Description

OFS is trades at 78% of NAV, yields 12.1% on its dividend that it is now starting to cover, and has room to grow the portfolio without having to tap the equity markets. For those who have invested in BDC's before, this is like investment porn.

Background: OFS was previously written up by Chewy back in June 2014. I recommend reading the description and the message thread, as it provides good background on how OFS came into being and the events that delayed the catalysts. Briefly, at the end of last year, there was a change in management that delayed the business plan. Then, just as OFS was starting t heat up, the high-yield market sagged.

"Show Me Some Love, Baby"

There have been a number of write-ups over the past 6-8 months on business development companies (BDC), including the following: MAIN, CMFN, PFLT, TICC, FSC, FULL. I know there is a general dislike on VIC for BDC's. I am not a fan of FSC, particularly its management, but OFS was trading last week at almost the same levels as FSC (the spreads have widened a bit since I started writing this up over the holidays). Here is a table of 50 BDC's based on price/NAV:

Here are 50 BDC's based on dividend yield:

(Source: BDCInvestor.com Note: This is a useful site for getting quick overviews of BDC's. Downside is that you have to register, which is free. You will get some promo emails for other products but just unsubscribe.)

Capital: As of 9/30/2015, OFS had finally maxed out the SBA debentures at $150 million. These notes are fixed at 3.18% and do not begin to mature until 2022. Also, SBA debt does not count towards the asset coverage ratio test for BDC's, so the company can add more leverage without having to raise equity. As of 9/30/2015, the company had $42 million in cash and could sell $24 million invested in a senior club loan portfolio that could be redeployed into higher yielding assets. Equity is $140 million, supporting $296 million of assets. There are 9.7 million shares outstanding, for a market cap of $107 million.

Fee Structure: OFS is externally managed, and as such has fees. There are three fees. One is the base 1.75% annual management fee. Next, the pre-incentive fee is 0% for net income up to 2% for the quarter, 100% from 2.0% to 2.5%, and then 20% above 2.5%. Finally, there is the capital gains fee, which is best summed up from the 10-K:

"The second part of the incentive fee (the “Capital Gains Fee”) is determined and payable in arrears as of the end of each calendar year (or upon termination of the Investment Advisory Agreement, as of the termination date) and is calculated at the end of each applicable year by subtracting (a) the sum of our cumulative aggregate realized capital losses and our aggregate unrealized capital depreciation from (b) our cumulative aggregate realized capital gains. If such amount is positive at the end of such year, then the Capital Gains Fee for such year is equal to 20.0% of such amount, less the aggregate amount of Capital Gains Fees paid in all prior years. If such amount is negative, then there is no Capital Gains Fee for such year. The Company accrues the Capital Gains Fee if, on a cumulative basis, the sum of net realized capital gains and (losses) plus net unrealized appreciation and (depreciation) is positive."

I like that the capital gains fee is cumulative, includes unrealized losses but not unrealized gains, and is paid annually. I also like that the external manager owns 30% of the shares. On the positive side, this aligns the interests of the manager with shareholders. Downside is that it raises the hurdle in changing the manager.  

Investment Portfolio: As of 9/30/2015, the portfolio consisted of 61% senior loans, 29% subordinated debt and 10% equity. Total investments were $247 million. The company had focused more on senior liens but sold a $67 million of loans to Madison Capital Funding in May 2015. OFS used the proceeds to repay a revolving debt facility with Wells Fargo. The goal was to invest in higher yielding securities. In a way, this has worked out well because it has dry powder to deploy into a market on better terms. The company has avoided investing in oil and gas, focusing on services, healthcare and a variety of other businesses. Also, 56% of the loans are floating rate, and will benefit from rising interest rates. Non-accruals consisted of two loans for $1.2 million or about 0.5% of investments.

Institutional Ownership: Earlier this year, the only 13 filer was UBS, which has subsequently, and significantly, reduced its position. Total institutional ownership as of 9/30/2015 is a scant 15% of shares outstanding. So, good news is that it is not a hedge fund hotel!

Opportunity: The catalyst here is for the company to continue originating loans and start leveraging up. The average yield on the debt portfolio was 11.8% at the end of the last quarter. So what are the possibilities? Let's start by assuming OFS puts $30 million into new investments. I will assume $12 million is kept for running the business and a similar investment mix. $30 mm X .9 loans X .118 = $3.2 mm or $0.33/sh. If that gets added to the dividend, and the stock yields the same 12.1%, the stock price would be about 25% higher, on top of the dividend. Now suppose the company gets to 60% leverage (excluding SBA debt) with a 5% spread. That would be $141.7 mm X .6 X .9 X .05 = $3.8 mm or $0.38/sh. Combining both translates into a share price 53% higher, plus dividends, and additional gains if the yield reverts to the average BDC.

Catalyst

Make more investments, generate more net investment income, increase dividend.