OFS Capital Corporation (“OFS”) is a busted business development company (“BDC”) IPO trading at 87% of book value with an 11% dividend yield.  After going public at book value in November 2012, the stock traded off in May 2013 as the company announced a delay in receiving drop-down approval for their small business investment company (“SBIC”).  This in turn delayed the ability to fully invest their SBIC and to cover the $1.36/yr dividend.  These issues have since been resolved and the company is currently deploying assets in its SBIC.  Once fully ramped, the company will be able to sustain a $1.81/sh dividend, which at the current share price would yield 14%.  At a peer valuation, we expect the total returns to be >60% over the next 2 years. 

Industry Background:

OFS is an externally managed BDC.  BDCs are investment vehicles, subject to the Invest Company Act of 1940 (“40’s Act”), that allow the general public to invest in private companies.  While there are multiple limitations to BDCs under the 40’s Act, the most salient are: (i) at least 70% of investments are required to be in eligible portfolio companies (essentially unlisted companies with a market capitalization below $250mm), (ii) leverage limitations of 1:1 debt to equity, and (iii) inability to sell equity below book value without shareholder consent. 

BDCs are considered Regulated Investment Companies by the IRS and as such are exempt from income taxes if they distribute more than 90% of their taxable income.  If a BDC distributes greater than 98% of its income, it is also exempt from excise taxes.  As such, most BDCs distribute greater than 98% of income and are considered yield vehicles.

OFS came public to raise capital to fully fund its SBIC, a government subsidized company that provides capital to small businesses.  This program is administered by the US Small Business Administration (“SBA”), and is attractive because it provides access to cheap capital:

• $150mm in government guaranteed debt at a leverage ratio of 2:1 ($75mm of equity for total investments of $225mm)
• Interest only with a fixed rate (10 year treasury + spread)
• 10 year bullet maturity
• Unsecured
• Non-recourse to the manager
• No pre-payment penalty

In exchange for attractive financing, OFS’ SBIC will invest in small businesses with EBITDA of $2-$12mm.  A typical investment will be a uni-tranche loan with leverage of 3.5x and a yield of 13% (total return is higher due to warrants).  Combined with government guaranteed 10yr debt at ~3.5%, the ROE is above 20%.

Company Background:

OFS consists of two different portfolios: the Senior Loan Portfolio and the SBIC portfolio.  Currently the Senior Loan Portfolio is the larger of the two portfolios with $202mm in assets.  It consists of senior secured variable rate loans with a weighted average yield of 6.9% and a cost of funds of ~3%.  We estimate this portfolio has a return on equity (“ROE”) of 3% (including management fees and corporate) and as such, is not a focus for the company. 

At the current time, the SBIC portfolio has $59mm in assets and management is focused on ramping up this business.

Why is it cheap?

The company went public in November 2012 to raise capital to fund their SBIC, which is the main driver of earnings.  Management initially expected to receive approval from the SBA to “drop-down” the SBIC into the BDC (making the SBIC a wholly owned subsidiary) in the first half of 2013.  Instead, on their Q113 conference call in May 2013, the company indicated that it had not received approval and would not be able to provide guidance as to when they would.  The stock sold off and the company went from trading at book value to trading at <80% of book value at one point.  OFS received drop-down approval from the SBA in Dec 2013.   

The delay in drop-down approval inhibited the SBIC from building its loan book.  The result is the company currently does not cover its dividend of $0.34/qtr.  To pay the dividend, the company has been returning capital to shareholders and current book value is $14.45/sh.

In addition, retail shareholders own 40% of the company and sell-side does not expect the company to cover the dividend until the end of 2015.  The result is retail shareholders are steered towards other BDCs that fully cover their dividend.  As detailed below we project that the company will fully cover its dividend by year end 2014, a full year before sell-side expects. 

What is OFS worth?

Fully ramped, the company will have $200mm in assets in the Senior Loan Fund and $225mm in assets at the SBIC and generate net income of $17.4mm or $1.81/sh.  This would equate to an ROE of 12.5% and a dividend yield of 14% at the current share price.  The closest comparable company is FDUS, which generates an ROE of 12% and trades at a dividend yield of 7.8% with a book value multiple of 1.3x.  Assuming OFS trades at a comparable valuation, we see a total return of 60% to 100% over the next two years. 

The key driver is OFS’ ability to fully invest the SBIC.  After receiving drop-down approval in December, management has hired additional investment professionals and is now solely focused on underwriting new loans.  Management has stated its goal is to underwrite $10mm/mnth in new loans and that they have built a healthy deal pipeline to meet that target.  OFS needs to underwrite $90mm of SBIC loans to fully cover their dividend, which we anticipate will occur at year-end 2014. 

So far in Q214, the company is on pace to hit their $10mm/mnth target.  On the Q114 conference call, the company noted that through May 8^th, they had originated two new loans with an aggregate principal balance of $13mm.  The company also gave color on their backlog (defined as investment opportunities with >50% closing within 3 months) noting they had potential investments totaling $87mm.  Assuming management’s guidance, at least $43.5mm of investment will close by the time of the Q214 conference call in early August.  $13mm in through May 8^th and $43.5mm combine to be more than 60% of the $90mm of SBIC investments needed to cover the dividend. 

Anecdotally, in our meeting with the CEO two weeks ago, he indicated that if they only originated $90mm in loans through Q414, they would be disappointed.  But actions speak louder than words: the CEO has acquired $523k of stock since Q114 results and $840k of stock in total since December 2013 through open market purchases at an average of $12.61/sh. 

Additional upside:

BDCs are currently allowed to have 2 SBIC licenses.  The first license allows the company to have up to $225mm in assets ($150mm of debentures and $75mm of regulatory capital).  Once ramped, the company can apply for a second license that is half the size of the first license ($112.5mm in assets funded with $75mm of debentures and $37.5mm of regulatory capital).  Assuming all else equal, the second SBIC license, would add $0.64 per share to EPS.  At a current peer multiple, this creates $7.00/sh in additional value.    

Also, given the success of the SBA program, a bill has been introduced in Congress to increase the total asset size of the first license from $225mm to $350mm.  Needless to say, this would allow the company to grow their dividend further. 

Management:

Management’s ability to execute is a key variable to understand.  In addition to meeting management a number of times, we have performed reference checks on the CEO and principals at the SBIC.  We believe they are an excellent and capable team. 

In addition, management is incentivized to make this work with as little risk as possible given that the external manager, Orchard First Source Asset Management (“OFSAM”) owns 30% of OFS.  On a look through basis, the CEO of OFS owns >10% of the company and has been purchasing shares on the open market.  No one stands to win more or lose more than management. 

Also, management has shown themselves to be shareholder friendly.  They do not earn a management fee on cash, they’ve cut the management fee by 50% for the past two years to lessen the burden on shareholders (themselves included) for the delay in ramping the SBIC, and are open to meeting investors. 

External Risks:

General economic downturn – SBICs lend to the small companies that are inordinately affected by economic downturns. 

Interest rate risk – Many BDCs are valued on a dividend yield and an increase in interest rates would negatively impact the yield at which BDCs trade.  In addition, increasing interest rates would put increasing financial pressure on companies in its Senior Loan Portfolio.

Internal Risks:

Execution risk – management may take longer than expected to fully invest the SBIC.

Dilution – potential to raise capital in the future at unattractive prices.  But as previously noted, BDCs cannot issue capital below book without shareholder approval.

Conflict of interest – OFS is an externally managed BDC and as such may be tempted to grow the BDC without regard to shareholders.

We believe all of these internal risks are mitigated by the external managers 30% ownership in OFS.