Executive Summary / Key Takeaways

• OFS Capital Corporation is strategically focused on enhancing Net Investment Income (NII) by rotating non-interest-earning equity positions, most notably its significant stake in Pfanstiehl Holdings, into income-producing debt assets.
• The company's investment portfolio emphasizes senior secured loans (100% of the loan portfolio at fair value) and industry diversification, positioning it defensively against macroeconomic headwinds and potential earnings pressure on portfolio companies.
• Recent financial performance in Q1 2025 saw a decrease in NII ($0.26 per share) and NAV ($11.97 per share) compared to Q4 2024, primarily driven by the absence of non-recurring income, lower interest rates impacting loan yields, and unrealized depreciation on investments.
• Key liquidity considerations include the upcoming end of the BNP Facility's reinvestment period in June 2025 and the maturity of a significant portion of unsecured notes in February 2026, requiring proactive refinancing or capital management.
• Leveraging the extensive experience and broad platform of its external adviser, OFS Capital Management, LLC, is a core component of the company's strategy to navigate market volatility, source deals, and manage portfolio risk through various credit cycles.

Setting the Scene: A BDC's Strategic Evolution

OFS Capital Corporation is an externally managed business development company (BDC) with a stated objective to deliver both current income and capital appreciation to its stockholders. Operating within the competitive landscape of middle-market and larger company financing, OFS Capital has evolved its strategy since commencing BDC operations in early 2011. Initially focused on specific areas, the company has strategically broadened its scope to include debt investments in larger U.S. companies and Structured Finance Securities, alongside its core middle-market lending and opportunistic equity plays.

The company's operations are guided by OFS Capital Management, LLC (OFS Advisor), its external investment adviser, and supported by OFS Capital Services, LLC (OFS Services) for administrative functions. This external management structure, backed by the broader Orchard First Source Asset Management platform, represents a key operational differentiator. While not a proprietary product technology in the traditional sense, the adviser's platform provides a competitive edge through its long-standing banking and capital markets relationships, deep industry expertise, and a track record spanning over 25 years and multiple credit cycles. This extensive experience is crucial for deal sourcing, rigorous due diligence, structuring investments, and ongoing portfolio monitoring, particularly in complex and uncertain market environments. The stated goal of this operational framework is to enable effective navigation of market volatility and support the company's investment strategy, although specific quantifiable metrics on the platform's efficiency or performance edge over competitors are not detailed.

Within the BDC sector, OFS Capital competes directly with established players like Ares Capital Corporation (ARCC), Golub Capital BDC (GBDC), Hercules Capital (HTGC), and BlackRock TCP Capital Corporation (TCPC), as well as indirectly with private equity firms and fintech lenders. Compared to larger peers like ARCC and GBDC, OFS Capital operates at a smaller scale, which can translate to higher operational costs per unit and potentially less pricing power in competitive deals. For instance, estimated operating costs per unit for OFS Capital are higher than those of larger BDCs. However, OFS Capital aims to differentiate itself through flexible capital solutions and a willingness to engage in tailored equity investments, which management believes can offer higher potential returns, particularly in niche markets. Its regulatory status as a RIC, coupled with a modified asset coverage requirement of 150% (down from 200% since May 2019), provides some flexibility in managing its balance sheet, a factor that helps it compete against peers like GBDC known for conservative risk management. Despite these strengths, OFS Capital's smaller scale can lead to weaker portfolio diversification compared to market leaders, potentially increasing exposure to individual credit events. The company's dependency on middle-market borrowers also presents a specific dynamic, requiring close dialogue and support, especially during economic slowdowns.

Portfolio Strategy and Composition: Leaning Senior and Seeking Income

OFS Capital's investment strategy is anchored by a commitment to investing higher in the capital structure. As of March 31, 2025, 100% of its loan portfolio at fair value consisted of senior secured loans (85% first lien, 15% second lien), a defensive posture designed to provide downside protection in uncertain economic times. The portfolio is also diversified across various industries, with significant exposures in Manufacturing, Health Care and Social Assistance, and Administrative and Support Services, totaling approximately 65% of the Portfolio Company Investment portfolio by fair value. This diversification aims to mitigate concentration risk and avoid the volatility inherent in highly cyclical sectors.

A central strategic initiative highlighted by management is the focus on increasing Net Investment Income (NII) over the long term. A key pathway to achieving this is the planned rotation of non-interest-earning equity positions into income-generating assets. The prime example of this strategy is the company's minority equity investment in Pfanstiehl Holdings, Inc. This investment, made over 11 years ago at a modest cost of $200,000, has seen significant appreciation and has already returned approximately $3.9 million in distributions (18 times cost). As of March 31, 2025, the Pfanstiehl equity position represented a substantial 22.5% of the total portfolio at fair value and 56.6% of total net assets, with the vast majority of its value ($90.5 million) being unrealized appreciation. Management is actively exploring alternatives to monetize this position, recognizing that redeploying these proceeds into interest-bearing debt could significantly boost recurring income and help bridge the gap between current NII and the quarterly distribution rate.

Beyond the loan portfolio, Structured Finance Securities, primarily CLO mezzanine debt and subordinated notes, constitute a notable portion of the portfolio (19.7% at fair value as of March 31, 2025). These investments, often domiciled in offshore entities, are generally considered non-qualifying assets under the 1940 Act. While they can offer attractive yields (weighted-average performing yield of 16.3% in Q1 2025), they also carry inherent risks related to the performance of the underlying loan pools and market liquidity.

Financial Performance: Navigating Headwinds

The first quarter of 2025 presented financial headwinds for OFS Capital. Net Investment Income decreased to $0.26 per share, down from $0.30 in the prior quarter. This decline was primarily attributed to the absence of non-recurring dividend and fee income that boosted Q4 2024 results, as well as an anticipated decrease in interest income from the loan portfolio due to the impact of U.S. Federal Reserve rate cuts enacted in late 2024. The weighted-average performing income yield on interest-bearing investments modestly decreased to 13.40% in Q1 2025 from 13.80% in Q4 2024, reflecting this pressure on floating-rate assets.

Net asset value (NAV) per share also saw a decrease, falling to $11.97 at March 31, 2025, from $12.85 at December 31, 2024. This $0.88 per share decrease was a result of the quarterly distribution ($0.34 per share) exceeding NII and, more significantly, a net loss on investments totaling $10.8 million for the quarter. This loss was driven by $8.2 million in net unrealized depreciation (net of taxes) and a $2.6 million net realized loss. The unrealized depreciation was recognized across all asset classes but was most pronounced in the loan portfolio, influenced by both issuer-specific factors and broader credit market price declines. The realized loss stemmed primarily from the sale of a non-performing Structured Finance Security.

Despite the decrease in NII and NAV, the company reported no new loans placed on non-accrual status in Q1 2025, indicating a degree of stability in the performing loan portfolio. Non-accrual loans represented 4.2% of total investments at fair value as of March 31, 2025 ($16.9 million fair value, $39.1 million amortized cost), a decrease from 5.1% at December 31, 2024 ($20.8 million fair value, $39.1 million amortized cost).

Operating expenses decreased in Q1 2025 compared to Q4 2024, primarily due to a lower Income Incentive Fee resulting from the decrease in NII and reduced non-recurring investment transaction expenses.

Liquidity and Capital Management: Addressing Upcoming Maturities

Managing liquidity and debt is a critical focus for OFS Capital. As of March 31, 2025, the company had $4.1 million in cash and cash equivalents. Its primary sources of additional liquidity are its revolving credit facilities: the Banc of California Credit Facility ($21.5 million unused commitment) and the BNP Facility ($85.5 million unused commitment). Both are subject to borrowing base requirements and other covenants.

A key point of attention is the BNP Facility, which had $64.6 million outstanding as of March 31, 2025. While the facility matures in June 2027, its reinvestment period ends on June 20, 2025. This means the ability to draw on the unused commitment terminates on that date unless the facility is amended or a new credit facility is established. Management acknowledges that failure to do so would significantly reduce short-term liquidity.

Furthermore, a substantial portion of the company's outstanding debt, $125 million of the $180 million Unsecured Notes, matures relatively soon on February 10, 2026. The Banc of California Facility ($3.5 million outstanding) also matures in February 2026. These upcoming maturities, totaling $128.5 million (52% of total outstanding debt), necessitate proactive refinancing or repayment strategies. While approximately 73% of the company's outstanding debt is unsecured and carries fixed rates (weighted-average fixed rate of 4.81% on Unsecured Notes), the unsecured nature means it is effectively subordinated to the secured credit facilities. Current market rates for similar debt are higher than the fixed rates on the maturing notes, suggesting refinancing could increase interest expense.

Despite these upcoming maturities and the potential reduction in the BNP Facility's availability, the company had unfunded commitments of $13.8 million to nine portfolio companies as of March 31, 2025. Management believes existing liquidity and available borrowings are sufficient to meet these commitments. The company's asset coverage ratio of 165% as of March 31, 2025, comfortably exceeded the minimum 150% requirement, providing regulatory capacity for additional leverage, subject to lender covenants.

The company also has authorization from stockholders to sell shares below NAV (up to 25% of outstanding shares) under certain conditions, providing a potential avenue for raising equity capital, although no shares have been sold under this authority to date. A stock repurchase program remains in place through May 2026, with approximately $9.6 million remaining under the authorization, offering flexibility to opportunistically repurchase shares.

Outlook and Risks: Navigating an Uncertain Horizon

Management's outlook is framed by the prevailing macroeconomic uncertainty. They explicitly cite the potential impact of global tariffs and the increased chances of an economic slowdown as factors that could lead to earnings pressure on portfolio companies and, consequently, on the BDC's earnings. This uncertain environment is also expected to continue dampening M&A activity in the near term, limiting opportunities for new originations and associated fee income, although a pickup is anticipated later as interest rate clarity improves.

The impact of interest rate changes remains a significant market risk. While past rate cuts have pressured loan yields, management also believes lower rates could benefit borrowers by reducing debt service burdens and potentially mitigating recession risk. However, with a significant portion of debt at fixed rates, falling interest rates could compress net interest margin. Conversely, rising rates would benefit floating-rate income but increase costs on floating-rate debt.

Investment valuation risk is inherent, particularly for Level 3 investments without readily available market values. Fair values are determined using significant unobservable inputs and management judgment, which can lead to fluctuations and potential differences between recorded values and ultimately realized amounts, especially in volatile markets. The illiquidity of many portfolio investments further exacerbates this risk, making timely or favorable exits challenging.

The upcoming end of the BNP Facility's reinvestment period and the maturity of the Unsecured Notes in early 2026 represent concrete refinancing risks. While management is proactively exploring options, there is no guarantee that new facilities or refinancings will be secured on favorable terms, if at all, which could constrain liquidity and investment capacity. Furthermore, instability in the banking system, although not currently impacting the company's cash balances held at high-quality institutions, remains a potential systemic risk that could affect credit facilities.

Despite these challenges, the core strategic focus on rotating equity to income assets, particularly the potential monetization of Pfanstiehl, provides a clear path for potential NII improvement. The company continues to rely heavily on the experience and relationships of its adviser to navigate the complex market, source opportunities, and manage risk effectively.

Conclusion

OFS Capital Corporation is currently focused on enhancing its Net Investment Income and managing its balance sheet amidst a backdrop of macroeconomic uncertainty and market volatility. The recent dip in NII and NAV in Q1 2025 underscores the impact of non-recurring income variability and interest rate pressures, highlighting the challenges in the current environment. However, the company's strategic emphasis on a defensively positioned, senior-secured loan portfolio and the stated goal of monetizing non-income-producing equity, particularly the highly appreciated Pfanstiehl stake, offer a clear potential catalyst for future income growth.

While upcoming debt maturities and the BNP Facility's reinvestment period present near-term liquidity and refinancing considerations, the company's current asset coverage provides regulatory flexibility. The external adviser's deep experience and platform remain a crucial asset in navigating deal sourcing, portfolio management, and market cycles. The investment thesis hinges on the successful execution of the portfolio repositioning strategy, the ability to manage refinancing risks effectively, and the resilience of the diversified, senior-secured portfolio in a potentially slowing economy. Investors should monitor progress on the equity monetization strategy and the company's approach to addressing its debt maturities as key indicators of future performance.