FS Investment Corp. Tests the Debt-Offering Waters

FS Investment is testing the waters with a new debt offering that could mark a shift in its funding sources.

Jul 8, 2014 at 6:00AM

FS Investment (NYSE:FSIC) is relatively new as a public business development company, following a long history as a nontraded organization.

Becoming part of the capital markets with a public listing has its advantages, one of which FS Investment hopes to tap with a new debt offering.

Capitalizing on its BBB rating
On Monday, FS Investment filed for an unsecured note offering sized at $250 million. It's a small offering -- only a fraction of the FS Investment's balance sheet -- but it may offer clues about the company's future.

For years, FS Investment has thrived on cheap credit facilities. Although these have the benefit of being low cost, they aren't an ideal source for leveraging the entire balance sheet. As we learned in the 2008 financial crisis, credit facilities can be pulled, leaving a BDC stranded and in need of new funding.

Its recent filing is for five-year unsecured debt. Other BDCs with investment-grade ratings have found good reception for five-year, unsecured note issuances. Fifth Street Finance (NASDAQ:FSC), a BDC with a BBB- rating from Standard & Poor's, raised $250 million in February at a 3.5% spread to five-year U.S. Treasury yields at the time. (It's worth pointing out that Fifth Street Finance's rating is one tier below FS Investment's BBB.)

Similar pricing for FS Investment would put its five-year debt at about 5.25%. Not cheap, but not necessarily expensive, either.

A best guess
Given FS Investment's track record, the reputation of its external manager, and declining yields on BDC debt, I believe the company can raise unsecured capital as cheap as 3.5%-4% per year.

That would give FS Investment a new source of locked-in capital for five years at a price just barely over its 2.8% weighted-average effective cost of borrowing as of the last quarter. That's a good deal -- a slightly higher rate in exchange for five-year funding.

On the previous conference call, management noted that the benefits of an investment-grade rating would have to be realized by capital markets activity. The company's credit facilities do not include an immediate "trigger" on which rates come down for achieving an investment-grade rating.

While it may seem unimportant -- $250 million in debt is equal to about 6% of total assets -- funding costs are just as important as investment yields when it comes to delivering returns for shareholders. Cheap long-term debt is the key to any successful business development company.

If this deal is successful, we'll likely see FS Investment transition its balance sheet funding from short-term credit facilities to long-term unsecured debt. While it could crimp short-term earnings, long-dated debt capital is worth the trade-off. 

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