UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2014.
COMMISSION FILE NUMBER: 814-00757
FS Investment Corporation
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
Cira Centre
2929 Arch Street, Suite 675
Philadelphia, Pennsylvania
Registrant’s telephone number, including area code: (215) 495-1150
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨.
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x.
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
The issuer has 262,282,173 shares of common stock outstanding as of May 14, 2014.
TABLE OF CONTENTS
PART I—FINANCIAL INFORMATION
ITEM 1.
Unaudited Consolidated Statements of Operations for the three months ended March 31, 2014 and 2013
Unaudited Consolidated Statements of Changes in Net Assets for the three months ended March 31, 2014 and 2013
Unaudited Consolidated Statements of Cash Flows for the three months ended March 31, 2014 and 2013
Consolidated Schedules of Investments as of March 31, 2014 (Unaudited) and December 31, 2013
ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3.
ITEM 4.
PART II—OTHER INFORMATION
ITEM 1A.
ITEM 5.
ITEM 6.
Consolidated Balance Sheets
(in thousands, except share and per share amounts)
Assets
Investments, at fair value (amortized cost—$3,983,796 and $4,054,085, respectively)
Cash
Receivable for investments sold and repaid
Interest receivable
Deferred financing costs
Prepaid expenses and other assets
Total assets
Liabilities
Payable for investments purchased
Credit facilities payable
Repurchase agreement payable(1)
Stockholder distributions payable
Management fees payable
Accrued capital gains incentive fees(2)
Subordinated income incentive fees payable(2)
Administrative services expense payable
Interest payable
Directors’ fees payable
Other accrued expenses and liabilities
Commitments and contingencies(3)
Total liabilities
Stockholders’ equity
Preferred stock, $0.001 par value, 50,000,000 shares authorized, none issued and outstanding
Common stock, $0.001 par value, 450,000,000 shares authorized, 261,301,955 and 259,320,161 shares issued and outstanding, respectively
Capital in excess of par value
Accumulated undistributed net realized gains on investments and gain/loss on foreign currency(4)
Accumulated undistributed (distributions in excess of) net investment income(4)
Net unrealized appreciation (depreciation) on investments and gain/loss on foreign currency
Total stockholders’ equity
Total liabilities and stockholders’ equity
Net asset value per share of common stock at period end
See notes to unaudited consolidated financial statements.
1
Unaudited Consolidated Statements of Operations
Investment income
Interest income
Fee income
Dividend income
Total investment income
Operating expenses
Management fees
Capital gains incentive fees(1)
Subordinated income incentive fees(1)
Administrative services expenses
Stock transfer agent fees
Accounting and administrative fees
Interest expense
Directors’ fees
Other general and administrative expenses
Total operating expenses
Net investment income
Realized and unrealized gain/loss
Net realized gain (loss) on investments
Net realized gain (loss) on foreign currency
Net change in unrealized appreciation (depreciation) on investments
Net change in unrealized gain (loss) on foreign currency
Total net realized and unrealized gain (loss) on investments
Net increase (decrease) in net assets resulting from operations
Per share information—basic and diluted
Net increase (decrease) in net assets resulting from operations (Earnings per Share)
Weighted average shares outstanding
2
Unaudited Consolidated Statements of Changes in Net Assets
(in thousands)
Operations
Net realized gain (loss) on investments and foreign currency
Stockholder distributions(1)
Distributions from net investment income
Distributions from net realized gain on investments
Net decrease in net assets resulting from stockholder distributions
Capital share transactions
Issuance of common stock
Reinvestment of stockholder distributions
Repurchases of common stock
Offering costs
Net increase in net assets resulting from capital share transactions
Total increase in net assets
Net assets at beginning of period
Net assets at end of period
Accumulated undistributed (distributions in excess of) net investment income(1)
3
Unaudited Consolidated Statements of Cash Flows
Cash flows from operating activities
Adjustments to reconcile net increase (decrease) in net assets resulting from operations to net cash provided by operating activities:
Purchases of investments
Paid-in-kind interest
Proceeds from sales and repayments of investments
Net realized (gain) loss on investments
Net change in unrealized (appreciation) depreciation on investments
Accretion of discount
Amortization of deferred financing costs
(Increase) decrease in receivable for investments sold and repaid
(Increase) decrease in interest receivable
(Increase) decrease in prepaid expenses and other assets
Increase (decrease) in payable for investments purchased
Increase (decrease) in management fees payable
Increase (decrease) in accrued capital gains incentive fees
Increase (decrease) in subordinated income incentive fees payable
Increase (decrease) in administrative services expense payable
Increase (decrease) in interest payable
Increase (decrease) in directors’ fees payable
Increase (decrease) in other accrued expenses and liabilities
Net cash provided by operating activities
Cash flows from financing activities
Stockholder distributions
Borrowings under credit facilities(1)
Borrowings under repurchase agreement(2)
Deferred financing costs paid
Net cash used in financing activities
Total increase (decrease) in cash
Cash at beginning of period
Cash at end of period
Supplemental disclosure
Local and excise taxes paid
4
Unaudited Consolidated Schedule of Investments
As of March 31, 2014
(in thousands, except share amounts)
Portfolio Company(a)
Industry
Senior Secured Loans—First Lien—76.4%
A.P. Plasman Inc.
AccentCare, Inc.
American Pacific Corp.
American Racing and Entertainment, LLC
AP Exhaust Acquisition, LLC
Aspect Software, Inc.
Attachmate Corp.
Avaya Inc.
Azure Midstream Energy LLC
BlackBrush TexStar L.P.
Boomerang Tube, LLC
Cadillac Jack, Inc.
Caesars Entertainment Operating Co.
Caesars Entertainment Resort Properties, LLC
Capital Vision Services, LLC
Cengage Learning, Inc.
Citgo Petroleum Corp.
Clear Channel Communications, Inc.
Clover Technologies Group, LLC
Corel Corp.
Corner Investment PropCo, LLC
CoSentry.Net, LLC
Crestwood Holdings LLC
Dent Wizard International Corp.
Eastman Kodak Co.
Education Management LLC
5
Unaudited Consolidated Schedule of Investments (continued)
ERC Ireland Holdings Ltd.
Extreme Reach, Inc.
FairPoint Communications, Inc.
Flanders Corp.
Florida Gaming Centers, Inc.
FR Utility Services LLC
Fram Group Holdings Inc.
Harlan Sprague Dawley, Inc.
HBC Solutions, Inc.
ILC Industries, LLC
Infiltrator Systems, Inc.
Infogroup Inc.
Insight Equity A.P. X, L.P.
Intralinks, Inc.
inVentiv Health, Inc.
Lantiq Deutschland GmbH
Larchmont Resources, LLC
Leading Edge Aviation Services, Inc.
Leedsworld Inc.
Maritime Telecommunications Network, Inc.
MB Precision Holdings LLC
MetoKote Corp.
Micronics, Inc.
MMI International Ltd.
MMM Holdings, Inc.
MModal Inc.
Mood Media Corp.
MSO of Puerto Rico, Inc.
New HB Acquisition, LLC
New Star Metals Inc.
Nova Wildcat Amerock, LLC
Panda Sherman Power, LLC
Panda Temple Power, LLC (TLA)
6
Princeton Review, Inc.
PRV Aerospace, LLC
RBS Holding Co. LLC
Reddy Ice Holdings, Inc.
Safariland, LLC
Shell Topco L.P.
Sirius Computer Solutions, Inc.
Smile Brands Group Inc.
Sorenson Communication, Inc.
Sports Authority, Inc.
Stallion Oilfield Holdings, Inc.
Swiss Watch International, Inc.
Technicolor SA
Tervita Corp.
Therakos, Inc.
ThermaSys Corp.
Totes Isotoner Corp.
Tri-Northern Acquisition, Inc.
Virtual Radiologic Corp.
VPG Group Holdings LLC
Willbros Group, Inc.
Total Senior Secured Loans—First Lien
Unfunded Loan Commitments
Net Senior Secured Loans—First Lien
Senior Secured Loans—Second Lien—33.9%
Advance Pierre Foods, Inc.
Advantage Sales & Marketing Inc.
Affordable Care, Inc.
Alliance Laundry Systems LLC
American Energy—Utica, LLC
7
Asurion, LLC
Brasa (Holdings) Inc.
Brock Holdings III, Inc.
Camp International Holding Co.
CHG Buyer Corp.
Consolidated Precision Products Corp.
DAE Aviation Holdings, Inc.
DEI Sales, Inc.
EZE Software Group LLC
Ikaria Acquisition Inc.
Kronos Inc.
LM U.S. Member LLC
OSP Group, Inc.
P2 Upstream Acquisition Co.
Paw Luxco II Sarl
Pelican Products, Inc.
Pregis Corp.
PSAV Acquisition Corp.
Ranpak Corp.
Sensus USA Inc.
SESAC Holdings Inc.
Stadium Management Corp.
TravelCLICK, Inc.
Travelport LLC
Vertafore, Inc.
8
Wall Street Systems Holdings, Inc.
Total Senior Secured Loans—Second Lien
Net Senior Secured Loans—Second Lien
Senior Secured Bonds—15.0%
Advanced Lighting Technologies, Inc.
Allen Systems Group, Inc.
FourPoint Energy, LLC
Global A&T Electronics Ltd.
HOA Restaurant Group, LLC
JW Aluminum Co.
Kinetic Concepts, Inc.
Logan’s Roadhouse Inc.
Neff Rental LLC
Ryerson Inc.
SFX Entertainment, Inc.
Speedy Cash Intermediate Holdings Corp.
Total Senior Secured Bonds
Subordinated Debt—14.2%
Alta Mesa Holdings, L.P.
Aurora Diagnostics, LLC
Comstock Resources, Inc.
Ipreo Holdings LLC
9
KODA Distribution Group, Inc.
Monitronics International, Inc.
QR Energy, L.P.
RKI Exploration & Production, LLC
Samson Investment Co.
Sequel Industrial Products Holdings, LLC
Sidewinder Drilling Inc.
Total Subordinated Debt
Collateralized Securities—5.0%
ACASC 2013-2A B
Apidos CDO IV Class E
Ares 2007 CLO 11A Class E
Carlyle Azure CLO Class Income
Dryden CDO 23A Class Subord.
JPMorgan Chase Bank, N.A. Credit-Linked Notes
Lightpoint CLO 2006 V Class D
Rampart CLO 2007 1A Class Subord.
Stone Tower CLO VI Class Subord.
Wind River CLO Ltd. 2012 1A Class Sub B
Total Collateralized Securities
10
Footnotes
Equity/Other—7.3%(l)
American Energy Ohio Holdings, LLC, Common Equity
AP Exhaust Holdings, LLC, Common Equity
Aquilex Corp., Common Equity, Class A Shares
Aquilex Corp., Common Equity, Class B Shares
Burleigh Point, Ltd., Warrants
CoSentry.Net, LLC, Preferred Equity
Eastman Kodak Co., Common Equity
ERC Ireland Holdings Ltd., Common Equity
ERC Ireland Holdings Ltd., Warrants
Flanders Corp., Common Equity
Florida Gaming Centers, Inc., Warrants
Florida Gaming Corp., Warrants
FourPoint Energy, LLC, Common Equity
HBC Solutions, Inc., Common Equity, Class A Units
Ipreo Holdings LLC, Common Equity
JW Aluminum Co., Common Equity
Leading Edge Aviation Services, Inc., Common Equity
Leading Edge Aviation Services, Inc., Preferred Equity
MB Precision Holdings LLC, Common Equity
Micronics, Inc., Common Equity
Micronics, Inc., Preferred Equity
Milagro Holdings, LLC, Common Equity
Milagro Holdings, LLC, Preferred Equity
New Star Metals Inc., Common Equity
Plains Offshore Operations Inc., Preferred Equity
Plains Offshore Operations Inc., Warrants
PSAV Holdings LLC, Common Equity
Safariland, LLC, Common Equity
Safariland, LLC, Preferred Equity
Safariland, LLC, Warrants
Sequel Industrial Products Holdings, LLC, Common Equity
Sequel Industrial Products Holdings, LLC, Preferred Equity
Sequel Industrial Products Holdings, LLC, Warrants
11
ThermaSys Corp., Common Equity
ThermaSys Corp., Preferred Equity
VPG Group Holdings LLC, Class A-2 Units
Total Equity/Other
TOTAL INVESTMENTS—151.8%
LIABILITIES IN EXCESS OF OTHER ASSETS—(51.8%)
NET ASSETS—100%
12
Consolidated Schedule of Investments
As of December 31, 2013
Senior Secured Loans—First Lien—80.4%
Alcatel-Lucent USA Inc.
Audio Visual Services Group, Inc.
Cenveo Corp.
Collective Brands, Inc.
13
Consolidated Schedule of Investments (continued)
14
McGraw-Hill Global Education Holdings, LLC
National Mentor Holdings, Inc.
National Vision, Inc.
Patheon Inc.
Smarte Carte, Inc.
15
Toys “R” Us-Delaware, Inc.
Senior Secured Loans—Second Lien—34.0%
16
Crossmark Holdings, Inc.
Keystone Automotive Operations, Inc.
Mitchell International, Inc.
TNT Crane & Rigging, Inc.
TriZetto Group, Inc.
17
WildHorse Resources, LLC
Senior Secured Bonds—14.6%
Blackboard Inc.
Chassix, Inc.
Dole Food Co., Inc.
18
Subordinated Debt—16.2%
Brand Energy & Infrastructure Services, Inc.
CrownRock, L.P.
Cumulus Media Inc.
Exopack Holdings S.A.
Harland Clarke Holdings Corp.
Hub International Ltd.
Resolute Energy Corp.
19
Collateralized Securities—5.3%
Ares 2007 CLO 12X Class E
JP Morgan Chase Bank, N.A. Credit-Linked Notes
20
Equity/Other—6.2%(k)
21
TOTAL INVESTMENTS—156.7%
LIABILITIES IN EXCESS OF OTHER ASSETS—(56.7%)
NET ASSETS—100.0%
22
23
Notes to Unaudited Consolidated Financial Statements
Note 1. Principal Business and Organization
FS Investment Corporation, or the Company, was incorporated under the general corporation laws of the State of Maryland on December 21, 2007 and formally commenced operations on January 2, 2009. The Company has elected to be regulated as a business development company, or BDC, under the Investment Company Act of 1940, as amended, or the 1940 Act. The Company is an externally managed, non-diversified, closed-end management investment company that has elected to be treated for federal income tax purposes, and intends to qualify annually, as a regulated investment company, or RIC, as defined under Subchapter M of the Internal Revenue Code of 1986, as amended, or the Code. As of March 31, 2014, the Company had five wholly-owned financing subsidiaries and two wholly-owned subsidiaries through which it holds equity interests in non-controlled and non-affiliated portfolio companies. The consolidated financial statements include both the Company’s accounts and the accounts of its wholly-owned subsidiaries as of March 31, 2014. All significant intercompany transactions have been eliminated in consolidation.
The Company’s investment objectives are to generate current income and, to a lesser extent, long-term capital appreciation by investing primarily in senior secured loans and second lien secured loans of private U.S. companies. The Company seeks to generate superior risk-adjusted returns by focusing on debt investments in a broad array of private U.S. companies, including middle market companies, which the Company defines as companies with annual revenues of $50 million to $2.5 billion at the time of investment. The Company may purchase interests in loans through secondary market transactions in the “over-the-counter” market for institutional loans or directly from its target companies as primary market investments.
Note 2. Summary of Significant Accounting Policies
Basis of Presentation: The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP, for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. For a more complete discussion of significant accounting policies and certain other information, the Company’s interim unaudited consolidated financial statements should be read in conjunction with its audited consolidated financial statements as of and for the year ended December 31, 2013 included in the Company’s annual report on Form 10-K for the year ended December 31, 2013. Operating results for the three months ended March 31, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. The December 31, 2013 consolidated balance sheet and consolidated schedule of investments are derived from the Company’s audited consolidated financial statements as of and for the year ended December 31, 2013. The Company has evaluated the impact of subsequent events through the date the consolidated financial statements were issued and filed with the Securities and Exchange Commission, or the SEC.
Use of Estimates: The preparation of the unaudited consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Many of the amounts have been rounded, and all amounts are in thousands, except share and per share amounts.
24
Notes to Unaudited Consolidated Financial Statements (continued)
Note 2. Summary of Significant Accounting Policies (continued)
Capital Gains Incentive Fee: At the Company’s 2013 annual meeting of stockholders, the Company received stockholder approval to amend and restate the investment advisory and administrative services agreement, dated February 12, 2008 (as amended on August 5, 2008), or the investment advisory and administrative services agreement, by and between the Company and FB Income Advisor, LLC, or FB Advisor, effective upon a listing of the Company’s shares of common stock on a national securities exchange. The Company’s shares of common stock were listed and commenced trading on the New York Stock Exchange LLC, or the NYSE, on April 16, 2014. On April 16, 2014, the Company entered into an amended and restated investment advisory agreement, or the amended investment advisory agreement, with FB Advisor. Also on April 16, 2014, the Company entered into an administration agreement with FB Advisor, or the administration agreement, which governs the administrative services provided to the Company by FB Advisor that had previously been addressed in the investment advisory and administrative services agreement. Because the amended investment advisory agreement and the administration agreement did not become effective until April 16, 2014, the investment advisory and administrative services agreement was the operative agreement between the Company and FB Advisor during the three months ended March 31, 2014.
Pursuant to the terms of both the investment advisory and administrative services agreement and the amended investment advisory agreement, the incentive fee on capital gains is determined and payable in arrears as of the end of each calendar year (or upon termination of such agreement). Such fee will equal 20.0% of the Company’s incentive fee capital gains (i.e., the Company’s realized capital gains on a cumulative basis from inception, calculated as of the end of the applicable period, net of all realized capital losses and unrealized capital depreciation on a cumulative basis), less the aggregate amount of any previously paid capital gains incentive fees. On a quarterly basis, the Company accrues for the capital gains incentive fee by calculating such fee as if it were due and payable as of the end of such period.
While the investment advisory and administrative services agreement and the amended investment advisory agreement neither include nor contemplate the inclusion of unrealized gains in the calculation of the capital gains incentive fee, pursuant to an interpretation of an American Institute of Certified Public Accountants, or AICPA, Technical Practice Aid for investment companies, commencing during the quarter ended December 31, 2010, the Company changed its methodology for accruing for this incentive fee to include unrealized gains in the calculation of the capital gains incentive fee expense and related accrued capital gains incentive fee. This accrual reflects the incentive fees that would be payable to FB Advisor if the Company’s entire portfolio was liquidated at its fair value as of the balance sheet date even though FB Advisor is not entitled to an incentive fee with respect to unrealized gains unless and until such gains are actually realized.
Subordinated Income Incentive Fee: Pursuant to both the investment advisory and administrative services agreement and the amended investment advisory agreement, FB Advisor may also be entitled to receive a subordinated incentive fee on income. The subordinated incentive fee on income under the investment advisory and administrative services agreement, which was calculated and payable quarterly in arrears, equaled 20.0% of “pre-incentive fee net investment income” for the immediately preceding quarter and was subject to a hurdle rate, expressed as a rate of return on adjusted capital, as defined in the investment advisory and administrative services agreement, equal to 2.0% per quarter, or an annualized hurdle rate of 8.0%. As a result, FB Advisor would not earn this incentive fee for any quarter until the Company’s pre-incentive fee net investment income for such quarter exceeds the hurdle rate of 2.0%. Once the Company’s pre-incentive fee net investment income in any quarter exceeds the hurdle rate, FB Advisor would be entitled to a “catch-up” fee equal to the amount of the pre-incentive
25
fee net investment income in excess of the hurdle rate, until the Company’s pre-incentive fee net investment income for such quarter equals 2.5%, or 10.0% annually, of adjusted capital. Thereafter, FB Advisor would receive 20.0% of pre-incentive fee net investment income. Under the amended investment advisory agreement, the subordinated incentive fee on income is calculated in the same manner, except that the hurdle rate used to compute the subordinated incentive fee on income is based on the net asset value of the Company’s assets rather than adjusted capital.
Under the amended investment advisory agreement, the subordinated incentive fee on income is subject to a total return requirement, which provides that no incentive fee in respect of the Company’s pre-incentive fee net investment income will be payable except to the extent that 20.0% of the cumulative net increase in net assets resulting from operations over the then-current and eleven preceding calendar quarters exceeds the cumulative incentive fees accrued and/or paid for the eleven preceding calendar quarters. Accordingly, any subordinated incentive fee on income that is payable in a calendar quarter will be limited to the lesser of (i) 20.0% of the amount by which the Company’s pre-incentive fee net investment income for such calendar quarter exceeds the 2.0% hurdle, subject to the “catch-up” provision, and (ii) (x) 20.0% of the cumulative net increase in net assets resulting from operations for the then-current and eleven preceding calendar quarters minus (y) the cumulative incentive fees accrued and/or paid for the eleven preceding calendar quarters. For the foregoing purpose, the “cumulative net increase in net assets resulting from operations” is the sum of pre-incentive fee net investment income, base management fees, realized gains and losses and unrealized appreciation and depreciation of the Company for the then-current and eleven preceding calendar quarters. There will be no accumulation of amounts on the hurdle rate from quarter to quarter and, accordingly, there will be no clawback of amounts previously paid if subsequent quarters are below the quarterly hurdle rate and there will be no delay of payment if prior quarters are below the quarterly hurdle rate.
FB Advisor has recommended that the amended investment advisory agreement be further amended to reduce the annualized hurdle rate used in connection with the calculation of the subordinated incentive fee on income, expressed as a rate of return on the Company’s net assets, from 8.0% to 7.5%. The Company’s board of directors has approved this amendment, and the Company plans to call a special meeting of stockholders of the Company scheduled for June 23, 2014, at which stockholders will be asked to vote on the proposal to amend the amended investment advisory agreement to, among other things, so reduce the annualized hurdle rate.
Reclassifications: Certain amounts in the unaudited consolidated financial statements for the three months ended March 31, 2013 have been reclassified to conform to the classifications used to prepare the unaudited consolidated financial statements for the three months ended March 31, 2014. These reclassifications had no material impact on the Company’s consolidated financial position, results of operations or cash flows as previously reported.
Note 3. Share Transactions
Below is a summary of transactions with respect to shares of the Company’s common stock during the three months ended March 31, 2014 and 2013:
Reinvestment of Distributions
Share Repurchase Program
Net Proceeds from Share Transactions
26
Note 3. Share Transactions (continued)
During the three months ended March 31, 2014 and 2013, the Company issued 2,854,659 and 2,638,800 shares of common stock pursuant to its distribution reinvestment plan for gross proceeds of $29,257 and $26,476 at an average price per share of $10.25 and $10.03, respectively. During the period from April 1, 2014 to May 14, 2014, the Company issued 949,685 shares of common stock pursuant to its distribution reinvestment plan for gross proceeds of $9,783 at a price per share of $10.30.
In connection with the listing of its shares of common stock on the NYSE on April 16, 2014, the Company terminated its distribution reinvestment plan.
Listing and Fractional Shares
The Company’s shares of common stock were listed and commenced trading on the NYSE on April 16, 2014. The Company eliminated any outstanding fractional shares of its common stock in connection with the listing, as permitted by the Maryland General Corporation Law. The Company eliminated all outstanding fractional shares by rounding up the number of fractional shares held by each of the Company’s stockholders to the nearest whole number of shares as of April 4, 2014. As a result of the fractional share round up, the number of outstanding shares was increased by 30,533 shares.
Historically, the Company conducted quarterly tender offers pursuant to its share repurchase program to provide limited liquidity to its stockholders. In anticipation of the listing of the Company’s shares of common stock on the NYSE, the Company’s board of directors terminated its share repurchase program effective March 21, 2014. The listing has provided liquidity to the Company’s stockholders, and therefore the Company does not expect to implement a new share repurchase program in the future.
The following table sets forth the number of shares of common stock repurchased by the Company under its share repurchase program during the three months ended March 31, 2014 and 2013:
For the Three Months Ended
Fiscal 2013
December 31, 2012
Fiscal 2014
December 31, 2013
Listing Tender Offer
On April 16, 2014, the Company commenced a modified “Dutch auction” tender offer, or the tender offer, to purchase for cash up to $250,000 in value of its shares of common stock from its stockholders. In accordance with the terms of the tender offer, the Company intends to select the lowest price, not greater than $11.00 per share or less than $10.35 per share, net to the tendering stockholder in cash, less any applicable withholding taxes
27
and without interest, that will enable the Company to purchase the maximum number of shares of common stock properly tendered in the tender offer and not properly withdrawn having an aggregate purchase price of up to $250,000 or such lesser number if less than $250,000 in value of its shares of common stock are properly tendered in the tender offer after giving effect to any shares of common stock properly withdrawn. The Company expects to use available cash and/or borrowings under its senior secured revolving credit facility with ING Capital LLC, or ING, as administrative agent, and the lenders party thereto, or the ING credit facility, to fund any purchases of its shares of common stock in the tender offer and to pay for all related fees and expenses.
Note 4. Related Party Transactions
Compensation of the Investment Adviser
Pursuant to the investment advisory and administrative services agreement and the amended investment advisory agreement, FB Advisor is entitled to an annual base management fee of 2.0% of the average value of the Company’s gross assets and an incentive fee based on the Company’s performance. The Company commenced accruing fees under the investment advisory and administrative services agreement on January 2, 2009, upon commencement of the Company’s operations. Management fees are paid on a quarterly basis in arrears.
The incentive fee, which had consisted of three parts under the investment advisory and administrative services agreement, now consists of two parts. The first part, which is referred to as the subordinated incentive fee on income is calculated and payable quarterly in arrears, equals 20.0% of “pre-incentive fee net investment income” for the immediately preceding quarter and is subject to a hurdle rate equal to 2.0% per quarter, or an annualized hurdle rate of 8.0%. As a result, FB Advisor will not earn this incentive fee for any quarter until the Company’s pre-incentive fee net investment income for such quarter exceeds the hurdle rate of 2.0%. Once the Company’s pre-incentive fee net investment income in any quarter exceeds the hurdle rate, FB Advisor will be entitled to a “catch-up” fee equal to the amount of the pre-incentive fee net investment income in excess of the hurdle rate, until the Company’s pre-incentive fee net investment income for such quarter equals 2.5%, or 10.0% annually. This “catch-up” feature allows FB Advisor to recoup the fees foregone as a result of the existence of the hurdle rate. Thereafter, FB Advisor will receive 20.0% of pre-incentive fee net investment income.
Under the investment advisory and administrative services agreement, the hurdle rate used to compute the subordinated incentive fee on income was based on adjusted capital. Under the amended investment advisory agreement, the hurdle rate used to compute the subordinated incentive fee on income is based on the net asset value of the Company’s assets rather than adjusted capital. In addition, under the amended investment advisory agreement, the subordinated incentive fee on income is subject to a total return requirement, which provides that no incentive fee in respect of the Company’s pre-incentive fee net investment income will be payable except to the extent that 20.0% of the cumulative net increase in net assets resulting from operations over the then-current and eleven preceding calendar quarters exceeds the cumulative incentive fees accrued and/or paid for the eleven preceding calendar quarters. In other words, any subordinated incentive fee on income that is payable in a calendar quarter will be limited to the lesser of (i) 20.0% of the amount by which the Company’s pre-incentive fee net investment income for such calendar quarter exceeds the 2.0% hurdle, subject to the “catch-up” provision, and (ii) (x) 20.0% of the cumulative net increase in net assets resulting from operations for the then-current and eleven preceding calendar quarters minus (y) the cumulative incentive fees accrued and/or paid for the eleven preceding calendar quarters. For the foregoing purpose, the “cumulative net increase in net assets resulting from operations” is the sum of pre-incentive fee net investment income, base management fees, realized gains and
28
Note 4. Related Party Transactions (continued)
losses and unrealized appreciation and depreciation of the Company for the then-current and eleven preceding calendar quarters. There will be no accumulation of amounts on the hurdle rate from quarter to quarter and, accordingly, there will be no clawback of amounts previously paid if subsequent quarters are below the quarterly hurdle rate and there will be no delay of payment if prior quarters are below the quarterly hurdle rate.
The second part of the incentive fee, which is referred to as the incentive fee on capital gains, is determined and payable in arrears as of the end of each calendar year (or upon termination of the amended investment advisory agreement). This fee equals 20.0% of the Company’s incentive fee capital gains, which equal the Company’s realized capital gains on a cumulative basis from inception, calculated as of the end of the applicable period, computed net of all realized capital losses and unrealized capital depreciation on a cumulative basis, less the aggregate amount of any previously paid capital gain incentive fees. The Company accrues for the capital gains incentive fee, which, if earned, is paid annually. The Company accrues the incentive fee based on net realized and unrealized gains; however, under the terms of the amended investment advisory agreement, the fee payable to FB Advisor is based on realized gains and no such fee is payable with respect to unrealized gains unless and until such gains are actually realized. The methodology for calculating the capital gains incentive fee under the investment advisory and administrative services agreement was identical to the methodology used to calculate such fee under the amended investment advisory agreement.
The third part of the incentive fee under the investment advisory and administrative services agreement was referred to as the subordinated liquidation incentive fee, which equaled 20.0% of the net proceeds from a liquidation of the Company in excess of adjusted capital, as calculated immediately prior to liquidation. The amended investment advisory agreement does not include the subordinated liquidation incentive fee.
In anticipation of the listing of the Company’s shares of common stock on the NYSE, FB Advisor recommended that the amended investment advisory agreement be further amended to (i) reduce the annualized hurdle rate used in connection with the calculation of the subordinated incentive fee on income, expressed as a rate of return on the Company’s net assets, from 8% to 7.5% and (ii) assuming the reduction to the hurdle rate is approved, reduce the base management fee from 2.0% to 1.75% of the average value of the Company’s gross assets. The Company’s board of directors has approved this amendment, and the Company plans to call a special meeting of stockholders of the Company scheduled for June 23, 2014, at which stockholders will be asked to vote on the proposal. Pending stockholder approval of the proposal, FB Advisor has agreed, effective April 1, 2014, to waive a portion of the base management fee to which it is entitled under the amended investment advisory agreement so that the fee received equals 1.75% of the average value of the Company’s gross assets. There can be no assurance this waiver will continue in the future.
Pursuant to the investment advisory and administrative services agreement, the Company reimbursed FB Advisor for expenses necessary to perform services related to the Company’s administration and operations. The amount of this reimbursement was set at the lesser of (1) FB Advisor’s actual costs incurred in providing such services and (2) the amount that the Company estimated it would be required to pay alternative service providers for comparable services in the same geographic location. FB Advisor was required to allocate the cost of such services to the Company based on factors such as total assets, revenues, time allocations and/or other reasonable metrics. The Company’s board of directors then assessed the reasonableness of such reimbursements based on the breadth, depth and quality of such services as compared to the estimated cost to the Company of obtaining similar services from third-party providers known to be available. In addition, the Company’s board of directors considered whether any single third-party service provider would be capable of providing all such services at comparable cost and quality. Finally, the Company’s board of directors compared the total amount paid to FB Advisor for such services as a percentage of the Company’s net assets to the same ratio as reported by other comparable BDCs.
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Pursuant to the administration agreement, FB Advisor will provide administrative services necessary for the operation of the Company, including general ledger accounting, fund accounting, legal services, investor relations and other administrative services. There will be no separate fee paid by the Company to FB Advisor in connection with the services provided under the administration agreement; provided, however, that the Company will reimburse FB Advisor no less than quarterly for all costs and expenses incurred by FB Advisor in performing its obligations and providing personnel and facilities thereunder. FB Advisor will allocate the cost of such services to the Company based on factors such as total assets, revenues, time allocations and/or other reasonable metrics.
The following table describes the fees and expenses accrued under the investment advisory and administrative services agreement during the three months ended March 31, 2014 and 2013:
Related Party
Source Agreement
Description
FB Advisor
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Potential Conflicts of Interest
FB Advisor’s senior management team is comprised of the same personnel as the senior management teams of FS Investment Advisor, LLC, FSIC II Advisor, LLC, FSIC III Advisor, LLC and FS Global Advisor, LLC, the investment advisers to Franklin Square Holdings’ other affiliated BDCs and affiliated closed-end management investment company. As a result, such personnel provide investment advisory services to the Company and each of FS Energy and Power Fund, FS Investment Corporation II, FS Investment Corporation III and FS Global Credit Opportunities Fund. While none of FB Advisor, FS Investment Advisor, LLC, FSIC II Advisor, LLC, FSIC III Advisor, LLC or FS Global Advisor, LLC is currently making private corporate debt investments for clients other than the Company, FS Energy and Power Fund, FS Investment Corporation II, FS Investment Corporation III or FS Global Credit Opportunities Fund, respectively, any, or all, may do so in the future. In the event that FB Advisor undertakes to provide investment advisory services to other clients in the future, it intends to allocate investment opportunities in a fair and equitable manner consistent with the Company’s investment objectives and strategies, if necessary, so that the Company will not be disadvantaged in relation to any other client of FB Advisor or its management team. In addition, even in the absence of FB Advisor retaining additional clients, it is possible that some investment opportunities may be provided to FS Energy and Power Fund, FS Investment Corporation II, FS Investment Corporation III and/or FS Global Credit Opportunities Fund rather than to the Company.
Exemptive Relief
In an order dated June 4, 2013, the SEC granted exemptive relief permitting the Company, subject to satisfaction of certain conditions, to co-invest in certain privately negotiated investment transactions with certain affiliates of FB Advisor, including FS Energy and Power Fund, FS Investment Corporation II, FS Investment Corporation III and any future BDCs that are advised by FB Advisor or its affiliated investment advisers, or, collectively, the Company’s co-investment affiliates. The Company believes this relief may not only enhance its ability to further its investment objectives and strategies, but may also increase favorable investment opportunities for the Company, in part by allowing it to participate in larger investments, together with the Company’s co-investment affiliates, than would be available to it if it had not obtained such relief. Because the Company did not seek exemptive relief to engage in co-investment transactions with its investment sub-adviser, GSO / Blackstone Debt Funds Management LLC, or GDFM, and its affiliates, it will continue to be permitted to co-invest with GDFM and its affiliates only in accordance with existing regulatory guidance.
Expense Reimbursement
Beginning on February 26, 2009, Franklin Square Holdings agreed to reimburse the Company for expenses in an amount that was sufficient to ensure that, for tax purposes, the Company’s net investment income and net capital gains were equal to or greater than the cumulative distributions paid to its stockholders in each quarter. This arrangement was designed to ensure that no portion of the Company’s distributions would represent a return of capital for its stockholders. Under this arrangement, Franklin Square Holdings had no obligation to reimburse any portion of the Company’s expenses.
Pursuant to an expense support and conditional reimbursement agreement, dated as of March 13, 2012, and amended and restated as of May 16, 2013, or, as amended and restated, the expense reimbursement agreement, Franklin Square Holdings has agreed to reimburse the Company for expenses in an amount that is sufficient to
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ensure that no portion of the Company’s distributions to stockholders will be paid from its offering proceeds or borrowings. However, because certain investments the Company may make, including preferred and common equity investments, may generate dividends and other distributions to the Company that are treated for tax purposes as a return of capital, a portion of the Company’s distributions to stockholders may also be deemed to constitute a return of capital for tax purposes to the extent that the Company may use such dividends or other distribution proceeds to fund its distributions to stockholders. Under those circumstances, Franklin Square Holdings will not reimburse the Company for the portion of such distributions to stockholders that represent a return of capital for tax purposes, as the purpose of the expense reimbursement arrangement is not to prevent tax-advantaged distributions to stockholders.
Under the expense reimbursement agreement, Franklin Square Holdings will reimburse the Company for expenses in an amount equal to the difference between the Company’s cumulative distributions paid to its stockholders in each quarter, less the sum of the Company’s net investment income for tax purposes, net capital gains and dividends and other distributions paid to the Company on account of preferred and common equity investments in portfolio companies (to the extent such amounts are not included in net investment income or net capital gains for tax purposes) in each quarter.
Pursuant to the expense reimbursement agreement, the Company has a conditional obligation to reimburse Franklin Square Holdings for any amounts funded by Franklin Square Holdings under such agreement if (and only to the extent that), during any fiscal quarter occurring within three years of the date on which Franklin Square Holdings funded such amount, the sum of the Company’s net investment income for tax purposes, net capital gains and the amount of any dividends and other distributions paid to the Company on account of preferred and common equity investments in portfolio companies (to the extent not included in net investment income or net capital gains for tax purposes) exceeds the distributions paid by the Company to stockholders; provided, however, that (i) the Company will only reimburse Franklin Square Holdings for expense support payments made by Franklin Square Holdings with respect to any calendar quarter beginning on or after July 1, 2013 to the extent that the payment of such reimbursement (together with any other reimbursement paid during such fiscal year) does not cause “other operating expenses” (as defined below) (on an annualized basis and net of any expense support payments received by the Company during such fiscal year) to exceed the lesser of (A) 1.75% of the Company’s average net assets attributable to its shares of common stock for the fiscal year-to-date period after taking such payments into account and (B) the percentage of the Company’s average net assets attributable to its shares of common stock represented by “other operating expenses” during the fiscal year in which such expense support payment from Franklin Square Holdings was made (provided, however, that this clause (B) shall not apply to any reimbursement payment which relates to an expense support payment from Franklin Square Holdings made during the same fiscal year) and (ii) the Company will not reimburse Franklin Square Holdings for expense support payments made by Franklin Square Holdings if the aggregate amount of distributions per share declared by the Company in such calendar quarter is less than the aggregate amount of distributions per share declared by the Company in the calendar quarter in which Franklin Square Holdings made the expense support payment to which such reimbursement relates. “Other operating expenses” means the Company’s total “operating expenses” (as defined below), excluding base management fees, incentive fees, organization and offering expenses, financing fees and costs, interest expense, brokerage commissions and extraordinary expenses. “Operating expenses” means all operating costs and expenses incurred, as determined in accordance with GAAP for investment companies.
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The Company or Franklin Square Holdings may terminate the expense reimbursement agreement at any time. The specific amount of expenses reimbursed by Franklin Square Holdings, if any, will be determined at the end of each quarter. Upon termination of the expense reimbursement agreement by Franklin Square Holdings, Franklin Square Holdings will be required to fund any amounts accrued thereunder as of the date of termination. Similarly, the Company’s conditional obligation to reimburse Franklin Square Holdings pursuant to the terms of the expense reimbursement agreement shall survive the termination of such agreement by either party.
Franklin Square Holdings is controlled by the Company’s chairman and chief executive officer, Michael C. Forman, and its vice-chairman, David J. Adelman. There can be no assurance that the expense reimbursement agreement will remain in effect or that Franklin Square Holdings will reimburse any portion of the Company’s expenses in future quarters. During the three months ended March 31, 2014 and 2013, no such reimbursements were required from Franklin Square Holdings.
Note 5. Distributions
The following table reflects the cash distributions per share that the Company has declared and paid on its common stock during the three months ended March 31, 2014 and 2013:
March 31, 2013
March 31, 2014
On March 31, 2014, the Company’s board of directors determined to increase the amount of the regular monthly cash distribution payable to stockholders of record from $0.0720 per share to $0.07425 per share in order to increase the Company’s annual distribution rate from 8.41% to 8.68% (based on the Company’s last publicly reported net asset value per share of $10.27 as of February 28, 2014). The increase in the regular monthly cash distribution to $0.07425 per share commenced with the regular monthly cash distribution payable on April 30, 2014 to stockholders of record as of April 29, 2014. On May 5, 2014, the Company’s board of directors declared a regular monthly cash distribution of $0.07425 per share. The regular monthly cash distribution will be paid on or about May 30, 2014 to stockholders of record on May 29, 2014.
The board of directors of the Company intends to declare two special cash distributions, each in the amount of $0.10 per share, that will be paid on or about August 15, 2014 and November 14, 2014 to stockholders of record as of July 31, 2014 and October 31, 2014, respectively. The payment of the two special cash distributions, like all future distributions, is subject to applicable legal restrictions and the sole discretion of the Company’s board of directors.
Historically, the Company had an “opt in” distribution reinvestment plan for its stockholders, which terminated upon the listing of the Company’s shares of common stock on the NYSE. Under that plan, if the Company made a cash distribution, its stockholders received distributions in cash unless they specifically “opted in” to the distribution reinvestment plan so as to have their cash distributions reinvested in additional shares of the Company’s common stock. The Company’s board of directors has approved the implementation of a new distribution reinvestment plan, the terms of which have not yet been finalized. The Company expects the new
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Note 5. Distributions (continued)
distribution reinvestment plan to be implemented in connection with the regular monthly cash distribution in June; however, there can be no assurance as to whether or when a new distribution reinvestment plan will be implemented. Pending the adoption of a new distribution reinvestment plan, stockholders that had elected to participate in the earlier distribution reinvestment plan will receive cash rather than shares of common stock in respect of any cash distribution the Company declares.
The Company may fund its cash distributions to stockholders from any sources of funds available to it, including proceeds from the sale of shares of the Company’s common stock, borrowings, net investment income from operations, capital gains proceeds from the sale of assets, non-capital gains proceeds from the sale of assets, dividends or other distributions paid to the Company on account of preferred and common equity investments in portfolio companies and expense reimbursements from Franklin Square Holdings. The Company has not established limits on the amount of funds it may use from available sources to make distributions. During certain periods, the Company’s distributions may exceed its earnings. As a result, it is possible that a portion of the distributions the Company makes will represent a return of capital. A return of capital generally is a return of a stockholder’s investment rather than a return of earnings or gains derived from the Company’s investment activities. Each year a statement on Form 1099-DIV identifying the sources of the distributions (i.e., paid from ordinary income, paid from net capital gains on the sale of securities, and/or a return of paid-in capital surplus, which is a nontaxable distribution) will be mailed to the Company’s stockholders. There can be no assurance that the Company will be able to pay distributions at a specific rate or at all.
The following table reflects the sources of the cash distributions on a tax basis that the Company has paid on its common stock during the three months ended March 31, 2014 and 2013:
Source of Distribution
Offering proceeds
Borrowings
Net investment income(1)
Capital gains proceeds from the sale of assets
Non-capital gains proceeds from the sale of assets
Distributions on account of preferred and common equity
Expense reimbursement from sponsor
Total
The Company’s net investment income on a tax basis for the three months ended March 31, 2014 and 2013 was $51,851 and $57,068, respectively. As of March 31, 2014 and December 31, 2013, the Company had $151,267 and $137,867, respectively, of undistributed net investment income and realized gains on a tax basis.
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The difference between the Company’s GAAP-basis net investment income and its tax-basis net investment income is primarily due to the reversal of the required accrual for GAAP purposes of incentive fees on unrealized gains even though no such incentive fees on unrealized gains are payable by the Company and the reclassification of unamortized original issue discount recognized upon prepayment of loans from income for GAAP purposes to realized gains for tax purposes.
The following table sets forth a reconciliation between GAAP-basis net investment income and tax-basis net investment income during the three months ended March 31, 2014 and 2013:
GAAP-basis net investment income
Reversal of incentive fee accrual on unrealized gains
Reclassification of unamortized original issue discount
Other miscellaneous differences
Tax-basis net investment income
The determination of the tax attributes of the Company’s distributions is made annually as of the end of the Company’s fiscal year based upon the Company’s taxable income for the full year and distributions paid for the full year. Therefore, a determination made on a quarterly basis may not be representative of the actual tax attributes of the Company’s distributions for a full year. The actual tax characteristics of distributions to stockholders are reported to stockholders annually on Form 1099-DIV.
As of March 31, 2014 and December 31, 2013, the components of accumulated earnings on a tax basis were as follows:
Distributable ordinary income
Distributable realized gains
Incentive fee accrual on unrealized gains
Unamortized organization costs
Net unrealized appreciation (depreciation) on investments and gain/loss on foreign currency(1)
The aggregate cost of the Company’s investments for federal income tax purposes totaled $4,000,025 and $4,070,314 as of March 31, 2014 and December 31, 2013, respectively. The aggregate net unrealized appreciation (depreciation) on a tax basis was $77,465 and $67,085 as of March 31, 2014 and December 31, 2013, respectively.
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Note 6. Investment Portfolio
The following table summarizes the composition of the Company’s investment portfolio at cost and fair value as of March 31, 2014 and December 31, 2013:
Senior Secured Loans—First Lien
Senior Secured Loans—Second Lien
Senior Secured Bonds
Subordinated Debt
Collateralized Securities
Equity/Other
As of March 31, 2014, the Company did not “control” and was not an “affiliate” of any of its portfolio companies, each as defined in the 1940 Act. In general, under the 1940 Act, the Company would be presumed to “control” a portfolio company if it owned 25% or more of its voting securities and would be an “affiliate” of a portfolio company if it owned 5% or more of its voting securities.
The Company’s investment portfolio may contain loans that are in the form of lines of credit or revolving credit facilities, which require the Company to provide funding when requested by portfolio companies in accordance with the terms of the underlying loan agreements. As of March 31, 2014, the Company had six such investments with aggregate unfunded commitments of $90,641 and one equity/other investment, American Energy Ohio Holdings, LLC, with an unfunded commitment of $2,313. As of December 31, 2013, the Company had five such investments with aggregate unfunded commitments of $48,439 and one equity/other investment, American Energy Ohio Holdings, LLC, with an unfunded commitment of $4,629. The Company maintains sufficient cash on hand and available borrowings to fund such unfunded commitments should the need arise.
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Note 6. Investment Portfolio (continued)
The table below describes investments by industry classification and enumerates the percentage, by fair value, of the total portfolio assets in such industries as of March 31, 2014 and December 31, 2013:
Industry Classification
Automobiles & Components
Capital Goods
Commercial & Professional Services
Consumer Durables & Apparel
Consumer Services
Diversified Financials
Energy
Food & Staples Retailing
Food, Beverage & Tobacco
Health Care Equipment & Services
Household & Personal Products
Insurance
Materials
Media
Pharmaceuticals, Biotechnology & Life Sciences
Retailing
Software & Services
Technology Hardware & Equipment
Telecommunication Services
Transportation
Note 7. Fair Value of Financial Instruments
Under existing accounting guidance, fair value is defined as the price that the Company would receive upon selling an investment or pay to transfer a liability in an orderly transaction to a market participant in the principal or most advantageous market for the investment. This accounting guidance emphasizes that valuation techniques maximize the use of observable market inputs and minimize the use of unobservable inputs. Inputs refer broadly to the assumptions that market participants would use in pricing an asset or liability, including assumptions about risk. Inputs may be observable or unobservable. Observable inputs are inputs that reflect the assumptions market participants would use in pricing an asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the assumptions market participants would use in pricing an asset or liability developed based on the best information available in the circumstances. The Company classifies the inputs used to measure these fair values into the following hierarchy as defined by current accounting guidance:
Level 1: Inputs that are quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2: Inputs that are quoted prices for similar assets or liabilities in active markets.
Level 3: Inputs that are unobservable for an asset or liability.
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Note 7. Fair Value of Financial Instruments (continued)
A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
As of March 31, 2014 and December 31, 2013, the Company’s investments were categorized as follows in the fair value hierarchy:
Valuation Inputs
Level 1—Price quotations in active markets
Level 2—Significant other observable inputs
Level 3—Significant unobservable inputs
The Company’s investments as of March 31, 2014 consisted primarily of debt securities that are traded on a private over-the-counter market for institutional investors. Except as described below, the Company valued its investments by using the midpoint of the prevailing bid and ask prices from dealers on the date of the relevant period end, which were provided by independent third-party pricing services and screened for validity by such services. Thirty-one senior secured loan investments, one senior secured bond investment, six subordinated debt investments and one collateralized security, for which broker quotes were not available, were valued by an independent valuation firm, which determined the fair value of such investments by considering, among other factors, the borrower’s ability to adequately service its debt, prevailing interest rates for like investments, expected cash flows, call features and other relevant terms of the debt. Except as described below, all of the Company’s equity/other investments were valued by the same independent valuation firm, which determined the fair value of such investments by considering, among other factors, contractual rights ascribed to such investments, as well as various income scenarios and multiples of earnings before interest, taxes, depreciation and amortization, or EBITDA, cash flows, net income, revenues or, in limited instances, book value or liquidation value. One senior secured loan investment and one equity investment, each of which was newly-issued and purchased near March 31, 2014, were valued at cost, as the Company’s board of directors determined that the cost of each such investment was the best indication of its fair value. Also, one equity investment which is traded on an active public market was valued at its closing price on March 31, 2014 and two equity/other investments were valued by an independent third-party pricing service in the manner described above.
The Company’s investments as of December 31, 2013 consisted primarily of debt securities that are traded on a private over-the-counter market for institutional investors. Except as described below, the Company valued its investments by using the midpoint of the prevailing bid and ask prices from dealers on the date of the relevant period end, which were provided by independent third-party pricing services and screened for validity by such services. Twenty-seven senior secured loan investments, six subordinated debt investments and one collateralized security, for which broker quotes were not available, were valued by an independent valuation firm, which determined the fair value of such investments by considering, among other factors, the borrower’s ability to adequately service its debt, prevailing interest rates for like investments, expected cash flows, call features and other relevant terms of the debt. Except as described below, all of the Company’s equity/other investments were valued by the same independent valuation firm, which determined the fair value of such investments by
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considering, among other factors, contractual rights ascribed to such investments, as well as various income scenarios and multiples of EBITDA, cash flows, net income, revenues or, in limited instances, book value or liquidation value. Also, one equity investment which is traded on an active public market was valued at its closing price as of December 31, 2013.
The Company periodically benchmarks the bid and ask prices it receives from the third-party pricing services against the actual prices at which the Company purchases and sells its investments. Based on the results of the benchmark analysis and the experience of the Company’s management in purchasing and selling these investments, the Company believes that these prices are reliable indicators of fair value. However, because of the private nature of this marketplace (meaning actual transactions are not publicly reported), the Company believes that these valuation inputs are classified as Level 3 within the fair value hierarchy. The Company may also use other methods to determine fair value for securities for which it cannot obtain prevailing bid and ask prices through third-party pricing services or independent dealers, including the use of an independent valuation firm. The Company periodically benchmarks the valuations provided by the independent valuation firm against the actual prices at which the Company purchases and sells its investments. The Company’s valuation committee and board of directors reviewed and approved the valuation determinations made with respect to these investments in a manner consistent with the Company’s valuation process.
The following is a reconciliation for the three months ended March 31, 2014 and 2013 of investments for which significant unobservable inputs (Level 3) were used in determining fair value:
Fair value at beginning of period
Accretion of discount (amortization of premium)
Net realized gain (loss)
Net change in unrealized appreciation (depreciation)
Purchases
Sales and redemptions
Net transfers in or out of Level 3
Fair value at end of period
The amount of total gains or losses for the period included in changes in net assets attributable to the change in unrealized gains or losses relating to investments still held at the reporting date
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The valuation techniques and significant unobservable inputs used in recurring Level 3 fair value measurements of assets valued by an independent valuation firm as of March 31, 2014 and December 31, 2013 were as follows:
Type of Investment
Valuation
Technique(2)
Unobservable Input
Except as otherwise described in this footnote, the remaining Level 3 assets were valued by using the midpoint of the prevailing bid and ask prices from dealers as of March 31, 2014, which were provided by independent third-party pricing services and screened for validity by such services. One senior secured loan investment ($40,000) and one equity investment ($750), each of which was newly-issued and purchased near March 31, 2014, were valued at cost, as the Company’s board of directors determined that the cost of
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ValuationTechnique(2)
Unobservable
Input
EBITDA
Multiples (x)
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Note 8. Financing Arrangements
The following table presents summary information with respect to the Company’s outstanding financing arrangements as of March 31, 2014. For additional information regarding these financing facilities, please see the notes to the Company’s audited consolidated financial statements contained in its annual report on Form 10-K for the year ended December 31, 2013 and the additional disclosure set forth in this Note 8.
Facility
Rate
Arch Street Credit Facility
Broad Street Credit Facility
JPM Facility
Walnut Street Credit Facility
On August 29, 2012, Arch Street Funding LLC, or Arch Street, the Company’s wholly-owned, special-purpose financing subsidiary, terminated its total return swap financing arrangement, or TRS, with Citibank, N.A., or Citibank, and entered into a revolving credit facility, or the Arch Street credit facility, with Citibank, as administrative agent, and the financial institutions and other lenders from time to time party thereto.
On March 31, 2014, Arch Street and Citibank amended the Arch Street credit facility to, among other things, (a) increase the interest rate applicable to loans outstanding thereunder (i) during the drawdown period to three-month LIBOR plus 2.05%, and (ii) thereafter, to three-month LIBOR plus 2.30%, (b) extend the final maturity date to August 29, 2016, (c) reduce the maximum commitments thereunder to $350,000, (d) add a financial covenant requiring that the Company maintain its net asset value at more than $200,000 and (e) modify the calculation of advance rates and certain eligibility and valuation criteria, in each case, applicable to Arch Street’s portfolio of debt securities that are pledged as collateral for the Arch Street credit facility. The Company paid certain fees to Citibank in connection with this amendment.
The Arch Street credit facility provides for borrowings in an aggregate principal amount up to $350,000 on a committed basis. The Company may contribute cash or debt securities to Arch Street from time to time, subject to certain restrictions set forth in the Arch Street credit facility, and will retain a residual interest in any assets contributed through its ownership of Arch Street or will receive fair market value for any debt securities sold to Arch Street. Arch Street may purchase additional debt securities from various sources. Arch Street’s obligations to the lenders under the facility are secured by a first priority security interest in substantially all of the assets of Arch Street, including its portfolio of debt securities. The obligations of Arch Street under the facility are non-recourse to the Company and the Company’s exposure under the facility is limited to the value of the Company’s investment in Arch Street.
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Note 8. Financing Arrangements (continued)
Borrowings under the Arch Street credit facility accrue interest at a rate equal to three-month LIBOR plus 2.05% per annum through August 29, 2014 and three-month LIBOR plus 2.30% per annum thereafter. Borrowings under the facility are subject to compliance with an equity coverage ratio with respect to the current value of Arch Street’s portfolio and a loan compliance test with respect to the initial acquisition of each debt security in Arch Street’s portfolio. Beginning November 27, 2012, Arch Street became required to pay a non-usage fee to the extent the aggregate principal amount available under the Arch Street credit facility is not borrowed. Outstanding borrowings under the facility will be amortized beginning nine months prior to the scheduled maturity date. Any amounts borrowed under the facility will mature, and all accrued and unpaid interest thereunder will be due and payable, on August 29, 2016.
As of March 31, 2014 and December 31, 2013, $373,682 was outstanding under the Arch Street credit facility. The carrying amount of the amount outstanding under the facility approximates its fair value. The Company incurred costs of $4,446 in connection with obtaining the Arch Street credit facility, which the Company has recorded as deferred financing costs on its consolidated balance sheets and amortizes to interest expense over the life of the facility. As of March 31, 2014, $2,093 of such deferred financing costs had yet to be amortized to interest expense.
For the three months ended March 31, 2014 and 2013, the components of total interest expense, cash paid for interest expense, average borrowings, effective interest rate and weighted average interest rate for the Arch Street credit facility were as follows:
Direct interest expense
Non-usage fees
Total interest expense
Cash paid for interest expense
Average borrowings under the facility
Effective interest rate on borrowings
Weighted average interest rate (including the effect of non-usage fees)
Borrowings of Arch Street will be considered borrowings of the Company for purposes of complying with the asset coverage requirements under the 1940 Act applicable to BDCs.
On January 28, 2011, Broad Street Funding LLC, or Broad Street, the Company’s wholly-owned, special-purpose financing subsidiary, Deutsche Bank AG, New York Branch, or Deutsche Bank, and the other lenders party thereto entered into an amended and restated multi-lender, syndicated revolving credit facility, or the Broad Street credit facility, which amended and restated the revolving credit facility that Broad Street originally entered into with Deutsche Bank on March 10, 2010 and the amendments thereto. On March 23, 2012, Broad Street and Deutsche Bank entered into an amendment to the Broad Street credit facility which extended the maturity date of
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the facility to March 23, 2013, increased the aggregate amount which could be borrowed under the facility to $380,000 and reduced the interest rate for all borrowings under the facility to a rate of LIBOR, for an interest period equal to the weighted average LIBOR interest period of debt securities owned by Broad Street, plus 1.50% per annum. On December 13, 2012, Broad Street repaid $140,000 of borrowings under the facility, thereby reducing the amount which could be borrowed under the facility to $240,000. On March 22, 2013, Broad Street and Deutsche Bank entered into an amendment to the facility to extend the maturity date of the facility to December 22, 2013. On December 20, 2013, Broad Street and Deutsche Bank entered into a further amendment to the facility which extended the maturity date to December 20, 2014 and reduced the maximum amount which could be borrowed under the facility to $125,000. The Broad Street credit facility provides for borrowings of up to $125,000 at a rate of LIBOR, for an interest period equal to the weighted average LIBOR interest period of debt securities owned by Broad Street, plus 1.50% per annum. Deutsche Bank is a lender and serves as administrative agent under the facility.
Under the Broad Street credit facility, the Company transfers debt securities to Broad Street from time to time as a contribution to capital and retains a residual interest in the contributed debt securities through its ownership of Broad Street. The obligations of Broad Street under the facility are non-recourse to the Company and its exposure under the facility is limited to the value of its investment in Broad Street.
As of March 31, 2014 and December 31, 2013, $125,000 was outstanding under the Broad Street credit facility. The carrying amount of the amount outstanding under the facility approximates its fair value. The Company incurred costs of $2,566 in connection with obtaining and amending the facility, which the Company has recorded as deferred financing costs on its consolidated balance sheets and amortizes to interest expense over the life of the facility. As of March 31, 2014, all of the deferred financing costs have been amortized to interest expense.
For the three months ended March 31, 2014 and 2013, the components of total interest expense, cash paid for interest expense, average borrowings, effective interest rate and weighted average interest rate for the Broad Street credit facility were as follows:
Borrowings of Broad Street will be considered borrowings of the Company for purposes of complying with the asset coverage requirements under the 1940 Act applicable to BDCs.
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JPM Financing
On April 23, 2013, through its two wholly-owned, special-purpose financing subsidiaries, Locust Street Funding LLC, or Locust Street, and Race Street Funding LLC, or Race Street, the Company entered into an amendment, or the April 2013 amendment, to its debt financing arrangement with JPMorgan Chase Bank, N.A., London Branch, or JPM, which was originally entered into on July 21, 2011 (and previously amended on September 26, 2012). The April 2013 amendment, among other things: (i) increased the amount of debt financing available under the arrangement from $700,000 to $950,000; and (ii) extended the final repurchase date under the financing arrangement from October 15, 2016 to April 15, 2017. The Company elected to structure the financing in the manner described more fully below in order to, among other things, obtain such financing at a lower cost than would be available through alternate arrangements.
Pursuant to the financing arrangement, the assets held by Locust Street secure the obligations of Locust Street under certain Class A Floating Rate Notes, or the Class A Notes, to be issued from time to time by Locust Street to Race Street pursuant to the Amended and Restated Indenture, dated as of September 26, 2012 and as supplemented by Supplemental Indenture No. 1, dated April 23, 2013, with Citibank, as trustee, or the Amended and Restated Indenture. Pursuant to the Amended and Restated Indenture, the aggregate principal amount of Class A Notes that may be issued by Locust Street from time to time is $1,140,000. All principal and interest on the Class A Notes will be due and payable on the stated maturity date of April 15, 2024. Race Street will purchase the Class A Notes to be issued by Locust Street from time to time at a purchase price equal to their par value.
Race Street, in turn, has entered into an amended repurchase transaction with JPM pursuant to the terms of an amended and restated global master repurchase agreement and the related annex and amended and restated confirmation thereto, each dated as of April 23, 2013, and subsequently amended as of October 24, 2013, or, collectively, the JPM Facility. Pursuant to the JPM Facility, JPM has agreed to purchase from time to time Class A Notes held by Race Street for an aggregate purchase price equal to approximately 83.33% of the principal amount of Class A Notes purchased. Subject to certain conditions, the maximum principal amount of Class A Notes that may be purchased under the JPM Facility is $1,140,000. Accordingly, the maximum amount payable at any time to Race Street under the JPM Facility is $950,000. Under the JPM Facility, Race Street will, on a quarterly basis, repurchase the Class A Notes sold to JPM under the JPM Facility and subsequently resell such Class A Notes to JPM. The final repurchase transaction must occur no later than April 15, 2017. The repurchase price paid by Race Street to JPM for each repurchase of Class A Notes will be equal to the purchase price paid by JPM for such Class A Notes, plus interest thereon accrued at a fixed rate of 3.25% per annum. Commencing April 15, 2015, Race Street is permitted to reduce (based on certain thresholds) the aggregate principal amount of Class A Notes subject to the JPM Facility. Such reductions, and any other reductions of the principal amount of Class A Notes, including upon an event of default, will be subject to breakage fees in an amount equal to the present value of 1.25% per annum over the remaining term of the JPM Facility applied to the amount of such reduction.
Pursuant to the financing arrangement, the assets held by Race Street secure the obligations of Race Street under the JPM Facility.
As of March 31, 2014 and December 31, 2013, Class A Notes in the aggregate principal amount of $1,140,000 had been purchased by Race Street from Locust Street and subsequently sold to JPM under the JPM Facility for aggregate proceeds of $950,000. The carrying amount outstanding under the JPM Facility approximates its fair
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value. The Company funded each purchase of Class A Notes by Race Street through a capital contribution to Race Street. As of March 31, 2014 and December 31, 2013, Race Street’s liability under the JPM Facility was $950,000, plus $6,518 and $6,690, respectively, of accrued interest expense. The Class A Notes issued by Locust Street and purchased by Race Street eliminate in consolidation on the Company’s financial statements.
As of March 31, 2014 and December 31, 2013, the fair value of assets held by Locust Street was $1,884,205 and $1,870,351, respectively, which included assets purchased by Locust Street with proceeds from the issuance of Class A Notes. As of March 31, 2014 and December 31, 2013, the fair value of assets held by Race Street was $776,130 and $747,330, respectively.
The Company incurred costs of $425 in connection with obtaining the JPM Facility, which the Company has recorded as deferred financing costs on its consolidated balance sheets and amortizes to interest expense over the life of the JPM Facility. As of March 31, 2014, $141 of such deferred financing costs had yet to be amortized to interest expense.
For the three months ended March 31, 2014 and 2013, the components of total interest expense, cash paid for interest expense, average borrowings, effective interest rate and weighted average interest rate for the JPM Facility were as follows:
Amounts outstanding under the JPM Facility will be considered borrowings of the Company for purposes of complying with the asset coverage requirements under the 1940 Act applicable to BDCs.
On March 11, 2014, Walnut Street Funding LLC, or Walnut Street, the Company’s wholly-owned, special-purpose financing subsidiary, Wells Fargo Securities, LLC, and Wells Fargo Bank, National Association, or collectively with Wells Fargo Securities, LLC, Wells Fargo, entered into an amendment, or the Walnut Street amendment, to the revolving credit facility originally entered into by such parties on May 17, 2012, or the Walnut Street credit facility. Wells Fargo Securities, LLC serves as the administrative agent and Wells Fargo Bank, National Association is the sole lender, collateral agent, account bank and collateral custodian under the facility.
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The Walnut Street amendment increased the maximum commitments available under the Walnut Street credit facility from $250,000 to $300,000 and decreased, from 2.75% to 2.50%, the applicable spread above three-month LIBOR that is payable on the portion of outstanding advances under the Walnut Street credit facility attributable to “Traditional Middle Market Loans,” “Fixed Rate Loans” and “Second Lien Loans,” in each case as defined in the Walnut Street credit facility. The Company paid certain fees to Wells Fargo in connection with the Walnut Street amendment.
Under the Walnut Street credit facility, the Company contributes cash or debt securities to Walnut Street from time to time and retains a residual interest in any assets contributed through its ownership of Walnut Street or receives fair market value for any debt securities sold to Walnut Street. The obligations of Walnut Street under the Walnut Street credit facility are non-recourse to the Company and the Company’s exposure under the facility is limited to the value of the Company’s investment in Walnut Street.
Borrowings under the Walnut Street credit facility accrue interest at a rate equal to three-month LIBOR, plus a spread ranging between 1.50% and 2.50% per annum, depending on the composition of the portfolio of debt securities for the relevant period. Beginning on September 17, 2012, Walnut Street became subject to a non-usage fee to the extent the aggregate principal amount available under the Walnut Street credit facility is not borrowed. Any amounts borrowed under the Walnut Street credit facility will mature, and all accrued and unpaid interest thereunder will be due and payable, on May 17, 2017.
As of March 31, 2014 and December 31, 2013, $239,800 and $225,000, respectively, was outstanding under the Walnut Street credit facility. The carrying amount of the amount outstanding under the facility approximates its fair value. The Company incurred costs of $4,020 in connection with obtaining and amending the Walnut Street credit facility, which the Company has recorded as deferred financing costs on its consolidated balance sheets and amortizes to interest expense over the life of the facility. As of March 31, 2014, $2,611 of such deferred financing costs had yet to be amortized to interest expense.
For the three months ended March 31, 2014 and 2013, the components of total interest expense, cash paid for interest expense, average borrowings, effective interest rate and weighted average interest rate for the Walnut Street credit facility were as follows:
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Borrowings of Walnut Street will be considered borrowings of the Company for purposes of complying with the asset coverage requirements under the 1940 Act applicable to BDCs.
Note 9. Commitments and Contingencies
The Company enters into contracts that contain a variety of indemnification provisions. The Company’s maximum exposure under these arrangements is unknown; however, the Company has not had prior claims or losses pursuant to these contracts. Management of FB Advisor has reviewed the Company’s existing contracts and expects the risk of loss to the Company to be remote.
The Company is not currently subject to any material legal proceedings and, to the Company’s knowledge, no material legal proceedings are threatened against the Company. From time to time, the Company may be a party to certain legal proceedings in the ordinary course of business, including proceedings relating to the enforcement of the Company’s rights under contracts with its portfolio companies. While the outcome of these legal proceedings cannot be predicted with certainty, the Company does not expect that these proceedings will have a material effect upon its financial condition or results of operations.
See Note 6 for a discussion of the Company’s unfunded commitments.
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Note 10. Financial Highlights
The following is a schedule of financial highlights of the Company for the three months ended March 31, 2014 and the year ended December 31, 2013:
Per Share Data:
Net asset value, beginning of period
Results of operations(1)
Net investment income (loss)
Net realized and unrealized appreciation (depreciation) on investments and gain/loss on foreign currency
Stockholder distributions(2)
Issuance of common stock(3)
Repurchases of common stock(4)
Net increase (decrease) in net assets resulting from capital share transactions
Net asset value, end of period
Shares outstanding, end of period
Total return(5)
Ratio/Supplemental Data:
Net assets, end of period
Ratio of net investment income to average net assets(6)
Ratio of total operating expenses to average net assets(6)
Portfolio turnover(7)
The total return for each period presented was calculated by taking the net asset value per share as of the end of the applicable period, adding the cash distributions per share which were declared during the period and
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Note 10. Financial Highlights (continued)
Ratio of accrued capital gains incentive fees to average net assets
Ratio of subordinated income incentive fees to average net assets
Ratio of interest expense to average net assets
Ratio of excise taxes to average net assets
Note 11. Subsequent Events
ING Credit Facility
On April 3, 2014, the Company entered into the ING credit facility. The ING credit facility provides for borrowings in U.S. dollars and certain agreed upon foreign currencies in an initial aggregate amount of up to $300,000, with an option for the Company to request, at one or more times after closing, that existing or new lenders, at their election, provide up to $100,000 of additional commitments. The ING credit facility provides for the issuance of letters of credit in an aggregate face amount not to exceed $25,000. The Company’s obligations under the ING credit facility are guaranteed by all of the Company’s subsidiaries, other than its special-purpose financing subsidiaries. The Company’s obligations under the ING credit facility are secured by a first priority security interest in substantially all of the assets of the Company and the subsidiary guarantors thereunder other than the equity interests of its special-purpose financing subsidiaries.
Borrowings under the ING credit facility are subject to compliance with a borrowing base. Interest under the ING credit facility for (i) loans for which the Company elects the base rate option is payable at a rate equal to 1.5% per annum plus the greatest of (x) the “U.S. Prime Rate” as published in The Wall Street Journal, (y) the federal funds effective rate plus 0.5% per annum and (z) three-month LIBOR plus 1% per annum and (ii) loans for which the Company elects the Eurocurrency option is payable at a rate equal to 2.50% per annum plus adjusted LIBOR. The ING credit facility will be subject to a non-usage fee of (a) 1% per annum on the unused
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Note 11. Subsequent Events (continued)
portion of the commitment under the ING credit facility for each day such unused portion exceeds 65% of the commitments and (b) 0.375% per annum on the unused portion of the commitments for each day the unused portion is 35% or less. The Company will pay letter of credit participation fees and a fronting fee on the average daily amount of any lender’s exposure with respect to any letters of credit issued under the ING credit facility.
In connection with the ING credit facility, the Company has made certain representations and warranties and must comply with various covenants and reporting requirements customary for facilities of this type. In addition, the Company must comply with the following financial covenants: (a) the Company’s minimum stockholders’ equity, measured as of each fiscal quarter-end, must be greater than or equal to the greater of (i) 40% of assets of the Company and its subsidiaries as of the last day of such fiscal quarter and (ii) $1,980,744 (less amounts paid to purchase common stock in the Company’s current tender offer), plus 50% of the net proceeds of any post-closing equity offerings; (b) the Company must maintain at all times a 200% asset coverage ratio; (c) the sum of (x) the Company and the guarantors’ net worth (defined as stockholders’ equity minus the net asset value held by the Company in any special-purpose financing subsidiaries) plus (y) 30% of the equity value of any special-purpose financing subsidiaries, must at all times be at least equal to the sum of (A) any unsecured longer-term debt of the Company and (B) accrued but unpaid base management fees and incentive fees at the time of measurement; and (d) the aggregate value of eligible portfolio investments that can be converted to cash in fewer than 20 business days without more than a 5% change in price must not be less than 10% of the covered debt amount (defined as the aggregate amount of outstanding loans and issued letters of credit under the facility, plus, to the extent incurred after closing of the ING credit facility, certain other permitted debt of the Company) for more than 30 business days during any period during which the covered debt amount (less cash and cash equivalents included in the borrowing base) is greater than 90% of the borrowing base (less cash and cash equivalents included therein).
The ING credit facility contains events of default customary for facilities of this type. Upon the occurrence of an event of default, ING, at the instruction of the lenders, may terminate the commitments and declare the outstanding advances and all other obligations under the ING credit facility immediately due and payable. During the continuation of an event of default and subject, in certain cases, to the instructions of the lenders, the Company must pay interest at a default rate.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. (in thousands, except share and per share amounts)
The information contained in this section should be read in conjunction with our unaudited consolidated financial statements and related notes thereto appearing elsewhere in this quarterly report on Form 10-Q. In this report, “we,” “us,” “our” and the “Company” refer to FS Investment Corporation.
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;
the impact of the investments that we expect to make;
the ability of our portfolio companies to achieve their objectives;
our current and expected financings and investments;
receiving and maintaining corporate credit ratings and change 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 FB Advisor, FS Investment Advisor, LLC, FS Energy and Power Fund, FSIC II Advisor, LLC, FS Investment Corporation II, FSIC III Advisor, LLC, FS Investment Corporation III, FS Global Advisor, LLC, FS Global Credit Opportunities Fund, GDFM or any of their affiliates;
the dependence of our future success on the general economy and its effect on the industries in which we may invest;
our use of financial leverage;
the ability of FB Advisor to locate suitable investments for us and to monitor and administer our investments;
the ability of FB 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 Wall Street Reform and Consumer Protection Act 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 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;
risks associated with possible disruption in our operations or the economy generally due to terrorism or natural disasters;
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future changes in laws or regulations and conditions in our operating areas;
the extent to which we may purchase shares of common stock following the listing pursuant to the tender offer which commenced on April 16, 2014;
the price at which shares of our common stock may trade on the NYSE, which may be higher or lower than the purchase price in such tender offer; and
the number of shares of common stock acquired pursuant to such tender offer and the costs of any indebtedness incurred to fund such purchases.
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. Stockholders are advised to consult any additional disclosures that we may make directly to stockholders or through reports that we may file in the future with the SEC, 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, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act.
Overview
We were incorporated under the general corporation laws of the State of Maryland on December 21, 2007, and commenced operations on January 2, 2009. 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 for federal income tax purposes, and intends to qualify annually, as a RIC under Subchapter M of the Code.
On April 16, 2014, shares of our common stock began trading on the NYSE under the ticker symbol “FSIC”. This listing accomplished our goal of providing our stockholders with greatly enhanced liquidity.
Our investment activities are managed by FB Advisor and supervised by our board of directors, a majority of whom are independent. Under our amended investment advisory agreement, we have agreed to pay FB Advisor an annual base management fee based on our gross assets as well as incentive fees based on our performance. FB Advisor has engaged GDFM to act as our investment sub-adviser. GDFM assists FB Advisor in identifying investment opportunities and makes investment recommendations for approval by FB Advisor according to guidelines set by FB Advisor.
Our investment objectives are to generate current income and, to a lesser extent, long-term capital appreciation. We have identified and intend to focus on the following investment categories, which we believe will allow us to generate an attractive total return with an acceptable level of risk.
Direct Originations: We intend to leverage our relationship with GDFM and its global sourcing and origination platform to directly source investment opportunities. Such investments are originated or structured specifically for us or made by us and are not generally available to the broader market. These investments may include both debt and equity components, although we do not expect to make equity investments independent of having an existing credit relationship. We believe directly originated investments may offer higher returns and more favorable protections than broadly syndicated transactions.
Opportunistic: We intend to seek to capitalize on market price inefficiencies by investing in loans, bonds and other securities where the market price of such investment reflects a lower value than deemed warranted by our fundamental analysis. We believe that market price inefficiencies may occur due to, among other things, general dislocations in the markets, a misunderstanding by the market of a particular company or an industry
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being out of favor with the broader investment community. We seek to allocate capital to these securities that have been misunderstood or mispriced by the market and where we believe there is an opportunity to earn an attractive return on our investment. Such opportunities may include event driven investments, anchor orders and collateralized loan obligations, or CLOs.
In the case of event driven investments, we intend to take advantage of dislocations that arise in the markets due to an impending event and where the market’s apparent expectation of value differs substantially from our fundamental analysis. Such events may include a looming debt maturity or default, a merger, spin-off or other corporate reorganization, an adverse regulatory or legal ruling, or a material contract expiration, any of which may significantly improve or impair a company’s financial position. Compared to other investment strategies, event driven investing depends more heavily on our ability to successfully predict the outcome of an individual event rather than on underlying macroeconomic fundamentals. As a result, successful event driven strategies may offer both substantial diversification benefits and the ability to generate performance in uncertain market environments.
We may also invest in certain opportunities that are originated and then syndicated by a commercial or investment bank, but where we provide a capital commitment significantly above the average syndicate participant, i.e., an anchor order. In these types of investments, we may receive fees, preferential pricing or other benefits not available to other lenders in return for our significant capital commitment. Our decision to provide an anchor order to a syndicated transaction is predicated on a rigorous credit analysis, our familiarity with a particular company, industry or financial sponsor, and the broader investment experiences of FB Advisor and GDFM.
In addition, our relationship with GSO Capital Partners LP, the parent of GDFM and one of the largest CLO managers in the world, allows us to opportunistically invest in CLOs. CLOs are a form of securitization where the cash flow from a pooled basket of syndicated loans is used to support distribution payments made to different tranches of securities. While collectively CLOs represent nearly fifty percent of the broadly syndicated loan universe, investing in individual CLO tranches requires a high degree of investor sophistication due to their structural complexity and the illiquid nature of their securities.
Broadly Syndicated/Other: Although our primary focus is to invest in directly originated transactions and opportunistic investments, in certain circumstances we will also invest in the broadly syndicated loan and high yield 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 addition, and because we typically receive more attractive financing terms on these positions than we do on our less liquid assets, we are able to leverage the broadly syndicated portion of our portfolio in such a way that maximizes the levered return potential of our portfolio.
Our portfolio is comprised primarily of investments in senior secured loans and second lien secured loans of private middle market U.S. companies and, to a lesser extent, subordinated loans of private U.S. companies. Although we do not expect a significant portion of our portfolio to be comprised of subordinated loans, there is no limit on the amount of such loans in which we may invest. We may purchase interests in loans through secondary market transactions in the “over-the-counter” market for institutional loans or directly from our target companies. In connection with our debt investments, we may on occasion receive equity interests such as warrants or options as additional consideration. We may also purchase minority interests in the form of common or preferred equity in our target companies, either in conjunction with one of our debt investments or through a co-investment with a financial sponsor, such as an institutional investor or private equity firm. In addition, a portion of our portfolio may be comprised of corporate bonds and other debt securities.
The senior secured and second lien secured loans in which we invest generally have stated terms of three to seven years and any subordinated debt investments that we make generally will have stated terms of up to ten years, but the expected average life of such securities is generally between three and seven years. However, there
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is no limit on the maturity or duration of any security in our portfolio. The loans in which we invest may be rated by a nationally recognized statistical rating organization and, in such case, generally will carry a rating below investment grade (rated lower than “Baa3” by Moody’s Investors Service, Inc., or Moody’s, or lower than “BBB-” by Standard & Poor’s Ratings Services).We also invest in non-rated debt securities.
Revenues
The principal measure of our financial performance is net increase in net assets resulting from operations, which includes net investment income, net realized gain or loss on investments, net realized gain or loss on foreign currency, net unrealized appreciation or depreciation on investments and net unrealized gain or loss on foreign currency. Net investment income is the difference between our income from interest, dividends, fees and other investment income and our operating expenses. Net realized gain or loss on investments is the difference between the proceeds received from dispositions of portfolio investments and their amortized cost. Net realized gain or loss on foreign currency is the portion of realized gain or loss attributable to foreign currency fluctuations. Net unrealized appreciation or depreciation on investments is the net change in the fair value of our investment portfolio. Net 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.
We principally generate revenues in the form of interest income on the debt investments we hold. In addition, we generate revenues in the form of commitment, closing, origination, structuring or diligence fees, monitoring fees, fees for providing managerial assistance, consulting fees, prepayment fees and performance-based fees. Any such fees generated in connection with our investments will be recognized as earned. We may also generate revenues in the form of dividends and other distributions on the equity or other securities we hold.
Expenses
Our primary operating expenses include the payment of advisory fees and other expenses under the amended investment advisory agreement and the administration agreement, interest expense from financing facilities and other expenses necessary for our operations. Our investment advisory fee compensates FB Advisor for its work in identifying, evaluating, negotiating, executing, monitoring and servicing our investments. FB Advisor is responsible for compensating our investment sub-adviser.
We reimburse FB Advisor for expenses necessary to perform services related to our administration and operations. Such services include the provision of general ledger accounting, fund accounting, legal services, investor relations and other administrative services. FB 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 stockholders and reports filed with the SEC. In addition, FB 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 stockholders, and generally overseeing the payment of our expenses and the performance of administrative and professional services rendered to us by others. FB Advisor will allocate the cost of such services to us based on factors such as total assets, revenues, time allocations and/or other reasonable metrics.
We bear all other expenses of our operations and transactions, including (without limitation) fees and expenses relating to:
corporate and organization expenses relating to offerings of our securities;
the cost of calculating our net asset value, including the cost of any third-party pricing or valuation services;
the cost of effecting sales and repurchases of shares of our common stock and other securities;
investment advisory fees;
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fees payable to third parties relating to, or associated with, making investments and valuing investments, including fees and expenses associated with performing due diligence reviews of prospective investments;
interest payments on our debt or related obligations;
transfer agent and custodial fees;
research and market data (including news and quotation equipment and services, and any computer hardware and connectivity hardware (e.g., telephone and fiber optic lines) incorporated into the cost of obtaining such research and market data);
fees and expenses associated with marketing efforts;
federal and state registration fees;
federal, state and local taxes;
fees and expenses of directors not also serving in an executive officer capacity for us or FB Advisor;
costs of proxy statements, stockholders’ reports, notices and other filings;
fidelity bond, directors and officers/errors and omissions liability insurance and other insurance premiums;
direct costs such as printing, mailing, long distance telephone and staff;
fees and expenses associated with accounting, corporate governance, independent audits and outside legal costs;
costs associated with our reporting and compliance obligations under the 1940 Act and applicable federal and state securities laws, including compliance with the Sarbanes-Oxley Act of 2002;
brokerage commissions for our investments;
costs associated with our chief compliance officer; and
all other expenses incurred by FB Advisor, GDFM or us in connection with administering our business, including expenses incurred by FB Advisor or GDFM in performing administrative services for us and administrative personnel paid by FB Advisor, to the extent they are not controlling persons of FB Advisor or any of its affiliates.
Pursuant to the expense reimbursement agreement, Franklin Square Holdings has agreed to reimburse us for expenses in an amount that is sufficient to ensure that no portion of our distributions to stockholders will be paid from proceeds of the sale of shares of our common stock or borrowings. However, because certain investments we may make, including preferred and common equity investments, may generate dividends and other distributions to us that are treated for tax purposes as a return of capital, a portion of our distributions to stockholders may also be deemed to constitute a return of capital for tax purposes to the extent that we may use such dividends or other distribution proceeds to fund our distributions to stockholders. Under those circumstances, Franklin Square Holdings will not reimburse us for the portion of such distributions to stockholders that represent a return of capital for tax purposes, as the purpose of the expense reimbursement arrangement is not to prevent tax-advantaged distributions to stockholders.
Under the expense reimbursement agreement, Franklin Square Holdings will reimburse us for expenses in an amount equal to the difference between our cumulative distributions paid to our stockholders in each quarter, less the sum of our net investment income for tax purposes, net capital gains and dividends and other distributions paid to us on account of preferred and common equity investments in portfolio companies (to the extent such amounts are not included in net investment income or net capital gains for tax purposes) in each quarter.
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Pursuant to the expense reimbursement agreement, we have a conditional obligation to reimburse Franklin Square Holdings for any amounts funded by Franklin Square Holdings under such agreement if (and only to the extent that), during any fiscal quarter occurring within three years of the date on which Franklin Square Holdings funded such amount, the sum of our net investment income for tax purposes, net capital gains and the amount of any dividends and other distributions paid to us on account of preferred and common equity investments in portfolio companies (to the extent not included in net investment income or net capital gains for tax purposes) exceeds the distributions paid by us to our stockholders; provided, however, that (i) we will only reimburse Franklin Square Holdings for expense support payments made by Franklin Square Holdings with respect to any calendar quarter beginning on or after July 1, 2013 to the extent that the payment of such reimbursement (together with any other reimbursement paid during such fiscal year) does not cause “other operating expenses” (as defined below) (on an annualized basis and net of any expense support payments received by us during such fiscal year) to exceed the lesser of (A) 1.75% of our average net assets attributable to shares of our common stock for the fiscal year-to-date period after taking such payments into account and (B) the percentage of our average net assets attributable to shares of our common stock represented by “other operating expenses” during the fiscal year in which such expense support payment from Franklin Square Holdings was made (provided, however, that this clause (B) shall not apply to any reimbursement payment which relates to an expense support payment from Franklin Square Holdings made during the same fiscal year) and (ii) we will not reimburse Franklin Square Holdings for expense support payments made by Franklin Square Holdings if the aggregate amount of distributions per share declared by us in such calendar quarter is less than the aggregate amount of distributions per share declared by us in the calendar quarter in which Franklin Square Holdings made the expense support payment to which such reimbursement relates. “Other operating expenses” means our total “operating expenses” (as defined below), excluding base management fees, incentive fees, organization and offering expenses, financing fees and costs, interest expense, brokerage commissions and extraordinary expenses. “Operating expenses” means all operating costs and expenses incurred, as determined in accordance with GAAP for investment companies.
We or Franklin Square Holdings may terminate the expense reimbursement agreement at any time. The specific amount of expenses reimbursed by Franklin Square Holdings, if any, will be determined at the end of each quarter. Upon termination of the expense reimbursement agreement by Franklin Square Holdings, Franklin Square Holdings will be required to fund any amounts accrued thereunder as of the date of termination. Similarly, our conditional obligation to reimburse Franklin Square Holdings pursuant to the terms of the expense reimbursement agreement shall survive the termination of such agreement by either party.
Franklin Square Holdings is controlled by our chairman and chief executive officer, Michael C. Forman, and our vice-chairman, David J. Adelman. There can be no assurance that the expense reimbursement agreement will remain in effect or that Franklin Square Holdings will reimburse any portion of our expenses in future quarters. As of March 31, 2014, there were no unreimbursed expense support payments subject to future reimbursement by us.
Portfolio Investment Activity for the Three Months Ended March 31, 2014 and for the Year Ended December 31, 2013
During the three months ended March 31, 2014, we made investments in portfolio companies totaling $471,491. During the same period, we sold investments for proceeds of $306,983 and received principal repayments of $259,132. As of March 31, 2014, our investment portfolio, with a total fair value of $4,077,627, consisted of interests in 148 portfolio companies (50% in first lien senior secured loans, 22% in second lien senior secured loans, 10% in senior secured bonds, 10% in subordinated debt, 3% in collateralized securities and 5% in equity/other). The portfolio companies that comprised our portfolio as of such date had an average annual EBITDA of approximately $174.2 million. As of March 31, 2014, the investments in our portfolio were purchased at a weighted average price of 97.1% of par or stated value, as applicable, the weighted average credit rating of the investments in our portfolio that were rated (constituting approximately 32.5% of our portfolio based on the fair value of our investments) was B3 based upon the Moody’s scale and our estimated gross annual
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portfolio yield (which represents the expected yield to be generated by us on our investment portfolio based on the composition of our portfolio as of such date), prior to leverage, was 10.2% based upon the amortized cost of our investments.
During the year ended December 31, 2013, we made investments in portfolio companies totaling $2,641,733. During the same period, we sold investments for proceeds of $1,137,264 and received principal repayments of $1,373,623. As of December 31, 2013, our investment portfolio, with a total fair value of $4,137,581, consisted of interests in 165 portfolio companies (51% in first lien senior secured loans, 22% in second lien senior secured loans, 9% in senior secured bonds, 10% in subordinated debt, 4% in collateralized securities and 4% in equity/other). The portfolio companies that comprised our portfolio as of such date had an average annual EBITDA of approximately $190.7 million. As of December 31, 2013, the investments in our portfolio were purchased at a weighted average price of 97.3% of par or stated value, as applicable, the weighted average credit rating of the investments in our portfolio that were rated (constituting approximately 40.7% of our portfolio based on the fair value of our investments) was B3 based upon the Moody’s scale and our estimated gross annual portfolio yield, prior to leverage, was 10.1% based upon the amortized cost of our investments.
Total Portfolio Activity
The following tables present certain selected information regarding our portfolio investment activity for the three months ended March 31, 2014 and year ended December 31, 2013:
Net Investment Activity
Sales and Redemptions
Net Portfolio Activity
New Investment Activity by Asset Class
The following table summarizes the composition of our investment portfolio at cost and fair value as of March 31, 2014 and December 31, 2013:
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Number of Portfolio Companies
% Variable Rate (based on fair value)
% Fixed Rate (based on fair value)
% Income Producing Equity or Other Investments (based on fair value)
% Non-Income Producing Equity or Other Investments (based on fair value)
Average Annual EBITDA of Portfolio Companies
Weighted Average Purchase Price of Investments (as a % of par or stated value)
Weighted Average Credit Rating of Investments that were Rated
% of Investments on Non-Accrual
Gross Portfolio Yield Prior to Leverage (based on amortized cost)
Gross Portfolio Yield Prior to Leverage (based on amortized cost)—ExcludingNon-Income Producing Assets
Direct Originations
The following tables present certain selected information regarding our direct originations for the three months ended March 31, 2014 and year ended December 31, 2013:
New Direct Originations
Total Commitments (including Unfunded Commitments)
Exited Investments (including partial paydowns)
Net Direct Originations
New Direct Originations by Asset Class
Average New Direct Origination Commitment Amount
Weighted Average Maturity for New Direct Originations
Gross Portfolio Yield Prior to Leverage (based on amortized cost) of New Direct Originations during Period
Gross Portfolio Yield Prior to Leverage (based on amortized cost) of New Direct Originations during Period—Excluding Non-Income Producing Assets
Gross Portfolio Yield Prior to Leverage (based on amortized cost) of Investments Exited during Period
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Characteristics of All Direct Originations held in Portfolio
Average Leverage Through Tranche of Portfolio Companies—Excluding Equity / Other and Collateralized Securities
Gross Portfolio Yield Prior to Leverage (based on amortized cost) of Funded Direct Originations
Gross Portfolio Yield Prior to Leverage (based on amortized cost) of Funded Direct Originations—Excluding Non-Income Producing Assets
Portfolio Composition by Strategy and Industry
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 March 31, 2014 and December 31, 2013:
Portfolio Composition by Strategy
Opportunistic
Broadly Syndicated/Other
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As of March 31, 2014, we did not “control” and were not an “affiliate” of any of our portfolio companies, each as defined in the 1940 Act. In general, under the 1940 Act, we would be presumed to “control” a portfolio company if we owned 25% or more of its voting securities and would be an “affiliate” of a portfolio company if we owned 5% or more of its voting securities.
Our investment portfolio may contain loans that are in the form of lines of credit or revolving credit facilities, which require us to provide funding when requested by portfolio companies in accordance with the terms of the underlying loan agreements. As of March 31, 2014, we had six such investments with aggregate unfunded commitments of $90,641 and one equity/other investment, American Energy Ohio Holdings, LLC, with an unfunded commitment of $2,313. As of December 31, 2013, we had five such investments with aggregate unfunded commitments of $48,439 and one equity/other investment, American Energy Ohio Holdings, LLC, with an unfunded commitment of $4,629. We maintain sufficient cash on hand and available borrowings to fund such unfunded commitments should the need arise.
Portfolio Asset Quality
In addition to various risk management and monitoring tools, FB Advisor uses an investment rating system to characterize and monitor the expected level of returns on each investment in our portfolio. FB Advisor uses an investment rating scale of 1 to 5. The following is a description of the conditions associated with each investment rating:
InvestmentRating
Summary Description
The following table shows the distribution of our investments on the 1 to 5 investment rating scale at fair value as of March 31, 2014 and December 31, 2013:
Investment Rating
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.
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Results of Operations
Comparison of the Three Months Ended March 31, 2014 and March 31, 2013
We generated investment income of $114,796 and $110,044 for the three months ended March 31, 2014 and 2013, respectively, in the form of interest and fees earned on senior secured loans, senior secured bonds, subordinated debt and collateralized securities in our portfolio and dividends and other distributions earned on equity/other investments. Such revenues represent $104,283 and $98,525 of cash income earned as well as $10,513 and $11,519 in non-cash portions relating to accretion of discount and PIK interest for the three months ended March 31, 2014 and 2013, 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 increase in investment income is due primarily to the increase in the number of directly originated transactions over the last year as part of the transition of the portfolio to higher yielding non-broadly syndicated assets.
Our total operating expenses were $58,919 and $59,315 for the three months ended March 31, 2014 and 2013, respectively. Our operating expenses include base management fees attributed to FB Advisor of $22,371 and $22,206 for the three months ended March 31, 2014 and 2013, respectively. Our operating expenses also include administrative services expenses attributed to FB Advisor of $1,200 and $1,436 for the three months ended March 31, 2014 and 2013, respectively.
FB Advisor is eligible to receive incentive fees based on performance. During the three months ended March 31, 2014 and 2013, we accrued subordinated incentive fees on income of $15,178 and $14,228, respectively, based upon the performance of our portfolio. During the three months ended March 31, 2014 and 2013, we accrued capital gains incentive fees of $4,836 and $6,350, respectively, based on the performance of our portfolio, of which $5,035 and $0, respectively, was based on realized gains and $(199) and $6,350, respectively, was based on unrealized gains. No such fee is actually payable by us with respect to unrealized gains unless and until those gains are actually realized. See “—Critical Accounting Policies—Capital Gains Incentive Fee.”
We recorded interest expense of $12,700 and $12,136 for the three months ended March 31, 2014 and 2013, respectively, in connection with our credit facilities and the JPM Facility. Fees incurred with our fund administrator, which provides various accounting and administrative services to us, totaled $332 and $365 for the three months ended March 31, 2014 and 2013, respectively. We incurred fees and expenses with our stock transfer agent of $451 and $890 for the three months ended March 31, 2014 and 2013, respectively. Fees for our board of directors were $265 and $225 for the three months ended March 31, 2014 and 2013, respectively.
Our other general and administrative expenses totaled $1,586 and $1,479 for the three months ended March 31, 2014 and 2013, respectively, and consisted of the following:
Expenses associated with our independent audit and related fees
Compensation of our chief compliance officer
Legal fees
Printing fees
Other
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During the three months ended March 31, 2014 and 2013, the ratio of our operating expenses to our average net assets was 2.20% and 2.34%, respectively. Our ratio of operating expenses to our average net assets during the three months ended March 31, 2014 and 2013 includes $12,700 and $12,136, respectively, related to interest expense and $20,014, and $20,578, respectively, related to accruals for incentive fees. Without such expenses, our ratio of operating expenses to average net assets would have been 0.97% and 1.05% for the three months ended March 31, 2014 and 2013, respectively. Incentive fees and interest expense, among other things, may increase or decrease our expense ratios relative to comparative periods depending on portfolio performance and changes in benchmark interest rates such as LIBOR, among other factors. The lower ratio of operating expenses to average net assets during the three months ended March 31, 2014 compared to the three months ended March 31, 2013 can primarily be attributed to a reduction in administrative services expenses and stock transfer agent fees charged to us.
Net Investment Income
Our net investment income totaled $55,877 ($0.22 per share) and $50,729 ($0.20 per share) for the three months ended March 31, 2014 and 2013, respectively. The increase in net investment income on a per share basis can be attributed to, among other things, the transition of our portfolio to higher yielding non-broadly syndicated assets.
Net Realized Gains or Losses
We sold investments and received principal repayments of $306,983 and $259,132, respectively, during the three months ended March 31, 2014, from which we realized a net gain of $13,822. We also realized a net loss of $19 from settlements on foreign currency during the three months ended March 31, 2014. We sold investments and received principal repayments of $147,944 and $395,873, respectively, during the three months ended March 31, 2013, from which we realized a net gain of $14,171. We also realized a net loss of $63 from settlements on foreign currency during the three months ended March 31, 2013.
Net Change in Unrealized Appreciation (Depreciation) on Investments and Unrealized Gain (Loss) on Foreign Currency
For the three months ended March 31, 2014, the net change in unrealized appreciation (depreciation) on investments totaled $10,335 and the net change in unrealized gain (loss) on foreign currency totaled $45. For the three months ended March 31, 2013, the net change in unrealized appreciation (depreciation) on investments totaled $17,518 and the net change in unrealized gain (loss) on foreign currency totaled $121. The net change in unrealized appreciation (depreciation) on our investments during the three months ended March 31, 2014 was primarily driven by strong performance of certain of our senior secured bonds and subordinated debt investments. The net change in unrealized appreciation (depreciation) on our investments during the three months ended March 31, 2013 was primarily driven by a general strengthening in the credit markets during the prior period and continued tightening of credit spreads in the first quarter of 2013.
Net Increase (Decrease) in Net Assets Resulting from Operations
For the three months ended March 31, 2014, the net increase in net assets resulting from operations was $80,060 ($0.32 per share) compared to a net increase in net assets resulting from operations of $82,476 ($0.33 per share) during the three months ended March 31, 2013.
Financial Condition, Liquidity and Capital Resources
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During the three months ended March 31, 2014 and 2013, we issued 2,854,659 and 2,638,800 shares of common stock pursuant to our distribution reinvestment plan for gross proceeds of $29,257 and $26,476, respectively, at an average price per share of $10.25 and $10.03, respectively. In connection with the listing of our shares of common stock on the NYSE on April 16, 2014, we terminated our distribution reinvestment plan. Our board of directors has approved the implementation of a new distribution reinvestment plan, the terms of which have not yet been finalized. We expect the new distribution reinvestment plan to be implemented in connection with the regular monthly cash distribution in June; however, there can be no assurance as to whether or when a new distribution reinvestment plan will be implemented.
We generate cash primarily from fees, interest and dividends earned from our investments as well as principal repayments and proceeds from sales of our investments.
Prior to investing in securities of portfolio companies, we invested the net proceeds from the issuance of shares of our common stock under our distribution reinvestment plan and from sales and paydowns of existing investments primarily in cash, cash equivalents, 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.
On April 16, 2014, we commenced a tender offer to purchase for cash up to $250,000 in value of shares of our common stock from our stockholders. In accordance with the terms of the tender offer, we intend to select the lowest price, not greater than $11.00 per share or less than $10.35 per share, net to the tendering stockholder in cash, less any applicable withholding taxes and without interest, that will enable us to purchase the maximum number of shares of common stock properly tendered in the tender offer and not properly withdrawn having an aggregate purchase price of up to $250,000 or such lesser number if less than $250,000 in value of our shares of common stock are properly tendered in the tender offer after giving effect to any shares of common stock properly withdrawn. We expect to use available cash and/or borrowings under the ING credit facility to fund any purchase of shares of common stock in the tender offer and to pay for all related fees and expenses.
Historically, we conducted quarterly tender offers pursuant to our share repurchase program to provide our stockholders with limited liquidity. In anticipation of the listing of our shares of common stock on the NYSE, our board of directors terminated our share repurchase program effective March 21, 2014.
The following table provides information concerning our repurchases pursuant to our share repurchase program during the three months ended March 31, 2014 and 2013:
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As of March 31, 2014, we had $297,685 in cash, which we held in a custodial account, and $60,200 in borrowings available under our financing facilities. On April 3, 2014, we entered into the ING credit facility which provides for borrowings of up to $300,000. For additional information regarding the ING credit facility, see Note 11 to our unaudited consolidated financial statements contained in this quarterly report on Form 10-Q. Below is a summary of our outstanding financing facilities as of March 31, 2014:
For additional information regarding our outstanding financing facilities as of March 31, 2014, see Note 8 to our unaudited consolidated financial statements contained in this quarterly report on Form 10-Q.
RIC Status and Distributions
We have elected to be treated for federal income tax purposes, and intend to qualify annually, as a RIC under Subchapter M of the Code. In order to qualify as a RIC, we must, among other things, distribute at least 90% of our “investment company taxable income,” as defined by the Code, each year. As long as the distributions are declared by the later of the fifteenth day of the ninth month following the close of the taxable year or the due date of the tax return, including extensions, distributions paid up to one year after the current tax year can be carried back to the prior tax year for determining the distributions paid in such tax year. We intend to make sufficient distributions to our stockholders to qualify for and maintain our RIC status each year. We are also subject to nondeductible federal excise taxes if we do not distribute at least 98% of net ordinary income, 98.2% of any capital gain net income, if any, and any recognized and undistributed income from prior years on which we paid no federal income taxes.
Following commencement of our operations, we declared our first distribution on January 29, 2009. Subject to our board of directors’ discretion and applicable legal restrictions, we intend to authorize and declare ordinary cash distributions on a monthly basis and pay such distributions on either a monthly or quarterly basis. While we previously paid distributions on a quarterly basis, commencing in the fourth quarter of 2010, we began to pay distributions on a monthly rather than quarterly basis. We will calculate each stockholder’s specific distribution amount for the period using record and declaration dates and each stockholder’s distributions will begin to accrue on the date that shares of our common stock are issued to such stockholder. From time to time, we may also pay special interim distributions in the form of cash or shares of our common stock at the discretion of our board of directors.
During certain periods, our distributions may exceed our earnings. As a result, it is possible that a portion of the distributions we make may represent a return of capital. 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. Each year a statement on Form 1099-DIV identifying the sources of the distributions will be mailed to our stockholders. No portion of the distributions paid during the three months ended March 31, 2014 or 2013 represented a return of capital.
We intend to continue to make our ordinary distributions in the form of cash out of assets legally available for distribution.
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The following table reflects the cash distributions per share that we have declared and paid on our common stock during the three months ended March 31, 2014 and 2013:
On March 31, 2014, our board of directors determined to increase the amount of the regular monthly cash distribution payable to stockholders of record from $0.0720 per share to $0.07425per share in order to increase our annual distribution rate from 8.41% to 8.68% (based on our last publicly reported net asset value per share of $10.27 as of February 28, 2014). The increase in the regular monthly cash distribution to $0.07425 per share commenced with the regular monthly cash distribution payable on April 30, 2014 to stockholders of record as of April 29, 2014. On May 5, 2014, our board of directors declared a regular monthly cash distribution of $0.07425 per share. The regular monthly cash distribution will be paid on or about May 30, 2014 to stockholders of record on May 29, 2014.
Our board of directors intends to declare two special cash distributions, each in the amount of $0.10 per share, that will be paid on or about August 15, 2014 and November 14, 2014 to stockholders of record as of July 31, 2014 and October 31, 2014, respectively. The payment of the two special cash distributions, like all future distributions, are subject to applicable legal restrictions and the sole discretion of our board of directors.
Historically, we had an “opt in” distribution reinvestment plan for our stockholders, which terminated upon the listing of our shares of common stock on the NYSE. Under that plan, if we made a cash distribution, our stockholders received distributions in cash unless they specifically “opted in” to the distribution reinvestment plan so as to have their cash distributions reinvested in additional shares of our common stock. Our board of directors has approved the implementation of a new distribution reinvestment plan, the terms of which have not yet been finalized. We expect the new distribution reinvestment plan to be implemented in connection with the regular monthly cash distribution in June; however, there can be no assurance as to whether or when a new distribution reinvestment plan will be implemented. Pending the adoption of a new distribution reinvestment plan, stockholders that had elected to participate in the earlier distribution reinvestment plan will receive cash rather than shares of common stock in respect of any cash distribution we declare.
We may fund our cash distributions to stockholders from any sources of funds available to us, including proceeds from the sale of shares of our common stock, borrowings, net investment income from operations, capital gains proceeds from the sale of assets, non-capital gains proceeds from the sale of assets, dividends or other distributions paid to us on account of preferred and common equity investments in portfolio companies and expense reimbursements from Franklin Square Holdings. We have not established limits on the amount of funds we may use from available sources to make distributions.
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The following table reflects the sources of the cash distributions on a tax basis that we have paid on our common stock during the three months ended March 31, 2014 and 2013:
Our net investment income on a tax basis for the three months ended March 31, 2014 and 2013 was $51,851 and $57,068, respectively. As of March 31, 2014 and December 31, 2013, we had $151,267 and $137,867, respectively, of undistributed net investment income and realized gains on a tax basis.
See Note 5 to our unaudited consolidated financial statements contained in this quarterly report on Form 10-Q for additional information regarding our distributions, including a reconciliation of our GAAP-basis net investment income to our tax-basis net investment income for the three months ended March 31, 2014 and 2013.
Critical Accounting Policies
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. 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. In preparing the financial statements, management has made 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. In preparing the financial statements, management has utilized available information, including our past history, industry standards and the current economic environment, among other factors, in forming its 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. 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.
Valuation of Portfolio Investments
We determine the net asset value of our investment portfolio each quarter. Securities that are publicly-traded are valued at the reported closing price on the valuation date. Securities that are not publicly-traded are valued at fair value as determined in good faith by our board of directors. In connection with that determination, FB Advisor provides our board of directors 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 third-party valuation services.
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Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosure, or ASC Topic 820, issued by the Financial Accounting Standards Board, 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 valuation process begins with FB Advisor’s management team providing a preliminary valuation of each portfolio company or investment to our valuation committee, which valuation may be obtained from an independent valuation firm, if applicable;
preliminary valuation conclusions are then documented and discussed with our valuation committee;
our valuation committee reviews the preliminary valuation and FB Advisor’s management team, together with our independent valuation firm, if applicable, responds and supplements the preliminary valuation to reflect any comments provided by the valuation committee; and
our board of directors discusses valuations and determines the fair value of each investment in our portfolio in good faith based on various statistical and other factors, including the input and recommendation of FB Advisor, the valuation committee and any third-party valuation firm, 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. Below is a description of factors that our board of directors may consider when valuing our debt and equity 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 our board of directors may consider 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 (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 directors, in its analysis of fair value, may consider various factors, such as multiples of EBITDA, cash flows, net income, revenues or, in limited instances, book value or liquidation value. All of these factors may be subject to adjustments 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.
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Our board of directors may also look to 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. Our board of directors may also consider the size and scope of a portfolio company and its specific strengths and weaknesses, as well as any other factors it deems relevant in assessing the 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, our board of directors allocates the cost basis in the investment between the debt securities and any such warrants or other equity securities received at the time of origination. Our board of directors subsequently values these warrants or other equity securities received at fair value.
The fair values of our investments are determined in good faith by our board of directors. Our board of directors 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 investments as of March 31, 2014 consisted primarily of debt securities that are traded on a private over-the-counter market for institutional investors. Except as described below, we valued our investments by using the midpoint of the prevailing bid and ask prices from dealers on the date of the relevant period end, which were provided by independent third-party pricing services and screened for validity by such services. Thirty-one senior secured loan investments, one senior secured bond investment, six subordinated debt investments and one collateralized security, for which broker quotes were not available, were valued by an independent valuation firm, which determined the fair value of such investments by considering, among other factors, the borrower’s ability to adequately service its debt, prevailing interest rates for like investments, expected cash flows, call features and other relevant terms of the debt. Except as described below, all of our equity/other investments were valued by the same independent valuation firm, which determined the fair value of such investments by considering, among other factors, contractual rights ascribed to such investments, as well as various income scenarios and multiples of EBITDA, cash flows, net income, revenues or, in limited instances, book value or liquidation value. One senior secured loan investment and one equity investment, each of which was newly-issued and purchased near March 31, 2014, were valued at cost, as our board of directors determined that the cost of each such investment was the best indication of its fair value. Also, one equity investment which is traded on an active public market was valued at its closing price on March 31, 2014 and two equity/other investments were valued by an independent third-party pricing service in the manner described above.
Our investments as of December 31, 2013 consisted primarily of debt securities that are traded on a private over-the-counter market for institutional investors. Except as described below, we valued our investments by using the midpoint of the prevailing bid and ask prices from dealers on the date of the relevant period end, which were provided by independent third-party pricing services and screened for validity by such services. Twenty-seven senior secured loan investments, six subordinated debt investments and one collateralized security, for which broker quotes were not available, were valued by an independent valuation firm, which determined the fair value of such investments by considering, among other factors, the borrower’s ability to adequately service its debt, prevailing interest rates for like investments, expected cash flows, call features and other relevant terms of the debt. Except as described below, all of our equity/other investments were valued by the same independent valuation firm, which determined the fair value of such investments by considering, among other factors, contractual rights ascribed to such investments, as well as various income scenarios and multiples of EBITDA, cash flows, net income, revenues or, in limited instances, book value or liquidation value. Also, one equity investment which is traded on an active public market was valued at its closing price as of December 31, 2013.
We periodically benchmark the bid and ask prices we receive from the third-party pricing services against the actual prices at which we purchase and sell our investments. Based on the results of the benchmark analysis and the experience of our management in purchasing and selling these investments, we believe that these prices
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are reliable indicators of fair value. However, because of the private nature of this marketplace (meaning actual transactions are not publicly reported), we believe that these valuation inputs are classified as Level 3 within the fair value hierarchy. We may also use other methods to determine fair value for securities for which we cannot obtain prevailing bid and ask prices through third-party pricing services or independent dealers, including the use of an independent valuation firm. We periodically benchmark the valuations provided by the independent valuation firm against the actual prices at which we purchase and sell our investments. Our valuation committee and board of directors reviewed and approved the valuation determinations made with respect to these investments in a manner consistent with our valuation process.
Revenue Recognition
Security transactions are accounted for on the trade date. We record interest income on an accrual basis to the extent that we expect to collect such amounts. We record dividend income on the ex-dividend date. We do not accrue as a receivable interest or dividends on loans and securities if we have reason to doubt our ability to collect such income. Loan origination fees, original issue discount and market discount are capitalized and we amortize such amounts as interest income over the respective term of the loan or security. Upon the prepayment of a loan or security, any unamortized loan origination fees and original issue discount are recorded as interest income. Upfront structuring fees are recorded as fee income when earned. We record prepayment premiums on loans and securities as fee income when we receive such amounts.
Net Realized Gains or Losses, Net Change in Unrealized Appreciation or Depreciation and Net Change in Unrealized Gains or Losses on Foreign Currency
Gains or losses on the sale of investments are calculated by using the specific identification method. We measure realized gains or losses by the difference between the net proceeds from the repayment or sale and the amortized cost basis of the investment, without regard to unrealized appreciation or depreciation previously recognized, but considering unamortized upfront fees. Net change in unrealized appreciation or depreciation reflects the change in portfolio investment values during the reporting period, including any reversal of previously recorded unrealized gains or losses when gains or losses are realized. Net change in unrealized gains or losses on foreign currency reflects the change in the value of receivables or accruals during the reporting period due to the impact of foreign currency fluctuations.
Capital Gains Incentive Fee
Pursuant to the terms of both the investment advisory and administrative services agreement and the amended investment advisory agreement, the incentive fee on capital gains is determined and payable in arrears as of the end of each calendar year (or upon termination of such agreement). Such fee will equal 20.0% of our incentive fee capital gains (i.e., our realized capital gains on a cumulative basis from inception, calculated as of the end of the applicable period, net of all realized capital losses and unrealized capital depreciation on a cumulative basis), less the aggregate amount of any previously paid capital gains incentive fees. On a quarterly basis, we accrue for the capital gains incentive fee by calculating such fee as if it were due and payable as of the end of such period.
While the investment advisory and administrative services agreement and the amended investment advisory agreement neither include nor contemplate the inclusion of unrealized gains in the calculation of the capital gains incentive fee, pursuant to an interpretation of an AICPA Technical Practice Aid for investment companies, commencing during the quarter ended December 31, 2010, we changed our methodology for accruing for this incentive fee to include unrealized gains in the calculation of the capital gains incentive fee expense and related accrued capital gains incentive fee. This accrual reflects the incentive fees that would be payable to FB Advisor if our entire portfolio were liquidated at its fair value as of the balance sheet date even though FB Advisor is not entitled to an incentive fee with respect to unrealized gains unless and until such gains are actually realized.
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Subordinated Income Incentive Fee
Pursuant to both the investment advisory and administrative services agreement and the amended investment advisory agreement, FB Advisor may also be entitled to receive a subordinated incentive fee on income. The subordinated incentive fee on income under the investment advisory and administrative services agreement, which was calculated and payable quarterly in arrears, equaled 20.0% of “pre-incentive fee net investment income” for the immediately preceding quarter and was subject to a hurdle rate, expressed as a rate of return on adjusted capital, as defined in the investment advisory and administrative services agreement, equal to 2.0% per quarter, or an annualized hurdle rate of 8.0%. As a result, FB Advisor would not earn this incentive fee for any quarter until our pre-incentive fee net investment income for such quarter exceeds the hurdle rate of 2.0%. Once our pre-incentive fee net investment income in any quarter exceeds the hurdle rate, FB Advisor would be entitled to a “catch-up” fee equal to the amount of the pre-incentive fee net investment income in excess of the hurdle rate, until our pre-incentive fee net investment income for such quarter equals 2.5%, or 10.0% annually, of adjusted capital. Thereafter, FB Advisor would receive 20.0% of pre-incentive fee net investment income. Under the amended investment advisory agreement, the subordinated incentive fee on income is calculated in the same manner, except that the hurdle rate used to compute the subordinated incentive fee on income is based on the net asset value of our assets rather than adjusted capital.
Under the amended investment advisory agreement, the subordinated incentive fee on income is subject to a total return requirement, which provides that no incentive fee in respect of our pre-incentive fee net investment income will be payable except to the extent that 20.0% of the cumulative net increase in net assets resulting from operations over the then-current and eleven preceding calendar quarters exceeds the cumulative incentive fees accrued and/or paid for the eleven preceding calendar quarters. Accordingly, any subordinated incentive fee on income that is payable in a calendar quarter will be limited to the lesser of (i) 20.0% of the amount by which our pre-incentive fee net investment income for such calendar quarter exceeds the 2.0% hurdle, subject to the “catch-up” provision, and (ii) (x) 20.0% of the cumulative net increase in net assets resulting from operations for the then-current and eleven preceding calendar quarters minus (y) the cumulative incentive fees accrued and/or paid for the eleven preceding calendar quarters. For the foregoing purpose, the “cumulative net increase in net assets resulting from operations” is the sum of our pre-incentive fee net investment income, base management fees, realized gains and losses and unrealized appreciation and depreciation for the then-current and eleven preceding calendar quarters. There will be no accumulation of amounts on the hurdle rate from quarter to quarter and, accordingly, there will be no clawback of amounts previously paid if subsequent quarters are below the quarterly hurdle rate and there will be no delay of payment if prior quarters are below the quarterly hurdle rate.
FB Advisor has recommended that the amended investment advisory agreement be further amended to reduce the annualized hurdle rate used in connection with the calculation of the subordinated incentive fee on income, expressed as a rate of return on our net assets, from 8% to 7.5%. Our board of directors has approved this amendment, and we plan to call a special meeting of our stockholders scheduled for June 23, 2014, at which stockholders will be asked to vote on the proposal to amend the amended investment advisory agreement to, among other things, so reduce the annualized hurdle rate.
Uncertainty in Income Taxes
We evaluate our tax positions to determine if the tax positions taken meet the minimum recognition threshold in connection with accounting for uncertainties in income tax positions taken or expected to be taken for the purposes of measuring and recognizing tax benefits or liabilities in our consolidated financial statements. Recognition of a tax benefit or liability with respect to an uncertain tax position is required only when the position is “more likely than not” to be sustained assuming examination by taxing authorities. We recognize interest and penalties, if any, related to unrecognized tax liabilities as income tax expense in our consolidated statements of operations. During the three months ended March 31, 2014 and 2013, we did not incur any interest or penalties.
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Contractual Obligations
We have entered into agreements with FB Advisor to provide us with investment advisory and administrative services. Payments for investment advisory services under the amended investment advisory agreement are equal to (a) an annual base management fee of 2.0% of the average value of our gross assets and (b) an incentive fee based on our performance. FB Advisor, and to the extent it is required to provide such services, our sub-adviser, are reimbursed for administrative expenses incurred on our behalf. In anticipation of the listing of our shares of common stock on the NYSE, FB Advisor recommended that the amended investment advisory agreement be further amended to (i) reduce the annualized hurdle rate used in connection with the calculation of the subordinated incentive fee on income, expressed as a rate of return on our net assets, from 8% to 7.5% and (ii) assuming the reduction to the hurdle rate is approved, reduce the base management fee from 2.0% to 1.75% of the average value of our gross assets. Our board of directors has approved this amendment, and we plan to call a special meeting of our stockholders scheduled for June 23, 2014, at which stockholders will be asked to vote on the proposal. Pending stockholder approval of this proposal, FB Advisor has agreed, effective April 1, 2014, to waive a portion of the base management fee to which it is entitled under the amended investment advisory agreement so that the fee received equals 1.75% of the average value of our gross assets. There can be no assurance that this waiver will continue in the future.
For the three months ended March 31, 2014 and 2013, we incurred $22,371 and $22,206, respectively, in base management fees and $1,200 and $1,436, respectively, in administrative services expenses. In addition, FB Advisor is eligible to receive incentive fees based on the performance of our portfolio. During the three months ended March 31, 2014 and 2013, we accrued subordinated incentive fees on income of $15,178 and $14,228, respectively, based upon the performance of our portfolio. During the three months ended March 31, 2014, we paid FB Advisor $14,303 in subordinated incentive fees on income. As of March 31, 2014, a subordinated incentive fee on income of $15,178 was payable to FB Advisor. During the three months ended March 31, 2014 and 2013, we accrued capital gains incentive fees of $4,836 and $6,350, respectively, based on the performance of our portfolio. As of December 31, 2013, we had accrued capital gains incentive fees of $32,133 based on the performance of our portfolio of which $30,543 was based on unrealized gains and $1,590 was based on realized gains. We paid FB Advisor $1,590 in capital gains incentive fees during the three months ended March 31, 2014. As of March 31, 2014, we had accrued $35,379 in capital gains incentive fees, of which only $5,035 was based on realized gains and was payable to FB Advisor.
A summary of our significant contractual payment obligations for the repayment of outstanding borrowings under the Arch Street credit facility, the Broad Street credit facility, the JPM Facility and the Walnut Street credit facility at March 31, 2014 is as follows:
Borrowings of Arch Street(1)
Borrowings of Broad Street(2)
Borrowings of Race Street(3)
Borrowings of Walnut Street(4)
At March 31, 2014, no amounts remained unused under the JPM Facility. Race Street will, on a quarterly basis, repurchase the Class A Notes sold to JPM under the JPM Facility and subsequently resell such
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Off-Balance Sheet Arrangements
We currently have no off-balance sheet arrangements, including any risk management of commodity pricing or other hedging practices.
Recently Issued Accounting Standards
None.
Related Party Transactions
Pursuant to both the investment advisory and administrative services agreement and the amended investment advisory agreement, FB Advisor is entitled to an annual base management fee of 2.0% of the average value of our gross assets and an incentive fee based on our performance. We commenced accruing fees under the investment advisory and administrative services agreement on January 2, 2009, upon commencement of our operations. Management fees are paid on a quarterly basis in arrears.
The incentive fee, which had consisted of three parts under the investment advisory and administrative services agreement, now consists of two parts. The first part, which is referred to as the subordinated incentive fee on income, is calculated and payable quarterly in arrears, equals 20.0% of “pre-incentive fee net investment income” for the immediately preceding quarter and is subject to a hurdle rate equal to 2.0% per quarter, or an annualized hurdle rate of 8.0%. Under the investment advisory and administrative services agreement, the hurdle rate used to compute the subordinated incentive fee on income was based on adjusted capital. Under the amended investment advisory agreement, the hurdle rate used to compute the subordinated incentive fee on income is based on the net asset value of our assets rather than adjusted capital. In addition, under the amended investment advisory agreement, the subordinated incentive fee on income is subject to a total return requirement.
The second part of the incentive fee, which is referred to as the incentive fee on capital gains, is accrued for on a quarterly basis and, if earned, is paid annually. We accrue the incentive fee based on net realized and unrealized gains; however, the fee payable to FB Advisor is based on realized gains and no such fee is payable with respect to unrealized gains unless and until such gains are actually realized. See Note 4 to our unaudited consolidated financial statements contained in this quarterly report on Form 10-Q for a discussion of the amended investment advisory agreement.
In anticipation of the listing of our shares of common stock on the NYSE, FB Advisor recommended that the amended investment advisory agreement be further amended to (i) reduce the annualized hurdle rate used in connection with the calculation of the subordinated incentive fee on income, expressed as a rate of return on our net assets, from 8% to 7.5% and (ii) assuming the reduction to the hurdle rate is approved, reduce the base management fee from 2.0% to 1.75% of the average value of our gross assets. Our board of directors has approved this amendment, and we plan to call a special meeting of our stockholders scheduled for June 23, 2014, at which stockholders will be asked to vote on the proposal. Pending stockholder approval of this proposal, FB Advisor has agreed, effective April 1, 2014, to waive a portion of the base management fee to which it is entitled under the amended investment advisory agreement so that the fee received equals 1.75% of the average value of our gross assets. There can be no assurance that this waiver will continue in the future.
Pursuant to the investment advisory and administrative services agreement, we reimbursed FB Advisor for expenses necessary to perform services related to our administration and operations. The amount of this
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reimbursement was set at the lesser of (1) FB Advisor’s actual costs incurred in providing such services and (2) the amount that we estimated we would be required to pay alternative service providers for comparable services in the same geographic location. FB Advisor was required to allocate the cost of such services to us based on factors such as total assets, revenues, time allocations and/or other reasonable metrics. Our board of directors then assessed the reasonableness of such reimbursements 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 providers known to be available. In addition, our board of directors considered whether any single third-party service provider would be capable of providing all such services at comparable cost and quality. Finally, our board of directors compared the total amount paid to FB Advisor for such services as a percentage of our net assets to the same ratio as reported by other comparable BDCs.
Pursuant to the administration agreement, FB Advisor will provide administrative services necessary for our operation, including general ledger accounting, fund accounting, legal services, investor relations and other administrative services. There will be no separate fee paid by us to FB Advisor in connection with the services provided under the administration agreement; provided, however, that we will reimburse FB Advisor no less than quarterly for all costs and expenses incurred by FB Advisor in performing its obligations and providing personnel and facilities thereunder. FB Advisor will allocate the cost of such services to us based on factors such as total assets, revenues, time allocations and/or other reasonable metrics.
See Note 4 to our unaudited consolidated financial statements contained in this quarterly report on Form 10-Q for additional information regarding our related party transactions and relationships, including potential conflicts of interest, our exemptive relief order and our expense reimbursement arrangement with Franklin Square Holdings.
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We are subject to financial market risks, including changes in interest rates. As of March 31, 2014, 71.3% of our portfolio investments (based on fair value) paid variable interest rates, 22.9% paid fixed interest rates, 2.5% were income producing equity or other investments, and the remaining 3.3% consisted of non-income producing equity or other investments. A rise in the general level of interest rates can be expected to lead to higher interest rates applicable to any variable rate investments we hold and to declines in the value of any fixed rate investments we hold. To the extent that a substantial portion of our investments may be in variable rate investments, an increase in interest rates would make it easier for us to meet or exceed the hurdle rate applicable to the subordinated incentive fee on income, and may result in a substantial increase in our net investment income and to the amount of incentive fees payable to FB Advisor with respect to our increased pre-incentive fee net investment income.
Pursuant to the terms of the Arch Street credit facility, the Broad Street credit facility and the Walnut Street credit facility, Arch Street, Broad Street and Walnut Street, respectively, borrow at a floating rate based on LIBOR. Under the terms of the JPM Facility, Race Street pays interest to JPM at a fixed rate. To the extent that any present or future credit facilities or other financing arrangements that we or any of our subsidiaries enter into are based on a floating interest rate, we will be subject to risks relating to changes in market interest rates. In periods of rising interest rates when we or our subsidiaries have such debt outstanding, our interest expense would increase, which could reduce our net investment income, especially to the extent we hold fixed rate investments.
The following table shows the effect over a twelve month period of changes in interest rates on our interest income, interest expense and net interest income, assuming no changes in our investment portfolio and borrowing arrangements in effect as of March 31, 2014 (dollar amounts are presented in thousands):
LIBOR Basis Point Change
Down 25 basis points
Current LIBOR
Up 100 basis points
Up 300 basis points
Up 500 basis points
We expect that our long-term investments will be financed primarily with equity and debt. If deemed prudent, we may use interest rate risk management techniques in an effort to minimize our exposure to interest rate fluctuations. These techniques may include various interest rate hedging activities to the extent permitted by the 1940 Act. Adverse developments resulting from changes in interest rates or hedging transactions could have a material adverse effect on our business, financial condition and results of operations. During the three months ended March 31, 2014 and 2013, we did not engage in interest rate hedging activities.
In addition, we may have risk regarding portfolio valuation. See “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies—Valuation of Portfolio Investments.”
As required by Rule 13a-15(b) under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including the chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2014.
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Based on the foregoing, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that we would meet our disclosure obligations.
There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) or 15d-15(f) of the Exchange Act) that occurred during the three month period ended March 31, 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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We are not currently subject to any material legal proceedings, nor, to our knowledge, is any material legal proceeding threatened against us. From time to time, we may be party to certain legal proceedings in the ordinary course of business, including proceedings relating to the enforcement of our rights under contracts with our portfolio companies. While the outcome of any legal proceedings cannot be predicted with certainty, we do not expect that these proceedings will have a material adverse effect upon our financial condition or results of operations.
There have been no material changes from the risk factors set forth in our annual report on Form 10-K for the year ended December 31, 2013.
The table below provides information concerning our repurchases of shares of our common stock during the period ended March 31, 2014 pursuant to our share repurchase program.
Period
January 1 to January 31, 2014
February 1 to February 28, 2014
March 1 to March 31, 2014
Not applicable.
(b) There have been changes to the procedures by which stockholders may recommend nominees to our board of directors. The details of the changes were provided in our Current Report on Form 8-K filed with the SEC on April 16, 2014. A complete copy of our second amended and restated bylaws was filed as Exhibit 3.2 to our Current Report on Form 8-K filed with the SEC on April 16, 2014.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on May 15, 2014.
/s/ Michael C. Forman
Michael C. Forman
Chief Executive Officer
(Principal Executive Officer)
/s/ William Goebel
William Goebel
Chief Financial Officer
(Principal Financial and Accounting Officer)
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