OFS CAPITAL CORPORATION The following analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes thereto contained elsewhere in this Quarterly Report on Form 10-Q. For additional overview information on the Company, see "Item 1. Business" in our Annual Report on Form 10-K for the year endedDecember 31, 2020 . Overview Key performance metrics are presented below:September 30, 2021 June 30 ,
2021
Net asset value per common share $ 14.16$ 13.42 Three Months Ended Nine Months Ended September 30, September 30, 2021 June 30, 2021 2021 2020 Net investment income per common share $ 0.24 $ 0.24$ 0.67 $ 0.69 Net increase (decrease) in net assets resulting from operations per common share 0.98 1.67 2.97 (0.58) Distributions paid per common share 0.24 0.22 0.66 0.68 Our NAV per common share increased 5.5% to$14.16 atSeptember 30, 2021 from$13.42 atJune 30, 2021 , primarily due to net gains on our investment portfolio of$10.2 million , or$0.76 per common share. Net investment income per share of$0.24 was stable compared to the prior quarter. Our net interest margin-total interest income less interest expense- decreased$0.04 per share due to lower interest income. The reduction in interest income was principally attributable to accelerations ofNet Loan Fees from loan prepayments that occurred in the prior quarter. The decrease in net interest margin during the quarter endedSeptember 30, 2021 was offset by a decrease in incentive fees of$0.05 per share. OnNovember 2, 2021 , the Board declared a distribution of$0.25 per share for the fourth quarter of 2021, payable onDecember 31, 2021 to stockholders of record as ofDecember 24, 2021 . As ofSeptember 30, 2021 andDecember 31, 2020 , floating rate loans at fair value, excluding Structured Finance Notes, comprised 97% and 96% of our debt portfolio, respectively, and fixed rate loans at fair value were 3% and 4% of this portfolio, respectively. Structured Finance Notes generally do not carry a stated rate of interest, but the loan portfolios underlying these investments are generally variable rate debt. As ofSeptember 30, 2021 , the weighted average yield on debt and Structured Finance Notes investment was 8.87%, compared to 8.91% as ofJune 30, 2021 . The slight decrease was primarily due to a decline in the yield of our senior secured debt to 7.55% from 7.66% in the prior quarter, as we continue to focus on lower-yielding, first lien senior secured loans to larger borrowers, which we believe will improve our overall risk profile. As ofSeptember 30, 2021 , approximately 86% of our debt was fixed rate and bore a weighted-average interest cost of 5.21%. During the three months endedSeptember 30, 2021 , our portfolio experienced net gains of$10.2 million , or$0.76 per share, principally due to a$8.9 million , or a 3.2%, improvement in the fair values of our directly originated debt and equity investments. The net appreciation in our directly originated investments was primarily attributable to a$6.4 million improvement on our common equity inPfanstiehl Holdings, Inc. , as well as a$1.0 million improvement on our common equity investment inMTE Holdings Corp. , in each case, as a result of improved operating results.Pfanstiehl Holdings, Inc. , a global manufacturer of high-purity pharmaceutical ingredients, accounted for 10.6% of our portfolio at fair value, and 29.3% of our consolidated net assets as ofSeptember 30, 2021 . Since OFS Advisor implemented its business continuity plan inmid-March 2020 , OFS Advisor's entire team has effectively transitioned to remote work and we are currently capable of maintaining our normal functionality to complete our operational requirements. 56 -------------------------------------------------------------------------------- OFS Advisor has actively monitored our portfolio companies throughout this period of economic uncertainty, which has included assessments of our portfolio companies' operational and liquidity outlook. During the three months endedSeptember 30, 2021 , we provided delayed draw term facilities with total commitments of$3.1 million to four portfolio companies and amended seven directly-originated loans. As ofSeptember 30, 2021 , we have unfunded commitments of$13.6 million to twelve portfolio companies. During the three months endedSeptember 30, 2021 , we purchased a Structured Finance Note for a cost of$8.5 million and completed$56.2 million inPortfolio Company Investments. AtSeptember 30, 2021 , our asset coverage ratio of 176% exceeded the minimum asset coverage requirements under the 1940 Act, and we remained in compliance with all applicable financial thresholds under our outstanding debt. As ofSeptember 30, 2021 , we had an unused commitment of$24.25 million under our PWB Credit Facility, as well as an unused commitment of$104.9 million under our BNP Facility, both subject to a borrowing base and other covenants. Based on our portfolio's fair value and our equity capital atSeptember 30, 2021 , we could access these available lines of credit for$133 million and remain in compliance with our asset coverage requirements. We continue to believe that we have sufficient levels of liquidity to support our existing portfolio companies and expect to continue to selectively deploy capital in new investment opportunities in this challenging environment. We cannot predict the full impact of the COVID-19 pandemic, including its duration inthe United States and worldwide, and the magnitude of the economic impact of the outbreak, including the impact of travel restrictions, business closures and other quarantine measures imposed on service providers and other individuals by various local, state, and federal governmental authorities, as well as non-U.S. governmental authorities. As such, we are unable to predict the duration and impact of additional business and supply-chain disruptions, the extent to which the COVID-19 pandemic will negatively affect our portfolio companies' operating results, or the impact that such disruptions may have on our results of operations and financial condition. Depending on the duration and extent of the disruption to the operations of our portfolio companies, we expect that certain portfolio companies will experience financial distress and possibly default on their financial obligations to us and their other capital providers. We also expect that some of our portfolio companies may significantly curtail business operations, furlough or lay-off employees and terminate service providers, and defer capital expenditures if subjected to prolonged and severe financial distress, which would likely impair their business on a permanent basis. These developments would likely result in a decrease in the value of our investment in any such portfolio company. We will continue to monitor the rapidly evolving situation relating to the COVID-19 pandemic and guidance fromU.S. and international authorities, including federal, state and local public health authorities, and may take additional actions based on their recommendations. In these circumstances, there may be developments outside our control requiring us to adjust our plan of operation. As such, given the dynamic nature of this situation, we cannot reasonably estimate the impacts of the COVID-19 pandemic on our financial condition, results of operations or cash flows in the future. However, to the extent our portfolio companies continue to be adversely impacted by the COVID-19 pandemic, our future net investment income, financial condition, results of operations and the fair value of our portfolio investments may be materially adversely impacted. We are also subject to financial risks, including changes in market interest rates. As ofSeptember 30, 2021 , approximately$376 million (principal amount) of our debt investments bore interest at variable rates, which are generally LIBOR-based, and many of which are subject to reference-rate floors. In connection with the COVID-19 pandemic, theU.S. Federal Reserve and other central banks have reduced certain interest rates contributing to the decline in other market interest reference rates, primarily in the second quarter of 2020. A prolonged reduction in interest rates will reduce our gross investment income and could result in a decrease in our net investment income if such decreases are not offset by a corresponding increase in the spread over the reference rates that we earn on our portfolio investments, a decrease in our operating expenses, including with respect to our Income Incentive Fee, or a decrease in the interest rate of our floating interest rate liabilities indexed to LIBOR, or its replacement reference rate(s) when determined. As ofSeptember 30, 2021 , the majority of our variable rate debt investments are subject to the base rate floor, partially mitigating the impact of the recent decrease in LIBOR on our gross investment income. Critical Accounting Policies and Significant Estimates Our critical accounting policies and estimates are those relating to revenue recognition and fair value estimates. Management has discussed the development and selection of each critical accounting policy and estimate with the Audit Committee of the Board. For descriptions of our revenue recognition and fair value policies, see "Item 8. Financial Statements - Notes to Financial Statements - Note 2" and "Management's Discussion and Analysis - Critical Accounting Policies and Significant Estimates" in our Annual Report on Form 10-K for the year endedDecember 31, 2020 . Fair value estimates. Our approach to fair value estimates was significantly adjusted in response to the economic uncertainty associated with the spread of the COVID-19 pandemic, principally through adjustments to the weights given the various methodologies we utilize to estimate discount rates, greater use of pandemic-adjusted forward-looking information, and shortening the evaluation periods used to assess the market depth and liquidity associated with Indicative Prices. These adjustments resulted from observed decreases in the historic correlation between observable inputs utilized on our valuation 57 --------------------------------------------------------------------------------
models. However, as of
Fair Value at Range of Fair Value
September 30,
Investment Type 2021 Low-end High-end
Debt investments:
Senior secured $ 331,970 $ 328,477 $ 335,324
Senior secured (valued at Transaction Prices) 15,977 15,977 15,977
Subordinated 17,525 17,046 18,003
Structured Finance Notes:
Subordinated notes 65,334 63,358 67,309
Mezzanine debt 2,792 2,748 2,837
Loan accumulation facility (valued at
Transaction Price) 8,500 8,500 8,500
Equity investments:
Preferred equity 9,805 8,491 11,060
Common equity, warrants and other 74,176 70,104 80,469
Common equity, warrants and other (valued at
Transaction Prices) 200 200 200
$ 526,279 $ 514,901 $ 539,679
The SEC issued a final rule in 2020 modifying Rule 2a-5 under the 1940 Act to
establish requirements for determining fair value in good faith for purposes of
the 1940 Act. We are evaluating the impact of adopting Rule 2a-5 on the
consolidated financial statements and intend to comply with the new rule's
requirements on or before the compliance date in September 2022 .
Related Party Transactions
We have entered into a number of business relationships with affiliated or
related parties, including the following:
•The Investment Advisory Agreement with OFS Advisor to manage our operating and
investment activities. Under the Investment Advisory Agreement we have agreed to
pay OFS Advisor an annual base management fee based on the average value of our
total assets (other than cash but including assets purchased with borrowed
amounts and including assets owned by any consolidated entity) as well as an
incentive fee based on our investment performance. See "Item 1-Financial
Statements-Note 3".
•The Administration Agreement with OFS Services, an affiliate of OFS Advisor, to
provide us with the office facilities and administrative services necessary to
conduct our operations. See "Item 1-Financial Statements-Note 3.
•A license agreement with OFSAM, the parent company of OFS Advisor, under which
OFSAM has agreed to grant us a non-exclusive, royalty-free license to use the
name "OFS." Under this agreement, we have a right to use the "OFS" name for so
long as OFS Advisor or one of its affiliates remains our investment adviser.
Other than with respect to this limited license, we have no legal right to the
"OFS" name. This license agreement will remain in effect for so long as the
Investment Advisory Agreement with OFS Advisor is in effect.
OFS Advisor's services under the Investment Advisory Agreement are not exclusive
to us and OFS Advisor is free to furnish similar services to other entities,
including other funds affiliated with OFS Advisor, so long as its services to us
are not impaired. OFS Advisor also serves as the investment adviser to CLO funds
and other assets, including HPCI and OCCI. Additionally, OFS Advisor provides
sub-advisory services to CMFT Securities Investments, LLC , a wholly owned
subsidiary of CIM Real Estate Finance Trust, Inc. , a corporation that qualifies
as a real estate investment trust. Additionally, OFS Advisor serves as
sub-adviser to CIM Real Assets & Credit Fund , an externally managed registered
investment company that operates as an interval fund that invests primarily in a
combination of real estate, credit and related investments.
Effective January 1, 2020 , OFS Advisor agreed to further reduce the base
management fee attributable to all of the OFSCC-FS Assets, without regard to the
Company's asset coverage. The agreement reduced the base management fee to 0.25%
per quarter (1.00% annualized) of the average value of the OFSCC-FS Assets at
the end of the two most recently completed
58
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calendar quarters. OFS Advisor's base management fee reduction is renewable on
an annual basis and OFS Advisor is not entitled to recoup the amount of the base
management fee reduced with respect to the OFSCC-FS Assets. This agreement was
renewed for the 2021 calendar year on February 16, 2021 .
The 1940 Act generally prohibits BDCs from making certain negotiated
co-investments with certain affiliates absent an order from the SEC permitting
the BDC to do so. On August 4, 2020 , we received the Order, which superseded a
previous order we received on October 12, 2016 and provides us with greater
flexibility to enter into co-investment transactions with Affiliated Funds. We
are generally permitted to co-invest with Affiliated Funds if a "required
majority" (as defined in Section 57(o) of the 1940 Act) of our independent
directors make certain conclusions in connection with a co-investment
transaction, including that (1) the terms of the transactions, including the
consideration to be paid, are reasonable and fair to us and our stockholders and
do not involve overreaching in respect of us or our stockholders on the part of
any person concerned and (2) the transaction is consistent with the interests of
our stockholders and is consistent with our investment objective and strategies.
In addition, pursuant to an exemptive order issued by the SEC on April 8, 2020
and applicable to all BDCs, through December 31, 2020 , we were permitted,
subject to the satisfaction of certain conditions, to co-invest in our existing
portfolio companies with certain affiliates, even if such other funds had not
previously invested in such existing portfolio company. Without this order,
affiliated funds would not be able to participate in such co-investments with us
unless the affiliated funds had previously acquired securities of the portfolio
company in a co-investment transaction with us. Although the conditional
exemptive order expired on December 31, 2020 , the SEC's Division of Investment
Management has indicated that until March 31, 2022 , it will not recommend
enforcement action, to the extent that any BDC with an existing co-investment
order continues to engage in certain transactions described in the conditional
exemptive order, pursuant to the same terms and conditions described therein.
Conflicts may arise when we make an investment in conjunction with an
investment being made by an Affiliated Account, or in a transaction where an
Affiliated Account has already made an investment. Investment opportunities are,
from time to time, appropriate for more than one account in the same, different
or overlapping securities of a portfolio company's capital structure. Conflicts
arise in determining the terms of investments, particularly where these accounts
may invest in different types of securities in a single portfolio company.
Potential conflicts arise when addressing, among other things, questions as to
whether payment obligations and covenants should be enforced, modified or
waived, or whether debt should be restructured, modified or refinanced. For a
discussion of the risks associated with conflicts of interest, see "Item 1.
Business - Conflicts of Interest", "Item 1A. Risk Factors - Risks Related to OFS
Advisor and its Affiliates -We have potential conflicts of interest related to
the purchases and sales that OFS Advisor makes on our behalf and/or on behalf of
Affiliated Accounts" and "Item 1A. Risk Factors - Regulations - Conflicts of
Interest - Conflicts Related to Portfolio Investments" in our Annual Report on
Form 10-K for the year ended December 31, 2020 .
Portfolio Composition and Investment Activity
Portfolio Composition
As of September 30, 2021 , the fair value of our debt investment portfolio
totaled $365.5 million in 70 portfolio companies, of which 95% and 5% were
senior secured loans and subordinated loans, respectively. As of September 30,
2021 , we had equity investments in 21 portfolio companies with a fair value of
approximately $84.2 million . We also have seventeen investments in Structured
Finance Notes with a fair value of $76.6 million . We had unfunded commitments of
$13.6 million to twelve portfolio companies at September 30, 2021 . Set forth in
the tables and charts below is selected information with respect to our
portfolio as of September 30, 2021 and December 31, 2020 .
The following table presents our investment portfolio by each wholly owned legal
entity within the consolidated group as of September 30, 2021 and December 31,
2020 (dollar amounts in thousands):
September 30, 2021 December 31, 2020
Amortized Cost Fair Value Amortized Cost Fair Value
OFS Capital Corporation (Parent) $ 175,554 $ 165,907 $ 190,627 $ 172,249
SBIC I LP 166,075 198,635 191,192 190,573
OFSCC-FS 154,180 154,494 67,781 68,037
OFSCC-MB 8,292 7,243 11,423 11,464
Total investments $ 504,101 $ 526,279 $ 461,023 $ 442,323
59--------------------------------------------------------------------------------
Portfolio Yields
The weighted average yield on total investments(1) was 8.39% and 8.56% at
September 30, 2021 December 31, 2020
Senior Senior
Secured Subordinated Structured Finance Secured Subordinated Structured Finance
Yield Range Debt Debt Notes Total Debt Debt Notes Total
Less than 8% 50.8 % - % - % 40.0 % 29.5 % - % 1.4 % 24.0 %
8% - 10% 35.0 - 2.5 28.0 52.0 - 1.4 42.2
10% - 12% 5.9 - 19.8 8.1 13.5 - - 10.9
12% - 14% 8.3 53.1 20.6 12.2 3.4 53.6 12.5 7.0
Greater than 14% - 46.9 57.1 11.7 1.6 46.4 84.7 15.9
Total 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 %Weighted average yield - performing debt and Structured Finance Note investments (2) 7.93 % 14.78 % 16.27 % 9.64 % 8.92 % 14.88 % 16.56 % 10.27 % Weighted average yield - total debt and Structured Finance Note investments (3) 7.55 % 6.68 % 16.27 % 8.87 % 8.38 % 5.53 % 16.56 % 9.15 % (1) Weighted average yield on total investments is computed as (a) the sum of (i) the annual stated accruing interest on our debt investments at the balance sheet date plus the annualized accretion ofNet Loan Fees , (ii) the effective yield on our performing preferred equity investments, and (iii) the annual effective yield on Structured Finance Notes, divided by (b) the total amortized cost of our investment portfolio, including equity securities and assets in non-accrual status as of the balance sheet date. (2) The weighted average yield on our performing debt and Structured Finance Note investments is computed as (a) the sum of (i) the annual stated accruing interest on debt investments plus the annualized accretion ofNet Loan Fees ; and (ii) the annual effective yield on Structured Finance Notes divided by (b) amortized cost of our debt and Structured Finance Note investments, excluding debt investments in non-accrual status as of the balance sheet date. (3) The weighted average yield on our total debt and Structured Finance Note investments is computed as (a) the sum of (i) the annual stated accruing interest plus the annualized accretion ofNet Loan Fees and (ii) plus the annual effective yield on Structured Finance Notes divided by (b) amortized cost of our debt and Structured Finance Note investments, including debt investments in non-accrual status as of the balance sheet date. The weighted average yield on performing portfolio company debt securities, including Structured Finance Notes, decreased to 9.64% atSeptember 30, 2021 from 10.27% atDecember 31, 2020 , primarily due to the 8.0% weighted average yield on new debt investments and Structured Finance Notes. During the nine months endedSeptember 30, 2021 , we purchased approximately$141.2 million in debt securities, primarily in lower-yielding, first lien senior secured loans to larger borrowers, with a weighted average yield of 6.9%. The weighted average yield on total debt, including Structured Finance Notes, decreased to 8.87% atSeptember 30, 2021 from 9.15% atDecember 31, 2020 . As ofSeptember 30, 2021 andDecember 31, 2020 , floating rate loans at fair value, excluding Structured Finance Notes, were 97% and 96% of our debt portfolio, respectively, and fixed rate loans at fair value were 3% and 4% of this portfolio, respectively. The weighted average yield of our investments is not the same as a return on investment for our stockholders, but rather the gross investment income from our investment portfolio before the payment of all of our fees and expenses. There can be no assurance that the weighted average yield will remain at its current level. 60 -------------------------------------------------------------------------------- Portfolio Company Investments The following table summarizes the composition of ourPortfolio Company Investments as ofSeptember 30, 2021 andDecember 31, 2020 (dollar amounts in thousands): September 30, 2021 December 31, 2020 Amortized Cost Fair Value Amortized Cost Fair Value Senior secured debt investments (1)$ 362,747 $
347,947
38,117 17,525 45,409 15,067
Preferred equity 13,675 9,805 18,648 11,543
Common equity, warrants and other 13,845 74,376 15,459 52,984
Total Portfolio Company Investments $ 428,384 $
449,653
83 83 62 62
(1) Includes debt investments in which we have entered into contractual
arrangements with colenders whereby, subject to certain conditions, we have
agreed to receive our principal payments after the repayment of certain
colenders pursuant to a payment waterfall. The aggregate amortized cost and
fair value of these investments was $22,400 and $22,800 , respectively, at
September 30, 2021 , and $55,776 and $56,217 , respectively, at December 31, 2020 .
At September 30, 2021 , 95% and 66% of our loan portfolio and total portfolio,
respectively, consisted of senior secured loans, based on fair value.
Approximately 77% of our Portfolio Company Investments at fair value are senior
securities of the borrower, rather than in the subordinated securities,
preferred equity or common equity. We believe the seniority of our debt
investments in the borrowers' capital structures may provide greater downside
protection against adverse economic changes, including those caused by the
COVID-19 pandemic.
As of September 30, 2021 , the three largest industries of our Portfolio Company
Investments by fair value, were (1) Manufacturing (24.7%), (2) Professional,
Scientific, and Technical Services (15.5%), and (3) Wholesale Trade (13.8%),
totaling approximately 54.0% of our Portfolio Company Investment portfolio. For
a full summary of our investment portfolio by industry, see "Item 1-Financial
Statements-Note 4."
As of September 30, 2021 , our common equity in Pfanstiehl Holdings, Inc. based
on its fair value of $55.6 million , $55.4 million of which represents an
unrealized gain, accounts for 10.6% of our total portfolio at fair value, or
29.3% of total net assets. Since December 31, 2020 and December 31, 2019 ,
Pfanstiehl Holdings, Inc. , a global manufacturer of high-purity pharmaceutical
ingredients, has appreciated $19.4 million and $43.6 million , respectively,
primarily due to improved operating results, as well as multiple expansion in
the pharmaceutical industry.
The following table presents our debt investment portfolio by investment size as
of September 30, 2021 and December 31, 2020 (dollar amounts in thousands):
Amortized Cost Fair Value
September 30, 2021 December 31, 2020 September 30, 2021 December 31, 2020
Up to $4,000 $ 66,948 16.7 % $ 30,427 8.2 % $ 67,274 18.4 % $ 33,149 10.3 %
$4,001 to $7,000 94,474 23.6 72,030 19.4 90,249 24.7 68,939 21.5
$7,001 to $10,000 44,039 11.0 51,874 14.0 40,690 11.1 43,735 13.6
$10,001 to $13,000 10,790 2.7 21,013 5.7 32,386 8.9 33,470 10.4
Greater than
$13,000 184,613 46.0 195,711 52.7 134,873 36.9 142,078 44.2
Total $ 400,864 100.0 % $ 371,055 100.0 % $ 365,472 100.0 % $ 321,371 100.0 %
61-------------------------------------------------------------------------------- Investment Activity The following is a summary of ourPortfolio Company Investment activity for the three and nine months endedSeptember 30, 2021 (dollar amounts in millions): Three Months Ended September 30, 2021 Nine Months Ended September 30, 2021 Debt Equity Debt Equity Investments Investments Investments
Investments
New Portfolio Company Investments $
29.5
Add-on Portfolio Company Investments 26.4 - 70.6 - Total Portfolio Company Investments $
55.9
14 1 46 1
Number of add-on Portfolio Company Investments 22 - 47 -
Proceeds/redemptions from principal payments/
equity investments 24.3 - 125.1 -
Proceeds from investments sold or redeemed 7.5 - 17.8 -
Total proceeds from principal payments, equity
distributions and investments sold $
31.8 $ -
Notable investments in new portfolio companies during the nine months endedSeptember 30, 2021 , includeKNS Acquisition Corp. ($5.0 million senior secured loan),Electrical Components International, Inc. ($5.6 million senior secured loan),TruGreen Limited Partnership ($4.6 million senior secured loan), RumbleOn, Inc. ($4.1 million senior secured loan),Directv Financing, LLC ($4.5 million senior secured loan) andMagenta Buyer LLC ($4.8 million senior secured loan). Notable add-on investments during the nine months endedSeptember 30, 2021 , includeAll Star Auto Lights, Inc. ($6.8 million senior secured loan) andConvergint Technologies Holdings, LLC ($10.0 million senior secured loans). During the nine months endedSeptember 30, 2021 , the weighted-average yield of new debt in Portfolio Company Investments was 6.9%. During the nine months endedSeptember 30, 2021 , we also invested$30.4 million in Structured Finance Notes with a weighted average annual effective yield of 15.3%. The following is a summary of ourPortfolio Company Investment activity for the three and nine months endedSeptember 30, 2020 (dollar amounts in millions): Three Months Ended Nine Months Ended September 30, 2020 September 30, 2020 Debt Equity Debt Equity Investments Investments Investments
Investments
Investments in new portfolio companies$ 1.5 $ -$ 43.8 $ - Investments in existing portfolio companies Follow-on investments 7.6 - 17.7 0.1 Restructured investments - 0.2 - 0.9 Delayed draw and revolver funding - - 5.7 - Total investments in existing portfolio companies 7.6 0.2 23.4 1.0 Total investments in new and existing portfolio companies$ 9.1 $ 0.2 $ 67.2 $ 1.0 Number of new portfolio company investments 3 - 13 - Number of existing portfolio company investments 1 3 16 6 Proceeds/distributions from principal payments/ equity investments 3.8 - 60.1 - Proceeds from investments sold or redeemed 1.9 - 63.8 3.6 Total proceeds from principal payments, equity distributions and investments sold$ 5.7 $ -$ 123.9 $ 3.6 62 -------------------------------------------------------------------------------- Notable investments in new portfolio companies during the nine months endedSeptember 30, 2020 , includeA&A Transfer, LLC ($23.7 million senior secured loan and$1.6 million revolver) andSourceHOV Tax, Inc. ($12.8 million senior secured loan). During the nine months endedSeptember 30, 2020 , the weighted-average yield of new debt in Portfolio Company Investments was 8.4%. During the nine months endedSeptember 30, 2020 , we also invested$13.6 million in Structured Finance Notes with a weighted average annual effective yield of 18.9%. Non-cash investment activity OnJune 11, 2021 ,My Alarm Center, LLC's bankruptcy plan became effective and our equity interests were cancelled. For the nine months endedSeptember 30, 2021 , the Company recognized a realized loss of$3.1 million , of which$3.0 million was recognized as an unrealized loss as ofDecember 31, 2020 . OnMarch 27, 2020 , our debt investment inConstellis Holdings, LLC was restructured. We converted our non-accrual debt investment into 20,628 shares of common equity. The fair value of the 20,628 shares of common equity received was$0.7 million , which we recognized as the investment's cost. Risk Monitoring We categorize direct investments in the debt securities of portfolio companies into seven risk categories based on relevant information about the ability of borrowers to service their debt. For additional information regarding our risk categories, see "Item 1. Business-Portfolio Review/Risk Monitoring" in our Annual Report on Form 10-K for the year endedDecember 31, 2020 . The following table shows the classification of our debt securities of portfolio companies, excluding Structured Finance Notes, by credit risk rating as ofSeptember 30, 2021 andDecember 31, 2020 (dollar amounts in thousands): Debt Investments, at Fair Value Risk Category September 30, 2021 December 31, 2020 1 (Low Risk) $ - - % $ - - % 2 (Below Average Risk) - - - - 3 (Average) 341,373 93.4 263,934 82.2 4 (Special Mention) 16,353 4.5 45,302 14.1 5 (Substandard) 7,001 1.9 11,684 3.6 6 (Doubtful) 745 0.2 451 0.1 7 (Loss) - - - -$ 365,472 100.0 %$ 321,371 100.0 % Changes in the distribution of our debt investments across risk categories were a result of new debt investments, the receipt of amortization payments on existing debt investments, repayment of certain debt investments in full, changes in the fair value of our existing debt investments, realized gains on the sale of investments, as well as changes in risk categories. During the nine months endedSeptember 30, 2021 , debt investments with an aggregate cost and fair value of$17.2 million and$16.8 million , respectively, had risk rating upgrades from risk category 4 to risk category 3 and a debt investment with a cost and fair value of$16.1 million and -0- million, respectively, had risk rating downgrades from risk category 5 to risk category 7. Non-Accrual Loans When there is reasonable doubt that principal, cash interest, or PIK interest will be collected, loan investments are placed on non-accrual status and the Company will generally cease recognizing cash interest, PIK interest, and/orNet Loan Fee amortization, as applicable. Interest accruals andNet Loan Fee amortization are resumed on non-accrual investments only when they are brought current with respect to principal, interest and when, in the judgment of management, the investments are estimated to be fully collectible as to all principal. No new loans were placed on non-accrual status during the nine months endedSeptember 30, 2021 . The aggregate amortized cost and fair value of loans on non-accrual status with respect to all interest andNet Loan Fee amortization was$38.2 million and$7.7 million , respectively, atSeptember 30, 2021 , and$48.1 million and$12.1 million , respectively, atDecember 31, 2020 . During the nine months endedSeptember 30, 2021 ,Community Intervention Services, Inc. , a non-accrual loan sinceSeptember 30, 2016 with a cost of$7.6 million , was sold for$0.1 million . 63 -------------------------------------------------------------------------------- Structured Finance Notes The following table summarizes the composition of our Structured Finance Notes as ofSeptember 30, 2021 , andDecember 31, 2020 (in thousands): September 30, 2021 December 31, 2020 Amortized Cost Fair Value Amortized Cost Fair Value Subordinated notes$ 64,572 $ 65,334 $ 54,280 $ 54,724 Mezzanine bonds 2,645 2,792 1,580 1,701 Loan accumulation facility $ 8,500$ 8,500 $ - $ - Total Structured Finance Notes$ 75,717 $
76,626
As ofSeptember 30, 2021 , the weighted average yield on Structured Finance Notes remained stable at 16.27%, compared to 16.56% atDecember 31, 2020 . During the nine months endedSeptember 30, 2021 , we purchased Structured Finance Notes with a the weighted average yield of 15.3%, based on current amortized cost. Results of Operations Our key financial measures are described in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Results of Operations-Key Financial Measures" in our Annual Report on Form 10-K for the year endedDecember 31, 2020 . The following is a discussion of the key financial measures that management employs in reviewing the performance of our operations. We do not believe that our historical operating performance is necessarily indicative of our future results of operations. We are primarily focused on debt investments in middle-market and larger companies inthe United States and, to a lesser extent, equity investments, including warrants and other minority equity securities and Structured Finance Notes, which differs to some degree from our historical investment concentration, in that we now also focus on the debt of largerU.S. companies and Structured Finance Notes. Moreover, as a BDC and a RIC, we will also be subject to certain constraints on our operations, including, but not limited to, limitations imposed by the 1940 Act and the Code. In addition,SBIC I LP is subject to regulation and oversight by the SBA. For the reasons described above, the results of operations described below may not necessarily be indicative of the results we expect to report in future periods. Net increase (decrease) in net assets resulting from operations can vary substantially from period to period for various reasons, including the recognition of realized gains and losses and unrealized appreciation and depreciation. As a result, annual comparisons of net increase (decrease) in net assets resulting from operations may not be meaningful. The following analysis compares our quarterly results of operations to the preceding quarter, as well as our year-to-date results of operations to the corresponding period in the prior year. We believe a comparison of our current quarterly results to the preceding quarter is more meaningful and transparent than a comparison to the corresponding prior-year quarter as our results of operations are not influenced by seasonal factors the latter comparison is designed to elicit and highlight. 64 -------------------------------------------------------------------------------- Comparison of the three months endedSeptember 30, 2021 andJune 30, 2021 and comparison of the nine months endedSeptember 30, 2021 and 2020 Consolidated operating results for the three months endedSeptember 30, 2021 andJune 30, 2021 and the nine months endedSeptember 30, 2021 and 2020 are as follows (in thousands): Nine Months Ended September Three Months Ended 30, September 30, 2021 June 30, 2021 2021 2020 Investment income Interest income: Cash interest income $ 6,771$ 6,972 $ 20,580 $ 26,565 PIK interest income 406 397 1,243 1,222 Net Loan Fee amortization 322 857 1,752 959 Accretion of interest income on Structured Finance Notes 2,645 2,392 7,315 4,141 Other interest income - - 12 54 Total interest income 10,144 10,618 30,902 32,941 Dividend income: Preferred equity PIK dividends 37 59 143 388 Common cash dividends 33 136 169 100 Total dividend income 70 195 312 488 Fee income: Syndication fees 124 439 780 467 Prepayment and other fees 251 164 502 442 Total fee income 375 603 1,282 909 Total investment income 10,589 11,416 32,496 34,338 Total expenses, net 7,354 8,181 23,476 25,047 Net investment income 3,235 3,235 9,020 9,291 Net gain (loss) on investments 10,154 19,206 33,283 (15,619) Loss on extinguishment of debt (224) - (2,523) (336) Loss on impairment of goodwill - - - (1,077) Net increase (decrease) in net assets resulting from operations $ 13,165 $
22,441
Interest income by debt investment type for the three months endedSeptember 30, 2021 andJune 30, 2021 and nine months endedSeptember 30, 2021 and 2020, is summarized below (in thousands): Nine Months Ended September Three Months Ended 30, September 30, 2021 June 30, 2021 2021 2020 Interest income: Senior secured debt investments $ 6,170
708 646 2,014 3,092
Structured Finance Notes 3,266 2,392 7,936 4,183
Total interest income 10,144 10,618 30,902 32,941
Less Net Loan Fees accelerations (118) (551) (1,011) (196)
Recurring interest income $ 10,026 Investment Income Other than acceleration ofNet Loan Fees recognized upon the repayment of a loan, we consider our interest income on direct debt investments to portfolio companies to be recurring in nature. Such recurring interest income remained stable during the three months endedSeptember 30, 2021 compared to the prior quarter. Recurring interest income decreased$2.9 million during the nine months endedSeptember 30, 2021 compared to the corresponding period in the prior year, primarily due to a 65 --------------------------------------------------------------------------------$3.7 million volume variance from a$50 million decrease in the average outstanding performing loan balance, partly offset by a$0.8 million increase from a 28 basis point increase in the recurring earned yield. During the three months endedSeptember 30, 2021 , dividend income decreased$0.1 million compared to the prior quarter due to a distribution from our equity investment inMTE Holding Corp during the prior quarter. Syndication fees, prepayment fees and the acceleration ofNet Loan Fees are considered non-recurring and generally result from periodic transactions rather than from holding portfolio investments. Syndication fees, which are recognized when OFS Advisor sources, structures, and arranges the lending group, and for which we are additionally compensated, decreased to$0.1 million for the three months endedSeptember 30, 2021 compared to$0.4 million for the three months endedJune 30, 2021 . Total fee income for the nine months endedSeptember 30, 2021 compared to the corresponding period in the prior year, increased from$0.9 million to$1.3 million primarily due to a$0.3 million increase in syndication fees. Expenses Operating expenses for the three months endedSeptember 30, 2021 andJune 30, 2021 and nine months endedSeptember 30, 2021 and 2020, are presented below (in thousands): Three Months Ended Nine Months Ended September 30, September 30, 2021 June 30, 2021 2021 2020 Interest expense $ 4,234$ 4,241 $ 13,300 $ 14,301 Management fee 1,950 1,876 5,660 5,759 Incentive fee 102 809 911 1,332 Professional fees 354 489 1,230 1,530 Administration fee 335 439 1,342 1,456 Other expenses 379 327 1,033 1,110 Total expenses before incentive fee waiver 7,354 8,181 23,476 25,488 Incentive fee waiver - - - (441) Total expenses, net of incentive fee waiver $ 7,354 $
8,181
Interest expense for the three months endedSeptember 30, 2021 remained stable compared to the preceding quarter. Interest expense for the nine months endedSeptember 30, 2021 decreased$1.0 million compared to the corresponding period in the prior year, primarily due to a$18.1 million decrease in the weighted average debt balance. Management fee expense for the three months endedSeptember 30, 2021 increased$0.1 million compared to the prior quarter primarily due to the increase in total assets. Management fee expense for the nine months endedSeptember 30, 2021 decreased$0.1 million compared to the corresponding period in the prior year consistent with changes in total assets. The incentive fees earned by OFS Advisor for the three months endedSeptember 30, 2021 decreased$0.7 million compared to the prior quarter due to pre-incentive fee net investment income not exceeding the performance hurdle for incentives in the three months endedSeptember 30, 2021 . For the three months endedSeptember 30, 2021 , the Company accrued a capital gains incentive fee of$0.1 million due to an increase in unrealized capital gains. Incentive fee expense for the nine months endedSeptember 30, 2021 decreased$0.4 million compared to the corresponding period in the prior year, before taking into account the incentive fee waiver during the three months endedMarch 31, 2020 , primarily due to the decrease in net interest margin during 2021. Professional fees for the three months endedSeptember 30, 2021 decreased$0.1 million compared to the prior quarter. Professional fees for the nine months endedSeptember 30, 2021 decreased$0.3 million compared to the corresponding period in the prior year due to a decrease in valuation and consulting services. Administration fee expense for the three and nine months endedSeptember 30, 2021 decreased$0.1 million and$0.1 million , respectively, compared to the prior quarter and prior year due to allocations of administrative services and software. Other expenses for the three months endedSeptember 30, 2021 increased$0.1 million compared to the prior quarter. Other expenses decreased$0.1 million over the prior year primarily due to tax expenses in the corresponding period in the prior year. 66 --------------------------------------------------------------------------------
Net realized and unrealized gain (loss) on investments
Net gain (loss), inclusive of realized and unrealized gains (losses), by
investment type for the three months ended
Three Months Ended Nine Months Ended September 30,
September 30, 2021 June 30, 2021 2021 2020
Senior secured debt $ (460) $ 918 4,338 $ (16,428)
Subordinated debt 145 3,513 2,216 (11,585)
Preferred equity 1,006 (81) 1,646 (2,752)
Common equity, warrants and other 9,094 14,371 24,838 16,942
Structured Finance Notes 196 690 344 (2,212)
Deferred income tax benefit (expense) 173 (205) (99) 416
Total net gain (loss) on investments $ 10,154 $
19,206
Net gain on investments for the three months endedSeptember 30, 2021 andJune 30, 2021 Three months endedSeptember 30, 2021 Our portfolio experienced net gains of$10.2 million in the third quarter of 2021, principally due to a$8.9 million , or 3.2%, improvement in the fair values of our directly originated debt and equity investments. Net gains for the quarter include realized gains of$3.3 million primarily on the sale of our preferred equity inNeosystems Corp. and our common equity inChemical Resources Holdings, Inc. During the three months endedSeptember 30, 2021 , our senior secured debt decreased$0.5 million primarily due to a decrease of$0.7 million in our debt investment inEnvocore Holding, LLC . During the three months endedSeptember 30, 2021 , our portfolio experienced net gains of$1.0 million and$9.1 million on our preferred equity and common equity, respectively. The net gains on our preferred equity investments were primarily attributable to the$0.6 million improvement inStancor, L.P. and$0.5 million improvement inContract Datascan Holdings, Inc. , respectively. The net gains on our common equity investments were primarily attributable to the$6.4 million improvement inPfanstiehl Holdings, Inc. These net gains were primarily attributable to the positive impact of portfolio company-specific performance factors. Three months endedJune 30, 2021 Our portfolio experienced net gains of$19.2 million in the second quarter of 2021, principally due to a$18.3 million , or 6.8%, improvement in the fair values of our directly originated debt and equity investments. Net gains for the quarter include realized losses of$10.8 million primarily on the sale of our subordinated debt investment inCommunity Intervention Services, LLC and the write-off of equity interests inMy Alarm Center, LLC , which were substantially recognized as unrealized losses in prior fiscal years. During the three months endedJune 30, 2021 , our senior secured debt remained stable with the prior quarter, experiencing experienced net gains of$0.9 million . The net appreciation of$3.5 million on our subordinated debt investments in the second quarter of 2021 was primarily attributable to a$3.5 million improvement on our debt investment inEblens Holdings, Inc. The net gain on our common equity in the second quarter of 2021 was primarily attributable to the$12.1 million improvement inPfanstiehl Holdings, Inc. Net gain on investments for the nine months endedSeptember 30, 2021 and 2020 Nine months endedSeptember 30, 2021 During the nine months endedSeptember 30, 2021 , our portfolio experienced net gains of$33.3 million , principally due to a$31.8 million net gain on our directly originated debt and equity investments. During the nine months endedSeptember 30, 2021 , our common equity investment inPfanstiehl Holdings, Inc. and our subordinated debt investment inEblens Holdings, Inc. had unrealized appreciation of$19.4 million and$4.2 million , respectively. Nine months endedSeptember 30, 2020 67 -------------------------------------------------------------------------------- During the nine months endedSeptember 30, 2020 , our portfolio experienced net losses of$15.6 million , primarily due to the adverse economic effects of the COVID-19 pandemic on market conditions and the overall economy, and the related declines in quoted loan prices. Additionally, we incurred realized losses of$10.0 million , primarily due to the loss of$9.1 million on the restructuring of our debt investment inConstellis Holdings, LLC , which was fully recognized as an unrealized loss as ofDecember 31, 2019 . Loss on Impairment ofGoodwill Nine months endedSeptember 30, 2020 The decline in the price of our common stock and the level at which it continues to trade relative to the broader stock indices for the BDC industry led us to conclude in the third quarter of 2020 that an impairment in the value of our goodwill was more likely than not. Moreover, the discount at which our stock traded to its net asset value resulted in our conclusion on the impairment of goodwill equal to the full amount of its carrying value of$1.1 million . The loss on impairment of goodwill did not impact our third quarter management or incentive fees. Loss on Extinguishment of Debt Three and nine months endedSeptember 30, 2021 During the nine months endedSeptember 30, 2021 , we prepaid$35.4 million of SBA debentures and redeemed$98.5 million of unsecured notes, and, as a result, we recognized losses on extinguishment of debt of$2.5 million related to the charge-off of deferred borrowing costs on these instruments. During the three months endedSeptember 30, 2021 , we prepaid$25.6 million of SBA debentures, and, as a result, we recognized a loss on extinguishment of debt of$0.2 million related to the charge-off of deferred borrowing costs on the prepaid debentures. Three and nine months endedSeptember 30, 2020 During the nine months endedSeptember 30, 2020 , we prepaid$21.1 million of SBA debentures that were contractually dueSeptember 1, 2023 ,March 1, 2024 andSeptember 1, 2024 . We recognized losses on extinguishment of debt of$0.24 million related to the charge-off of deferred borrowing costs on the prepaid debentures. During the three months endedSeptember 30, 2020 , the BLA was amended to reduce the total commitment from$100.0 million to$50.0 million . We recognized a loss on extinguishment of debt of$0.1 million related to the charge-off of deferred borrowing costs on the commitment reduction. Liquidity and Capital Resources AtSeptember 30, 2021 , we held cash of$7.0 million , which includes$3.9 million held bySBIC I LP , our wholly owned SBIC, and$1.5 million held by OFSCC-FS. Our use of cash held bySBIC I LP may be restricted by SBA regulation, including limitations on the amount of cashSBIC I LP can distribute to the Parent. Any such distributions to the Parent fromSBIC I LP are generally restricted under SBA regulations to a statutory measure of undistributed accumulated earnings or regulatory capital ofSBIC I LP , and require the prior approval of the SBA. During the nine months endedSeptember 30, 2021 , the Parent received a return of capital distribution of$19.1 million fromSBIC I LP . The Company is limited to follow-on investments in current portfolio companies held throughSBIC I LP . Distributions from OFSCC-FS to the Parent are restricted by the terms and conditions of the BNP Facility. During the nine months endedSeptember 30, 2021 , the Parent received$3.4 million in cash distributions from OFSCC-FS. As ofSeptember 30, 2021 , cash available to be distributed fromSBIC I LP and OFSCC-FS were$16.5 million and$-0 -, respectively. AtSeptember 30, 2021 , we had an unused commitment of$24.25 million under our PWB Credit Facility, as well as an unused commitment of$104.9 million under our BNP Facility, both subject to a borrowing base requirements and other covenants. Based on fair values and equity capital atSeptember 30, 2021 , we could access available lines of credit for$133 million and remain in compliance with our asset coverage requirements. As ofNovember 2, 2021 , we had cash on hand of approximately$37.6 million . We continue to believe that we have sufficient levels of liquidity to support our existing portfolio companies and selectively deploy capital in new investment opportunities in this challenging environment. The Parent may make unsecured loans toSBIC I LP , the aggregate which cannot exceed$35 million at any given time, and no interest may be charged on the unpaid principal balance. There were no intercompany loans between theParent and SBIC I LP as ofSeptember 30, 2021 . Sources and Uses of Cash We generate operating cash flows from net investment income and the net liquidation of portfolio investments, and use cash in our operations in the net purchase of portfolio investments and payment of expenses. Significant variations may exist between net investment income and cash from net investment income, primarily due to the recognition of non-cash investment 68
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