UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2013.
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 19104
(Address of principal executive office)
(215) 495-1150
(Registrant’s telephone number, including area code)
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, a non-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 254,341,184 shares of common stock outstanding as of May 14, 2013.
TABLE OF CONTENTS
PART I—FINANCIAL INFORMATION
ITEM 1.
Consolidated Balance Sheets as of March 31, 2013 (Unaudited) and December 31, 2012
Unaudited Consolidated Statements of Operations for the three months ended March 31, 2013 and 2012
Unaudited Consolidated Statements of Changes in Net Assets for the three months ended March 31, 2013 and 2012
Unaudited Consolidated Statements of Cash Flows for the three months ended March 31, 2013 and 2012
Consolidated Schedules of Investments as of March 31, 2013 (Unaudited) and December 31, 2012
Notes to Unaudited Consolidated Financial Statements
ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4.
CONTROLS AND PROCEDURES
PART II—OTHER INFORMATION
LEGAL PROCEEDINGS
ITEM 1A.
RISK FACTORS
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
DEFAULTS UPON SENIOR SECURITIES
MINE SAFETY DISCLOSURES
ITEM 5.
OTHER INFORMATION
ITEM 6.
EXHIBITS
SIGNATURES
Consolidated Balance Sheets
(in thousands, except share and per share amounts)
Assets
Investments, at fair value (amortized cost—$3,957,033 and $3,825,244, 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
Other accrued expenses and liabilities
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, 253,646,574 and 251,890,821 shares issued and outstanding, respectively
Capital in excess of par value
Accumulated undistributed net realized gains on investments and gain/loss on foreign currency(3)
Accumulated undistributed (distributions in excess of) net investment income(3)
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
Capitals gains incentive fees(1)
Subordinated income incentive fees(1)
Administrative services expenses
Stock transfer agent fees
Accounting and administrative fees
Interest expense
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 total return swap(2)
Net realized gain (loss) on foreign currency
Net change in unrealized appreciation (depreciation) on investments
Net change in unrealized appreciation (depreciation) on total return swap(2)
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 investment income (loss)
Net realized gain (loss) on investments, total return swap and foreign currency(1)
Net change in unrealized appreciation (depreciation) on total return swap(1)
Stockholder distributions(2)
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(2)
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 used in 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
Net change in unrealized (appreciation) depreciation on total return swap(1)
Accretion of discount
Amortization of deferred financing costs
(Increase) decrease in due from counterparty
(Increase) decrease in receivable for investments sold and repaid
(Increase) decrease in interest receivable
(Increase) decrease in receivable due on total return swap(1)
(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 other accrued expenses and liabilities
Net cash used in operating activities
Cash flows from financing activities
Stockholder distributions
Borrowings under credit facilities(2)
Borrowings under repurchase agreement(3)
Deferred financing costs paid
Net cash provided by financing activities
Total increase 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, 2013
(in thousands, except share amounts)
Portfolio Company(a)
Industry
Senior Secured Loans—First Lien—77.6%
A.P. Plasman Inc., L+850, 1.5% LIBOR Floor, 12/29/16(f)(h)(j)
AccentCare, Inc., L+500, 1.5% LIBOR Floor, 12/22/16(d)
Advantage Sales & Marketing Inc., L+325, 1.0% LIBOR Floor, 12/18/17(d)
Alcatel-Lucent USA Inc., L+525, 1.0% LIBOR Floor, 7/31/16(d)(e)(j)
Alcatel-Lucent USA Inc., L+625, 1.0% LIBOR Floor, 1/30/19(d)(e)(j)
Allied Security Holdings, LLC, L+400, 1.3% LIBOR Floor, 2/3/17(d)
Amaya Holdings Corp., L+775, 1.3% LIBOR Floor, 11/5/15(d)(h)(j)
American & Efird Global, LLC, L+900, 1.5% LIBOR Floor, 12/21/16(f)(h)
American Racing and Entertainment, LLC, Term Loan A, L+700, 6/30/14(f)
American Racing and Entertainment, LLC, Term Loan B, 9.0%, 6/30/14(f)
American Racing and Entertainment, LLC, Term Loan C, 9.0%, 6/30/14(f)
Applied Systems, Inc., L+400, 1.5% LIBOR Floor, 12/8/16(d)
Ardent Medical Services, Inc., L+525, 1.5% LIBOR Floor, 5/23/18(d)(e)
Aspect Software, Inc., L+525, 1.8% LIBOR Floor, 5/6/16(d)
Attachmate Corp., L+575, 1.5% LIBOR Floor, 11/22/17(d)(e)
Audio Visual Services Group, Inc., L+550, 1.3% LIBOR Floor, 11/9/18(d)
Avaya Inc., L+450, 10/26/17(d)(e)
Avaya Inc., L+675, 1.3% LIBOR Floor, 3/31/18(d)(i)
Barbri, Inc., L+450, 1.5% LIBOR Floor, 6/16/17(d)
Barrington Broadcasting Group LLC, L+600, 1.5% LIBOR Floor, 6/14/17(f)
Blackboard Inc., L+475, 1.5% LIBOR Floor, 10/4/18(d)(f)(h)
Boomerang Tube, LLC, L+950, 1.5% LIBOR Floor, 10/11/17(d)(h)
Brasa (Holdings) Inc., L+625, 1.3% LIBOR Floor, 7/19/19(d)
Bushnell Inc., L+425, 1.5% LIBOR Floor, 8/24/15(d)
Caesars Entertainment Operating Co., L+425, 1/26/18(d)(e)(f)(j)
Calceus Acquisition, Inc., L+450, 1.3% LIBOR Floor, 1/31/20(d)
Cannery Casino Resorts, LLC, L+475, 1.3% LIBOR Floor, 10/2/18(d)
Capital Vision Services, LLC, PRIME+625, 1.3% PRIME Floor, 12/3/17(f)(h)
Capital Vision Services, LLC, L+100, 12/3/17
CCM Merger, Inc., L+475, 1.3% LIBOR Floor, 3/1/17(d)
Cengage Learning Acquisitions, Inc., L+250, 7/3/14(d)
Chrysler Group LLC, L+475, 1.3% LIBOR Floor, 5/24/17(d)(e)(f)(h)
Citgo Petroleum Corp., L+600, 2.0% LIBOR Floor, 6/24/15(e)(j)
Citgo Petroleum Corp., L+700, 2.0% LIBOR Floor, 6/23/17(e)(f)(j)
Clear Channel Communications, Inc., L+365, 1/29/16(d)(e)(f)
Collective Brands, Inc., L+600, 1.3% LIBOR Floor, 10/9/19(d)(f)
CompuCom Systems, Inc., L+525, 1.3% LIBOR Floor, 10/4/18(d)
The Container Store, Inc., L+500, 1.3% LIBOR Floor, 4/5/19(d)(e)(i)
Corel Corp., L+700, 5/2/14(d)(j)
Corner Investment PropCo, LLC, L+975, 1.3% LIBOR Floor, 11/2/19(d)(f)(j)
Crestwood Holdings LLC, L+825, 1.5% LIBOR Floor, 3/26/18(f)
DAE Aviation Holdings, Inc., L+500, 1.3% LIBOR Floor, 11/2/18(h)
Drumm Investors LLC, L+375, 1.3% LIBOR Floor, 5/4/18(d)(f)
Dynegy Power, LLC (GasCo), L+775, 1.5% LIBOR Floor, 8/5/16(f)
Eastman Kodak Co., 10.6%, 9/30/13(f)
Eastman Kodak Co., 9.8%, 9/30/13
Eastman Kodak Co., L+1050, 1.0% LIBOR Floor, 9/30/13(d)(f)
Education Management LLC, L+400, 6/1/16(f)(j)
Education Management LLC, L+700, 1.3% LIBOR Floor, 3/29/18(e)(j)
Edwards (Cayman Island II) Ltd., L+350, 1.3% LIBOR Floor, 3/26/20(i)(j)
5
Unaudited Consolidated Schedule of Investments (continued)
EquiPower Resources Holdings, LLC, L+425, 1.3% LIBOR Floor, 12/21/18(d)
ERC Ireland Holdings Ltd., EURIBOR+300, 1.0% PIK, 9/30/17(i)(j)
FairPoint Communications, Inc., L+625, 1.3% LIBOR Floor, 2/14/19(d)(e)
Flanders Corp., L+950, 1.5% LIBOR Floor, 5/16/18(f)(h)
Fleetgistics Holdings, Inc., L+588, 2.0% LIBOR Floor, 3/23/15(f)
Florida Gaming Centers, Inc., 15.8%, 4/25/16(f)
FoxCo Acquisition Sub, LLC, L+450, 1.0% LIBOR Floor, 7/14/17(i)
Fram Group Holdings Inc., L+500, 1.5% LIBOR Floor, 7/29/17(d)
FREIF North American Power I LLC (TLB), L+450, 1.5% LIBOR Floor, 3/29/19(d)
FREIF North American Power I LLC (TLC), L+450, 1.5% LIBOR Floor, 3/29/19(d)
Generac Power Systems, Inc., L+500, 1.3% LIBOR Floor, 5/30/18(d)(j)
Generic Drug Holdings, Inc., L+375, 1.3% LIBOR Floor, 10/29/19(d)
Genesys Telecom Holdings, U.S., Inc., L+300, 1.0% LIBOR Floor, 1/25/20(d)
Gymboree Corp., L+350, 1.5% LIBOR Floor, 2/23/18(d)
Halifax Media Holdings LLC, L+1050, 0.8% LIBOR Floor, 6/30/16(f)(h)
Hamilton Lane Advisors, LLC, L+500, 1.5% LIBOR Floor, 2/23/18(d)
Harbor Freight Tools USA, Inc., L+425, 1.3% LIBOR Floor, 11/14/17(d)
HarbourVest Partners L.P., L+375, 1.0% LIBOR Floor, 11/21/17(d)
Harland Clarke Holdings Corp., L+250, 6/30/14(f)
Hawaiian Telcom Communications, Inc., L+575, 1.3% LIBOR Floor, 2/28/17(d)(f)(h)
HBC Solutions, Inc., L+875, 1.5% LIBOR Floor, 2/4/18(d)(f)(g)(h)
Hyland Software, Inc., L+425, 1.3% LIBOR Floor, 10/25/19(d)
Ikaria Acquisition Inc., L+650, 1.3% LIBOR Floor, 9/18/17(d)
ILC Industries, LLC, L+600, 1.5% LIBOR Floor, 7/11/18(d)(h)
Ineos Finance Plc, L+525, 1.3% LIBOR Floor, 5/4/18(d)(e)(f)(j)
Infogroup Inc., L+425, 1.5% LIBOR Floor, 5/25/18(d)
Insight Equity A.P. X, L.P., L+850, 1.0% LIBOR Floor, 10/26/18(f)(g)(h)
Intelsat Jackson Holdings SA, L+325, 1.3% LIBOR Floor, 4/2/18(d)(j)
Intralinks, Inc., L+425, 1.5% LIBOR Floor, 6/15/14(f)(j)
inVentiv Health, Inc., L+600, 1.5% LIBOR Floor, 8/4/16(d)
inVentiv Health, Inc., L+625, 1.5% LIBOR Floor, 5/15/18(e)
Ipreo Holdings LLC, L+525, 1.3% LIBOR Floor, 8/7/17(d)(f)
JHCI Acquisition, Inc., L+250, 6/19/14(d)(e)(i)
KIK Custom Products Inc., L+225, 6/2/14(e)(j)
La Paloma Generating Co., LLC, L+550, 1.5% LIBOR Floor, 8/25/17(e)(f)
Lantiq Deutschland GmbH, L+900, 2.0% LIBOR Floor, 11/16/15(f)(j)
Leading Edge Aviation Services, Inc., L+850, 1.5% LIBOR Floor, 4/5/18(d)(g)(h)
Maritime Telecommunications Network, Inc., L+600, 1.5% LIBOR Floor, 3/3/16(f)
McGraw-Hill Global Education Holdings, LLC, L+775, 1.3% LIBOR Floor, 3/22/19(d)(e)(i)
Micronics, Inc., L+800, 1.3% LIBOR Floor, 3/28/19(d)(h)
MMM Holdings, Inc., L+825, 1.5% LIBOR Floor, 12/12/17
Mood Media Corp., L+550, 1.5% LIBOR Floor, 5/7/18(d)(j)
MSO of Puerto Rico, Inc., L+825, 1.5% LIBOR Floor, 12/12/17
National Mentor Holdings, Inc., L+525, 1.3% LIBOR Floor, 2/9/17(d)
National Vision, Inc., L+575, 1.3% LIBOR Floor, 8/2/18(d)
Natural Products Group, LLC, PRIME+600, 4.0% PRIME Floor, 3/5/15(g)
Navistar, Inc., L+550, 1.5% LIBOR Floor, 8/17/17(d)(f)(h)(j)
NCI Building Systems, Inc., L+675, 1.3% LIBOR Floor, 5/2/18(d)(e)(g)(h)(j)
NCO Group, Inc., L+675, 1.3% LIBOR Floor, 4/3/18(e)(h)
New HB Acquisition, LLC, L+550, 1.3% LIBOR Floor, 3/31/20(d)(i)
Nexeo Solutions, LLC, L+350, 1.5% LIBOR Floor, 9/8/17
6
NSH Merger Sub, Inc., L+650, 1.8% LIBOR Floor, 2/2/17(d)(f)
On Assignment, Inc., L+375, 1.3% LIBOR Floor, 5/15/19(d)(j)
Onex Carestream Finance L.P., L+350, 1.5% LIBOR Floor, 2/25/17(d)(j)
Ozburn-Hessey Holding Co., LLC, L+625, 2.0% LIBOR Floor, 4/8/16(d)(f)
Panda Sherman Power, LLC, L+750, 1.5% LIBOR Floor, 9/14/18(d)
Panda Temple Power, LLC (TLA), L+700, 1.5% LIBOR Floor, 7/17/18(f)
Patheon Inc., L+600, 1.3% LIBOR Floor, 12/6/18(d)(j)
Pelican Products, Inc., L+550, 1.5% LIBOR Floor, 7/11/18(d)
Peninsula Gaming LLC, L+450, 1.3% LIBOR Floor, 8/3/17(f)(j)
Pharmaceutical Research Associates, Inc., L+525, 1.3% LIBOR Floor, 12/10/17(d)
Presidio, Inc., L+450, 1.3% LIBOR Floor, 3/31/17(d)(f)(g)(h)
Princeton Review, Inc., PRIME+550, 12/7/14(g)
Property Data (U.S.) I, Inc., L+550, 1.5% LIBOR Floor, 1/4/17(f)
Protection One, Inc., L+325, 1.0% LIBOR Floor, 3/21/19(d)
PRV Aerospace, LLC, L+525, 1.3% LIBOR Floor, 5/9/18(d)
RBS Holding Co. LLC, PRIME+600, 3/23/17(d)
RBS Worldpay, Inc., L+400, 1.3% LIBOR Floor, 11/30/17(d)
Reynolds Group Holdings, Inc., L+375, 1.0% LIBOR Floor, 9/28/18(d)(j)
Rocket Software, Inc., L+450, 1.3% LIBOR Floor, 2/8/18(d)
Roundy’s Supermarkets, Inc., L+450, 1.3% LIBOR Floor, 2/13/19(d)(j)
Safariland, LLC, L+925, 1.5% LIBOR Floor, 7/27/18(d)(f)(h)
Sagittarius Restaurants LLC, L+550, 2.0% LIBOR Floor, 5/18/15(d)(f)
SESAC Holdings Inc., L+475, 1.3% LIBOR Floor, 2/7/19(d)
Shell Topco L.P., L+750, 1.5% LIBOR Floor, 9/28/18(d)(h)
Sheridan Production Co., LLC, L+375, 1.3% LIBOR Floor, 10/1/19(e)
Shield Finance Co. Sarl, L+525, 1.3% LIBOR Floor, 5/10/19(f)(j)
Sirius Computer Solutions, Inc., L+575, 1.3% LIBOR Floor, 11/30/18(d)
Six3 Systems, Inc., L+575, 1.3% LIBOR Floor, 10/4/19(d)
Smarte Carte, Inc., L+650, 1.3% LIBOR Floor, 11/30/17(d)(f)(h)
Smile Brands Group Inc., L+525, 1.8% LIBOR Floor, 12/21/17(d)(e)
Sorenson Communication, Inc., L+825, 1.3% LIBOR Floor, 10/31/14(d)(e)(f)(h)(i)
Spansion LLC, L+400, 1.3% LIBOR Floor, 12/11/18(e)(j)
Sports Authority, Inc., L+600, 1.5% LIBOR Floor, 11/16/17(d)(e)(f)
Sprouts Farmers Markets Holdings, LLC, L+475, 4/18/16
Sprouts Farmers Markets Holdings, LLC, L+475, 1.3% LIBOR Floor, 4/18/18(d)
Star West Generation LLC, L+400, 1.0% LIBOR Floor, 3/13/20
SuperValu Inc., L+500, 1.3% LIBOR Floor, 2/28/19(d)(e)(i)(j)
Surgery Center Holdings, Inc., L+500, 1.5% LIBOR Floor, 2/6/17(d)(f)(h)
Swiss Watch International, Inc., L+725, 1.3% LIBOR Floor, 11/8/18(d)(f)(h)
Technicolor SA, EURIBOR+500, 2.0% EURIBOR Floor, 5/26/16(j)
Technicolor SA, EURIBOR+600, 2.0% EURIBOR Floor, 5/26/17(j)
Technicolor SA, L+500, 2.0% LIBOR Floor, 5/26/16(g)(j)
Technicolor SA, L+600, 2.0% LIBOR Floor, 5/26/17(g)(j)
Tervita Corp., L+500, 1.3% LIBOR Floor, 5/15/18(d)(j)
Texas Competitive Electric Holdings Co. LLC, L+350, 10/10/14(d)(e)(f)(g)
Texas Competitive Electric Holdings Co. LLC, L+450, 10/10/17(g)
Therakos, Inc., L+625, 1.3% LIBOR Floor, 12/27/17(d)(f)(i)
Titlemax, Inc., L+850, 1.5% LIBOR Floor, 6/15/15(f)(h)
TNS, Inc., L+400, 1.0% LIBOR Floor, 2/15/20(d)(i)
Topaz Power Holdings, LLC, L+400, 1.3% LIBOR Floor, 2/26/20(d)
Total Safety U.S., Inc., L+450, 1.3% LIBOR Floor, 3/12/20(d)(i)
Totes Isotoner Corp., L+575, 1.5% LIBOR Floor, 7/7/17(d)
Toys “R” Us-Delaware, Inc., L+450, 1.5% LIBOR Floor, 9/1/16(d)(e)
TravelCLICK, Inc., L+500, 1.5% LIBOR Floor, 3/16/16(d)
Travelport LLC, L+475, 8/21/15(e)(f)(g)
7
U.S. Security Associates Holdings, Inc., L+475, 1.3% LIBOR Floor, 7/28/17(d)
United Surgical Partners International Inc., L+475, 1.3% LIBOR Floor, 4/3/19(d)
Univar Inc., L+350, 1.5% LIBOR Floor, 6/30/17(e)
Univision Communications Inc., L+425, 3/31/17(e)(f)
Virtual Radiologic Corp., PRIME+450, 12/22/16(g)
Vision Solutions, Inc., L+450, 1.5% LIBOR Floor, 7/22/16(d)
VPG Group Holdings LLC, L+900, 1.0% LIBOR Floor, 10/4/16(f)(h)
Wall Street Systems Holdings, Inc., L+450, 1.3% LIBOR Floor, 10/25/19(d)
Wide OpenWest Finance LLC, L+500, 1.3% LIBOR Floor, 7/17/18(d)
Willbros United States Holdings, Inc., L+750, 2.0% LIBOR Floor, 6/30/14(h)(j)
WireCo WorldGroup Inc., L+475, 1.3% LIBOR Floor, 2/15/17(d)
Total Senior Secured Loans—First Lien
Unfunded Loan Commitments
Net Senior Secured Loans—First Lien
Senior Secured Loans—Second Lien—33.3%
Advance Pierre Foods, Inc., L+825, 1.3% LIBOR Floor, 10/10/17(e)(f)(g)
Advantage Sales & Marketing Inc., L+725, 1.0% LIBOR Floor, 6/12/18(e)(f)
Affordable Care, Inc., L+925, 1.3% LIBOR Floor, 12/26/19(d)(e)(f)(g)(h)
AlixPartners, LLP, L+925, 1.5% LIBOR Floor, 12/27/19(e)
Alliance Laundry Systems LLC, L+825, 1.3% LIBOR Floor, 12/10/19(d)(e)
American Racing and Entertainment, LLC, 12.0%, 7/2/18(g)
Attachmate Corp., L+950, 1.5% LIBOR Floor, 11/22/18(e)(f)
Audio Visual Services Group, Inc., L+950, 1.3% LIBOR Floor, 5/9/18(d)(f)(g)
BJ’s Wholesale Club, Inc., L+850, 1.3% LIBOR Floor, 3/26/20(e)(f)
Blackboard Inc., L+1000, 1.5% LIBOR Floor, 4/4/19(f)(g)
BNY ConvergEx Group, LLC, L+700, 1.8% LIBOR Floor, 12/18/17(g)
Brasa (Holdings) Inc., L+950, 1.5% LIBOR Floor, 1/20/20(f)
Brock Holdings III, Inc., L+825, 1.8% LIBOR Floor, 3/16/18(e)
Camp International Holding Co., L+875, 1.3% LIBOR Floor, 11/29/19(d)
Cannery Casino Resorts, LLC, L+875, 1.3% LIBOR Floor, 10/2/19(g)
CHG Buyer Corp., L+775, 1.3% LIBOR Floor, 11/19/20(d)
Crossmark Holdings, Inc., L+750, 1.3% LIBOR Floor, 12/21/20(e)
DEI Sales, Inc., L+850, 1.5% LIBOR Floor, 1/15/18(f)(g)
EquiPower Resources Holdings, LLC, L+850, 1.5% LIBOR Floor, 6/21/19(d)
EZE Software Group LLC, L+750, 1.3% LIBOR Floor, 2/22/21(e)(i)
FR Brand Acquisition Corp., L+975, 1.3% LIBOR Floor, 10/11/19(e)(g)
Fram Group Holdings Inc., L+900, 1.5% LIBOR Floor, 1/29/18(e)
ILC Industries, LLC, L+1000, 1.5% LIBOR Floor, 6/14/19(f)(g)
JHCI Acquisition, Inc., L+550, 12/19/14(g)
John Henry Holdings, Inc., L+900, 1.3% LIBOR Floor, 5/6/19(f)
Kronos Inc., L+850, 1.3% LIBOR Floor, 4/30/20(d)(e)(f)
LM U.S. Member LLC, L+825, 1.3% LIBOR Floor, 10/19/20
NES Rentals Holdings, Inc., L+1150, 1.8% LIBOR Floor, 10/14/14(g)
OSP Group, Inc., L+900, 1.3% LIBOR Floor, 7/31/20(d)(f)(g)(h)
Paw Luxco II Sarl, EURIBOR+950, 1/29/19(j)
Pelican Products, Inc., L+1000, 1.5% LIBOR Floor, 6/14/19(d)
Pharmaceutical Research Associates, Inc., L+925, 1.3% LIBOR Floor, 6/10/19(f)(i)
Pregis Corp., L+1000, 1.5% LIBOR Floor, 3/23/18(f)(g)
8
Samson Investment Co., L+475, 1.3% LIBOR Floor, 9/25/18(d)
Sedgwick CMS Holdings Inc., L+750, 1.5% LIBOR Floor, 5/30/17
Sensus USA Inc., L+725, 1.3% LIBOR Floor, 5/9/18(d)(e)
SESAC Holdings Inc., L+875, 1.3% LIBOR Floor, 7/12/19(f)
Smart & Final Inc., L+925, 1.3% LIBOR Floor, 11/16/20(g)
SRAM, LLC, L+700, 1.5% LIBOR Floor, 12/7/18(d)
Stadium Management Corp., L+950, 1.3% LIBOR Floor, 12/7/18(f)
TravelCLICK, Inc., L+850, 1.3% LIBOR Floor, 3/26/18(f)(g)
TriZetto Group, Inc., L+725, 1.3% LIBOR Floor, 3/28/19
Vertafore, Inc., L+825, 1.5% LIBOR Floor, 10/27/17(e)
Wall Street Systems Holdings, Inc., L+800, 1.3% LIBOR Floor, 10/25/20(d)(i)
WP CPP Holdings, LLC, L+925, 1.3% LIBOR Floor, 6/28/20(d)(e)(h)
Total Senior Secured Loans—Second Lien
Senior Secured Bonds—19.5%
Advanced Lighting Technologies, Inc., 10.5%, 6/1/19(f)(g)
Allen Systems Group, Inc., 10.5%, 11/15/16(f)
Aspect Software, Inc., 10.6%, 5/15/17(e)
Avaya Inc., 7.0%, 4/1/19(e)(f)(g)
Avaya Inc., 9.0%, 4/1/19(e)
Cenveo Corp., 8.9%, 2/1/18(e)(f)
Chester Downs & Marina, LLC, 9.3%, 2/1/20(e)
Clear Channel Communications, Inc., 9.0%, 12/15/19(d)(e)
Eastman Kodak Co., 10.6%, 3/15/19(f)
Eastman Kodak Co., 9.8%, 3/1/18
Edgen Murray Corp., 8.8%, 11/1/20(e)
Energy Future Intermediate Holding Co. LLC, 11.8%, 3/1/22(f)
FairPoint Communications, Inc., 8.8%, 8/15/19(e)(f)
Global A&T Electronics Ltd., 10.0%, 2/1/19(e)(j)
HOA Restaurant Group, LLC, 11.3%, 4/1/17(f)
JW Aluminum Co., 11.5%, 11/15/17(f)
Kinetic Concepts, Inc., 10.5%, 11/1/18(e)(f)
Logan’s Roadhouse Inc., 10.8%, 10/15/17(e)(i)
Neff Rental LLC, 9.6%, 5/15/16
NES Rentals Holdings, Inc., 12.3%, 4/15/15(f)(g)
Palace Entertainment Holdings, LLC, 8.9%, 4/15/17(e)
PH Holding LLC, 9.8%, 12/31/17(f)
Reynolds Group Holdings, Inc., 5.8%, 10/15/20(e)(j)
Ryerson Inc., 9.0%, 10/15/17(e)
Sorenson Communication, Inc., 10.5%, 2/1/15(g)
Speedy Cash Intermediate Holdings Corp., 10.8%, 5/15/18(e)(f)
Symbion, Inc., 8.0%, 6/15/16(e)(f)
Technicolor SA, 9.4%, 4/23/16(d)(g)(i)(j)
Technicolor SA, 9.4%, 5/26/17(d)(g)(i)(j)
Tervita Corp., 8.0%, 11/15/18(e)(j)
Texas Competitive Electric Holdings Co. LLC, 11.5%, 10/1/20(f)
Titlemax, Inc., 13.3%, 7/15/15(f)
Tops Holding Corp., 8.9%, 12/15/17(e)
Travelport LLC, L+600 PIK, 12/1/16(g)
Trinseo Materials Operating SCA, 8.8%, 2/1/19(e)
Viasystems Group Inc., 7.9%, 5/1/19(e)(j)
Total Senior Secured Bonds
9
Subordinated Debt—20.0%
Advantage Sales & Marketing Inc., 13.0%, 12/23/18(g)
Alta Mesa Holdings, L.P., 9.6%, 10/15/18(e)
Asurion, LLC, L+950, 1.5% LIBOR Floor, 8/16/19(f)
Aurora Diagnostics, LLC, 10.8%, 1/15/18(f)
Aurora USA Oil & Gas, Inc., 7.5%, 4/1/20(e)(j)
BakerCorp. International Inc., 8.3%, 6/1/19(f)
Bresnan Broadband Holdings LLC, 8.0%, 12/15/18(e)(j)
Cedar Fair, L.P., 5.3%, 3/15/21(e)(j)
Cincinnati Bell Inc., 8.4%, 10/15/20(e)(j)
Comstock Resources, Inc., 9.5%, 6/15/20(e)(f)(j)
Cumulus Media Inc., 7.8%, 5/1/19(f)(j)
Del Monte Foods Co., 7.6%, 2/15/19(e)
DigitalGlobe, Inc., 5.3%, 2/1/21(e)(j)
Entercom Radio, LLC, 10.5%, 12/1/19(e)(j)
EPL Oil & Gas, Inc., 8.3%, 2/15/18(e)(j)
Flanders Corp., 10.0%, 3.8% PIK, 5/14/18(g)
Gymboree Corp., 9.1%, 12/1/18(g)
Harland Clarke Holdings Corp., 9.5%, 5/15/15(g)
HD Supply Inc., 7.5%, 7/15/20(e)
Infiltrator Systems, Inc., 12.0%, 2.0% PIK, 3/11/18
Ipreo Holdings LLC, 11.8%, 8/15/18(f)
Jefferies Finance LLC, 7.4%, 4/1/20(e)(g)
Kinetic Concepts, Inc., 12.5%, 11/1/19(e)(f)(g)
Martin Midstream Partners L.P., 7.3%, 2/15/21(e)(j)
MModal Inc., 10.8%, 8/15/20(e)(g)
Monitronics International, Inc., 9.1%, 4/1/20(e)(j)
Mood Media Corp., 9.3%, 10/15/20(e)(f)(j)
The Pantry, Inc., 8.4%, 8/1/20(g)(j)
Petco Holdings, Inc., 8.5%, 10/15/17(e)
QR Energy, L.P., 9.3%, 8/1/20(e)(j)
Resolute Energy Corp., 8.5%, 5/1/20(e)(j)
Revlon Consumer Products Corp., 5.8%, 2/15/21(e)(j)
Samson Investment Co., 9.8%, 2/15/20(e)(f)
SandRidge Energy, Inc., 8.1%, 10/15/22(e)(j)
Sequel Industrial Products Holdings, LLC, 12.0%, 2.5% PIK, 5/10/18(g)
Sidewinder Drilling Inc., 9.8%, 11/15/19(f)(g)
Symmetry Medical Inc., 12.0%, 2.0% PIK, 12/29/17(g)(j)
ThermaSys Corp., 10.0%, 2.5% PIK, 12/31/16
Viking Cruises, Ltd., 8.5%, 10/15/22(e)(j)
Total Subordinated Debt
Collateralized Securities—4.0%
Apidos CDO IV Class E, L+360, 10/27/18(g)(j)
Ares 2007 CLO 11A Class E, L+600, 10/11/21(g)(j)
Ares 2007 CLO 12X Class E, L+575, 11/25/20(g)(j)
Carlyle Azure CLO Class Income, 22.0%, 5/27/20(j)
Dryden CDO 23A Class E, L+700, 7/20/23(j)
Dryden CDO 23A Class Subord, 14.5%, 7/17/23(j)
Galaxy VII CLO Class Subord., 22.3%, 10/13/18(j)
Lightpoint CLO 2006 V Class D, L+365, 8/5/19(g)(j)
Rampart CLO 2007 1A Class Subord., 56.8%, 10/25/21(j)
10
Stone Tower CLO VI Class Subord., 54.8%, 4/17/21(g)(j)
Wind River CLO Ltd. 2012 1A Class Sub B, 16.8%, 1/15/24(j)
Total Collateralized Securities
Aquilex Corp., Common Equity, Class A Shares(f)(l)
Aquilex Corp., Common Equity, Class B Shares(f)(g)(l)
ERC Ireland Holdings Ltd., Common Equity(j)(l)
ERC Ireland Holdings Ltd., Warrants(j)(l)
Flanders Corp., Common Equity(g)(l)
Florida Gaming Centers, Inc., Strike: $0.01, Warrants(g)(l)
Florida Gaming Corp., Strike: $25.00, Warrants(g)(l)
HBC Solutions, Inc., Common Equity, Class A Units(l)
Ipreo Holdings LLC, Common Equity(g)(l)
JW Aluminum Co., Common Equity(g)(l)
Leading Edge Aviation Services, Inc., Common Equity(g)(l)
Leading Edge Aviation Services, Inc., Preferred Equity(g)(l)
Micronics, Inc., Common Equity(l)
Milagro Holdings, LLC, Common Equity(g)(l)
Milagro Holdings, LLC, Preferred Equity(l)
Plains Offshore Operations Inc., Preferred Equity(f)(g)
Plains Offshore Operations Inc., Strike: $20.00, Warrants(f)(g)(l)
Safariland, LLC, Common Equity(g)(l)
Safariland, LLC, Preferred Equity(g)
Safariland, LLC, Warrants(g)(l)
Sequel Industrial Products Holdings, LLC, Common Equity(g)(l)
Sequel Industrial Products Holdings, LLC, Preferred Equity(g)(l)
Sequel Industrial Products Holdings, LLC, Strike: $100.00, Warrants(g)(l)
ThermaSys Corp., Common Equity(g)(l)
ThermaSys Corp., Preferred Equity(g)(l)
VPG Group Holdings LLC, Class A-2 Units(g)(l)
Total Equity/Other
TOTAL INVESTMENTS—159.5%
LIABILITIES IN EXCESS OF OTHER ASSETS—(59.5%)
NET ASSETS—100.0%
11
12
Consolidated Schedule of Investments
As of December 31, 2012
Senior Secured Loans—First Lien—77.5%
Advantage Sales & Marketing Inc., L+375, 1.5% LIBOR Floor, 12/18/17(d)
Airvana Network Solutions Inc., L+800, 2.0% LIBOR Floor, 3/25/15(f)
AlixPartners, LLP, L+525, 1.3% LIBOR Floor, 6/28/19(d)(f)
Alkermes, Inc., L+350, 1.0% LIBOR Floor, 9/18/19(d)(j)
Altegrity, Inc., L+600, 1.8% LIBOR Floor, 2/20/15(d)(e)
Amaya Holdings Corp., L+775, 1.3% LIBOR Floor, 11/5/15(d)(h)
American Racing and Entertainment, LLC Term Loan A, L+700, 6/30/14(f)
American Racing and Entertainment, LLC Term Loan B, 9.0%, 6/30/14(f)
American Racing and Entertainment, LLC Term Loan C, 9.0%, 6/30/14(f)
Ardent Medical Services, Inc., L+500, 1.5% LIBOR Floor, 9/15/15(d)(e)
Ardent Medical Services, Inc., L+525, 1.5% LIBOR Floor, 5/23/18(d)(e)(i)
Avaya Inc., L+275, 10/24/14(d)
AZ Chem U.S. Inc., L+575, 1.5% LIBOR Floor, 12/22/17(h)(i)
BBB Industries, LLC, L+450, 2.0% LIBOR Floor, 6/27/14(f)
BJ’s Wholesale Club, Inc., L+450, 1.3% LIBOR Floor, 9/26/19(d)(e)
Blackboard Inc., L+600, 1.5% LIBOR Floor, 10/4/18(d)(f)(h)
Capital Vision Services, LLC, Prime+625, 1.3% PRIME Floor, 12/3/17(f)(h)
Cengage Learning Acquisitions, Inc., L+225, 7/3/14(d)(i)
Clear Channel Communications, Inc., L+365, 1/29/16(d)(e)(f)(i)
Collective Brands Finance, Inc., L+600, 1.3% LIBOR Floor, 10/9/19(f)
The Container Store, Inc., L+500, 1.3% LIBOR Floor, 4/5/19(d)(e)
Corner Investment PropCo, LLC, L+975, 1.3% LIBOR Floor, 11/1/19(d)(f)(j)
DAE Aviation Holdings, Inc., L+500, 1.3% LIBOR Floor, 10/29/18(h)
Del Monte Foods Co., L+300, 1.5% LIBOR Floor, 3/8/18(d)
Dynegy Holdings Inc. (GasCo), L+775, 1.5% LIBOR Floor, 8/5/16(f)
Eastman Kodak Co., L+750, 1.0% LIBOR Floor, 7/19/13(g)
Electrical Components International, Inc., L+525, 1.5% LIBOR Floor, 2/4/16(f)
Electrical Components International, Inc., L+525, 1.5% LIBOR Floor, 2/4/17(g)
13
Consolidated Schedule of Investments (continued)
Fairway Group Acquisition Co., L+675, 1.5% LIBOR Floor, 8/17/18(d)(f)(h)
Flexera Software, Inc., L+625, 1.3% LIBOR Floor, 9/29/17(d)
Generic Drug Holdings, Inc., L+475, 1.3% LIBOR Floor, 9/28/19(d)
Genesys Telecom Holdings, U.S., Inc., L+525, 1.5% LIBOR Floor, 1/31/19(d)
Hupah Finance Inc., L+500, 1.3% LIBOR Floor, 1/21/19(d)(e)
IASIS Healthcare LLC, L+375, 1.3% LIBOR Floor, 5/3/18(d)
Immucor, Inc., L+450, 1.3% LIBOR Floor, 8/17/18(d)
INC Research, LLC, L+575, 1.3% LIBOR Floor, 7/12/18(d)(f)
inVentiv Health, Inc., L+500, 1.5% LIBOR Floor, 8/4/16(d)
inVentiv Health, Inc., L+525, 1.5% LIBOR Floor, 5/15/18(e)
Jason Inc. (TLA), L+625, 2.0% LIBOR Floor, 9/21/14(g)
Jason Inc. (TLB), L+625, 2.0% LIBOR Floor, 9/21/14(g)
JHCI Acquisition, Inc., L+250, 6/19/14(d)
Kronos Inc., L+425, 1.3% LIBOR Floor, 10/25/19(d)
Natural Products Group, LLC, Prime+600, 4.0% PRIME Floor, 3/5/15(g)
Nexeo Solutions, LLC, L+350, 1.5% LIBOR Floor, 9/17/17
Nuveen Investments, Inc., L+550, 5/13/17(d)
NXP BV, L+425, 1.3% LIBOR Floor, 3/3/17(d)(j)
14
Orbitz Worldwide, Inc., L+300, 7/25/14(d)(j)
Panda Sherman Power, LLC, L+750, 1.5% LIBOR Floor, 9/13/18(d)
Party City Holdings Inc., L+450, 1.3% LIBOR Floor, 7/26/19(d)(e)(f)
Patheon Inc., L+600, 1.3% LIBOR Floor, 12/6/18(d)(i)(j)
Pharmaceutical Product Development, Inc., L+500, 1.3% LIBOR Floor, 12/5/18(d)
Pharmaceutical Research Associates, Inc., L+525, 1.3% LIBOR Floor, 11/27/18(d)(i)
PL Propylene LLC, L+575, 1.3% LIBOR Floor, 3/23/17(d)(j)
Princeton Review, Inc., L+550, 1.5% LIBOR Floor, 12/7/14(g)
Protection One, Inc., L+450, 1.3% LIBOR Floor, 3/21/19(d)
RBS Holding Co. LLC, Prime+600, 3/23/17(d)
Remy International, Inc., L+450, 1.8% LIBOR Floor, 12/16/16(d)(j)
Sabre Inc., L+575, 12/29/17(d)
Sabre Inc., L+600, 1.3% LIBOR Floor, 12/29/17(e)
Sheridan Production Co., LLC, L+375, 1.3% LIBOR Floor, 9/14/19(e)
Sirius Computer Solutions, Inc., L+575, 1.3% LIBOR Floor, 11/30/18(d)(i)
Sitel, LLC, L+675, 1/30/17(e)
Sophia, L.P., L+500, 1.3% LIBOR Floor, 7/19/18(d)(e)(f)
Sorenson Communication, Inc., L+400, 2.0% LIBOR Floor, 8/16/13(d)(e)(f)(h)
Spansion LLC, L+350, 1.3% LIBOR Floor, 2/9/15(e)(j)
SRA International, Inc., L+525, 1.3% LIBOR Floor, 7/20/18(d)(e)(f)
Star West Generation LLC, L+450, 1.5% LIBOR Floor, 5/17/18(d)
Texas Competitive Electric Holdings Co. LLC, L+350, 10/10/14(d)(e)(f)(g)(i)
TI Group Automotive Systems, LLC, L+550, 1.3% LIBOR Floor, 3/14/18(d)(e)(j)
Total Safety U.S., Inc., L+625, 1.3% LIBOR Floor, 10/31/17(d)(f)
15
Unifrax I LLC, L+500, 1.5% LIBOR Floor, 11/28/18(e)(f)
Virtual Radiologic Corp., Prime+450, 12/22/16(g)
Wall Street Systems Holdings, Inc., L+450, 1.3% LIBOR Floor, 10/24/19(d)
WASH Multifamily Laundry Systems, LLC, Prime+375, 8/28/14(g)
West Corp., L+450, 1.3% LIBOR Floor, 6/29/18(d)
Wide Open West Finance LLC, L+500, 1.3% LIBOR Floor, 7/17/18(d)
Woodstream Corp., L+350, 8/31/14(f)
Woodstream Corp., Prime+375, 8/31/14(g)
Senior Secured Loans—Second Lien—30.4%
Advantage Sales & Marketing Inc., L+775, 1.5% LIBOR Floor, 6/18/18(e)(f)
Affordable Care, Inc., Prime+825, 12/26/19(d)(e)(f)(g)(h)
AssuraMed Holding, Inc., L+800, 1.3% LIBOR Floor, 4/24/20(f)
Asurion, LLC, L+750, 1.5% LIBOR Floor, 5/24/19(d)(e)
Audio Visual Services Group, Inc., L+900, 1.3% LIBOR Floor, 4/30/19(d)(f)(g)
CHG Buyer Corp., L+775, 1.3% LIBOR Floor, 11/20/20(d)
Consolidated Precision Products Corp., L+925, 1.3% LIBOR Floor, 6/19/20(d)(e)(h)(i)
FR Brand Acquisition Corp., L+975, 1.3% LIBOR Floor, 10/11/19(e)(g)(i)
Hubbard Radio, LLC, L+725, 1.5% LIBOR Floor, 4/30/18(f)
LM U.S. Member LLC, L+825, 1.3% LIBOR Floor, 10/15/20
Multi Packaging Solutions, Inc., L+900, 1.3% LIBOR Floor, 5/4/19(f)
Pharmaceutical Research Associates, Inc., L+925, 1.3% LIBOR Floor, 11/27/19(f)
16
Sensus U.S.A. Inc., L+725, 1.3% LIBOR Floor, 5/9/18(d)(e)
Sheridan Holdings, Inc., L+775, 1.3% LIBOR Floor, 7/1/19(f)
Southern Pacific Resource Corp., Prime+750, 1/7/16(e)(f)(j)
TriZetto Group, Inc., L+725, 1.3% LIBOR Floor, 3/27/19
Venoco, Inc., L+700, 1.5% LIBOR Floor, 6/30/17(d)(g)
Wall Street Systems Holdings, Inc., L+800, 1.3% LIBOR Floor, 4/24/20(d)
Web.com Group, Inc., L+950, 1.5% LIBOR Floor, 10/26/18(d)(f)(j)
Senior Secured Bonds—18.6%
Clear Channel Communications, Inc., 9.0%, 12/15/19(d)(e)(f)(i)
Eastman Kodak Co., 10.6%, 3/15/19(f)(l)
Eastman Kodak Co., 9.8%, 3/1/18(l)
Edgen Murray Corp., 8.8%, 11/1/20(e)(j)
Energy Future Intermediate Holding Co. LLC, 6.9%, 8/15/17(g)
First Data Corp., 6.8%, 11/1/20(g)
Ineos Finance Plc, 7.5%, 5/1/20(e)(j)
Ineos Finance Plc, 8.4%, 2/15/19(e)(j)
Paetec Holdings Corp., 8.9%, 6/30/17(e)(j)
Reynolds Group Holdings, Inc., 7.1%, 4/15/19(e)(j)
Speedy Cash Intermediate Holdings Corp., 10.8%, 5/15/18(f)
Technicolor SA, 9.4%, 4/23/16(g)(j)
Technicolor SA, 9.4%, 5/26/17(g)(j)
Tops Markets LLC, 8.9%, 12/15/17(e)
Univision Communications Inc., 6.9%, 5/15/19(f)
17
Subordinated Debt—20.4%
Aurora USA Oil & Gas, Inc., 9.9%, 2/15/17(j)
Calumet Lubricants Co., L.P., 9.4%, 5/1/19(f)(j)
Calumet Lubricants Co., L.P., 9.6%, 8/1/20(f)(j)
EPL Oil & Gas Inc., 8.3%, 2/15/18(e)(j)
First Data Corp., 12.6%, 1/15/21(g)
J.Crew Group, Inc., 8.1%, 3/1/19
JBS U.S.A. LLC, 8.3%, 2/1/20(e)(j)
Lin Television Corp., 6.4%, 1/15/21(e)(j)
Lone Pine Resources Canada Ltd., 10.4%, 2/15/17(g)(j)
The Pantry Inc., 8.4%, 8/1/20(g)(j)
Pharmaceutical Product Development, Inc., 9.5%, 12/1/19(g)
Quicksilver Resources Inc., 7.1%, 4/1/16(e)(j)
Sidewinder Drilling, Inc., 9.8%, 11/15/19(f)(g)
Univar Inc., 12.0%, 6/30/18(f)
Collateralized Securities—4.7%
Carlyle Azure CLO Class Income, 23.3%, 5/27/20(j)
Dryden CDO 23A Class Subord, 15.2%, 7/17/23(j)
Galaxy VII CLO Class Subord., 28.9%, 10/13/18(j)
Mountain View CLO II Class Pref., 34.5%, 1/12/21(j)
Octagon CLO 2006 10A Class Income, 54.0%, 10/18/20(j)
Rampart CLO 2007 1A Class Subord., 55.8%, 10/25/21(j)
Stone Tower CLO VI Class Subord., 48.9%, 4/17/21(g)(j)
18
Equity/Other—5.1%(k)
ERC Ireland Holdings Ltd., Common Equity(i)(j)(l)
ERC Ireland Holdings Ltd., Warrants(i)(j)(l)
TOTAL INVESTMENTS—156.7%
LIABILITIES IN EXCESS OF OTHER ASSETS—(56.7%)
19
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, 2013, the Company had five wholly-owned financing subsidiaries, Broad Street Funding LLC, or Broad Street, Arch Street Funding LLC, or Arch Street, Locust Street Funding LLC, or Locust Street, Race Street Funding LLC, or Race Street, and Walnut Street Funding LLC, or Walnut Street. The consolidated financial statements include both the Company’s accounts and the accounts of its wholly-owned financing subsidiaries. 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 revenue 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, or proprietary, 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, 2012 included in the Company’s annual report on Form 10-K. Operating results for the three months ended March 31, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013. The December 31, 2012 balance sheet and schedule of investments are derived from the 2012 audited consolidated financial statements. 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.
20
Notes to Unaudited Consolidated Financial Statements (continued)
Note 2. Summary of Significant Accounting Policies (continued)
Capital Gains Incentive Fee: The Company has entered into an investment advisory and administrative services agreement with FB Income Advisor, LLC, or FB Advisor, dated as of February 12, 2008, which was amended on August 5, 2008, and which, as amended, is referred to herein as the investment advisory and administrative serves agreement. Pursuant to the terms of the investment advisory and administrative services agreement, the incentive fee on capital gains during operations prior to a liquidation of the Company is determined and payable in arrears as of the end of each calendar year (or upon termination of the investment advisory and administrative services 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 with FB Advisor neither includes nor contemplates 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 the investment advisory and administrative services agreement, FB Advisor may also be entitled to receive a subordinated incentive fee on income. The subordinated incentive fee on income, which 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, 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 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, of adjusted capital. Thereafter, FB Advisor will receive 20.0% of pre-incentive fee net investment income.
Reclassifications: Certain amounts in the unaudited consolidated financial statements for the three months ended March 31, 2012 have been reclassified to conform to the classifications used to prepare the unaudited consolidated financial statements for the three months ended March 31, 2013. These reclassifications had no material impact on the Company’s consolidated financial position, results of operations or cash flows as previously reported.
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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, 2013 and 2012:
Gross Proceeds from Offering(1)
Reinvestment of Distributions
Total Gross Proceeds
Commissions and Dealer Manager Fees
Net Proceeds to Company
Share Repurchase Program
Net Proceeds from Share Transactions
Public Offering of Shares
In May 2012, the Company closed its continuous public offering of shares of common stock to new investors. The Company sold 247,454,171 shares (as adjusted for stock distributions) of common stock for gross proceeds of $2,605,158 in its continuous public offering. Following the closing of its continuous public offering, the Company has continued to issue shares pursuant to its distribution reinvestment plan. As of May 14, 2013, the Company had sold a total of 258,844,374 shares (as adjusted for stock distributions) of common stock and raised total gross proceeds of $2,717,668, including approximately $1,000 contributed by the principals of the Company’s investment adviser in February 2008.
During the three months ended March 31, 2013 and 2012, the Company sold 2,638,800 and 42,836,184 shares for gross proceeds of $26,476 and $452,338 at an average price per share of $10.03 and $10.56, respectively. The gross proceeds received during the three months ended March 31, 2012 include reinvested stockholder distributions of $17,206, for which the Company issued 1,792,143 shares of common stock. During the period from April 1, 2013 to May 14, 2013, the Company issued 1,747,729 shares of common stock for gross proceeds of $17,739 at an average price per share of $10.15 pursuant to its distribution reinvestment plan.
The proceeds from the issuance of common stock as presented on the Company’s unaudited consolidated statements of changes in net assets and unaudited consolidated statements of cash flows are presented net of selling commissions and dealer manager fees of $0 and $40,660 for the three months ended March 31, 2013 and 2012, respectively.
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Note 3. Share Transactions (continued)
The Company intends to conduct quarterly tender offers pursuant to its share repurchase program. The Company’s board of directors will consider the following factors, among others, in making its determination regarding whether to cause the Company to offer to repurchase shares of common stock and under what terms:
the effect of such repurchases on the Company’s qualification as a RIC (including the consequences of any necessary asset sales);
the liquidity of its assets (including fees and costs associated with disposing of assets);
the Company’s investment plans and working capital requirements;
the relative economies of scale with respect to the Company’s size;
the Company’s history in repurchasing shares or portions thereof; and
the condition of the securities markets.
The Company currently intends to limit the number of shares of common stock to be repurchased during any calendar year to the number of shares of common stock it can repurchase with the proceeds it receives from the sale of shares of common stock under its distribution reinvestment plan. At the discretion of the Company’s board of directors, the Company may also use cash on hand, cash available from borrowings and cash from liquidation of securities investments as of the end of the applicable period to repurchase shares of common stock. In addition, the Company will limit the number of shares of common stock to be repurchased in any calendar year to 10% of the weighted average number of shares of common stock outstanding in the prior calendar year, or 2.5% in each quarter, though the actual number of shares of common stock that the Company offers to repurchase may be less in light of the limitations noted above.
Under the share repurchase program, the Company intends to offer to repurchase shares of common stock on each date of repurchase at a price equal to the price at which shares of common stock are issued pursuant to the Company’s distribution reinvestment plan on the distribution date coinciding with the applicable share repurchase date. The repurchase price is determined by the Company’s board of directors or a committee thereof, in its sole discretion, and will be (i) not less than the net asset value per share of the Company’s common stock (as determined in good faith by the Company’s board of directors or a committee thereof) immediately prior to the repurchase date and (ii) not more than 2.5% greater than the net asset value per share as of such date.
The Company’s board of directors may amend, suspend or terminate the repurchase program at any time, upon 30 days’ notice. The first such tender offer commenced in March 2010, and the repurchase occurred in connection with the Company’s April 1, 2010 semi-monthly closing.
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The following table sets forth the number of shares of common stock repurchased by the Company during the three months ended March 31, 2013 and 2012:
For the Three Months Ended
Fiscal 2012
December 31, 2011
Fiscal 2013
December 31, 2012
On April 1, 2013, the Company repurchased 1,053,119 shares (representing 100% of shares of common stock tendered for repurchase) at $10.10 per share for aggregate consideration totaling $10,637.
Note 4. Related Party Transactions
Compensation of the Dealer Manager and Investment Adviser
Pursuant to the investment advisory and administrative services 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 the commencement of the Company’s operations. Management fees are paid on a quarterly basis in arrears.
The incentive fee consists of three parts. The first part, which is referred to as the subordinated incentive fee on income, is calculated and payable quarterly in arrears and equals 20.0% of “pre-incentive fee net investment income” for the immediately preceding quarter and is 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 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, of adjusted capital. 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.
The second part of the incentive fee, which is referred to as the incentive fee on capital gains during operations, is an incentive fee on capital gains during operations prior to a liquidation of the Company and is determined and payable in arrears as of the end of each calendar year (or upon termination of the investment advisory and administrative services agreement). This fee equals 20.0% of the Company’s incentive fee capital gains, which equals the Company’s realized capital gains on a cumulative basis from inception, calculated as of the end of each calendar year, 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
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Note 4. Related Party Transactions (continued)
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 investment advisory and administrative services 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 third part of the incentive fee, which is referred to as the subordinated liquidation incentive fee, equals 20.0% of the net proceeds from a liquidation of the Company in excess of adjusted capital, as calculated immediately prior to liquidation.
The Company reimburses FB Advisor for expenses necessary to perform services related to the Company’s administration and operations. The amount of this reimbursement is set at the lesser of (1) FB Advisor’s actual costs incurred in providing such services and (2) the amount that the Company estimates it would be required to pay alternative service providers for comparable services in the same geographic location. FB Advisor is required to allocate the cost of such services to the Company based on objective factors such as total assets, revenues, time allocations and/or other reasonable metrics. The Company’s board of directors then assesses 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 considers 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 compares 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.
Franklin Square Holdings, L.P., or Franklin Square Holdings, the Company’s sponsor and an affiliate of FB Advisor, has funded certain of the Company’s offering costs and organization costs. Under the terms of the investment advisory and administrative services agreement, when the Company’s registration statement was declared effective by the SEC and the Company was successful in raising gross proceeds in excess of $2,500, or the minimum offering requirement, from persons who were not affiliated with the Company or FB Advisor, FB Advisor became entitled to receive 1.5% of gross proceeds raised in the Company’s continuous public offering until all offering costs and organization costs funded by FB Advisor or its affiliates (including Franklin Square Holdings) had been recovered. On January 2, 2009, the Company satisfied the minimum offering requirement. The Company did not pay any reimbursements under this arrangement during the three months ended March 31, 2013 or 2012.
The dealer manager for the Company’s continuous public offering was FS2 Capital Partners, LLC, or FS2, which is one of the Company’s affiliates. Under the dealer manager agreement among the Company, FB Advisor and FS2, FS2 was entitled to receive sales commissions and dealer manager fees in connection with the sale of shares of common stock in the Company’s continuous public offering, all or a portion of which were re-allowed to selected broker-dealers.
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The following table describes the fees and expenses accrued under the investment advisory and administrative services agreement and the dealer manager agreement during the three months ended March 31, 2013 and 2012:
Related Party
Source Agreement
Description
FB Advisor
FS2
Represents aggregate sales commissions and dealer manager fees retained by FS2 and not re-allowed to selected broker dealers.
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 and FSIC II Advisor, LLC, the investment advisers to Franklin Square Holdings’ other affiliated BDCs, FS Energy and Power Fund and FS Investment Corporation II, respectively. As a result, such personnel provide investment advisory services to each of the Company, FS Energy and Power Fund and FS Investment Corporation II. While none of FB Advisor, FS Investment Advisor, LLC or FSIC II Advisor, LLC is currently making private corporate debt investments for clients other than the Company, FS Energy and Power Fund and FS Investment Corporation II, 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 and/or FS Investment Corporation II rather than to the Company.
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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, or the expense reimbursement agreement, Franklin Square Holdings has agreed to reimburse the Company for expenses in an amount that is sufficient to 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 will 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 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. The expense reimbursement agreement does not apply to any amounts funded by Franklin Square Holdings prior to the date of such agreement.
The Company or Franklin Square Holdings may terminate the expense reimbursement agreement at any time. If the Company terminates the investment advisory and administrative services agreement with FB Advisor, the Company will be required to repay Franklin Square Holdings all reimbursements funded by Franklin Square Holdings within three years of the date of termination.
The specific amount of expenses reimbursed by Franklin Square Holdings, if any, will be determined at the end of each quarter. During the three months ended March 31, 2013 and 2012, no such reimbursements were
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required from Franklin Square Holdings. Franklin Square Holdings is controlled by the Company’s chairman and chief executive officer, Michael C. Forman, and the Company’s 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.
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, 2013 and 2012:
March 31, 2012
March 31, 2013
On April 11, 2013, the Company’s board of directors declared a regular monthly cash distribution of $0.0675 per share, which was paid on April 30, 2013 to stockholders of record on April 29, 2013. On May 8, 2013, the Company’s board of directors declared a regular monthly cash distribution of $0.0675 per share, which will be paid on May 31, 2013 to stockholders of record on May 30, 2013. The timing and amount of any future distributions to stockholders are subject to applicable legal restrictions and the sole discretion of the Company’s board of directors.
The Company has adopted an “opt in” distribution reinvestment plan for its stockholders. As a result, if the Company makes a distribution, its stockholders will receive distributions in cash unless they specifically “opt 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 may fund its cash distributions to stockholders from any sources of funds available to it, including offering proceeds, 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 for tax purposes. 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 source 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.
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Note 5. Distributions (continued)
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, 2013 and 2012:
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, 2013 and 2012 was $57,068 and $35,006, respectively. As of March 31, 2013 and December 31, 2012, the Company had $70,535 and $53,010, respectively, of undistributed net investment income on a tax basis.
The difference between the Company’s GAAP-basis net investment income and its tax-basis net investment income is due to the tax-basis amortization of organization costs incurred prior to the commencement of the Company’s operations, 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, with respect to the three months ended March 31, 2012, the inclusion of a portion of the periodic net settlement payments due on the Company’s total return swap in tax-basis net investment income and the accretion of discount on the total return swap.
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, 2013 and 2012:
GAAP-basis net investment income
Tax-basis amortization of organization costs
Reversal of incentive fee accrual on unrealized gains
Tax-basis net investment income portion of total return swap payments
Accretion of discount on total return swap
Tax-basis net investment income
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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.
The following table reflects the stock distributions per share that the Company declared on its common stock through March 31, 2013:
Date Declared
Fiscal 2009
March 31, 2009
April 30, 2009
May 29, 2009
June 30, 2009
July 30, 2009
August 31, 2009
December 31, 2009
Fiscal 2010
January 28, 2010
The purpose of these special stock distributions was to maintain a net asset value per share that was below the then-current offering price, after deducting selling commissions and dealer manager fees, as required by the 1940 Act, subject to certain limited exceptions. The Company’s board of directors determined that its portfolio performance sufficiently warranted taking these actions.
The stock distributions increased the number of shares outstanding, thereby reducing the Company’s net asset value per share. However, because the stock distributions were issued to all stockholders as of the applicable record date in proportion to their holdings as of such date, the reduction in net asset value per share as a result of the stock distributions was offset exactly by the increase in the number of shares owned by each investor. As overall value to an investor was not reduced as a result of the special stock distributions, the Company’s board of directors determined that these issuances would not be dilutive to stockholders as of the applicable record date. As the stock distributions did not change any stockholder’s proportionate interest in the Company, they did not represent taxable distributions. Specific tax characteristics of all stock distributions are reported to stockholders annually on Form 1099-DIV.
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As of March 31, 2013 and December 31, 2012, the components of accumulated earnings on a tax basis were as follows:
Distributable ordinary income
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 $3,974,837 and $3,845,515 as of March 31, 2013 and December 31, 2012, respectively. The aggregate net unrealized appreciation (depreciation) on a tax basis was $109,188 and $89,082 as of March 31, 2013 and December 31, 2012, respectively.
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, 2013 and December 31, 2012:
Senior Secured Loans—First Lien
Senior Secured Loans—Second Lien
Senior Secured Bonds
Subordinated Debt
Collateralized Securities
Equity/Other
The Company does not “control” and is 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.
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Note 6. Investment Portfolio (continued)
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, 2013, the Company had three such investments with an aggregate unfunded commitment of $14,004. As of December 31, 2012, the Company had three such investments with an aggregate unfunded commitment of $14,804. The Company maintains sufficient cash on hand to fund such unfunded loan commitments should the need arise.
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, 2013 and December 31, 2012:
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
Semiconductors & Semiconductor Equipment
Software & Services
Technology Hardware & Equipment
Telecommunication Services
Transportation
Utilities
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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.
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, 2013 and December 31, 2012, 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, 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 independent third-party pricing services, which provided prevailing bid and ask prices from dealers on the date of the relevant period end that were screened for validity by such services. Twenty-one senior secured loan investments, one senior secured bond investment and six subordinated debt investments, 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, 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/other investment, both of which were newly-issued and purchased near March 31, 2013, 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.
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Note 7. Fair Value of Financial Instruments (continued)
The Company’s investments as of December 31, 2012 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 independent third-party pricing services, which provided prevailing bid and ask prices from dealers on the date of the relevant period end that were screened for validity by such services. Twenty-one senior secured loan investments, one senior secured bond investment and seven subordinated debt investments, 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, call features and other relevant terms of the debt. 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 EBITDA, cash flows, net income, revenues or, in limited instances, book value or liquidation value. One senior secured loan investment, which was newly-issued and purchased near December 31, 2012, was valued at cost, as the Company’s board of directors determined that the cost of such investment was the best indication of its fair value.
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.
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The following is a reconciliation for the three months ended March 31, 2013 and 2012 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, 2013 and December 31, 2012 were as follows:
Type of Investment
Valuation
Technique(2)
Unobservable
Input
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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, 2013. For additional information regarding these financing facilities, please see the notes to the Company’s audited financial statements contained in its annual report on Form 10-K for the year ended December 31, 2012 and the additional disclosure set forth in this Note 8.
Facility
Type of Facility
Maturity Date
Arch Street Credit Facility
Broad Street Credit Facility
JPM Facility(1)
Walnut Street Credit Facility
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Note 8. Financing Arrangements (continued)
On August 29, 2012, 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. The Arch Street credit facility provides for borrowings in an aggregate principal amount up to $550,000 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.
Borrowings under the Arch Street credit facility accrue interest at a rate equal to the three-month London Interbank Offered Rate, or LIBOR, plus 1.75% per annum during the first two years of the facility and three-month LIBOR plus 2.00% 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, 2015.
As of March 31, 2013 and December 31, 2012, $497,682 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, 2013, $3,574 of such deferred financing costs had yet to be amortized to interest expense.
The effective interest rate on the borrowings under the Arch Street credit facility was 2.34% per annum as of March 31, 2013. Interest is payable quarterly in arrears and commenced August 29, 2012. The Company recorded interest expense of $3,338 for the three months ended March 31, 2013, of which $365 related to the amortization of deferred financing costs and $65 related to commitment fees on the unused portion of the credit facility. The Company paid $4,250 in interest expense during the three months ended March 31, 2013. The average borrowings under the Arch Street credit facility for the three months ended March 31, 2013 were $497,682, with a weighted average interest rate of 2.39%.
On January 28, 2011, 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
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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 entered into an amendment to the Broad Street credit facility which extended the maturity date of 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 + 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. The Broad Street credit facility provides for borrowings of up to $240,000 at a rate of LIBOR 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, 2013 and December 31, 2012, $240,000 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, 2013, all of the deferred financing costs have been amortized to interest expense.
The effective interest rate under the Broad Street credit facility was 1.78% per annum as of March 31, 2013. Interest is paid quarterly in arrears and commenced August 20, 2010. The Company recorded interest expense of $1,296 and $2,424 for the three months ended March 31, 2013 and 2012, respectively, of which $225 and $194, respectively, related to the amortization of deferred financing costs. The Company paid $1,101 and $2,236 in interest expense for the three months ended March 31, 2013 and 2012, respectively. The average borrowings under the credit facility for the three months ended March 31, 2013 and 2012 were $240,000 and $340,000, respectively, with a weighted average interest rate of 1.79% and 2.62%, respectively.
JPM Financing
On April 23, 2013, through its two wholly-owned, special-purpose financing subsidiaries, Locust Street and Race Street, the Company entered into an amendment, or the April 2013 amendment, to its conventional debt financing arrangement with JPMorgan Chase Bank, N.A., London Branch, or JPM, which was originally entered into on July 21, 2011. 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.
In connection with the increase in the amount available under the debt financing arrangement, the aggregate market value of loans expected to be held by Locust Street when the financing arrangement, as amended, is fully-ramped was increased from $1,320,000 to $1,791,500.
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The loans held by Locust Street secure the obligations of Locust Street under certain Class A Floating Rate Notes, or, together with the notes issued prior to April 23, 2013, 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 was increased from $840,000 to $1,140,000 and the stated maturity date of the Class A Notes was changed from October 15, 2023 to April 15, 2024. All principal and interest on the Class A Notes will be due and payable on the stated maturity date. 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.
In connection with the increase in the amount available under the debt financing arrangement, Race Street 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, 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 was increased from $840,000 to $1,140,000. Accordingly, the maximum amount payable at any time to Race Street under the JPM Facility was increased from $700,000 to $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 the 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.
In connection with the increase in the amount available under the debt financing arrangement, the aggregate market value of loans expected to be held by Race Street when the financing arrangement, as amended, is fully-ramped was increased from $600,000 to $814,000. The loans held by Race Street secure the obligations of Race Street under the JPM Facility.
As of March 31, 2013 and December 31, 2012, Class A Notes in the aggregate principal amount of $840,000 and $812,000, respectively, had been purchased by Race Street from Locust Street and subsequently sold to JPM under the JPM Facility for aggregate proceeds of $700,000 and $676,667, respectively. The Company funded each purchase of Class A Notes by Race Street through a capital contribution to Race Street. As of March 31, 2013 and December 31, 2012, Race Street’s liability under the JPM Facility was $700,000 and $676,667, respectively, plus $4,767 and $4,298, 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, 2013 and December 31, 2012, the fair value of loans held by Locust Street was $1,319,603 and $1,307,933, respectively, which included loans purchased by Locust Street with proceeds from the issuance of Class A Notes. As of March 31, 2013 and December 31, 2012, the fair value of loans held by Race Street was $623,603 and $598,528, respectively.
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As of March 31, 2013, the Company had 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, 2013, $246 of such deferred financing costs had yet to be amortized to interest expense.
The effective interest rate on the borrowings under the JPM Facility was 3.25% as of March 31, 2013. The Company recorded interest expense of $5,652 and $2,757 for the three months ended March 31, 2013 and 2012, respectively, of which $33 and $27, respectively, related to the amortization of deferred financing costs. The Company paid $5,150 and $1,639 in interest expense during the three months ended March 31, 2013 and 2012, respectively. The average borrowings under the JPM Facility for the three months ended March 31, 2013 and 2012 were $691,963 and $283,987, respectively, with a weighted average interest rate of 3.25% and 3.79%, respectively.
On May 17, 2012, 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 a revolving credit facility, 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. The Walnut Street credit facility provides for borrowings in an aggregate principal amount up to $250,000 on a committed basis.
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.
Pricing under the Walnut Street credit facility is based on LIBOR for an interest period equal to the weighted average LIBOR interest period of eligible debt securities owned by Walnut Street, plus a spread ranging between 1.50% and 2.75% 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, 2013 and December 31, 2012, $240,964 and $235,364, 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 $3,761 in connection with obtaining 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, 2013, $3,110 of such deferred financing costs had yet to be amortized to interest expense.
The effective interest rate on the borrowings under the Walnut Street credit facility was 2.76% per annum as of March 31, 2013. Interest is payable quarterly in arrears and commenced October 15, 2012. The Company recorded interest expense of $1,850 for the three months ended March 31, 2013, of which $182 related to the amortization of deferred financing costs and $14 related to commitment fees on the unused portion of the credit
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facility. The Company paid $1,583 in interest expense during the three months ended March 31, 2013. The average borrowings under the Walnut Street credit facility for the three months ended March 31, 2013 were $238,848, with a weighted average interest rate (including the effect of non-usage fees) of 2.79%.
Note 9. Financial Highlights
The following is a schedule of financial highlights of the Company for the three months ended March 31, 2013 and the year ended December 31, 2012:
Per Share Data:
Net asset value, beginning of period
Results of operations(1)
Net realized and unrealized appreciation (depreciation) on investments and total return swap and gain/loss on foreign currency
Issuance of common stock(3)
Repurchases of common stock(4)
Offering costs(1)
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 accrued capital gains incentive fees to average net assets(6)
Ratio of subordinated incentive fees to average net assets(6)
Ratio of interest expense to average net assets(6)
Ratio of operating expenses to average net assets(6)
Portfolio turnover(7)
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Note 9. Financial Highlights (continued)
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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
The following discussion should be read in conjunction with our unaudited consolidated financial statements and the notes thereto included elsewhere in this quarterly report on Form 10-Q.
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 our portfolio companies;
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;
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, GSO / Blackstone Debt Funds Management LLC, or 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 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;
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risks associated with possible disruption in our operations or the economy generally due to terrorism or natural disasters; and
future changes in laws or regulations and conditions in our operating areas.
We have based the forward-looking statements included in this quarterly report on Form 10-Q on information available to us on the date of this quarterly report on Form 10-Q, and we assume no obligation to update any such forward-looking statements. 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 upon raising gross proceeds in excess of $2,500 from the sale of shares of our common stock in our continuous public offering to persons who were not affiliated with us or FB Advisor. 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. In May 2012, we closed our continuous public offering of shares of common stock to new investors.
Our investment activities are managed by FB Advisor and supervised by our board of directors, a majority of whom are independent. Under our investment advisory and administrative services 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 six investment categories, which we believe will allow us to generate an attractive total return with an acceptable level of risk.
Originated/Proprietary Transactions: We intend to leverage our relationship with GDFM and their global sourcing and origination platform to identify proprietary investment opportunities. We define proprietary investments as any investment originated or structured specifically for us or made by us that was not generally available to the broader market. Proprietary 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 proprietary transactions may offer attractive investment opportunities as they typically offer higher returns than broadly syndicated transactions.
Anchor Orders: In addition to proprietary transactions, we will 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. 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 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.
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Event Driven: 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.
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 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.
Collateralized Securities: Collateralized loan obligations, or 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. Our relationship with GSO Capital Partners LP, one of the largest CLO managers in the world, allows us to invest in these securities with confidence and to capitalize on opportunities in the secondary CLO market.
Broadly Syndicated/Other: Although our primary focus is to invest in proprietary transactions, 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 proprietary investments and provide a complement to our more illiquid proprietary 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 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 is no limit on the maturity or duration of any security in our portfolio. The loans in which we invest are often rated by a nationally-recognized statistical ratings organization and generally will carry a rating below investment grade (rated lower than “Baa3” by Moody’s Investor Service, Inc., or Moody’s, or lower than “BBB-” by Standard & Poor’s Corporation). However, we also invest in non-rated debt securities.
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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 on investments, net realized gain on total return swap, net unrealized appreciation and depreciation on investments, net unrealized appreciation and depreciation on total return swap and net unrealized gain and loss on foreign currency. In the future, we do not expect our revenues to include net realized gain on total return swap or net unrealized appreciation and depreciation on total return swap as a result of the termination of the TRS on August 29, 2012. We may, however, elect to utilize a total return swap in the future. Net investment income is the difference between our income from interest, dividends, fees and other investment income and our operating expenses. Net realized gain on investments is the difference between the proceeds received from dispositions of portfolio investments and their amortized cost. Net realized gain on total return swap is the net monthly settlement payments received on the TRS. Net unrealized appreciation and depreciation on investments is the net change in the fair value of our investment portfolio. Net unrealized appreciation and depreciation on total return swap is the net change in the fair value of the TRS. Net unrealized gain and 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. We may also generate revenues in the form of dividends and other distributions on the equity or other securities we may hold. In addition, we may generate revenues in the form of commitment, closing, origination, structuring or diligence fees, monitoring fees, fees for providing managerial assistance, consulting fees and performance-based fees. Any such fees generated in connection with our investments will be recognized as earned.
Expenses
Our primary operating expenses include the payment of advisory fees and other expenses under the investment advisory and administrative services agreement, interest expense from financing facilities and other expenses necessary for our operations. Our investment advisory fees compensate 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 which 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. See “—Related Party Transactions” for additional information regarding the reimbursements payable to FB Advisor for administrative services and the methodology for determining the amount of any such reimbursements. We bear all other expenses of our operations and transactions. For additional information regarding these expenses, see our annual report on Form 10-K for the year ended December 31, 2012.
Portfolio Investment Activity for the Three Months Ended March 31, 2013 and for the Year Ended December 31, 2012
During the three months ended March 31, 2013, we made investments in portfolio companies totaling $649,916. During the same period, we sold investments totaling $147,944 and received principal repayments of $395,873. As of March 31, 2013, our investment portfolio, with a total fair value of $4,084,029, consisted of interests in 245 portfolio companies (49% in first lien senior secured loans, 21% in second lien senior secured loans, 12% in senior secured bonds, 13% in subordinated debt, 2% in collateralized securities and 3% in equity/other). The portfolio companies that comprised our portfolio as of such date had an average annual EBITDA of
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approximately $294.1 million. As of March 31, 2013, the investments in our portfolio were purchased at an average price of 95.7% of par or stated value, as applicable, the weighted average credit rating of the investments in our portfolio that were rated (constituting approximately 59.5% of our portfolio based on the fair value of our investments) was B3 based upon the Moody’s scale and our estimated gross annual portfolio yield, prior to leverage, was 10.4% based upon the amortized cost of our investments.
During the year ended December 31, 2012, we made investments in portfolio companies totaling $3,863,334. During the same period, we sold investments for proceeds of $926,136 and received principal repayments of $1,045,311. As of December 31, 2012, our investment portfolio, with a total fair value of $3,934,722, consisted of interests in 263 portfolio companies (50% in first lien senior secured loans, 19% in second lien senior secured loans, 12% in senior secured bonds, 13% in subordinated debt, 3% in collateralized securities and 3% in equity/other). The portfolio companies that comprised our portfolio as of such date had an average annual EBITDA of approximately $302.0 million. As of December 31, 2012, the investments in our portfolio were purchased at a weighted average price of 95.4% of par or stated value, as applicable, the weighted average credit rating of the investments in our portfolio that were rated (constituting approximately 59.4% 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 10.4% based upon the amortized cost of our investments.
The following table summarizes the composition of our investment portfolio at cost and fair value as of March 31, 2013 and December 31, 2012:
We do not “control” and are 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, 2013, we had three such investments with an aggregate unfunded commitment of $14,004. As of December 31, 2012, we had three such investments with an aggregate unfunded commitment of $14,804. We maintain sufficient cash on hand to fund such unfunded loan commitments should the need arise.
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As of March 31, 2013 and December 31, 2012, approximately 63% and 58%, respectively, of our portfolio based on fair value constituted non-broadly syndicated investments. We define non-broadly syndicated investments as any investment that is considered proprietary, an anchor order, an opportunistic or event driven investment, or a collateralized security. The table below enumerates the percentage, by fair value, of the types of investments in our portfolio as of March 31, 2013 and December 31, 2012:
Deal Composition
Originated/Proprietary
Anchor Order
Event Driven
Opportunistic
Broadly Syndicated/Other
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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:
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, 2013 and December 31, 2012:
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.
Results of Operations
Comparison of the Three Months Ended March 31, 2013 and March 31, 2012
We generated investment income of $110,044 and $50,535 for the three months ended March 31, 2013 and 2012, 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 $98,525 and $47,455 of cash income earned as well as $11,519 and $3,080 in non-cash portions relating to accretion of discount and PIK interest for the three months ended March 31, 2013 and 2012, 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 growth of our portfolio over the last year. The level of income we receive is directly related to the balance of income-producing investments multiplied by the weighted average yield of our investments. We expect the dollar amount of interest and any dividend income that we earn to level off as the size of our investment portfolio stabilizes as a result of the closing of our public offering in May 2012.
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Our total operating expenses were $59,315 and $35,643 for the three months ended March 31, 2013 and 2012, respectively. Our operating expenses include base management fees attributed to FB Advisor of $22,206 and $12,204 for the three months ended March 31, 2013 and 2012, respectively. Our operating expenses also include administrative services expenses attributed to FB Advisor of $1,436 and $903 for the three months ended March 31, 2013 and 2012, respectively.
FB Advisor is eligible to receive incentive fees based on performance. As of December 31, 2012, $13,393 in subordinated income incentive fees were payable by us to FB Advisor, $12,020 of which we paid to FB Advisor during the three months ended March 31, 2013. During the three months ended March 31, 2013, we accrued an additional subordinated income incentive fee of $14,228 based upon the performance of our portfolio. We did not accrue any subordinated income incentive fees during the three months ended March 31, 2012. During the three months ended March 31, 2013 and 2012, we accrued capital gains incentive fees of $6,350 and $14,801, respectively, based on the performance of our portfolio, of which $6,350 and $14,719, respectively, was based on unrealized gains and $0 and $82, respectively, was based on realized 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 $12,136 and $5,181 for the three months ended March 31, 2013 and 2012, 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 $365 and $421 for the three months ended March 31, 2013 and 2012, respectively. We incurred fees and expenses with our stock transfer agent of $890 and $940 for the three months ended March 31, 2013 and 2012, respectively.
Our other general and administrative expenses totaled $1,704 and $1,193 for the three months ended March 31, 2013 and 2012, 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
Directors’ fees
Other
During the three months ended March 31, 2013 and 2012, the ratio of our operating expenses to our average net assets was 2.34% and 2.08%, respectively. Our ratio of operating expenses to our average net assets during the three months ended March 31, 2013 and 2012 includes $12,136 and $5,181, respectively, related to interest expense and $20,578 and $14,801, respectively, related to accruals for incentive fees. Without such expenses, our ratio of operating expenses to average net assets would have been 1.05% and 0.92% for the three months ended March 31, 2013 and 2012, respectively. Incentive fees and interest expense, among other things, may increase or decrease our operating expenses in relation to our expense ratios relative to comparative periods depending on portfolio performance and changes in benchmark interest rates such as LIBOR, among other factors. The higher ratio of operating expenses to average net assets during the three months ended March 31, 2013 compared to the three months ended March 31, 2012 can primarily be attributed to higher management fees as a percentage of average net assets as a result of the termination of the TRS and the replacement of such financing arrangement with a revolving credit facility.
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As the size of our asset base and number of investors grew prior to the closing of our continuous public offering, our general and administrative expenses increased accordingly. Legal fees increased as the number of filings increased and printing costs increased with the increase in the number of filings and the number of stockholders. Our operating expenses related to our ongoing operations have begun to level off as the size of our asset base has stabilized as a result of the closing of our public offering in May 2012.
Beginning on February 26, 2009, Franklin Square Holdings agreed to reimburse us for expenses in an amount that was sufficient to ensure that, for tax purposes, our net investment income and net capital gains were equal to or greater than the cumulative distributions paid to our stockholders in each quarter. This arrangement was designed to ensure that no portion of our distributions would represent a return of capital for our stockholders. Under this arrangement, Franklin Square Holdings had no obligation to reimburse any portion of our expenses.
Pursuant to the expense reimbursement agreement entered into on March 13, 2012, 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 our offering proceeds 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.
Pursuant to the expense reimbursement agreement, we will 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 stockholders. The expense reimbursement agreement does not apply to any amounts funded by Franklin Square Holdings prior to the date of such agreement.
We or Franklin Square Holdings may terminate the expense reimbursement agreement at any time. If we terminate the investment advisory and administrative services agreement with FB Advisor, we will be required to repay Franklin Square Holdings all reimbursements funded by Franklin Square Holdings within three years of the date of termination.
The specific amount of expenses reimbursed by Franklin Square Holdings, if any, will be determined at the end of each quarter. During the three months ended March 31, 2013 and 2012, no such reimbursements were required from Franklin Square Holdings. 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.
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Net Investment Income
Our net investment income totaled $50,729 ($0.20 per share) and $14,892 ($0.08 per share) for the three months ended March 31, 2013 and 2012, respectively. The increase in net investment income on a per share basis can be attributed to, among other things, our ability to efficiently deploy capital following the closing of our public offering and 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 $147,944 and $395,873, respectively, during the three months ended March 31, 2013, from which we realized net gains of $14,171. We also realized a net loss of $63 from settlements on foreign currency during the three months ended March 31, 2013. We sold investments and received principal repayments of $79,704 and $139,880, respectively, during the three months ended March 31, 2012, from which we realized net losses of $3,102. We also earned $5,074 from periodic net settlement payments on our TRS and realized a net gain of $17 from settlements on foreign currency during the three months ended March 31, 2012.
Net Change in Unrealized Appreciation (Depreciation) on Investments and Total Return Swap and Unrealized Gain (Loss) on Foreign Currency
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. For the three months ended March 31, 2012, the net change in unrealized appreciation (depreciation) on investments totaled $61,017, the net change in unrealized appreciation (depreciation) on our TRS was $4,512 and the net change in unrealized gain (loss) on foreign currency totaled $0. The net change in unrealized appreciation (depreciation) on our investments during each of the three months ended March 31, 2013 and 2012 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, 2013, the net increase in net assets resulting from operations was $82,476 ($0.33 per share) compared to a net increase in net assets resulting from operations of $82,410 ($0.45 per share) during the three months ended March 31, 2012.
Financial Condition, Liquidity and Capital Resources
As of March 31, 2013, we had $362,896 in cash, which we held in a custodial account, and $61,354 in borrowings available under our financing facilities. Below is a summary of our outstanding financing facilities as of March 31, 2013:
Rate
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During the three months ended March 31, 2013, we issued 2,638,800 shares of our common stock for gross proceeds of $26,476 at an average price per share of $10.03 pursuant to our distribution reinvestment plan.
During the three months ended March 31, 2012, we sold 42,836,184 shares of our common stock for gross proceeds of $452,338 at an average price per share of $10.56. The gross proceeds received during the three months ended March 31, 2012 include reinvested stockholder distributions of $17,206, for which we issued 1,792,143 shares of common stock. During the three months ended March 31, 2012, we also incurred offering costs of $1,515 in connection with the sale of our common stock, which consisted primarily of legal, due diligence and printing fees. The offering costs were offset against capital in excess of par value in our consolidated financial statements. The sales commissions and dealer manager fees related to the sale of our common stock were $40,660 for the three months ended March 31, 2012. These sales commissions and fees include $7,783 retained by the dealer manager, FS2, which is one of our affiliates.
As of May 14, 2013, we have sold 258,844,374 shares (as adjusted for stock distributions) of our common stock for gross proceeds of $2,717,668, including the seed capital contributed by Messrs. Forman and Adelman.
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. In May 2012, we closed our continuous public offering of shares of our common stock and, following the closing, sell shares only pursuant to our distribution reinvestment plan.
Prior to investing in securities of portfolio companies, we invest the net proceeds from the sale 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.
To provide our stockholders with limited liquidity, we conduct quarterly tender offers pursuant to our share repurchase program. The following table provides information concerning our repurchases pursuant to our share repurchase program during the three months ended March 31, 2013 and 2012:
On April 1, 2013, we repurchased 1,053,119 shares (representing 100% of shares of common stock tendered for repurchase) at $10.10 per share for aggregate consideration totaling $10,637.
On August 29, 2012, Arch Street terminated its TRS with Citibank and entered into the Arch Street credit facility with Citibank, as administrative agent, and the financial institutions and other lenders from time to time party thereto. The Arch Street credit facility provides for borrowings in an aggregate principal amount up to $550,000 on a committed basis. We 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 our 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
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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 us and our exposure under the facility is limited to the value of our investment in Arch Street.
Borrowings under the Arch Street credit facility accrue interest at a rate equal to three-month LIBOR plus 1.75% per annum during the first two years of the facility and three-month LIBOR plus 2.00% 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, 2015.
As of March 31, 2013 and December 31, 2012, $497,682 was outstanding under the Arch Street credit facility. The carrying amount of the amount outstanding under the facility approximates its fair value. We incurred costs of $4,446 in connection with obtaining the Arch Street credit facility, which we have recorded as deferred financing costs on our consolidated balance sheets and amortize to interest expense over the life of the facility. As of March 31, 2013, $3,574 of such deferred financing costs had yet to be amortized to interest expense.
The effective interest rate on the borrowings under the Arch Street credit facility was 2.34% per annum as of March 31, 2013. Interest is payable quarterly in arrears and commenced August 29, 2012. We recorded interest expense of $3,338 for the three months ended March 31, 2013, of which $365 related to the amortization of deferred financing costs and $65 related to commitment fees on the unused portion of the credit facility. We paid $4,250 in interest expense during the three months ended March 31, 2013. The average borrowings under the Arch Street credit facility for the three months ended March 31, 2013 were $497,682, with a weighted average interest rate of 2.39%.
On January 28, 2011, Broad Street, Deutsche Bank and the other lenders party thereto entered into 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 entered into an amendment to the Broad Street credit facility which extended the maturity date of 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 + 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. The Broad Street credit facility provides for borrowings of up to $240,000 at a rate of LIBOR plus 1.50% per annum. Deutsche Bank is a lender and serves as administrative agent under the facility.
Under the Broad Street credit facility, we transfer debt securities to Broad Street from time to time as a contribution to capital and retain a residual interest in the contributed debt securities through our ownership of Broad Street. The obligations of Broad Street under the facility are non-recourse to us and our exposure under the facility is limited to the value of our investment in Broad Street.
As of March 31, 2013 and December 31, 2012, $240,000 was outstanding under the Broad Street credit facility. The carrying amount of the amount outstanding under the facility approximates its fair value. We incurred costs of $2,566 in connection with obtaining and amending the facility, which we have recorded as deferred financing costs on our consolidated balance sheets and amortize to interest expense over the life of the facility. As of March 31, 2013, all of such deferred financing costs have been amortized to interest expense.
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The effective interest rate under the Broad Street credit facility was 1.78% per annum as of March 31, 2013. Interest is paid quarterly in arrears and commenced August 20, 2010. We recorded interest expense of $1,296 and $2,424 for the three months ended March 31, 2013 and 2012, respectively, of which $225 and $194, respectively, related to the amortization of deferred financing costs. We paid $1,101 and $2,236 in interest expense for the three months ended March 31, 2013 and 2012, respectively. The average borrowings under the credit facility for the three months ended March 31, 2013 and 2012 were $240,000 and $340,000, respectively, with a weighted average interest rate of 1.79% and 2.62%, respectively.
On April 23, 2013, through our two wholly-owned, special purpose financing subsidiaries, Locust Street and Race Street, we entered into the April 2013 amendment to our conventional debt financing arrangement with JPM, which was originally entered into on July 21, 2011. 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. We 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.
The loans held by Locust Street secure the obligations of Locust Street under the Class A Floating Rate Notes to be issued from time to time by Locust Street to Race Street pursuant to 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 was increased from $840,000 to $1,140,000 and the stated maturity date of the Class A Notes was changed from October 15, 2023 to April 15, 2024. All principal and interest on the Class A Notes will be due and payable on the stated maturity date. 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.
In connection with the increase in the amount available under the debt financing arrangement, Race Street entered into an amendment to 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 was increased from $840,000 to $1,140,000 in connection with the April 2013 amendment. Accordingly, the maximum amount payable at any time to Race Street under the JPM Facility was increased from $700,000 to $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 the 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.
In connection with the increase in the amount available under the debt financing arrangement, the aggregate market value of loans expected to be held by Race Street when the financing arrangement, as amended, is fully-ramped, was increased from $600,000 to $814,000. The loans held by Race Street secure the obligations of Race Street under the JPM Facility.
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As of March 31, 2013 and December 31, 2012, Class A Notes in the aggregate principal amount of $840,000 and $812,000, respectively, had been purchased by Race Street from Locust Street and subsequently sold to JPM under the JPM Facility for aggregate proceeds of $700,000 and $676,667, respectively. We funded each purchase of Class A Notes by Race Street through a capital contribution to Race Street. As of March 31, 2013 and December 31, 2012, Race Street’s liability under the JPM Facility was $700,000 and $676,667, respectively, plus $4,767 and $4,298, respectively, of accrued interest expense. The Class A Notes issued by Locust Street and purchased by Race Street eliminate in consolidation on our financial statements.
As of March 31, 2013, we had incurred costs of $425 in connection with obtaining the JPM Facility, which we have recorded as deferred financing costs on our consolidated balance sheets and amortize to interest expense over the life of the JPM Facility. As of March 31, 2013, $246 of such deferred financing costs had yet to be amortized to interest expense.
The effective interest rate on the borrowings under the JPM Facility was 3.25% as of March 31, 2013. We recorded interest expense of $5,652 and $2,757 for the three months ended March 31, 2013 and 2012, respectively, of which $33 and $27, respectively, related to the amortization of deferred financing costs. We paid $5,150 and $1,639 in interest expense during the three months ended March 31, 2013 and 2012, respectively. The average borrowings under the JPM Facility for the three months ended March 31, 2013 and 2012 were $691,963 and $283,987, respectively, with a weighted average interest rate of 3.25% and 3.79%, respectively.
On May 17, 2012, Walnut Street and Wells Fargo entered into 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. The Walnut Street credit facility provides for borrowings in an aggregate principal amount up to $250,000 on a committed basis.
Under the Walnut Street credit facility, we contribute cash or debt securities to Walnut Street from time to time and retain a residual interest in any assets contributed through our ownership of Walnut Street or receive 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 us and our exposure under the facility is limited to the value of our investment in Walnut Street.
As of March 31, 2013 and December 31, 2012, $240,964 and $235,364, respectively, was outstanding under the Walnut Street credit facility. The carrying amount of the amount outstanding under the facility approximates its fair value. We incurred costs of $3,761 in connection with obtaining the Walnut Street credit facility, which we have recorded as deferred financing costs on our consolidated balance sheets and amortize to interest expense over the life of the facility. As of March 31, 2013, $3,110 of such deferred financing costs had yet to be amortized to interest expense.
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The effective interest rate on the borrowings under the Walnut Street credit facility was 2.76% per annum as of March 31, 2013. Interest is payable quarterly in arrears and commenced October 15, 2012. We recorded interest expense of $1,850 for the three months ended March 31, 2013, of which $182 related to the amortization of deferred financing costs and $14 related to commitment fees on the unused portion of the credit facility. We paid $1,583 in interest expense during the three months ended March 31, 2013. The average borrowings under the Walnut Street credit facility for the three months ended March 31, 2013 were $238,848, with a weighted average interest rate (including the effect of non-usage fees) of 2.79%.
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 historically 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 for tax purposes. 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, 2013 or 2012 represented a return of capital for tax purposes.
We intend to continue to make our ordinary distributions in the form of cash out of assets legally available for distribution, unless stockholders elect to receive their cash distributions in additional shares of our common stock under our distribution reinvestment plan. Any distributions reinvested under the plan will nevertheless remain taxable to a U.S. stockholder.
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, 2013 and 2012:
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On April 11, 2013, our board of directors declared a regular monthly cash distribution of $0.0675 per share, which was paid on April 30, 2013 to stockholders of record on April 29, 2013. On May 8, 2013, our board of directors declared a regular monthly cash distribution of $0.0675 per share, which will be paid on May 31, 2013 to stockholders of record on May 30, 2013. The timing and amount of any future distributions to stockholders are subject to applicable legal restrictions and the sole discretion of our board of directors.
We may fund our cash distributions to stockholders from any sources of funds available to us, including offering proceeds, 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.
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, 2013 and 2012:
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 information regarding stock distributions declared on our common stock and a reconciliation of our GAAP-basis net investment income and tax-basis net investment income for the three months ended March 31, 2013 and 2012.
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.
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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.
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 our sub-adviser or 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.
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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.
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, 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 independent third-party pricing services, which provided prevailing bid and ask prices from dealers on the date of the relevant period end that were screened for validity by such services. Twenty-one senior secured loan investments, one senior secured bond investment and six subordinated debt investments, 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, 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/other investment, both of which were newly-issued and purchased near March 31, 2013, 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.
Our investments as of December 31, 2012 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 independent third-party pricing services, which provided prevailing bid and ask prices from dealers on the date of the relevant period end that were screened for validity by such services. Twenty-one senior secured loan investments, one senior secured bond investment and seven subordinated debt investments, 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, call features and other relevant terms of the debt. 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, which was newly-issued and purchased near December 31, 2012, was valued at cost, as our board of directors determined that the cost of such investment was the best indication of its fair value.
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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 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 fee income. Upfront structuring fees are recorded as 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 the investment advisory and administrative services agreement, the incentive fee on capital gains during operations prior to our liquidation is determined and payable in arrears as of the end of each calendar year (or upon termination of the investment advisory and administrative services 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 neither includes nor contemplates 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 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.
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Subordinated Income Incentive Fee
Pursuant to the investment advisory and administrative services agreement, FB Advisor may also be entitled to receive a subordinated incentive fee on income. The subordinated incentive fee on income, which 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, 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 will 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 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 our pre-incentive fee net investment income for such quarter equals 2.5%, or 10.0% annually, of adjusted capital. Thereafter, FB Advisor will receive 20.0% of pre-incentive fee net investment income.
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, 2013 and 2012, we did not incur any interest or penalties.
Contractual Obligations
We have entered into an agreement with FB Advisor to provide us with investment advisory and administrative services. Payments for investment advisory services under the investment advisory and administrative services 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. For the three months ended March 31, 2013 and 2012, we incurred $22,206 and $12,204, respectively, in base management fees and $1,436 and $903, respectively, in administrative services expenses under the investment advisory and administrative services agreement. In addition, FB Advisor is eligible to receive incentive fees based on the performance of our portfolio. As of December 31, 2012, a subordinated incentive fee on income of $13,393 was payable to FB Advisor, $12,020 of which was paid to FB Advisor during the three months ended March 31, 2013. During the three months ended March 31, 2013, we accrued a subordinated incentive fee on income of $14,228 based upon the performance of our portfolio. As of March 31, 2013, a subordinated incentive fee on income of $15,601 was payable to FB Advisor. As of December 31, 2012, we had accrued capital gains incentive fees of $39,751 based on the performance of our portfolio, of which $27,960 was based on unrealized gains and $11,791 was based on realized gains. During the three months ended March 31, 2013, we paid $10,933 in respect of the capital gains incentive fee and accrued capital gains incentive fees of $6,350 based on the performance of our portfolio, of which $6,350 was based on unrealized gains and $0 was based on realized gains. During the three months ended March 31, 2012, we accrued capital gains incentive fees of $14,801 based on the performance of our portfolio, of which $14,719 was based on unrealized gains and $82 was based on realized gains. As of March 31, 2013, we had accrued $35,168 in capital gains incentive fees, of which only $858 was based on realized gains and was payable to FB Advisor.
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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, 2013 is as follows:
Borrowings of Arch Street(1)
Borrowings of Broad Street(2)
Borrowings of Race Street(3)
Borrowings of Walnut Street(4)
Off-Balance Sheet Arrangements
We currently have no off-balance sheet arrangements, including any risk management of commodity pricing or other hedging practices.
Related Party Transactions
Pursuant to the investment advisory and administrative services 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 the commencement of our operations. Management fees are paid on a quarterly basis in arrears.
The incentive fee consists of three parts. The first part, which is referred to as the subordinated incentive fee on income, is calculated and payable quarterly in arrears and equals 20.0% of “pre-incentive fee net investment income” for the immediately preceding quarter and is 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%. The second part of the incentive fee, which is referred to as the incentive fee on capital gains during operations, 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, under the terms of the investment advisory and administrative services 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 third part of the incentive fee, which is referred to as the subordinated liquidation incentive fee, equals 20.0% of the net proceeds in excess of adjusted capital from our liquidation, as calculated immediately prior to liquidation.
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We reimburse FB Advisor for expenses necessary to perform services related to our administration and operations. The amount of this reimbursement is set at the lesser of (1) FB Advisor’s actual costs incurred in providing such services and (2) the amount that we estimate we would be required to pay alternative service providers for comparable services in the same geographic location. FB Advisor is required to allocate the cost of such services to us based on objective factors such as total assets, revenues, time allocations and/or other reasonable metrics. Our board of directors then assesses 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 considers whether any single third-party service provider would be capable of providing all such services at comparable cost and quality. Finally, our board of directors compares 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.
Franklin Square Holdings has funded certain of our offering costs and organization costs. Under the terms of the investment advisory and administrative services agreement, when our registration statement was declared effective by the SEC and we were successful in satisfying the minimum offering requirement, FB Advisor became entitled to receive 1.5% of gross proceeds raised in our continuous public offering until all offering costs and organization costs funded by FB Advisor or its affiliates (including Franklin Square Holdings) had been recovered. On January 2, 2009, the Company satisfied the minimum offering requirement. We did not pay any reimbursements under this arrangement during the three months ended March 31, 2013 or 2012.
The dealer manager for our continuous public offering was FS2, which is one of our affiliates. Under our dealer manager agreement with FS2, FS2 was entitled to receive sales commissions and dealer manager fees in connection with the sale of shares of common stock in our continuous public offering, all or a portion of which were re-allowed to selected broker-dealers.
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FB Advisor’s senior management team is comprised of the same personnel as the senior management teams of FS Investment Advisor, LLC and FSIC II Advisor, LLC, the investment advisers to Franklin Square Holdings’ other affiliated BDCs, FS Energy and Power Fund and FS Investment Corporation II, respectively. As a result, such personnel provide investment advisory services to us and each of FS Energy and Power Fund and FS Investment Corporation II. While none of FB Advisor, FS Investment Advisor, LLC or FSIC II Advisor, LLC is currently making private corporate debt investments for clients other than us, FS Energy and Power Fund and FS Investment Corporation II, 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 our investment objectives and strategies, if necessary, so that we 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 and/or FS Investment Corporation II rather than to us.
Pursuant to the expense reimbursement agreement entered into on March 13, 2012, 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 our offering proceeds or borrowings. See “—Results of Operations—Comparison of the Three Months Ended March 31, 2013 and 2012—Expense Reimbursement” for a detailed description of the expense reimbursement agreement.
During the three months ended March 31, 2013 and 2012, no such reimbursements were required from Franklin Square Holdings.
We are subject to financial market risks, including changes in interest rates. As of March 31, 2013, 69.6% of our portfolio investments (based on fair value) paid variable interest rates, 27.2% paid fixed interest rates, 1.6% were income producing preferred equity investments, and the remainder (1.6%) 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 our incentive fee hurdle rate, as described in the investment advisory and administrative services agreement we have entered into with FB Advisor, 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.
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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, 2013 (dollar amounts are presented in thousands):
LIBOR Basis Point Change
Down 35 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, 2013 and 2012, 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) of 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, 2013. 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 months ended March 31, 2012 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, 2012.
The table below provides information concerning our repurchases of shares of our common stock during the quarter ended March 31, 2013 pursuant to our share repurchase program.
Period
January 1 to January 31, 2013
February 1 to February 28, 2013
March 1 to March 31, 2013
See Note 3 to our unaudited consolidated financial statements contained in this quarterly report on Form 10-Q for a more detailed discussion of the terms of our share repurchase program.
Not applicable.
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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, 2013.
Michael C. Forman
Chief Executive Officer
(Principal Executive Officer)
William Goebel
Chief Financial Officer
(Principal Financial and Accounting Officer)
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