OREANDA-NEWS. Fitch Ratings has affirmed the long-term Issuer Default Rating (IDR), secured debt rating, and unsecured debt rating of FS Investment Corporation (FSIC) at 'BBB-'. The Rating Outlook is Stable. Today's rating actions have been taken as part of Fitch's periodic peer review of Business Development Companies (BDCs), which comprises 10 publicly rated firms.

BDC INDUSTRY OUTLOOK
Fitch's outlook for the BDC sector is negative; reflecting competitive underwriting conditions, earnings pressure, underperforming energy investments, unsustainable asset quality metrics, increased activist pressure, and limited access to growth capital. While some firms are better positioned, given their more conservative financial profiles and portfolio characteristics, others are likely to see rating pressure over the outlook horizon.

BDCs are heavily dependent on the equity markets to fund portfolio growth, but access to the market has been almost non-existent over the last 18 months as share prices continue to trade at steep discounts to net asset value (NAV). At March 7, 2016, rated BDCs were trading at an 18.3% average discount to NAV, thus preventing most from issuing stock without significantly diluting existing shareholders. While the reduction in portfolio growth is viewed favorably by Fitch, given tough underwriting conditions, some firms may struggle to close the trading gap, leaving them at a competitive disadvantage if and when investment opportunities arise.

The decline in commodity prices has yielded the first notable crack in asset quality performance for BDCs. More broadly, asset quality metrics remain at unsustainably low levels, in Fitch's opinion. While strong portfolio company performance has been supported by an improving economic environment, low interest rates are likely masking some potential underlying company-specific issues, as issuers have been able to refinance themselves out of trouble rather easily in recent years. Fitch believes asset quality metrics are likely to deteriorate over the near term; however, the pace of deterioration will be somewhat dependent upon the rate of change in interest rates, the backdrop of the broader economic environment, differing sector exposures, and the integrity of individual firms' underwriting.

Fitch has not observed a marked increase in leverage levels for the sector, with average leverage for investment grade-rated BDCs of approximately 0.74x at year-end 2015 compared to 0.60x at year-end 2014. However, there is a wide dispersion of leverage around the average, and those with the most energy exposure often also have the highest leverage ratios. Share repurchase activity has also increased in the sector in recent quarters, which could inflate leverage ratios further. Fitch believes that BDCs heavily focused on maximizing leverage run the risk of having less dry powder to deploy if and when underwriting conditions improve, thus weakening earnings upside.

KEY RATING DRIVERS
IDRs AND SENIOR DEBT
The rating affirmations reflect the strength of FSIC's relationships with Franklin Square Capital Partners and GSO Capital Partners (a subsidiary of The Blackstone Group; long-term IDR 'A+'), modest portfolio concentrations, strong asset quality, limited exposure to equity investments, consistent operating performance, improved funding flexibility as a result of public unsecured debt issuances and strong dividend coverage.

Rating constraints reflect the company's relatively limited performance track record, given its inception since the onset of the financial crisis, which makes it difficult to assess management's middle market underwriting acumen through a credit cycle. This is mitigated, in part, by the stable performance of the BDC since its inception, as well as GSO's strong and established track record in credit. Other rating constraints include FSIC's outsized historical growth and elevated repayment activity, which creates vintage concentration to periods of aggressive credit conditions, outsized exposure to energy, modestly elevated leverage, the valuation impact on balance sheet leverage, unproven access to the equity markets, and an inability to retain capital due to distribution requirements.

FSIC has a relatively attractive funding profile, having accessed the unsecured debt markets three times since inception. The most recent issuance occurred in April 2015, when FSIC raised $275 million of 4.75% notes maturing in May 2022. At Dec. 31, 2015, unsecured debt accounted for 54.5% of total debt, which is at the high-end of the peer group and provides the firm with greater funding flexibility, in Fitch's opinion. The Broad Street facility, which had no borrowings outstanding at year-end 2015 (YE15), expired in January 2016. FSIC has no debt maturities until April 2017.

The amount of fixed rate debt in FSIC's capital structure is significant (98.1% of total debt at YE15) and positions the firm to benefit from a rising rate environment, as the majority of assets are floating rate. That said; Fitch believes rising interest rates, beyond LIBOR floors, could contribute to asset-quality issues at the underlying portfolio company level if borrowers are not able to manage higher debt service burdens. If interest rate increases are accompanied by a strengthening economy, revenue and EBITDA at the portfolio company level are expected to benefit, which should make higher payment burdens manageable.

Leverage, as measured by debt to equity, amounted to 0.83 times (x) at Dec. 31, 2015, or 0.79x net of balance sheet cash, which is above the firm's targeted range of 0.70x-0.75x. Fitch would view a decline in leverage favorably, particularly given the firm's relatively large exposure to the energy sector. Additionally, BDC leverage ratios could be adversely affected by realized or unrealized valuation marks, resulting from yield spread movements or asset quality deterioration, particularly as access to the equity markets may continue to be uncertain, with many firms continuing to trade below net asset value. Fitch expects a portion of portfolio repayment proceeds will be used to reduce borrowings, and therefore leverage, in coming quarters. Failure to do so could result in negative rating action.

Still, relative to other BDCs with outsized energy exposure and higher-than-peer leverage, Fitch believes FSIC has retained more operating flexibility. Portfolio repayments remain significant, dividend coverage is strong, spillover income is meaningful, non-accruals are minimal, valuation marks have been relatively conservative on non-energy investments, reflecting broker quotes and market spread widening, meaning there is some unrealized depreciation cushion already built into the portfolio, and there is no share repurchase program in place which could inflate leverage beyond current levels if overused.

Energy investments represented approximately 9.1% of FSIC's portfolio, at fair value, at Dec. 31, 2015, which is at the high-end of the peer group. About 2.7% of the energy book is in subordinated debt and 23.5% is in equity and other securities. Despite the fact that more than a quarter of the energy exposure is in subordinated/equity positions, the vast majority of marks have been taken with respect to the secured positions, which had an aggregate fair value at 82.7% of cost at YE15, excluding unfunded commitments. In aggregate, the fair value of the energy portfolio represented 81.3% of the cost basis, excluding unfunded commitments, and three investments account for 87.2% of the energy portfolio, excluding unfunded commitments. Fitch believes energy investments are exposed to potential additional valuation declines. In the unlikely event that the fair value of the energy portfolio were written off completely, FSIC's balance sheet leverage would increase to 0.99x, which means it would still be in compliance with regulatory asset coverage requirements, but the cushion would be slight.

Asset quality trends have been strong since inception, supported, in part, by relatively benign market conditions and the timing of the firm's inception. FSIC had their first non-accrual in the second quarter of 2014 (2Q14), which amounted to 0.3% of the portfolio at value at YE14, but this investment has since been restructured into a controlling equity position for FSIC. Two other non-accrual positions, Boomerang Tube, LLC and Samson Investment Co. were restructured and exited in 2015. There were no non-accrual investments at YE15, however, FSIC placed its investment in SandRidge Energy, Inc. on non-accrual subsequent to quarter-end. This investment represented 0.15% of the portfolio, at value, at year-end. Fitch believes credit metrics are at unsustainably low levels longer term.

The company continues to focus on the senior part of the capital structure, with first and second lien senior debt and senior bonds accounting for 75.4% of the investment portfolio at 4Q15, based on fair value. Exposure to equity investments, which can experience meaningful valuation volatility, was 11.6% of the portfolio, at fair value, at Dec. 31, 2015, up from 7.7% at YE14 but consistent with the peer average. Still, this metric may tick-up in coming quarters, given preferred equity commitments to aircraft leasing and solar financing businesses. Fitch would expect a material increase in equity exposures to be counterbalanced with a decline in the leverage target.

The investment portfolio is modestly more concentrated than the peer average, with top 10 investments accounting for 65.3% of equity at Dec. 31, 2015, excluding unfunded commitments. Portfolio concentrations have risen in recent years, as the overall size of the investment portfolio has remained static and leverage has increased. Fitch believes concentrations will remain near current levels going forward.

FSIC's core earnings improved modestly in 2015, despite a relatively flat portfolio, given growth in interest and dividend income and a decline in adjusted expenses. Net investment income (NII) grew 9.6% annually on a reported basis, or 5.1% adjusting for noncash incentive accruals, excluding excise taxes. NII yields are in-line with the peer average, given the firm's rotation into higher-yielding, directly-originated deals in recent years.

Net income declined 80.3% given the recognition of realized losses and unrealized depreciation on the portfolio resulting from declines in energy investments and market spread widening. However, FSIC has generated $111.4 million of cumulative net realized gains on its portfolio from inception through YE15, which compares favorably to peers. Fitch believes core operating performance should remain relatively stable heading into 2016, unless portfolio credit quality deteriorates.

FSIC's liquidity profile is considered sound with $80.8 million of balance sheet cash, and $390.4 million of availability on various secured funding facilities, subject to borrowing base requirements, at Dec. 31, 2015. Additionally, cash flows from investment repayments and exits remained relatively significant, amounting to $1.6 billion. Additionally, a modest portion of the portfolio is considered relatively liquid, with 3% of the portfolio being invested in broadly syndicated deals at 4Q15.

Cash earnings coverage of regular dividends, which adjusts for non-cash incentive payment accruals and non-cash income, was sound at approximately 99.9% in 2015, excluding excise taxes. Dividend coverage would have been higher adjusting for cash realizations of non-cash income accruals. The dividend is further supported by the presence of spillover income, amounting to approximately $0.64 per share, or about 72% of annualized dividends, which Fitch believes provides stability to the dividend over the medium term, particularly in a challenging operating environment.

The Stable Outlook reflects Fitch's expectations for relative operating consistency, the maintenance of good asset quality, a reduction in leverage to the targeted range, and strong dividend coverage.

RATING SENSITIVITIES
IDRs AND SENIOR DEBT
Negative rating action for FSIC could be driven by an extended increase in leverage above the targeted range of approximately 0.70x-0.75x, resulting from increased borrowings or material realized or unrealized depreciation, and/or a meaningful increase in the proportion of equity holdings without a commensurate decline in leverage. A spike in non-accrual levels, an inability to refinance debt maturities, weaker cash income dividend coverage, or a meaningful increase in portfolio energy exposure would also be viewed unfavorably from a ratings perspective.

Positive rating momentum for FSIC is viewed as limited over the outlook horizon, particularly given the challenging market backdrop, but could develop over time with increased funding flexibility, including continued extension of the debt maturity profile and the ability to opportunistically issue public equity for growth capital. Other positive rating factors could include a continuation of solid asset quality performance, particularly given the competitive market environment, a reduction in portfolio energy exposure, and the maintenance of leverage within the targeted range.

FSIC is an externally managed business development company, organized in December 2007 and commencing investment operations in January 2009. As of Dec. 31, 2015, the company had investments in 114 portfolio companies amounting to approximately $4 billion.

Fitch has affirmed the following ratings:

FS Investment Corporation
--Long-term IDR at 'BBB-';
--Senior secured debt at 'BBB-';
--Senior unsecured debt at 'BBB-'.

The Rating Outlook is Stable.