conclusion is unduly harsh.

In our case, though, when we rate credit outlook as Poor, we avoid investing in the BDC involved because the potential impact on future earnings and distributions is material.

We would rather be “safe than sorry “.

Others may not be fazed by what may turn out to be false credit alarms.

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