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Why OFS Capital Was Downgraded By Oppenheimer

|Includes: OFS Capital (OFS)

BDC Reporter: Today, Oppenheimer downgraded the stock of Business Development Company newbie OFS Capital. We thought it would be useful to provide some context around the story. The fly in the ointment is what is happening-or not-about the Company's intention to convert the investment in it's SBIC investment into a wholly-owned subsidiary.

We read the IQ Conference Call (best as we can-transcriptions make some of the language goofy). Certainly, management had to admit on the call that there was considerable uncertainty about converting their separately owned SBIC into a subsidiary, and getting heir hands on that large amount of cheap capital. Otherwise, the Company's remaining cash and unused Revolver capacity won't be sufficient to cover their current dividend. Here's the basic language in the Earnings Report:

"Simultaneously, we continue to work towards converting our Tamarix Capital Partners L.P. (Tamarix LP) investment into a drop-down small business investment company fund (SBIC) within OFS Capital. We are working to obtain the necessary investor and regulatory approvals. "

Here is what the CEO Bob Pittson said early in the Conference Call about the process of getting the SBIC into the Company:

"... I want to update everyone on our progress and converting the SBIC fund into a drop-down subsidiary. I personally had conversations with a large number of third-party investors in the fund. Based on these discussions, we will soon be sending out a proposal to acquire all their commitments on which $4.5 million is currently funded. We are also finalizing a drop-down documentation, which will be submitted to the SBA for their approval. While we are generally pleased with our progress, there are number of variables that could impact consummation of the drop-down and we cannot provide guidance as to the timing or ultimate outcome. The company [ph] required unanimous consent, there are by my count about 20 potential stakeholders including SBA, who's non-approval could materially alter the drop-down process or derail the process in its entirety".

Later on, following an analyst's question the CEO made it clear that if SBIC and shareholder approvals from the 20 "stakeholders" are not received, the strategy of OFS will be to invest $25mn in the SBIC anyway (as a minority investor). If approvals are received, the goal is to invest $75mn to maximize the SBIC leverage.

"We currently have a firm commitment to invest. I think we're roughly at $19 million to $20 million in commitment for the fund, but there is overarching commitment depending on the diversification of investors in the fund, that commitment can move up to $25 million, if we don't become a drop-down. In case of becoming a drop-down, our plan is to and our discussions with the SBA involves committing $75 million in capital to that to maximize the benefits and roll the fund to $225 million."

The CEO spelled out later why the economics of the planned SBIC subsidiary are so critical to the Company's future:

"(At the time of the roadshow in October 2012) we were looking at the SBIC fund generating a rate of return fully utilizing the leverage and looking at today's interest rates where they're above 20% rate of return on that investment and the senior loan fund itself, is kind of below teens maybe 12% depending on how much leverage, we can put into that.

The strategy works, concert with one another getting that exemptive relief essentially creates the ability to create a little more leverage in the BDC with very low cost long-term capital. So really does drive our profitability. ...Our interest rates haven't moved much, maybe there's been a little competition and compression in maybe risk premium side. I'd still hold to mid teens kind of rate of return off of this business model, net of management, based management fees."

The CEO went on to explain that the projected risk-adjusted return at the SBIC should be very good, especially as OFS intends to provide uni-tranche financing in the SBIC rather than pure mezzanine debt. That means a portion of the assets will be higher up in the capital structure and losses should be lower than in a pure mezzanine vehicle.

All of that is in the future, and at a time when loan spreads are under pressure, so the uncertainty about getting the SBIC subsidiary approvals is weighing on the stock price. Not helping is that management admits the time being spent on getting the SBIC approved has kept OFS from booking much in new uni-tranche deals.

The good news here is that the existing portfolio of 58 senior loans is performing well, with only one non-performing loans on nearly a quarter billion of assets. However, management did mention that pricing pressure in the market, has caused the syndicates in which OFS is invested to lower rates on 15% of the portfolio in recent weeks. There is no reason to believe that this won't continue, and only makes more important the ability to invest bi-laterally at higher rates through the SBIC.

There's too much uncertainty here for Oppenheimer, which downgraded the stock. The price has been stumbling, down $2 off the IPO price and could go lower until the uncertainty about the Company's likely business model is resolved.

Disclosure: I am long OFS.