FS ENERGY AND POWER FUND The information contained in this section should be read in conjunction with our unaudited consolidated financial statements and related notes thereto included elsewhere in this quarterly report on Form 10-Q. In this report, "we," "us" and "our" refer toFS Energy and Power Fund and "FS/EIG Advisor" refers toFS/EIG Advisor, LLC . Forward-Looking Statements Some of the statements in this quarterly report on Form 10-Q constitute forward-looking statements because they relate to future events or our future performance or financial condition. The forward-looking statements contained in this quarterly report on Form 10-Q may include statements as to:
•our future operating results;
• our business prospects and the prospects of the companies in which we may invest, including our and their ability to achieve our respective objectives as a result of the current COVID-19 pandemic; • the impact of the investments that we expect to make; • the ability of our portfolio companies to achieve their objectives; • our current and expected financing arrangements and investments;
•changes in the general interest rate environment;
• the adequacy of our cash resources, financing sources and working capital;
• the timing and amount of cash flows, distributions and dividends, if any, from our portfolio companies;
• our contractual arrangements and relationships with third parties;
• actual and potential conflicts of interest with FS/EIG Advisor, FS Investments, EIG, or any of their respective affiliates;
• the dependence of our future success on the general economy and its effect on the industries in which we may invest;
• general economic and political trends and other external factors, including the current COVID-19 pandemic and related disruptions caused thereby;
• our use of financial leverage;
• the ability of FS/EIG Advisor to locate suitable investments for us and to monitor and administer our investments;
• the ability of FS/EIG Advisor or its affiliates to attract and retain highly talented professionals;
• our ability to maintain our qualification as a RIC and as a BDC;
• the impact on our business of the Dodd-Frank Act, as amended, and the rules and regulations issued thereunder;
• the effect of changes to tax legislation and our tax position; and
• the tax status of the enterprises in which we may invest.
In addition, words such as "anticipate," "believe," "expect" and "intend" indicate a forward-looking statement, although not all forward-looking statements include these words. The forward-looking statements contained in this quarterly report on Form 10-Q involve risks and uncertainties. Our actual results could differ materially from those implied or expressed in the forward-looking statements for any reason. Factors that could cause actual results to differ materially include:
• changes in the economy; • geo-political risks;
• risks associated with possible disruption in our operations or the economy generally due to terrorism, natural disasters or pandemics; and
• future changes in laws or regulations and conditions in our operating areas.
We have based the forward-looking statements included in this quarterly report on Form 10-Q on information available to us on the date of this quarterly report on Form 10-Q. Except as required by the federal securities laws, we undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise. Shareholders are advised to consult any additional disclosures that we may make directly to shareholders or through reports that we may file in the future with theSEC , including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. The forward-looking statements and projections contained in this quarterly report on Form 10-Q are excluded from the safe harbor protection provided by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. 38 -------------------------------------------------------------------------------- Table of Contents Overview We were formed as aDelaware statutory trust under theDelaware Statutory Trust Act onSeptember 16, 2010 and formally commenced investment operations onJuly 18, 2011 . We are an externally managed, non-diversified, closed-end management investment company that has elected to be regulated as a BDC under the 1940 Act and has elected to be treated forU.S. federal income tax purposes, and intends to qualify annually, as a RIC under Subchapter M of the Code. InNovember 2016 , we closed our continuous public offering of common shares to new investors. Our investment activities are managed by FS/EIG Advisor and supervised by our board of trustees, a majority of whom are independent. Under the FS/EIG investment advisory agreement, we have agreed to pay FS/EIG Advisor an annual base management fee based on the average weekly value of our gross assets and an incentive fee based on our performance. Our investment policy is to invest, under normal circumstances, at least 80% of our total assets in securities of Energy companies. This investment policy may not be changed without at least 60 days' prior notice to holders of our common shares of any such change. Our investment objective is to generate current income and long-term capital appreciation. We pursue our investment objective by focusing on the following seven investment themes: (i) basin-on-basin competition inU.S. shale, (ii) globalization of natural gas, (iii) coal retirements and the evolving energy generation mix, (iv) renewables focused on power grid parity, (v) export infrastructure for emergingU.S. producers, (vi) market liberalization opening new markets and (vii) midstream infrastructure connecting new supplies. However, we may pursue other investment opportunities if we believe it is in our best interests and consistent with our investment objectives.
Within the above investment themes, we intend to focus on the following investment categories in an effort to generate returns for our investors with an acceptable level of risk.
Direct Originations: Through FS/EIG Advisor, we intend to directly source investment opportunities across the Energy industry. Such investments are typically originated and structured through a negotiated process in which we directly participate and are not generally available to the broader market. These investments may include both debt and equity components. We believe directly originated investments may offer higher returns and more favorable protections than broadly syndicated transactions.
Broadly Syndicated Loan and Bond Transactions: Although our primary focus is to invest in directly originated transactions, in certain circumstances we will also invest in the broadly syndicated loan and high yield bond markets. Broadly syndicated loans and bonds are generally more liquid than our directly originated investments and provide a complement to our less liquid strategies. In the case of broadly syndicated investments, we generally intend to capitalize on market inefficiencies by investing in loans, bonds, and other asset classes where the market price of such investment reflects a lower value than we believe is warranted based on our fundamental analysis, providing us with an opportunity to earn an attractive return on our investment. The majority of our portfolio is comprised of income-oriented securities, which principally refers to debt securities and income-oriented preferred and common equity interests, of privately-held Energy companies withinthe United States . Generally, we expect to invest primarily in directly originated investments and primary market transactions, as this will provide us with the ability to tailor investments to best match a project's or company's needs with our investment objectives. We intend to weight our portfolio towards senior secured debt and directly originated preferred equity investments, which we believe offer opportunities for superior risk-adjusted returns and income generation. Our debt investments may take the form of corporate or project loans or bonds, may be secured or unsecured and may, in some cases, be accompanied by yield enhancements. These yield enhancements are typically expected to include royalty interests in mineral, oil and gas properties, warrants, options, net profits interests, cash flow participations or other forms of equity participation that can provide additional consideration or "upside" in a transaction. Our preferred equity investments are mostly directly originated and may take the form of perpetual or redeemable securities, typically with a current income component and minimum base returns. In addition, certain income-oriented preferred or common equity interests may include interests in master limited partnerships and a portion of our portfolio may be comprised of derivatives, including the use of total return swaps, credit default swaps and other commodity swap contracts. In connection with certain of our debt investments or any restructuring of these debt investments, we may on occasion receive equity interests, including warrants or options, as additional consideration or otherwise in connection with a restructuring. FS/EIG Advisor will seek to tailor our investment focus as market conditions evolve. 39 -------------------------------------------------------------------------------- Table of Contents Revenues The principal measure of our financial performance is net increase or decrease in net assets resulting from operations, which includes net investment income, net realized gain or loss on investments, foreign currency, swap contracts and debt extinguishment, net change in unrealized appreciation or depreciation on investments, net change in unrealized gain or loss on foreign currency and net change in unrealized appreciation or depreciation on swap contracts. Net investment income is the difference between our income from interest, dividends, fees and other investment income and our operating and other expenses. Net realized gain or loss on investments is the difference between the proceeds received from dispositions of portfolio investments and their amortized cost, including the respective realized gain or loss on foreign currency for those foreign denominated investment transactions. Net realized gain or loss on foreign currency is the portion of realized gain or loss attributable to foreign currency fluctuations. Net realized gain or loss on swap contracts is the portion of realized gain or loss attributable to the difference between the fixed price specified in the contract and the referenced settlement price. Net change in unrealized appreciation or depreciation on investments is the net change in the fair value of our investment portfolio, including the respective unrealized gain or loss on foreign currency for those foreign denominated investments. Net change in unrealized gain or loss on foreign currency is the net change in the value of receivables or accruals due to the impact of foreign currency fluctuations. Net change in unrealized appreciation or depreciation on swap contracts is the net change in the value of receivables or accruals due to the impact of the difference between the fixed price specified in the contract and the referenced settlement price.
We principally generate revenues in the form of interest income on the debt investments we hold. We also generate revenues in the form of dividends and other distributions on the equity or other securities we may hold. In addition, we may generate revenues in the form of non-recurring commitment, closing, origination, structuring or diligence fees, fees for providing managerial assistance, consulting fees, prepayment fees and performance-based fees.
Expenses
Our primary operating expenses include the payment of management and incentive fees and other expenses under the FS/EIG investment advisory agreement, interest expense from financing arrangements and other indebtedness, and other expenses necessary for our operations. The management and incentive fees compensate FS/EIG Advisor for its work in identifying, evaluating, negotiating, executing, monitoring and servicing our investments. FS/EIG Advisor oversees our day-to-day operations, including the provision of general ledger accounting, fund accounting, legal services, investor relations, certain government and regulatory affairs activities, and other administrative services. FS/EIG Advisor also performs, or oversees the performance of, our corporate operations and required administrative services, which includes being responsible for the financial records that we are required to maintain and preparing reports for our shareholders and reports filed with theSEC . In addition, FS/EIG Advisor assists us in calculating our net asset value, overseeing the preparation and filing of tax returns and the printing and dissemination of reports to our shareholders, and generally overseeing the payment of our expenses and the performance of administrative and professional services rendered to us by others. We reimburse FS/EIG Advisor for expenses necessary to perform services related to our administration and operations, including FS/EIG Advisor's allocable portion of the compensation and related expenses of certain personnel of FS Investments and EIG providing administrative services to us on behalf of FS/EIG Advisor, and for transactional expenses for prospective investments, such as fees and expenses associated with performing due diligence reviews of investments that do not close, often referred to as "broken deal" costs. We reimburse FS/EIG Advisor no less than quarterly for all costs and expenses incurred by FS/EIG Advisor in performing its obligations and providing personnel under the FS/EIG investment advisory agreement. The amount of this reimbursement is set at the lesser of (1) FS/EIG Advisor's actual costs incurred in providing such services and (2) the amount that we estimate would be required to pay alternative service providers for comparable services in the same geographic location. FS/EIG Advisor allocates the cost of such services to us based on factors such as time allocations and other reasonable metrics. Our board of trustees reviews the methodology employed in determining how the expenses are allocated to us and assesses the reasonableness of such reimbursements for expenses allocated to us based on the breadth, depth and quality of such services as compared to the estimated cost to us of obtaining similar services from third-party service providers known to be available. In addition, our board of trustees considers whether any single third-party service provider would be capable of providing all such services at comparable cost and quality. Finally, our board of trustees compares the total amount paid to FS/EIG Advisor for such services as a percentage of our net assets to the same ratio as reported by other comparable BDCs. We do not reimburse FS/EIG Advisor for any services for which it receives a separate fee, or for rent, depreciation, utilities, capital equipment or other administrative items allocated to a controlling person of FS/EIG Advisor. We bear all other expenses of our operations and transactions, including all other expenses incurred by FS/EIG Advisor in performing services for us and administrative personnel paid by FS/EIG Advisor, to the extent they are not controlling persons of FS/EIG Advisor or any of its affiliates, subject to the limitations included in the FS/EIG investment advisory agreement. In addition, we have contracted withState Street to provide various accounting and administrative services, including, but not limited to, preparing preliminary financial information for review by FS/EIG Advisor, preparing and monitoring expense budgets, 40
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Table of Contents maintaining accounting and corporate books and records, processing trade information provided by us and performing testing with respect to RIC compliance.
For information regarding the fee offset with FS/EIG Advisor, see Note 4 to our unaudited consolidated financial statements included herein.
COVID-19 and Energy Market Developments
Recent events such as the rapid spread of the COVID-19 pandemic, global lockdowns and ongoing negotiations regarding production levels between oil producing countries, have at times resulted in lower demand for crude oil and, as a result, lower commodity prices. Although the energy markets have had a notable recovery in recent quarters, volatility in the energy markets may persist, recur or worsen, including as a result of other macroeconomic events, such as the current conflict inUkraine and sanctions imposed onRussia in response thereto. The impact of these events on theU.S. and global economies (including energy markets), has negatively impacted, and could continue to negatively impact, the business operations of some of our portfolio companies. We cannot at this time fully predict the continued or future impact of the above events on our business or the business of our portfolio companies, their duration or magnitude or the extent to which they will negatively impact our portfolio companies' operating results or our own results of operations or financial condition. We expect that certain of our portfolio companies may continue to experience economic distress for the foreseeable future and may become insolvent or otherwise significantly limit business operations if subjected to prolonged economic distress, including as a result of depressed commodity prices or other declines in the energy markets. These developments could result in a further decrease in the value of our investments. These events have previously had adverse effects on our investment income and we expect that such adverse effects may continue for some time. These adverse effects have required and may again require us to restructure certain of our investments, which could result in further reductions to our investment income or in impairments on our investments. In addition, disruptions in the capital markets have resulted in illiquidity in certain market areas at times. These market disruptions and illiquidity have had and may continue to have an adverse effect on our business, financial condition, results of operations and cash flows. Unfavorable economic conditions caused by these events may increase our funding costs and limit our access to the capital markets. These events have previously limited our investment originations, which may continue for the immediate future, and have also previously had a material negative impact on our operating results for a period of time. In addition, the growth of non-income producing equity investments as a percentage of the portfolio has materially reduced the value of collateral available to secure our financing arrangements. Consequently, this has adversely impacted our liquidity, may cause us to fall out of compliance with certain portfolio requirements under the 1940 Act that are tied to the value of our investments and, in each case, may continue to do so in the future. In particular, as a result of these events during 2020 and the early part of 2021, we needed to sell certain investments to satisfy certain margin obligations, and if such market conditions recur or worsen, we may need to sell additional investments at similarly or even more disadvantageous prices, or enter into other transactions on terms that are disadvantageous to us, to satisfy obligations under our financing arrangements. In light of such difficult market conditions and in an effort to preserve our liquidity, our board of trustees determined to suspend for an indefinite period of time our share repurchase program and will reassess our ability to recommence such program in future periods. Although our board of trustees has not declared or resumed regular cash distributions to shareholders for any period afterMarch 31, 2020 , our board of trustees has since declared three cash distributions in 2020, four cash distributions in 2021 and two cash distributions in 2022, each in the amount of$0.03 per share. FS/EIG Advisor and our board of trustees expect that future regular cash distributions to shareholders will remain suspended until such time that our board of trustees and FS/EIG Advisor believe that market conditions and our financial condition support the resumption of such distributions. Our board of trustees has and will continue to evaluate our ability to pay any distributions in the future. There can be no assurance that we will be able to pay distributions in the future. We will continue to carefully monitor the impact of the COVID-19 pandemic; the current conflict inUkraine and government responses thereto; and other disruptions in the energy markets on our business and the business of our portfolio companies. Because the full effects of these events are not capable of being known at this time, we cannot estimate the impacts on our future financial condition, results of operations or cash flows. We do, however, expect that these events may have a negative impact on our business and the financial condition of certain of our portfolio companies. 41 -------------------------------------------------------------------------------- Table of Contents Portfolio Investment Activity for the Three and Six Months EndedJune 30, 2022 and for the Year EndedDecember 31, 2021
Total Portfolio Activity
The following tables present certain selected information regarding our portfolio investment activity for the three and six months endedJune 30, 2022 : For the Three Months Ended For the Six Months Ended Net Investment Activity June 30, 2022 June 30, 2022 Purchases $ 220,408 $ 344,498 Sales and Repayments (267,067) (507,402) Net Portfolio Activity $ (46,659) $ (162,904) For the Three Months Ended For the Six Months Ended June 30, 2022 June 30, 2022 New Investment Activity by Asset Class Purchases Percentage Purchases Percentage Senior Secured Loans-First Lien$ 115,986 53 %$ 133,628 39 % Senior Secured Loans-Second Lien 46,900 21 % 110,150 32 % Unsecured Debt 19,228 9 % 53,269 15 % Equity/Other 38,294 17 % 47,451 14 % Total$ 220,408 100 %$ 344,498 100 %
The following table summarizes the composition of our investment portfolio at
cost and fair value as of
June 30, 2022
(Unaudited) December 31, 2021
Amortized Percentage Amortized Percentage
Cost(1) Fair Value of Portfolio Cost(1) Fair Value of Portfolio
Senior Secured Loans-First Lien $ 770,769 $ 762,753 31 % $ 832,257 $ 812,335 34 %
Senior Secured Loans-Second Lien 176,003 177,184 7 % 83,322 84,083 3 %
Senior Secured Bonds 10,040 10,356 0 % 77,266 81,646 3 %
Unsecured Debt 389,039 359,450 15 % 425,715 397,068 17 %
Preferred Equity 497,019 475,077 20 % 515,711 497,288 21 %
Sustainable Infrastructure
Investments, LLC 54,514 52,131 2 % 54,514 50,770 2 %
Equity/Other 340,584 594,385 25 % 364,272 472,033 20 %
Total $ 2,237,968 $ 2,431,336 100 % $ 2,353,057 $ 2,395,223 100 %
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(1) Amortized cost represents the original cost adjusted for the amortization of premiums and/or accretion of discounts, as applicable, on investments.
The following table presents certain selected information regarding the
composition of our investment portfolio as of
June 30, 2022 December 31, 2021
Number of Portfolio Companies 71 71
% Variable Rate (based on fair value) 34.4% 35.1%
% Fixed Rate (based on fair value) 19.5% 22.3%
% Income Producing Preferred Equity and Equity/Other Investments (based on fair value)
14.3% 14.1%
% Non-Income Producing Preferred Equity and Equity/Other Investments (based on fair value)
31.8% 28.5%
Weighted Average Purchase Price of Debt Investments (as a % of par value)
99.3% 98.5%
% of Investments on Non-Accrual (based on fair value) 9.5% 10.4%
Gross Portfolio Yield Prior to Leverage (based on amortized cost)
6.3% 5.5%
Gross Portfolio Yield Prior to Leverage (based on amortized cost)-Excluding Non-Income Producing Assets
8.4% 7.8%
Although our board of trustees has not declared or resumed regular cash
distributions to shareholders for any period after March 31, 2020 , our board of
trustees has since declared three cash distributions in 2020, four cash
distributions in 2021 and two cash distributions in 2022, each in the amount of
$0.03 per share. FS/EIG Advisor and our board of trustees expect that future
regular cash distributions to shareholders will remain suspended until such time
that our board of trustees and FS/EIG Advisor believe that market conditions and
our financial condition support the resumption of such distributions. Our board
of trustees has and will continue to
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Table of Contents
evaluate our ability to pay any distributions in the future. There can be no
assurance that we will be able to pay distributions in the future. For the six
months ended June 30, 2022 and the year ended December 31, 2021 , our total
return was 12.81% and 14.22%, respectively, and our total return without
assuming reinvestment of distributions was 12.81% and 14.15%, respectively.
Our estimated gross portfolio yield does not represent actual investment returns
to shareholders. Our gross annual portfolio yield is subject to change and in
the future may be greater or less than the rates set forth above. See the
sections entitled "Risk Factors" in our annual report on Form 10-K for the
fiscal year ended December 31, 2021 and in our other periodic reports filed with
the SEC for a discussion of the uncertainties, risks and assumptions associated
with these statements.
Direct Originations
We define Direct Originations as any investment where FS/EIG Advisor or its
affiliates negotiates the terms of the transaction beyond just the price, which,
for example, may include negotiating financial covenants, maturity dates or
interest rate terms. These Direct Originations include participation in other
originated transactions where there may be third parties involved, or a bank
acting as an intermediary, for a closely held club, or similar transactions. The
following table presents certain selected information regarding our Direct
Originations as of June 30, 2022 and December 31, 2021 :
Characteristics of All Direct Originations held in Portfolio June 30, 2022 December 31, 2021
Number of Portfolio Companies 44 43
% of Investments on Non-Accrual (based on fair value) 12.9% 15.4%
Total Cost of Direct Originations $1,546,521 $1,586,099
Total Fair Value of Direct Originations $1,790,041 $1,621,482
% of Total Investments, at Fair Value 73.6% 67.7%
Gross Portfolio Yield Prior to Leverage (based on amortized cost) of Funded Direct Originations
6.2% 5.1%
Gross Portfolio Yield Prior to Leverage (based on amortized cost) of Funded Direct Originations-Excluding Non-Income Producing Assets
9.7% 8.4%
Portfolio Composition by Strategy
The table below summarizes the composition of our investment portfolio by
strategy and enumerates the percentage, by fair value, of the total portfolio
assets in such strategies as of
June 30, 2022 December 31, 2021
Percentage of Percentage of
Portfolio Composition by Strategy Fair Value Portfolio Fair Value Portfolio
Direct Originations $ 1,790,041 74 % $ 1,621,482 68 %
Broadly Syndicated/Other 641,295 26 % 773,741 32 %
Total $ 2,431,336 100 % $ 2,395,223 100 %
See Note 7 to our unaudited consolidated financial statements included herein for additional information regarding our investment portfolio.
Portfolio Asset Quality
In addition to various risk management and monitoring tools, FS/EIG Advisor uses
an investment rating system to characterize and monitor the expected level of
returns on each investment in our portfolio. FS/EIG Advisor uses an investment
rating scale of 1 to 5. The following is a description of the conditions
associated with each investment rating:
Investment
Rating Summary Description
1 Investment exceeding expectations and/or capital gain expected.
2 Performing investment generally executing inaccordance with the portfolio
company's business plan-full return of principal and interest expected.
3 Performing investment requiring closer monitoring.
4 Underperforming investment-some loss of interest ordividend possible, but still
expecting a positive return on investment.
5 Underperforming investment with expected loss of interest and some principal.
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Table of Contents The following table shows the distribution of our investments on the 1 to 5 investment rating scale at fair value as ofJune 30, 2022 andDecember 31, 2021 : June 30, 2022 December 31, 2021 Percentage Percentage Investment Rating Fair Value of Portfolio Fair Value of Portfolio 1 $ - - $ - - 2 1,878,180 77 % 1,771,346 74 % 3 164,034 7 % 232,319 10 % 4 314,885 13 % 284,055 12 % 5 74,237 3 % 107,503 4 % Total$ 2,431,336 100 %$ 2,395,223 100 %
The amount of the portfolio in each grading category may vary substantially from period to period resulting primarily from changes in the composition of the portfolio as a result of new investment, repayment and exit activities. In addition, changes in the grade of investments may be made to reflect our expectation of performance and changes in investment values.
Results of Operations
Comparison of the Three and Six Months Ended
Revenues
Our investment income for the three and six months endedJune 30, 2022 and 2021 was as follows: Three Months Ended June 30, Six Months Ended June 30, 2022 2021 2022 2021 Percentage of Percentage of Percentage of Percentage of Amount Total Income Amount Total Income Amount Total Income Amount Total Income Interest income$ 26,815 57 %$ 27,342 70 %$ 53,902 65 %$ 56,507 73 % Paid-in-kind interest income 7,341 15 % 9,361 24 % 12,469 15 % 17,841 23 % Fee income 9,226 20 % 679 2 % 10,459 13 % 1,195 2 % Dividend income 3,691 8 % 1,574 4 % 6,152 7 % 1,574 2 % Total investment income(1)$ 47,073 100 %$ 38,956 100 %$ 82,982 100 %$ 77,117 100 %
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(1) Such revenues represent$37,875 and$27,139 of cash income earned as well as$9,198 and$11,817 in non-cash portions relating to accretion of discount and PIK interest for the three months endedJune 30, 2022 and 2021, respectively, and represent$66,627 and$53,293 of cash income earned as well as$16,355 and$23,824 in non-cash portions relating to accretion of discount and PIK interest for the six months endedJune 30, 2022 and 2021, respectively. Cash flows related to such non-cash revenues may not occur for a number of reporting periods or years after such revenues are recognized. The level of interest income we receive is generally related to the balance of income-producing investments multiplied by the weighted average yield of our investments. We may experience volatility in the amount of interest income that we earn as the accrual status of existing portfolio investments may fluctuate due to ongoing restructuring activity in the portfolio. The decrease in the amount of interest income and PIK income for the three and six months endedJune 30, 2022 compared to the three and six months endedJune 30, 2021 was primarily due to an increase in repayments on higher-yielding debt investments which were reinvested into assets with lower yields. Fee income is transaction based, and typically consists of prepayment fees and structuring fees. As such, future fee income is generally dependent on new direct origination investments and the occurrence of events at existing portfolio companies resulting in such fees. The increase in the amount of fee income for the three and six months endedJune 30, 2022 compared to the three and six months endedJune 30, 2021 was primarily due to an increase in prepayment fees. The increase in the amount of dividend income for the three and six months endedJune 30, 2022 compared to the three and six months endedJune 30, 2021 was primarily due to the increase in dividends paid with respect to our investments in certain common equity andSustainable Infrastructure Investments, LLC . 44 -------------------------------------------------------------------------------- Table of Contents Expenses Our operating expenses for the three and six months endedJune 30, 2022 and 2021 were as follows: Three Months Ended Six Months Ended June 30, June 30, 2022 2021 2022 2021 Management fees$ 11,276 $ 10,278 $ 22,011 $ 20,928 Administrative services expenses 1,490 1,442 2,910 3,023 Share transfer agent fees 728 728 1,448 1,446 Accounting and administrative fees 189 161 366 347 Interest expense 13,196 12,744 26,890 28,234 Trustees' fees 190 191 417 398 Expenses associated with our independent audit and related fees 112 112 223 223 Legal fees 150 - 150 3 Printing fees 76 123 409 310 Other 530 425 1,530 796 Total operating expenses 27,937 26,204 56,354 55,708 Less: Management fee offset (1,700) (321) (2,398) (323) Net operating expenses$ 26,237 $ 25,883 $ 53,956 $ 55,385 The following table reflects selected expense ratios as a percent of average net assets for the three and six months endedJune 30, 2022 and 2021 (not annualized): Three Months Ended Six Months Ended June 30, June 30, 2022 2021 2022 2021 Ratio of operating expenses to average net assets 1.59 % 1.63 % 3.35 % 3.56 % Ratio of management fee offset to average net assets (0.10) % (0.02) % (0.14) % (0.02) % Ratio of net operating expenses to average net assets 1.49 % 1.61 % 3.21 % 3.54 % Ratio of interest expense to average net assets (0.75) % (0.79) % (1.60) % (1.80) % Ratio of net operating expenses, excluding interest expense, to average net assets 0.74 % 0.82 % 1.61 % 1.74 %
Interest expense may increase or decrease our expense ratios relative to comparative periods depending on changes in benchmark interest rates such as LIBOR, utilization rates and the terms of our financing arrangements, among other factors.
Management Fee Offset
Structuring, upfront or certain other fees received by FS/EIG Advisor or its members which were offset against management fees due to FS/EIG Advisor from us were$1,700 and$321 for the three months endedJune 30, 2022 and 2021, respectively, and$2,398 and$323 for the six months endedJune 30, 2022 and 2021, respectively. See Note 4 to our unaudited consolidated financial statements contained in this quarterly report on Form 10-Q for a discussion of the management fee offset for the three and six months endedJune 30, 2022 and 2021. Net Investment Income Our net investment income totaled$20,836 ($0.05 per share) and$13,073 ($0.03 per share) for the three months endedJune 30, 2022 and 2021, respectively, and$29,026 ($0.06 per share) and$21,732 ($0.05 per share) for the six months endedJune 30, 2022 and 2021, respectively. 45 -------------------------------------------------------------------------------- Table of Contents Net Realized Gains or Losses Our net realized gains (losses) on investments, foreign currency, swap contracts and debt extinguishment for the three and six months endedJune 30, 2022 and 2021, were as follows: Three Months Ended Six Months Ended June 30, June 30, 2022 2021 2022 2021 Net realized gain (loss) on investments(1)$ 60,504
- (6) - (6)
Net realized gain (loss) on swap contracts (1,392) - (1,808) -
Net realized gain (loss) on debt extinguishment (183) - (929) -
Total net realized gain (loss) $ 58,929 _________________________
(1) We sold investments and received principal repayments of$201,929 and$65,138 , respectively, during the three months endedJune 30, 2022 and$97,177 and$129,908 , respectively, during the three months endedJune 30, 2021 . We sold investments and received principal repayments of$270,691 and$236,711 , respectively, during the six months endedJune 30, 2022 and$208,545 and$303,269 , respectively, during the six months endedJune 30, 2021 .
Net Change in Unrealized Appreciation (Depreciation) on Investments and Swap Contracts and Unrealized Gain (Loss) on Foreign Currency
Our net change in unrealized appreciation (depreciation) on investments and swap contracts and unrealized gain (loss) on foreign currency for the three and six months endedJune 30, 2022 and 2021 were as follows: Three Months Ended Six Months Ended June 30, June 30, 2022 2021 2022 2021
Net change in unrealized appreciation (depreciation) on investments
$ (64,079)
(106) - (3,588) -
Net change in unrealized gain (loss) on foreign
currency - 4 - 8
Total net change in unrealized appreciation
(depreciation) and unrealized gain (loss) $ (64,185) During the three and six months endedJune 30, 2022 , the net change in unrealized appreciation (depreciation) on our investments was primarily driven by the performance of our directly originated assets and certain of our upstream equity/other investments and the conversion of unrealized depreciation to realized losses. During the three and six months endedJune 30, 2021 , the net change in unrealized appreciation (depreciation) on our investments was primarily driven by the performance of our directly originated assets and the conversion of unrealized depreciation to realized losses.
Net Increase (Decrease) in Net Assets Resulting from Operations
For the three months endedJune 30, 2022 and 2021, the net increase (decrease) in net assets resulting from operations was$15,580 ($0.03 per share) and$(20,579) ($(0.05) per share), respectively. For the six months endedJune 30, 2022 and 2021, the net increase (decrease) in net assets resulting from operations was$205,363 ($0.46 per share) and$119,207 ($0.27 per share), respectively.
This "Results of Operations" section should be read in conjunction with "COVID-19 and Energy Market Developments" above.
Financial Condition, Liquidity and Capital Resources
Overview
As ofJune 30, 2022 , we had$131,334 in cash, which we held in custodial accounts. As ofJune 30, 2022 , we also had broadly syndicated investments that could be sold to create additional liquidity. As ofJune 30, 2022 , we had eight senior secured loan investments with aggregate unfunded commitments of$60,599 and unfunded commitments of$7,625 inU.S. dollars and$858 in Canadian dollars to contribute capital toSustainable Infrastructure Investments, LLC . We maintain sufficient cash on hand, available borrowings and/or liquid securities to fund such unfunded commitments should the need arise. We generate cash primarily from the issuance of shares under our distribution reinvestment plan and from cash flows from fees, interest and dividends earned from our investments as well as principal repayments and proceeds from sales of our investments. To seek to enhance our returns, we also employ leverage as market conditions permit and at the discretion of FS/EIG Advisor, but unless and until we elect otherwise, as permitted by the 1940 Act, in no event will leverage employed exceed 50% of the value of our assets, as required by the 1940 Act. See "-Financing Arrangements." 46 -------------------------------------------------------------------------------- Table of Contents Prior to investing in securities of portfolio companies, we invest the net proceeds from the issuance of shares under our distribution reinvestment plan as well as from sales and paydowns of existing investments primarily in cash, cash equivalents, including money market funds,U.S. government securities, repurchase agreements and high-quality debt instruments maturing in one year or less from the time of investment, consistent with our BDC election and our election to be taxed as a RIC. In light of difficult market conditions, we took several steps in 2020 to seek to enhance our liquidity by, among other things, suspending our share repurchase program, suspending regular cash distributions and reducing leverage by paying down borrowings. The share repurchase program and regular cash distributions currently remain suspended. This "Financial Condition, Liquidity and Capital Resources" section should be read in conjunction with "COVID-19 and Energy Market Developments" above and "-Financing Arrangements" below.
Financing Arrangements
The following table presents a summary of information with respect to our
outstanding financing arrangements as of
Type of Amount Amount
Arrangement(1) Arrangement Rate(2) Outstanding Available Maturity Date
JPMorgan Facility Revolving/Term L+3.00% $ 305,676 $ - February 16, 2023
Senior Secured Notes(3) Bond 7.50% 457,075 - August 15, 2023 Total$ 762,751 $ -
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(1) The carrying amount outstanding under the facility approximates its fair value, unless otherwise noted.
(2) LIBOR is subject to a 0.00% floor.
(3) As of
The JPMorgan Facility matures onFebruary 16, 2023 and the Senior Secured Notes mature onAugust 15, 2023 . For additional information regarding our financing arrangements, see Note 9 to our unaudited consolidated financial statements included herein.
RIC Tax Treatment and Distributions
We have elected to be treated forU.S. federal income tax purposes, and intend to qualify annually, as a RIC under Subchapter M of the Code. As a RIC, we generally do not have to pay corporate-levelU.S. federal income taxes on any ordinary income or capital gains that we distribute as dividends to our shareholders. To maintain our qualification as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements. In addition, in order to maintain RIC tax treatment, we must distribute to our shareholders, for each tax year, dividends generally of an amount at least equal to 90% of our "investment company taxable income," which is generally the sum of our net ordinary income plus the excess, if any, of realized net short-term capital gains over realized net long-term capital losses, determined without regard to any deduction for dividends paid. In addition, we may, in certain cases, satisfy the Annual Distribution Requirement by distributing dividends relating to a tax year after the close of such tax year under the "spillover dividend" provisions of Subchapter M of the Code. If we distribute a spillover dividend, such dividend will be included in a shareholder's gross income for the tax year in which the spillover distribution is paid. We intend to make sufficient distributions to our shareholders to maintain our RIC tax treatment each tax year. We will also be subject to nondeductibleU.S. federal excise taxes on certain undistributed income unless we distribute in a timely manner to our shareholders of an amount at least equal to the sum of (1) 98% of our net ordinary taxable income (taking into account certain deferrals and elections) for the calendar year, (2) 98.2% of our capital gain net income, which is the excess of capital gains over capital losses (adjusted for certain ordinary losses), for the one-year period endingOctober 31 of that calendar year and (3) 100% of any ordinary income and capital gain net income recognized for the preceding years that were not distributed during such years and on which we paid noU.S. federal income tax. Any distribution declared by us during October, November or December of any calendar year, payable to our shareholders of record on a specified date in such a month and actually paid during January of the following calendar year, will be treated as if it had been paid by us, as well as received by ourU.S. shareholders, onDecember 31 of the calendar year in which the distribution was declared. In general, when we pay regular cash distributions, we intend to declare them on a quarterly or monthly basis and pay them on a monthly basis. We will calculate each shareholder's specific distribution amount for the period using record and declaration dates and each shareholder's distributions will begin to accrue on the date that common shares are issued to such shareholder. From time to time, we may also pay special interim distributions in the form of cash or common shares at the discretion of our board of trustees. The timing and amount of any future distributions to shareholders are subject to applicable legal restrictions and the sole discretion of our board of trustees. 47 -------------------------------------------------------------------------------- Table of Contents Our distribution proceeds have exceeded and in the future may exceed our earnings. Therefore, portions of the distributions that we have made represented, and may make in the future may represent, a return of capital to shareholders, which lowers their tax basis in their common shares. A return of capital generally is a return of an investor's investment rather than a return of earnings or gains derived from our investment activities and will be made after deducting the fees and expenses payable in connection with our continuous public offering, including any fees payable to FS/EIG Advisor. Moreover, a return of capital will generally not be taxable, but will reduce each shareholder's cost basis in our common shares, and will result in a higher reported capital gain or lower reported capital loss when the common shares on which such return of capital was received are sold. Each year a statement on Form 1099-DIV identifying the sources of the distributions will be mailed to our shareholders. We intend to make any regular distributions in the form of cash, out of assets legally available for distribution, unless shareholders elect to receive their cash distributions in additional common shares under our distribution reinvestment plan. Any distributions reinvested under the plan will nevertheless remain taxable to aU.S. shareholder. Although our board of trustees has not declared or resumed regular cash distributions to shareholders for any period afterMarch 31, 2020 , our board of trustees has since declared three cash distributions in 2020, four cash distributions in 2021 and two cash distributions in 2022, each in the amount of$0.03 per share. FS/EIG Advisor and our board of trustees expect that future regular cash distributions to shareholders will remain suspended until such time that our board of trustees and FS/EIG Advisor believe that market conditions and our financial condition support the resumption of such distributions. Our board of trustees has and will continue to evaluate our ability to pay any distributions in the future. There can be no assurance that we will be able to pay distributions in the future. The timing and amount of any future distributions to shareholders are subject to applicable legal restrictions and the sole discretion of our board of trustees. Furthermore, the JPMorgan Facility restricts our ability to make certain discretionary cash dividends and distributions and other restricted payments.
The following table reflects the cash distributions per share that we have
declared on our common shares during the six months ended
Distribution
For the Three Months Ended Per Share Amount
Fiscal 2021
March 31, 2021 $ 0.03 $ 13,249
June 30, 2021 0.03 13,294
Total $ 0.06 $ 26,543
Fiscal 2022
March 31, 2022 $ 0.03 $ 13,426
June 30, 2022 0.03 13,465
Total $ 0.06 $ 26,891 See Note 5 to our unaudited consolidated financial statements included herein for additional information regarding our distributions.
Critical Accounting Policies and Estimates
Our financial statements are prepared in conformity with GAAP, which requires us
to make estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting periods. Management has utilized
available information, including our past history, industry standards and the
current economic environment, among other factors, in forming the estimates and
judgments, giving due consideration to materiality. Actual results may differ
from these estimates. In addition, other companies may utilize different
estimates, which may impact the comparability of our results of operations to
those of companies in similar businesses. Understanding our accounting policies
and the extent to which we use management judgment and estimates in applying
these policies is integral to understanding our financial statements. We
describe our most significant accounting policies in Note 2 to our unaudited
consolidated financial statements included herein. Critical accounting policies
are those that require the application of management's most difficult,
subjective or complex judgments, often because of the need to make estimates
about the effect of matters that are inherently uncertain and that may change in
subsequent periods. We evaluate our critical accounting estimates and judgments
required by our policies on an ongoing basis and update them as necessary based
on changing conditions. We have identified one of our accounting policies,
valuation of portfolio investments, as critical because it involves significant
judgments and assumptions about highly complex and inherently uncertain matters,
and the use of reasonably different estimates and assumptions could have a
material impact on our reported results of operations or financial condition. As
we execute our operating plans, we will describe additional critical accounting
policies in the notes to our future financial statements in addition to those
discussed below.
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Valuation of Portfolio Investments
We determine the fair value of our investment portfolio each quarter. Securities
are valued at fair value as determined in good faith by our board of trustees.
In connection with that determination, FS/EIG Advisor provides our board of
trustees with portfolio company valuations which are based on relevant inputs,
including, but not limited to, indicative dealer quotes, values of like
securities, recent portfolio company financial statements and forecasts, and
valuations prepared by independent third-party valuation services.
Accounting Standards Codification Topic 820, Fair Value Measurements and
Disclosure, or ASC Topic 820, issued by the Financial Accounting Standards
Board , or the FASB, clarifies the definition of fair value and requires
companies to expand their disclosure about the use of fair value to measure
assets and liabilities in interim and annual periods subsequent to initial
recognition. ASC Topic 820 defines fair value as the price that would be
received from the sale of an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date. ASC Topic 820
also establishes a three-tier fair value hierarchy, which prioritizes the inputs
used in measuring fair value. These tiers include: Level 1, defined as
observable inputs such as quoted prices in active markets; Level 2, which
includes inputs such as quoted prices for similar securities in active markets
and quoted prices for identical securities where there is little or no activity
in the market; and Level 3, defined as unobservable inputs for which little or
no market data exists, therefore requiring an entity to develop its own
assumptions.
With respect to investments for which market quotations are not readily available, we undertake a multi-step valuation process each quarter, as described below:
•our quarterly fair valuation process begins with FS/EIG Advisor reviewing and documenting preliminary valuations of each portfolio company or investment;
•such preliminary valuations for each portfolio company or investment are compared to a valuation range that is obtained from an independent third-party valuation service;
•FS/EIG Advisor then provides the valuation committee of our board of trustees, or the valuation committee, its valuation recommendation for each portfolio company or investment, along with supporting materials;
•preliminary valuations are then discussed with the valuation committee;
•the valuation committee reviews the preliminary valuations and FS/EIG Advisor, together with our independent third-party valuation services, if applicable, supplements the preliminary valuations to reflect any comments provided by the valuation committee;
•following its review, the valuation committee will recommend that our board of trustees approve our fair valuations; and
•our board of trustees discusses the valuations and determines the fair value of
each such investment in our portfolio in good faith based on various statistical
and other factors, including the input and recommendation of FS/EIG Advisor, the
valuation committee and any independent third-party valuation services, if
applicable.
Determination of fair value involves subjective judgments and estimates.
Accordingly, the notes to our consolidated financial statements refer to the
uncertainty with respect to the possible effect of such valuations and any
change in such valuations on our consolidated financial statements. In making
its determination of fair value, our board of trustees may use any approved
independent third-party pricing or valuation services. However, our board of
trustees is not required to determine fair value in accordance with the
valuation provided by any single source, and may use any relevant data,
including information obtained from FS/EIG Advisor or any approved independent
third-party valuation or pricing service that our board of trustees deems to be
reliable in determining fair value under the circumstances. Below is a
description of factors that FS/EIG Advisor, any approved independent third-party
valuation services and our board of trustees may consider when determining the
fair value of our investments.
Valuation of fixed income investments, such as loans and debt securities,
depends upon a number of factors, including prevailing interest rates for like
securities, expected volatility in future interest rates, call features, put
features and other relevant terms of the debt. For investments without readily
available market prices, we may incorporate these factors into discounted cash
flow models to arrive at fair value. Other factors that may be considered
include the borrower's ability to adequately service its debt, the fair market
value of the portfolio company in relation to the face amount of its outstanding
debt and the quality of collateral securing our debt investments.
For convertible debt securities, fair value generally approximates the fair
value of the debt plus the fair value of an option to purchase the underlying
security (i.e., the security into which the debt may convert) at the conversion
price. To value such an option, a standard option pricing model may be used.
Our equity interests in portfolio companies for which there is no liquid public
market are valued at fair value. Our board of trustees, in its determination of
fair value, may consider various factors, such as multiples of EBITDA, cash
flows, net income, revenues or, in limited instances, book value, PV-10
multiples or liquidation value. All of these factors may be subject to
adjustments
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based upon the particular circumstances of a portfolio company or our actual
investment position. For example, adjustments to EBITDA may take into account
compensation to previous owners or acquisition, recapitalization, restructuring
or other related items.
FS/EIG Advisor, any approved independent third-party valuation services and our
board of trustees may also consider private merger and acquisition statistics,
public trading multiples discounted for illiquidity and other factors,
valuations implied by third-party investments in the portfolio companies or
industry practices in determining fair value. FS/EIG Advisor, any approved
independent third-party valuation services and our board of trustees may also
consider the size and scope of a portfolio company and its specific strengths
and weaknesses, and may apply discounts or premiums, where and as appropriate,
due to the higher (or lower) financial risk and/or the smaller size of portfolio
companies relative to comparable firms, as well as such other factors as our
board of trustees, in consultation with FS/EIG Advisor and any approved
independent third-party valuation services, if applicable, may consider relevant
in assessing fair value. Generally, the value of our equity interests in public
companies for which market quotations are readily available is based upon the
most recent closing public market price. Portfolio securities that carry certain
restrictions on sale are typically valued at a discount from the public market
value of the security.
When we receive warrants or other equity securities at nominal or no additional
cost in connection with an investment in a debt security, the cost basis in the
investment will be allocated between the debt securities and any such warrants
or other equity securities received at the time of origination. Our board of
trustees subsequently values these warrants or other equity securities received
at their fair value.
Swap contracts typically are valued at their daily prices obtained from an
independent third party. The aggregate settlement values and notional amounts of
the swap contracts are not recorded in the statements of assets and liabilities.
Fluctuations in the value of the swap contracts are recorded in the statements
of assets and liabilities as gross assets and gross liabilities and in the
statements of operations as unrealized appreciation (depreciation) until closed,
when they will be recorded as net realized gain (loss).
The fair values of our investments are determined in good faith by our board of
trustees. Our board of trustees is solely responsible for the valuation of our
portfolio investments at fair value as determined in good faith pursuant to our
valuation policy and consistently applied valuation process. Our board of
trustees has delegated day-to-day responsibility for implementing our valuation
policy to FS/EIG Advisor, and has authorized FS/EIG Advisor to utilize
independent third-party valuation and pricing services that have been approved
by our board of trustees. The valuation committee is responsible for overseeing
FS/EIG Advisor's implementation of the valuation process.
See Note 8 to our unaudited consolidated financial statements included herein for additional information regarding the fair value of our financial instruments.
Contractual Obligations
We have entered into an agreement with FS/EIG Advisor to provide us with investment advisory and administrative services. Payments for investment advisory services under the FS/EIG investment advisory agreement are equal to 1.75% of the average weekly value of our gross assets and an incentive fee based on our performance. Base management fees are generally paid on a quarterly basis in arrears. FS/EIG Advisor is reimbursed for administrative services expenses incurred on our behalf. See Note 4 to our unaudited consolidated financial statements included herein for a discussion of this agreement and for the amount of fees and expenses accrued under this agreement during the six months endedJune 30, 2022 and 2021.
Recently Issued Accounting Standards
InMarch 2020 , the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848), or ASU 2020-04, which provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The amendments apply only to contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued because of reference rate reform. InJanuary 2021 , the FASB issued ASU No. 2021-01, Reference Rate Reform (Topic 848), or ASU 2021-01, which expanded the scope of Topic 848 to include derivative instruments impacted by discounting transition. ASU 2020-04 and ASU 2021-01 are effective for all entities throughDecember 31, 2022 . The expedients and exceptions provided by the amendments do not apply to contract modifications and hedging relationships entered into or evaluated afterDecember 31, 2022 , except for hedging transactions as ofDecember 31, 2022 , that an entity has elected certain optional expedients for and that are retained through the end of the hedging relationship. We are currently evaluating the impact of the adoption of ASU 2020-04 and ASU 2021-01 on our consolidated financial statements.
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