OFS Capital Corporation (OFSSH): A Diversified BDC Navigating Market Volatility with Prudence

Published on March 08, 2025 | Ticker: OFSSH

OFS Capital Corporation (OFSSH) is a diversified business development company (BDC) that has demonstrated its ability to successfully navigate complex market environments over the past 13 years. With a seasoned management team, a disciplined investment approach, and a focus on capital preservation, OFS Capital has established itself as a prudent operator in the middle-market lending space.

Establishment and Early Challenges

Established in 2011 as a closed-end, non-diversified management investment company, OFS Capital has built a diverse portfolio of debt and equity investments, with a primary focus on senior secured loans to middle-market and larger U.S. companies, as well as investments in structured finance securities. The company's investment strategy is guided by a commitment to avoiding highly cyclical industries and maintaining a senior position in borrowers' capital structures. OFS Capital's common stock is traded on the Nasdaq Global Select Market under the symbol "OFS".

In 2012, OFS entered into an investment advisory agreement with OFS Advisor, a wholly-owned subsidiary of Orchard First Source Asset Management (OFSAM), to manage the company's day-to-day operations and investment activities. This partnership has allowed OFS to leverage OFSAM's expertise and experience in the middle market lending space.

The company faced early challenges in navigating the regulatory environment as a newly formed BDC. In 2016, OFS received an exemptive relief order from the SEC that allowed it to co-invest in portfolio companies with affiliated funds in a manner consistent with its investment objective and strategies.

Strategic Moves

In 2019, OFS formed a wholly-owned subsidiary, OFSCC-FS, to acquire senior secured loan investments, which was financed through a $150 million revolving credit facility with BNP Paribas. This strategic move has contributed to the growth of the company's investment portfolio.

A unique challenge arose in 2023 when OFS's wholly-owned SBIC subsidiary, SBIC I LP, fully repaid its outstanding SBA debentures and surrendered its SBIC license. This event marked the end of OFS's participation in the SBIC program, which had previously provided the company with access to long-term, low-cost leverage to support its investment activities.

Investment Strategy and Portfolio

Despite these challenges, OFS has maintained a disciplined investment approach, with a focus on capital preservation and risk-adjusted returns. The company's portfolio has been diversified across industries and has historically performed well, with a cumulative net realized loss of just 3.2% since 2011 while generating attractive risk-adjusted returns.

As of September 30, 2024, OFS Capital's investment portfolio had a fair value of $394.7 million, comprising 82% first lien debt investments and 18% second lien debt investments. The company's top industry exposures were in Manufacturing (33.4%), Health Care and Social Assistance (20.5%), and Professional, Scientific, and Technical Services (8.8%). Importantly, 100% of OFS Capital's loan portfolio was secured, reflecting the management team's disciplined approach to risk management.

OFS Capital's investment portfolio consists of three main segments: Debt Investments, Equity Investments, and Structured Finance Securities. As of September 30, 2024, the company's debt investments totaled $231.10 million, accounting for 58.6% of the total investment portfolio. These debt investments were primarily first lien (82%) and second lien (18%) loans made to 42 portfolio companies across various industries. The weighted-average performing income yield on the debt investment portfolio was 13.6% for the three months ended September 30, 2024, up from 13.4% in the prior quarter.

Equity investments totaled $89.82 million, representing 22.8% of the total investment portfolio. These investments consisted of preferred equity (11.1%) and common equity, warrants, and other securities (88.9%) in 15 portfolio companies. The company's largest equity investment was its common equity stake in Pfanstiehl Holdings, Inc., a global manufacturer of high-purity pharmaceutical ingredients, which accounted for 18.7% of the total investment portfolio and 48.7% of OFS's net assets.

In addition, OFS held $73.83 million in Structured Finance Securities, primarily collateralized loan obligation (CLO) subordinated notes and mezzanine debt, representing 18.7% of its total investment portfolio. These Structured Finance Securities generated a weighted-average performing income yield of 14.2% for the three months ended September 30, 2024, up from 12.4% in the prior quarter.

Overall, OFS's investment portfolio was diversified across 52 portfolio companies and 17 Structured Finance Securities as of September 30, 2024. The top ten investments, based on fair value, accounted for 47.8% of the total investment portfolio and 124.9% of the company's net assets.

Financials and Liquidity

OFS Capital's net investment income for the nine months ended September 30, 2024 was $12.6 million, or $0.94 per share. While this represented a decrease from the prior-year period, the company has demonstrated its ability to adapt to changing market conditions. For instance, during the fourth quarter of 2024, net investment income increased by 13% sequentially to $0.30 per share, driven by a rise in non-recurring dividend and fee income.

The company's net asset value (NAV) per share increased by 14% in the fourth quarter of 2024 to $12.85, primarily due to net unrealized appreciation on its investment portfolio. This was largely attributable to a $15.6 million increase in the fair value of OFS Capital's largest equity investment, a minority stake in Fansteel Holdings, a global manufacturer of high-purity pharmaceutical ingredients.

For the most recent quarter, OFS Capital reported revenue of -$188,000, net income of $1,688,000, operating cash flow of $23,817,000, and free cash flow of $23,817,000. While year-over-year growth figures were not provided, these results demonstrate the company's ability to generate positive cash flow despite challenging market conditions.

Balance Sheet and Liquidity

OFS Capital's balance sheet remains well-capitalized, with a regulatory asset coverage ratio of 169% as of December 31, 2024. Approximately 72% of the company's outstanding debt was unsecured at the end of the quarter, providing operational flexibility. The company also maintains a $25 million revolving credit facility with Bank of California and a $150 million non-recourse facility with BNP Paribas, which matures in 2027.

As of September 30, 2024, OFS Capital had $20.28 million in cash and cash equivalents. The company also had access to $25 million in unused commitment under its Banc of California Credit Facility and $80.90 million in unused commitment under its BNP Facility, providing a total of $105.9 million in available credit lines. This strong liquidity position enables OFS Capital to take advantage of attractive investment opportunities and navigate potential market uncertainties.

Risk Management

In navigating the current volatile market environment, OFS Capital has demonstrated its commitment to capital preservation and disciplined underwriting. The company has not reported any new non-accrual loans in recent quarters, and its existing non-accrual loans represented only 5.4% of the total portfolio at fair value as of September 30, 2024.

Future Outlook

Looking ahead, OFS Capital remains focused on increasing its net investment income over the long term, primarily by exploring the sale of certain non-interest-earning equity investments and redeploying the proceeds into interest-earning assets. The company's management team, with over 25 years of experience through multiple credit cycles, is well-positioned to identify attractive investment opportunities and manage risk effectively.

OFS Capital has announced that its quarterly distribution will remain at $0.34 per share for Q1 2025. At the end of Q4 2024, this distribution rate represented a 16.9% annualized yield based on the market price of the company's common stock. Management remains committed to improving net investment income to exceed the distribution rate, with a particular focus on monetizing equity investments, especially their minority stake in Fansteel Holdings.

Despite the challenges posed by the current macroeconomic environment, OFS Capital's diversified portfolio, conservative financing strategy, and experienced management team position the company well to weather market volatility and continue generating attractive risk-adjusted returns for its shareholders.

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