Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
☒
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2023
OR
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 001-35730
STELLUS CAPITAL INVESTMENT CORPORATION
(Exact name of registrant as specified in its charter)
Maryland
46-0937320
(State or other jurisdiction ofincorporation or organization)
(I.R.S. EmployerIdentification Number)
4400 Post Oak Parkway, Suite 2200, Houston, TX
77027
(Address of principal executive offices)
(Zip Code)
Registrant’s telephone number, including area code: (713) 292-5400
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class
Name of Each Exchange on Which Registered
Common Stock, par value $0.001 per share
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☒
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒
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 ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. Yes ☐ No ☒
If securities are registered pursuant to Section 12(b) of the Act, indicate by check mark whether the financial statements of the registrant included in the filing reflect the correction of an error to previously issued financial statements. ☐
Indicate by check mark whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the registrant’s executive officers during the relevant recovery period pursuant to § 240.10D-1(b). ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒
The aggregate market value of the Registrant’s common stock held by non-affiliates of the registrant as of June 30, 2023 was: $291,372,749.
The number of shares of the issuer’s Common Stock, $0.001 par value per share, outstanding as of March 4, 2024 was 24,125,642.
Documents Incorporated by Reference
Portions of the registrant’s definitive Proxy Statement relating to the registrant’s 2024 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company’s fiscal year, are incorporated by reference in Part III of this Annual Report on Form 10-K as indicated herein.
FORM 10-K FOR THE FISCAL YEAR
ENDED DECEMBER 31, 2023
TABLE OF CONTENTS
PART I.
ITEM 1.
BUSINESS
1
ITEM 1A.
RISK FACTORS
34
ITEM 1B.
UNRESOLVED STAFF COMMENTS
68
ITEM 1C.
CYBERSECURITY
ITEM 2.
PROPERTIES
69
ITEM 3.
LEGAL PROCEEDINGS
ITEM 4.
MINE SAFETY DISCLOSURES
PART II.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
70
ITEM 6.
[RESERVED]
73
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
74
ITEM 7A.
QUANTITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
94
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
96
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
164
ITEM 9A.
CONTROLS AND PROCEDURES
ITEM 9B.
OTHER INFORMATION
165
ITEM 9C.
DISCLOSURE REGARDING FOREIGN JURISDICTIONS THAT PREVENT INSPECTIONS
166
PART III
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
167
ITEM 11.
EXECUTIVE COMPENSATION
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
PART IV
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
168
SIGNATURES
173
PART I
Item 1. Business
Except as otherwise indicated, the terms “we,” “us,” “our,” and the “Company” refer to Stellus Capital Investment Corporation; and “Stellus Capital Management,” the “Advisor” or the “Administrator” refer to our investment adviser and administrator, Stellus Capital Management, LLC.
General
We are an externally managed, closed-end, non-diversified management investment company that has elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). We were organized as a Maryland corporation on May 8, 2012, and formally commenced operations on November 7, 2012. We originate and invest primarily in private middle-market companies (typically those with $5 million to $50 million of EBITDA (earnings before interest, taxes, depreciation and amortization)) through first lien (including unitranche), second lien, and unsecured debt financing, often with corresponding equity co-investments. Unitranche structures may combine characteristics of first lien senior secured as well as second lien and/or subordinated loans, and our unitranche loans will expose us to the risks associated with second lien and subordinated loans to the extent we invest in the “last-out” tranche. Unsecured debt includes senior unsecured and subordinated loans.
Our investment activities are managed by our investment adviser, Stellus Capital Management, an investment advisory firm led by Robert T. Ladd and its other senior investment professionals. We source investments primarily through the extensive network of relationships that the senior investment professionals of Stellus Capital Management have developed with financial sponsor firms, financial institutions, middle-market companies, management teams and other professional intermediaries. The companies in which we invest are typically highly leveraged, and in most cases, our investments in such companies will not be rated by national rating agencies. If such investments were rated, we believe that they would likely receive a rating that is often referred to as “junk.”
Our investment objective is to maximize the total return to our stockholders in the form of current income and capital appreciation. We seek to achieve our investment objective by:
On May 9, 2022, we and certain of our affiliates received an exemptive order (the “Order”) from the Securities and Exchange Commission (“SEC”) that superseded the prior co-investment exemptive relief orders granted to us by the SEC that permits us to co-invest with additional types of private funds, other BDCs, and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common
control with Stellus Capital Management, subject to the conditions included therein. Pursuant to the Order, a “required majority” (as defined in Section 57(o) of the 1940 Act) of the Company’s independent directors must make certain conclusions in connection with a co-investment transaction, including (1) the terms of the proposed transaction, including the consideration to be paid, are reasonable and fair to the Company and its stockholders and do not involve overreaching of the Company or its stockholders on the part of any person concerned and (2) the transaction is consistent with the interests of the Company’s stockholders and is consistent with its investment objectives and strategies. We co-invest, subject to the conditions in the Order, with an affiliated private BDC and other private credit funds managed by Stellus Capital Management that have an investment strategy that is similar or identical to our investment strategy, and we may co-invest with other BDCs and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management in the future. We believe that such co-investments may afford us additional investment opportunities and an ability to achieve greater diversification.
As a BDC, we are required to comply with certain regulatory requirements. For instance, as a BDC, we may not acquire any assets other than “qualifying assets” specified in the 1940 Act unless, at the time the acquisition is made, at least 70% of our total assets are qualifying assets. Qualifying assets include investments in “eligible portfolio companies.” Under the relevant SEC rules, the term “eligible portfolio company” includes all private operating companies, operating companies whose securities are not listed on a national securities exchange, and certain public operating companies that have listed their securities on a national securities exchange and have a market capitalization of less than $250 million, in each case organized and with their principal of business in the United States.
We have elected, qualified, and intend to continue to qualify annually to be treated for U.S. federal income tax purposes as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). To maintain our qualification as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements. As of December 31, 2023, we were in compliance with the RIC requirements. As a RIC, we generally will not be subject to U.S. federal income tax on any income we timely distribute to our stockholders.
Under the provisions of the 1940 Act, we are permitted, as a BDC that has satisfied certain requirements, to issue senior securities in amounts such that our asset coverage ratio, as defined in the 1940 Act, equals at least 150% of our gross assets, less all liabilities and indebtedness not represented by senior securities, after each issuance of senior securities. As of December 31, 2023, our asset coverage ratio was 223%. The amount of leverage that we employ at any time depends on our assessment of the market and other factors at the time of any proposed borrowing.
Our principal executive office is currently located at 4400 Post Oak Parkway, Suite 2200, Houston, TX 77027, and our telephone number is (713) 292-5400. We maintain a website on the Internet at www.stelluscapital.com (under the “Public Investors” section). Information contained on our website is not incorporated by reference into this Annual Report on Form 10-K and you should not consider information contained on our website to be part of this Annual Report on Form 10-K.
SBIC Licenses
Two of our wholly owned subsidiaries, Stellus Capital SBIC LP and Stellus Capital SBIC II LP (together, the “SBIC subsidiaries” and individually, the “SBIC I subsidiary” and “SBIC II subsidiary,” respectively), hold a license to operate as small business investment companies (“SBICs”). Current U.S. Small Business Administration (“SBA”) regulations allow a single SBIC to obtain leverage by issuing debentures guaranteed by the SBA up to a maximum of $175 million, subject to required capitalization of the SBIC subsidiary, SBA approval, and other requirements. The maximum leverage available to a “family” of SBIC funds is $350.0 million, subject to SBA approval. SBA-guaranteed debentures have fixed interest rates that equal prevailing 10-year Treasury Note rates plus a market spread and have a maturity of ten years with interest payable semi-annually. The principal amount of the debentures is not required to be paid before maturity but may be pre-paid at any time with no prepayment penalty. We believe that the SBA-guaranteed debentures are an attractive source of debt capital.
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We have obtained exemptive relief from the SEC to permit us to exclude the debt of the SBIC subsidiaries guaranteed by the SBA from our asset coverage test under the 1940 Act. The exemptive relief provides us with increased flexibility under the asset coverage test by permitting us to borrow up to $325.0 million more than we would otherwise be able to absent the receipt of this exemptive relief.
Summary Risk Factors
Investing in our securities involves a high degree of risk. You should carefully consider the information in “Item 1A. Risk Factors”, including, but not limited to, the following risks:
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Portfolio Composition
Our investments generally range in size from $5 million to $30 million, and we may also selectively invest in larger positions. We generally expect that the size of our positions will increase in proportion to the size of our capital base. Pending such investments, we may reduce our outstanding indebtedness or invest in cash, cash equivalents, U.S. government securities and other high-quality debt investments with a maturity of one year or less. In the future, we may adjust opportunistically the percentage of our assets held in various types of loans, our principal loan sources and the industries to which we have greatest exposure, based on market conditions, the credit cycle, available financing and our desired risk/return profile.
The following table provides a summary of our portfolio investments as of December 31, 2023:
As of
December 31, 2023
($ in millions)
Number of investments in portfolio companies
93
Fair value(a)
$
874.5
Cost
902.1
% of portfolio at fair value – first lien debt(b)
88.6
%
% of portfolio at fair value – second lien debt
2.5
% of portfolio at fair value – unsecured debt
0.7
% of portfolio at fair value – equity
8.2
Weighted-average annual yield(c)
11.1
4
Stellus Capital Management
Stellus Capital Management manages our investment activities and is responsible for analyzing investment opportunities, conducting research and performing due diligence on potential investments, negotiating and structuring our investments, originating prospective investments and monitoring our investments and portfolio companies on an ongoing basis.
The senior investment professionals of Stellus Capital Management have an average of over 35 years of investing, corporate finance, restructuring, consulting and accounting experience and have worked together at several companies. The Stellus Capital Management senior investment professionals have a wide range of experience in middle-market investing, including originating, structuring and managing loans and debt securities through market cycles. The Stellus Capital Management senior investment professionals continue to provide investment sub-advisory services to the D. E. Shaw & Co., L.P. and its associated investment funds (the “D.E. Shaw group”).
In addition to serving as our investment adviser and the sub-advisor to the D. E. Shaw group as noted above, Stellus Capital Management currently manages private credit funds, some of which have an investment strategy that is similar or identical to our investment strategy. We received the Order from the SEC, which permits us to co-invest with investment funds managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management, where doing so is consistent with our investment strategy as well as applicable law (including the terms and conditions of the Order). We believe that such co-investments may afford us additional investment opportunities and an ability to achieve greater diversification. In addition, we will not co-invest with D.E. Shaw group funds.
Stellus Capital Management is headquartered in Houston, Texas, and also maintains offices in the Washington, D.C. area and Charlotte, North Carolina.
Market Opportunity
We originate and invest primarily in private middle-market companies through first lien (including unitranche), second lien and unsecured debt financing, often with corresponding equity co-investments. We believe the environment for investing in middle-market companies is attractive for several reasons, including:
Robust Demand for Debt Capital
We believe that private equity firms have significant committed but uncalled capital, a large portion of which is still available for investment in the United States. We expect the large amount of uninvested capital commitments will drive buyout activity over the next several years, which should, in turn, create lending opportunities for us.
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Attractive Environment to Lend To Middle-Market Companies
The current strength of the U.S. economy provides an attractive environment to lend to middle-market companies. The U.S. services, healthcare, technology and consumer products sectors continue to show strong growth and profitability, allowing middle-market companies to continue to service their debt and prudently borrow to support growth initiatives and mergers and acquisitions activity. This dynamism, coupled with ample capital from private equity firms to support middle-market companies, is creating a large population of credit worthy companies looking for debt capital.
Attractive Deal Pricing and Structures
We believe that the pricing of middle-market debt investments is higher, and the terms of such investments are more conservative, compared to larger liquid, public debt financings, due to the more limited universe of lenders as well as the highly negotiated nature of these financings. These transactions tend to offer stronger covenant packages, higher interest rates, lower leverage levels and better call protection compared to larger financings. In addition, middle-market loans typically offer other investor protections such as default penalties, lien protection, change of control provisions and information rights for lenders.
Specialized Lending Requirements
Lending to middle-market companies requires in-depth diligence, credit expertise, restructuring experience and active portfolio management. We believe that several factors render many U.S. financial institutions ill-suited to lend to middle-market companies. For example, based on the experience of Stellus Capital Management’s senior investment professionals, lending to middle-market companies in the United States (a) is generally more labor intensive than lending to larger companies due to the smaller size of each investment and the fragmented nature of the information available with respect to such companies, (b) requires specialized due diligence and underwriting capabilities, and (c) may also require more extensive ongoing monitoring by the lender. We believe that, through Stellus Capital Management, we have the experience and expertise to meet these specialized lending requirements.
Competitive Strengths
We believe that the following competitive strengths will allow us to achieve positive returns for our investors:
Experienced Investment Team
Through our investment adviser, Stellus Capital Management, we have access to the experience and expertise of the Stellus Capital Management senior investment professionals, including its senior investment professionals who have an average of over 35 years of investing, corporate finance, restructuring, consulting and accounting experience and have worked together at several companies. The Stellus Capital Management investment professionals have a wide range of experience in middle-market investing, including originating, structuring and managing debt and equity securities through market cycles. We believe the members of Stellus Capital Management’s senior investment team are proven and experienced, with extensive capabilities in credit investing, having participated in these markets for the predominant portion of their careers. We believe that these characteristics enhance the quantity and quality of investment opportunities available to us.
Established, Rigorous Investment and Monitoring Process
The Stellus Capital Management investment professionals have developed an extensive review and credit analysis process. Each investment that is reviewed by Stellus Capital Management is brought through a structured, multi-stage approval process. In addition, Stellus Capital Management takes an active approach in monitoring all investments, including reviews of financial performance on at least a quarterly basis and regular discussions with management. Stellus Capital Management’s investment and monitoring process and the depth and experience of its investment professionals should allow it to conduct the type of due diligence and monitoring that enables it to identify and evaluate risks and opportunities.
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Demonstrated Ability to Structure Investments Creatively
Stellus Capital Management has the expertise and ability to structure investments across all levels of a company’s capital structure. Furthermore, we believe that current market conditions will allow us to structure attractively priced debt investments and may allow us to incorporate other return-enhancing mechanisms such as commitment fees, original issue discounts, early redemption premiums, PIK, interest and various forms of equity securities.
Resources of Stellus Capital Management Platform
We have access to the resources and capabilities of Stellus Capital Management, which has 17 investment professionals, including Robert T. Ladd, Dean D’Angelo, and Joshua T. Davis, who are supported by five managing directors, four vice presidents and four analysts. These individuals have developed long-term relationships with middle-market companies, management teams, financial sponsors, lending institutions and deal intermediaries by providing flexible financing throughout the capital structure. We believe that these relationships provide us with a competitive advantage in identifying investment opportunities in our target market. We also expect to benefit from Stellus Capital Management’s due diligence, credit analysis, origination and transaction execution experience and capabilities, including the support provided with respect to those functions by W. Todd Huskinson, who serves as our Chief Financial Officer and Chief Compliance Officer, and his staff of nine finance and operations professionals.
Investment Strategy
The Stellus Capital Management senior investment professionals employ an opportunistic and flexible investing approach, combined with strong risk management processes, which we believe yields a highly diversified portfolio across companies, geographies, industries, and investment types. We seek direct origination opportunities of first lien (including unitranche), second lien, and unsecured debt financing, often with corresponding equity co-investments, in middle-market companies. We believe that businesses in this size range often have limited access to public financial markets, and will benefit from Stellus Capital Management’s reliable lending approach. Many financing providers have chosen to focus on large corporate clients and managing capital markets transactions rather than lending to middle-market businesses. Further, many financial institutions and traditional lenders are faced with constrained balance sheets and are requiring existing borrowers to reduce leverage.
With an average of over 35 years of investing, corporate finance, restructuring, consulting and accounting experience, the senior investment professionals of Stellus Capital Management have demonstrated investment expertise throughout the balance sheet and in a variety of situations, including financial sponsor buyouts, growth capital, debt refinancing, balance sheet recapitalizations, rescue financings, distressed opportunities, and acquisition financings. Our investment philosophy emphasizes capital preservation through superior credit selection and risk mitigation. We expect our portfolio to provide downside protection through conservative cash flow and asset coverage requirements, priority in the capital structure and information requirements. We also anticipate benefiting from equity participation through equity co-investments. This flexible approach enables Stellus Capital Management to respond to market conditions and offer customized lending solutions.
Stellus Capital Management invests across a wide range of industries with deep expertise in select verticals including, but not limited to, business services, retail, general industrial, government services, healthcare, software and specialty finance. Our typical transactions include providing financing for leveraged buyouts, acquisitions, recapitalizations and growth opportunities. We seek to maintain a diversified portfolio of investments as a method to manage risk and capitalize on specific sector trends. In addition, we co-invest with private credit funds and a private BDC managed by Stellus Capital Management or its affiliates that have a similar, overlapping or identical investment strategy as us and where doing so is consistent with conditions of the Order, and we may co-invest with other BDCs and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management in the future.
Our objective is to act as the lead or largest investor in transactions, generally investing between $5 million and $30 million per transaction. We expect the average investment holding period to be between two and four years, depending upon portfolio company objectives and conditions in the capital markets.
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We focus on middle-market companies with between $5 million and $50 million of EBITDA in a variety of industry sectors with positive long-term dynamics and dependable cash flows. We seek businesses with management teams with demonstrated track records and economic incentives in strong franchises and sustainable competitive advantages with dependable and predictable cash flows.
We employ leverage prudently and within the limitations of the applicable laws and regulations for BDCs. Any decision on our part to use leverage will depend upon our assessment of the attractiveness of available investment opportunities in relation to the costs and perceived risks of such leverage.
Transaction Sourcing
As access to investment opportunities is highly relationship-driven, the senior investment team and other investment professionals of Stellus Capital Management spend considerable time developing and maintaining contacts with key deal sources, including private equity firms, investment banks and senior lenders. The senior investment team and other investment professionals of Stellus Capital Management have been actively investing in the middle-market for more than a decade and have focused on extensive calling and marketing efforts via speaking engagements, sponsorships, industry events and referrals to broaden their relationship network. Existing relationships are constantly cultivated through transactional work and other personal contacts.
In addition to financial sponsors, Stellus Capital Management has developed a network of other deal sources, including:
We believe that Stellus Capital Management’s broad network of deal origination contacts will afford us with a continuous source of investment opportunities.
These origination relationships provide access not only to potential investment opportunities but also to market intelligence on trends across the credit markets. Since inception, Stellus Capital Management has completed financing transactions with more than 190 equity sponsors and completed multiple financing transactions with more than 35 of those equity sponsors.
We believe that, over the past decade, the senior investment team and other investment professionals of Stellus Capital Management have built a reputation as a thoughtful and disciplined provider of capital to middle-market companies and a preferred financing source for private equity sponsors and management teams. We believe these factors give Stellus Capital Management a competitive advantage in sourcing investment opportunities, which are put to use for our benefit.
Investment Structuring
Stellus Capital Management believes that each investment has unique characteristics that must be considered, understood and analyzed. Stellus Capital Management structures investment terms based on the business, the credit profile, the outlook for the industry in which a potential portfolio company operates, the competitive landscape, the
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products or services which the company sells and the management team and ownership of the company, among other factors. Stellus Capital Management relies upon the analysis conducted and information gathered through the investment process to evaluate the appropriate structure for our investments.
We invest primarily in the debt securities of middle-market companies. Our investments typically carry a high level of cash pay interest and may incorporate other return-enhancing mechanisms such as commitment fees, original issue discounts, early redemption premiums, PIK interest and some form of equity participation, including preferred stock, common stock, warrants and other forms of equity participation. We expect that a typical debt investment in which we invest will have a term at origination of between five and seven years. We expect to hold most of our investments to maturity or repayment, but we may sell some of our investments earlier if a liquidity event occurs, such as a sale, recapitalization or worsening of the credit quality of the portfolio company.
Stellus Capital Management negotiates covenants in connection with debt investments that provide protection for us but allow appropriate flexibility for the portfolio company. Such covenants may include affirmative and negative covenants, default penalties, lien protection and change of control provisions. Stellus Capital Management requires comprehensive information rights including access to management, financial statements and budgets and, in some cases, membership on the portfolio company’s board of directors or board observation rights. Additionally, Stellus Capital Management generally requires financial covenants and terms that restrict an issuer’s use of leverage and limitations on asset sales and capital expenditures.
Secured Debt
Secured debt, including first lien (including unitranche) and second lien financing, has liens on the assets of the borrower that serve as collateral in support of the repayment of such loans.
First Lien Debt First lien debt is structured with first-priority liens on the assets of the borrower that serve as collateral in support of the repayment of such loans. First lien loans may provide for moderate loan amortization in the early years of the loan, with the majority of the amortization deferred until loan maturity.
Unitranche Debt Unitranche debt typically is structured as first lien loans that combine both senior and junior debt, with lenders agreeing separately to an order of priority among them. To the extent that we invest in the “last out” tranche of a unitranche facility, our unitranche investments will have certain risk characteristics of second lien debt. Unitranche debt typically provides for moderate loan amortization in the initial years of the debt, with the majority of the principal payment deferred until loan maturity. Since unitranche debt generally allows the borrower to make a large lump sum payment of principal at the end of the loan term, there is a risk of loss if the borrower is unable to pay the lump sum or refinance the amount owed at maturity. In some cases, we will be the sole lender, or we, together with our affiliates, will be the sole lender, of unitranche debt, which can provide us with more influence interacting with a borrower in terms of monitoring and, if necessary, remediation in the event of underperformance.
Second Lien Debt Second lien debt is structured as junior, secured loans with second priority liens on an issuer’s assets. These loans typically provide for moderate loan amortization in the initial years of the loan, with the majority of the amortization deferred until loan maturity.
Unsecured Debt
Unsecured debt, including senior unsecured and subordinated loans, is not secured by any collateral and is effectively subordinated to the borrower’s secured indebtedness (to the extent of the collateral securing such indebtedness), including pursuant to one or more intercreditor agreements that we enter into with holders of a borrower’s senior debt.
Senior Unsecured Loans Senior unsecured loans are structured as loans that rank senior in right of payment to any of the borrower’s unsecured indebtedness that is contractually subordinated to such loans. These loans generally provide for fixed interest rates and amortize evenly over the term of the loan. Senior unsecured loans are generally less volatile than subordinated loans due to their priority over subordinated loans.
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Subordinated Loans Subordinated loans are structured as unsecured, subordinated loans that provide for relatively high, fixed interest rates that provide us with significant current interest income. These loans typically have interest-only payments (often representing a combination of cash pay and PIK interest) in the early years, with amortization of principal deferred to maturity. Subordinated loans generally allow the borrower to make a large lump sum payment of principal at the end of the loan term, and there is a risk of loss if the borrower is unable to pay the lump sum or refinance the amount owed at maturity. Subordinated loans are generally more volatile than secured loans and senior unsecured loans and may involve a greater risk of loss of principal as compared to other types of loans. Subordinated loans often include a PIK feature, which effectively operates as negative amortization of loan principal, thereby increasing credit risk exposure over the life of the loan.
Equity Securities
In connection with some of our debt investments, we may also invest in preferred or common stock or receive nominally priced warrants or options to buy an equity interest in the portfolio company. As a result, as a portfolio company appreciates in value, we may achieve additional investment return from this equity interest. We may structure such equity investments and warrants to include provisions protecting our rights as a minority-interest holder, as well as a “put,” or right to sell such securities back to the issuer, upon the occurrence of specified events. In many cases, we may also seek to obtain registration rights in connection with these equity interests, which may include demand and “piggyback” registration rights.
Investment Process
Through the resources of Stellus Capital Management, we have access to significant research resources, experienced investment professionals, internal information systems and a credit analysis framework and investment process. Stellus Capital Management has designed a highly involved and interactive investment management process, which is the core of its culture and the basis for what we believe is a strong track record of investment returns. The investment process seeks to select only those investments that it believes have the most attractive risk/reward characteristics. The process involves several levels of review and is coordinated in an effort to identify risks in potential investments. Stellus Capital Management applies its expertise to screen our investment opportunities as described below. This rigorous process, combined with its broad origination capabilities, has allowed the Stellus Capital Management team to be prudent in selecting opportunities in which to make an investment.
All potential investment opportunities undergo an initial informal review by Stellus Capital Management’s investment professionals. Each potential investment opportunity that an investment professional determines merits consideration is presented and evaluated at a weekly meeting during which Stellus Capital Management’s senior investment professionals discuss the merits and risks of the potential investment opportunity as well as the due diligence process and the pricing and structure. If Stellus Capital Management’s senior investment professionals believe an investment opportunity merits further review, the investment opportunity is assigned a deal team and the deal team prepares and presents to the investment committee for initial review a prescreen memorandum that generally describes the potential transaction and includes a description of the risks, due diligence process and proposed structure and pricing for the proposed investment opportunity.
Prior to making an investment, Stellus Capital Management conducts rigorous diligence on each investment opportunity. In connection with its due diligence on a potential investment opportunity, Stellus Capital Management utilizes its internal diligence resources, which include its internally developed credit analytical framework, subscriptions to third party research resources, discussions with industry experts, internal information sharing systems and the analytical expertise of its investment professionals. Stellus Capital Management typically reviews the company’s historical financials; industry drivers and outlook, competitive threats, customer concentration, asset coverage, projected financials and credit metrics; management background checks; and, if applicable, the track record and funding capabilities of the private equity sponsor.
Upon review of the prescreen memorandum, if the investment committee determines to proceed with the review of an investment opportunity, the deal team continues its diligence and deal structuring plans and prepares a credit approval memorandum for review by the investment committee. The credit approval memorandum updates the prescreen
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memorandum with more deal-specific detail, including an update to the diligence process and any changes in the structure and pricing of the proposed investment.
Investment Committee
Each new investment opportunity must be unanimously approved by Stellus Capital Management’s investment committee. Follow-on investments in existing portfolio companies also require the investment committee’s unanimous approval. Stellus Capital Management’s Chief Investment Officer, Robert T. Ladd, reviews any amendments before finalizing and closing negotiations with the prospective portfolio company. The purpose of Stellus Capital Management’s investment committee is to evaluate and approve all of our investments, subject at all times to the oversight of our Board. The investment committee process is intended to bring the diverse experience and perspectives of the committee’s members to the analysis and consideration of each investment. The investment committee consists of Robert T. Ladd, Dean D’Angelo, Joshua T. Davis and W. Todd Huskinson. The investment committee serves to provide investment consistency and adherence to our core investment philosophy and policies. The investment committee also determines appropriate investment sizing and suggests ongoing monitoring requirements.
In addition to reviewing investments, investment committee meetings serve as a forum to discuss credit views and outlooks. Potential transactions and deal flow are reviewed on a regular basis. Members of the investment team are encouraged to share information and views on credits with the investment committee early in their analysis. We believe this process improves the quality of the analysis and assists the deal team members to work more efficiently.
Each member of the investment committee performs a similar role for other accounts managed by Stellus Capital Management. In certain instances, including in connection with co-investments under the Order, approval by our Board may also be required prior to the making of an investment.
Monitoring Investments
In most cases, we do not have board influence over our portfolio companies. In some instances, Stellus Capital Management’s senior investment professionals may obtain board representation or observation rights in conjunction with our investments. Stellus Capital Management takes an active approach in monitoring all investments, including reviews of financial performance on at least a quarterly basis and regular discussions with management. The monitoring process begins with structuring terms and conditions, which require the timely delivery and access to critical financial and business information on portfolio companies.
Specifically, Stellus Capital Management’s monitoring system consists of the following activities:
Regular Investment Committee Updates Key portfolio company developments are discussed each week as part of the standard investment committee meeting agenda.
Written Reports The deal teams provide periodic written updates as appropriate for key events that impact portfolio company performance or valuation. In addition, deal teams provide written updates following each portfolio company board meeting.
Quarterly Full Portfolio Review Stellus Capital Management’s Chief Investment Officer and our Chief Compliance Officer perform a quarterly comprehensive review of every portfolio company with the deal teams. This process includes a written performance and valuation update, and credit-specific discussion on each of our portfolio companies. In addition, pursuant to our valuation policy, the valuation of each portfolio investment for which a market quotation is not readily available is reviewed by our independent third-party valuation firm at least twice annually. In addition, portfolio investments that are not publicly traded or whose market price is not readily available are valued at fair value as determined in good faith by our Board based on the input of Stellus Capital Management’s investment professionals and our Board’s audit committee.
As part of the monitoring process, Stellus Capital Management also tracks developments in the broader marketplace. Stellus Capital Management’s investment professionals have a wealth of information on the competitive
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landscape, industry trends, relative valuation metrics, and analyses that assist in the execution of our investment strategy. In addition, Stellus Capital Management’s extensive communications with brokers and dealers allows its investment professionals to monitor market and industry trends that could affect portfolio investments. Stellus Capital Management may provide ongoing strategic, financial and operational guidance to some portfolio companies either directly or by recommending its investment professionals or other experienced representatives to participate on the portfolio company’s board of directors. Stellus Capital Management maintains an extensive network of strategic and operational advisers to call upon for industry expertise or to supplement existing management teams.
Asset Quality
In addition to various risk management and monitoring tools, Stellus Capital Management uses an investment ranking system to characterize and monitor the credit profile and expected level of returns on each investment in our portfolio. This investment ranking system uses a five-level numeric scale. The following is a description of the conditions associated with each investment category:
Investment Category 1 is used for investments that are performing above expectations, and whose risks remain favorable compared to the expected risk at the time of the original investment.
Investment Category 2 is used for investments that are performing within expectations and whose risks remain neutral compared to the expected risk at the time of the original investment. All new loans are initially rated 2.
Investment Category 3 is used for investments that are performing below expectations and that require closer monitoring, but where no loss of return or principal is expected. Portfolio companies with a rating of 3 may be out of compliance with financial covenants.
Investment Category 4 is used for investments that are performing substantially below expectations and whose risks have increased substantially since the original investment. These investments are often in work out. Investments with a rating of 4 are those for which some loss of contractual return but no loss of principal is expected.
Investment Category 5 is used for investments that are performing substantially below expectations and whose risks have increased substantially since the original investment. These investments are almost always in work out. Investments with a rating of 5 are those for which some loss of return and principal is expected.
In the event that Stellus Capital Management determines that an investment is underperforming, or circumstances suggest that the risk associated with a particular investment has significantly increased, Stellus Capital Management will increase its monitoring intensity and prepare regular updates for the investment committee, summarizing current operating results and material impending events and suggesting recommended actions. While the investment ranking system identifies the relative risk for each investment, the ranking alone does not dictate the scope and/or frequency of any monitoring that is performed. The frequency of Stellus Capital Management’s monitoring of an investment is determined by a number of factors, including, but not limited to, the trends in the financial performance of the portfolio company, the investment structure and the type of collateral securing the investment.
Determination of Net Asset Value and Portfolio Valuation Process
The net asset value per share of our outstanding shares of common stock is determined quarterly by dividing the value of total assets minus liabilities by the total number of shares outstanding.
Rule 2a-5 under the 1940 Act (“Rule 2a-5”) establishes requirements for determining fair value in good faith for purposes of the 1940 Act. Rule 2a-5 permits boards, subject to board oversight and certain other conditions, to designate certain parties to perform fair value determinations. Rule 2a-5 also defines when market quotations are “readily available” for purposes of the 1940 Act and the threshold for determining whether a fund must determine the fair value of a security. Rule 31a-4 under the 1940 Act (“Rule 31a-4”) regulates recordkeeping associated with fair value determinations. While our Board has not elected to designate Stellus Capital Management as the valuation designee, we
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have adopted certain revisions to our valuation policies and procedures in order comply with the applicable requirements of Rule 2a-5 and Rule 31a-4.
As a BDC, we will generally invest in illiquid loans and securities, including debt and equity securities of private middle-market companies. Section 2(a)(41) of the 1940 Act requires that a BDC value its assets as follows: (i) the third party price for securities for which a quotation is readily available; and (ii) for all other securities and assets, fair value, as determined in good faith by a BDC's board.
In calculating the value of our total assets, investment transactions will be recorded on the trade date. Realized gains or losses will be computed using the specific identification method.
Under procedures established by our Board, we intend to value investments for which market quotations are readily available at such market quotations. The Company will obtain these market values from an independent pricing service or at the midpoint of the bid and ask prices obtained from at least two brokers or dealers (if available, otherwise by a principal market maker or a primary market dealer). Debt and equity securities that are not publicly traded or whose market prices are not readily available will be valued at fair value as determined in good faith by our Board. Such determination of fair values may involve subjective judgments and estimates. We also engage independent valuation providers to review the valuation of each portfolio investment that does not have a readily available market quotation at least twice annually.
Debt and equity investments purchased within approximately 90 days of the valuation date will be valued at cost, plus accreted discount, or minus amortized premium, which approximates fair value. With respect to unquoted securities, our Board will value each investment considering, among other measures, discounted cash flow models, comparisons of financial ratios of peer companies that are public and other factors. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, the Board will use the pricing indicated by the external event to corroborate and/or assist in determining the valuation. Because we expect that there will not be a readily available market quotation for many of the investments in our portfolio, the Company expects to value most of its portfolio investments at fair value as determined in good faith by the Board using a documented valuation policy and a consistently applied valuation process. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ significantly from the values that would have been used had a readily available market value existed for such investments, and the differences could be material. In addition, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different from the valuations currently assigned.
We have adopted Accounting Standards Board Accounting Standards Codification 820, Fair Value Measurements and Disclosures (“ASC 820”). This accounting statement requires us to assume that the portfolio investment is assumed to be sold in the principal market to market participants, or in the absence of a principal market, the most advantageous market, which may be a hypothetical market. Market participants are defined as buyers and sellers in the principal or most advantageous market that are independent, knowledgeable, and willing and able to transact. In accordance with ASC 820, the market in which we can exit portfolio investments with the greatest volume and level activity is considered our principal market.
With respect to investments for which market quotations are not readily available, our Board undertakes a multi-step valuation process each quarter, as described below:
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In following these approaches, the types of factors that are taken into account in fair value pricing our investments include, as relevant, but are not limited to:
Realization of Investments
The potential exit scenarios of a portfolio company play an important role in evaluating investment decisions. Our debt orientation provides for increased potential exit opportunities, including (a) the sale of investments in the private markets, (b) the refinancing of investments held, often due to maturity or recapitalizations, and (c) other liquidity events, including the sale or merger of the portfolio company. Since we seek to maintain a debt orientation in our investments, we expect to receive interest income over the course of the investment period, resulting in a return on invested capital well in advance of final exit.
Derivatives
We may utilize hedging techniques such as interest rate swaps to mitigate potential interest rate risk on our indebtedness. Such interest rate swaps would principally be used to protect us against higher costs on our indebtedness resulting from increases in both short-term and long-term interest rates. We also may use various hedging and other risk management strategies to seek to manage various risks, including changes in currency exchange rates and market interest rates. Such hedging strategies would be utilized to seek to protect the value of our portfolio investments, for example, against possible adverse changes in the market value of securities held in our portfolio.
Rule 18f-4 requires BDCs that use derivatives to, among other things, comply with a value-at-risk leverage limit, adopt a derivatives risk management program, and implement certain testing and board reporting procedures. Rule 18f-4 exempts BDCs that qualify as “limited derivatives users” from the aforementioned requirements, provided that these BDCs adopt written policies and procedures that are reasonably designed to manage the BDC’s derivatives risks and comply with certain recordkeeping requirements. We currently qualify as a “limited derivatives user” and expect to
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continue to do so. We adopted a derivatives policy by Rule 18f-4’s August 2022 compliance date, and comply with the recordkeeping requirements.
Managerial Assistance
As a BDC, we offer, and must provide upon request, managerial assistance to our portfolio companies. This assistance could involve monitoring the operations of our portfolio companies, participating in board and management meetings, consulting with and advising officers of portfolio companies and providing other organizational and financial guidance. Stellus Capital Management or an affiliate of Stellus Capital Management provides such managerial assistance on our behalf to portfolio companies that request this assistance. We may receive fees for these services and will reimburse Stellus Capital Management or an affiliate of Stellus Capital Management, as applicable, for its allocated costs in providing such assistance, subject to the review by our Board, including our independent directors.
Competition
Our primary competitors in providing financing to middle-market companies include public and private funds, other BDCs, commercial and investment banks, commercial financing companies and, to the extent they provide an alternative form of financing, private equity and hedge funds. Many of our competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, we believe some competitors may have access to funding sources that are not available to us. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships than us. Furthermore, many of our competitors are not subject to the regulatory restrictions that the 1940 Act imposes on us as a BDC or to the distribution and other requirements we must satisfy to maintain our qualification as a RIC.
We use the expertise of the investment professionals of Stellus Capital Management to which we have access to assess investment risks and determine appropriate pricing for our investments in portfolio companies. In addition, we believe that the relationships of the investment professionals of Stellus Capital Management enable us to learn about, and compete effectively for, financing opportunities with attractive middle-market companies in the industries in which we invest.
Employees
We do not have any direct employees, and our day-to-day investment operations are managed by Stellus Capital Management. We have a Chief Executive Officer and President and a Chief Financial Officer, Chief Compliance Officer, Treasurer and Secretary. To the extent necessary, we may hire additional personnel going forward. Our officers are employees of Stellus Capital Management and our allocable portion of the cost of our Chief Financial Officer and Chief Compliance Officer and his staff is paid by us pursuant to the Administration Agreement that we have entered into with Stellus Capital Management (the “Administration Agreement”).
Management Agreements
Stellus Capital Management serves as our investment adviser and is registered as an investment adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). In addition, Stellus Capital Management serves as our administrator.
Investment Advisory Agreement
Subject to the overall supervision of our Board and in accordance with the 1940 Act, Stellus Capital Management manages our day-to-day operations and provides investment advisory services to us. Under the terms of the Investment Advisory Agreement (the “Investment Advisory Agreement”), Stellus Capital Management:
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Pursuant to the Investment Advisory Agreement, we have agreed to pay Stellus Capital Management a fee for investment advisory and management services consisting of two components — a base management fee and an incentive fee. The cost of both the base management fee and the incentive fee is borne by our stockholders.
Management Fee
The base management fee is calculated at an annual rate of 1.75% of our gross assets, including assets purchased with borrowed funds or other forms of leverage (including preferred stock, public and private debt issuances, derivative instruments, repurchase agreements and other similar instruments or arrangements) and excluding cash and cash equivalents. For services rendered under the Investment Advisory Agreement, the base management fee is payable quarterly in arrears. The base management fee is calculated based on the average value of our gross assets, excluding cash and cash equivalents, at the end of the two most recently completed calendar quarters. Base management fees for any partial month or quarter are appropriately pro-rated.
Incentive Fee
The incentive fee, which provides Stellus Capital Management with a share of the income that it generates for us, has two components, ordinary income and capital gains, calculated as follows:
The ordinary income component is calculated and payable quarterly in arrears based on our pre-incentive fee net investment income for the immediately preceding calendar quarter, subject to a total return requirement, and deferral of non-cash amounts, and is 20.0% of the amount, if any, by which our pre-incentive fee net investment income, expressed as a rate of return on the value of our net assets attributable to our common stock, for the immediately preceding calendar quarter, exceeds a 2.0% (which is 8.0% annualized) hurdle rate and a “catch-up” provision, for the benefit of Stellus Capital Management, measured as of the end of each calendar quarter. Under this provision, in any calendar quarter, Stellus Capital Management receives no incentive fee until our pre-incentive fee net investment income equals the hurdle rate of 2.0%, but then receives, as a “catch-up,” 100% of our pre-incentive fee net investment income with respect to that portion of such pre-incentive fee net investment income, if any, that exceeds the hurdle rate but is less than 2.5%.
The effect of the “catch-up” provision is that, subject to the total return provision discussed below, if pre-incentive fee net investment income exceeds 2.5% in any calendar quarter, Stellus Capital Management receives 20.0% of our pre-incentive fee net investment income as if a hurdle rate did not apply. For this purpose, pre-incentive fee net investment income means interest income, dividend income and any other income (including any other fees, such as commitment, origination, structuring, diligence, managerial assistance and consulting fees or other fees that we receive from portfolio companies) accrued during the calendar quarter, minus our operating expenses for the quarter (including the base management fee, expenses payable under the Administration Agreement, and any interest expense and any distributions paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-incentive fee net investment income includes, in the case of investments with a deferred interest feature (such as original issue discount (“OID”), debt instruments with PIK interest and zero coupon securities), accrued income that we have not yet received in cash. The foregoing incentive fee is subject to a total return requirement, which provides that no incentive fee in respect of the Company’s pre-incentive fee net investment income will be payable except to the extent 20.0% of the cumulative net
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increase in net assets resulting from operations over the then current and 11 preceding quarters exceeds the cumulative incentive fees accrued and/or paid for the 11 preceding quarters. In other words, any ordinary income incentive fee that is payable in a calendar quarter will be limited to the lesser of (i) 20.0% of the amount by which our pre-incentive fee net investment income for such calendar quarter exceeds the 2.0% hurdle, subject to the “catch-up” provision, and (ii) (x) 20.0% of the cumulative net increase in net assets resulting from operations for the then current and 11 preceding calendar quarters minus (y) the cumulative incentive fees accrued and/or paid for the 11 preceding calendar quarters.
For the foregoing purpose, the “cumulative net increase in net assets resulting from operations” is the amount, if positive, of the sum of pre-incentive fee net investment income, realized gains and losses and unrealized appreciation and depreciation of the Company for the then current and 11 preceding calendar quarters. In addition, the portion of such incentive fee that is attributable to deferred interest (such as PIK interest or OID) will be paid to Stellus Capital Management, without any interest thereon, only if and to the extent we actually receive such interest in cash, and any accrual thereof will be reversed if and to the extent such interest is reversed in connection with any write-off or similar treatment of the investment giving rise to any deferred interest accrual. Any reversal of such amounts would reduce net income for the quarter by the net amount of the reversal (after taking into account the reversal of incentive fees payable) and would result in a reduction and possible elimination of the incentive fees for such quarter. There is no accumulation of amounts on the hurdle rate from quarter to quarter, and accordingly there is no clawback of amounts previously paid if subsequent quarters are below the quarterly hurdle, and there is no delay of payment if prior quarters are below the quarterly hurdle. Stellus Capital Management has agreed to permanently waive any interest accrued on the portion of the incentive fee attributable to deferred interest (such as PIK interest or OID).
Pre-incentive fee net investment income does not include any realized capital gains, realized capital losses or unrealized capital appreciation or depreciation. Because of the structure of the incentive fee, it is possible that we may pay an incentive fee in a quarter where we incur a loss, subject to the total return requirement. For example, if we receive pre-incentive fee net investment income in excess of the quarterly minimum hurdle rate, we will pay the applicable incentive fee even if we have incurred a loss in that quarter due to realized and unrealized capital losses. Our net investment income used to calculate this component of the incentive fee is also included in the amount of our gross assets used to calculate the 1.75% base management fee. These calculations are appropriately prorated for any period of less than three months and adjusted for any share issuances or repurchases during the current quarter.
The following is a graphical representation of the calculation of the income-related portion of the incentive fee:
Quarterly Incentive Fee Based on Net Investment Income
Pre-Incentive Fee Net Investment Income
(expressed as a percentage of the value of net assets)
Percentage of Pre-incentive Fee Net Investment Income
Allocated to Income-Related Portion of Incentive Fee
The capital gains component of the incentive fee is determined and payable in arrears as of the end of each calendar year (or upon termination of the Investment Advisory Agreement, as of the termination date), and is equal to 20.0% of our cumulative aggregate realized capital gains from inception through the end of that calendar year, computed net of our aggregate cumulative realized capital losses and our aggregate cumulative unrealized capital depreciation through the end of such year, less the aggregate amount of any previously paid capital gains incentive fees. If such amount is negative, then no capital gains incentive fee will be payable for such year. Additionally, if the Investment
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Advisory Agreement is terminated as of a date that is not a calendar year end, the termination date will be treated as though it were a calendar year end for purposes of calculating and paying the capital gains incentive fee.
Examples of Quarterly Incentive Fee Calculation
Example 1: Income Related Portion of Incentive Fee before Total Return Requirement Calculation:
Alternative 1
Assumptions
Investment income (including interest, dividends, fees, etc.) = 1.25%Hurdle rate(1) = 2.0%Management fee(2) = 0.4375%Other expenses (legal, accounting, custodian, transfer agent, etc.) = 0.2%Pre-incentive fee net investment income(investment income — (management fee + other expenses)) = 0.6125%
Pre-incentive fee net investment income does not exceed hurdle rate, therefore there is no income-related incentive fee.
Alternative 2
Investment income (including interest, dividends, fees, etc.) = 2.9%Hurdle rate(1) = 2.0%Management fee(2) = 0.4375% Other expenses (legal, accounting, custodian, transfer agent, etc.) = 0.2%Pre-incentive fee net investment income(investment income — (management fee + other expenses)) = 2.2625%
Incentive fee
= 100% × Pre-incentive fee net investment income (subject to “catch-up”)(3)= 100% × (2.2625% — 2.0%)= 0.2625%
Pre-incentive fee net investment income exceeds the hurdle rate, but does not fully satisfy the “catch-up” provision, therefore the income related portion of the incentive fee is 0.2625%.
Alternative 3
Investment income (including interest, dividends, fees, etc.) = 3.5%Hurdle rate(1) = 2.0%Management fee(2) = 0.4375%Other expenses (legal, accounting, custodian, transfer agent, etc.) = 0.2%Pre-incentive fee net investment income(investment income — (management fee + other expenses)) = 2.8625%Incentive fee = 100% × Pre-incentive fee net investment income (subject to “catch-up”)(3)Incentive fee = 100% × “catch-up” + (20.0% × (Pre-Incentive Fee Net Investment Income — 2.5%))
“Catch-up”
= 2.5% — 2.0%= 0.5%
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= (100% × 0.5%) + (20.0% × (2.8625% — 2.5%))= 0.5% + (20.0% × 0.3625%)= 0.5% + 0.0725%= 0.5725%
Pre-incentive fee net investment income exceeds the hurdle rate, and fully satisfies the “catch-up” provision, therefore the income related portion of the incentive fee is 0.5725%.
Example 2: Income Portion of Incentive Fee with Total Return Requirement Calculation:
Alternative 1:
Investment income (including interest, dividends, fees, etc.) = 3.5%Hurdle rate(1) = 2.0%Management fee(2) = 0.4375%Other expenses (legal, accounting, custodian, transfer agent, etc.) = 0.2%Pre-incentive fee net investment income(investment income — (management fee + other expenses) = 2.8625%Cumulative incentive compensation accrued and/or paid for preceding 11 calendar quarters = $9,000,00020.0% of cumulative net increase in net assets resulting from operations over current and preceding 11 calendar quarters = $8,000,000
Although our pre-incentive fee net investment income exceeds the hurdle rate of 2.0% (as shown in Alternative 3 of Example 1 above), no incentive fee is payable because 20.0% of the cumulative net increase in net assets resulting from operations over the then current and 11 preceding calendar quarters did not exceed the cumulative income and capital gains incentive fees accrued and/or paid for the preceding 11 calendar quarters.
Alternative 2:
Investment income (including interest, dividends, fees, etc.) = 3.5%Hurdle rate(1) = 2.0%Management fee(2) = 0.4375%Other expenses (legal, accounting, custodian, transfer agent, etc.) = 0.2%Pre-incentive fee net investment income(investment income — (management fee + other expenses) = 2.8625%Cumulative incentive compensation accrued and/or paid for preceding 11 calendar quarters = $9,000,00020.0% of cumulative net increase in net assets resulting from operations over current and preceding11 calendar quarters = $10,000,000
Because our pre-incentive fee net investment income exceeds the hurdle rate of 2.0% and because 20.0% of the cumulative net increase in net assets resulting from operations over the then current and 11 preceding calendar quarters exceeds the cumulative income and capital gains incentive fees accrued and/or paid for the preceding 11 calendar quarters, an incentive fee would be payable, as shown in Alternative 3 of Example 1 above.
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Example 3: Capital Gains Portion of Incentive Fee(*):
Year 1: $2.0 million investment made in Company A (“Investment A”), and $3.0 million investment made in Company B (“Investment B”)
Year 2: Investment A sold for $5.0 million and fair market value (“FMV”) of Investment B determined to be $3.5 million
Year 3: FMV of Investment B determined to be $2.0 million
Year 4: Investment B sold for $3.25 million
The capital gains portion of the incentive fee would be:
Year 1: None
Year 2: Capital gains incentive fee of $0.6 million — ($3.0 million realized capital gains on sale of Investment A multiplied by 20.0%)
Year 3: None — $0.4 million (20.0% multiplied by ($3.0 million cumulative capital gains less $1.0 million cumulative capital depreciation)) less $0.6 million (previous capital gains fee paid in Year 2)
Year 4: Capital gains incentive fee of $50,000 — $0.65 million ($3.25 million cumulative realized capital gains multiplied by 20.0%) less $0.6 million (capital gains incentive fee taken in Year 2)
Year 1: $2.0 million investment made in Company A (“Investment A”), $5.25 million investment made in Company B (“Investment B”) and $4.5 million investment made in Company C (“Investment C”)
Year 2: Investment A sold for $4.5 million, FMV of Investment B determined to be $4.75 million and FMV of Investment C determined to be $4.5 million
Year 3: FMV of Investment B determined to be $5.0 million and Investment C sold for $5.5 million
Year 4: FMV of Investment B determined to be $6.0 million
Year 5: Investment B sold for $4.0 million
The capital gains incentive fee, if any, would be:
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Year 2: $0.4 million capital gains incentive fee — 20.0% multiplied by $2.0 million ($2.5 million realized capital gains on Investment A less $0.5 million unrealized capital depreciation on Investment B)
Year 3: $0.25 million capital gains incentive fee(1) — $0.65 million (20.0% multiplied by $3.25 million ($3.5 million cumulative realized capital gains less $0.25 million unrealized capital depreciation)) less $0.4 million capital gains incentive fee received in Year 2
Year 4: $0.05 million capital gains incentive fee — $0.7 million ($3.50 million cumulative realized capital gains multiplied by 20.0%) less $0.65 million cumulative capital gains incentive fee paid in Year 2 and Year 3
Year 5: None — $0.45 million (20.0% multiplied by $2.25 million (cumulative realized capital gains of $3.5 million less realized capital losses of $1.25 million)) less $0.7 million cumulative capital gains incentive fee paid in Year 2, Year 3 and Year 4(2)
*
The hypothetical amounts of returns shown are based on a percentage of our total net assets and assume no leverage. There is no guarantee that positive returns will be realized and actual returns may vary from those shown in this example.
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Payment of Our Expenses
All investment professionals of Stellus Capital Management, when and to the extent engaged in providing investment advisory and management services to us, and the compensation and routine overhead expenses of personnel allocable to these services to us, are provided and paid for by Stellus Capital Management and not by us. We bear all other out-of-pocket costs and expenses of our operations and transactions, including, without limitation, those relating to:
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Duration and Termination
Unless terminated earlier as described below, the Investment Advisory Agreement will continue in effect from year to year if approved annually by our Board or by the affirmative vote of the holders of a majority of our outstanding voting securities, and, in either case, if also approved by a majority of the independent directors. The Investment Advisory Agreement automatically terminates in the event of its assignment, as defined in the 1940 Act, by Stellus Capital Management and may be terminated by either party without penalty upon 60 days’ written notice to the other. The holders of a majority of our outstanding voting securities may also terminate the Investment Advisory Agreement without penalty upon 60 days’ written notice. See Item 1A. “Risk Factors — Risks Related to our Operations” in this Annual Report on Form 10-K. We are dependent upon key personnel of Stellus Capital Management for our future success. If Stellus Capital Management were to lose any of its key personnel, our ability to achieve our investment objective could be significantly harmed.
Indemnification
The Investment Advisory Agreement provides that Stellus Capital Management and its officers, managers, partners, agents, employees, controlling persons and members, and any other person or entity affiliated with it, are entitled to indemnification from us for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of Stellus Capital Management’s services under the Investment Advisory Agreement or otherwise as our investment adviser. Our obligation to provide indemnification under the Investment Advisory Agreement, however, is limited by the 1940 Act and Investment Company Act Release No. 11330, which, among other things, prohibit us from indemnifying any director, officer or other individual from any liability resulting directly from the willful misconduct, bad faith, gross negligence in the performance of duties or reckless disregard of applicable obligations and duties of the directors, officers or other individuals and require us to set forth reasonable and fair means for determining whether indemnification shall be made.
Board Approval of the Investment Advisory Agreement
Our Board, including a majority of our independent directors, approved the Investment Advisory Agreement at its first meeting, held on September 24, 2012, and approved the annual continuation of the Investment Advisory Agreement on January 10, 2024 by virtual means in reliance on relief provided by the SEC in response to the COVID-19 pandemic. As a condition of the SEC's COVID-19 relief, our Board will be required to ratify the re-approval of the Investment Advisory Agreement at its next in-person meeting. In its consideration of the Investment Advisory Agreement, the Board focused on information it had received relating to, among other things: (a) the nature, quality and extent of the advisory and other services to be provided to us by our investment adviser; (b) comparative data with respect to advisory fees or similar expenses paid by other BDCs with similar investment objectives; (c) our projected operating expenses and expense ratio compared to BDCs with similar investment objectives; (d) any existing and potential sources of indirect income to our investment adviser from its relationships with us and the profitability of those relationships; (e) information about the services to be performed and the personnel performing such services under the Investment Advisory Agreement; (f) the organizational capability and financial condition of our investment adviser; and (g) various other factors.
In voting to approve the Investment Advisory Agreement, our Board, including all of the directors who are not “interested persons,” of the Company, made the following conclusions:
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Based on the information reviewed and the discussions, the Board, including a majority of the independent directors, concluded that the investment management fee rates and terms are reasonable in relation to the services to be provided and approved the Investment Advisory Agreement as being in the best interests of our stockholders.
Administration Agreement
Under the Administration Agreement, Stellus Capital Management furnishes us with office facilities and equipment and will provide us with clerical, bookkeeping, recordkeeping and other administrative services at such facilities. Stellus Capital Management also performs, or oversees the performance of, our required administrative services, which include being responsible for the financial and other records that we are required to maintain and preparing reports to our stockholders and reports and other materials filed with the SEC. In addition, Stellus Capital Management assists us in determining and publishing our net asset value, oversees the preparation and filing of our tax returns and the printing and dissemination of reports and other materials to our stockholders, and generally oversees the payment of our expenses and the performance of administrative and professional services rendered to us by others. Under the Administration Agreement, Stellus Capital Management also provides managerial assistance on our behalf to those portfolio companies that have accepted our offer to provide such assistance.
Payments under the Administration Agreement are equal to an amount based upon our allocable portion (subject to the review of our Board) of Stellus Capital Management’s overhead in performing its obligations under the Administration Agreement, including rent, the fees and expenses associated with performing compliance functions and our allocable portion of the cost of our Chief Financial Officer and Chief Compliance Officer and his staff. In addition, if requested to provide significant managerial assistance to our portfolio companies, Stellus Capital Management will be paid an additional amount based on the services provided, which shall not exceed the amount we receive from such portfolio companies for providing this assistance. The Administration Agreement has an initial term of two years and may be renewed with the approval of our Board. The Administration Agreement may be terminated by either party without penalty upon 60 days’ written notice to the other party. To the extent that Stellus Capital Management outsources any of its functions, we will pay the fees associated with such functions on a direct basis without any incremental profit to Stellus Capital Management. Stockholder approval is not required to amend the Administration Agreement.
The Administration Agreement provides that Stellus Capital Management, its affiliates and their respective, officers, managers, partners, agents, employees, controlling persons and members, and any other person or entity affiliated with it, are entitled to indemnification from us for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of Stellus Capital Management’s services under the Administration Agreement or otherwise as our administrator. Our obligation to provide indemnification under the Administration Agreement, however, is limited by the 1940 Act and Investment Company Act Release No. 11330, which, among other things, prohibit us from indemnifying any director, officer or other individual from any liability resulting directly from the willful misconduct, bad faith, gross negligence in the performance of duties or reckless disregard of applicable obligations and duties of the directors, officers or other individuals and require us to set forth reasonable and fair means for determining whether indemnification shall be made.
License Agreement
We have entered into a license agreement with Stellus Capital Management under which Stellus Capital Management has agreed to grant us a non-exclusive, royalty-free license to use the name “Stellus Capital.” Under this agreement, we have a right to use the “Stellus Capital” name for so long as Stellus Capital Management or one of its affiliates remains our investment adviser. Other than with respect to this limited license, we have no legal right to the “Stellus Capital” name. This license agreement will remain in effect for so long as the Investment Advisory Agreement with Stellus Capital Management is in effect.
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Exchange Act Reports
We maintain a website at www.stelluscapital.com (under the public investors section). The information on our website is not incorporated by reference in this Annual Report on Form 10-K.
We make available on or through our website certain reports and amendments to those reports that we file with or furnish to the SEC in accordance with the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These include our annual reports on Form 10-K, our quarterly reports on Form 10-Q and our current reports on Form 8-K. We make this information available on our website free of charge as soon as reasonably practicable after we electronically file the information with, or furnish it to, the SEC.
Regulation as a Business Development Company
We are a BDC under the 1940 Act that has elected to be treated as a RIC under the Code. The 1940 Act contains prohibitions and restrictions relating to transactions between BDCs and their affiliates (including any investment advisers), principal underwriters and affiliates of those affiliates or underwriters and requires that a majority of the directors be persons other than “interested persons,” as that term is defined in Section 2(a)(19) of the 1940 Act. In addition, the 1940 Act provides that we may not change the nature of our business so as to cease to be, or to withdraw our election as, a BDC unless approved by the holders of a majority of our outstanding voting securities.
We may invest up to 100% of our assets in securities acquired directly from issuers in privately negotiated transactions. With respect to such securities, we may, for the purpose of public resale, be deemed an “underwriter,” as that term is defined in the Securities Act of 1933, as amended (the “Securities Act”). Our intention is to not write (sell) or buy put or call options to manage risks associated with the publicly traded securities of our portfolio companies, except that we may enter into hedging transactions to manage the risks associated with interest rate fluctuations. However, we may purchase or otherwise receive warrants to purchase the common stock of our portfolio companies in connection with acquisition financing or other investments. Similarly, in connection with an acquisition, we may acquire rights to require the issuers of acquired securities or their affiliates to repurchase them under certain circumstances. We also do not intend to acquire securities issued by any investment company that exceed the limits imposed by the 1940 Act. Under these limits, we generally cannot acquire more than 3% of the voting stock of any registered investment company, invest more than 5% of the value of our total assets in the securities of one investment company or invest more than 10% of the value of our total assets in the securities of more than one investment company. With regard to that portion of our portfolio invested in securities issued by investment companies, it should be noted that such investments might subject our stockholders to additional expenses. None of these policies is fundamental and may be changed without stockholder approval upon 60 days’ prior written notice to stockholders.
Qualifying Assets
Under the 1940 Act, a BDC may not acquire any asset other than assets of the type listed in Section 55(a) of the 1940 Act, which are referred to as “qualifying assets,” unless, at the time the acquisition is made, qualifying assets represent at least 70% of the company’s total assets. The principal categories of qualifying assets relevant to our business are the following:
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The regulations defining qualifying assets may change over time. We may adjust our investment focus as needed to comply with and/or take advantage of any regulatory, legislative, administrative or judicial actions in this area.
Managerial Assistance to Portfolio Companies
In order to count portfolio securities as qualifying assets for the purpose of the 70% test, a BDC must either control the issuer of the securities or must offer to make available to the issuer of the securities significant managerial assistance. However, when the BDC purchases securities in conjunction with one or more other persons acting together, one of the other persons in the group may make available such managerial assistance. Making available managerial assistance means any arrangement whereby the BDC, through its directors, officers, employees or agents, offers to provide, and, if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company. With respect to an SBIC, making available managerial assistance means the making of loans to a portfolio company. Stellus Capital Management will provide such managerial assistance on our behalf to portfolio companies that request this assistance.
Temporary Investments
Pending investment in other types of qualifying assets, as described above, our investments may consist of cash, cash equivalents, U.S. government securities, repurchase agreements and high-quality debt investments that mature in one year or less from the date of investment, which we refer to, collectively, as temporary investments, so that 70% of our assets are qualifying assets or temporary investments. Typically, we will invest in U.S. Treasury bills or in repurchase agreements, so long as the agreements are fully collateralized by cash or securities issued by the U.S. government or its agencies. A repurchase agreement involves the purchase by an investor, such as us, of a specified security and the simultaneous agreement by the seller to repurchase it at an agreed-upon future date and at a price that is greater than the purchase price by an amount that reflects an agreed-upon interest rate. There is no percentage restriction on the proportion of our assets that may be invested in such repurchase agreements. However, if more than 25% of our total assets constitute repurchase agreements from a single counterparty, we would not meet the diversification tests in order to maintain our qualification as a RIC for U.S. federal income tax purposes. Accordingly, we do not intend to enter into repurchase agreements with a single counterparty in excess of this limit. Stellus Capital Management will monitor the creditworthiness of the counterparties with which we enter into repurchase agreement transactions.
Warrants and Options
Under the 1940 Act, a BDC is subject to restrictions on the amount of warrants, options, restricted stock or rights to purchase shares of capital stock that it may have outstanding at any time. Under the 1940 Act, we may generally only offer warrants provided that (i) the warrants expire by their terms within ten years, (ii) the exercise or conversion price is
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not less than the current market value at the date of issuance, (iii) our stockholders authorize the proposal to issue such warrants, and our Board approves such issuance on the basis that the issuance is in the best interests of us and our stockholders and (iv) if the warrants are accompanied by other securities, the warrants are not separately transferable unless no class of such warrants and the securities accompanying them have been publicly distributed. The 1940 Act also provides that the amount of our voting securities that would result from the exercise of all outstanding warrants, as well as options and rights, at the time of issuance may not exceed 25% of our outstanding voting securities. In particular, the amount of capital stock that would result from the conversion or exercise of all outstanding warrants, options or rights to purchase capital stock cannot exceed 25% of the BDC’s total outstanding shares of capital stock.
Senior Securities
We are permitted, under specified conditions, to issue multiple classes of indebtedness and one class of stock senior to our common stock if our asset coverage, as defined in the 1940 Act, is at least equal to 150% immediately after each such issuance. We may also borrow amounts up to 5% of the value of our total assets for temporary or emergency purposes without regard to asset coverage. For a discussion of the risks associated with leverage, see “Item 1A. Risk Factors — Risks Relating to our Business and Structure — Regulations governing our operation as a BDC affect our ability to, and the way in which we, raise additional capital. As a BDC, the necessity of raising additional capital may expose us to risks, including the typical risks associated with leverage” in this Annual Report on Form 10-K.
Common Stock
We are not generally able to issue and sell our common stock at a price below net asset value per share. We may, however, sell our common stock at a price below the current net asset value of the common stock if our Board determines that such sale is in our and our stockholders’ best interests, and our stockholders approve such sale. In any such case, the price at which our securities are to be issued and sold may not be less than a price which, in the determination of our Board, closely approximates the market value of such securities (less any distributing commission or discount). We would need approval from our stockholders to issue shares below the then current net asset value per share any time after the expiration of the current approval. We may also make rights offerings to our stockholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act.
Codes of Ethics
We and Stellus Capital Management have each adopted a code of ethics pursuant to Rule 17j-1 under the 1940 Act that establishes procedures for personal investments and restricts certain personal securities transactions. Personnel subject to each such code may invest in securities for their personal investment accounts, including securities that may be purchased or held by us, so long as such investments are made in accordance with such code’s requirements. In addition, each code of ethics is available on the EDGAR database on the SEC’s website at www.sec.gov. You may also obtain copies of each code of ethics, after paying a duplicating fee, by electronic request at the following e-mail address: publicinfo@sec.gov.
Proxy Voting Policies and Procedures
We have delegated our proxy voting responsibility to Stellus Capital Management. The proxy voting policies and procedures of Stellus Capital Management are set out below. The guidelines will be reviewed periodically by Stellus Capital Management and our independent directors and, accordingly, are subject to change.
Introduction. As an investment adviser registered under the Advisers Act, Stellus Capital Management has a fiduciary duty to act solely in our best interests. As part of this duty, Stellus Capital Management recognizes that it must vote our securities in a timely manner free of conflicts of interest and in our best interests.
Stellus Capital Management’s policies and procedures for voting proxies for its investment advisory clients are intended to comply with Section 206 of, and Rule 206(4)-6 under, the Advisers Act.
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Proxy Policies. Stellus Capital Management votes proxies relating to our portfolio securities in what it perceives to be the best interest of our stockholders. Stellus Capital Management reviews on a case-by-case basis each proposal submitted to a stockholder vote to determine its effect on the portfolio securities we hold. In most cases, Stellus Capital Management will vote in favor of proposals that Stellus Capital Management believes are likely to increase the value of the portfolio securities we hold. Although Stellus Capital Management will generally vote against proposals that may have a negative effect on our portfolio securities, Stellus Capital Management may vote for such a proposal if there exist compelling long-term reasons to do so.
Stellus Capital Management has established a proxy voting committee and adopted proxy voting guidelines and related procedures. The proxy voting committee establishes proxy voting guidelines and procedures, oversees the internal proxy voting process, and reviews proxy voting issues. To ensure that Stellus Capital Management’s vote is not the product of a conflict of interest, Stellus Capital Management requires that anyone involved in the decision-making process disclose to our Chief Compliance Officer any potential conflict that he or she is aware of and any contact that he or she has had with any interested party regarding a proxy vote. Where conflicts of interest may be present, Stellus Capital Management will disclose such conflicts to us, including our independent directors, and may request guidance from us on how to vote such proxies.
Proxy Voting Records. You may obtain information about how Stellus Capital Management voted proxies by making a written request for proxy voting information to: Stellus Capital Investment Corporation, Attention: Investor Relations, 4400 Post Oak Parkway, Suite 2200, Houston, TX 77027, or by calling us collect at (713) 292-5414. The SEC also maintains a website at www.sec.gov that contains this information.
Privacy Principles
We are committed to maintaining the privacy of our stockholders and to safeguarding their non-public personal information. The following information is provided to help you understand what personal information we collect, how we protect that information and why, in certain cases, we may share information with select other parties.
Generally, we do not receive any non-public personal information relating to our stockholders, although certain non-public personal information of our stockholders may become available to us. We do not disclose any non-public personal information about our stockholders or former stockholders to anyone, except as permitted by law or as is necessary in order to service stockholder accounts (for example, to a transfer agent or third-party administrator).
We restrict access to non-public personal information about our stockholders to employees of Stellus Capital Management and its affiliates with a legitimate business need for the information. We intend to maintain physical, electronic and procedural safeguards designed to protect the non-public personal information of our stockholders.
Other
We are required to provide and maintain a bond issued by a reputable fidelity insurance company to protect us against larceny and embezzlement. Furthermore, as a BDC, we are prohibited from protecting any director or officer against any liability to us or our stockholders arising from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office.
We and Stellus Capital Management are each required to adopt and implement written policies and procedures reasonably designed to prevent violation of relevant federal securities laws, review these policies and procedures annually for their adequacy and the effectiveness of their implementation, and designate a Chief Compliance Officer to be responsible for administering the policies and procedures.
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Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) imposes a wide variety of regulatory requirements on publicly held companies and their insiders. Many of these requirements affect us. For example:
Taxation as a Regulated Investment Company
As a BDC, we have elected, qualified, and intend to continue to qualify annually to be treated as a RIC under Subchapter M of the Code. As a RIC, we generally will not be subject to U.S. federal income tax on any net ordinary income or capital gains that we timely distribute to our stockholders as dividends. To continue to maintain our qualification as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements (as described below). In addition, to maintain our RIC treatment, we must distribute to our stockholders, for each taxable year, at least 90% of our “investment company taxable income,” which is generally our ordinary income plus the excess of our realized net short-term capital gains over our realized net long-term capital losses (the “Annual Distribution Requirement”).
For any taxable year in which we:
we will not be subject to U.S. federal income tax on the portion of our income we timely distribute to stockholders. We will be subject to U.S. federal income tax at the regular corporate rates on any income or capital gains not distributed (or deemed distributed) to our stockholders.
We will be subject to a 4% nondeductible U.S. federal excise tax on our undistributed income unless we distribute in a timely manner an amount at least equal to the sum of (a) 98% of our net ordinary income for each calendar year, (b) 98.2% of our capital gain net income for the one-year period ending December 31, and (c) any income and capital gain net income that we recognized in preceding years, but were not distributed during such years and on which we paid no U.S. federal income tax (the “Excise Tax Avoidance Requirement”). For this purpose, however, any net ordinary income or capital gain net income retained by us that is subject to U.S. federal income tax for the tax year ending in that calendar year will be considered to have been distributed by year end (or earlier if estimated taxes are paid). In order to qualify as a RIC for U.S. federal income tax purposes, we must, among other things:
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We may invest in partnerships, including qualified publicly traded partnerships, which may result in our being subject to state, local or foreign income, franchise or withholding tax liabilities.
We may be required to recognize taxable income in circumstances in which we do not receive cash. For example, if we hold debt obligations that are treated under applicable tax rules as having OID (such as debt instruments with PIK interest or, in certain cases, with increasing interest rates or issued with warrants), we must include in income each year a portion of the OID that accrues over the life of the obligation, regardless of whether cash representing such income is received by us in the same taxable year. Because any OID accrued will be included in our investment company taxable income for the year of accrual, we may be required to make a distribution to our stockholders in order to satisfy the Annual Distribution Requirement, even though we will not have received any corresponding cash amount. If we are not able to obtain sufficient cash from other sources to satisfy the Annual Distribution Requirement, we may fail to maintain our tax treatment as a RIC and become subject to corporate-level U.S. federal income taxes on all of our taxable income without the benefit of the dividends-paid deduction.
Although we do not presently expect to do so, we are authorized to borrow funds and to sell assets in order to satisfy (i) the Annual Distribution Requirement and to otherwise eliminate our liability for U.S. federal income and excise taxes and/or (ii) the Diversification Tests. However, under the 1940 Act, we are not permitted in certain circumstances to make distributions to our stockholders while our debt obligations and other senior securities are outstanding unless certain “asset coverage” tests are met. See “Item 1. Business Regulation as a Business Development Company — Senior Securities” in this Annual Report on Form 10-K. Moreover, our ability to dispose of assets to meet the Annual Distribution Requirement, the Excise Tax Avoidance Requirement or the Diversification Tests may be limited by (a) the illiquid nature of our portfolio and/or (b) other requirements relating to our qualifications as a RIC, including the Diversification Tests. If we dispose of assets in order to meet the Annual Distribution Requirement, the Excise Tax Avoidance Requirement or the Diversification Tests, we may make such dispositions at times that, from an investment standpoint, are not advantageous.
In addition, we have formed and operate two SBIC subsidiaries, and are partially dependent on the SBIC subsidiaries for cash distributions to enable us to meet the RIC distribution requirement. The SBIC subsidiaries may be limited by the Small Business Investment Act of 1958, and SBA regulations governing SBICs, from making certain distributions to us that may be necessary to maintain our tax treatment as a RIC. We may have to request a waiver of the SBA’s restrictions for the SBIC subsidiaries to make certain distributions to maintain our RIC tax treatment. We cannot assure you that the SBA will grant such waiver. If the SBIC subsidiaries are unable to obtain a waiver, compliance with the SBA regulations may cause us to fail to maintain our tax treatment as a RIC, which would result in us becoming subject to U.S. federal income tax.
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Certain of our investment practices may be subject to special and complex U.S. federal income tax provisions that may, among other things, (a) treat dividends that would otherwise constitute qualified dividend income as non-qualified dividend income, (b) treat dividends that would otherwise be eligible for the corporate dividends received deduction as ineligible for such treatment, (c) disallow, suspend or otherwise limit the allowance of certain losses or deductions, (d) convert lower-taxed long term capital gain into higher-taxed short-term capital gain or ordinary income, (e) convert an ordinary loss or a deduction into a capital loss (the deductibility of which is more limited), (f) cause us to recognize income or gain without a corresponding receipt of cash, (g) adversely affect the time as to when a purchase or sale of stock or securities is deemed to occur, (h) adversely alter the characterization of certain complex financial transactions and (i) produce income that will not be qualifying income for purposes of the 90% Income Test. We intend to monitor our transactions and may make certain tax elections to mitigate the effect of these provisions and prevent our disqualification as a RIC.
Gain or loss realized by us from warrants acquired by us as well as any loss attributable to the lapse of such warrants generally will be treated as capital gain or loss. Such capital gain or loss generally will be long term or short term, depending on how long we held a particular warrant. Some of the income and fees that we may recognize will not satisfy the 90% Income Test. In order to ensure that such income and fees do not disqualify us as a RIC for a failure to satisfy the 90% Income Test, we may hold assets that generate such income and provide services that generate such fees indirectly through one or more entities treated as corporations for U.S. federal income tax purposes. Such corporations will be required to pay U.S. federal income tax at corporate rates on their earnings, which ultimately will reduce our return on such income and fees.
If we are unable to qualify for tax treatment as a RIC, and if certain remedial provisions are not available, we would be subject to U.S. federal income tax on all of our taxable income at regular corporate rates. We would not be able to deduct distributions to stockholders, nor would they be required to be made. Subject to certain limitations under the Code, corporate stockholders would be eligible to claim a dividends received deduction with respect to such distributions, non-corporate stockholders would be able to treat such dividend income as “qualified dividend income,” which is subject to reduced rates of U.S. federal income tax. Distributions in excess of our current and accumulated earnings and profits would be treated first as a return of capital to the extent of the stockholder’s adjusted tax basis, and any remaining distributions would be treated as a capital gain. If we fail to qualify as a RIC for a period greater than two taxable years, to requalify as a RIC in a subsequent year we may be subject to regular corporate tax on any net built-in gains with respect to certain of our assets (i.e. the excess of the aggregate gains, including items of income, over aggregate losses that would have been realized with respect to such assets if we had been liquidated) that we elect to recognize on requalification or when recognized over the next five years.
Our Status as an Emerging Growth Company
We ceased to qualify as an “emerging growth company” beginning January 1, 2017.
NYSE Corporate Governance Regulations
NYSE has adopted corporate governance regulations that listed companies must comply with. We are in compliance with such corporate governance listing standards applicable to BDCs.
Regulation as a Small Business Investment Company
Our wholly owned subsidiaries’ SBIC licenses allow them to incur leverage by issuing SBA-guaranteed debentures, subject to customary procedures. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and a ten-year maturity. The principal amount of SBA-guaranteed debentures is not required to be paid prior to maturity but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed at the time of issuance at a market-driven spread over U.S. Treasury Notes with ten-year maturities.
SBICs are designed to stimulate the flow of private equity capital to eligible small businesses. Under SBA regulations, SBICs may make loans to eligible small businesses and invest in the equity securities of small businesses. Under present SBA regulations, eligible small businesses (together with their affiliates) include businesses that have a
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tangible net worth not exceeding $24.0 million and have average annual net income after U.S federal income taxes not exceeding $8.0 million (average net income to be computed without benefit of any carryover loss) for the two most recent fiscal years. In addition, an SBIC must devote 25% of its investment activity to “smaller enterprises,” as defined by the SBA. A smaller enterprise is a business (together with its affiliates) that has a net worth not exceeding $6 million and has average annual net income after U.S. federal income taxes not exceeding $2 million (average net income to be computed without benefit of any carryover loss) for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility of a small business or a smaller enterprise, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales of the business and its affiliates. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services.
The SBA generally prohibits an SBIC from providing financing to small businesses with certain characteristics, such as relending or businesses with the majority of their employees located outside the United States, and business engaged in certain prohibited industries, such as project finance, real estate, farmland, financial intermediaries or “passive” (i.e. non-operating) businesses. Without prior SBA approval, an SBIC may not provide financing or a commitment to a small business in an amount equal to more than approximately 30.0% of the SBIC’s regulatory capital in any one company and its affiliates.
SBA regulations currently limit the amount that an SBIC subsidiary may borrow to a maximum of $175.0 million with at least $87.5 million in regulatory capital (as defined in the SBA regulations), subject to SBA approval. The maximum leverage available to a “family” of SBIC funds is $350.0 million, subject to SBA approval. As of December 31, 2023, our SBIC I subsidiary had $75.0 million in regulatory capital and $150.0 million in SBA-guaranteed debentures outstanding, which approximated their fair value. As of December 31, 2023, our SBIC II subsidiary had $87.5 million in regulatory capital and $175.0 million in SBA-guaranteed debentures outstanding. As of December 31, 2023, the estimated fair values of the SBA-guaranteed debentures as prepared for disclosure purposes was $293.2 million.
We have received exemptive relief from the SEC to permit us to exclude the debt of our SBIC subsidiaries guaranteed by the SBA from the definition of senior securities in the 150% asset coverage test under the 1940 Act. This allows us increased flexibility under the 150% asset coverage test by permitting us to borrow up to $325.0 million more (subject to SBA approval) than we would otherwise be able to absent the receipt of this exemptive relief.
The SBA restricts the ability of SBICs to repurchase their capital stock. The SBA restricts the ability of an SBIC to provide financing to an “associate,” as defined in the SBA regulations, without prior written approval from the SBA. SBA regulations also prohibit, without prior SBA approval, a “change of control” or “change in ownership” of an SBIC (as such terms are defined in the SBA regulations) and require that SBICs invest idle funds in accordance with SBA regulations. In addition, our SBIC subsidiaries may be limited in their ability to make distributions to us if they do not have sufficient capital, in accordance with SBA regulations.
Our SBIC subsidiaries are subject to regulation and oversight by the SBA, including, among other things, requirements with respect to maintaining certain minimum financial ratios and other covenants, a periodic examination by an SBA examiner, and the performance of a financial audit by an independent auditor. Receipt of an SBIC license does not assure that our SBIC subsidiaries will receive SBA-guaranteed debenture funding, which is dependent upon our SBIC subsidiaries continuing to be in compliance with SBA regulations and policies. The SBA, as a creditor, will have a superior claim to our SBIC subsidiaries’ assets over our stockholders in the event we liquidate one or both of our SBIC subsidiaries or the SBA exercises its remedies under the SBA-guaranteed debentures issued by our SBIC subsidiaries upon an event of default.
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Item 1A. Risk Factors
Investing in our securities involves a number of significant risks. Before you invest in our securities, you should be aware of various risks, including those described below. You should carefully consider these risk factors, together with all of the other information included in this Annual Report on Form 10-K, before you decide whether to make an investment in our securities. The risks set out below are the principal risks with respect to an investment in our securities generally and with respect to a BDC with investment objectives, investment policies, capital structures or trading markets similar to ours. However, they may not be the only risks we face. Additional risks and uncertainties not presently known to us or not presently deemed material by us may also impair our operations and performance. If any of the following events occur, our business, financial condition, results of operations and cash flows could be materially and adversely affected. In such case, our net asset value and the trading price of our securities could decline, and you may lose all or part of your investment.
Risks Relating to our Business and Structure
The capital markets may experience periods of disruption and instability. Such market conditions may materially and adversely affect debt and equity capital markets, which may have a negative impact on our business and operations.
From time to time, capital markets may experience periods of disruption and instability, including during portions of the past four fiscal years. In addition, between 2008 and 2009, the global capital markets were unstable, as evidenced by periodic disruptions in liquidity in the debt capital markets, significant write-offs in the financial services sector, the re-pricing of credit risk in the broadly syndicated credit market and the failure of major financial institutions. Despite actions of the U.S. federal government and foreign governments, these events contributed to worsening general economic conditions that materially and adversely impacted the broader financial and credit markets and reduced the availability of debt and equity capital for the market as a whole and financial services firms in particular. There can be no assurance these market conditions will not continue or worsen in the future, including as a result of inflation and rising interest rates, the wars in Ukraine and Russia and the Middle East, and health epidemics and pandemics.
Equity capital may be difficult to raise during such periods of adverse or volatile market conditions because, subject to some limited exceptions, as a BDC, we are generally not able to issue additional shares of our common stock at a price less than net asset value without first obtaining approval for such issuance from our stockholders and our independent directors.
Volatility and dislocation in the capital markets can also create a challenging environment in which to raise or access debt capital. The reappearance of market conditions similar to those experienced during portions of the past three fiscal years and from 2008 through 2009 for any substantial length of time could make it difficult to extend the maturity of or refinance our existing indebtedness or obtain new indebtedness with similar terms and any failure to do so could have a material adverse effect on our business. The debt capital that will be available to us in the future, if at all, may be at a higher cost and on less favorable terms and conditions than what we have historically experienced, including the current rising interest rate environment. If we are unable to raise or refinance debt, then our equity investors may not benefit from the potential for increased returns on equity resulting from leverage and we may be limited in our ability to make new commitments or to fund existing commitments to our portfolio companies.
Significant changes or volatility in the capital markets may also have a negative effect on the valuations of our investments. While most of our investments are not publicly traded, applicable accounting standards require us to assume as part of our valuation process that our investments are sold in a principal market to market participants (even if we plan on holding an investment through its maturity).
Significant changes in the capital markets may adversely affect the pace of our investment activity and economic activity generally. The illiquidity of our investments may make it difficult for us to sell such investments to access capital if required, and as a result, we could realize significantly less than the value at which we have recorded our investments if we were required to sell them for liquidity purposes. An inability to raise or access capital, and any required sale of all or a portion of our investments as a result, could have a material adverse effect on our business, financial condition or results of operations.
Any public health emergency, including the COVID-19 pandemic and any outbreak of other existing or new epidemic diseases, or the threat thereof, and the resulting financial and economic market uncertainty, could have a significant adverse impact on us and the fair value of our investments and our portfolio companies.
The extent of the impact of any public health emergency, such as the COVID-19 pandemic, on our and our portfolio companies’ operational and financial performance will depend on many factors, including the duration and scope of such public health emergency, the actions taken by governmental authorities to contain its financial and economic impact, the extent of any related travel advisories and restrictions implemented, the impact of such public health emergency on overall supply and demand, goods and services, investor liquidity, consumer confidence and levels of economic activity and the extent of its disruption to important global, regional and local supply chains and economic markets, all of which are highly uncertain and cannot be predicted. In addition, our and our portfolio companies’ operations may be significantly impacted, or even temporarily or permanently halted, as a result of government quarantine measures, voluntary and precautionary restrictions on travel or meetings and other factors related to a public health emergency, including its potential adverse impact on the health of any of our or our portfolio companies’ personnel. This could create widespread business continuity issues for us and our portfolio companies. These factors may also cause the valuation of our investments to differ materially from the values that we may ultimately realize. Our valuations, and particularly valuations of private investments and private companies, are inherently uncertain, may fluctuate over short periods of time and are often based on estimates, comparisons and qualitative evaluations of private information.
Any public health emergency, pandemic or any outbreak of other existing or new epidemic diseases, or the threat thereof, and the resulting financial and economic market uncertainty could have a significant adverse impact on us and the fair value of our investments and our portfolio companies.
We are exposed to risks associated with changes in interest rates.
General interest rate fluctuations may have a negative impact on our investments and our investment returns and, accordingly, may have a material adverse effect on our investment objective and our net investment income.
Because we borrow money to make investments and may in the future issue additional senior securities, including preferred stock and debt securities, our net investment income will depend, in part, upon the difference between the rate at which we borrow funds and the rate at which we invest those funds. As a result, we can offer no assurance that rising interest rates would not have a material adverse effect on our net investment income in the event we use debt to finance our investments. In the most recent period of rising interest rates, our cost of funds has increased, which may reduce our net investment income. Conversely, if interest rates decrease, we may earn less interest income from investments and our cost of funds will also decrease, to a lesser extent, resulting in lower net investment income. From time to time, we may also enter into certain hedging transactions to mitigate our exposure to changes in interest rates. In the past, we have entered into certain hedging transactions to mitigate our exposure to adverse fluctuations in interest rates, and we may do so again in the future. However, we cannot assure you that such transactions will be successful in mitigating our exposure to interest rate risk. There can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income.
Rising interest rates may increase the cost of debt for our underlying portfolio companies, which could adversely impact their financial performance and ability to meet ongoing obligations to us. Also, an increase in interest rates available to investors could make an investment in our common stock less attractive if we are not able to pay dividends at a level that provides a similar return, which could reduce the value of our common stock.
Inflation has adversely affected and may continue to adversely affect the business, results of operations and financial condition of our portfolio companies.
Certain of our portfolio companies are in industries that have been impacted by inflation. Recent inflationary pressures have increased the costs of labor, energy and raw materials and have adversely affected consumer spending, economic growth and our portfolio companies’ operations. If such portfolio companies are unable to pass any increases in their costs of operations along to their customers, it could adversely affect their operating results and impact their ability to pay interest and principal on our loans, particularly if interest rates rise in response to inflation. In addition, any
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projected future decreases in our portfolio companies’ operating results due to inflation could adversely impact the fair value of those investments. Any decreases in the fair value of our investments could result in future realized or unrealized losses and therefore reduce our net assets resulting from operations. Additionally, the Federal Reserve has raised, and has indicated its intent to continue raising, certain benchmark interest rates in an effort to combat inflation. See “—We are exposed to risks associated with changes in interest rates.”
We are subject to risks related to corporate social responsibility.
Our business faces increasing public scrutiny related to environmental, social and governance (“ESG”) activities. We risk damage to our brand and reputation if we fail to act responsibly in a number of areas, such as environmental stewardship, corporate governance and transparency and considering ESG factors in our investment processes. Adverse incidents with respect to ESG activities could impact the value of our brand and relationships with investors, all of which could adversely affect our business and results of operations. Additionally, new regulatory initiatives related to ESG could adversely affect us and our portfolio companies.
We are dependent upon key personnel of Stellus Capital Management for our future success. If Stellus Capital Management were to lose any of its key personnel, our ability to achieve our investment objective could be significantly harmed.
We depend on the diligence, skill and network of business contacts of the senior investment professionals of Stellus Capital Management to achieve our investment objective. Stellus Capital Management’s team of investment professionals evaluates, negotiates, structures, closes and monitors our investments in accordance with the terms of our Investment Advisory Agreement. We can offer no assurance, however, that Stellus Capital Management’s investment professionals will continue to provide investment advice to us.
Stellus Capital Management’s investment committee, which provides oversight over our investment activities, is provided to us by Stellus Capital Management under the Investment Advisory Agreement. Stellus Capital Management’s investment committee consists of four members, including Messrs. Ladd, and D’Angelo, each a member of our Board, Mr. Huskinson, Chief Fnancial Officer and Chief Compliance Officer for us and Stellus Capital Management, and Mr. Davis, a senior investment professional of Stellus Capital Management. The loss of one or more of the members of Stellus Capital Management’s investment committee may limit our ability to achieve our investment objective and operate our business. This could have a material adverse effect on our financial condition, results of operations and cash flows.
Our business model depends to a significant extent upon strong referral relationships. Any inability of Stellus Capital Management to maintain or develop these relationships, or the failure of these relationships to generate investment opportunities, could adversely affect our business.
We depend upon the investment professionals of Stellus Capital Management to maintain their relationships with private equity sponsors, placement agents, investment banks, management groups and other financial institutions, and we rely to a significant extent upon these relationships to provide us with potential investment opportunities. If the investment professionals of Stellus Capital Management fail to maintain such relationships, or to develop new relationships with other sources of investment opportunities, we will not be able to grow our investment portfolio. In addition, individuals with whom the investment professionals of Stellus Capital Management have relationships are not obligated to provide us with investment opportunities, and we can offer no assurance that these relationships will generate investment opportunities for us in the future.
Our financial condition, results of operations and cash flows will depend on our ability to manage our business effectively.
Our ability to achieve our investment objective will depend on our ability to manage our business and to grow our investments and earnings. This will depend, in turn, on Stellus Capital Management’s ability to identify, invest in and monitor portfolio companies that meet our investment criteria. The achievement of our investment objective on a cost-effective basis will depend upon Stellus Capital Management’s execution of our investment process, its ability to provide
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competent, attentive and efficient services to us and, to a lesser extent, our access to financing on acceptable terms. Stellus Capital Management’s senior investment professionals will have substantial responsibilities in connection with the management of other investment funds, accounts and investment vehicles. The personnel of Stellus Capital Management may be called upon to provide managerial assistance to our portfolio companies. These activities may distract them from sourcing new investment opportunities for us or slow our rate of investment. Any failure to manage our business and our future growth effectively could have a material adverse effect on our business, financial condition, results of operations and cash flows.
There are significant potential conflicts of interest that could negatively affect our investment returns.
The members of Stellus Capital Management’s investment committee serve, or may serve, as officers, directors, members, or principals of entities that operate in the same or a related line of business as we do, or of investment funds, accounts, or investment vehicles managed by Stellus Capital Management. Similarly, Stellus Capital Management and its affiliates may have other clients with similar, different or competing investment objectives. In serving in these multiple capacities, they may have obligations to other clients or investors in those entities, the fulfillment of which may not be in the best interests of us or our stockholders. For example, Stellus Capital Management and its affiliates currently manage private credit funds and another BDC that have investment strategies that are similar to, overlapping with or identical to our investment strategy, and with which we co-invest. Stellus Capital Management also provides sub-advisory services to the D. E. Shaw group with respect to a private investment fund and a strategy of a private multi-strategy investment fund to which the D. E. Shaw group serves as investment adviser that have an investment strategy similar to our investment strategy.
In addition, there may be times when Stellus Capital Management, members of its investment committee or its other investment professionals have interests that differ from those of our stockholders, giving rise to a conflict of interest. Although our investment adviser will endeavor to handle these investment and other decisions in a fair and equitable manner, we and the holders of the shares of our common stock could be adversely affected by these decisions. Moreover, given the subjective nature of the investment and other decisions made by our investment adviser on our behalf, we are unable to monitor these potential conflicts of interest between us and our investment adviser; however, our Board, including the independent directors, reviews conflicts of interest in connection with its review of the performance of our investment adviser. As a BDC, we may also be prohibited under the 1940 Act from knowingly participating in certain transactions with our affiliates, including our officers, directors, Stellus Capital Management, principal underwriters and certain of their affiliates, without the prior approval of the members of our Board who are not interested persons and, in some cases, prior approval by the SEC through an exemptive order (other than pursuant to current regulatory guidance).
The senior investment professionals and other investment team members of Stellus Capital Management may, from time to time, possess material non-public information, limiting our investment discretion.
The senior investment professionals and other investment team members of Stellus Capital Management, including members of Stellus Capital Management’s investment committee, may serve as directors of, or in a similar capacity with, portfolio companies in which we invest, the securities of which are purchased or sold on our behalf. In the event that material non-public information is obtained with respect to such companies, or we become subject to trading restrictions under the internal trading policies of those companies or as a result of applicable law or regulations, we could be prohibited for a period of time from purchasing or selling the securities of such companies, and this prohibition may have an adverse effect on us.
Our management and incentive fees may induce Stellus Capital Management to incur additional leverage.
Generally, the management and incentive fees payable by us to Stellus Capital Management may create an incentive for Stellus Capital Management to use any additional available leverage. For example, the fact that the base management fee that we pay to Stellus Capital Management is payable based upon our gross assets (which includes any borrowings for investment purposes) may encourage Stellus Capital Management to use leverage to make additional investments. Such a practice could result in our investing in more speculative securities than would otherwise be the case, which could result in higher investment losses, particularly during cyclical economic downturns. Under certain circumstances,
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the use of additional leverage may increase the likelihood of our default on our borrowings, which would disfavor holders of our common stock.
In addition, because the incentive fee on net investment income is calculated as a percentage of our net assets subject to a hurdle, having additional leverage available may encourage Stellus Capital Management to use leverage to increase the leveraged return on our investment portfolio. To the extent additional leverage is available at favorable rates, Stellus Capital Management could use leverage to increase the size of our investment portfolio to generate additional income, which may make it easier to meet the incentive fee hurdle. As a result, the incentives for Stellus Capital Management to cause us to use additional leverage may be greater.
Our Board is charged with protecting our interests by monitoring how Stellus Capital Management addresses these and other conflicts of interests associated with its management services and compensation. While our Board is not expected to review or approve each investment decision, borrowing or incurrence of leverage, our independent directors will periodically review Stellus Capital Management’s services and fees as well as its portfolio management decisions and portfolio performance. In connection with these reviews, our independent directors will consider whether our fees and expenses (including those related to leverage) remain appropriate.
Our incentive fee may induce Stellus Capital Management to make speculative investments.
We pay Stellus Capital Management an incentive fee based, in part, upon net capital gains realized on our investments. Unlike that portion of the incentive fee based on income, there is no hurdle rate applicable to the portion of the incentive fee based on net capital gains. Additionally, under the incentive fee structure, Stellus Capital Management may benefit when capital gains are recognized and, because Stellus Capital Management will determine when to sell a holding, Stellus Capital Management will control the timing of the recognition of such capital gains. As a result, Stellus Capital Management may have a tendency to invest more capital in investments that are likely to result in capital gains as compared to income-producing securities. Such a practice could result in our investing in more speculative securities than would otherwise be the case, which could result in higher investment losses, particularly during economic downturns.
We may be obligated to pay Stellus Capital Management incentive compensation even if we incur a loss and may pay more than 20.0% of our net capital gains because we cannot recover payments made in previous years.
Stellus Capital Management is entitled to incentive compensation for each fiscal quarter in an amount equal to a percentage of the excess of our investment income for that quarter (before deducting incentive compensation) above a threshold return for that quarter and subject to a total return requirement. The general effect of this total return requirement is to prevent payment of the foregoing incentive compensation except to the extent 20.0% of the cumulative net increase in net assets resulting from operations over the then current and 11 preceding calendar quarters exceeds the cumulative incentive fees accrued and/or paid for the 11 preceding calendar quarters. Consequently, we may pay an incentive fee if we incurred losses more than three years prior to the current calendar quarter even if such losses have not yet been recovered in full. Thus, we may be required to pay Stellus Capital Management incentive compensation for a fiscal quarter even if there is a decline in the value of our portfolio or we incur a net loss for that quarter. If we pay an incentive fee of 20.0% of our realized capital gains (net of all realized capital losses and unrealized capital depreciation on a cumulative basis) and thereafter experience additional realized capital losses or unrealized capital depreciation, we will not be able to recover any portion of the incentive fee previously paid.
We operate in a highly competitive market for investment opportunities, which could reduce returns and result in losses.
A number of entities compete with us to make the types of investments that we make. We compete with public and private funds, commercial and investment banks, commercial financing companies and, to the extent they provide an alternative form of financing, private equity and hedge funds. Many of our competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, we believe some of our competitors may have access to funding sources that are not available to us. In addition, some of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of
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investments and establish more relationships than us. Furthermore, many of our competitors are not subject to the regulatory restrictions that the 1940 Act imposes on us as a BDC or the source-of-income, asset diversification and distribution requirements we must satisfy to maintain our RIC qualification. The competitive pressures we face may have a material adverse effect on our business, financial condition, results of operations and cash flows. As a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time, and we may not be able to identify and make investments that are consistent with our investment objective.
With respect to the investments we make, we do not seek to compete based primarily on the interest rates we offer, and we believe that some of our competitors may make loans with interest rates that are lower than the rates we offer. With respect to all investments, we may lose some investment opportunities if we do not match our competitors’ pricing, terms and structure. However, if we match our competitors’ pricing, terms and structure, we may experience decreased net interest income, lower yields and increased risk of credit loss. We may also compete for investment opportunities with investment funds, accounts and investment vehicles managed by Stellus Capital Management. Although Stellus Capital Management will allocate opportunities in accordance with its policies and procedures, allocations to such investment funds, accounts and investment vehicles will reduce the amount and frequency of opportunities available to us and may not be in the best interests of us and our stockholders.
Our investments in the business services industry are subject to unique risks relating to technological developments, regulatory changes and changes in customer preferences.
Our investments in portfolio companies that operate in the business services industry represent 23.78% of our total portfolio as of December 31, 2023. Our investments in portfolio companies in the business services sector include those that provide services related to data and information, building, cleaning and maintenance services, and energy efficiency services. Portfolio companies in the business services sector are subject to many risks, including the negative impact of regulation, changing technology, a competitive marketplace and difficulty in obtaining financing. Portfolio companies in the business services industry must respond quickly to technological changes and understand the impact of these changes on customers’ preferences. Adverse economic, business, or regulatory developments affecting the business services sector could have a negative impact on the value of our investments in portfolio companies operating in this industry, and therefore could negatively impact our business and results of operations.
We may be subject to risks associated with our investments in the healthcare industry.
Our investments in portfolio companies that operate in the healthcare & pharmaceuticals industry represent 11.77% of our total portfolio as of December 31, 2023. Any of our portfolio companies operating in the healthcare information and services industry are subject to extensive government regulation and certain other risks particular to that industry. As part of our investment strategy, we plan to invest in companies in the healthcare information and services industry. Such portfolio companies provide technology to companies that are subject to extensive regulation, including Medicare and Medicaid payment rules and regulation, the False Claims Act and federal and state laws regarding the collection, use and disclosure of patient health information and the storage handling and administration of pharmaceuticals. If any of our portfolio companies or the companies to which they provide such technology fail to comply with applicable regulations, they could be subject to significant penalties and claims that could materially and adversely affect their operations. Portfolio companies in the healthcare information or services industry are also subject to the risk that changes in applicable regulations will render their technology obsolete or less desirable in the marketplace.
Portfolio companies in the healthcare information and services industry may also have a limited number of suppliers of necessary components or a limited number of manufacturers for their products, and therefore face a risk of disruption to their manufacturing process if they are unable to find alternative suppliers when needed. Any of these factors could materially and adversely affect the operations of a portfolio company in this industry and, in turn, impair our ability to timely collect principal and interest payments owed to us.
We may be subject to risks associated with our investments in the high tech industry.
Our investments in portfolio companies that operate in the high tech industry represent 10.52% of our total portfolio as of December 31, 2023. Any of our portfolio companies operating in the high tech industry are subject to substantial
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risks. The market prices and values of companies operating in the technology industry - including software and consumer and business services companies - tend to exhibit a greater degree of risk and volatility than other types of investments. These companies may fall in and out of favor with the public and investors rapidly, which may cause sudden selling and dramatically lower market prices. These companies also may be affected adversely by changes in technology, consumer and business purchasing patterns, short product cycles, falling prices and profits, government regulation, lack of standardization or compatibility with existing technologies, intense competition, aggressive pricing, advances in artificial intelligence and machine learning, dependence on copyright and/or patent protection and/or obsolete products or services. Certain technology-related companies may face special risks that their products or services may not prove to be commercially successful. Technology-related companies are also strongly affected by worldwide scientific or technological developments. As a result, their products may rapidly become obsolete.
Companies in the application software industry, in particular, may also be negatively affected by the decline or fluctuation of subscription renewal rates for their products and services, which may have an adverse effect on profit margins. Companies in the systems software industry may be adversely affected by, among other things, actual or perceived security vulnerabilities in their products and services, which may result in individual or class action lawsuits, state or federal enforcement actions and other remediation costs.
Such companies are also often subject to governmental regulation and may, therefore, be adversely affected by governmental policies. In addition, a rising interest rate environment tends to negatively affect technology and technology-related companies. Those technology or technology-related companies seeking to finance their expansion would have increased borrowing costs, which may negatively impact their earnings. Technology-related companies are often smaller and less experienced companies and may be subject to greater risks than larger companies, such as limited product lines, markets and financial and managerial resources. These risks may be heightened for technology companies in foreign markets.
We will be subject to U.S. federal income tax and may default under our revolving Credit Facility if we are unable to maintain our tax treatment as a RIC under Subchapter M of the Code.
To maintain our tax treatment as a RIC under Subchapter M of the Code, we must meet certain source-of-income, asset diversification and distribution requirements. The distribution requirement for a RIC generally is satisfied if we distribute at least 90% of our net ordinary income and net short-term capital gains in excess of net long-term capital losses, if any, to our stockholders on an annual basis. Because we incur debt, we are subject to certain asset coverage ratio requirements under the 1940 Act and financial covenants under loan and credit agreements that could, under certain circumstances, restrict us from making distributions necessary to maintain our tax treatment as a RIC. If we are unable to obtain cash from other sources, we may fail to maintain our tax treatment as a RIC and, thus, may be subject to corporate-level income tax. To maintain our tax treatment as a RIC, we must also meet certain asset diversification requirements at the end of each calendar quarter. Failure to meet these tests may result in our having to dispose of certain investments quickly in order to prevent the loss of our tax treatment as a RIC. Because most of our investments are in private or thinly-traded public companies, any such dispositions may be made at disadvantageous prices and may result in substantial losses. No certainty can be provided, that we will satisfy the asset diversification requirements or the other requirements necessary to maintain our tax treatment as a RIC. If we fail to maintain our tax treatment as a RIC for any reason and become subject to U.S. federal income tax, the resulting taxes could substantially reduce our net assets, the amount of income available for distributions to our stockholders and the amount of funds available for new investments. Furthermore, if we fail to maintain our tax treatment as a RIC, we may be in default under the terms of our amended and restated senior secured revolving credit agreement with certain lenders party thereto and Zions Bancorporation, N.A. dba Amegy Bank, as administrative agent (as amended from time to time, the “Credit Facility”). Such a failure could have a material adverse effect on us and our stockholders.
Legislative or regulatory tax changes could have an adverse impact on us and our stockholders.
At any time, the federal income tax laws governing RICs or the administrative interpretations of those laws or regulations may be amended. The Biden Administration has announced a number of tax law proposals, including American Families Plan and Made in America Tax Plan, which include increases in the corporate and individual tax rates, and impose a minimum tax on book income and profits of certain multinational corporations. Any new laws,
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regulations or interpretations may take effect retroactively and could adversely affect the taxation of us or our stockholders. Therefore, changes in tax laws, regulations or administrative interpretations or any amendments thereto could diminish the value of an investment in our shares or the value or the resale potential of our investments.
We may have difficulty paying our required distributions if we recognize income before, or without, receiving cash representing such income.
For U.S. federal income tax purposes, we include in income certain amounts that we have not yet received in cash, such as the accrual of OID. This may arise if we receive warrants in connection with the making of a loan and in other circumstances, or through contracted PIK interest, which represents contractual interest added to the loan balance and due at the end of the loan term. Such OID, which could be significant relative to our overall investment activities, and increases in loan balances as a result of contracted PIK arrangements are included in income before we receive any corresponding cash payments. We also may be required to include in income certain other amounts that we will not receive in cash.
Since in certain cases we may recognize income before or without receiving cash representing such income, we may have difficulty meeting the requirement to distribute at least 90% of our net ordinary income and net short-term capital gains in excess of net long-term capital losses, if any, to maintain our tax treatment as a RIC. In such a case, we may have to sell some of our investments at times we would not consider advantageous or raise additional debt or equity capital or reduce new investment originations to meet these distribution requirements. If we are not able to obtain such cash from other sources, we may fail to maintain our tax treatment as a RIC and thus be subject to income tax.
We may in the future choose to pay dividends in our own common stock, in which case you may be required to pay tax in excess of the cash you receive.
We currently expect to be treated as a publicly offered RIC, although there can be no assurance that we will in fact so qualify for any of our taxable years, and we may distribute taxable dividends that are payable in part in our common stock. In accordance with certain applicable Treasury regulations and published guidance issued by the Internal Revenue Service, a publicly offered RIC may treat a distribution of its own stock as fulfilling the RIC distribution requirements if each stockholder may elect to receive his or her entire distribution in either cash or stock of the RIC, subject to a limitation that the aggregate amount of cash to be distributed to all stockholders must be at least 20% of the aggregate declared distribution. If too many stockholders elect to receive cash, the cash available for distribution must be allocated among the stockholders electing to receive cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive less than the lesser of (a) the portion of the distribution such stockholder has elected to receive in cash or (b) an amount equal to his or her entire distribution times the percentage limitation on cash available for distribution. If these and certain other requirements are met, for U.S. federal income tax purposes, the amount of the dividend paid in stock will be equal to the amount of cash that could have been received instead of stock. Taxable stockholders receiving such dividends will be required to include the amount of the dividends as ordinary income (or as long-term capital gain to the extent such distribution is properly reported as a capital gain dividend) to the extent of our current and accumulated earnings and profits for U.S. federal income tax purposes. As a result, a U.S. stockholder may be required to pay tax with respect to such dividends in excess of any cash received. If a U.S. stockholder sells the stock it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of our common stock at the time of the sale. Furthermore, with respect to non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in common stock. In addition, if a significant number of our stockholders determine to sell shares of our common stock in order to pay taxes owed on dividends, it may put downward pressure on the trading price of our common stock.
PIK interest payments we receive will increase our assets under management and, as a result, will increase the amount of base management fees and incentive fees payable by us to Stellus Capital Management.
Certain of our debt investments may contain provisions providing for the payment of PIK interest. Because PIK interest results in an increase in the size of the loan balance of the underlying loan, the receipt by us of PIK interest will have the effect of increasing our assets under management. As a result, because the base management fee that we pay to
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Stellus Capital Management is based on the value of our gross assets, the receipt by us of PIK interest will result in an increase in the amount of the base management fee payable by us. In addition, any such increase in a loan balance due to the receipt of PIK interest will cause such loan to accrue interest on the higher loan balance, which will result in an increase in our pre-incentive fee net investment income and, as a result, an increase in incentive fees that are payable by us to Stellus Capital Management.
Regulations governing our operation as a BDC affect our ability to, and the way in which we, raise additional capital. As a BDC, the necessity of raising additional capital may expose us to risks, including the typical risks associated with leverage.
We may issue debt securities or preferred stock and/or borrow money from banks or other financial institutions, which we refer to collectively as “senior securities,” up to the maximum amount permitted by the 1940 Act. Under the provisions of the 1940 Act, we are permitted as a BDC that has satisfied certain requirements to issue senior securities in amounts such that our asset coverage ratio, as defined in the 1940 Act, equals at least 150% of our gross assets less all liabilities and indebtedness not represented by senior securities, after each issuance of senior securities. If the value of our assets declines, we may be unable to satisfy this test. If that happens, we would not be able to borrow additional funds until we were able to comply with the 150% asset coverage ratio applicable to us under the 1940 Act. Also, any amounts that we use to service our indebtedness would not be available for distributions to our common stockholders. If we issue senior securities, we will be exposed to typical risks associated with leverage, including an increased risk of loss.
We are not generally able to issue and sell our common stock at a price below net asset value per share. We may, however, sell our common stock, or warrants, options or rights to acquire our common stock, at a price below then-current net asset value per share of our common stock if our Board determines that such sale is in our best interests, and if our stockholders approve such sale. A proposal, approved by our stockholders at our 2023 annual stockholders meeting, authorizes us to sell shares equal to up to 25% of our outstanding common stock below the then current net asset value per share of our common stock in one or more offerings. This approval will expire on the earlier of our 2024 annual stockholder meeting or June 22, 2024, the one-year anniversary of our 2023 annual stockholders meeting. The proposal approved by our stockholders did not specify a maximum discount below net asset value at which we are able to issue our common stock, although the number of shares sold in each offering may not exceed 25% of our outstanding common stock immediately prior to such sale. We would need similar future approval from our stockholders to issue shares below the then current net asset value per share any time after the expiration of the current approval. In addition, we intend to distribute between 90% and 100% of our taxable income to our stockholders in order to satisfy the requirements applicable to RICs under Subchapter M of the Code. Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio companies or to repay borrowings. In addition, the illiquidity of our portfolio investments may make it difficult for us to sell these investments when desired and, if we are required to sell these investments, we may realize significantly less than their recorded value. In addition, we cannot issue shares of our common stock below net asset value unless our Board determines that it would be in our and our stockholders’ best interests to do so. Sales of common stock at prices below net asset value per share dilute the interests of existing stockholders, have the effect of reducing our net asset value per share and may reduce our market price per share. In addition, continuous sales of common stock below net asset value may have a negative impact on total returns and could have a negative impact on the market price of our shares of common stock. If we raise additional funds by issuing common stock, then the percentage ownership of our stockholders at that time will decrease, and you may experience dilution.
Because we finance our investments with borrowed money, the potential for gain or loss on amounts invested in us is magnified and may increase the risk of investing in us.
The use of leverage magnifies the potential for gain or loss on amounts invested. The use of leverage is generally considered a speculative investment technique and increases the risks associated with investing in our securities. If we continue to use leverage to partially finance our investments through banks, insurance companies and other lenders, you will experience increased risks of investing in our common stock. Lenders of these funds have fixed dollar claims on our assets that are superior to the claims of our common stockholders, and we would expect such lenders to seek recovery against our assets in the event of a default. We, through our SBIC subsidiaries, intend to issue debt securities guaranteed
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by the SBA and sold in the capital markets. Upon any such issuance of debt securities and as a result of its guarantee of the debt securities, if any, the SBA would also have fixed dollar claims on the assets of our SBIC subsidiaries that are superior to the claims of our common stockholders.
If we are unable to meet the financial obligations under our 4.875% notes due 2026 or (the “2026 Notes”), as issued on January 14, 2021, or the Credit Facility, the SBA, as a creditor, has a superior claim to the assets of our SBIC subsidiaries over our stockholders in the event we liquidate or the SBA exercises its remedies under such debentures as the result of a default by us. In addition, under the terms of the Credit Facility and any borrowing facility or other debt instrument we may enter into, we are likely to be required to use the net proceeds of any investments that we sell to repay a portion of the amount borrowed under such facility or instrument before applying such net proceeds to any other uses. If the value of our assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged, thereby magnifying losses or eliminating our stake in a leveraged investment. Similarly, any decrease in our revenue or income will cause our net income to decline more sharply than it would have had we not borrowed. Such a decline would also negatively affect our ability to make distributions with respect to our common stock. Our ability to service any debt depends largely on our financial performance and is subject to prevailing economic conditions and competitive pressures. Moreover, as the base management fee payable to Stellus Capital Management is payable based on the value of our gross assets, including those assets acquired through the use of leverage, Stellus Capital Management will have a financial incentive to incur leverage, which may not be consistent with our stockholders’ interests. In addition, our common stockholders bear the burden of any increase in our expenses as a result of our use of leverage, including interest expenses and any increase in the base management fee payable to Stellus Capital Management.
As a BDC that has satisfied certain requirements under the 1940 Act, we generally are required to meet a coverage ratio of total assets to total borrowings and other senior securities, which include all of our borrowings and any preferred stock that we may issue in the future, of at least 150%. If this ratio declines below 150%, we will not be able to incur additional debt until we are able to comply with the 150% asset coverage ratio applicable to us under the 1940 Act. This could have a material adverse effect on our operations, and we may not be able to make distributions. The amount of leverage that we employ will depend on Stellus Capital Management’s and our Board’s assessment of market and other factors at the time of any proposed borrowing. We cannot assure you that we will be able to obtain credit at all or on terms acceptable to us.
We have received exemptive relief from the SEC to permit us to exclude the debt of our SBIC subsidiaries guaranteed by the SBA from the definition of senior securities in the 150% asset coverage ratio that we are required to maintain under the 1940 Act. This relief allows us increased flexibility under the 150% asset coverage test by allowing us to borrow up to $325 million more through our SBIC subsidiaries than we would otherwise be able to borrow absent the receipt of this exemptive relief.
In addition, our debt facilities may impose financial and operating covenants that restrict our business activities, including limitations that hinder our ability to finance additional loans and investments or to make the distributions required to maintain our qualification as a RIC under the Code.
Substantially all of our assets are subject to security interests under the Credit Facility or claims of the SBA with respect to SBA-guaranteed debentures we issue and, if we default on our obligations thereunder, we may suffer adverse consequences, including foreclosure on our assets.
As of December 31, 2023, substantially all of our assets were pledged as collateral under the Credit Facility or are subject to a superior claim over the holders of our common stock by the SBA pursuant to the SBA-guaranteed debentures. If we default on our obligations under the Credit Facility or the SBA-guaranteed debentures, the lenders and/or the SBA may have the right to foreclose upon and sell, or otherwise transfer, the collateral subject to their security interests or their superior claim. In such event, we may be forced to sell our investments to raise funds to repay our outstanding borrowings in order to avoid foreclosure, and these forced sales may be at times and at prices we would not consider advantageous. Moreover, such deleveraging of our company could significantly impair our ability to effectively operate our business in the manner in which we have historically operated. As a result, we could be forced to
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curtail or cease new investment activities and lower or eliminate the dividends that we have historically paid to our stockholders.
In addition, if the lenders exercise their right to sell the assets pledged under the Credit Facility, such sales may be completed at distressed sale prices, thereby diminishing or potentially eliminating the amount of cash available to us after repayment of the amounts outstanding under the Credit Facility.
Provisions in the Credit Facility or any other future borrowing facility may limit our discretion in operating our business.
The Credit Facility is, and any future borrowing facility may be, backed by all or a portion of our loans and securities on which the lenders will or, in the case of a future facility, may have a security interest. We may pledge up to 100% of our assets and may grant a security interest in all of our assets under the terms of any debt instrument we enter into with lenders. We expect that any security interests we grant will be set forth in a guarantee and security agreement and evidenced by the filing of financing statements by the agent for the lenders. In addition, we expect that the custodian for our securities serving as collateral for such loan would include in its electronic systems notices indicating the existence of such security interests and, following notice of occurrence of an event of default, if any, and during its continuance, will only accept transfer instructions with respect to any such securities from the lender or its designee. If we were to default under the terms of any debt instrument, the agent for the applicable lenders would be able to assume control of the timing of disposition of any or all of our assets securing such debt, which would have a material adverse effect on our business, financial condition, results of operations and cash flows.
In addition, any security interests as well as negative covenants under the Credit Facility or any other borrowing facility may limit our ability to incur additional liens or debt and may make it difficult for us to restructure or refinance indebtedness at or prior to maturity or obtain additional debt or equity financing. For example, under the terms of the Credit Facility, we have generally agreed to not incur any additional secured indebtedness, other than certain indebtedness that we may incur, in accordance with the Credit Facility, to allow us to purchase investments in U.S. Treasury Bills. In addition, we have agreed not to incur any additional indebtedness that has a maturity date prior to the maturity date of the Credit Facility. Further, if our borrowing base under the Credit Facility or any other borrowing facility were to decrease, we would be required to secure additional assets in an amount equal to any borrowing base deficiency. In the event that all of our assets are secured at the time of such a borrowing base deficiency, we could be required to repay advances under the Credit Facility or any other borrowing facility or make deposits to a collection account, either of which could have a material adverse impact on our ability to fund future investments and to make stockholder distributions.
In addition, under the Credit Facility or any other borrowing facility, we may be subject to limitations as to how borrowed funds may be used, which may include restrictions on geographic and industry concentrations, loan size, payment frequency and status, average life, collateral interests and investment ratings, as well as regulatory restrictions on leverage which may affect the amount of funding that may be obtained. There may also be certain requirements relating to portfolio performance, including required minimum portfolio yield and limitations on delinquencies and charge-offs, a violation of which could limit further advances and, in some cases, result in an event of default. Furthermore, we expect that the terms of the Credit Facility will contain a covenant requiring us to maintain compliance with RIC provisions at all times, subject to certain remedial provisions. Thus, a failure to maintain compliance with RIC provisions could result in an event of default under the Credit Facility. An event of default under the Credit Facility or any other borrowing facility could result in an accelerated maturity date for all amounts outstanding thereunder, which could have a material adverse effect on our business and financial condition. This could reduce our revenues and, by delaying any cash payment allowed to us under the Credit Facility or any other borrowing facility until the lenders have been paid in full, reduce our liquidity and cash flow and impair our ability to grow our business and maintain our qualification as a RIC.
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Because we use debt to finance our investments and may in the future issue senior securities including preferred stock and debt securities, if market interest rates were to increase, our cost of capital could increase, which could reduce our net investment income.
Because we borrow money to make investments and may in the future issue additional senior securities including preferred stock and debt securities, our net investment income will depend, in part, upon the difference between the rate at which we borrow funds and the rate at which we invests those funds. As a result, we can offer no assurance that a significant change in market interest rates would not have a material adverse effect on our net investment income in the event we use debt to finance our investments. In periods of rising interest rates, our cost of funds would increase, which could reduce our net investment income. We may use interest rate risk management techniques in an effort to limit our exposure to interest rate fluctuations. We may utilize instruments such as forward contracts, currency options and interest rate swaps, caps, collars and floors to seek to hedge against fluctuations in the relative values of our portfolio positions from changes in currency exchange rates and market interest rates to the extent permitted by the 1940 Act.
Adverse developments in the credit markets may impair our ability to enter into any other future borrowing facility.
In past economic downturns, such as the financial crisis in the United States that began in mid-2007 and during other times of extreme market volatility, many commercial banks and other financial institutions stopped lending or significantly curtailed their lending activity. In addition, in an effort to stem losses and reduce their exposure to segments of the economy deemed to be high risk, some financial institutions limited routine refinancing and loan modification transactions and even reviewed the terms of existing facilities to identify bases for accelerating the maturity of existing lending facilities. If these conditions recur, for example as a result of the COVID-19 pandemic, it may be difficult for us to obtain desired financing to finance the growth of our investments on acceptable economic terms, or at all.
If we are unable to consummate credit facilities on commercially reasonable terms, our liquidity may be reduced significantly. If we are unable to repay amounts outstanding under any facility we may enter into and are declared in default or are unable to renew or refinance any such facility, it would limit our ability to initiate significant originations or to operate our business in the normal course. These situations may arise due to circumstances that we may be unable to control, such as inaccessibility of the credit markets, a severe decline in the value of the U.S. dollar, a further economic downturn or an operational problem that affects third parties or us, and could materially damage our business. Moreover, we are unable to predict when economic and market conditions may become more favorable. Even if such conditions improve broadly and significantly over the long term, adverse conditions in particular sectors of the financial markets could adversely impact our business.
Most of our portfolio investments are recorded at fair value as determined in good faith by our Board and, as a result, there may be uncertainty as to the value of our portfolio investments.
Most of our portfolio investments will take the form of securities that are not publicly traded. The fair value of loans, securities and other investments that are not publicly traded may not be readily determinable, and we value these investments at fair value as determined in good faith by our Board, including to reflect significant events affecting the value of our investments. Most, if not all, of our investments (other than cash and cash equivalents) are classified as Level 3 under ASC Topic 820. This means that our portfolio valuations are based on unobservable inputs and our own assumptions about how market participants would price the asset or liability in question. Inputs into the determination of fair value of our portfolio investments require significant management judgment or estimation. Even if observable market data is available, such information may be the result of consensus pricing information or broker quotes, which include a disclaimer that the broker would not be held to such a price in an actual transaction. The non-binding nature of consensus pricing and/or quotes accompanied by disclaimers materially reduces the reliability of such information. We have retained the services of independent service providers to review the valuation of these loans and securities. The types of factors that Board may take into account in determining the fair value of our investments generally include, as appropriate, comparison to publicly traded securities including such factors as yield, maturity and measures of credit quality, the enterprise value of a portfolio company, the nature and realizable value of any collateral, the portfolio company’s ability to make payments and its earnings and discounted cash flow, the markets in which the portfolio company does business and
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other relevant factors. Because such valuations, and particularly valuations of private securities and private companies, are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these loans and securities existed. Our net asset value could be adversely affected if our determinations regarding the fair value of our investments were materially higher than the values that we ultimately realize upon the disposal of such loans and securities.
We adjust quarterly the valuation of our portfolio to reflect our Board’s determination of the fair value of each investment in our portfolio. Any changes in fair value are recorded in our statement of operations as net change in unrealized appreciation or depreciation.
We may expose ourselves to risks if we engage in hedging transactions.
We may utilize instruments such as forward contracts, currency options and interest rate swaps, caps, collars and floors to seek to hedge against fluctuations in the relative values of our portfolio positions from changes in currency exchange rates and market interest rates. Use of these hedging instruments may expose us to counter-party credit risk. Hedging against a decline in the values of our portfolio positions does not eliminate the possibility of fluctuations in the values of such positions or prevent losses if the values of such positions decline. However, such hedging can establish other positions designed to gain from those same developments, thereby offsetting the decline in the value of such portfolio positions. Such hedging transactions may also limit the opportunity for gain if the values of the portfolio positions should increase. Moreover, it may not be possible to hedge against an exchange rate or interest rate fluctuation that is generally anticipated at an acceptable price.
If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud. As a result, stockholders could lose confidence in our financial and other public reporting, which would harm our business and the trading price of our common stock.
Effective internal controls over financial reporting are necessary for us to provide reliable financial reports and, together with adequate disclosure controls and procedures, are designed to prevent fraud. Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could cause us to fail to meet our reporting obligations. In addition, any testing by us conducted in connection with Section 404 of the Sarbanes-Oxley Act may reveal deficiencies in our internal controls over financial reporting that are deemed to be material weaknesses or that may require prospective or retroactive changes to our consolidated financial statements or identify other areas for further attention or improvement. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.
We incur significant costs as a result of being a publicly traded company.
As a publicly traded company, we incur legal, accounting, investor relations and other expenses, including costs associated with corporate governance requirements, such as those under the Sarbanes-Oxley Act, other rules implemented by the SEC and the listing standards of the NYSE. These costs may be significant, and thus may reduce the amount of funds we have available to deploy as investments, reducing our efficiency and potentially hampering our business, financial condition, and results of operations.
We are obligated to maintain proper and effective internal control over financial reporting. We may not complete our analysis of our internal control over financial reporting in a timely manner, or our internal controls may not be determined to be effective, which may adversely affect investor confidence in our company and, as a result, the value of our securities.
Complying with Section 404 of the Sarbanes-Oxley Act requires a rigorous compliance program as well as adequate time and resources. We may not be able to complete our internal control evaluation, testing and any required remediation in a timely fashion. Additionally, if we identify one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal controls are effective. If we
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are unable to assert that our internal control over financial reporting is effective, we could lose investor confidence in the accuracy and completeness of our financial reports, which would have a material adverse effect on the price of our securities.
We are required to disclose changes made in our internal control and procedures on a quarterly basis and our management is required to assess the effectiveness of these controls annually. Undetected material weaknesses in our internal controls could lead to financial statement restatements and require us to incur the expense of remediation.
As a non-accelerated filer, we are not required to comply with the auditor attestation requirements of the Sarbanes-Oxley Act.
We are a non-accelerated filer under the Exchange Act and, therefore, we are not required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act. Therefore, our internal controls over financial reporting will not receive the level of review provided by the process relating to the auditor attestation included in annual reports of issuers that are subject to the auditor attestation requirements. In addition, we cannot predict if investors will find our common stock less attractive because we are not required to comply with the auditor attestation requirements. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and trading price for our common stock may be negatively affected.
We and our portfolio companies may be subjected to potential adverse effects of new or modified laws or regulations.
We and our portfolio companies are subject to regulation at the local, state, federal and, in some cases, foreign levels. These laws and regulations, as well as their interpretation, are likely to change from time to time, and new laws and regulations may be enacted. Accordingly, any change in these laws or regulations, changes in their interpretation, or newly enacted laws or regulations, or any failure by us or our portfolio companies to comply with these laws or regulations, could require changes to certain of the our or our portfolio companies’ business practices, negatively impact our or our portfolio companies’ operations, cash flows or financial condition, impose additional costs on us or our portfolio companies or otherwise adversely affect our business or the business of our portfolio companies. In addition to the legal, tax and regulatory changes that are expected to occur, there may be unanticipated changes. The legal, tax and regulatory environment for BDCs, investment advisers and the instruments that they utilize (including derivative instruments) is continuously evolving.
Over the last several years, there also has been an increase in regulatory attention to the extension of credit outside of the traditional banking sector, raising the possibility that some portion of the non-bank financial sector will be subject to new regulation. While it cannot be known at this time whether any regulation will be implemented or what form it will take, increased regulation of non-bank credit extension could negatively impact the our operations, cash flows or financial condition, impose additional costs on us, intensify the regulatory supervision of us or otherwise adversely affect our business, financial condition and results of operations.
Legislative or other actions relating to taxes could have a negative effect on us.
The rules dealing with U.S. federal income taxation are constantly under review by persons involved in the legislative process and by the IRS and the U.S. Treasury Department. New legislation and any U.S. Treasury regulations, administrative interpretations or court decisions interpreting such legislation could significantly and negatively affect our ability to qualify for tax treatment as a RIC or the U.S. federal income tax consequences to us and our investors of such qualification, or could have other adverse consequences. Investors are urged to consult with their tax advisor regarding tax legislative, regulatory or administrative developments and proposals and their potential effect on an investment in our securities.
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Any failure to comply with SBA regulations could have an adverse effect on our SBIC subsidiaries’ operations.
On June 20, 2014 and August 14, 2019, our wholly owned subsidiaries, SBIC I and SBIC II, respectively, received licenses from the SBA to operate as SBICs. The SBA places certain limitations on the financing terms of investments by SBICs in portfolio companies and prohibits SBICs from providing funds for certain purposes or to businesses in a few prohibited industries. Compliance with SBIC requirements may cause our SBIC subsidiaries to forgo attractive investment opportunities that are not permitted under SBA regulations.
Further, SBA regulations require that an SBIC be examined by the SBA to determine its compliance with the relevant SBA regulations at least every two years. The SBA prohibits, without prior SBA approval, a “change of control” of an SBIC or transfers that would result in any person (or a group of persons acting in concert) owning 10% or more of a class of capital stock of an SBIC. If either of our SBIC subsidiaries fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit its use of debentures, declare outstanding debentures immediately due and payable, and/or limit it from making new investments. In addition, the SBA can revoke or suspend a license for willful or repeated violation of, or willful or repeated failure to observe, any provision of the Small Business Investment Act of 1958 or any rule or regulation promulgated thereunder. These actions by the SBA would, in turn, negatively affect us because our SBIC subsidiaries are our wholly owned subsidiaries.
Risks Related to Our Operations
Because we intend to distribute substantially all of our income to our stockholders to obtain and maintain our status as a RIC, we will continue to need additional capital to finance our growth. If additional funds are unavailable or not available on favorable terms, our ability to grow may be impaired.
We will need additional capital to fund new investments and grow our portfolio of investments. We intend to access the capital markets periodically to issue debt or equity securities or borrow from financial institutions in order to obtain such additional capital. Unfavorable economic conditions could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us. A reduction in the availability of new capital could limit our ability to grow. In addition, we are required to distribute at least 90% of our net ordinary income and net short-term capital gains in excess of net long-term capital losses, if any, to our stockholders to maintain our qualification as a RIC. As a result, these earnings will not be available to fund new investments. An inability on our part to access the capital markets successfully could limit our ability to grow our business and execute our business strategy fully and could decrease our earnings, if any, which would have an adverse effect on the value of our shares of common stock.
As a BDC that has satisfied certain conditions under the 1940 Act, we are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities and excluding SBA-guaranteed debentures as permitted by exemptive relief obtained from the SEC, to total senior securities, which includes all of our borrowings with the exception of SBA-guaranteed debentures, of at least 150%. This requirement limits the amount that we may borrow. Since we continue to need capital to grow our investment portfolio, these limitations may prevent us from incurring debt and require us to raise additional equity at a time when it may be disadvantageous to do so. While we expect that we will be able to borrow and to issue additional debt securities and expect that we will be able to issue additional equity securities, which would in turn increase the equity capital available to us, we cannot assure you that debt and equity financing will be available to us on favorable terms, or at all. In addition, as a BDC, we generally are not permitted to issue equity securities priced below net asset value without stockholder approval. If additional funds are not available us, we may be forced to curtail or cease new investment activities, and our net asset value could decline.
Our wholly owned SBIC subsidiaries may be unable to make distributions to us that will enable us to maintain RIC tax treatment, which could result in the imposition of U.S. federal income tax.
In order for us to continue to qualify for RIC tax treatment and to minimize corporate-level taxes, we are required to distribute substantially all of our net ordinary income and net capital gain income, including income
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from certain of our subsidiaries, which includes the income from our SBIC subsidiaries. We are partially dependent on our SBIC subsidiaries for cash distributions to enable us to meet the RIC distribution requirements. Our SBIC subsidiaries may be limited by the Small Business Investment Act of 1958, and SBA regulations governing SBICs, from making certain distributions to us that may be necessary to maintain our tax treatment as a RIC. We may have to request a waiver of the SBA’s restrictions for our SBIC subsidiaries to make certain distributions to maintain our RIC tax treatment. We cannot assure you that the SBA will grant such waiver and if our SBIC subsidiaries are unable to obtain a waiver, compliance with the SBA regulations may result in loss of RIC tax treatment and a consequent imposition of U.S. federal income on our income.
Our ability to enter into certain transactions with our affiliates is restricted, which may limit the scope of investments available to us.
We are prohibited under the 1940 Act from participating in certain transactions with our affiliates without the prior approval of our independent directors and, in some cases, the SEC. Any person that owns, directly or indirectly, 5% or more of our outstanding voting securities will be our affiliate for purposes of the 1940 Act, and we are generally prohibited from buying or selling any security from or to such affiliate without the prior approval of our independent directors. The 1940 Act also prohibits certain “joint” transactions with certain of our affiliates, which could include concurrent investments in the same portfolio company, without prior approval of our independent directors and, in some cases, of the SEC. We are prohibited from buying or selling any security from or to any person that controls us or who owns more than 25% of our voting securities or certain of that person’s affiliates, or entering into prohibited joint transactions with such persons, absent the prior approval of the SEC. As a result of these restrictions, we may be prohibited from buying or selling any security (other than any security of which we are the issuer) from or to any portfolio company of a private fund managed by Stellus Capital Management or its affiliates without the prior approval of the SEC, which may limit the scope of investment opportunities that would otherwise be available to us.
The involvement of our interested directors in the valuation process may create conflicts of interest.
We make many of our portfolio investments in the form of loans and securities that are not publicly traded and for which no market-based price quotation is available. As a result, our Board determines the fair value of these loans and securities in good faith as described elsewhere in this Annual Report on Form 10-K. In connection with that determination, investment professionals from Stellus Capital Management provide our Board with valuations based upon the most recent portfolio company financial statements available and projected financial results of each portfolio company. While the valuation for each portfolio investment is reviewed by an independent valuation firm at least twice annually, the ultimate determination of fair value is made by our Board, including our interested directors, and not by such third-party valuation firm. In addition, Messrs. Ladd and D’Angelo, each an interested member of our Board, has a direct pecuniary interest in Stellus Capital Management. The participation of Stellus Capital Management’s investment professionals in our valuation process, and the pecuniary interest in Stellus Capital Management by certain members of our Board, could result in a conflict of interest as Stellus Capital Management’s management fee is based, in part, on the value of our gross assets, and incentive fees are based, in part, on realized gains and realized and unrealized losses.
There are conflicts related to other arrangements with Stellus Capital Management.
We have entered into a license agreement with Stellus Capital Management under which Stellus Capital Management has agreed to grant us a non-exclusive, royalty-free license to use the name “Stellus Capital.” In addition, we have entered into an Administration Agreement with Stellus Capital Management, pursuant to which we are required to pay to Stellus Capital Management our allocable portion of overhead and other expenses incurred by Stellus Capital Management in performing its obligations under such Administration Agreement, such as rent and our allocable portion of the cost of our Chief Financial Officer and Chief Compliance Officer and his staff. This will create conflicts of interest that our Board will monitor. For example, under the terms of the license agreement, we will be unable to preclude Stellus Capital Management from licensing or transferring the ownership of the “Stellus Capital” name to third parties, some of whom may compete against us. Consequently, we will be unable to prevent any damage to goodwill that may occur as a result of the activities of Stellus Capital
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Management or others. Furthermore, in the event the license agreement is terminated, we will be required to change our name and cease using “Stellus Capital” as part of our name. Any of these events could disrupt our recognition in the marketplace, damage any goodwill we may have generated and otherwise harm our business.
The Investment Advisory Agreement and the Administration Agreement with Stellus Capital Management were not negotiated on an arm’s length basis and may not be as favorable to us as if they had been negotiated with an unaffiliated third party.
The Investment Advisory Agreement and the Administration Agreement were negotiated between related parties. Consequently, their terms, including fees payable to Stellus Capital Management, may not be as favorable to us as if they had been negotiated with an unaffiliated third party. In addition, we may choose not to enforce, or to enforce less vigorously, our rights and remedies under these agreements because of our desire to maintain our ongoing relationship with Stellus Capital Management and its affiliates. Any such decision, however, would breach our fiduciary obligations to our stockholders.
The time and resources that Stellus Capital Management devote to us may be diverted, and we may face additional competition due to the fact that Stellus Capital Management and its affiliates are not prohibited from raising money for, or managing, another entity that makes the same types of investments that we target.
Stellus Capital Management and some of its affiliates, including our officers and our interested directors, are not prohibited from raising money for, or managing, another investment entity that makes the same types of investments as those we target. For example, Stellus Capital Management and/or its affiliates currently manage a private BDC and other private credit funds that have investment strategies that are similar, overlapping or identical to our investment strategy and with which we co-invest. In addition, pursuant to sub-advisory arrangements, Stellus Capital Management provides non-discretionary advisory services to the D. E. Shaw group related to a private investment fund and a strategy of a private multi-strategy investment fund to which the D. E. Shaw group serves as investment adviser. As a result, the time and resources they could devote to us may be diverted. In addition, we may compete with any such investment entity for the same investors and investment opportunities.
Our incentive fee arrangements with Stellus Capital Management may vary from those of other investment funds, account or investment vehicles managed by Stellus Capital Management, which may create an incentive for Stellus Capital Management to devote time and resources to a higher fee-paying fund.
If Stellus Capital Management is paid a higher performance-based fee from any of its other funds, it may have an incentive to devote more research and development or other activities, and/or recommend the allocation of investment opportunities, to such higher fee-paying fund. For example, to the extent Stellus Capital Management’s incentive compensation is not subject to a hurdle or total return requirement with respect to another fund, it may have an incentive to devote time and resources to such other fund. Any such diversion of Stellus Capital Management's time and resources could negatively impact our business, financial condition, or results.
Stellus Capital Management’s liability is limited under the Investment Advisory Agreement and we have agreed to indemnify Stellus Capital Management against certain liabilities, which may lead Stellus Capital Management to act in a riskier manner on our behalf than it would when acting for its own account.
Under the Investment Advisory Agreement, Stellus Capital Management has not assumed any responsibility to us other than to render the services called for under that agreement. It will not be responsible for any action of our Board in following or declining to follow Stellus Capital Management’s advice or recommendations. Under the Investment Advisory Agreement, Stellus Capital Management, its officers, members and personnel, and any person controlling or controlled by Stellus Capital Management will not be liable to us, any subsidiary of ours, our directors, our stockholders or any subsidiary’s stockholders or partners for acts or omissions performed in accordance with and pursuant to the Investment Advisory Agreement, except those resulting from acts constituting gross negligence, willful misfeasance, bad faith or reckless disregard of the duties that Stellus Capital Management owes to us under the Investment Advisory Agreement. In addition, as part of the Investment Advisory Agreement, we have agreed to indemnify Stellus Capital Management and each of its officers, directors, members, managers
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and employees from and against any claims or liabilities, including reasonable legal fees and other expenses reasonably incurred, arising out of or in connection with our business and operations or any action taken or omitted on our behalf pursuant to authority granted by the Investment Advisory Agreement, except where attributable to gross negligence, willful misfeasance, bad faith or reckless disregard of such person’s duties under the Investment Advisory Agreement. These protections may lead Stellus Capital Management to act in a riskier manner when acting on our behalf than it would when acting for its own account.
Stellus Capital Management can resign as our investment adviser or administrator upon 60 days’ notice and we may not be able to find a suitable replacement within that time, or at all, resulting in a disruption in our operations that could adversely affect our financial condition, business and results of operations.
Stellus Capital Management has the right under the Investment Advisory Agreement to resign as our investment adviser at any time upon 60 days’ written notice, whether we have found a replacement or not. Similarly, Stellus Capital Management has the right under the Administration Agreement to resign at any time upon 60 days’ written notice, whether we have found a replacement or not. If Stellus Capital Management was to resign, we may not be able to find a new investment adviser or administrator or hire internal management with similar expertise and ability to provide the same or equivalent services on acceptable terms within 60 days, or at all. If we are unable to do so quickly, our operations are likely to experience a disruption, our financial condition, business and results of operations as well as our ability to pay distributions to our stockholders are likely to be adversely affected and the market price of our shares may decline. In addition, the coordination of our internal management and investment or administrative activities, as applicable, is likely to suffer if we are unable to identify and reach an agreement with a single institution or group of executives having the expertise possessed by Stellus Capital Management. Even if we are able to retain comparable management, whether internal or external, the integration of such management and their lack of familiarity with our investment objective may result in additional costs and time delays that may adversely affect our business, financial condition, results of operations and cash flows.
If we fail to maintain our status as a BDC, our business and operating flexibility could be significantly reduced.
We have elected to be regulated as a BDC under the 1940 Act. The 1940 Act imposes numerous constraints on the operations of BDCs. For example, BDCs are required to invest at least 70% of their total assets in specified types of securities, primarily in private companies or thinly-traded U.S. public companies, cash, cash equivalents, U.S. government securities and other high quality debt investments that mature in one year or less. Failure to comply with the requirements imposed on BDCs by the 1940 Act could cause the SEC to bring an enforcement action against us and/or expose us to claims of private litigants. In addition, upon approval of a majority of our stockholders, we may elect to withdraw their respective election as a BDC. If we decide to withdraw our election, we may be required to register as an investment company under the 1940 Act and be subject to the substantially greater regulation under the 1940 Act as a closed-end investment company. Compliance with these regulations would significantly decrease our operating flexibility and could significantly increase our cost of doing business.
If we do not invest a sufficient portion of our assets in qualifying assets, we could violate the 1940 Act provisions applicable to BDCs or be precluded from investing according to our current business strategy.
As a BDC, we may not acquire any assets other than “qualifying assets” unless, at the time of and after giving effect to such acquisition, at least 70% of our total assets are qualifying assets.
We believe that most of the investments that we may acquire in the future will constitute qualifying assets. However, we may be precluded from investing in what we believe to be attractive investments if such investments are not qualifying assets for purposes of the 1940 Act. If we do not invest a sufficient portion of our assets in qualifying assets, we could violate the 1940 Act provisions applicable to BDCs. As a result of such violation, specific rules under the 1940 Act could prevent us, for example, from making follow-on investments in existing portfolio companies (which could result in the dilution of our position).
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If we do not maintain our election to be regulated as a BDC, we would be subject to regulation as a registered closed-end investment company under the 1940 Act. As a registered closed-end investment company, we would be subject to substantially more regulatory restrictions under the 1940 Act which would significantly decrease our operating flexibility.
We may experience fluctuations in our annual and quarterly operating results.
We could experience fluctuations in our annual and quarterly operating results due to a number of factors, including the interest rate payable on the loans and debt securities we acquire, the default rate on such loans and securities, the level of our expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our markets and general economic conditions. In light of these factors, results for any period should not be relied upon as being indicative of performance in future periods.
Our Board may change our investment objective, operating policies and strategies without prior notice or stockholder approval.
Our Board has the authority, except as otherwise provided in the 1940 Act, to modify or waive certain of our operating policies and strategies without prior notice and without stockholder approval. However, absent stockholder approval, we may not change the nature of our business so as to cease to be, or withdraw our election as, a BDC. We cannot predict the effect any changes to our current operating policies and strategies would have on our business, operating results and the market price of our common stock. Nevertheless, any such changes could adversely affect our business and impair our ability to make distributions to our stockholders.
Our Board is authorized to reclassify any unissued shares of common stock into one or more classes of preferred stock, which could convey special rights and privileges to its owners.
Under Maryland General Corporation Law and our charter, our Board is authorized to classify and reclassify any authorized but unissued shares of stock into one or more classes of stock, including preferred stock. Prior to issuance of shares of each class or series, the Board will be required by Maryland law and our charter to set the terms, preferences, conversion or other rights, voting powers, restrictions, limitations as to stockholder distributions, qualifications and terms or conditions of redemption for each class or series. Thus, the Board could authorize the issuance of shares of preferred stock with terms and conditions which could have the effect of delaying, deferring or preventing a transaction or a change in control that might involve a premium price for holders of our common stock or that otherwise might be in their best interest. The cost of any such reclassification would be borne by our common stockholders. Certain matters under the 1940 Act require the separate vote of the holders of any issued and outstanding preferred stock. For example, the 1940 Act provides that holders of preferred stock are entitled to vote separately from holders of common stock to elect two preferred stock directors. We currently have no plans to issue preferred stock. The issuance of preferred shares convertible into shares of common stock may also reduce the net income and net asset value per share of our common stock upon conversion, provided, that we will only be permitted to issue such convertible preferred stock to the extent we comply with the requirements of Section 61 of the 1940 Act, including obtaining common stockholder approval. These effects, among others, could have an adverse effect on your investment in our common stock.
Provisions of the Maryland General Corporation Law and of our charter and bylaws could deter takeover attempts and have an adverse impact on the price of our common stock.
The Maryland General Corporation Law and our charter and bylaws contain provisions that may discourage, delay or make more difficult a change in control of Stellus Capital Investment Corporation or the removal of our directors. We are subject to the Maryland Business Combination Act, subject to any applicable requirements of the 1940 Act. Our Board has adopted a resolution exempting from the Business Combination Act any business combination between us and any other person, subject to prior approval of such business combination by our Board, including approval by a majority of our independent directors. If the resolution exempting business combinations is repealed or our Board does not approve a business combination, the Business Combination Act
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may discourage third parties from trying to acquire control of us and increase the difficulty of consummating such an offer. Our bylaws exempt from the Maryland Control Share Acquisition Act acquisitions of our stock by any person. If we amend our bylaws to repeal the exemption from the Control Share Acquisition Act, the Control Share Acquisition Act also may make it more difficult for a third party to obtain control of us and increase the difficulty of consummating such a transaction.
We have also adopted measures that may make it difficult for a third party to obtain control of us, including provisions of our charter classifying our Board in three classes serving staggered three-year terms, and authorizing our Board to classify or reclassify shares of our stock in one or more classes or series, to cause the issuance of additional shares of our stock, to amend our charter without stockholder approval and to increase or decrease the number of shares of stock that we have authority to issue. These provisions, as well as other provisions of our charter and bylaws, may delay, defer or prevent a transaction or a change in control that might otherwise be in the best interests of our stockholders.
We are highly dependent on information systems and systems failures could significantly disrupt our business, which may, in turn, negatively affect the market price of our common stock and our ability to make distributions to our stockholders.
Our business is highly dependent on the communications and information systems of Stellus Capital Management. In addition, certain of these systems are provided to Stellus Capital Management by third party service providers. Any failure or interruption of such systems, including as a result of the termination of an agreement with any such third-party service provider, could cause delays or other problems in our activities. This, in turn, could have a material adverse effect on our operating results and negatively affect the market price of our common stock and our ability to make distributions to our stockholders.
The failure in cyber security systems, as well as the occurrence of events unanticipated in our disaster recovery systems and management continuity planning could impair our ability to conduct business effectively.
The occurrence of a disaster, such as a cyber-attack against us or against a third-party that has access to our data or networks, a natural catastrophe, an industrial accident, failure of our disaster recovery systems, or consequential employee error, could have an adverse effect on our ability to communicate or conduct business, negatively impacting our operations and financial condition. This adverse effect can become particularly acute if those events affect our electronic data processing, transmission, storage, and retrieval systems, or impact the availability, integrity, or confidentiality of our data.
We depend heavily upon computer systems to perform necessary business functions. Despite our implementation of a variety of security measures, our computer systems, networks, and data, like those of other companies, could be subject to cyber-attacks and unauthorized access, use, alteration, or destruction, such as from physical and electronic break-ins or unauthorized tampering, malware and computer virus attacks, or system failures and disruptions. If one or more of these events occurs, it could potentially jeopardize the confidential, proprietary, and other information processed, stored in, and transmitted through our computer systems and networks. Such an attack could cause interruptions or malfunctions in our operations, which could result in financial losses, litigation, regulatory penalties, client dissatisfaction or loss, reputational damage, and increased costs associated with mitigation of damages and remediation.
Third parties with which we do business may also be sources of cybersecurity or other technological risks. We outsource certain functions and these relationships allow for the storage and processing of our information, as well as customer, counterparty, employee and borrower information. Cybersecurity failures or breaches by Stellus Capital Management and other service providers (including, but not limited to, accountants, custodians, transfer agents and administrators), and the issuers of securities in which we invest, also have the ability to cause disruptions and impact business operations, potentially resulting in financial losses, interference with our ability to calculate its net asset value, impediments to trading, the inability of our stockholders to transact business, violations of applicable privacy and other laws, regulatory fines, penalties, reputation damages, reimbursement of other compensation costs, or additional compliance costs. While we engage in actions to reduce our exposure
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resulting from outsourcing, ongoing threats may result in unauthorized access, loss, exposure or destruction of data, or other cybersecurity incidents, with increased costs and other consequences, including those described above. In addition, substantial costs may be incurred in order to prevent any cyber incidents in the future.
Privacy and information security laws and regulation changes, and compliance with those changes, may result in cost increases due to system changes and the development of new administrative processes. In addition, we may be required to expend significant additional resources to modify our protective measures and to investigate and remediate vulnerabilities or other exposures arising from operational and security risks. We currently do not maintain insurance coverage relating to cybersecurity risks, and we may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are not fully insured.
We, Stellus Capital Management and our portfolio companies are subject to risks associated with “phishing” and other cyber-attacks.
Our business and the business of our portfolio companies relies upon secure information technology systems for data processing, storage and reporting. Despite careful security and controls design, implementation and updating, our and our portfolio companies’ information technology systems could become subject to cyber-attacks. Cyber-attacks include, but are not limited to, gaining unauthorized access to digital systems (e.g., through “hacking”, malicious software coding, social engineering or “phishing” attempts) for purposes of misappropriating assets or sensitive information, corrupting data, or causing operational disruption. Cyber-attacks may also be carried out in a manner that does not require gaining unauthorized access, such as causing denial-of service attacks on websites (i.e., efforts to make network services unavailable to intended users). Stellus Capital Management’s employees have been and expect to continue to be the target of fraudulent calls, emails and other forms of activities. The result of these incidents may include disrupted operations, misstated or unreliable financial data, liability for stolen information, misappropriation of assets, increased cybersecurity protection and insurance costs, litigation and damage to our business relationships, regulatory fines or penalties, or other adverse effects on our business, financial condition or results of operations. In addition, we may be required to expend significant additional resources to modify its protective measures and to investigate and remediate vulnerabilities or other exposures arising from operational and security risks related to cyber-attacks.
Stellus Capital Management’s and other service providers’ increased use of mobile and cloud technologies could heighten the risk of a cyber-attack as well as other operational risks, as certain aspects of the security of such technologies may be complex, unpredictable or beyond their control. These service providers’ reliance on mobile or cloud technology or any failure by mobile technology and cloud service providers to adequately safeguard their systems and prevent cyber-attacks could disrupt their operations and result in misappropriation, corruption or loss of personal, confidential or proprietary information. In addition, there is a risk that encryption and other protective measures against cyber-attacks may be circumvented, particularly to the extent that new computing technologies increase the speed and computing power available.
Risks Related to Economic Conditions
Global economic, political and market conditions may adversely affect our business, financial condition and results of operations, including our revenue growth and profitability.
The U.S. debt ceiling and budget deficit concerns have raised the possibility of additional credit-rating downgrades and economic slowdowns in the United States and globally. Legislation passed in June 2023 suspends the debt ceiling through early 2025, unless Congress takes further legislative action to extend it. Downgrades by rating agencies to the U.S. government’s credit rating or concerns about its credit and deficit levels in general could cause interest rates and borrowing costs to rise, which may negatively impact both the perception of credit risk associated with our debt portfolio and our ability to access the debt markets on favorable terms. In addition, a decreased U.S. government credit rating could create broader financial turmoil and uncertainty, which may weigh heavily on our financial performance and the value of our common stock.
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Deterioration in the economic conditions in the Eurozone and other regions or countries globally and the resulting instability in global financial markets may pose a risk to our business. Financial markets have been affected at times by a number of global macroeconomic events, including the following: large sovereign debts and fiscal deficits of several countries in Europe and in emerging markets jurisdictions, levels of non-performing loans on the balance sheets of European banks, the effect of the United Kingdom (the “U.K.”) leaving the European Union (the “EU”), instability in the Chinese capital markets and the COVID-19 pandemic. Global market and economic disruptions have affected, and may in the future affect, the U.S. capital markets, which could adversely affect our business, financial condition or results of operations. We cannot assure you that market disruptions in Europe and other regions or countries, including the increased cost of funding for certain governments and financial institutions, will not impact the global economy, and we cannot assure you that assistance packages will be available, or if available, be sufficient to stabilize countries and markets in Europe or elsewhere affected by a financial crisis. To the extent uncertainty regarding any economic recovery in Europe negatively impacts consumer confidence and consumer credit factors, our business, financial condition and results of operations could be significantly and adversely affected. Moreover, there is a risk of both sector-specific and broad-based corrections and/or downturns in the equity and credit markets. Any of the foregoing could have a significant impact on the markets in which we operate and could have a material adverse impact on our business prospects and financial condition.
Various social and political circumstances in the U.S. and around the world (including wars and other forms of conflict, including rising trade tensions between the United States and China, and other uncertainties regarding actual and potential shifts in the U.S. and foreign, trade, economic and other policies with other countries, terrorist acts, security operations and catastrophic events such as fires, floods, earthquakes, tornadoes, hurricanes and global health epidemics), may also contribute to increased market volatility and economic uncertainties or deterioration in the U.S. and worldwide. Specifically, the ongoing conflict between Russia and Ukraine, and the resulting market volatility, could adversely affect our business, financial condition or results of operations. In response to the conflict between Russia and Ukraine, the U.S. and other countries have imposed sanctions or other restrictive actions against Russia. Any of the above factors, including sanctions, export controls, tariffs, trade wars and other governmental actions, could have a material adverse effect on our business, financial condition, cash flows and results of operations and could cause the market value of our common shares and/or debt securities to decline. These market and economic disruptions could also negatively impact the operating results of our portfolio companies.
Additionally, the Federal Reserve may further raise, or may announce its intention to further raise, the Federal Funds Rate in 2023. These developments, along with the United States government’s credit and deficit concerns, global economic uncertainties and market volatility and the impacts of COVID-19, could cause interest rates to be volatile, which may negatively impact our ability to access the debt markets and capital markets on favorable terms.
Increased geopolitical unrest, terrorist attacks, or acts of war may impact the businesses in which we invests, and harm our business, operating results, and financial conditions.
Terrorist activity and the continued threat of terrorism and acts of civil or international hostility, both within the United States and abroad, as well as ongoing military and other actions and heightened security measures in response to these types of threats, may cause significant volatility and declines in the global markets, loss of life, property damage, disruptions to commerce and reduced economic activity, which may negatively impact the businesses in which we invests directly or indirectly and, in turn, could have a material adverse impact on the our business, operating results, and financial condition. Losses from terrorist attacks are generally uninsurable.
Risks Related to our Investments
Our business and our portfolio companies may be susceptible to economic slowdowns or recessions which would harm our operating results.
Many of the portfolio companies in which we have invested or expect to make investments are likely to be susceptible to economic slowdowns or recessions, including those resulting from the COVID-19 pandemic, and may be unable to repay our loans during such periods. Therefore, the number of our non-performing assets is likely to increase, and the value of our portfolio is likely to decrease during such periods. Adverse economic conditions may decrease the
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value of collateral securing some of our loans and debt securities and the value of our equity investments. Economic slowdowns or recessions could lead to financial losses in our portfolio and a decrease in revenues, net income and assets. Unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us. These events could prevent us from increasing our investments and harm our operating results.
A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, termination of its loans and foreclosure on its assets, which could trigger cross-defaults under other agreements and jeopardize our portfolio company’s ability to meet its obligations under the loans and debt securities that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting portfolio company. In addition, lenders in certain cases can be subject to lender liability claims for actions taken by them when they become too involved in the borrower’s business or exercise control over a borrower. It is possible that we could become subject to a lender’s liability claim, including as a result of actions taken if we render significant managerial assistance to the borrower.
Furthermore, if one of our portfolio companies were to file for bankruptcy protection, a bankruptcy court might re-characterize our debt holding and subordinate all or a portion of our claim to claims of other creditors, even though we may have structured our investment as senior secured debt. The likelihood of such a re-characterization would depend on the facts and circumstances, including the extent to which we provided managerial assistance to that portfolio company.
Unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us. These events could prevent us from increasing our investments and harm business, financial condition, operating results and prospects.
We may be subject to risks related to bank impairments or failures either directly or through our portfolio companies, which, in turn, could indirectly impact our performance and results of operations.
In March 2023, the U.S. Federal Deposit Insurance Corporation (“FDIC”) took control of Silicon Valley Bank and Signature Bank, and in May 2023, the FDIC took control of First Republic Bank due to liquidity concerns. The impairment or failure of one or more banks with whom we or any of our portfolio companies transact may inhibit our ability or the ability of our portfolio companies to access depository accounts, including cash and cash equivalents, as well as investment accounts, which, in turn, may directly or indirectly impact our performance and results of operations. In the event of a bank impairment or failure we may be forced to delay or forgo investments, and affected portfolio companies may default on their debt obligations to us, either of which would impact our performance. In the event of such a failure of a banking institution where one or more of our portfolio companies holds depository accounts, access to such accounts could be restricted and FDIC protection may not be available for balances in excess of amounts insured by the FDIC. In such instances, we or our affected portfolio companies would not recover such excess, uninsured amounts, and they may not be able to cure any defaults. Additionally, unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us. These events could prevent us from increasing our investments and harm business, financial condition, operating results and prospects. We closely monitor activity in the banking sector as it relates to any of our borrowers and continually assess any potential direct or indirect impact to us as a result of the same.
Our investments in leveraged portfolio companies may be risky, and we could lose all or part of our investment.
Investment in leveraged companies involves a number of significant risks. Leveraged companies in which we invest may have limited financial resources and may be unable to meet their obligations under their loans and debt securities that we hold. Such developments may be accompanied by a deterioration in the value of any collateralsecuring the investment and/or equity co-investments we hold and a reduction in the likelihood of our realizing any guarantees that we may have obtained in connection with our investment. Smaller leveraged companies also may have less predictable operating results and may require substantial additional capital to support their operations, finance their expansion or maintain their competitive position.
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We may hold the loans and debt securities of leveraged companies that may, due to the significant operating volatility typical of such companies, enter into bankruptcy proceedings.
Leveraged companies may experience bankruptcy or similar financial distress. The bankruptcy process has a number of significant inherent risks. Many events in a bankruptcy proceeding are the product of contested matters and adversary proceedings and are beyond the control of the creditors. A bankruptcy filing by a portfolio company may adversely and permanently affect that company. If the proceeding is converted to a liquidation, the value of the portfolio company may not equal the liquidation value that was believed to exist at the time of the investment. The duration of a bankruptcy proceeding is also difficult to predict, and a creditor’s return on investment can be adversely affected by delays until the plan of reorganization or liquidation ultimately becomes effective. The administrative costs in connection with a bankruptcy proceeding are frequently high and would be paid out of the debtor’s estate prior to any return to creditors. Because the standards for classification of claims under bankruptcy law are vague, our influence with respect to the class of securities or other obligations we own may be lost by increases in the number and amount of claims in the same class or by different classification and treatment. In the early stages of the bankruptcy process, it is often difficult to estimate the extent of, or even to identify, any contingent claims that might be made. In addition, certain claims that have priority by law (for example, claims for taxes) may be substantial.
Our investments in private and middle-market portfolio companies are risky, and we could lose all or part of our investment.
Investment in private and middle-market companies involves a number of significant risks. Generally, little public information exists about these companies, and we rely on the ability of Stellus Capital Management’s investment professionals to obtain adequate information to evaluate the potential returns from investing in these companies. If we are unable to uncover all material information about these companies, we may not make a fully informed investment decision, and we may lose money on our investments. Middle-market companies may have limited financial resources and may be unable to meet their obligations under their loans and debt securities that we hold, which may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of our realizing any guarantees we may have obtained in connection with our investment. In addition, such companies typically have shorter operating histories, narrower product lines and smaller market shares than larger businesses, which tend to render them more vulnerable to competitors’ actions and market conditions, as well as general economic downturns. Additionally, middle-market companies are more likely to depend on the management talents and efforts of a small group of persons. Therefore, the death, disability, resignation or termination of one or more of these persons could have a material adverse impact on one or more of the portfolio companies we invest in and, in turn, on us. Middle-market companies also may be parties to litigation and may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence. In addition, our executive officers, directors and Stellus Capital Management may, in the ordinary course of business, be named as defendants in litigation arising from our investments in portfolio companies, the commencement and duration of which could distract from their roles or service to us and negatively impact our business.
The lack of liquidity in our investments may adversely affect our business.
Most of our assets are invested in illiquid loans and securities, and a substantial portion of our investments in leveraged companies are subject to legal and other restrictions on resale or are otherwise less liquid than more broadly traded public securities. The illiquidity of these investments may make it difficult for us to sell such investments if the need arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded our investments. Also, as noted above, we may be limited or prohibited in our ability to sell or otherwise exit certain positions in our portfolio, as such a transaction could be considered a joint transaction prohibited by the 1940 Act.
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Price declines and illiquidity in the corporate debt markets may adversely affect the fair value of our portfolio investments, reducing our net asset value through increased net unrealized depreciation.
As a BDC, we are required to carry our investments at market value or, if no market value is ascertainable, at fair value as determined in good faith by our Board. As part of the valuation process, our Board may take into account the following types of factors, if relevant, in determining the fair value of our investments:
When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, we use the pricing indicated by the external event to corroborate our valuation. We record decreases in the market values or fair values of our investments as unrealized depreciation. Declines in prices and liquidity in the corporate debt markets may result in significant net unrealized depreciation in our portfolio. The effect of all of these factors on our portfolio may reduce our net asset value by increasing net unrealized depreciation in our portfolio. Depending on market conditions, we could incur substantial realized losses and may suffer additional unrealized losses in future periods, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.
We are a non-diversified investment company within the meaning of the 1940 Act, and therefore, we are not limited with respect to the proportion of our assets that may be invested in securities of a single issuer.
We are classified as a non-diversified investment company within the meaning of the 1940 Act, which means that we are not limited by the 1940 Act with respect to the proportion of our assets that we may invest in securities of a single issuer. Beyond the asset diversification requirements associated with our qualification as a RIC under the Code, we do not have fixed guidelines for diversification. To the extent that we assume large positions in the securities of a small number of issuers or our investments are concentrated in relatively few industries, our net asset value may fluctuate to a greater extent than that of a diversified investment company as a result of changes in the financial condition or the market’s assessment of the issuer. We may also be more susceptible to any single economic or regulatory occurrence than a diversified investment company.
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Our failure to make follow-on investments in our portfolio companies could impair the value of our portfolio.
Following an initial investment in a portfolio company, we may make additional investments in that portfolio company as “follow-on” investments, in seeking to:
We generally have discretion to make follow-on investments, subject to the availability of capital resources. Failure on our part to make follow-on investments may, in some circumstances, jeopardize the continued viability of a portfolio company and our initial investment, or may result in a missed opportunity for us to increase our participation in a successful operation. Even if we have sufficient capital to make a desired follow-on investment, we may elect not to make a follow-on investment because we may not want to increase our level of risk, because we prefer other opportunities or because we are inhibited by compliance with BDC requirements of the 1940 Act or the desire to maintain our qualification as a RIC. Our ability to make follow-on investments may also be limited by our compliance with the conditions under the Order we received from the SEC related to co-investments with investment funds managed by Stellus Capital Management (or an affiliate thereof) or Stellus Capital Management’s allocation policy.
Because we generally do not hold controlling equity interests in our portfolio companies, we may not be able to exercise control over our portfolio companies or to prevent decisions by management of our portfolio companies that could decrease the value of our investments.
We do not hold controlling equity positions in any of the portfolio companies included in our portfolio and, although we may do so in the future, we do not currently intend to hold controlling equity positions in our portfolio companies (including those included in our portfolio). As a result, we are subject to the risk that a portfolio company may make business decisions with which we disagree, and that the management and/or stockholders of a portfolio company may take risks or otherwise act in ways that are adverse to our interests. Due to the lack of liquidity of the debt and equity investments that we hold in our portfolio companies, we may not be able to dispose of our investments in the event we disagree with the actions of a portfolio company and may therefore suffer a decrease in the value of our investments.
Defaults by our portfolio companies will harm our operating results.
A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, termination of its loans and foreclosure on its assets. This could trigger cross-defaults under other agreements and jeopardize such portfolio company’s ability to meet its obligations under the loans or debt or equity securities that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms, which may include the waiver of certain financial covenants, with a defaulting portfolio company.
Prepayments of our debt investments by our portfolio companies could adversely impact our results of operations and ability to make stockholder distributions and result in a decline in the market price of our shares.
We are subject to the risk that the debt investments we make in our portfolio companies may be repaid prior to maturity. We expect that our investments will generally allow for repayment at any time subject to certain penalties. When this occurs, we intend to generally reinvest these proceeds in temporary investments, pending their future investment in accordance with our investment strategy. These temporary investments will typically have substantially lower yields than the debt being prepaid, and we could experience significant delays in reinvesting these amounts. Any future investment may also be at lower yields than the debt that was repaid. As a result, our results of operations could be materially adversely affected if one or more of our portfolio companies elects to prepay amounts owed to us.
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Additionally, prepayments could negatively impact our ability to make, or the amount of, stockholder distributions with respect to our common stock, which could result in a decline in the market price of our shares.
The phase-out and replacement of LIBOR may adversely affect the value of our portfolio securities.
As of June 30, 2023, no settings of the London Interbank Offered Rate (“LIBOR”) continue to be published on a representative basis, and publication of many non-U.S. Dollar LIBOR settings have been entirely discontinued. On July 29, 2021, the U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, recommended replacing U.S. dollar LIBOR with alternative reference rates based on the Secured Overnight Financing Rate (“SOFR”). SOFR significantly differs from LIBOR, both in the actual rate and how it is calculated. Further, on March 15, 2022, the Consolidated Appropriations Act of 2022, which includes the Adjustable Interest Rate (LIBOR) Act (“LIBOR Act”), was signed into law in the United States. This legislation established a uniform benchmark replacement process for certain financial contracts that mature after June 30, 2023 that do not contain clearly defined or practicable LIBOR fallback provisions. The legislation also created a safe harbor that shields lenders from litigation if they choose to utilize a replacement rate recommended by the Board of Governors of the U.S. Federal Reserve. In addition, the U.K. Financial Conduct Authority, which regulates the publisher of LIBOR (ICR Benchmark Administration) has announced that it will require the continued publication of one, three and six month tenors of U.S. dollar LIBOR on a non-representative synthetic basis until the end of September 2024, which may result in certain non-U.S. law-governed contracts and U.S. law-governed contracts not being covered by the federal legislation remaining on synthetic U.S. dollar LIBOR until the end of this period. The transition from LIBOR or the use of synthetic LIBOR in floating-rate debt securities in our portfolio or issued by us could have a material and adverse impact on the value or liquidity of those instruments. The transition away from LIBOR to alternative reference rates is complex and could have a material adverse effect on our business, financial condition and results of operations, including as a result of any changes in the pricing of our investments, changes to the documentation for certain of our investments and the pace of such changes, disputes and other actions regarding the interpretation of current and prospective loan documentation or modifications to processes and systems.
The effect of global climate change may impact the operations of our portfolio companies.
Climate change creates physical and financial risk and some of our portfolio companies may be adversely affected by climate change. For example, the needs of customers of energy companies vary with weather conditions, primarily temperature and humidity. To the extent weather conditions are affected by climate change, energy use could increase or decrease depending on the duration and magnitude of any changes. Increases in the cost of energy could adversely affect the cost of operations of our portfolio companies if the use of energy products or services is material to their business. A decrease in energy use due to weather changes may affect some of our portfolio companies’ financial condition, through decreased revenues. Extreme weather conditions in general require more system backup, adding to costs, and can contribute to increased system stresses, including service interruptions.
Our portfolio companies may incur debt that ranks equally with, or senior to, our investments in such companies.
We invest a portion of our capital in second lien and subordinated loans issued by our portfolio companies. The portfolio companies usually have, or may be permitted to incur, other debt that ranks equally with, or senior to, the loans in which we invest. By their terms, such debt instruments may provide that the holders are entitled to receive payment of interest or principal on or before the dates on which we are entitled to receive payments in respect of the loans in which we invest. Also, in the event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company, holders of debt instruments ranking senior to our investment in that portfolio company would typically be entitled to receive payment in full before we receive any distribution in respect of our investment. After repaying senior creditors, a portfolio company may not have any remaining assets to use for repaying its obligation to us. In the case of debt ranking equally with loans in which we invest, we would have to share any distributions on an equal and ratable basis with other creditors holding such debt in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy of the relevant portfolio company.
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Additionally, certain loans that we make to portfolio companies may be secured on a second priority basis by the same collateral securing senior secured debt of such companies. The first priority liens on the collateral will secure the portfolio company’s obligations under any outstanding senior debt and may secure certain other future debt that may be permitted to be incurred by the portfolio company under the agreements governing the loans. The holders of obligations secured by first priority liens on the collateral will generally control the liquidation of, and be entitled to receive proceeds from, any realization of the collateral to repay their obligations in full before us. In addition, the value of the collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. There can be no assurance that the proceeds, if any, from sales of all of the collateral would be sufficient to satisfy the loan obligations secured by the second priority liens after payment in full of all obligations secured by the first priority liens on the collateral. If such proceeds were not sufficient to repay amounts outstanding under the loan obligations secured by the second priority liens, then we, to the extent not repaid from the proceeds of the sale of the collateral, will only have an unsecured claim against the portfolio company’s remaining assets, if any.
We may also make unsecured loans to portfolio companies, meaning that such loans will not benefit from any interest in collateral of such companies. Liens on such portfolio companies’ collateral, if any, will secure the portfolio company’s obligations under its outstanding secured debt and may secure certain future debt that is permitted to be incurred by the portfolio company under its secured loan agreements. The holders of obligations secured by such liens will generally control the liquidation of, and be entitled to receive proceeds from, any realization of such collateral to repay their obligations in full before us. In addition, the value of such collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. There can be no assurance that the proceeds, if any, from sales of such collateral would be sufficient to satisfy our unsecured loan obligations after payment in full of all secured loan obligations. If such proceeds were not sufficient to repay the outstanding secured loan obligations, then our unsecured claims would rank equally with the unpaid portion of such secured creditors’ claims against the portfolio company’s remaining assets, if any.
The rights we may have with respect to the collateral securing the loans we make to our portfolio companies with senior debt outstanding may also be limited pursuant to the terms of one or more intercreditor agreements that we enter into with the holders of such senior debt. Under a typical intercreditor agreement, at any time that obligations that have the benefit of the first priority liens are outstanding, any of the following actions that may be taken in respect of the collateral will be at the direction of the holders of the obligations secured by the first priority liens:
We may not have the ability to control or direct such actions, even if our rights are adversely affected.
We may be exposed to special risks associated with bankruptcy cases.
One or more of our portfolio companies may be involved in bankruptcy or other reorganization or liquidation proceedings. Many of the events within a bankruptcy case are adversarial and often beyond the control of the creditors. While creditors generally are afforded an opportunity to object to significant actions, we cannot assure you that a bankruptcy court would not approve actions that may be contrary to our interests. There also are instances where creditors can lose their ranking and priority if they are considered to have taken over management of a borrower.
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To the extent that portfolio companies in which we have invested through a unitranche facility are involved in bankruptcy proceedings, the outcome of such proceedings may be uncertain. For example, it is unclear whether a bankruptcy court would enforce an agreement among lenders which sets the priority of payments among unitranche lenders. In such a case, the “first out” lenders in the unitranche facility may not receive the same degree of protection as they would if the agreement among lenders was enforced.
The reorganization of a company can involve substantial legal, professional and administrative costs to a lender and the borrower. Bankruptcy and reorganization proceedings are frequently subject to unpredictable and lengthy delays, and during the process, the debtor company’s competitive position may erode, key management may depart and the debtor company may not be able to invest adequately. In some cases, the debtor company may not be able to reorganize and may be required to liquidate assets. The debt of companies in financial reorganization will, in most cases, not pay current interest, may not accrue interest during reorganization and may be adversely affected by an erosion of the issuer’s fundamental value.
In addition, lenders can be subject to lender liability claims for actions taken by them where they become too involved in the borrower’s business or exercise control over the borrower. For example, we could become subject to a lender liability claim (alleging that we misused our influence on the borrower for the benefit of its lenders), if, among other things, the borrower requests significant managerial assistance from us and we provide that assistance. To the extent we and an affiliate both hold investments in the same portfolio company that are of a different character, we may also face restrictions on our ability to become actively involved in the event that portfolio company becomes distressed as a result of the restrictions imposed on transactions involving affiliates under the 1940 Act. In such cases, we may be unable to exercise rights we may otherwise have to protect our interests as security holders in such portfolio company.
If we make subordinated investments, the obligors or the portfolio companies may not generate sufficient cash flow to service their debt obligations to us.
We may make subordinated investments that rank below other obligations of the obligor in right of payment. Subordinated investments are subject to greater risk of default than senior obligations as a result of adverse changes in the financial condition of the obligor or economic conditions in general. If we make a subordinated investment in a portfolio company, the portfolio company may be highly leveraged, and its relatively high debt-to-equity ratio may create increased risks that its operations might not generate sufficient cash flow to service all of its debt obligations.
The disposition of our investments may result in contingent liabilities.
Substantially all of our investments involve loans and private securities. In connection with the disposition of an investment in loans and private securities, we may be required to make representations about the business and financial affairs of the portfolio company typical of those made in connection with the sale of a business. We may also be required to indemnify the purchasers of such investment to the extent that any such representations turn out to be inaccurate or with respect to potential liabilities. These arrangements may result in contingent liabilities that ultimately result in funding obligations that we must satisfy through our return of distributions previously made to us.
We may not realize gains from our equity investments.
When we invest in loans and debt securities, we may acquire warrants or other equity securities of portfolio companies as well. We may also invest in equity securities directly. To the extent we hold equity investments, we will attempt to dispose of them and realize gains upon our disposition of them. However, the equity interests we receive may not appreciate in value and, may decline in value. As a result, we may not be able to realize gains from our equity interests, and any gains that we do realize on the disposition of any equity interests may not be sufficient to offset any other losses we experience.
Our ability to enter transactions involving derivatives and financial commitment transactions may be limited.
Pursuant to SEC rules, BDCs that use derivatives are subject to a value-at-risk (“VaR”) leverage limit, certain other derivatives risk management program and testing requirements and requirements related to board reporting. These
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requirements apply unless the BDC qualified as a “limited derivatives user,” as defined in the SEC’s adopted rules. A BDC that enters into reverse repurchase agreements or similar financing transactions may either comply with the asset coverage requirements of Section 18 when engaging in reverse repurchase agreements or (ii) chose to treat such agreements as derivatives transactions under the adopted rule. A BDC may enter into an unfunded commitment agreement that is not a derivatives transaction, such as an agreement to provide financing to a portfolio company, if the BDC has a reasonable belief, at the time it enters into such an agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements, in each case as it becomes due. If the BDC cannot meet this test, it is required to treat unfunded commitments as a derivatives transaction subject to the requirements of the SEC rules. Collectively, these requirements may limit our ability to use derivatives and/or enter into certain other financial contracts.
Risks Relating to Our Common Stock
There is a risk that you may not receive distributions or that our distributions may not grow over time and a portion of our distributions may be a return of capital.
We intend to make distributions on a monthly basis to our stockholders out of assets legally available for distribution (i.e., not subject to any legal restrictions under Maryland law on the distribution thereof). We cannot assure you that we will achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions. All distributions will be made at the discretion of our Board and will depend on our earnings, financial condition, maintenance of RIC status, compliance with applicable BDC requirements and SBA regulations and such other factors as our Board may deem relative from time to time. We cannot assure you that we will make distributions to our stockholders in the future.
Our ability to pay distributions might be adversely affected by the impact of one or more of the risk factors described in this Annual Report on Form 10-K. Due to the asset coverage test applicable to us under the 1940 Act as a BDC, we may be limited in our ability to make distributions. In addition, restrictions and provisions in our Credit Facility, the 2026 Notes and any future credit facilities, as well as in the terms of any debt securities we issue, may limit our ability to make distributions in certain circumstances.
When we make distributions, we will be required to determine the extent to which such distributions are paid out of current or accumulated earnings and profits. Distributions in excess of current and accumulated earnings and profits will be treated as a non-taxable return of capital to the extent of an investor’s basis in our stock and, assuming that an investor holds our stock as a capital asset, thereafter as a capital gain.
Stockholders may experience dilution in their ownership percentage if they do not participate in our dividend reinvestment plan.
All distributions declared in cash payable to stockholders that are participants in our dividend reinvestment plan are generally automatically reinvested in shares of our common stock. As a result, stockholders that do not participate in the dividend reinvestment plan may experience dilution over time. Stockholders who receive distributions in shares of common stock may experience accretion to the net asset value of their shares if our shares are trading at a premium and dilution if our shares are trading at a discount. The level of accretion or discount would depend on various factors, including the proportion of our stockholders who participate in the plan, the level of premium or discount at which our shares are trading and the amount of the distribution payable to a stockholder.
Our shares might trade at premiums that are unsustainable or at discounts from net asset value.
Shares of BDCs like us may, during some periods, trade at prices higher than their net asset value per share and, during other periods, as frequently occurs with closed-end investment companies, trade at prices lower than their net asset value per share. The perceived value of our investment portfolio may be affected by a number of factors including perceived prospects for individual companies we invest in, market conditions for common stock generally, for initial public offerings and other exit events for venture capital backed companies, and the mix of companies in our investment
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portfolio over time. Negative or unforeseen developments affecting the perceived value of companies in our investment portfolio could result in a decline in the trading price of our common stock relative to our net asset value per share.
The possibility that our shares will trade at a discount from net asset value or at premiums that are unsustainable are risks separate and distinct from the risk that our net asset value per share will decrease. The risk of purchasing shares of a BDC that might trade at a discount or unsustainable premium is more pronounced for investors who wish to sell their shares in a relatively short period of time because, for those investors, realization of a gain or loss on their investments is likely to be more dependent upon changes in premium or discount levels than upon increases or decreases in net asset value per share.
Investing in our securities may involve an above average degree of risk.
The investments we make in accordance with our investment objective may result in a higher amount of risk, and higher volatility or loss of principal, than alternative investment options. Our investments in portfolio companies may be speculative and, therefore, an investment in our securities may not be suitable for someone with lower risk tolerance.
The market price of our securities may fluctuate significantly.
The market price and liquidity of the market for our securities may be significantly affected by numerous factors, some of which are beyond our control and may not be directly related to our operating performance. These factors include:
Risks Relating to Our Debt Securities
The 2026 Notes are unsecured and therefore are effectively subordinated to any secured indebtedness we have currently incurred or may incur in the future and rank pari passu with, or equal to, all outstanding and future unsecured indebtedness issued by and us and our general liabilities (total liabilities, less debt).
The 2026 Notes are not and will not be secured by any of our assets or any of the assets of any of our subsidiaries. As a result, the 2026 Notes are effectively subordinated to any secured indebtedness we or our subsidiaries have incurred and may incur in the future (or any indebtedness that is initially unsecured as to which we subsequently grant security) to
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the extent of the value of the assets securing such indebtedness. In any liquidation, dissolution, bankruptcy or other similar proceeding, the holders of any of our existing or future secured indebtedness and the secured indebtedness of our subsidiaries may assert rights against the assets pledged to secure that indebtedness in order to receive full payment of their indebtedness before the assets may be used to pay other creditors, including the holders of the 2026 Notes. In addition, the 2026 Notes rank pari passu with, or equal to, all outstanding and future unsecured, unsubordinated indebtedness issued by us and our general liabilities (total liabilities, less debt). As of December 31, 2023 we had $160.1 million in outstanding indebtedness under our Credit Facility. The indebtedness under the Credit Facility is effectively senior to the 2026 Notes to the extent of the value of the assets securing such indebtedness.
The 2026 Notes are structurally subordinated to the indebtedness and other liabilities of our subsidiaries.
The 2026 Notes are obligations exclusively of Stellus Capital Investment Corporation, and not of any of our subsidiaries. None of our subsidiaries are or will be a guarantor of the 2026 Notes, and the 2026 Notes are not required to be guaranteed by any subsidiary we may acquire or create in the future. Any assets of our subsidiaries are not directly available to satisfy the claims of our creditors, including holders of the 2026 Notes. Except to the extent we are a creditor with recognized claims against our subsidiaries, all claims of creditors of our subsidiaries will have priority over our equity interests in such entities (and therefore the claims of our creditors, including holders of the 2026 Notes) with respect to the assets of such entities. Even if we are recognized as a creditor of one or more of these entities, our claims would still be effectively subordinated to any security interests in the assets of any such entity and to any indebtedness or other liabilities of any such entity senior to our claims. Consequently, the 2026 Notes are structurally subordinated to all indebtedness and other liabilities, including trade payables, of any of our existing or future subsidiaries, including the SBIC subsidiaries. As of December 31, 2023, our subsidiaries had total indebtedness outstanding of $325.0 million. Certain of these entities (excluding our SBIC subsidiaries) currently serve as guarantors under our Credit Facility, and in the future our subsidiaries may incur substantial additional indebtedness, all of which is and would be structurally senior to the 2026 Notes.
The indenture under which the 2026 Notes are issued contains limited protection for holders of the 2026 Notes.
The indenture under which the 2026 Notes are issued offers limited protection to holders of the 2026 Notes. The terms of the indenture and the 2026 Notes do not restrict our or any of our subsidiaries’ ability to engage in, or otherwise be a party to, a variety of corporate transactions, circumstances or events that could have a material adverse impact on an investment in the 2026 Notes. In particular, the terms of the indenture and the 2026 Notes do not place any restrictions on our or our subsidiaries’ ability to:
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Furthermore, the terms of the indenture and the 2026 Notes do not protect holders of the 2026 Notes in the event that we experience changes (including significant adverse changes) in our financial condition, results of operations or credit ratings, if any, as they do not require that we or our subsidiaries adhere to any financial tests or ratios or specified levels of net worth, revenues, income, cash flow, or liquidity.
Our ability to recapitalize, incur additional debt (including additional debt that matures prior to the maturity of the 2026 Notes) and take a number of other actions that are not limited by the terms of the 2026 Notes may have important consequences for holders of the 2026 Notes, including making it more difficult for us to satisfy our obligations with respect to the 2026 Notes or negatively affecting the market value of the 2026 Notes.
Other debt we issue or incur in the future could contain more protections for its holders than the indenture and the 2026 Notes, including additional covenants and events of default. The issuance or incurrence of any such debt with incremental protections could affect the market for, trading levels, and prices of the 2026 Notes.
There is no active trading market for the 2026 Notes. If an active trading market does not develop for the 2026 Notes, you may not be able to sell them.
The 2026 Notes are debt securities for which there currently is no trading market. We do not intend to list the 2026 Notes on any securities exchange or for quotation of the 2026 Notes on any automated dealer quotation system. If the 2026 Notes are traded after their initial issuance, they may trade at a discount to their initial offering price depending on prevailing interest rates, the market for similar securities, our credit ratings, our financial condition, performance and prospects, general economic conditions, or other relevant factors. Although the underwriter has informed us that it intends to make a market in the 2026 Notes, it is not obligated to do so, and the underwriter may discontinue any market-making in the 2026 Notes at any time at its sole discretion. Accordingly, we cannot assure you that a liquid trading market will develop or be maintained for the 2026 Notes, that you will be able to sell your 2026 Notes at a particular time or that the price you receive when you sell will be favorable. To the extent an active trading market does not develop, the liquidity and trading price for the 2026 Notes may be harmed. Accordingly, you may be required to bear the financial risk of an investment in the 2026 Notes for an indefinite period of time.
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If we default on our obligations to pay our other indebtedness, we may not be able to make payments on the 2026 Notes.
Any default under the agreements governing our indebtedness, including a default under the Credit Facility or other indebtedness to which we may be a party, that is not waived by the required lenders or holders, and the remedies sought by the lenders or holders of such indebtedness could make us unable to pay principal, premium, if any, and interest on the 2026 Notes and substantially decrease the market value of the 2026 Notes. If we are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants, including financial and operating covenants, as applicable, in the instruments governing our indebtedness (including the Credit Facility), we could be in default under the terms of the agreements governing such indebtedness, including the 2026 Notes. In the event of such default, the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest, the lenders under the Credit Facility or other debt we may incur in the future could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to refinance or restructure our debt, including the 2026 Notes, sell assets, reduce or delay capital investments, seek to raise additional capital or seek to obtain waivers from the required lenders under the Credit Facility or other debt that we may incur in the future to avoid being in default. If we are unable to implement one or more of these alternatives, we may not be able to meet our payment obligations under the 2026 Notes or our other debt. If we breach our covenants under the Credit Facility or our other debt and seek a waiver, we may not be able to obtain a waiver from the required lenders or holders thereof. If this occurs, we would be in default under the Credit Facility or other debt, the lenders or holders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation. If we are unable to repay debt, lenders having secured obligations, including the lenders under the Credit Facility, could proceed against the collateral securing the debt. Because the Credit Facility has, the indenture governing the 2026 Notes has, and any future credit facilities will likely have, customary cross-default provisions, if the indebtedness under the 2026 Notes, the Credit Facility or under any future credit facility is accelerated, we may be unable to repay or finance the amounts due.
We may choose to redeem the 2026 Notes when prevailing interest rates are relatively low.
The 2026 Notes are redeemable in whole or in part upon certain conditions at any time or from time to time at our option. We may choose to redeem the 2026 Notes from time to time, especially if prevailing interest rates are lower than the rate borne by the 2026 Notes. If prevailing rates are lower at the time of redemption, and we redeem the 2026 Notes, you likely would not be able to reinvest the redemption proceeds in a comparable security at an effective interest rate as high as the interest rate on the 2026 Notes being redeemed.
We may not be able to repurchase the 2026 Notes upon a Change of Control Repurchase Event.
We may not be able to repurchase the 2026 Notes upon a Change of Control Repurchase Event (as defined in the supplemental indenture governing the 2026 Notes) because we may not have sufficient funds. We would not be able to borrow under our Credit Facility to finance such a repurchase of the 2026 Notes, and we expect that any future credit facility would have similar limitations. Upon a Change of Control Repurchase Event, holders of the 2026 Notes may require us to repurchase for cash some or all of the 2026 Notes at a repurchase price equal to 100% of the aggregate principal amount of the 2026 Notes being repurchased, plus accrued and unpaid interest to, but not including, the repurchase date. The terms of our Credit Facility provide that certain change of control events will constitute an event of default thereunder entitling the lenders to accelerate any indebtedness outstanding under our Credit Facility at that time and to terminate our Credit Facility. In addition, the occurrence of a Change of Control Repurchase Event enabling the holders of the 2026 Notes to require the mandatory purchase of the 2026 Notes will constitute an event of default under our Credit Facility, entitling the lenders to accelerate any indebtedness outstanding under our Credit Facility at that time and to terminate our Credit Facility. Our and our subsidiaries’ future financing facilities may contain similar restrictions and provisions. Our failure to purchase such tendered Notes upon the occurrence of such Change of Control Repurchase Event would cause an event of default under the indenture governing the 2026 Notes and a cross-default under the agreements governing the Credit Facility, which may result in the acceleration of such indebtedness requiring us to repay that indebtedness immediately. If the holders of the 2026 Notes exercise their right to require us to repurchase
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Notes upon a Change of Control Repurchase Event, the financial effect of this repurchase could cause a default under our current and future debt instruments, and we may not have sufficient funds to repay any such accelerated indebtedness.
A downgrade, suspension or withdrawal of the credit rating assigned by a rating agency to us or the 2026 Notes or change in the debt markets could cause the liquidity or market value of the 2026 Notes to decline significantly.
Our credit ratings are an assessment by rating agencies of our ability to pay our debts when due. Consequently, real or anticipated changes in our credit ratings will generally affect the market value of the 2026 Notes. These credit ratings may not reflect the potential impact of risks relating to the structure or marketing of the 2026 Notes. Credit ratings are not a recommendation to buy, sell or hold any security, and may be revised or withdrawn at any time by the issuing organization in its sole discretion. Neither we nor the underwriter undertakes any obligation to maintain our credit ratings or to advise holders of Notes of any changes in our credit ratings. There can be no assurance that our credit ratings will remain for any given period of time or that such credit ratings will not be lowered or withdrawn entirely by the rating agencies if in their judgment future circumstances relating to the basis of the credit ratings, such as adverse changes in our Company, so warrant. The conditions of the financial markets and prevailing interest rates have fluctuated in the past and are likely to fluctuate in the future, which could have an adverse effect on the market prices of the 2026 Notes.
Item 1B. Unresolved Staff Comments
Not applicable.
Item 1C. Cybersecurity
Risk Management and Strategy
We have processes in place for assessing, identifying, and managing material risks from potential unauthorized occurrences on or through our electronic information systems that could negatively impact the confidentiality, integrity, or availability of our information systems or the information held on such systems. These processes include controls, procedures, systems and tools that are designed to prevent, detect, or mitigate data loss, theft, misuse, unauthorized access, or other security incidents or vulnerabilities affecting the data. Such processes are set forth in our joint Cybersecurity Policy, Written Information Security Policy and Incident Response Plan with Stellus Capital Management (collectively, the “Cybersecurity Policy”). The Cybersecurity Policy also sets forth the role of our Chief Compliance Officer and our Information Security Team in preparing, implementing, and maintaining incident response procedures.
Our Chief Compliance Officer and Information Security Team are responsible for the development and implementation of policies and technical measures to reasonably prevent security incidents. At times we may also engage assessors, consultants, auditors or other third parties to assist with assessing, identifying and managing cybersecurity risk. As part of our risk management process, we conduct assessment and penetration testing, including regular trainings completed by employees of Stellus Capital Management who provide services to us pursuant to the Administration Agreement.
Material Impact of Cybersecurity Risks
As of the date of this Annual Report on Form 10-K, we are not aware of any material risks from cybersecurity threats that have materially affected, or are reasonably likely to materially affect, us, including our business strategy, results of operations, or financial condition. However, future incidents could have a material impact on our business. Additional information about the cybersecurity risks that we face is discussed in Item 1A of Part I, “Risk Factors,” in this Annual Report on Form 10-K under the heading “We, Stellus Capital Management and our portfolio companies are subject to risks associated with “phishing” and other cyber-attacks.”
Oversight of Cybersecurity Risks
Our cybersecurity risks and associated mitigation strategies are evaluated by our management and the Information Security Team as needed, but no less frequently than annually. On at least a quarterly basis, the Information Security Team reports to our Board on developments to cybersecurity risks we face. Such reports include, among other things, an overview of the controls and procedures related to assessing, identifying, and managing risks related to cybersecurity threats, oversight of third-party service providers and related cybersecurity threats, and Information Security Team's evaluation of cybersecurity risks that are material to us.
Item 2. Properties
We do not own any real estate or other physical properties materially important to our operation. Our headquarters are located at 4400 Post Oak Parkway, Suite 2200, Houston, Texas. We also maintain offices in Charlotte, North Carolina and in the Washington, D.C. area. All locations are provided to us by Stellus Capital Management pursuant to the Administration Agreement. We believe that our office facilities are suitable and adequate for our business as we contemplate conducting it.
Item 3. Legal Proceedings
We, Stellus Capital Management or our subsidiaries are not currently subject to any material legal proceedings, nor, to our knowledge, is any material legal proceeding threatened against us, Stellus Capital Management or our subsidiaries. From time to time, we may be a 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 these legal proceedings cannot be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations.
Item 4. Mine Safety Disclosures
PART II
Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is traded on the NYSE under the symbol “SCM.” As of March 4, 2024, we had nine stockholders of record, which did not include stockholders for whom shares are held in nominee or street name.
We generally intend to pay distributions to our stockholders out of assets legally available for distribution. Our distributions and their frequency, if any, will be determined by our Board. From January 2014 through March 2020, we paid aggregate monthly distributions of $0.1133 per share on our common shares. For the period April 2020 through December 2020, we paid quarterly distributions of $0.25 per share on our common shares. For the period January 2021 through June 2021, we paid monthly distributions of $0.0833 per share on our common shares. For the period July 2021 through September 2021, we paid monthly distributions of $0.1000 per share on our common shares. For the period October 2021 through December 2021, we paid monthly distributions of $0.0933 per share on our common shares. For the period January 2022 through March 2022, we paid monthly distributions of $0.0933 per share on our common shares. For the period April 2022 through December 2023, we paid monthly distributions of $0.1133 per share on our common shares. Payment of dividends on our common shares is within the discretion of the Board, and depends on, among other factors, net earnings, capital requirements and our financial condition. However, we intend to continue to pay comparable dividends to stockholders in the future.
Recent Sales of Unregistered Securities
None.
Use of Proceeds from Recent Sales of Registered Securities
On November 16, 2021, the Company entered into an equity distribution agreement, as amended and restated on August 29, 2022 (the “2021 Equity Distribution Agreement”) with Keefe Bruyette & Woods, Inc. and Raymond James & Associates, Inc., as sales agents and/or principals thereunder. Under the 2021 Equity Distribution Agreement, the Company may issue and sell, from time to time, up to $50,000,000 in aggregate offering price of shares of our common stock, par value $0.001 per share, with the intention to use the net proceeds from this at-the-market sales program to repay certain outstanding indebtedness and make investments in portfolio companies in accordance with our investment objective and strategies.
On August 11, 2023, we entered into an equity distribution agreement (the “2023 Equity Distribution Agreement” and together with the 2021 Equity Distribution Agreement, the "Equity Distribution Agreements") with Keefe Bruyette & Woods, Inc. and Raymond James & Associates, Inc., as sales agents and/or principals thereunder. Under the Equity Distribution Agreement, we may issue and sell, from time to time, up to $100,000,000 in aggregate offering price of shares of our common stock, par value $0.001 per share, with the intention to use the net proceeds from this at-the-market sales program to repay certain outstanding indebtedness and make investments in portfolio companies in accordance with our investment objective and strategies. Upon execution of the 2023 Equity Distribution Agreement, we no longer sold any shares under the 2021 Equity Distribution Agreement. We refers to the issuance and sale of shares under the Equity Distribution Agreements as the "ATM Program".
In November 2021, we sold 31,592 shares of common stock through the ATM Program for net proceeds of $442,770, which was used to repay borrowings under the Credit Facility.
In March 2022, we sold 14,924 shares of common stock through the ATM Program for net proceeds of $205,870, which was used to repay borrowings under the Credit Facility.
In April 2022, we sold 13,416 shares of common stock through the ATM Program for net proceeds of $185,144, which was used to repay borrowings under the Credit Facility.
In November 2022, we sold 120,834 shares of common stock through the ATM Program for net proceeds of $1,648,854, which was used to repay borrowings under the Credit Facility.
In January 2023, we sold 33,812 shares of common stock through the ATM Program for net proceeds of $459,187, which was used to repay borrowings under the Credit Facility.
In March 2023, we sold 547,802 shares of common stock through the ATM Program for net proceeds of $7,832,670, which was used to repay borrowings under the Credit Facility.
In April 2023, we sold 587,363 shares of common stock through the ATM Program for net proceeds of $8,027,626, which was used to repay borrowings under the Credit Facility.
In May 2023, we sold 730,424 shares of common stock through the ATM Program for net proceeds of $10,471,012, which was used to repay borrowings under the Credit Facility.
In June 2023, we sold 991,734 shares of common stock through the ATM Program for net proceeds of $13,566,642, which was used to repay borrowings under the Credit Facility.
In August 2023, we sold 294,993 shares of common stock through the ATM Program for net proceeds of $4,092,986, which was used to repay borrowings under the Credit Facility.
In September 2023, we sold 1,272,745 shares of common stock through the ATM Program for net proceeds of $17,477,976, which was used to repay borrowings under the Credit Facility.
Purchases of Equity Securities
Dividend Reinvestment Plan
During the year ended December 31, 2023, as a part of our distribution reinvestment plan ("DRIP"), we purchased 152,097 shares of our common stock for an average price per share of $13.84 in the open market in order to satisfy the reinvestment portion of our dividends. The following chart outlines such purchases of our common stock during the year ended December 31, 2023:
Total Number
Average Price
of Shares
Paid Per
Period
Purchased
Share
January 1, 2023 – January 31, 2023
9,770
13.28
February 1, 2023 – February 28, 2023
9,956
15.61
March 1, 2023 – March 31, 2023
11,093
13.88
April 1, 2023 – April 30, 2023
11,986
13.73
May 1, 2023 – May 31, 2023
9,865
15.03
June 1, 2023 – June 30, 2023
10,586
13.93
July 1, 2023 – July 31, 2023
11,978
14.57
August 1, 2023 – August 31, 2023
16,490
14.29
September 1, 2023 – September 30, 2023
12,563
13.91
October 1, 2023 – October 31, 2023
15,894
13.34
November 1, 2023 – November 30, 2023
16,249
12.88
December 1, 2023 – December 31, 2023
15,667
12.77
Total
152,097
13.84
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Price Range of Common Stock
Our shares of common stock are traded on the NYSE under the symbol “SCM.” In connection with our initial public offering, our shares of common stock began trading on November 8, 2012, and before that date, there was no established trading market for shares of our common stock.
The following table sets forth, for each fiscal quarter of the three most recent fiscal years, the range of high and low closing prices of our common stock as reported on the NYSE and the sales price as a percentage of our net asset value (“NAV”).
Premium or
Discount of
NAV Per
Closing Sales Price(2)
High Sales
Low Sales
Fiscal Year Ended
Share(1)
High
Low
NAV(3)
Fourth quarter
13.26
12.34
3.54
(6.94)
Third quarter
13.19
15.27
13.60
15.77
3.11
Second quarter
13.67
15.00
13.64
9.73
(0.22)
First quarter
13.87
15.97
13.14
15.14
(5.26)
December 31, 2022
14.02
13.96
11.98
(0.43)
(14.55)
14.15
14.08
11.44
(0.49)
(19.15)
14.07
14.20
11.13
0.92
(20.90)
14.03
13.08
0.86
(6.77)
December 31, 2021
14.65
12.38
4.42
(11.76)
13.17
13.61
12.45
3.34
(5.47)
13.66
12.40
2.40
(7.05)
11.55
12.70
10.18
9.96
(11.86)
Shares of BDCs’ common stock may trade at a market price that is less than the value of the net assets attributable to those shares of common stock. The possibility that our shares of common stock will trade at a discount from NAV or at premiums that are unsustainable over the long term are separate and distinct from the risk that our NAV will decrease. Since our shares of common stock began trading on November 8, 2012, in connection with our initial public offering, our shares of common stock have traded at times at a discount to the net assets attributable to those shares of common stock.
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Stock Performance Graph
This graph compares the return on our shares of common stock with that of the Standard & Poor’s 500 Stock Index, the Russell 2000 Financial Services Index, and the Raymond James BDC Index, for the period from inception through December 31, 2023. The graph assumes that, at inception, a person invested $100 in each share of our common stock, the S&P 500 Index, the Russell 2000 Financial Services Index, and the Raymond James BDC Index. The graph measures total stockholder return, which takes into account both changes in stock price and dividends. It assumes that dividends paid are invested in like securities.
The graph and other information furnished under this Part II, Item 5 of this Annual Report on Form 10-K shall not be deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C, or to the liabilities of Section 18 of the Exchange Act. The stock price performance included in the above graph is not necessarily indicative of future stock price performance.
Item 6. [Reserved]
Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
Some of the statements in this Annual Report on Form 10-K constitute forward-looking statements, which relate to future events or our future performance or financial condition. The forward-looking statements contained in this Annual Report on Form 10-K involve risks and uncertainties, including statements as to:
Such forward-looking statements may include statements preceded by, followed by or that otherwise include the words “may,” “might,” “will,” “intend,” “should,” “could,” “can,” “would,” “expect,” “believe,” “estimate,” “anticipate,” “predict,” “potential,” “plan” or similar words.
We have based the forward-looking statements included in this Annual Report on Form 10-K on information available to us on the date of this Annual Report on Form 10-K. Actual results could differ materially from those anticipated in our forward-looking statements, and future results could differ materially from historical performance. We undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law or SEC rule or regulation. You are advised to consult any additional disclosures that we may make directly to you or through reports that we in the future may file with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.
Overview
We were organized as a Maryland corporation on May 18, 2012 and formally commenced operations on November 7, 2012. Our investment objective is to maximize the total return to our stockholders in the form of current income and capital appreciation through debt and related equity investments in middle-market companies.
We are an externally managed, non-diversified, closed-end investment company that has elected to be regulated as a BDC under the 1940 Act. Our investment activities are managed by our investment adviser, Stellus Capital Management.
As a BDC, we are required to comply with certain regulatory requirements. For instance, as a BDC, we must not acquire any assets other than “qualifying assets” specified in the 1940 Act unless, at the time the acquisition is made, at least 70% of our total assets are qualifying assets. Qualifying assets include investments in “eligible portfolio companies” (as defined in the 1940 Act). Under the relevant SEC rules, the term “eligible portfolio company” includes all private operating companies, operating companies whose securities are not listed on a national securities exchange, and certain public operating companies that have listed their securities on a national securities exchange and have a market capitalization of less than $250 million, in each case organized and with their principal place of business in the United States.
We have elected, qualified, and intend to continue to qualify annually to be treated for tax purposes as a RIC under Subchapter M of the Code. To maintain our qualification as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements. As of December 31, 2023, we were in compliance with the RIC requirements. As a RIC, we generally will not have to pay corporate-level U.S. federal income tax on any income we distribute to our stockholders.
Under the 1940 Act, we are allowed to incur a maximum asset coverage ratio of 150% if certain requirements are met, including the approval of a "required majority" (as such term is defined in Section 57(o) of the 1940 Act) of Board and the approval of our stockholders.
On April 4, 2018, the Board, including a “required majority” of the Board, approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. At our 2018 annual meeting of stockholders, our stockholders also approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. As a result, the asset coverage ratio applicable to us was decreased from 200% to 150%, effective June 29, 2018, which effectively increased the amount of leverage we may incur. As of December 31, 2023, our asset coverage ratio was 223%. The amount of leverage that we employ at any time depends on our assessment of the market and other factors at the time of any proposed borrowing.
Economic Developments
Economic activity has continued to accelerate across sectors and regions. Nonetheless, we have observed and continue to observe supply chain interruptions, labor resource shortages, commodity inflation, rising interest rates, bank impairments and failures, economic sanctions in response to international conflicts and instances of geopolitical, economic and financial market instability in the United States and abroad. One or more of these factors may contribute to increased market volatility and may have long- and short-term effects in the United States and worldwide financial markets.
Portfolio Composition and Investment Activity
We originate and invest primarily in private middle-market companies (typically those with $5.0 million to $50.0 million of EBITDA) through first lien (including unitranche), second lien, and unsecured debt financing, oftentimes with a corresponding equity investment.
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As of December 31, 2023, we had $874.5 million (at fair value) invested in 93 companies. As of December 31, 2023, our portfolio included approximately 89% of first lien debt (including unitranche investments), 2% of second lien debt, 1% of unsecured debt and 8% of equity investments at fair value. The composition of our investments at cost and fair value as of December 31, 2023 was as follows:
Fair Value
Senior Secured – First Lien(1)
793,819,152
774,789,320
Senior Secured – Second Lien
42,269,568
21,957,500
6,138,183
5,956,280
Equity
59,916,647
71,757,583
Total Investments
902,143,550
874,460,683
As of December 31, 2022, we had $844.7 million (at fair value) invested in 85 companies. As of December 31, 2022, our portfolio included approximately 87% of first lien debt (including unitranche investments), 5% of second lien debt, 1% of unsecured debt and 7% of equity investments at fair value. The composition of our investments at cost and fair value as of December 31, 2022 was as follows:
750,527,999
735,555,508
69,989,477
45,304,300
5,657,964
4,823,898
49,647,737
59,049,932
875,823,177
844,733,638
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 and conditions of the underlying loan agreements. As of December 31, 2023 and December 31, 2022, we had unfunded commitments of $37.0 million and $27.8 million, respectively, to provide debt financing for 57 and 52 portfolio companies, respectively. As of December 31, 2023, we had sufficient liquidity (through cash on hand and available borrowings under the Credit Facility) to fund such unfunded commitments should the need arise.
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The following is a summary of geographical concentration of our investment portfolio as of December 31, 2023:
% of Total
Investments at
Texas
182,531,256
175,311,724
20.04
California
175,207,692
167,713,589
19.18
Florida
93,155,844
92,297,574
10.55
Pennsylvania
49,939,315
50,188,102
5.74
Illinois
58,633,617
49,834,429
5.70
Arizona
42,136,322
44,558,279
5.10
Ohio
31,805,370
34,370,277
3.93
Colorado
31,525,420
30,971,079
Wisconsin
27,452,444
26,190,771
3.00
Washington
24,321,085
24,540,695
2.81
Georgia
9,100,050
18,885,409
2.16
16,676,194
16,718,728
1.91
New York
14,692,043
14,931,263
1.71
Indiana
14,235,403
14,488,700
1.66
North Carolina
13,891,930
14,532,532
District of Columbia
13,030,899
14,006,563
1.60
New Jersey
10,461,226
11,191,295
1.28
Michigan
10,664,100
10,736,783
1.23
Massachusetts
10,151,621
10,515,487
1.20
Tennessee
9,390,657
9,379,311
1.07
Missouri
8,862,512
8,850,162
1.01
Canada
8,700,383
8,813,132
Idaho
8,405,946
8,470,065
0.97
Minnesota
5,976,818
5,907,639
0.68
Louisiana
5,538,823
5,536,231
0.63
South Carolina
4,946,375
5,083,862
0.58
United Kingdom
20,710,205
437,002
0.05
100.00
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The following is a summary of geographical concentration of our investment portfolio as of December 31, 2022:
191,422,143
171,165,597
20.26
167,833,384
165,340,017
19.57
60,593,839
59,421,775
7.03
64,421,998
53,218,615
6.30
43,129,283
44,277,625
5.24
42,899,504
41,889,344
4.96
34,223,452
37,333,236
28,978,375
28,480,471
3.37
25,395,054
25,140,343
2.98
27,533,402
24,271,761
2.87
17,236,556
21,124,347
2.50
10,919,642
19,692,757
2.33
19,089,373
18,654,782
2.21
16,824,077
16,576,554
1.96
16,972,086
15,952,072
1.89
20,530,087
14,445,481
15,204,934
14,295,470
1.69
14,346,082
14,245,432
13,333,737
13,266,669
1.57
10,461,551
10,649,232
1.26
10,215,356
10,527,659
1.25
9,873,093
9,863,103
1.17
9,142,111
9,656,287
1.14
5,096,152
5,096,008
0.61
147,906
149,001
0.02
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The following is a summary of industry concentration of our investment portfolio as of December 31, 2023:
Services: Business
198,018,290
207,963,749
23.78
Healthcare & Pharmaceuticals
100,724,952
102,915,887
11.77
High Tech Industries
90,795,799
91,992,012
10.52
Media: Advertising, Printing & Publishing
57,640,321
58,741,061
6.72
Consumer Goods: Non-Durable
63,145,301
52,938,611
6.05
Beverage, Food, & Tobacco
42,554,582
45,074,817
5.15
Consumer Goods: Durable
49,046,730
43,725,324
5.00
Capital Equipment
32,517,673
33,879,801
3.87
Services: Consumer
33,976,976
33,260,111
3.80
Construction & Building
30,319,119
30,486,411
3.49
Aerospace & Defense
46,745,104
24,541,921
Environmental Industries
24,219,811
22,997,844
2.63
Media: Broadcasting & Subscription
17,952,103
20,760,920
2.37
Transportation & Logistics
17,235,150
17,661,859
2.02
Chemicals, Plastics, & Rubber
18,338,366
17,569,176
2.01
Metals & Mining
16,580,562
16,625,000
1.90
Containers, Packaging, & Glass
17,432,252
15,539,555
1.78
Utilities: Oil & Gas
9,943,041
10,000,000
Education
10,251,179
8,367,469
0.96
FIRE: Real Estate
17,285,138
6,175,994
0.71
Media: Diversified & Production
5,662,174
5,763,247
0.66
Finance
569,039
5,736,868
Hotel, Gaming, & Leisure
—
890,968
0.10
Energy: Oil & Gas
1,189,888
852,078
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The following is a summary of industry concentration of our investment portfolio as of December 31, 2022:
207,234,534
218,866,572
25.91
86,469,854
88,103,319
10.43
52,830,447
52,525,839
6.22
54,683,102
51,280,593
6.07
45,601,928
44,529,176
5.27
48,137,394
39,526,086
4.68
Software
37,582,855
37,975,255
4.50
33,538,647
33,801,951
4.00
34,000,918
32,755,054
3.88
26,948,135
26,406,849
3.13
27,771,798
26,247,936
43,302,101
24,616,706
2.92
18,615,052
21,445,307
2.54
18,487,206
17,903,999
2.12
16,768,763
17,161,972
2.03
16,708,750
16,464,001
1.95
17,436,600
13,977,250
1.65
Retail
13,303,536
13,217,256
1.56
14,126,954
12,648,347
1.50
Automotive
11,252,581
11,342,751
1.34
11,057,921
10,498,760
1.24
9,921,469
9,800,000
1.16
7,314,230
7,355,074
0.87
15,642,093
5,866,397
0.69
5,517,409
5,534,710
1,568,900
4,082,579
0.48
799,899
0.09
At December 31, 2023, our average portfolio company investment at amortized cost and fair value was approximately $9.7 million and $9.4 million, respectively, and our largest portfolio company investment at amortized cost and fair value was approximately $21.7 million and $18.9 million, respectively. At December 31, 2022, our average portfolio company investment at amortized cost and fair value was approximately $10.3 million and $9.9 million, respectively, and our largest portfolio company investment at amortized cost and fair value was approximately $20.4 million and $21.1 million, respectively.
At December 31, 2023, 98% of our debt investments bore interest based on floating rates (subject to interest rate floors), such as SOFR, and 2% bore interest at fixed rates. At December 31, 2022, 97% of our debt investments bore interest based on floating rates (subject to interest rate floors), such as LIBOR, and 3% bore interest at fixed rates.
The weighted average yield on all of our debt investments as of December 31, 2023 and December 31, 2022 was approximately 11.9% and 11.1%, respectively. The weighted average yield on all of our investments, including non-income producing equity positions, as of December 31, 2023 and December 31, 2022 was approximately 11.1% and 10.4%, respectively. The weighted average yield was computed using the effective interest rates for all of our debt investments, including accretion of OID. The weighted average yield of our debt investments is not the same as a return on investment for our stockholders, but rather relates to a portion of our investment portfolio and is calculated before the payment of all of our subsidiaries’ fees and expenses.
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As of December 31, 2023 and December 31, 2022, we had cash and cash equivalents of $26.1 million and $48.0 million, respectively, the majority of which was held in our SBIC subsidiaries.
Investment Activity
During the year ended December 31, 2023, we made $190.9 million of investments in 18 new portfolio companies and 28 existing portfolio companies. During the year ended December 31, 2023, we received an aggregate of $141.3 million in proceeds from repayments of our investments.
During the year ended December 31, 2022, we made $211.0 million of investments in 22 new portfolio companies and 28 existing portfolio companies. During the year ended December 31, 2022, we received an aggregate of $127.5 million in proceeds from repayments of our investments.
Our level of investment activity can vary substantially from period to period depending on many factors, including the amount of debt and equity capital to middle-market companies, the level of merger and acquisition activity, the general economic environment and the competitive environment for the types of investments we make.
In addition to various risk management and monitoring tools, Stellus Capital Management uses an investment rating system to characterize and monitor the credit profile and expected level of returns on each investment in our portfolio. This investment rating system uses a five-level numeric scale. The following is a description of the conditions associated with each investment category:
The following is a summary of asset quality ratings of our investment portfolio as of December 31, 2023 and December 31, 2022:
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As of December 31, 2023
As of December 31, 2022
(dollars in millions)
Number of
Portfolio
Investment Category
Companies(1)
Companies
214.1
146.6
535.3
553.2
107.2
120.7
18.3
6.8
5.9
100
844.7
85
Loans and Debt Securities on Non-Accrual Status
We will not accrue interest on loans and debt securities if we have reason to doubt our ability to collect such interest. As of December 31, 2023, we had loans to four portfolio companies that were on non-accrual status, which represented approximately 4.2% of our loan portfolio at cost and 1.3% at fair value. As of December 31, 2022, we had loans to three portfolio companies that were on non-accrual status, which represented approximately 5.2% of our loan portfolio at cost and 2.3% at fair value. As of December 31, 2023 and December 31, 2022, $7.5 million and $4.8 million of income from investments on non-accrual had not been accrued, respectively.
Results of Operations
An important measure of our financial performance is net increase (decrease) in net assets resulting from operations, which includes net investment income (loss), net realized gain (loss) and net unrealized appreciation (depreciation). Net investment income (loss) is the difference between our income from interest, dividends, fees and other investment income and our operating expenses including interest on borrowed funds. Net realized gain (loss) on investments is the difference between the proceeds received from dispositions of portfolio investments and their amortized cost. Net unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio.
Comparison of the Years Ended December 31, 2023, 2022, and 2021
Revenues
We generate revenue in the form of interest income on debt investments and capital gains and distributions, if any, on investment securities that we may acquire in portfolio companies. Our debt investments typically have a term of five to seven years and bear interest at primarily floating rates. Interest on our debt securities is generally payable quarterly. Payments of principal on our debt investments may be amortized over the stated term of the investment, deferred for several years or due entirely at maturity. In some cases, our debt investments may pay PIK interest. Any outstanding principal amount of our debt securities and any accrued but unpaid interest will generally become due at the maturity date. The level of interest income we receive is directly related to the balance of interest-bearing investments multiplied by the weighted average yield of our investments. We expect that the total dollar amount of interest and any dividend income that we earn will increase as the size of our investment portfolio increases. In addition, we may generate revenue in the form of prepayment fees, commitment, loan origination, structuring or due diligence fees, fees for providing significant managerial assistance and consulting fees.
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The following shows the breakdown of investment income for the years ended December 31, 2023, 2022, and 2021 (in millions).
For the year ended
Interest income(1)
96.9
70.8
60.7
PIK interest
3.8
1.4
0.9
Miscellaneous fees(1)
5.1
2.9
2.1
105.8
75.1
63.7
The increase in interest income from the year ended December 31, 2022 to the year ended December 31, 2023 was due primarily to growth in the overall investment portfolio and rising interest rates. The increase in interest income from the year ended December 31, 2021 to the year ended December 31, 2022 was due primarily to growth in the overall investment portfolio and rising interest rates.
Expenses
Our primary operating expenses include the payment of fees to Stellus Capital Management under the Investment Advisory Agreement, our allocable portion of overhead expenses under the Administration Agreement and other operating costs described below. We bear all other out-of-pocket costs and expenses of our operations and transactions, which may include:
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The following shows the breakdown of operating expenses for the years ended December 31, 2023, 2022, and 2021 (in millions).
Operating Expenses
Management fees
15.5
14.8
13.2
Valuation fees
0.4
0.3
Administrative services expenses
1.9
1.8
Income incentive fees
10.2
3.0
Capital gains incentive (reversal) fee
(0.6)
(2.8)
Professional fees
1.1
Directors’ fees
Insurance expense
0.5
Interest expense and other fees
32.0
24.5
18.7
Income tax expense
1.3
1.2
Other general and administrative expenses
1.0
Total Operating Expenses
63.9
46.5
43.9
Income incentive fee waiver
(0.3)
Total Operating Expenses, net of fee waivers
63.6
The increase in operating expenses for the year ended December 31, 2023 as compared to the year ended December 31, 2022 was due to (1) higher interest expense as a result of higher outstanding balances on our SBA-guaranteed debentures, as well as rising interest rates, (2) higher management fees due to a larger investment portfolio and (3) higher incentive fees due to portfolio performance. The increase in operating expenses for the year ended December 31, 2022 as compared to the year ended December 31, 2021 was due to (1) higher interest expense as a result of higher outstanding balances on our SBA-guaranteed debentures, as well as rising interest rates, (2) higher management fees due to a larger investment portfolio and (3) higher incentive fees due to portfolio performance.
Net Investment Income
For the year ended December 31, 2023, net investment income was $42.2 million, or $1.92 per common share based on 22,004,648 weighted-average common shares outstanding. For the year ended December 31, 2022, net investment income was $28.6 million, or $1.46 per common share based on 19,552,931 weighted-average common shares
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outstanding. For the year ended December 31, 2021, net investment income was $19.8 million, or $1.01 per common share based on 19,489,750 weighted-average common shares outstanding.
Net investment income for the year ended December 31, 2023 increased compared to the year ended December 31, 2022 as a result of growth in the overall investment portfolio and rising interest rates, offset by higher operating expenses as explained in the “Expenses” section above.
Net investment income for the year ended December 31, 2022 increased compared to the year ended December 31, 2021 as a result of growth in the overall investment portfolio and rising interest rates, offset by higher operating expenses as explained in the “Expenses” section above.
Net Realized Gains and Losses
We measure realized gains or losses by the difference between the net proceeds from the repayment, sale or other disposition and the amortized cost basis of the investment, using the specific identification method, without regard to unrealized appreciation or depreciation previously recognized.
Proceeds from repayments of investments and amortization of certain other investments for the year ended December 31, 2023 totaled $141.3 million and net realized losses totaled $30.3 million. Net realized losses during the year ended December 31, 2023 resulted primarily from losses from the realization of our debt investments in certain portfolio companies, partially offset from gains from the realization of our equity investments. Proceeds from repayments of investments and amortization of certain other investments for the year ended December 31, 2022 totaled $127.5 million resulting in net realized gains totaling $3.7 million, primarily from gains from the realization of our equity investments in certain portfolio companies, offset by dispositions of loans in our portfolio. Proceeds from repayments of investments and amortization of certain other investments for the year ended December 31, 2021 totaled $287.6 million resulting in net realized gains totaling $23.7 million, primarily from gains from the realization of our equity investments in certain portfolio companies.
Net Change in Unrealized Appreciation (Depreciation) of Investments
Net change in unrealized appreciation (depreciation) primarily reflects the change in portfolio investment values during the reporting period, including the reversal of previously recorded appreciation or depreciation when gains or losses are realized.
Net change in unrealized appreciation (depreciation) on investments and cash equivalents, including foreign currency translations, for the year ended December 31, 2023, 2022, and 2021 totaled $2.8 million, ($17.5) million, and ($6.9) million, respectively.
The change in unrealized appreciation in 2023 was primarily due to realizations on investments previously written down. The change in unrealized depreciation in 2022 was primarily due to write downs on specific investments. The change in unrealized depreciation in 2021 was primarily due to realizations on equity investments previously written up.
(Provision) Benefit for Taxes on Unrealized (Appreciation) Depreciation on Investments
We have direct wholly owned subsidiaries that have elected to be treated as corporations for U.S. federal income tax purposes (the “Taxable Subsidiaries”), and as a result, the income of the Taxable Subsidiaries is subject to U.S. federal income tax at corporate rates. The Taxable Subsidiaries permit us to hold equity investments in portfolio companies which are “pass through” entities for U.S. federal income tax purposes and continue to comply with the “source income” requirements contained in RIC tax provisions of the Code. The Taxable Subsidiaries are not consolidated with us for U.S. federal income tax purposes and may generate U.S. federal income tax expense, benefit, and the related tax assets and liabilities, as a result of their ownership of certain portfolio investments. The U.S. federal income tax expense, or benefit, if any, and related tax assets and liabilities are reflected in our Consolidated Financial Statements.
For the years ended December 31, 2023, 2022 and 2021, we recognized a deferred tax (provision) benefit related to unrealized appreciation on certain equity investments for income tax at our Taxable Subsidiaries of approximately ($127.0) thousand, ($213.2) thousand, and $510.9 thousand, respectively.
For the years ended December 31, 2023 and 2021, we recognized tax benefit (expense) related to losses (gains) realized on certain debt (equity) investments held at our Taxable Subsidiaries of $3.0 million and ($3.0) million, respectively. There was no such tax expense for the year ended December 31, 2022. As of December 31, 2023, a tax receivable related to the tax benefit on realized losses of $1.6 million was included on the Consolidated Statement of Assets and Liabilities. As of December 31, 2023 and 2022, a deferred tax liability of $188.9 thousand and $61.9 thousand, respectively, was included in Consolidated Statement of Assets and Liabilities.
Net Increase in Net Assets Resulting from Operations
Net increase in net assets resulting from operations totaled $17.5 million, or $0.80 per common share based on weighted-average common shares of 22,004,648 outstanding for the year ended December 31, 2023, $14.5 million, or $0.74 per common share based on weighted-average common shares of 19,552,931 outstanding for the year ended December 31, 2022, and $33.6 million, or $1.72 per common share based on weighted-average common hares of 19,489,750 outstanding for the year ended December 31, 2021.
The net increase in net assets resulting from operations for the year ended December 31, 2023 as compared to the year ended December 31, 2022 was primarily due to an increase in net investment income, offset by realized losses. The net decrease in net assets resulting from operations for the year ended December 31, 2022 as compared to the year ended December 31, 2021 was primarily due to unrealized losses, offset by realized gains.
Financial Condition, Liquidity and Capital Resources
Cash Flows from Operating and Financing Activities
Our operating activities used net cash of $17.3 million for the year ended December 31, 2023, primarily in connection with the purchase of portfolio investments, offset by sales and repayments of portfolio investments. Our financing activities for the year ended December 31, 2023 used cash of $4.7 million primarily from stockholder distibutions and net payments on our Credit Facility, offset by proceeds from our ATM Program.
Our operating activities used net cash of $56.3 million for the year ended December 31, 2022, primarily in connection with the purchase of portfolio investments, offset by sales and repayments of portfolio investments. Our financing activities for the year ended December 31, 2022 provided cash of $60.2 million primarily from proceeds from SBA-guaranteed debentures and net borrowings on our Credit Facility.
Our operating activities used net cash of $76.1 million for the year ended December 31, 2021, primarily in connection with the purchase of portfolio investments, offset by sales and repayments of portfolio investments. Our financing activities for the year ended December 31, 2021 provided cash of $101.8 million primarily from proceeds from the 2026 Notes issuance, SBA-guaranteed debentures, and net borrowings on our Credit Facility.
Liquidity and Capital Resources
Our liquidity and capital resources are derived from the Credit Facility, 2026 Notes, offerings of our common stock, SBA-guaranteed debentures and cash flows from operations, including investment sales and repayments, and income earned. Our primary use of funds from operations includes investments in portfolio companies and other operating expenses we incur, as well as the payment of dividends to the holders of our common stock. We used, and expect to continue to use, these capital resources as well as proceeds from turnover within our portfolio and from public and private offerings of securities to finance our investment activities. Although we expect to fund the growth of our investment portfolio through the net proceeds from future public and private equity offerings and issuances of senior securities or future borrowings to the extent permitted by the 1940 Act, our plans to raise capital may not be successful. In this regard, if our common stock trades at a price below our then-current net asset value per share, we may be limited
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in our ability to raise equity capital given that we cannot sell our common stock at a price below net asset value per share unless our stockholders approve such a sale and our Board makes certain determinations in connection therewith. A proposal, approved by our stockholders at our 2023 annual stockholders meeting, authorizes us to sell up to 25% of our outstanding common shares at a price equal to or below the then current net asset value per share in one or more offerings. This authorization will expire on the earlier of June 22, 2024, the one-year anniversary of our 2023 annual stockholders meeting, or our 2024 annual stockholders meeting. We would need similar future approval from our stockholders to issue shares below the then current net asset value per share any time after the expiration of the current approval. In addition, we intend to distribute between 90% and 100% of our taxable income to our stockholders in order to satisfy the requirements applicable to RICs under Subchapter M of the Code. Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio companies or to repay borrowings. In addition, the illiquidity of our portfolio investments may make it difficult for us to sell these investments when desired and, if we are required to sell these investments, we may realize significantly less than their recorded value.
Also, as a BDC, we generally are required to meet an asset coverage coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, over the aggregate amount of our senior securities, which includes all of our borrowings and any outstanding preferred stock, of at least 150% effective June 29, 2018 (at least 200% prior to June 29, 2018). This requirement limits the amount that we may borrow. We have received exemptive relief from the SEC to permit us to exclude the debt of the SBIC subsidiaries guaranteed by the SBA from the definition of senior securities in the asset coverage test under the 1940 Act. We were in compliance with the asset coverage ratio requirements at all times. As of December 31, 2023 and December 31, 2022, our asset coverage ratio was 223% and 192%, respectively. The amount of leverage that we employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing, such as the maturity, covenant package and rate structure of the proposed borrowings, our ability to raise funds through the issuance of shares of our common stock and the risks of such borrowings within the context of our investment outlook. Ultimately, we only intend to use leverage if the expected returns from borrowing to make investments will exceed the cost of such borrowing. As of December 31, 2023 and December 31, 2022, we had cash and cash equivalents of $26.1 million and $48.0 million, respectively.
Credit Facility
On October 11, 2017, we entered into a senior secured revolving credit agreement, as amended, dated as of October 10, 2017, that was amended and restated on December 21, 2021, February 28, 2022, May 13, 2022 and November 21, 2023, with Zions Bancorporation, N.A., dba Amegy Bank and various other lenders.
The Credit Facility provides for borrowings up to a maximum of $260.0 million on a committed basis with an accordion feature that allows us to increase the aggregate commitments up to $350.0 million, subject to new or existing lenders agreeing to participate in the increase and other customary conditions.
Pursuant to the Third Amendment and Commitment Increase to the Amended and Restated Senior Secured Revolving Credit Agreement, the Credit Facility will bear interest, subject to our election, on a per annum basis equal to (i) term SOFR plus 2.50% (or 2.75% during certain periods in which our asset coverage ratio is equal to or below 1.90 to 1.00) plus a SOFR credit spread adjustment (0.10% for one-month term SOFR and 0.15% for three-month term SOFR), with a 0.25% SOFR floor, or (ii) 1.50% (or 1.75% during certain periods in which the our asset coverage ratio is equal to or below 1.90 to 1.00) plus an alternate base rate based on the highest of the prime rate (subject to a 3% floor), Federal Funds Rate plus 0.50% and one-month term SOFR plus 1.00%. We pay unused commitment fees of 0.50% per annum on the unused lender commitments under the Credit Facility. Interest is payable monthly or quarterly in arrears. The commitment to fund the revolver expires on November 21, 2027, after which we may no longer borrow under the Credit Facility and must begin repaying principal equal to 1/12 of the aggregate amount outstanding under the Credit Facility each month. Any amounts borrowed under the Credit Facility will mature, and all accrued and unpaid interest thereunder will be due and payable, on November 21, 2028.
Our obligations to the lenders are secured by a first priority security interest in our portfolio of securities and cash not held at the SBIC subsidiaries, but excluding short term investments. The Credit Facility contains certain covenants, including but not limited to: (i) maintaining a minimum liquidity test of at least $10.0 million, including cash, liquid
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investments and undrawn availability, (ii) maintaining an asset coverage ratio of at least 1.67 to 1.00, (iii) maintaining a minimum stockholder’s equity, and (iv) maintaining a minimum interest coverage ratio of at least 1.75 to 1.00. As of December 31, 2023, we were in compliance with these covenants.
As of December 31, 2023 and December 31, 2022, the outstanding balance under the Credit Facility was $160.1 million and $199.2 million, respectively. The carrying amount of the amount outstanding under the Credit Facility approximates its fair value. The fair value of the Credit Facility is determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The fair value of the Credit Facility is estimated based upon market interest rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any. We have incurred costs of $6.6 million in connection with the current Credit Facility, which were capitalized and are being amortized over the life of the facility. Additionally, $0.3 million of costs from a prior credit facility will continue to be amortized over the life of the Credit Facility. As of December 31, 2023 and 2022, $3.5 million and $1.5 million of such prepaid loan structure fees and administration fees had yet to be amortized, respectively. These prepaid loan fees are presented on our Consolidated Statement of Assets and Liabilities as a deduction from the debt liability attributable to the Credit Facility.
Interest is paid monthly or quarterly in arrears. The following table summarizes the interest expense and amortized loan fees on the Credit Facility for the years ended December 31, 2023, 2022, and 2021 (dollars in millions):
Interest expense
14.7
9.2
5.2
Loan fee amortization
0.6
Total interest and financing expenses
15.4
9.8
5.8
Weighted average interest rate
7.9
4.4
2.8
Effective interest rate (including fee amortization)
8.3
4.8
3.3
Average debt outstanding
186.1
204.3
176.9
Cash paid for interest and unused fees
14.5
9.0
5.3
SBA-guaranteed debentures
Due to the SBIC subsidiaries’ status as licensed SBICs, we can issue debentures guaranteed by the SBA at favorable interest rates. Under the regulations applicable to SBIC funds, a single licensee can have outstanding SBA-guaranteed debentures, subject to a regulatory leverage limit, up to two times the amount of regulatory capital. As of both December 31, 2023 and 2022, the SBIC I subsidiary had $75.0 million in “regulatory capital”, as such term is defined by the SBA. As of both December 31, 2023 and 2022, the SBIC II subsidiary had $87.5 million in regulatory capital.
On August 12, 2014, we obtained exemptive relief from the SEC to permit us to exclude the SBA-guaranteed debentures from our asset coverage test under the 1940 Act. The exemptive relief provides us with increased flexibility under the asset coverage test by permitting us to borrow up to $325.0 million more than we would otherwise be able to absent the receipt of this exemptive relief.
On a stand-alone basis, the SBIC subsidiaries held $485.2 million and $470.7 million in assets at December 31, 2023 and 2022, respectively, which accounted for approximately 53.4% and 52.4% of our total consolidated assets at December 31, 2023 and 2022, respectively.
SBA-guaranteed debentures have fixed interest rates that equal prevailing 10-year Treasury Note rates plus a market spread and have a maturity of ten years with interest payable semi-annually. The principal amount of the SBA-guaranteed debentures is not required to be paid before maturity but may be pre-paid at any time with no prepayment penalty. As of December 31, 2023 and 2022, the SBIC subsidiaries had $325.0 million and $250.0 of the SBA-guaranteed debentures outstanding, respectively. SBA-guaranteed debentures drawn before October 1, 2019 incur upfront fees of 3.425%, which consists of a 1.00% commitment fee and a 2.425% issuance discount, which are amortized over the life of the SBA-guaranteed debentures. SBA-guaranteed debentures drawn after October 1, 2019
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incur upfront fees of 3.435%, which consists of a 1.00% commitment fee and a 2.435% issuance discount, which are amortized over the life of the SBA-guaranteed debentures. Once pooled, which occurs in March and September of each applicable year, the SBA-guaranteed debentures bear interest at a fixed rate that is set to the current 10-year treasury rate plus a spread at each pooling date.
As of December 31, 2023, the carrying amount of the SBA-guaranteed debentures was $320.3 million. At the measurement date, the estimated fair value of the SBA-guaranteed debentures as prepared for disclosure purposes was $293.2 million. As of December 31, 2022, the carrying amount of the SBA-guaranteed debentures approximated their fair value. The fair value of the SBA-guaranteed debentures is determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The fair value of the SBA-guaranteed debentures is estimated based upon market interest rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any. At December 31, 2023 and 2022, the SBA-guaranteed debentures would be deemed to be Level 3, as defined in Note 6 to our Consolidated Financial Statements.
As of December 31, 2023 and 2022, we have incurred $11.1 million and $10.9 million in financing costs related to the SBA-guaranteed debentures since the SBIC subsidiaries have received their licenses, respectively, which were recorded as prepaid loan fees. As of December 31, 2023 and 2022, $4.7 million and $5.7 million of prepaid financing costs had yet to be amortized, respectively. These prepaid loan fees are presented on the Consolidated Statement of Assets and Liabilities as a deduction from the debt liability.
The following table summarizes the interest expense and amortized fees on the SBA-guaranteed debentures for the years ended December 31, 2023, 2022, and 2021 (dollars in millions):
10.0
6.4
Debenture fee amortization
11.3
9.4
7.5
3.2
3.5
318.8
288.2
227.8
Cash paid for interest
9.6
7.4
Notes Offering
On August 21, 2017, we issued $42.5 million in aggregate principal amount of 5.75% fixed-rate notes due September 15, 2022 (the “2022 Notes”). On September 8, 2017, we issued an additional $6.4 million in aggregate principal amount of the 2022 Notes pursuant to a full exercise of the underwriters’ overallotment option. On January 13, 2021, we caused notices to be issued to the holders of our 2022 Notes regarding our exercise of our option to redeem all of the issued and outstanding 2022 Notes, pursuant to the Second Supplemental Indenture dated as of August 21, 2017, between us and U.S. Bank National Association, as trustee. We redeemed all $48.9 million in aggregate principal amount of the 2022 Notes on February 12, 2021. The 2022 Notes were redeemed at 100% of their principal amount, plus the accrued and unpaid interest thereon through the redemption date. As a result of the redemption, we recognized a loss on debt extinguishment of $0.5 million due to the write off of the remaining deferred financing costs on the 2022 Notes. This loss is included in the Consolidated Statement of Operations for the year ended December 31, 2021.
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The following table summarizes the interest expense and deferred financing costs on the 2022 Notes for the year ended December 31, 2021 (in millions):
Deferred financing costs
0.1
Loss on extinguishment of debt(1)
Weighted average interest rate(2)
5.7
Effective interest rate (including fee amortization)(2)
Average debt outstanding(3)
48.9
On January 14, 2021, we issued $100.0 million in aggregate principal amount of the 2026 Notes. The 2026 Notes will mature on March 30, 2026 and may be redeemed in whole or in part at any time or from time to time at our option on or after December 31, 2025 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest. Interest on the 2026 Notes is payable semi-annually beginning September 30, 2021.
We used the net proceeds from the 2026 Notes offering to fully redeem the 2022 Notes and repay a portion of the amount outstanding under the Credit Facility.
Prior to their redemption on February 12, 2021, the 2022 Notes were listed on New York Stock Exchange under the trading symbol “SCA”. The 2026 Notes are institutional, non-traded notes. As of December 31, 2023, the carrying amount of the 2026 Notes was $99.0 million. At the measurement date, the estimated fair value of the 2026 Notes as prepared for disclosure purposes was $93.0 million.
In connection with the issuance and maintenance of the 2026 Notes, we incurred $2.3 million of fees, which are being amortized over the term of the 2026 Notes. As of December 31, 2023 and December 31, 2022, $1.0 million and $1.5 million remained to be amortized, respectively. These financing costs are presented on the Consolidated Statement of Assets and Liabilities as a deduction from the debt liability.
The following table summarizes the interest expense and deferred financing costs on the 2026 Notes for the years ended December 31, 2023, 2022, and 2021 (in millions):
For the years ended
4.9
4.7
%(1)
100.0
(1)
90
Contractual Obligations
2029 and
2024
2025
2026
2027
2028
thereafter
(in millions)
Credit Facility payable
160.1
13.3
146.7
2026 Notes payable
325.0
26.0
39.0
82.5
177.5
585.1
139.0
229.2
Off-Balance Sheet Arrangements
We may be a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our portfolio companies. As of December 31, 2023, our only off-balance sheet arrangements consisted of $36.7 million of unfunded commitments to provide debt financing to 56 existing portfolio companies and $0.3 million in unfunded equity commitments to one existing portfolio company. As of December 31, 2022, our only off-balance sheet arrangements consisted of $27.5 million of unfunded commitments to provide debt financing to 52 existing portfolio companies and $0.3 million in unfunded equity commitments to one existing portfolio company. As of December 31, 2023, we had sufficient liquidity (through cash on hand and available borrowings under the Credit Facility) to fund such unfunded commitments should the need arise.
RIC Status and Dividends
We have elected, qualified, and intend to continue to qualify annually to be treated for U.S. federal income tax purposes as a RIC under Subchapter M of the Code. So long as we maintain our qualification as a RIC, we will not be subject to U.S. federal income tax on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders as dividends on a timely basis.
Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation until realized. Distributions declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital.
To qualify for RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company net taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any). If we maintain our qualification as a RIC, we must also satisfy certain distribution requirements each calendar year to avoid a U.S. federal excise tax on our undistributed earnings of a RIC. As of December 31, 2023, we had $37.0 million of undistributed taxable income that will be carried forward toward distributions paid during the year ending December 31, 2024. As of December 31, 2022, we had $28.6 million of undistributed taxable income that was carried forward toward distributions paid during the year ending December 31, 2023.
We intend to distribute to our stockholders between 90% and 100% of our annual taxable income (which includes our taxable interest and fee income). However, the covenants contained in the Credit Facility may prohibit us from making distributions to our stockholders, and, as a result, could hinder our ability to satisfy the Annual Distribution Requirement. In addition, we may retain for investment some or all our net taxable capital gains (i.e., realized net long-term capital gains in excess of realized net short-term capital losses) and treat such amounts as deemed distributions to our stockholders. If we do this, our stockholders will be treated as if they received actual distributions of the capital gains we retained and then reinvested the net after-tax proceeds in shares of our common stock. Our stockholders also may be eligible to claim tax credits (or, in certain circumstances, tax refunds) equal to their allocable share of the tax we paid on the capital gains deemed distributed to them. To the extent our taxable earnings for a fiscal taxable year fall
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below the total amount of our dividends for that fiscal year, a portion of those dividend distributions may be deemed a return of capital to our stockholders.
We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a BDC under the 1940 Act and due to provisions in the Credit Facility. We cannot assure stockholders that they will receive any distributions or distributions at a particular level.
In accordance with certain applicable U.S. Treasury regulations and private letter rulings issued by the Internal Revenue Service (the “IRS”), a publicly offered RIC may treat a distribution of its own stock as fulfilling its RIC distribution requirements if each stockholder may elect to receive his or her entire distribution in either cash or stock of the RIC, subject to a limitation that the aggregate amount of cash to be distributed to all stockholders must be at least 20% of the aggregate declared distribution. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a pro rata amount of cash (with the balance of the distribution paid in shares of our common stock). In no event will any stockholder, electing to receive cash, receive less than 20% of his or her entire distribution in cash, except as described below.
If these and certain other requirements are met, for U.S. federal income tax purposes, the amount of the dividend paid in shares of our common stock will be equal to the amount of cash that could have been received instead of stock. We have no current intention of paying dividends in shares of our common stock in accordance with these U.S. Treasury regulations or private letter rulings. However, we continue to monitor the Company’s liquidity position and the overall economy and will continue to assess whether it would be in our and our stockholders’ best interest to take advantage of the IRS rulings.
Recent Accounting Pronouncements
See Note 1 to the Consolidated Financial Statements contained herein for a description of recent accounting pronouncements, if any, including the expected dates of adoption and the anticipated impact on the financial statements.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Changes in the economic environment, financial markets and any other parameters used in determining such estimates could cause actual results to differ materially.
For a description of our critical accounting policies, see Note 1, “Summary of Significant Accounting Policies” to our Consolidated Financial Statements included in this report. We consider the most significant accounting policies to be those related to our Valuation of Portfolio Investments and Revenue Recognition.
Investment Portfolio Valuation
The most significant determination inherent in the preparation of our Consolidated Financial Statements is the valuation of our investment portfolio and the related amounts of unrealized appreciation and depreciation. We consider this determination to be a critical accounting estimate, given the significant judgments and subjective measurements required. As of December 31, 2023 and 2022, our investment portfolio valued at fair value represented approximately 96% and 94% of our total assets, respectively. We are required to report our investments at fair value. We follow the provisions of ASC 820. ASC 820 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure requirements for fair value measurements. ASC 820 requires us to assume that the portfolio investment is to be sold in the principal market to independent market participants, which may be a hypothetical market. Market participants are defined as buyers and
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sellers in the principal market that are independent, knowledgeable and willing and able to transact. See Note 1 to the Consolidated Financial Statements contained herein for a detailed discussion of our investment portfolio valuation process and procedures.
Due to the inherent uncertainty in the valuation process, our determination of fair value for our investment portfolio may differ materially from the values that would have been determined had a ready market for the securities existed. In addition, changes in the market environment, portfolio company performance and other events that may occur over the lives of the investments may cause the gains or losses ultimately realized on these investments to be materially different than the valuations currently assigned. We determine the fair value of each individual investment and record changes in fair value as unrealized appreciation or depreciation.
We believe our investment portfolio as of December 31, 2023 and 2022 approximates fair value as of those dates based on the markets in which we operate and other conditions in existence on those reporting dates.
Subsequent Events
Investment Portfolio
We invested in the following portfolio companies subsequent to December 31, 2023:
Activity Type
Date
Company Name
Company Description
Investment Amount
Instrument Type
Add-On Investment
January 5, 2024
Whisps Holdings LP*
Manufacturer of cheese-based snacks
75,192
January 8, 2024
EH Real Estate Services, LLC*
Offers residential property brokerage, title & settlement, and property and casualty insurance brokerage services to home buyers and sellers
475,233
Senior Secured – First Lien
January 9, 2024
Morgan Electrical Group Intermediate Holdings, Inc.*
Provider of commercial electrical services
23,531
January 12, 2024
Impact Home Services LLC*
Residential garage door, electrical, and plumbing services provider
50,914
January 31, 2024
22,331
February 7, 2024
Unicat Catalyst Holdings, LLC*
Manufacturer and distributor of catalysts and other industrial products
7,032
February 28, 2024
Monitorus Holding, LLC*
Provider of media monitoring and evaluation services
13,290
Existing portfolio company
We realized an investment in following portfolio company subsequent to December 31, 2023:
Proceeds Received
Full Repayment
Peltram Plumbing Holdings, LLC*
Provider of plumbing solutions.
16,160,003
The outstanding balance of our the Credit Facility as of March 4, 2024 was $148.5 million.
SBA-guaranteed Debentures
The outstanding balance under SBA-guaranteed debentures as of March 4, 2024 was $325.0 million.
Dividend Declared
On January 13, 2024, our Board declared a regular monthly distribution for each of January, February and March 2024 as follows:
Ex-Dividend
Record
Payment
Amount per
Declared
1/13/2024
1/30/2024
1/31/2024
2/15/2024
0.1333
2/28/2024
2/29/2024
3/15/2024
3/28/2024
3/29/2024
4/15/2024
Item 7A.Quantitative and Qualitative Disclosures About Market Risk
We are subject to financial market risks, including changes in interest rates. In connection with the COVID-19 pandemic, the U.S. Federal Reserve (the “Federal Reserve”) and other central banks had reduced certain interest rates. However, in March 2022, the Federal Reserve raised interest rates for the first time since December 2018, and subsequently raised interest rates several times, most recently in July 2023, bringing the target for the federal funds rate to 5.25% - 5.50%, the highest since January 2001. As of December 31, 2023 and December 31, 2022, 98% and 97% of the loans in our portfolio bore interest at floating rates, respectively. These floating rate loans typically bear interest in reference to SOFR, which is indexed to 30-day or 90-day SOFR rates, subject to an interest rate floor. As of December 31, 2023 and December 31, 2022, the weighted average interest rate floor on our floating rate loans was 1.26% and 1.07%, respectively.
On July 1, 2023, the publication of all LIBOR settings as representative rates has ceased. As of December 31, 2023, we have facilitated an orderly transition of our LIBOR-based investments to SOFR.
Assuming that the Consolidated Statement of Assets and Liabilities as of December 31, 2023 were to remain constant and no actions were taken to alter the existing interest rate sensitivity, the following table shows the annual impact on net income of changes in interest rates:
Interest
Net Interest
Change in Basis Points(2)
Income
Expense(3)
Income(1)
Up 200 basis points
15.9
(3.2)
12.7
Up 150 basis points
11.9
(2.4)
9.5
Up 100 basis points
8.0
(1.6)
Up 50 basis points
4.0
(0.8)
Down 50 basis points
(4.0)
0.8
Down 100 basis points
(8.0)
1.6
(6.4)
Down 150 basis points
(11.9)
2.4
(9.5)
Down 200 basis points
(15.9)
(12.7)
Although we believe that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of the assets on the balance sheet and other business developments that could affect net increase in net assets resulting from operations. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by this estimate. We may hedge against interest rate fluctuations by using standard hedging instruments such as futures, options and forward contacts subject to the requirements of the 1940 Act. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in the benefits of lower interest rates with respect to our portfolio of investments. For the years ended December 31, 2023 and 2022, we did not engage in interest rate hedging activities.
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Item 8.Financial Statements and Supplementary Data
Index to Financial Statements
Page
Report of Independent Registered Public Accounting Firm (Grant Thornton LLP, Dallas, Texas, PCAOB ID Number 248)
97
Statements of Assets and Liabilities as of December 31, 2023 and December 31, 2022
99
Statements of Operations for the years ended December 31, 2023, 2022, and 2021
Statements of Changes in Net Assets for the years ended December 31, 2023, 2022, and 2021
101
Statements of Cash Flows for the years ended December 31, 2023, 2022, and 2021
102
Schedule of Investments as of December 31, 2023 and December 31, 2022
103
Notes to Financial Statements
128
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders Stellus Capital Investment Corporation
Opinion on the financial statements
We have audited the accompanying consolidated statements of assets and liabilities of Stellus Capital Investment Corporation (a Maryland corporation) and subsidiaries (the “Company”), including the consolidated schedule of investments, as of December 31, 2023 and 2022, the related consolidated statements of operations, changes in net assets and cash flows for each of the three years in the period ended December 31, 2023, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2023 and 2022, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2023, in conformity with accounting principles generally accepted in the United States of America.
Basis for opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our procedures included verification by confirmation of securities as of December 31, 2023 and 2022, by correspondence with portfolio companies or agents, or by other appropriate auditing procedures where replies were not received. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical audit matter
The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Fair value of investments
As described further in Note 6 to the financial statements, the Company had investments in portfolio companies with a fair value of $874,460,683. Investment values are based on prices or valuation techniques that require inputs that are significant and unobservable. The determination of fair value also requires management judgement. As such, we identified fair value of investments as a critical audit matter.
The principal considerations for our determination that the fair value of investments is a critical audit matter are that the assets are valued using unobservable inputs, which are considered level 3 in nature under the valuation hierarchy of US GAAP. In addition, investments at fair value is material to the financial statements, and there is a high level of judgement in determining the fair value. As a result, obtaining sufficient appropriate audit evidence related to the fair value measurement required significant auditor judgement.
Our audit procedures related to the fair value of investments included the following, among others.
In testing the inputs/assumptions above, we considered available third-party market information, current economic conditions, and client specific source information.
/s/ GRANT THORNTON LLP
We have served as the Company’s auditor since 2012.
Dallas, Texas March 4, 2024
98
PART I — FINANCIAL INFORMATION
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
ASSETS
Control investments at fair value (amortized cost of $17,285,138 and $0, respectively)
Non-controlled, non-affiliated investments, at fair value (amortized cost of $884,858,412 and $875,823,177, respectively)
868,284,689
Cash and cash equivalents
26,125,741
48,043,329
Receivable for sales and repayments of investments
371,877
718,794
Interest receivable
4,882,338
3,984,409
Income tax receivable
1,588,708
Other receivables
42,995
34,245
Deferred offering costs
7,312
1,100
Prepaid expenses
606,674
667,267
Total Assets
908,086,328
898,182,782
LIABILITIES
98,996,412
98,549,692
156,564,776
197,685,281
320,273,358
307,895,195
Management fees payable
2,918,536
7,150,407
Income incentive fees payable
2,885,180
2,464,408
Capital gains incentive fees payable
569,528
Interest payable
5,241,164
4,640,841
Related party payable
1,060,321
Unearned revenue
397,725
320,675
Administrative services payable
402,151
356,919
Income tax payable
1,175,373
Deferred tax liability
188,893
61,936
Other accrued expenses and liabilities
278,345
475,593
Total Liabilities
588,146,540
622,406,169
Commitments and contingencies (Note 7)
Net Assets
319,939,788
275,776,613
NET ASSETS
Common stock, par value $0.001 per share (100,000,000 shares authorized; 24,125,642 and 19,666,769 issued and outstanding, respectively)
24,125
19,667
Paid-in capital
335,918,984
275,114,720
Total distributable (loss) earnings
(16,003,321)
642,226
Total Liabilities and Net Assets
Net Asset Value Per Share
CONSOLIDATED STATEMENTS OF OPERATIONS
INVESTMENT INCOME
From control investments:
Interest income
37,897
From non-controlled, non-affiliated investments
101,978,891
72,964,999
61,536,686
Other income
3,830,780
2,147,577
2,142,308
Total Investment Income
105,847,568
75,112,576
63,678,994
OPERATING EXPENSES
15,452,347
14,848,174
13,169,606
373,628
351,752
313,437
1,908,191
1,810,576
1,798,966
10,189,888
3,782,151
3,043,470
(569,528)
(2,818,623)
2,867,131
1,455,372
1,103,693
1,082,917
406,000
329,000
315,000
492,596
503,907
482,140
32,011,317
24,469,285
18,721,058
1,333,452
1,161,668
1,102,374
891,170
984,309
1,006,428
63,944,433
46,525,892
43,902,527
(307,442)
63,636,991
42,210,577
28,586,684
19,776,467
Net realized loss on non-controlled, non-affiliated investments
(30,211,467)
3,660,595
23,710,167
Net realized loss on foreign currency translation
(112,481)
(6,091)
Loss on debt extinguishment
(539,250)
Net change in unrealized depreciation on control investments
(430,577)
Net change in unrealized appreciation (depreciation) on non-controlled, non-affiliated investments
3,222,729
(17,542,230)
(6,928,160)
Net change in unrealized (depreciation) appreciation on foreign currency translation
(6,504)
6,040
(Provision) benefit for taxes on net unrealized (appreciation) depreciation on investments
(126,957)
(213,214)
510,868
Benefit (provision) for taxes on net realized loss (gain) on investments
2,987,847
(2,957,220)
17,533,167
14,491,784
33,572,872
Net Investment Income Per Share—basic and diluted
1.92
1.46
Net Increase in Net Assets Resulting from Operations Per Share – basic and diluted
0.80
0.74
1.72
Weighted Average Shares of Common Stock Outstanding—basic and diluted
22,004,648
19,552,931
19,489,750
Distributions Per Share—basic and diluted
1.61
1.30
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
Number
Par
Paid-in
distributable
of shares
value
capital
(loss) earnings
Balances as of December 31, 2020
19,486,003
19,486
276,026,667
(2,685,504)
273,360,649
Net investment income
Net realized gain on investments
Net change in unrealized depreciation on investments
Benefit for taxes on unrealized depreciation on investments
Provision for taxes on realized gain on investments
Return of capital and other tax related adjustments
(1,861,213)
1,861,213
Distributions from net investment income
(21,201,567)
Distributions from net realized capital gains
(1,014,420)
Issuance of common stock, net of offering costs(1)
31,592
393,667
393,699
Balances at December 31, 2021
19,517,595
19,518
274,559,121
10,532,594
285,111,233
Net change in unrealized appreciation on foreign currency translations
Provision for taxes on unrealized appreciation on investments
(1,040,884)
1,040,884
(21,633,343)
(3,789,693)
149,174
149
1,596,483
1,596,632
Balances at December 31, 2022
19,666,769
Net realized loss on investments
Net change in unrealized appreciation on investments
2,792,152
Net change in unrealized depreciation on foreign currency translations
Benefit for taxes on realized loss on investments
(1,348,766)
1,348,766
(35,080,734)
(446,746)
4,458,873
4,458
62,153,030
62,157,488
Balances at December 31, 2023
24,125,642
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities
Net increase in net assets resulting from operations
Adjustments to reconcile net increase in net assets from operations to net cash used in operating activities:
Purchases of investments
(183,858,762)
(211,010,869)
(387,281,160)
Proceeds from sales and repayments of investments
134,223,224
127,548,194
287,639,512
Net change in unrealized (appreciation) depreciation on investments
(2,792,152)
17,542,230
6,928,160
Net change in unrealized depreciation (appreciation) on foreign currency translations
6,360
(5,897)
Increase in investments due to PIK
(3,799,843)
(1,357,177)
(939,030)
Amortization of premium and accretion of discount, net
(2,749,543)
(2,519,462)
(2,412,991)
Deferred tax provision (benefit)
126,957
213,214
(510,868)
Amortization of loan structure fees
657,323
567,375
518,930
Amortization of deferred financing costs
446,720
446,719
444,153
Amortization of loan fees on SBA-guaranteed debentures
1,255,753
1,227,952
1,088,132
Net realized loss (gain) on investments
30,211,467
(3,660,595)
(23,703,499)
539,250
Changes in other assets and liabilities
Increase in interest receivable
(897,929)
(1,039,810)
(755,151)
Increase in income tax receivable
(1,588,708)
(Increase) decrease in other receivables
(8,750)
20,507
(29,257)
Decrease (increase) in prepaid expenses
60,593
(155,053)
(25,026)
(Decrease) increase in management fees payable
(4,231,871)
3,696,182
628,903
Increase in income incentive fees payable
420,772
715,278
1,067,470
(Decrease) increase in capital gains incentive fees payable
2,867,130
Increase (decrease) in administrative services payable
45,232
(29,449)
(5,123)
Increase in interest payable
600,323
947,179
1,549,577
(Decrease) increase in related party payable
(1,060,321)
Increase (decrease) in unearned revenue
77,050
(209,051)
6,302
(Decrease) increase in income tax payable
(1,175,373)
(2,094,141)
2,544,749
(Decrease) increase in other accrued expenses and liabilities
(197,248)
136,635
164,227
Net Cash Used in Operating Activities
(17,265,087)
(56,286,557)
(76,102,738)
Cash flows from Financing Activities
Proceeds from the issuance of common stock
63,348,436
2,158,540
449,515
Sales load for common stock issued
(943,248)
(31,066)
(2,489)
Offering costs paid for common stock issued
(253,913)
(517,054)
(53,327)
Stockholder distributions paid
(35,527,480)
(26,594,095)
(21,044,928)
Repayment of Notes
(48,875,000)
Proceeds from issuance of Notes
100,000,000
Financing costs paid on Notes
(2,237,835)
Proceeds from SBA-guaranteed debentures
11,400,000
63,600,000
73,500,000
Financing costs paid on SBA-guaranteed debentures
(277,590)
(1,548,660)
(3,139,725)
Financing costs paid on Credit facility
(2,663,106)
(193,635)
(136,219)
Borrowings under Credit Facility
108,400,000
149,888,800
268,700,000
Repayments of Credit Facility
(148,135,600)
(126,607,800)
(265,360,000)
Partial share redemption
Net Cash (Used) Provided by Financing Activities
(4,652,501)
60,155,030
101,799,992
Net (Decrease) Increase in Cash and Cash Equivalents
(21,917,588)
3,868,473
25,697,254
Cash and Cash Equivalents Balance at Beginning of Period
44,174,856
18,477,602
Cash and Cash Equivalents Balance at End of Period
Supplemental and Non-Cash Activities
Cash paid for interest expense
29,051,198
21,280,060
15,099,656
Income and excise tax paid
2,508,825
3,255,809
1,445,000
(Decrease) increase in distributions payable
(1,171,059)
1,171,059
Increase (decrease) in deferred offering costs
6,212
(13,788)
(75,112)
Gain on conversion of equity investment
6,668
Exchange of investments
3,610,846
CONSOLIDATED SCHEDULE OF INVESTMENTS
Principal
% of
Investment
Headquarters/
Amount/
Amortized
Fair
Net
Investments
Footnotes
Security(2)
Coupon
Floor
Cash
PIK
Maturity
Industry
Shares(3)
Value(1)
Assets
Control investments (23)
(4)(5)
EH Real Estate Services, LLC
(22)
Skokie, IL
Term Loan A-1 (SBIC)
(4)(16)
1st Lien
10.00
-
9/3/2021
9/3/2026
5,337,200
5,255,564
3,042,204
0.95
Term Loan A-2 (SBIC)
4/3/2023
1,140,558
650,118
0.20
Term Loan A-2
(16)
570,279
325,059
Term Loan A-3 (SBIC)
6/7/2023
392,910
223,959
0.07
Term Loan A-3
196,455
111,979
0.04
Term Loan A-4 (SBIC)
7/12/2023
1,003,691
993,654
0.31
Term Loan A-4
501,846
496,828
0.16
Revolver
10/3/2023
332,190
EH Holdco, LLC Common Units
15,356
0.00
EH Holdco, LLC Series A Preferred Units
7,892
7,891,642
1.93
Total Control investments
Non-control, non-affiliated investments
2X LLC
(9)
Berwyn, PA
Term Loan
(11)
3M SOFR+
6.50
2.00
11.85
6/5/2023
6/5/2028
5,486,458
5,361,018
5,431,593
1.70
10/31/2023
1,444,767
1,409,607
1,430,319
0.45
2X Investors LP Class A Units
58,949
589,496
644,844
7,360,121
7,506,756
2.35
Ad.Net Acquisition, LLC
Los Angeles, CA
Term Loan (SBIC II)
(5)(11)
6.00
1.00
11.61
5/7/2021
5/7/2026
15,198,529
15,079,548
4.75
649,510
Ad.Net Holdings, Inc. Series A Common Stock (SBIC II)
(5)
7,794
77,941
58,566
Ad.Net Holdings, Inc. Series A Preferred Stock (SBIC II)
7,015
701,471
527,094
16,508,470
16,433,699
5.13
AdCellerant LLC
Denver, CO
Term A Loan (SBIC II)
1M SOFR+
11.35
12/12/2023
12/12/2028
9,802,403
3.06
AdCellerant Holdings, LLC Series A Units
728,710
0.23
10,531,113
3.29
ADS Group Opco, LLC
Lakewood, CO
6.75
12.20
6/4/2021
6/4/2026
14,250,000
14,095,019
14,178,750
4.43
100,000
99,500
0.03
ADS Group Topco, LLC Class A Units
77,626
288,691
ADS Group Topco, LLC Class B Units
56,819
211,309
ADS Group Topco, LLC Class Y Units
4/11/2023
23,859
88,733
112,626
ADS Group Topco, LLC Class Z Units
6/15/2022
72,043
267,929
15,051,681
14,390,876
Advanced Barrier Extrusions, LLC
Rhinelander, WI
Term Loan B (SBIC)
(4)(11)
7.50
11/30/2020
11/30/2026
16,975,000
16,789,930
15,447,250
4.83
GP ABX Holdings Partnership, L.P. Partner Interests
8/8/2018
644,737
528,395
GP ABX Holdings Partnership, L.P. Series B Preferred Interests
1/5/2023
1,139
113,927
92,305
4.86
American Refrigeration, LLC
Jacksonville, FL
Term Loan (SBIC)
6.25
11.60
3/31/2023
3/31/2028
8,213,610
8,031,788
2.57
AR-USA Holdings, LLC Class A Units
141
141,261
220,296
8,173,049
8,433,906
2.64
Amika OpCo LLC
Brooklyn, NY
6M SOFR+
5.25
0.75
10.87
7/1/2022
7/1/2029
94,638
93,031
93,218
5.75
11.24
12/5/2023
9,705,893
9,513,799
9,560,305
2.99
Ishtar Co-Invest-B LP Partnership Interests
(6)
77,778
42,813
200,675
0.06
Oshun Co-Invest-B LP Partnership Interests
22,222
57,335
9,671,865
9,911,533
3.10
Anne Lewis Strategies, LLC
Washington, DC
7.00
12.35
3/5/2021
5/9/2028
9,189,074
9,098,232
9,005,293
4/15/2022
2,867,632
2,833,029
2,810,279
0.88
SG AL Investment, LLC Common Units
1,000
606,733
1,205,165
0.38
SG AL Investment, LLC Common-A Units
12/22/2023
239
492,905
985,826
4.38
APE Holdings, LLC
Deer Park, TX
Class A Units
9/5/2014
375,000
49,816
Atmosphere Aggregator Holdings II, L.P.
Atlanta, GA
Common Units
1/26/2016
254,250
2,471,396
0.77
Stratose Aggregator Holdings, L.P. Common Units
6/30/2015
750,000
7,290,252
2.28
9,761,648
3.05
ArborWorks, LLC
(21)
Oakhurst, CA
(11)(17)
11/6/2023
11/6/2028
3,461,538
3,184,615
924,871
850,881
0.27
ArborWorks Intermediate Holdco, LLC Class A-1 Preferred Units
16,037
3,610,847
2,695,747
0.84
ArborWorks Intermediate Holdco, LLC Class B-1 Preferred Units
ArborWorks Intermediate Holdco, LLC Class A-1 Common Units
1,923
7,997,256
6,731,243
2.11
Archer Systems, LLC
Houston, TX
CF Arch Holdings LLC Class A Units
8/10/2022
151,447
Axis Portable Air, LLC
Phoenix, AZ
11.25
3/22/2022
3/22/2028
9,500,000
9,357,284
2.97
4/17/2023
1,893,610
1,859,720
0.59
Delayed Draw Term Loan
99,199
Axis Air Parent, LLC Preferred Units
4,436
443,636
1,039,036
0.32
11,759,839
12,532,646
3.91
Baker Manufacturing Company, LLC
Evansville, IN
(5)(10)(12)
11.42
7/5/2022
7/5/2027
13,701,636
13,491,633
13,633,128
4.26
BSC Blue Water Holdings, LLC Series A Units (SBIC II)
743,770
855,572
4.53
BLP Buyer, Inc.
BL Products Parent, L.P. Class A Units
2/1/2022
879,060
983,608
1,322,224
0.41
Café Valley, Inc.
7.24
12.59
8/28/2019
8/28/2025
15,548,810
15,499,968
CF Topco LLC Units
9,160
916,015
1,148,854
0.36
16,415,983
16,697,664
5.22
Camp Profiles LLC
Boston, MA
10.75
10,019,375
9,901,621
CIVC VI-A 829 Blocker, LLC Units
250
250,000
496,112
104
CEATI International Inc.
(7)(9)
Montreal, Canada
2/19/2021
2/19/2026
8,532,718
8,450,383
2.67
CEATI Holdings, LP Class A Units
280,414
2.76
Cerebro Buyer, LLC
Columbia, SC
12.21
3/15/2023
3/15/2029
4,647,205
4,542,323
1.45
Cerebro Holdings Partnership, L.P. Series A Partner Interests
62,961
68,042
Cerebro Holdings Partnership, L.P. Series B Partner Interests
341,091
368,615
0.12
1.59
CF512, Inc.
Blue Bell, PA
11.57
9/1/2021
9/1/2026
13,911,253
13,747,760
13,772,140
4.30
11.54
3,003,933
2,985,566
2,973,894
0.93
StellPen Holdings, LLC Membership Interests
220,930
209,747
16,954,256
16,955,781
5.30
Channel Partners Intermediateco, LLC
Tampa Bay, FL
12.66
2/24/2022
2/7/2027
13,253,232
13,163,476
13,054,434
4.08
3/27/2023
1,689,882
1,675,663
1,664,534
0.52
12.60
33,333
32,833
0.01
14,872,472
14,751,801
4.61
CompleteCase, LLC
Seattle, WA
12.00
12/21/2020
12/21/2025
6,676,113
6,616,263
6,642,732
2.08
16,667
16,584
CompleteCase Holdings, Inc. Class A Common Stock (SBIC II)
417
CompleteCase Holdings, Inc. Series A Preferred Stock (SBIC II)
522
521,734
398,991
CompleteCase Holdings, Inc. Class A Common Stock
4/27/2023
CompleteCase Holdings, Inc. Series C Preferred Stock
111
111,408
85,199
7,266,078
7,143,511
2.24
Compost 360 Acquisition, LLC
Tampa, FL
11.89
8/2/2023
8/2/2028
9,595,100
9,369,680
9,403,198
2.94
32,666
Compost 360 Investments, LLC Class A Units
2,508
250,761
226,512
9,653,774
9,662,376
3.02
COPILOT Provider Support Services, LLC
Maitland, FL
11/22/2022
11/22/2027
4,937,500
4,855,637
1.54
12.02
20,000
QHP Project Captivate Blocker, Inc. Common Stock
285,714
282,009
5,161,351
5,239,509
1.64
Craftable Intermediate II Inc.
Dallas, TX
6/30/2023
6/30/2028
10,083,715
9,897,128
9,982,878
3.12
Gauge Craftable LP Partnership Interests
626,690
727,010
10,523,818
10,709,888
3.35
Curion Holdings, LLC
Chicago, IL
12.25
7/29/2022
7/29/2027
12,896,751
12,700,039
12,703,300
3.97
98,500
SP CS Holdings LLC Class A Units
739,999
901,644
0.28
13,540,038
13,703,444
4.28
Dresser Utility Solutions, LLC
Bradford, PA
2nd Lien
8.50
10/1/2018
4/1/2026
105
DRS Holdings III, Inc.
St. Louis, MO
11.71
11/1/2019
11/1/2025
8,894,635
2.77
DTE Enterprises, LLC
Roselle, IL
DTE Holding Company, LLC Class A-2 Units
4/13/2018
776,316
466,204
DTE Holding Company, LLC Class AA Units
723,684
EHI Buyer, Inc.
Grand Prarie, TX
Term A Loan (SBIC)
7/31/2023
7/31/2029
6,096,064
5,950,980
5,974,143
1.87
EHI Group Holdings, L.P. Class A Units
618
617,801
630,082
6,568,781
6,604,225
2.07
Elliott Aviation, LLC
Moline, IL
8.00
11.51
1/31/2020
6/30/2025
8,536,150
8,495,851
8,023,981
2.51
Unsecured
10/26/2023
1/31/2026
56,794
42,596
Revolver A
1,410,357
1,325,736
SP EA Holdings LLC Class A Units
1,048,896
901,489
10,864,491
9,392,313
2.93
EOS Fitness Holdings, LLC
Class A Preferred Units
12/30/2014
118
Class B Common Units
3,017
Equine Network, LLC
Boulder, CO
12.11
5/22/2023
5/22/2028
5,936,305
5,799,443
5,906,623
1.85
83,333
82,916
59,850
59,551
5,942,626
6,049,090
evolv Consulting, LLC
12.13
12/7/2023
12/7/2028
9,802,352
evolv Holdco, LLC Preferred Units
473,485
0.15
10,275,837
3.21
Evriholder Acquisition, Inc.
Anaheim, CA
1/23/2023
1/24/2028
12,756,250
12,482,481
3.99
KEJ Holdings LP Class A Units
873,333
1,070,891
0.33
13,355,814
13,827,141
4.32
Exacta Land Surveyors, LLC
(19)
Cleveland, OH
2/8/2019
2/8/2024
16,316,361
16,303,438
15,174,216
4.74
7/15/2022
991,806
989,698
922,380
0.29
SP ELS Holdings LLC Class A Units
1,122,250
172,674
18,415,386
16,269,270
5.08
Exigo, LLC
11.46
3/16/2022
3/16/2027
8,811,898
8,720,761
2.75
Gauge Exigo Coinvest, LLC Common Units
377,535
9,098,296
9,189,433
Florachem Corporation
4/29/2022
4/29/2028
9,850,000
9,698,462
9,751,500
23,333
23,100
53,750
53,213
SK FC Holdings, L.P. Class A Units
362
362,434
465,212
10,137,979
10,293,025
3.23
106
General LED OPCO, LLC
San Antonio, TX
9.00
14.45
5/1/2018
3/31/2026
4,500,000
4,472,890
4,342,500
1.36
Green Intermediateco II, Inc.
Irvine, CA
8/8/2023
8/8/2028
11,142,326
10,880,445
10,919,479
3.41
408,127
403,154
399,964
0.13
Green Topco Holdings, LLC Class A Units
271,401
272,055
11,555,000
11,591,498
3.63
GS HVAM Intermediate, LLC
Carlsbad, CA
11.96
10/18/2019
4/2/2025
12,394,128
12,370,361
1,803,030
0.56
HV GS Acquisition, LP Class A Interests
10/2/2019
2,144
1,967,133
4,703,284
1.47
16,140,524
18,900,442
5.90
Health Monitor Holdings, LLC
Montvale, NJ
Series A Preferred Units
5/15/2019
1,105,838
1,052,919
1,348,494
0.42
Heartland Business Systems, LLC
Little Chute, WI
11.75
8/26/2022
8/26/2027
9,875,000
9,721,122
3.09
49,625
49,197
AMCO HBS Holdings, LP Class A Units
2,861
249,873
726,591
10,020,192
10,651,216
HV Watterson Holdings, LLC
Schaumburg, IL
11.50
12/17/2021
12/17/2026
13,167,870
12,998,250
13,036,191
4.07
80,000
79,200
319,869
317,522
316,670
HV Watterson Parent, LLC Class A Units
1,632
1,631,591
2,154,608
0.67
15,027,363
15,586,669
I2P Holdings, LLC
1/31/2018
3,341,856
1.04
ICD Holdings, LLC
(7)
San Francisco, CA
1/2/2018
9,962
449,758
1,710,337
0.53
Impact Home Services LLC
4/28/2023
4/28/2028
5,907,215
5,774,440
5,818,607
1.82
10/11/2023
538,369
525,461
530,293
0.17
268,510
262,321
264,482
0.08
82,500
81,263
Impact Holdings Georgia LLC Class A Units
324
324,242
213,311
6,968,964
6,907,956
2.17
Infolinks Media Buyco, LLC
Ridgewood, NJ
11.21
11/1/2021
11/1/2026
7,613,871
7,519,532
2.38
1,477,575
1,464,619
0.46
Tower Arch Infolinks Media, LP LP Interests
(6)(15)
10/28/2021
451,688
424,156
751,355
9,408,307
9,842,801
3.07
Informativ, LLC
Fresno, CA
7/30/2021
7/30/2026
8,481,549
8,386,574
8,396,734
2.62
3/31/2022
6,393,699
6,312,673
6,329,762
1.98
Credit Connection Holdings, LLC Series A Units
804,384
1,044,566
15,503,631
15,771,062
4.93
107
Inoapps Bidco, LLC
Term Loan B
3M SONIA+
11.12
2/15/2022
2/15/2027
£
13,176,385
12,352,226
3.86
11.22
40,000
39,800
11.39
82,292
81,689
81,881
Inoapps Holdings, LLC Series A-1 Preferred Units
739,844
783,756
928,462
14,081,830
13,402,369
4.19
Integrated Oncology Network, LLC
Newport Beach, CA
7/17/2019
6/24/2025
15,689,031
15,652,169
15,453,696
1,086,000
1,081,580
1,069,710
11.53
554,070
545,759
17,287,819
17,069,165
5.33
Intuitive Health, LLC
Plano, TX
5.50
12.19
10/18/2027
5,771,920
5,718,925
1.80
(10)(12)
8,117,989
8,043,856
8/31/2021
3,040,324
3,009,699
Legacy Parent, Inc. Class A Common Stock
10/30/2020
213,240
16,772,480
17,143,473
5.36
Invincible Boat Company LLC
Opa Locka, FL
5,356,627
5,321,375
5,303,061
4,944,579
4,911,947
4,895,133
1.53
6/1/2021
1,099,244
1,089,662
1,088,252
0.34
531,915
526,596
Warbird Parent Holdco, LLC Class A Units
1,362,575
1,299,691
1,184,219
0.37
13,154,590
12,997,261
4.06
J.R. Watkins, LLC
(4)
12/22/2017
3/31/2024
13,597,208
4,894,995
J.R. Watkins Holdings, Inc. Class A Preferred Stock
1,133
1,132,576
14,729,784
Jurassic Acquisition Corp.
Sparks, MD
10.96
12/28/2018
11/15/2024
5.20
KidKraft, Inc.
(10)(12)(18)
PRIME+
4/3/2020
6/30/2024
1,580,768
KidKraft Group Holdings, LLC Preferred B Units
4,000,000
5,580,768
Ledge Lounger, Inc.
Katy, TX
Term Loan A (SBIC)
11/9/2021
11/9/2026
7,491,842
7,398,788
2.34
75,000
SP L2 Holdings LLC Class A Units (SBIC)
(6)(4)
242,696
7,848,788
7,809,538
2.44
Lightning Intermediate II, LLC
11.93
6/6/2022
6/6/2027
13,243,091
13,048,737
13,044,445
30,000
29,550
Gauge Vimergy Coinvest, LLC Units
399
391,274
128,766
13,470,011
13,202,761
4.13
MacKenzie-Childs Acquisition, Inc.
Aurora, NY
9/2/2022
9/2/2027
98,750
97,591
98,256
46,667
46,434
MacKenzie-Childs Investment, LP Partnership Interests
96,532
244,258
241,222
108
Madison Logic Holdings, Inc.
New York, NY
12/30/2022
12/30/2028
4,495,248
4,381,153
4,450,296
1.39
BC Partners Glengarry Co-Investment LP Class 1 Interests
7/7/2023
394,767
328,212
4,775,920
4,778,508
1.49
Michelli, LLC
New Orleans, LA
12/21/2023
12/21/2028
5,000,000
4,900,000
129,608
127,016
SP MWM Holdco LLC Class A Units
509,215
1.73
Microbe Formulas LLC
Meridian, ID
4/4/2022
4/3/2028
2.65
MOM Enterprises, LLC
Richmond, CA
6.48
11.83
5/19/2021
5/19/2026
16,055,000
15,884,362
15,814,175
4.94
50,000
49,250
MBliss SPC Holdings, LLC Units
933,333
595,832
0.19
16,867,695
16,459,257
Monitorus Holding, LLC
London, UK
14.00
5/24/2022
5/24/2027
100,989
100,260
99,979
€
109,791
108,693
101,929
100,910
Sapphire Aggregator S.a r.l. Convertible Bonds
11/15/2023
3/31/2025
5,532
5,938
6,045
Sapphire Aggregator S.a r.l. Class A Shares
9/1/2022
557,689
11,156
13,487
Sapphire Aggregator S.a r.l. Class B Shares
557,682
13,486
Sapphire Aggregator S.a r.l. Class C Shares
Sapphire Aggregator S.a r.l. Class D Shares
Sapphire Aggregator S.a r.l. Class E Shares
Sapphire Aggregator S.a r.l. Class F Shares
Sapphire Aggregator S.a r.l. Class G Shares
Sapphire Aggregator S.a r.l. Class H Shares
Sapphire Aggregator S.a r.l. Class I Shares
418,322
Morgan Electrical Group Intermediate Holdings, Inc.
Fremont, CA
8/3/2023
8/3/2029
4,439,439
4,344,311
4,372,847
1.37
Morgan Electrical Group Holdings, LLC Series A-2 Preferred Units
357
356,800
351,351
0.11
4,701,111
4,724,198
1.48
Naumann/Hobbs Material Handling Corporation II, Inc.
12.10
8/30/2019
8/30/2024
8,317,483
8,291,166
8,275,896
2.59
5,245,036
5,228,576
5,218,811
1.63
Naumann Hobbs Holdings, L.P. Class A-1 Units
9/29/2022
123
220,379
471,147
Naumann Hobbs Holdings, L.P. Class A-2 Units
13,960,500
14,437,001
4.52
NINJIO, LLC
Westlake Village, CA
10/12/2022
10/12/2027
4,962,500
4,882,796
1.55
NINJIO Holdings, LLC Units
184
313,253
226,849
Gauge NINJIO Blocker LLC Preferred Units
9/22/2023
14,470
103,563
5,243,852
5,326,245
NS412, LLC
13.95
5/6/2019
11/6/2025
7,615,000
7,561,754
NS Group Holding Company, LLC Class A Units
782
795,002
879,589
8,356,756
8,494,589
109
NuMet Machining Techniques, LLC
Birmingham, UK
(11)(13)
11/5/2019
5/5/2026
12,675,000
12,563,025
Bromford Industries Limited Term Loan
7,800,000
7,728,858
20,291,883
NuSource Financial, LLC
Eden Prairie, MN
NuSource Financial Acquisition, Inc. (SBIC II)
13.75
9.75
1/29/2021
7/29/2026
6,028,203
NuSource Holdings, Inc. Warrants (SBIC II)
54,966
Nutritional Medicinals, LLC
Centerville, OH
6.21
11.56
11/15/2018
11/15/2025
8,793,840
8,753,238
3,692,025
3,663,943
1.15
Functional Aggregator, LLC Units
12,500
972,803
2,273,286
13,389,984
14,759,151
Onpoint Industrial Services, LLC
1.75
11/16/2022
11/16/2027
12,764,326
12,552,435
Spearhead TopCo, LLC Class A Units
606,742
701,538
0.22
13,159,177
13,465,864
4.21
PCP MT Aggregator Holdings, L.P.
Oak Brook, IL
3/29/2019
825,020
119,281
4,026,531
PCS Software, Inc.
Shenandoah, TX
7/1/2019
7/1/2024
13,918,747
13,880,996
4.35
1,825,410
1,820,459
0.57
571,195
0.18
962,500
0.30
PCS Software Parent, LLC Class A Common Units
9/16/2022
461,216
384,007
5.52
Pearl Media Holdings, LLC
Garland, TX
8/31/2022
8/31/2027
9,669,444
9,518,772
9,524,402
22,983
9,542,105
9,547,385
Peltram Plumbing Holdings, LLC
Auburn, WA
12/30/2021
12/30/2026
15,951,839
5.05
60,000
Peltram Group Holdings LLC Class A Units
508,516
506,119
418,449
16,517,958
16,638,452
Premiere Digital Services, Inc.
10.72
11/3/2021
11/3/2026
13,216,883
13,176,183
Premiere Digital Holdings, Inc. Common Stock
10/18/2018
5,000
2,765,529
15,982,412
4.99
Red's All Natural, LLC
Franklin, TN
12.57
1/31/2023
1/31/2029
8,837,476
8,680,057
8,793,289
Centeotl Co-Invest B, LP Common Units
710,600
586,022
RIA Advisory Borrower, LLC
Coral Gables, FL
12.03
5/1/2023
8/2/2027
5,955,000
5,850,377
5,925,225
27,257
27,121
RIA Advisory Aggregator, LLC Class A Units
104,425
165,078
113,278
RIA Products Aggregator, LLC Class A Units
81,251
78,390
6,121,102
6,144,014
110
Rogers Mechanical Contractors, LLC
12.71
4/28/2021
9/9/2025
9,123,801
9,054,460
9,078,182
2.84
45,808
45,590
45,579
9,123,761
2.85
Sales Benchmark Index, LLC
1/7/2020
1/7/2025
12,148,958
12,088,362
12,088,213
3.78
SBI Holdings Investments LLC Class A Units
66,573
665,730
394,609
12,754,092
12,482,822
3.90
Service Minds Company, LLC
Bradenton, FL
11.19
2/7/2022
2/7/2028
5,331,274
5,253,965
4,504,927
1.41
11.04
90,266
76,275
99,128
98,321
83,763
5,442,552
4,664,965
TAC LifePort Holdings, LLC
Woodland, WA
3/1/2021
546,543
537,049
758,732
0.24
The Hardenbergh Group, Inc.
Livonia, MI
11.70
8/7/2023
8/7/2028
10,475,643
10,229,596
10,318,508
BV HGI Holdings, L.P. Class A Units
434,504
418,275
3.36
Tilley Distribution, Inc.
Baltimore, MD
4/1/2022
12/31/2026
96,627
95,632
93,728
Trade Education Acquisition, L.L.C.
Austin, TX
12/28/2021
12/28/2027
9,727,847
9,588,519
8,365,948
2.61
Trade Education Holdings, L.L.C. Class A Units
662,660
1,521
TradePending OpCo Aggregator, LLC
Carrboro, NC
3/2/2021
3/2/2026
9,626,768
9,532,209
9,530,500
8/4/2023
2,460,860
2,418,287
2,436,251
0.76
33,000
687,007
680,733
680,137
0.21
TradePending Holdings, LLC Series A Units
908,333
967,114
1,466,224
TradePending Holdings, LLC Series A-1 Units
132,783
260,254
386,420
4.54
Unicat Catalyst Holdings, LLC
(20)
Alvin, TX
4/27/2021
4/27/2026
7,031,250
6,958,652
6,750,000
Unicat Catalyst, LLC Class A Units
7,500
361,345
Unicat Catalyst, LLC Class A-1 Units
12/13/2023
382
21,103
21,262
7,729,755
7,132,607
2.23
U.S. Expediters, LLC
Stafford, TX
11.80
12/22/2021
12/22/2026
15,706,527
15,504,206
15,627,994
4.88
Cathay Hypnos LLC Units
1,372,932
1,316,740
1,530,385
16,820,946
17,158,379
Venbrook Buyer, LLC
3/13/2020
3/13/2026
13,686,954
13,577,731
11,976,085
3.74
155,730
154,487
136,264
2,395,666
2,096,208
4,666,672
4,645,016
4,083,338
Venbrook Holdings, LLC Convertible Term Loan
(14)
12/20/2028
98,633
Venbrook Holdings, LLC Common Units
822,758
819,262
21,690,795
18,291,895
5.72
Whisps Holdings LP
Elgin, IL
4/18/2019
500,000
Class A-1 Units
3/6/2023
107,418
97,400
607,418
Xanitos, Inc.
Newtown Square, PA
6/25/2021
6/25/2026
12,480,000
12,342,824
12,417,600
2,198,745
2,185,595
2,187,751
Pure TopCo, LLC Class A Units
442,133
1,053,478
1,020,714
15,681,897
15,725,565
4.91
Total Non-control, non-affiliated investments
884,858,412
271.39
Net Investments
273.32
LIABILITIES IN EXCESS OF OTHER ASSETS
(554,520,895)
(173.32)
112
Unused
Unfunded
Commitment
Security
Fee
0.50%
June 5, 2028
May 7, 2026
875,995
December 12, 2028
March 31, 2028
1.00%
July 1, 2028
May 9, 2028
March 22, 2028
September 3, 2026
February 19, 2026
March 15, 2029
September 1, 2026
66,667
February 7, 2027
150,000
December 21, 2025
August 2, 2028
4,096,741
November 22, 2027
June 30, 2028
909,091
November 1, 2025
July 31, 2029
3,055,671
Revolver B
666,667
June 30, 2025
May 22, 2028
1,363,636
December 7, 2028
January 24, 2028
March 16, 2027
76,667
April 29, 2028
848,485
April 2, 2025
August 26, 2027
December 17, 2026
2,555,354
17,500
April 28, 2028
July 30, 2026
February 15, 2027
August 28, 2025
113
25,000
November 9, 2026
70,000
June 6, 2027
53,333
September 2, 2027
December 30, 2027
1,166,469
December 21, 2028
3,888,228
April 3, 2028
May 19, 2026
2,864,154
August 3, 2029
Revolver – Working Capital
1,763,033
August 30, 2024
October 12, 2027
2,000,000
November 15, 2025
746,948
July 1, 2024
August 31, 2027
December 30, 2026
576,923
November 3, 2026
72,743
August 2, 2027
0.75%
September 9, 2025
1,331,461
January 7, 2025
10,000
February 7, 2028
August 6, 2028
December 31, 2026
March 2, 2026
December 22, 2026
114
Abbreviation LegendBSBY — Bloomberg Short-Term Bank Yield Index
PIK — Payment-In-Kind
SOFR — Secured Overnight Financing Rate
SONIA — Sterling Overnight Index Average
115
CONOLIDATED SCHEDULE OF INVESTMENTS
Non-controlled, non-affiliated investments
First Lien
10.84
15,354,412
15,190,375
15,124,097
5.48
1,039,216
1,023,628
85,488
769,393
17,009,003
17,002,606
6.16
3M LIBOR+
11.48
14,550,000
14,337,005
13,822,500
5.01
95,000
48,571
35,552
293,847
5.18
11.88
17,150,000
16,908,205
5.07
AIP ATCO Buyer, LLC
Sterling Heights, MI
11.31
5/17/2022
5/17/2028
99,750
97,906
99,251
10.93
49,750
11.23
3/5/2026
10,493,750
10,349,704
3.81
6,311,895
6,206,222
2.29
680,630
4,318,702
7.67
29,209
2,134,220
6,295,635
8,429,855
ArborWorks Acquisition LLC
13.56
11/23/2021
14,662,500
14,543,314
13,636,125
13.41
2,307,692
2,146,154
0.78
ArborWorks Holdings LLC Units
12/29/2021
115,385
16,966,391
15,782,279
10.92
8/11/2022
8/11/2027
1,000,000
981,305
985,000
106,221
1,081,305
1,091,221
0.40
10.48
12,000,000
11,784,686
11,940,000
4.33
99,050
686,447
0.25
12,327,372
12,725,947
4.62
13,863,087
13,602,312
13,655,141
4.95
590,291
5.16
116
BDS Solutions Intermediateco, LLC
10.71
13,388,469
13,273,471
13,187,642
4.78
30,065
29,614
4.79
10.49
2/1/2027
6,178,740
6,074,029
6,024,272
2.18
10.67
36,566
35,652
754,598
770,648
6,865,193
6,830,572
2.47
11.82
8/28/2024
15,725,000
15,606,117
15,410,501
5.60
976,521
0.35
16,522,132
16,387,022
5.95
9.98
10,121,875
9,965,356
3.67
405,784
3.82
13,263,750
13,083,737
12,998,475
4.71
268,194
4.81
10.76
14,180,959
13,961,673
13,684,625
10.73
3,062,093
3,037,434
2,954,920
22.09%
218,292
17,220,037
16,857,837
6.11
11,248,696
11,103,143
10,967,479
3.98
39,000
403,084
11,664,882
11,409,567
4.14
4,987,500
4,888,742
1.77
5,174,456
Credit Connection, LLC
9,726,674
9,776,250
7,443,750
7,317,403
7,369,313
Series A Units
961,718
17,848,461
18,107,281
6.56
10.98
13,027,351
12,784,145
12,701,667
68,250
590,535
13,594,144
13,360,452
4.84
Data Centrum Communications, Inc.
13.29
5/15/2024
15,760,360
15,661,301
15,445,154
5.61
Health Monitor Holdings, LLC Series A Preferred Units
458,500
16,661,301
15,903,654
5.78
117
Douglas Products Group, LP
Liberty, MO
Partnership Interests
12/27/2018
322
695,072
Second Lien
1M LIBOR+
3.55
10.13
9,190,990
8,961,215
3.25
12.24
4/13/2023
6,134,219
6,124,342
2.22
706,459
0.26
514,396
7,874,359
7,750,451
2.13
10.38
1/31/2025
10,010,654
9,920,657
8,959,535
1,382,146
1,237,021
900,000
146,541
12,202,803
10,343,097
3.75
232,320
567,579
16,374,375
16,286,433
16,128,760
5.86
995,000
980,742
980,075
969,726
18,389,425
18,078,561
6.57
8,992,885
8,875,308
8,857,992
19,700
341,050
9,272,843
9,218,742
9,950,000
9,768,170
9,751,000
365,198
10,130,604
10,116,198
(11)(14)
4,462,793
4,140,000
10/2/2024
12,523,234
12,472,183
12,398,002
2,539,470
2,514,075
0.91
1,455,955
16,978,786
16,368,032
5.94
10.79
9,975,000
9,785,984
9,825,375
3.56
10.91
24,753
24,625
286,065
444,511
10,096,802
10,294,511
3.73
Heat Makes Sense Shared Services, LLC
9.63
97,814
98,254
10.37
7/1/2028
88,684
25,338
217,814
231,976
13,302,236
13,081,774
12,903,169
16,000
15,520
323,108
320,082
313,415
HV Acquisition VI, LLC Class A Units
1,374,844
0.50
15,049,447
14,606,948
3,238,328
1/1/2018
464,619
1,033,332
10.23
8,439,750
8,304,246
(6)(17)
447,183
429,507
796,939
8,733,753
9,236,689
9.09
13,260,842
11,801,635
10.19
83,125
82,356
81,463
765,249
4.59
9.71
15,832,478
15,724,809
15,357,505
5.58
1,095,930
1,083,042
1,063,052
0.39
16,807,851
16,420,557
5.97
International Designs Holdings LLC
Farmingville, NY
200,000
195,412
Interstate Waste Services, Inc.
Amsterdam, OH
1/15/2020
21,925
946,125
615,657
5,835,000
5,769,877
8,206,709
8,115,519
3,073,431
3,035,678
1.11
191,375
16,921,074
17,306,515
6.28
119
5,381,042
5,294,704
5,219,611
4,967,116
4,916,760
4,818,103
1,104,255
1,089,478
1,071,127
319,149
309,575
733,149
12,919,782
12,151,565
4.41
San Francisco
12,764,441
11,168,886
4.05
149,640
13,897,017
11,318,526
4.10
9.92
16,800,000
5.98
Kelleyamerit Holdings, Inc.
Walnut Creek, CA
(4)(10)(12)
1M BSBY+
12.36
12/24/2020
12/24/2025
9,750,000
9,624,052
9,701,250
3.52
1,500,000
1,480,623
1,492,500
0.54
11,104,675
11,193,750
7,568,289
7,446,619
7,416,923
2.69
302,593
7,854,952
7,752,182
13,587,067
13,340,843
13,179,455
398,677
298,376
13,739,520
13,477,831
4.89
98,331
86,667
85,367
91,659
284,998
275,280
11.58
4,529,217
4,393,340
9,962,730
3.58
16,219,667
15,984,825
15,651,980
5.69
37,500
36,188
700,989
16,955,658
16,389,157
120
11.73
99,095
99,000
100,931
106,132
12,511
300,430
317,731
11.33
8,552,022
8,487,053
8,423,742
5,392,937
5,351,968
5,312,043
314,486
14,279,779
14,364,757
4,903,726
5,216,979
13.23
7,536,527
7,386,550
2.68
536,120
8,331,529
7,922,670
(11)(15)
12,524,972
8,745,750
3.17
7,704,685
5,382,000
20,229,657
14,127,750
5.12
13.12
1/29/2026
11,562,548
11,403,406
11,215,672
5,638,571
5,568,680
4,736,400
5.79
9,848,290
9,781,484
9,700,566
4,180,294
4,133,615
4,117,590
1,582,534
14,887,902
15,400,690
12,893,258
12,638,571
4.58
13,245,313
4.80
1,686,647
121
14,064,493
13,964,812
13,923,848
1,844,524
1,831,451
1,826,079
972,500
962,775
449,270
9,775,500
9,819,317
9,808,166
16,579,758
16,304,977
15,999,467
5.81
311,668
16,813,493
16,311,135
5.92
9.64
14,278,846
14,221,712
2,773,121
17,051,967
6.19
Protect America, Inc.
7.75
8/30/2017
9/1/2024
17,979,749
10,001,068
9,884,999
9,851,052
3.57
49,643
9,934,642
9,900,302
3.59
12,481,823
12,366,809
12,169,777
390,822
0.14
13,032,539
12,560,599
4.55
9.29
5,357,887
5,264,150
5,223,940
9.44
29,250
32,081
31,791
31,279
5,325,941
5,284,469
SIB Holdings, LLC
Charleston, SC
11.01
10/29/2021
10/29/2026
12,789,331
12,584,996
12,405,651
859,747
842,658
833,955
7/20/2022
2,292,657
2,250,559
2,223,877
0.81
2,865,822
2,840,406
2,779,847
70,754
68,631
SIB Holdings, LLC Units
238,095
342,821
6.76
759,769
10.14
99,245
97,936
95,771
17,391
16,782
115,327
112,553
122
10.63
10,496,533
10,315,261
9,919,224
3.60
75,600
503,936
TradePending, LLC
9,725,758
9,592,801
9,531,243
3.46
829,167
868,750
1,117,989
7,218,750
7,116,275
6,821,719
129,248
7,866,275
6,950,967
2.52
U.S. Auto Sales, Inc. et al
Lawrenceville, GA
USASF Blocker II LLC Units
6/8/2015
441
441,000
USASF Blocker III LLC 2018 Series Units
2/13/2018
53,040
USASF Blocker III LLC 2019 Series Units
12/27/2019
79,560
USASF Blocker IV LLC Units
5/27/2020
110,000
330,000
USASF Blocker IV LLC 2022 Series Units
7/28/2022
300,000
USASF Blocker V LLC Units
12/20/2022
200
600,000
USASF Blocker LLC Units
9,000
1,362,600
15,866,798
15,603,833
15,866,799
5.76
2,702,795
0.98
16,920,573
18,569,594
6.74
5.73
12,872,663
12,719,565
12,615,210
4.57
146,465
144,723
143,536
2,231,119
2,186,497
0.79
4,388,645
4,358,279
4,300,872
Venbrook Holdings, LLC Term Loan
89,284
87,498
121,938
20,362,232
19,455,551
7.04
Vortex Companies, LLC
9.50
14.18
6/21/2026
9,859,282
12,608,000
12,421,258
12,166,720
77,200
2,221,181
2,203,262
2,143,440
844,147
15,757,998
15,231,507
5.53
Total Non-controlled, non-affiliated investments
306.31
(563,881,593)
(206.31)
124
259,804
May 17, 2028
March 5, 2026
ArborWorks Acquisition LLC (a)
1,153,846
August 11, 2027
69,935
63,434
February 1, 2027
3,750,000
July 29, 2027
April 13, 2023
February 8, 2024
112,045
October 2, 2024
84,000
2,475,000
November 1, 2026
553,517
June 24, 2025
744,681
125
13,333
62,500
May 24, 2027
1,318,143
67,677
29,246
October 29, 2026
82,609
December 28, 2027
April 27, 2026
June 25, 2026
126
LIBOR — London Interbank Offered Rate
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NOTE 1 — NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations
Stellus Capital Investment Corporation (“we”, “us”, “our” and the “Company”) was formed as a Maryland corporation on May 18, 2012 (“Inception”) and is an externally managed, closed-end, non-diversified investment management company. The Company is applying the guidance of Accounting Standards Codification (“ASC”) Topic 946, Financial Services Investment Companies. The Company has elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”), and has elected, has qualified, and intends to qualify annually to be treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”), for U.S. federal income tax purposes. The Company’s investment activities are managed by its investment adviser, Stellus Capital Management, LLC (“Stellus Capital” or the “Advisor”).
As of December 31, 2023, the Company had issued a total of 24,125,642 shares and raised $352,021,617 in gross proceeds since Inception, incurring an aggregate of $11,044,123 in offering expenses and sales load fees. Additionally, the Company has received $672,917 in offering expenses reimbursements from the Advisor for net proceeds from offerings of $341,650,411. The Company’s shares are currently listed on the New York Stock Exchange under the symbol “SCM”. See Note 4 for further details.
The Company has established the following wholly owned subsidiaries: SCIC — Consolidated Blocker, Inc., SCIC — ICD Blocker 1, Inc., SCIC — Invincible Blocker 1, Inc., SCIC — SKP Blocker 1, Inc., SCIC — APE Blocker 1, Inc., SCIC — Venbrook Blocker, Inc., SCIC — CC Blocker 1, Inc., SCIC — ERC Blocker 1, Inc., and SCIC — Hollander Blocker 1, Inc., which are structured as Delaware entities, to hold equity or equity-like investments in portfolio companies organized as limited liability companies, or LLCs (or other forms of pass-through entities) (collectively, the “Taxable Subsidiaries”). The Taxable Subsidiaries are consolidated for U.S. generally accepted accounting principles (“U.S. GAAP”) reporting purposes, and the portfolio investments held by them are included in the consolidated financial statements.
On June 14, 2013, the Company formed Stellus Capital SBIC, LP (the “SBIC I subsidiary”), a Delaware limited partnership, and its general partner, Stellus Capital SBIC GP, LLC, a Delaware limited liability company, as wholly owned subsidiaries of the Company. On June 20, 2014, the SBIC I subsidiary received a license from the U.S. Small Business Administration (“SBA”) to operate as a Small Business Investment Company (“SBIC”) under Section 301(c) of the Small Business Investment Company Act of 1958, as amended (the “SBIC Act”). The SBIC I subsidiary and its general partner are consolidated for U.S. GAAP reporting purposes, and the portfolio investments held by it are included in the consolidated financial statements.
On November 29, 2018, the Company formed Stellus Capital SBIC II, LP (the “SBIC II subsidiary”, and together with the SBIC I subsidiary, the “SBIC subsidiaries”), a Delaware limited partnership. On August 14, 2019, the SBIC II subsidiary received a license from the SBA to operate as an SBIC under Section 301(c) of the SBIC Act. The SBIC II subsidiary and its general partner, Stellus Capital SBIC GP, LLC, are consolidated for U.S. GAAP reporting purposes, and the portfolio investments held by it are included in the consolidated financial statements.
The SBIC licenses allow the SBIC subsidiaries to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and other customary procedures. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and have a ten year maturity. The principal amount of SBA-guaranteed debentures is not required to be paid prior to maturity but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed on a semi-annual basis at a market-driven spread over U.S. Treasury Notes with 10-year maturities. The SBA, as a creditor, will have a superior claim to the SBIC subsidiaries’ assets over the Company’s stockholders in the event the Company liquidates one or both of the SBIC subsidiaries or the SBA exercises its remedies under the SBA-guaranteed debentures issued by the SBIC subsidiaries upon an event of default. For the SBIC I subsidiary, SBA regulations currently limit the amount that a single licensee may borrow to a maximum of $150,000,000 when it has at least $75,000,000 in regulatory capital, as such term is defined by the SBA, receives a capital commitment from the SBA and has been through an examination by the SBA
subsequent to licensing. For the SBIC II subsidiary, SBA regulations limit these amounts to $175,000,000 of borrowings when it has at least $87,500,000 of “regulatory capital”, as such term is defined by the SBA.
As of both December 31, 2023 and 2022, the SBIC I subsidiary had $75,000,000 of regulatory capital. As of both December 31, 2023 and 2022, the SBIC I subsidiary had $150,000,000 of SBA-guaranteed debentures outstanding.
As of both December 31, 2023 and 2022, the SBIC II subsidiary had $87,500,000 of regulatory capital and $175,000,000 and $163,600,000 of SBA-guaranteed debentures outstanding, respectively. See footnotes (4) and (5) of the Consolidated Schedule of Investments for additional information regarding the treatment of investments in the SBIC subsidiaries with respect to the Credit Facility (as defined in Note 9).
Under the 1940 Act, the Company allowed to incur a maximum asset coverage ratio of 150% if certain requirements are met, including the approval of a "required majority" (as such term is defined in Section 57(o) of the 1940 Act) of the Company's Board of Directors (the "Board") and the approval of the Company's stockholders.
On April 4, 2018, the Company’s Board, including a “required majority” (as such term is defined in Section 57(o) of the 1940 Act) of the Board, approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. At the Company’s 2018 annual meeting of stockholders, the Company’s stockholders also approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. As a result, the asset coverage ratio test applicable to the Company was decreased from 200% to 150%, effective June 29, 2018. The amount of leverage that the Company employs at any time depends on the Company’s assessment of the market and other factors at the time of any proposed borrowing. As of December 31, 2023, the Company’s asset coverage ratio was 223%.
The Company’s investment objective is to maximize the total return to its stockholders in the form of current income and capital appreciation through debt and related equity investments in middle-market companies. The Company seeks to achieve its investment objective by originating and investing primarily in private U.S. middle-market companies (typically those with $5.0 million to $50.0 million of EBITDA (earnings before interest, taxes, depreciation and amortization)) through first lien, second lien, unitranche and unsecured debt financing, with corresponding equity co-investments. It sources investments primarily through the extensive network of relationships that the principals of Stellus Capital have developed with financial sponsor firms, financial institutions, middle-market companies, management teams and other professional intermediaries.
Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in conformity with generally accepted accounting principles in the U.S. GAAP and pursuant to the requirements for reporting on Form 10-K and Article 10 of Regulation S-X under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Accordingly, certain disclosures accompanying the annual financial statements prepared in accordance with U.S. GAAP are omitted. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries.
In the opinion of management, the consolidated financial results included herein contain all adjustments, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements for the periods included herein. Certain reclassifications have been made to certain prior period balances to conform with current presentation.
In accordance with Regulation S-X under the Exchange Act, the Company does not consolidate portfolio company investments. The accounting records of the Company are maintained in U.S. dollars.
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Economic activity has continued to accelerate across sectors and regions. Nonetheless, we have observed and continue to observe supply chain interruptions, labor resource shortages, commodity inflation, rising interest rates, economic sanctions in response to international conflicts and instances of geopolitical, economic and financial market instability in the United States and abroad. One or more of these factors may contribute to increased market volatility and may have long- and short-term effects in the United States and worldwide financial markets.
Portfolio Investment Classification
The Company classifies its portfolio investments with the requirements of the 1940 Act as follows: (a) “Control Investments” are defined as investments in which the Company owns more than 25% of the voting securities or has rights to maintain greater than 50% of the board representation, (b) “Affiliate Investments” are defined as investments in which the Company owns between 5% and 25% of the voting securities and does not have rights to maintain greater than 50% of the board representation, and (c) “Non-controlled, non-affiliate investments” are defined as investments that are neither Control Investments or Affiliate Investments.
Cash and Cash Equivalents
At December 31, 2023, cash balances totaling $925,548 exceeded Federal Deposit Insurance Corporation insurance protection levels of $250,000 by $675,548. In addition, at December 31, 2023, the Company held $25,199,894 in cash equivalents, which are carried at cost, which approximates fair value, and held foreign currency of $299 (acquisition cost of $299). All of the Company's cash deposits are held at large established high credit quality financial institutions and management believes that risk of loss associated with any uninsured balances is remote.
Cash consists of bank demand deposits. We deem certain U.S. Treasury Bills and other high-quality, short-term debt securities as cash equivalents.
Fair Value Measurements
We account for all of our financial instruments at fair value in accordance with ASC Topic 820, Fair Value Measurements and Disclosures (“ASC Topic 820”). ASC Topic 820 defines fair value, establishes a framework used to measure fair value, and requires disclosures for fair value measurements, including the categorization of financial instruments into a three-level hierarchy based on the transparency of valuation inputs. ASC Topic 820 requires disclosure of the fair value of financial instruments for which it is practical to estimate such value. We believe that the carrying amounts of our financial instruments such as cash, receivables and payables approximate the fair value of these items due to the short maturity of these instruments. This is considered a Level 1 valuation technique.
The Credit Facility, SBA-guaranteed debentures, and Notes Payable are carried at amortized cost in the Consolidated Statements of Assets and Liabilities. As of December 31, 2023, the estimated fair value of the Credit Facility approximates the carrying value because the interest rates adjust to the current market interest rate (Level 3 input). The estimated fair value of the SBA-guaranteed debentures and Notes Payable was determined by discounting projected remaining payments using market interest rates for borrowings of the Company and entities with similar credit risks at the measurement date. At the measurement date, the estimated fair values of the SBA-guaranteed debentures and Notes Payable as prepared for disclosure purposes was $293,215,000 and $93,041,000, respectively. See Note 6 to the consolidated financial statements for further discussion regarding the fair value measurements and hierarchy.
Consolidation
As permitted under Regulation S-X under the Exchange Act and ASC Topic 946, we generally do not consolidate our investment in a portfolio company other than an investment company subsidiary. Accordingly, we consolidated the results of the SBIC subsidiaries and the Taxable Subsidiaries. All intercompany balances have been eliminated upon consolidation.
130
Use of Estimates
The preparation of the statement of assets and liabilities in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ materially. Additionally, as explained in Note 1 contained herein, the Consolidated Financial Statements includes investments in the portfolio whose values have been estimated by the Company, pursuant to procedures established by our Board, in the absence of readily ascertainable market values. Because of the inherent uncertainty of the investment portfolio valuations, those estimated values may differ materially from the values that would have been determined had a ready market for the securities existed.
Deferred Financing Costs
Deferred financing costs, prepaid loan fees on SBA-guaranteed debentures and prepaid loan structure fees consist of fees and expenses paid in connection with the closing of the Company’s Credit Facility, 2022 Notes (as defined in Note 11), 2026 Notes, and SBA-guaranteed debentures and are capitalized at the time of payment. These costs are amortized using the straight-line method over the term of the respective instrument.
Offering Costs
Deferred offering costs consist of fees and expenses incurred in connection with the offer and sale of the Company’s common stock, including legal, accounting, printing fees and other related expenses, as well as costs incurred in connection with the filing of a shelf registration statement. These costs are capitalized when incurred and recognized as a reduction of offering proceeds when the offering is consummated and shown on the Consolidated Statement of Changes in Net Assets and Liabilities as a reduction to Paid-in-Capital. During the year ended December 31, 2023, the Company incurred $247,701 of costs related to the preparation of its shelf registration statement, which were capitalized and treated as discussed above as part of the Company’s ATM Program (as defined in Note 4) throughout various ATM Program offerings in 2023. As of December 31, 2023, $7,312 of costs related to the preparation of a registration statement were capitalized and will be treated as discussed above in the event an offering is consummated. During the year ended December 31, 2022, the Company incurred $1,100 of costs related to the preparation of a registration statement, which were capitalized until the related offering consummated during March 2023.
Rule 2a-5 under the 1940 Act (“Rule 2a-5”) establishes requirements for determining fair value in good faith for purposes of the 1940 Act. Rule 2a-5 permits boards, subject to board oversight and certain other conditions, to designate certain parties to perform fair value determinations. Rule 2a-5 also defines when market quotations are “readily available” for purposes of the 1940 Act and the threshold for determining whether a fund must determine the fair value of a security. Rule 31a-4 under the 1940 Act (“Rule 31a-4”), provides the recordkeeping requirements associated with fair value determinations. While the Board has not elected to designate the Advisor as the valuation designee, the Company has adopted certain revisions to its valuation policies and procedures in order comply with the applicable requirements of Rule 2a-5 and Rule 31a-4.
As a BDC, the Company will generally invest in illiquid loans and securities including debt and equity securities of private middle-market companies. Section 2(a)(41) of the 1940 Act requires that a BDC value its assets as follows: (i) the third party price for securities for which a quotation is readily available; and (ii) for all other securities and assets, fair value, as determined in good faith by a BDC's board. Under procedures established by our Board, the Company intends to value investments for which market quotations are readily available at such market quotations. The Company will obtain these market values from an independent pricing service or at the median between the bid and ask prices obtained from at least two brokers or dealers (if available, otherwise by a principal market maker or a primary market dealer). Debt and equity securities that are not publicly traded or whose market prices are not readily available will be valued at fair value as determined in good faith by the Board. Such determination of fair values may involve subjective
131
judgments and estimates. The Company also engages independent valuation providers to review the valuation of each portfolio investment that does not have a readily available market quotation at least twice annually.
Investments purchased within approximately 90 days of the valuation date will be valued at cost plus accreted discount, or minus amortized premium, which approximates fair value. With respect to unquoted securities, the Board will value each investment considering, among other measures, discounted cash flow models, comparisons of financial ratios of peer companies that are public and other factors. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, the Board will use the pricing indicated by the external event to corroborate and/or assist in the valuation. Because the Company expects that there will not be a readily available market for many of the investments in its portfolio, the Company expects to value most of its portfolio investments at fair value as determined in good faith by the Board using a documented valuation policy and a consistently applied valuation process. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ significantly from the values that would have been used had a readily available market value existed for such investments, and the differences could be material.
In following these approaches, the types of factors that will be taken into account in fair value pricing investments will include, as relevant, but not be limited to:
Revenue Recognition
We record interest income on an accrual basis to the extent such interest is deemed collectible. Payment-in-kind (“PIK”) interest represents contractual interest accrued and added to the loan balance that generally becomes due at maturity. We will not accrue any form of interest on loans and debt securities if we have reason to doubt our ability to collect such interest. Loan origination fees, original issue discount and market discount or premium are capitalized, and we then accrete or amortize such amounts using the effective interest method as interest income. Upon the prepayment of a loan or debt security, any unamortized loan origination fee is recorded as interest income. We record prepayment premiums on loans and debt securities as other income. Dividend income, if any, will be recognized on the declaration date.
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A presentation of the interest income we have received from portfolio companies for the years ended December 31, 2023, 2022, and 2021 is as follows:
Loan interest
93,976,863
68,026,701
55,780,814
PIK income
3,801,637
1,357,177
939,030
Fee amortization income(1)
2,954,512
2,782,309
2,785,964
Fee income acceleration(2)
1,283,776
798,812
2,030,878
Total Interest Income
102,016,788
To maintain our treatment as a RIC, substantially all of this income must be paid to stockholders in the form of distributions, even if we have not collected any cash.
Management considers portfolio company specific circumstances as well as other economic factors in determining collectability. As of December 31, 2023, the Company had four loans on non-accrual status, which represented approximately 4.2% of the Company’s loan portfolio at cost and 1.3% at fair value. As of December 31, 2022, the Company had three loans on non-accrual status, which represented approximately 5.2% of the Company’s loan portfolio at cost and 2.3% at fair value. As of December 31, 2023 and 2022, $7,545,775 and $4,828,880 of income from investments on non-accrual has not been accrued, respectively. If a loan or debt security’s status significantly improves regarding the debtor’s ability to service the debt or other obligations, or if a loan or debt security is sold or written off, the Company will remove it from non-accrual status.
Net Realized Gains or Losses and Net Change in Unrealized Appreciation or Depreciation
Realized gains or losses are measured by the difference between the net proceeds from the repayment, sale or disposition and the amortized cost basis of the investment, without regard to unrealized appreciation or depreciation previously recognized. 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 appreciation or depreciation, when gains or losses are realized.
Investment Transaction Costs
Costs that are material associated with an investment transaction, including legal expenses, are included in the cost basis of purchases and deducted from the proceeds of sales unless such costs are reimbursed by the borrower.
Receivables and Payables for Unsettled Securities Transaction
The Company records all investments on a trade date basis.
U.S. Federal Income Taxes
The Company has elected, has qualified, and intends to be qualified annually to be treated as a RIC under Subchapter M of the Code, and to operate in a manner to qualify for the tax treatment applicable to RICs. To qualify for tax treatment as a RIC, among other things, the Company is required to timely distribute to its stockholders at least 90% of investment company taxable income, as defined by the Code, for each year. So long as the Company maintains its status as a RIC, it generally will be subject to U.S. federal income tax on any ordinary income or capital gains that it distributes at least annually to its stockholders as dividends. Rather, any tax liability related to income earned by the Company represents obligations of the Company’s investors and will not be reflected in the Consolidated Financial Statements of the Company.
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To avoid a 4% U.S federal excise tax on undistributed earnings, the Company is required to distribute each calendar year the sum of (i) 98% of its ordinary income for such calendar year, (ii) 98.2% of its net capital gains for the one-year period ending December 31, and (iii) any income recognized, but not distributed, in preceding years and on which the Company paid no federal income tax, or the “Excise Tax Avoidance Requirement”. For this purpose, however, any net ordinary income or capital gain net income retained by us that is subject to corporate income tax for the tax year ending in that calendar year will be considered to have been distributed by year end (or earlier if estimated taxes are paid). The Company, at its discretion, may choose not to distribute all its taxable income for the calendar year and pay a non-deductible 4% excise tax on this income. If the Company chooses to do so, all other things being equal, this would increase expenses and reduce the amount of cash available to be distributed to stockholders. To the extent that the Company determines that its estimated current year annual taxable income will be in excess of estimated current year dividend distributions from such taxable income, the Company accrues excise taxes on estimated excess taxable income as taxable income is earned. As of December 31, 2023, the Company had approximately $36,997,829 of undistributed taxable income that was carried forward toward distributions to be paid in 2024.
Current income tax (benefit) expense for the years ended December 31, 2023, 2022, and 2021 of ($1,654,935), $1,161,668, and $4,059,594, respectively, is related to federal and state income taxes and federal excise taxes.
The Company evaluates tax positions taken or expected to be taken while preparing its tax returns to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authority. Tax positions deemed to meet a “more-likely-than-not” threshold would be recorded as a tax benefit or expense in the applicable period.
As of December 31, 2023 and 2022, the Company had not recorded a liability for any unrecognized tax positions. Management’s evaluation of uncertain tax positions may be subject to review and adjustment at a later date based upon factors including, but not limited to, an ongoing analysis of tax laws, regulations and interpretations thereof. The Company’s policy is to include interest and penalties related to income taxes, if applicable, in general and administrative expenses. Any expenses for the years ended December 31, 2023, 2022, and 2021 were de minimis.
The Taxable Subsidiaries are direct wholly owned subsidiaries of the Company that have elected to be treated as corporations for U.S. federal income tax purposes, and as a result, the income of Taxable Subsidiaries is subject to U.S. federal income tax at corporate rates. The Taxable Subsidiaries permit the Company to hold equity investments in portfolio companies that are “pass through” entities for tax purposes and continue to comply with the “source-of-income” requirements contained in RIC tax provisions of the Code. The Taxable Subsidiaries are not consolidated with the Company for income tax purposes and may generate income tax expense, benefit, and the related tax assets and liabilities, as a result of their ownership of certain portfolio investments. The income tax expense, or benefit, if any, and related tax assets and liabilities of the Taxable Subsidiaries are reflected in the Company’s Consolidated Financial Statements.
The Taxable Subsidiaries use the liability method in accounting for income taxes. Deferred tax assets and liabilities are recorded for temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, using statutory tax rates in effect for the year in which the temporary differences are expected to reverse. A valuation allowance is provided against deferred tax assets when it is more likely than not that some portion or all of the deferred tax asset will not be realized.
Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses. Taxable income generally excludes net unrealized appreciation or depreciation, as investment gains or losses are not included in taxable income until they are realized.
For the years ended December 31, 2023, 2022, and 2021, the Company recorded deferred income tax (provision) benefit of ($126,957), ($213,214), and $510,868, respectively, related to the Taxable Subsidiaries. As of December 31, 2023 and 2022, the Company had a net deferred tax liability of $188,893, and $61,936, respectively.
134
Earnings per Share
Basic per share calculations are computed utilizing the weighted average number of shares of the Company’s common stock outstanding for the period. The Company has no common stock equivalents. As a result, there is no difference between diluted earnings per share and basic per share amounts.
Paid In Capital
The Company records the proceeds from the sale of shares of its common stock on a net basis to (i) capital stock and (ii) paid in capital in excess of par value, excluding all commissions and marketing support fees.
Distributable (Loss) Earnings
The components that make up distributable (loss) earnings on the Consolidated Statement of Assets and Liabilities as of December 31, 2023 and 2022 were as follows:
Accumulated net realized (loss) gain from investments, net of cumulative dividends of $29,808,394 and $29,361,649, respectively
(25,107,128)
2,675,719
Net unrealized depreciation on non-controlled, non-affiliated investments and cash equivalents, net of deferred tax liability of $188,893 and $61,936, respectively
(27,071,601)
(29,736,797)
Net unrealized (depreciation) appreciation on foreign currency translations
(464)
Accumulated undistributed net investment income
36,175,872
27,697,264
Recently Issued Accounting Standards
In March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform. The amendments in ASU 2020-04 provide optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The standard is effective as of March 12, 2020 through December 31, 2022. The Company has agreements that have LIBOR as a reference rate with certain portfolio companies and with certain lenders. Many of these agreements include language for choosing an alternative successor rate if LIBOR reference is no longer considered to be appropriate. Contract modifications are required to be evaluated in determining whether the modifications result in the establishment of new contracts or the continuation of existing contracts. The Company adopted this amendment in March 2020 and plans to apply the amendments in this update to account for contract modifications as contracts are amended to include a new reference rate or when LIBOR reference is no longer used. The Company did not utilize the optional expedients and exceptions provided by ASU 2020-04 during the year ended December 31, 2023.
In November 2022, the FASB issued ASU 2022-06, Reference Rate Reform (Topic 848) - Deferral of the Sunset Date of Topic 848, which deferred the sunset date of ASU 2020-04 from December 31, 2022 to December 31, 2024 after which entities will no longer be permitted to apply the relief in ASU 2020-04. The Company did not utilize the optional expedients and exceptions provided by ASU 2020-04 and extended by ASU 2022-06 during the year ended December 31, 2023. The Company does not expect ASU 2022-06 to have a material impact to the Consolidated Financial State,emts and the notes thereto.
In December 2023, the FASB issued ASU 2023-09, Improvements to Income Tax Disclosures. The amendments in this update require more disaggregated information on income taxes paid. ASU 2023-09 is effective for years beginning after December 15, 2024. Early adoption is permitted; however, the Company has not elected to adopt this provision as of the date of the financial statements contained in this Annual Report on Form 10-K. The Company is still assessing the impact of the new guidance. However, it does not expect ASU 2023-09 to have a material impact on the Consolidated Financial Statements and the notes thereto.
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From time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. The Company believes the impact of the recently issued standards and any that are not yet effective will not have a material impact on its consolidated financial statements upon adoption.
NOTE 2 — RELATED PARTY ARRANGEMENTS
The Company has entered into an Investment Advisory Agreement (the “Investment Advisory Agreement”) with Stellus Capital pursuant to which Stellus Capital serves as its investment adviser. Pursuant to this agreement, the Company has agreed to pay to Stellus Capital an annual base management fee of 1.75% of gross assets, including assets purchased with borrowed funds or other forms of leverage and excluding cash and cash equivalents, and an incentive fee.
For the years ended December 31, 2023, 2022, and 2021, the Company recorded an expense for base management fees of $15,452,347, $14,848,174, $13,169,606, respectively. As of December 31, 2023 and December 31, 2022, $2,918,536 and $7,150,407, respectively, was payable to Stellus Capital.
The incentive fee has two components, investment income and capital gains, as follows:
Investment Income Incentive Fee
The investment income component (“Income Incentive Fee”) is calculated, and payable to the Advisor, quarterly in arrears based on the Company’s pre-incentive fee net investment income for the immediately preceding calendar quarter, subject to a cumulative total return requirement and to deferral of non-cash amounts. The pre-incentive fee net investment income, which is expressed as a rate of return on the value of the Company’s net assets attributable to the Company’s common stock, for the immediately preceding calendar quarter, will have a 2.0% (which is 8.0% annualized) hurdle rate (also referred to as the “Hurdle”). Pre-incentive fee net investment income means interest income, dividend income and any other income accrued during the calendar quarter, minus the Company’s operating expenses for the quarter excluding the incentive fee. Pre-incentive fee net investment income includes, in the case of investments with a deferred interest feature (such as original issue discount, debt instruments with PIK interest and zero coupon securities), accrued income that the Company has not yet received in cash. The Advisor receives no incentive fee for any calendar quarter in which the Company’s pre-incentive fee net investment income does not exceed the Hurdle. Subject to the cumulative total return requirement described below, the Advisor receives 100% of the Company’s pre-incentive fee net investment income for any calendar quarter with respect to that portion of the pre-incentive net investment income for such quarter, if any, that exceeds the Hurdle but is less than 2.5% (which is 10.0% annualized) of net assets (also referred to as the “Catch-up”) and 20.0% of the Company’s pre-incentive fee net investment income for such calendar quarter, if any, greater than 2.5% (10.0% annualized) of net assets.
The foregoing Income Incentive Fee is subject to a total return requirement, which provides that no incentive fee in respect of the Company’s pre-incentive fee net investment income is payable except to the extent 20.0% of the cumulative net increase in net assets resulting from operations over the then current and 11 preceding calendar quarters exceeds the cumulative incentive fees accrued and/or paid for the 11 preceding quarters. In other words, any Income Incentive Fee that is payable in a calendar quarter is limited to the lesser of (i) 20% of the amount by which the Company’s pre-incentive fee net investment income for such calendar quarter exceeds the 2.0% hurdle, subject to the Catch-up, and (ii) (x) 20% of the cumulative net increase in net assets resulting from operations for the then current and 11 preceding quarters minus (y) the cumulative incentive fees accrued and/or paid for the 11 preceding calendar quarters. For the foregoing purpose, the “cumulative net increase in net assets resulting from operations” is the amount, if positive, of the sum of pre-incentive fee net investment income, realized gains and losses and unrealized appreciation and depreciation of the Company for the then current and 11 preceding calendar quarters. In addition, the Advisor is not paid the portion of such incentive fee that is attributable to deferred interest until the Company actually receives such interest in cash.
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For the years ended December 31, 2023, 2022, and 2021, the Company incurred $10,189,888, $3,782,151, $3,043,470, respectively, of Investment Income Incentive Fees. As of December 31, 2023 and 2022, $2,885,180 and $2,464,408, respectively, of such incentive fees were payable to the Advisor, of which $2,444,865 and $2,083,928, respectively, were currently payable (as explained below). As of December 31, 2023 and 2022, $440,313 and $380,480, respectively, of incentive fees incurred but not paid by the Company were generated from deferred interest (i.e. PIK, certain discount accretion and deferred interest) and are not payable until such amounts are received in cash. As of December 31, 2023, $307,442 of Income Incentive Fees accrued but not paid by the Company were permanently written off due to the Cumulative Pre-Incentive Fee Net Return limitation.
Capital Gains Incentive Fee
The Company also pays the Advisor an incentive fee based on capital gains (the “Capital Gains Incentive Fee”). The Capital Gains Incentive Fee is determined and payable in arrears as of the end of each calendar year (or upon termination of the investment management agreement, as of the termination date). The Capital Gains Incentive Fee is equal to 20.0% of the Company’s cumulative aggregate realized capital gains from Inception through the end of that calendar year, computed net of the cumulative aggregate realized capital losses and cumulative aggregate unrealized capital depreciation through the end of such year. The aggregate amount of any previously paid Capital Gains Incentive Fees is subtracted from such Capital Gains Incentive Fee calculated.
U.S. GAAP requires that the incentive fee accrual considers the cumulative aggregate realized gains and losses and unrealized capital appreciation and depreciation of investments or other financial instruments in the calculation, as an incentive fee would be payable if such unrealized capital appreciation or depreciation were realized, even though such unrealized capital appreciation is not permitted to be considered in calculating the fee actually payable under the Investment Advisory Agreement. There can be no assurance that unrealized appreciation or depreciation will be realized in the future. Accordingly, such fees, as calculated and accrued, may not necessarily be payable under the Investment Advisory Agreement, and may never be paid based upon the computation of incentive fees in subsequent periods. For the years ended December 31, 2023, 2022, and 2021, the Company (reversed) incurred Capital Gains Incentive Fees of ($569,528), ($2,818,623), and $2,867,131, respectively. As of December 31, 2023 and December 31, 2022, $0 and $569,528, respectively, of Capital Gains Incentive Fees were accrued but not currently payable to the Advisor.
The following tables summarize the components of the incentive fees discussed above:
Investment income incentive fees incurred
Capital gains incentive fees reversed
Incentive fees expense
9,312,918
963,528
5,910,601
Investment income incentive fee currently payable
2,444,867
2,083,928
Investment income incentive fee deferred
440,313
380,480
Capital gains incentive fee deferred
Incentive fee payable
3,033,936
Director Fees
For the years ended December 31, 2023, 2022, and 2021, the Company recorded an expense relating to director fees of $406,000, $329,000, and $315,000, respectively. As of December 31, 2023 and 2022, the Company owed its independent directors no unpaid director fees.
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Co-Investments
On May 9, 2022, the Company received a new exemptive order (the “Order”) that superseded prior co-investment exemptive relief orders and permits the Company to co-invest with additional types of private funds, other BDCs, and registered investment companies managed by Stellus Capital or an adviser that is controlled, controlling, or under common control with Stellus Capital, subject to the conditions included therein. Pursuant to the Order, a “required majority” (as defined in Section 57(o) of the 1940 Act) of the Company’s independent directors must make certain conclusions in connection with a co-investment transaction, including (1) the terms of the proposed transaction, including the consideration to be paid, are reasonable and fair to the Company and its stockholders and do not involve overreaching of the Company or its stockholders on the part of any person concerned and (2) the transaction is consistent with the interests of the Company’s stockholders and is consistent with its investment objectives and strategies. The Company co-invests, subject to the conditions in the Order, with a private BDC and private credit funds managed by Stellus Capital or an affiliate thereof that have investment strategies that are similar or identical to the Company’s investment strategy, and the Company may co-invest with other BDCs and registered investment companies managed by Stellus Capital or an adviser that is controlled, controlling, or under common control with Stellus Capital in the future. The Company believes that such co-investments may afford it additional investment opportunities and an ability to achieve greater diversification.
Administrative Agent
The Company serves as the administrative agent on certain investment transactions, including co-investments with its affiliates under the Order. As of December 31, 2023, there was no cash due to other investment funds related to interest paid by a borrower to the Company as administrative agent. As of December 31, 2022, there was $326,122 due to other investment funds related to interest paid by a borrower to the Company as administrative agent, which is included in “Other accrued expenses and liabilities” on the Consolidated Statement of Assets and Liabilities. Additionally, as of December 31, 2022, there was $1,060,321 due to related parties related to interest paid by a borrower to the Company as administrative agent, which is included in “Related party payable” on the Consolidated Statement of Assets and Liabilities.
The Company has entered into a license agreement with Stellus Capital under which Stellus Capital has agreed to grant the Company a non-exclusive, royalty-free license to use the name “Stellus Capital.” Under this agreement, the Company has a right to use the “Stellus Capital” name for so long as Stellus Capital or one of its affiliates remains its investment adviser. Other than with respect to this limited license, the Company has no legal right to the “Stellus Capital” name. This license agreement will remain in effect for so long as the Investment Advisory Agreement with Stellus Capital is in effect.
The Company entered into an administration agreement (the "Administration Agreement") with Stellus Capital, pursuant to which Stellus Capital will furnish the Company with office facilities and equipment and will provide the Company with the clerical, bookkeeping, recordkeeping and other administrative services necessary to conduct day-to-day operations. Under this Administration Agreement, Stellus Capital will perform, or oversee the performance of, its required administrative services, which includes, among other things, being responsible for the financial records which it is required to maintain and preparing reports to its stockholders and reports filed with the SEC.
For the years ended December 31, 2023, 2022, and 2021, the Company recorded expenses of $1,561,394, $1,506,344, and $1,515,630, respectively, related to the Administration Agreement, which are included in administrative services expenses on our Consolidated Statement of Operations. As of December 31, 2023 and December 31, 2022, $397,953 and $343,817, respectively, remained payable to Stellus Capital relating to the Administration Agreement, which are included in administrative services payable on our Consolidated Statement of Assets and Liabilities.
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The Investment Advisory Agreement provides that, absent willful misfeasance, bad faith or gross negligence in the performance of its duties or by reason of the reckless disregard of its duties and obligations under the Investment Advisory Agreement, Stellus Capital and its officers, managers, partners, agents, employees, controlling persons and members, and any other person or entity affiliated with it, are entitled to indemnification from the Company for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of Stellus Capital’s services under the Investment Advisory Agreement or otherwise as our investment adviser.
The Company has also entered into indemnification agreements with its directors. The indemnification agreements are intended to provide the Company’s directors the maximum indemnification permitted under Maryland law and the 1940 Act. Each indemnification agreement provides that the Company shall indemnify the director who is a party to the agreement (an “Indemnitee”), including the advancement of legal expenses, if, by reason of his or her corporate status, the Indemnitee is, or is threatened to be, made a party to or a witness in any threatened, pending, or completed proceeding, other than a proceeding by or in the right of the Company.
NOTE 3 — DISTRIBUTIONS
Distributions are generally declared by the Company’s Board each calendar quarter and recognized as distribution liabilities on the declaration date. The stockholder distributions, if any, will be determined by the Board. Any distribution to stockholders will be declared out of assets legally available for distribution. The Company has declared distributions of $14.95 per share on its common stock from Inception through December 31, 2023.
The following table reflects the Company’s distributions declared and paid on its common stock since Inception:
Date Declared
Record Date
Payment Date
Per Share(1)
Fiscal 2012
Fiscal 2013
Fiscal 2014
1.42
Fiscal 2015
Fiscal 2016
Fiscal 2017
Various
Fiscal 2018
Fiscal 2019
Fiscal 2020
Fiscal 2021
Fiscal 2022
Fiscal 2023
January 11, 2023
January 31, 2023
February 15, 2023
February 28, 2023
March 15, 2023
March 31, 2023
April 14, 2023
April 19, 2023
May 1, 2023
May 15, 2023
May 31, 2023
June 15, 2023
June 30, 2023
July 14, 2023
July 31, 2023
August 15, 2023
August 31, 2023
September 15, 2023
September 29, 2023
October 13, 2023
October 5, 2023
October 31, 2023
November 15, 2023
November 30, 2023
December 15, 2023
December 18, 2023
December 29, 2023
14.95
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The Company has adopted an “opt out” dividend reinvestment plan (“DRIP”) pursuant to which a stockholder whose shares are held in their own name will receive distributions in shares of the Company’s common stock under the Company’s DRIP unless they elect to receive distributions in cash. Stockholders whose shares are held in the name of a broker or the nominee of a broker may have distributions reinvested only if such service is provided by the broker or the nominee, or if the broker of the nominee permits participation in our DRIP.
Although distributions paid in the form of additional shares of the Company’s common stock will generally be subject to U.S. federal, state and local taxes in the same manner as cash distributions, investors participating in the Company’s DRIP will not receive any corresponding cash distributions with which to pay any such applicable taxes. Any distributions reinvested through the issuance of shares through the Company’s DRIP will increase the Company’s gross assets on which the base management fee and the incentive fee are determined and paid to Stellus Capital. The Company did not issue any new shares in connection with the DRIP during the years ended December 31, 2023 and December 31, 2022.
NOTE 4 — EQUITY OFFERINGS AND RELATED EXPENSES
The table below illustrates the number of common stock shares the Company issued since inception through various equity offerings and pursuant to the Company’s DRIP.
Average
Gross
Underwriting
Offering
Fees Covered
Issuance of Common Stock
Shares
Proceeds(1)(2)
fees
by Advisor
Proceeds(3)
Price
Year ended December 31, 2012
12,035,023
180,522,093
4,959,720
835,500
174,726,873
14.90
Year ended December 31, 2013
63,998
899,964
14.06
Year ended December 31, 2014
380,936
5,485,780
75,510
29,904
5,380,366
14.47
Year ended December 31, 2017
3,465,922
48,741,406
1,358,880
307,021
47,075,505
Year ended December 31, 2018
7,931
93,737
Year ended December 31, 2019
3,177,936
45,862,995
1,015,127
559,261
37,546
44,326,153
14.43
Year ended December 31, 2020
354,257
5,023,843
5,680
84,592
66,423
4,999,994
14.40
Year ended December 31, 2021
6,744
53,327
4,255
14.23
Year ended December 31, 2022
2,070,935
31,066
530,842
87,605
Year ended December 31, 2023
62,871,349
943,248
247,701
477,088
14.10
352,021,617
8,395,975
2,648,148
672,917
341,650,411
The Company issued 4,458,873 shares during the year ended December 31, 2023 under the At-the-Market (“ATM”) Program, for gross proceeds of $62,871,349 and underwriting fees and other expenses of $1,190,949. The average per share offering price of shares issued in the ATM Program during 2023 was $14.10. Gross proceeds resulting from the ATM Program in 2022 and 2021 totaled $2,070,935 and $449,515, respectively, and underwriting fees and other expenses totaled $561,908 and $60,071, respectively. The average per share offering price of shares issued in the ATM Program during 2022 and 2021 was $13.88 and $14.23, respectively. The Advisor agreed to reimburse the Company for underwriting fees and expenses to the extent the per share price of the shares to the public, less underwriting fees, was less then net asset value per share. For the year ended December 31, 2023, the Advisor reimbursed the Company $477,088, which resulted in net proceeds of $62,157,488, or $14.00 per share, excluding the impact of offering expenses.
The Company did not issue any shares of common stock through the DRIP for the years ended December 31, 2023 and 2022.
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NOTE 5 — NET INCREASE IN NET ASSETS PER COMMON SHARE
The following information sets forth the computation of net increase in net assets resulting from operations per common share for the years ended December 31, 2023, 2022, and 2021.
Weighted average common shares
Net increase in net assets resulting from operations per share
NOTE 6 — PORTFOLIO INVESTMENTS AND FAIR VALUE
In accordance with the authoritative guidance on fair value measurements and disclosures under U.S. GAAP, the Company discloses the fair value of its investments in a hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The guidance establishes three levels of the fair value hierarchy as follows:
Level 1 — Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2 — Quoted prices in markets that are not considered to be active or financial instruments for which significant inputs are observable, either directly or indirectly;
Level 3 — Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.
The level of an asset or liability within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. However, the determination of what constitutes “observable” requires significant judgment by management.
The Company considers whether the volume and level of activity for the asset or liability have significantly decreased and identifies transactions that are not orderly in determining fair value. Accordingly, if the Company determines that either the volume and/or level of activity for an asset or liability has significantly decreased (from normal conditions for that asset or liability) or price quotations or observable inputs are not associated with orderly transactions, increased analysis and management judgment will be required to estimate fair value. Valuation techniques such as an income approach might be appropriate to supplement or replace a market approach in those circumstances.
At December 31, 2023, the Company had investments in 93 portfolio companies. The total cost and fair value of the investments were $902,143,550 and $874,460,683, respectively. The composition of our investments as of December 31, 2023 is as follows:
At December 31, 2022, the Company had investments in 85 portfolio companies. The total cost and fair value of the investments were $875,823,177 and $844,733,638, respectively. The composition of our investments as of December 31, 2023 is as follows:
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 December 31, 2023 and December 31, 2022, the Company had 57 and 52 such investments with aggregate unfunded commitments of $37,021,242 and $27,824,917, respectively. The Company maintains sufficient liquidity (through cash on hand and available borrowings under the Credit Facility) to fund such unfunded loan commitments should the need arise.
The fair values of our investments disaggregated into the three levels of the fair value hierarchy based upon the lowest level of significant input used in the valuation as of December 31, 2023 were as follows:
Quoted Prices
in Active
Markets
Significant Other
Significant
for Identical
Observable
Unobservable
Securities
Inputs
(Level 1)
(Level 2)
(Level 3)
The fair values of our investments disaggregated into the three levels of the fair value hierarchy based upon the lowest level of significant input used in the valuation as of December 31, 2022 were as follows:
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The aggregate values of Level 3 portfolio investments changed during the year ended December 31, 2023 were as follows:
Senior Secured
Loans-First
Loans-Second
Lien
Debt
Fair value at beginning of period
174,156,432
62,086
13,251,090
187,469,608
Payment-in-kind interest
3,185,845
613,998
3,799,843
Sales and redemptions
(125,442,776)
(9,882,105)
(211,627)
(2,280,087)
(137,816,595)
Realized losses
(11,200,184)
(17,979,749)
(702,093)
(29,882,026)
Change in unrealized (depreciation) appreciation included in earnings(1)
(4,667,866)
4,373,111
651,997
2,434,910
Change in unrealized appreciation on foreign currency included in earnings
610,523
3,831
614,520
2,591,838
141,943
15,762
2,749,543
Fair value at end of period
There were no Level 3 transfers during the year ended December 31, 2023.
The aggregate values of Level 3 portfolio investments changed during the year ended December 31, 2022 were as follows:
646,352,935
56,733,110
4,883,854
64,903,427
772,873,326
196,925,873
83,511
9,101,485
211,010,869
826,816
530,361
(98,160,329)
(10,809,276)
(18,873,195)
(127,842,800)
Realized (losses) gains
(3,929,334)
(4,109,525)
11,811,371
3,772,512
Change in unrealized depreciation included in earnings(1)
(7,342,462)
(1,611,688)
(687,778)
(7,900,302)
Change in unrealized (depreciation) appreciation on foreign currency included in earnings
(1,421,824)
7,146
(1,414,678)
2,303,833
201,679
13,950
2,519,462
There were no Level 3 transfers during the year ended December 31, 2022.
143
The following is a summary of geographical concentration of the Company’s investment portfolio as of December 31, 2023:
144
The following is a summary of geographical concentration of the Company’s investment portfolio as of December 31, 2022:
at Fair Value
145
The following is a summary of industry concentration of the Company’s investment portfolio as of December 31, 2023:
146
The following is a summary of industry concentration of the Company’s investment portfolio as of December 31, 2022:
147
The following provides quantitative information about Level 3 fair value measurements as of December 31, 2023:
Description:
Valuation Technique
Unobservable Inputs
Range (Average)(1)(3)
First lien debt
Income/Market
HY credit spreads,
-3.00% to 8.11% (-0.23%)
approach(2)
Risk free rates
-1.62% to 2.03% (0.04%)
Market multiples
5.2x to 22.5x (11.0x)(4)
Second lien debt
-0.97% to -0.33% (-0.63%)
-0.51% to 0.31% (-0.23%)
6.5x to 17.5x (10.9x)(4)
Unsecured debt
4.98% to 4.98% (4.98%)
4.47% to 4.47% (4.47%)
9.5x to 9.5x (9.5x)(4)
Equity investments
Market approach(5)
Underwriting multiple/
EBITDA multiple
3.5x to 23.2x (12.1x)
Total Long Term Level 3 Investments
148
The following provides quantitative information about Level 3 fair value measurements As of December 31, 2022:
-2.29% to 6.53% (1.52%)
-1.43% to 4.31% (2.31%)
4.5x to 19.3x (10.1x)(4)
-0.17% to 5.18% (2.39%)
-0.02% to 3.91% (1.94%)
5.6x to 15.1x (11.4x)(4)
7.97% to 7.97% 7.97%)
3.63% to 3.63% (3.63%)
9.1x to 9.1x (9.1x)(4)
1.3x to 24.8x (11.7x)
NOTE 7 — COMMITMENTS AND CONTINGENCIES
The Company is currently not subject to any material legal proceedings, nor, to our knowledge, is any material legal proceeding threatened against us. From time to time, the Company may be a party to certain legal proceedings in the ordinary course of business, including proceedings relating to the enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot be predicted with certainty, the Company does not expect that these proceedings will have a material effect upon our business, financial condition or results of operations.
As of December 31, 2023, the Company had $36,722,930 in unfunded debt commitments and $298,312 in unfunded equity commitments to 57 existing portfolio companies. As of December 31, 2022, the Company had $27,522,100 in unfunded debt commitments and $302,817 in unfunded equity commitments to 52 existing portfolio companies. As of both December 31, 2023 and 2022, the Company did not record any fair value adjustments that resulted in any unrealized gains (losses) on these positions. As of December 31, 2023, the Company had sufficient liquidity (through cash on hand and available borrowings under the Credit Facility) to fund such unfunded loan commitments should the need arise.
150
NOTE 8 — FINANCIAL HIGHLIGHTS
December 31,
2023
2022
2021
2020
2019
Per Share Data:(1)
Net asset value at beginning of period
14.61
14.14
14.09
1.13
Change in unrealized appreciation (depreciation) on investments
(0.90)
(0.36)
0.44
(0.85)
Net realized (loss) gain
(1.38)
1.22
(0.52)
(0.03)
Benefit (provision) for taxes on net realized losses (gains) on investments
(0.15)
(0.01)
Total from operations
Sales load
(0.04)
(0.06)
Offering costs
Stockholder distributions from:
(1.59)
(1.11)
(1.09)
(1.15)
(0.54)
Net realized capital gains
(0.02)
(0.19)
(0.05)
(0.82)
Accretive effect of stock offerings (issuing shares above net asset value per share)
Other(3)
Net asset value at end of period
Per share market value at end of period
12.85
13.02
10.88
Total return based on market value(2)
8.72
12.32
30.78
(13.73)
21.97
Weighted average shares outstanding for the period
19,471,500
18,275,696
Ratio/Supplemental Data:(1)
Net assets at end of period
270,571,173
Weighted average net assets
301,285,626
281,745,332
274,188,692
253,034,571
259,020,507
Annualized ratio of gross operating expenses to net assets(5)
21.27
16.59
16.90
14.11
Annualized ratio of net operating expenses to net assets(5)(6)
21.16
Annualized ratio of interest expense and other fees to net assets
10.62
8.68
6.83
6.29
Annualized ratio of net investment income before fee waiver to net assets(5)
Annualized ratio of net investment income to net assets(5)
14.01
10.15
7.21
8.58
8.64
Portfolio turnover(3)
Notes payable
48,875,000
160,085,705
199,200,425
177,340,000
174,000,000
161,550,000
325,000,000
313,600,000
250,000,000
176,500,000
161,000,000
Asset coverage ratio(4)
x
151
2018
2017
2016
2015
2014
Net asset value at beginning of year/period
13.81
13.69
13.94
14.54
1.21
1.33
Change in unrealized appreciation on investments
(0.11)
(0.74)
(0.53)
Net realized gain
(1.05)
Benefit for taxes on net unrealized depreciation on investments
Total from investment operations
1.52
1.86
0.83
Issuance of common shares
Sales Load
(0.09)
(1.03)
(1.20)
(1.36)
(1.33)
(1.31)
(0.33)
(0.16)
(0.12)
Net asset value at the end of year/period
Per share market value at end of year/period
12.95
12.06
11.78
20.29
42.83
(7.76)
(13.09)
Weighted average shares outstanding at the end of period
15,953,571
14,870,981
12,479,959
12,479,961
12,281,178
224,845,007
220,247,242
170,881,785
164,651,104
173,949,452
223,750,302
195,211,550
165,189,142
173,453,813
176,458,141
Annualized ratio of gross operating expenses to net assets(7)(8)
13.72
11.10
13.20
11.16
Annualized ratio of net operating expenses to net assets(7)(8)
10.78
9.12
5.51
4.02
3.01
Annualized ratio of net investment income before fee waiver to net assets(7)
10.09
9.21
9.11
8.40
Annualized ratio of net investment income to net assets(7)
9.49
9.19
Portfolio Turnover(5)
Notes Payable
25,000,000
Credit Facility Payable
99,550,000
40,750,000
116,000,000
109,500,000
106,500,000
SBA Debentures
150,000,000
90,000,000
65,000,000
16,250,000
Asset Coverage Ratio(6)
2.32
152
NOTE 9 — CREDIT FACILITY
On October 11, 2017, the Company entered into a senior secured revolving credit agreement, as amended, dated as of October 10, 2017, that was amended and restated on December 21, 2021, February 28, 2022, May 13, 2022, and November 21, 2023 with Zions Bancorporation, N.A., dba Amegy Bank and various other lenders (the “Credit Facility”).
The Credit Facility provides for borrowings up to a maximum of $260,000,000 on a committed basis with an accordion feature that allows the Company to increase the aggregate commitments up to $350,000,000, subject to new or existing lenders agreeing to participate in the increase and other customary conditions.
Pursuant to the Third Amendment and Commitment Increase to Amended and Restated Senior Secured Revolving Credit Agreement, the Credit Facility will bear interest, subject to the Company’s election, on a per annum basis equal to (i) term SOFR plus 2.50% (or 2.75% during certain periods in which the Company’s asset coverage ratio is equal to or below 1.90 to 1.00) plus a SOFR credit spread adjustment (0.10% for one-month term SOFR and 0.15% for three-month term SOFR), with a 0.25% SOFR floor, or (ii) 1.50% (or 1.75% during certain periods in which the Company’s asset coverage ratio is equal to or below 1.90 to 1.00) plus an alternate base rate based on the highest of the prime rate (subject to a 3% floor), Federal Funds Rate plus 0.50% and one-month term SOFR plus 1.00%. The Company pays unused commitment fees of 0.50% per annum on the unused lender commitments under the Credit Facility. Interest is payable monthly or quarterly in arrears. The commitment to fund the revolver expires on November 21, 2027, after which the Company may no longer borrow under the Credit Facility and must begin repaying principal equal to 1/12 of the aggregate amount outstanding under the Credit Facility each month. Any amounts borrowed under the Credit Facility will mature, and all accrued and unpaid interest thereunder will be due and payable, on November 21, 2028.
The Company’s obligations to the lenders are secured by a first priority security interest in its portfolio of securities and cash not held at the SBIC subsidiaries, but excluding short term investments. The Credit Facility contains certain covenants, including but not limited to: (i) maintaining a minimum liquidity test of at least $10,000,000, including cash, liquid investments and undrawn availability, (ii) maintaining an asset coverage ratio of at least 1.67 to 1.00, (iii) maintaining a minimum stockholder’s equity, and (iv) maintaining a minimum interest coverage ratio of at least 1.75 to 1.00. As of December 31, 2023, the Company was in compliance with these covenants.
As of December 31, 2023 and December 31, 2022, the outstanding balance under the Credit Facility was $160,085,705 and $199,200,425, respectively. The carrying amount of the amount outstanding under the Credit Facility approximates its fair value. The fair value of the Credit Facility is determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The fair value of the Credit Facility is estimated based upon market interest rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any. The Company has incurred costs of $6,630,390 in connection with the current Credit Facility, which are being amortized over the life of the facility. Additionally, $341,979 of costs from a prior credit facility will continue to be amortized over the life of the Credit Facility. As of December 31, 2023 and 2022, $3,520,929 and $1,515,144 of such prepaid loan structure fees and administration fees had yet to be amortized, respectively. These prepaid loan fees are presented on our Consolidated Statement of Assets and Liabilities as a deduction from the debt liability.
The following is a summary of the Credit Facility, net of prepaid loan structure fees:
Prepaid loan structure fees
(3,520,929)
(1,515,144)
Credit Facility payable, net of prepaid loan structure fees
153
Interest is paid monthly or quarterly in arrears. The following table summarizes the interest expense and amortized loan fees on the Credit Facility for the years ended December 31, 2023, 2022, and 2021:
14,723,463
9,190,425
5,231,698
519,653
15,380,786
9,757,800
5,751,351
186,144,622
204,276,134
176,870,712
14,523,350
9,034,765
5,271,348
NOTE 10 — SBA-GUARANTEED DEBENTURES
Due to the SBIC subsidiaries’ status as licensed SBICs, the Company has the ability to issue debentures guaranteed by the SBA at favorable interest rates. Under the regulations applicable to SBIC funds, a single licensee can have outstanding debentures guaranteed by the SBA subject to a regulatory leverage limit, up to two times the amount of “regulatory capital”, as such term is defined by the SBA.
As of both December 31, 2023 and 2022, the SBIC I subsidiary had $75,000,000 in regulatory capital and $150,000,000 of SBA-guaranteed debentures outstanding. As of both December 31, 2023 and 2022, the SBIC II subsidiary had $87,500,000 in regulatory capital and $175,000,000 and $163,600,000 of SBA-guaranteed debentures outstanding, respectively.
On August 12, 2014, the Company obtained exemptive relief from the SEC to permit it to exclude the SBA-guaranteed debentures from its asset coverage test under the 1940 Act. The exemptive relief provides the Company with increased flexibility under the asset coverage test by permitting it to borrow up to $325,000,000 more than it would otherwise be able to absent the receipt of this exemptive relief.
On a stand-alone basis, the SBIC subsidiaries collectively held $485,152,670 and $470,659,123 in assets at December 31, 2023 and 2022, respectively, which accounted for approximately 53.4% and 52.4% of our total consolidated assets at December 31, 2023 and 2022, respectively.
SBA-guaranteed debentures have fixed interest rates that equal prevailing 10-year U.S. Treasury Note rates plus a market spread and have a maturity of ten years with interest payable semi-annually. The principal amount of the SBA-guaranteed debentures is not required to be paid before maturity but may be pre-paid at any time with no prepayment penalty. SBA-guaranteed debentures drawn before October 1, 2019 incur upfront fees of 3.425%, which consists of a 1.00% commitment fee and a 2.425% issuance discount, which are amortized over the life of the SBA-guaranteed debentures. SBA-guaranteed debentures drawn after October 1, 2019 incur upfront fees of 3.435%, which consists of a 1.00% commitment fee and a 2.435% issuance discount, which are amortized over the life of the SBA-guaranteed debentures. Once pooled, which occurs in March and September of each applicable year, the SBA-guaranteed debentures bear interest at a fixed rate that is set to the current 10-year U.S. Treasury Note rate plus a spread at each pooling date.
154
The following table summarizes the SBIC I subsidiary’s SBA-guaranteed debentures as of December 31, 2023:
Issuance Date
Licensee
Maturity Date
Debenture Amount
Interest Rate
SBA Annual Charge
October 14, 2014
SBIC I
March 1, 2025
6,500,000
October 17, 2014
December 24, 2014
3,250,000
June 29, 2015
September 1, 2025
2.83
October 22, 2015
March 1, 2026
November 10, 2015
8,800,000
November 18, 2015
November 25, 2015
December 16, 2015
2,200,000
December 29, 2015
9,700,000
November 28, 2017
March 1, 2028
3.19
April 27, 2018
September 1, 2028
40,000,000
July 30, 2018
17,500,000
September 25, 2018
March 1, 2029
2,500,000
Total SBIC I Subsidiary SBA-guaranteed Debentures
SBIC II SBA-guaranteed Debentures
October 17, 2019
SBIC II
March 1, 2030
6,000,000
November 15, 2019
December 17, 2020
March 1, 2031
9,000,000
1.67
February 16, 2021
13,500,000
February 26, 2021
March 2, 2021
April 21, 2021
September 1, 2031
May 14, 2021
6,700,000
May 28, 2021
7,300,000
July 23, 2021
16,000,000
February 25, 2022
March 1, 2032
March 29, 2022
September 1, 2032
April 1, 2022
6,670,000
April 12, 2022
6,665,000
April 21, 2022
June 30, 2022
3,600,000
July 28, 2022
6,400,000
September 9, 2022
March 1, 2033
5.17
November 9, 2022
7,600,000
August 8, 2023
September 1, 2033
9,120,000
September 19, 2023
March 1, 2034
2,280,000
6.04
% (1)
Total SBIC II Subsidiary SBA-guaranteed Debentures
175,000,000
Total SBA-guaranteed Debentures
155
The fair values of the SBA-guaranteed debentures are determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The fair values of the SBA-guaranteed debentures are estimated based upon market interest rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any. As of December 31, 2023, the estimated fair values of the SBA-guaranteed debentures as prepared for disclosure purposes was $293,215,000. As of December 31, 2022, the carrying amount of the SBA-guaranteed debentures approximated their fair value. At December 31, 2023 and 2022, the SBA-guaranteed debentures would be deemed to be Level 3, as defined in Note 6.
As of December 31, 2023, the Company has incurred $11,148,750, in financing costs related to the SBA-guaranteed debentures since receiving its licenses, which were recorded as prepaid loan fees. As of December 31, 2023 and 2022, $4,726,642 and $5,704,805 of prepaid financing costs had yet to be amortized, respectively. These prepaid loan fees are presented on the Consolidated Statement of Assets and Liabilities as a deduction from the debt liability.
The following is a summary of the SBA-guaranteed debentures, net of prepaid loan fees:
SBA-guaranteed Debentures payable
Prepaid loan fees
(4,726,642)
(5,704,805)
SBA-guaranteed Debentures, net of prepaid loan fees
The following table summarizes the interest expense and amortized fees on the SBA-guaranteed debentures for the years ended December 31, 2023, 2022, and 2021:
10,047,058
8,151,814
6,389,513
11,302,811
9,379,766
7,477,645
318,847,123
288,167,082
227,826,849
9,646,849
7,360,295
5,907,676
NOTE 11 — NOTES
On August 21, 2017, the Company issued $42,500,000 in aggregate principal amount of 5.75% fixed-rate notes due September 15, 2022 (the “2022 Notes”). On September 8, 2017, the Company issued an additional $6,375,000 in aggregate principal amount of the 2022 Notes pursuant to a full exercise of the underwriters’ overallotment option. On January 13, 2021, the Company caused notices to be issued to the holders of its 2022 Notes regarding the Company’s exercise of its option to redeem all of the issued and outstanding 2022 Notes, pursuant to the Second Supplemental Indenture dated as of August 21, 2017, between the Company and U.S. Bank National Association, as trustee. The Company redeemed all $48,875,000 in aggregate principal amount of the 2022 Notes on February 12, 2021. The 2022 Notes were redeemed at 100% of their principal amount, plus the accrued and unpaid interest thereon through the redemption date. As a result of the redemption, the Company recognized a loss on debt extinguishment of $539,250 due to the write off of the remaining deferred financing costs on the 2022 Notes. This loss is included in the Consolidated Statement of Operations for the year ended December 31, 2021.
156
The following table summarizes the interest expense and deferred financing costs on the 2022 Notes for the year ended December 31, 2021:
320,063
28,231
Administration fees
357,294
Loss on debt extinguishment(1)
453,966
On January 14, 2021, the Company issued $100,000,000 in aggregate principal amount of 4.875% fixed-rate notes due 2026 (the “2026 Notes”). The 2026 Notes will mature on March 30, 2026, and may be redeemed in whole or in part at any time or from time to time at our option on or after December 31, 2025 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest. Interest on the 2026 Notes is payable semi-annually beginning September 30, 2021.
The Company used the net proceeds from the 2026 Notes offering to fully redeem the 2022 Notes and repay a portion of the amount outstanding under the Credit Facility. As of December 31, 2023, the aggregate carrying amount of the 2026 Notes was $98,996,412.
Prior to their redemption on February 12, 2021, the 2022 Notes were listed on New York Stock Exchange under the trading symbol “SCA”. As of December 31, 2022, the fair value of the 2022 Notes was $49,168,250. The 2026 Notes are institutional, non-traded notes. The 2026 Notes are carried at cost. At the measurement date, the estimated fair value of the 2026 Notes as prepared for disclosure purposes was $93,041,000. See Note 6 to the Consolidated Financial Statements for further discussion regarding the fair value measurements and hierarchy.
In connection with the issuance and maintenance of the 2026 Notes, the Company incurred $2,327,835 of fees, which are being amortized over the term of the 2026 Notes, of which $1,003,588 remains to be amortized as of December 31, 2023. These financing costs are presented on the Consolidated Statement of Assets and Liabilities as a deduction from the debt liability.
The following is a summary of the 2026 Notes Payable, net of deferred financing costs:
(1,003,588)
(1,450,308)
2026 Notes payable, net of deferred financing costs
157
The following table summarizes the interest expense and deferred financing costs on the 2026 Notes for the years ended December 31, 2023, 2022, and 2021:
4,881,000
4,885,000
4,698,958
435,809
5,327,720
5,331,719
5,134,767
(1)
3,466,667
The indenture and supplements thereto relating to the 2026 Notes contain certain covenants, including but not limited to (i) a requirement that the Company comply with the asset coverage requirements of the 1940 Act or any successor provisions, and (ii) a requirement to provide financial information to the holders of the notes and the trustee under the indenture if the Company should no longer be subject to the reporting requirements under the Exchange Act. As of December 31, 2023, the Company was in compliance with these covenants.
NOTE 12 — INCOME TAXES
As of December 31, 2023 and December 31, 2022, the Company had $36,240,561and $27,456,044, respectively, of undistributed ordinary income.(1) Undistributed capital gains were $757,268 and $1,150,000 for the periods ended December 31, 2023 and December 31, 2022, respectively. Undistributed qualified dividends were $0 and $48,171 for the periods ended December 31, 2023 and December 31, 2022, respectively. All of the undistributed ordinary income and capital gains as of December 31, 2023 will have been distributed within the required period of time such that the Company will not be subject to U.S. federal income tax for the year ended December 31, 2023. We will be subject to a 4% nondeductible U.S. federal excise tax on our undistributed income to the extent we did not distribute an amount equal to at least 98% of our net ordinary income plus 98.2% of our capital gain net income attributable to the period. The Company has accrued $1,399,689 and $1,118,153 of U.S. federal excise tax for the tax years ended December 31, 2023 and December 31, 2022, respectively, independent of prior year adjustments. See Note 1 for further discussion of tax expense in each year.
158
Ordinary dividend distributions from a RIC do not qualify for the reduced maximum tax rate on qualified dividend income from domestic corporations, except to the extent that the RIC received the income in the form of qualifying dividends from domestic corporations and qualified foreign corporations. The tax character(2) of distributions paid in the years ended December 31, 2023 and 2022 was as follows:
Ordinary income
35,032,563
22,279,384
Qualified dividends
48,171
525,313
Distributions of long-term capital gains(2)
446,746
3,789,693
Total distributions paid to common stockholders(3)
35,527,480
26,594,390
Listed below is a reconciliation of “Net increase in net assets resulting from operations” to taxable income and total distributions declared to common stockholders for the years ended December 31, 2023, 2022, and 2021:
Net increase in net assets resulting from operations (includes net investment income, realized gain (loss), unrealized appreciation (depreciation) and taxes)
Net change in unrealized (appreciation) depreciation
(2,785,648)
17,536,190
Income tax provision
(2,860,890)
2,446,352
Pre-tax expense (income), loss (gain) reported at Taxable Subsidiaries, not consolidated for tax purposes
20,172,550
1,392,247
(16,619,608)
Long term capital loss carryover
(4,896,643)
Book income and tax income differences, including debt origination, interest accrual, income from pass-through investments, dividends, realized gains (losses) and changes in estimates
11,860,086
(3,615,815)
3,205,514
Estimated taxable income
43,919,265
30,017,620
25,175,897
Taxable income earned in prior year and carried forward for distribution in current year
28,606,043
24,011,459
21,051,549
Adjustment for cumulative effect of distributions carried forward
Taxable income earned prior to period end and carried forward
(36,997,828)
(28,606,043)
(25,182,518)
Distribution payable as of period end and paid in following period
Total distributions accrued or paid to common stockholders
25,423,036
22,215,987
159
The aggregate gross unrealized appreciation and depreciation, the net unrealized appreciation, and the aggregate cost of the Company’s portfolio company securities for U.S. federal income tax purposes as of December 31, 2023 and December 31, 2022 were as follows:
Aggregate cost of portfolio company securities
Gross unrealized appreciation of portfolio company securities
38,379,839
28,927,746
Gross unrealized depreciation of portfolio company securities
(65,262,547)
(58,602,607)
Gross unrealized appreciation on foreign currency translations of portfolio company securities
11,142
Gross unrealized depreciation on foreign currency translations of portfolio company securities
(811,301)
Aggregate fair value of portfolio company securities
As of December 31, 2023, the Taxable Subsidiaries had unrealized losses in investments and net operating loss (“NOL”) carryovers creating a net deferred tax liability equal to $188,893 as reflected below. As of December 31, 2023, for U.S. federal income tax purposes, the Taxable Subsidiaries had net operating loss carryforwards totaling $5,509,104, of which $918,232 will expire during the tax years 2034 through 2037 if unused. Due to the nature of the Taxable Subsidiaries’ holdings, a valuation allowance was established as we determined it is more likely than not that some of the deferred tax assets will not be realized prior to expiration. Although our future projections indicate that we may be able to realize a portion of these deferred tax assets, due to the degree of uncertainty of these projections, management has recorded a deferred tax asset valuation allowance of $6,507,196.
Deferred tax asset
6,507,196
4,939,367
(188,893)
(61,936)
Total deferred tax asset before valuation allowance
6,318,303
4,877,431
Deferred tax valuation allowance
(6,507,196)
(4,939,367)
Net deferred tax liability
The Company has recorded a tax reclassification of stockholders’ equity in accordance with U.S. GAAP to reduce paid-in capital and increases distributable earnings (increasing accumulated undistributed investment income) for book to tax differences that it has determined to be permanent. For the years ended December 31, 2023 and 2022, this reclassification was $1,348,766 and $1,040,884, respectively. The total adjustment on the Consolidated Statement of Assets and Liabilities as of December 31, 2023 and 2022 was $5,707,301 and $4,358,534, respectively.
Although the Company files federal and state tax returns, its major tax jurisdiction is federal. The 2020, 2021 and 2022 federal tax years for the Company remain subject to examination by the IRS.
160
NOTE 13 — SENIOR SECURITIES
Information about the Company’s senior securities is shown in the following table for the fiscal years ended December 31, 2012 through 2023.
Outstanding
Involuntary
Exclusive of
Asset
Liquidating
Treasury
Coverage per
Preference
Market Value
Class and Year
Securities(1)
Unit(2)
per Unit(3)
per Unit(4)
(In thousands, except per unit amounts)
16,250
N/A
65,000
90,000
161,000
176,500
313,600
325,000
Original Credit Facility(7)
38,000
3,090
2,470
106,500
2,320
109,500
2,220
116,000
2,210
40,750
3,460
99,550
2,520
161,550
2,286
174,000
2,230
177,340
2,030
199,200
1,920
160,086
4.875% Notes due 2026
5.75% Notes due 2022(9)
48,875
25.34
25.18
24.43
23.64
6.50% Notes due 2019(8)
25.41
25.27
25.11
Short-Term Loan(5)
45,000
161
NOTE 14 — SUBSEQUENT EVENTS
The Company invested in the following portfolio companies subsequent to December 31, 2023:
We realized the following portfolio company subsequent to December 31, 2023:
The outstanding balance under the Credit Facility as of March 4, 2024 was $148,527,500.
The outstanding balance of SBA-guaranteed debentures as of March 4, 2024 was $325,000,000.
162
Distributions Declared
On January 13, 2024, the Company’s Board declared a regular monthly distribution for each of January, February and March 2024 as follows:
163
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A. Controls and Procedures.
(a) Evaluation of Disclosure Controls and Procedures
As of December 31, 2023 (the end of the period covered by this report), we, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act). Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective and provided reasonable assurance that information required to be disclosed in our periodic SEC filings is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. However, in evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
(b) Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rule 13a-15(f), and for performing an assessment of the effectiveness of internal control over financial reporting as of December 31, 2023. Internal control over financial reporting is a process designed by, or under the supervision of, our principal executive and principal financial officers, or persons performing similar functions, and effected by our Board, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Management performed an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2023 based upon the criteria set forth in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our assessment, management determined that our internal control over financial reporting was effective as of December 31, 2023.
(c) Changes in Internal Controls Over Financial Reporting
There have been no changes in our internal control over financing reporting that occurred during the calendar year 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B. Other Information.
Fees and Expenses
The following table is intended to assist you in understanding the various costs and expenses that an investor in our common stock will bear directly or indirectly. We caution you that some of the percentages indicated in the table below are estimates and may vary. The footnotes to the fee table state which items are estimates. The following table should not be considered a representation of our future expenses; actual expenses may be greater or less than shown. Except where the context suggests otherwise, whenever this Annual Report on Form 10-K contains a reference to fees or expenses paid by “you,” “us,” “the Company” or “Stellus,” or that “we” will pay fees or expenses, stockholders will indirectly bear such fees or expenses as investors in us.
Stockholder transaction expenses:
Sales load (as percentage of offering price)
Offering expenses born by us (as a percentage of offering price)
(2)
Dividend reinvestment plan expenses
(3)
Total stockholder transaction expenses paid by us (as a percentage of offering price)
(4)
Annual expenses (as a percentage of net assets attributable to common stock)(5):
Base management fee
4.90
% (6)
Incentive fees payable under Investment Advisory Agreement
% (7)
Interest expense on borrowed funds
% (8)
Other expenses
% (9)
Total annual expenses
20.23
% (10)
Example
The following example demonstrates the projected dollar amount of total cumulative expenses over various periods with respect to a hypothetical investment in us. In calculating the following expense amounts, we have assumed we would have no additional leverage, that none of our assets are cash or cash equivalents and that our annual operating expenses would remain at the levels set forth in the table above. Transaction expenses are not included in the following example.
1 year
3 years
5 years
10 years
You would pay the following expenses on a $1,000 investment, assuming a 5.0% annual return
198
486
693
992
You would pay the following expenses on a $1,000 investment, assuming a 5.0% annual return resulting entirely from net realized capital gains (all of which is subject to our incentive fee on capital gains)
The foregoing table is to assist you in understanding the various costs and expenses that an investor in our common stock will bear directly or indirectly. While the example assumes, as required by the SEC, a 5.0% annual return, our performance will vary and may result in a return greater or less than 5.0%. Assuming a 5.0% annual return, the incentive fee under the Investment Advisory Agreement would either not be payable or have an insignificant impact on the expense amounts shown above. If we achieve sufficient returns on our investments, including through the realization of capital gains, to trigger an incentive fee of a material amount, our expenses, and returns to our investors, would be higher. In addition, while the example assumes reinvestment of all distributions at net asset value, if our Board authorizes and we declare a cash dividend, participants in our dividend reinvestment plan who have not otherwise elected to receive cash will receive a number of shares of our common stock, determined by dividing the total dollar amount of the distribution payable to a participant by the market price per share of our common stock at the close of trading on the valuation date for the distribution.
This example and the expenses in the table above should not be considered a representation of our future expenses, and actual expenses (including the cost of debt, if any, and other expenses) may be greater or less than those shown.
Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections
We will file with the SEC a definitive Proxy Statement for our 2024 Annual Meeting of Stockholders, pursuant to Regulation 14A, not later than 120 days after the end of our fiscal year. Accordingly, certain information required by Part III has been omitted under General Instruction G(3) to the Annual Report on Form 10-K. Only those sections of our definitive Proxy Statement that specifically address the items set forth herein are incorporated by reference.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by Item 10 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to our 2024 Annual Meeting of Stockholders, to be filed with the SEC within 120 days following the end of the Company’s fiscal year.
We have adopted a code of business conduct and ethics that applies to our directors, officers and employees. This code of ethics is published on our website at www.stelluscapital.com. We intend to disclose any future amendments to, or waivers from, this code of conduct within four business days of the waiver or amendment through a website posting.
Item 11. Executive Compensation
The information required by Item 11 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to the Company’s 2024 Annual Meeting of Stockholders, to be filed with the SEC within 120 days following the end of the Company’s fiscal year.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by Item 12 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to the Company’s 2024 Annual Meeting of Stockholders, to be filed with the SEC within 120 days following the end of the Company’s fiscal year.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by Item 13 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to the Company’s 2024 Annual Meeting of Stockholders, to be filed with the SEC within 120 days following the end of the Company’s fiscal year.
Item 14. Principal Accountant Fees and Services
The information required by Item 14 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to the Company’s 2024 Annual Meeting of Stockholders, to be filed with the SEC within 120 days following the end of the Company’s fiscal year.
Item 15. Exhibits, Financial Statement Schedules
a. Documents Filed as Part of this Report
The following financial statements are set forth in Item 8:
b. Exhibits
The following exhibits are filed as part of this report or hereby incorporated by reference to exhibits previously filed with the SEC:
3.1
Articles of Amendment and Restatement (Incorporated by reference to Exhibit (a)(1) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012).
Bylaws (Incorporated by reference to Exhibit (b)(1) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012).
4.1
Form of Stock Certificate (Incorporated by reference to Exhibit (d) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012).
4.2
Form of Indenture (Incorporated by reference to Exhibit (d)(2) to the Registrant’s Registration Statement on Form N-2 (File No. 333-189938), filed January 29, 2014).
Second Supplemental Indenture between the Registrant and U.S. Bank National Association, date August 21, 2017, (Incorporated by reference on exhibit (d)(4) to the Registrant’s Registration Statement on Form N-2 (File No. 333-216138), filed on August 21, 2017).
4.5
Third Supplemental Indenture between the Registrant and U.S. Bank National Association, date January 14, 2021 (Incorporated by reference Exhibit 4.1 to the Registrant’s Current Report on Form 8-K (File No 814-00971), filed on January 14, 2021).
4.6
Form of Global Note with respect to the 5.75% Note due 2022 (Incorporated by reference to Exhibit 4.4).
Form of Global Note with respect to the 4.875% Note due 2026 (Incorporated by reference to Exhibit 4.5).
Description of Securities (Incorporated by reference to Exhibit 4.8 to the Registrant’s Current Report on Form 10-K (File No. 814-00971), filed on March 1, 2022).
10.1
Form of Investment Advisory Agreement between Registrant and Stellus Capital Management, LLC (Incorporated by reference to Exhibit (g) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012).
Custody Agreement between Registrant and ZB, National Association (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 814-00971), filed on November 7, 2017).
10.3
Administration Agreement between Registrant and Stellus Capital Management, LLC (Incorporated by reference to Exhibit (k)(1) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012).
10.4
Dividend Reinvestment Plan (Incorporated by reference to Exhibit (e) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012).
10.5
Form of License Agreement between the Registrant and Stellus Capital Management (Incorporated by reference to Exhibit (k)(2) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012).
10.6
Form of Indemnification Agreement between the Registrant and the directors (Incorporated by reference to Exhibit (k)(3) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012).
169
10.7
Form of Guarantee and Security Agreement, the Registrant, ZB, N.A., dba Amegy Bank, as administrative agent, and ZB, N.A. dba Amegy Bank, as collateral agent (Incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K (File No. 814-00971), filed on October 13, 2017).
10.8
Consent and Waiver, dated March 28, 2018, between the Registrant, as a borrower, the lenders party hereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 10-Q (File No. 814-00971), filed on May 8, 2018).
10.9
Third Amendment and Commitment Increase to Amended and Restated Senior Secured Revolving Credit Agreement, dated as of May 13, 2022, between the Registrant, as borrower, the lenders party thereto, and Zions Bancorporation, N.A. dba Amegy Bank, as the administrative agent. (Incorporated by reference to Exhibit 10.1 to the Registrant's Current Report on Form 8-K (File No. 814-00971), filed on May 19, 2022).
10.10
First Amendment and Commitment Increase to Amended and Restated Senior Secured Revolving Credit Agreement, dated December 22, 2021, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 814-00971), filed on December 22, 2021).
10.11
Amended and Restated Senior Secured Revolving Credit Agreement, dated September 18, 2020, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 814-00971), filed on September 21, 2020).
10.12
Third Amendment to Senior Secured Revolving Credit Agreement and Commitment Increase, dated May 15, 2020, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 814-00971), filed on May 18, 2020).
Increase Agreement, dated December 27, 2019, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.12 to the Registrant’s Current Report on Form 10-K (File No. 814-00971), filed on March 3, 2020).
Second Amendment to Senior Secured Revolving Credit Agreement and Commitment Increase, dated September 13, 2019, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 814-00971), filed on September 18, 2019).
First Amendment to Senior Secured Revolving Credit Agreement and Commitment Increase, dated August 2, 2018, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 10-Q (File No. 814-00971), filed on August 8, 2018).
10.16
Senior Secured Revolving Credit Agreement, dated October 10, 2017, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 814-00971), filed on October 13, 2017).
10.17
Equity Distribution Agreement, dated November 16, 2021 between Registrant and sales agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K(File No. 814-00971), filed on November 16, 2021).
Amended and Restated Equity Distribution Agreement, dated August 29, 2022 between Registrant and sales agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8 K (File No. 814-00971), filed on August 29, 2022).
170
Custody Agreement, dated November 2, 2022, by and among Stellus Capital SBIC LP and Frost Bank, as custodian. (Incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q (File No. 814-00971), filed on November 3, 2022).
14.1
Code of Ethics (Incorporated by reference to Exhibit (r)(1) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012).
21.1
Subsidiaries of the Registrant and jurisdiction of incorporation/organizations:
Stellus Capital SBIC, LP — Delaware
Stellus Capital SBIC GP, LLC — Delaware
Stellus Capital SBIC II, LP — Delaware
SCIC-SKP Blocker 1, Inc. — Delaware
SCIC-ERC Blocker 1, Inc. — Delaware
SCIC-Consolidated Blocker, Inc. — Delaware
SCIC-CC Blocker 1, Inc. — Delaware
SCIC-APE Blocker 1, Inc. — Delaware
SCIC-Hollander Blocker 1, Inc. — Delaware
SCIC — Invincible Blocker 1, Inc. — Delaware
SCIC-ICD Blocker 1, Inc. — Delaware
SCIC-Venbrook Blocker, Inc. — Delaware
23.1*
Consent of Grant Thornton LLP
31.1*
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
31.2*
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
32.1*
Certification of Chief Executive Officer pursuant to Section 906 of The Sarbanes-Oxley Act of 2002.
32.2*
Certification of Chief Financial Officer pursuant to Section 906 of The Sarbanes-Oxley Act of 2002.
97.1
Dodd-Frank Compensation Recoupment Policy*
101.INS*
XBRL Instance Document — the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.
101.SCH*
Inline XBRL Taxonomy Extension Schema Document
101.CAL*
Inline XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF*
Inline XBRL Taxonomy Extension Definition Linkbase Document
101.LAB*
Inline XBRL Taxonomy Extension Label Linkbase Document
101.PRE*
Inline XBRL Taxonomy Extension Presentation Linkbase Document
171
Exhibit 104
Cover Page Interactive Data File — The cover page interactive data file does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document
Filed herewith.
c. Financial statement schedules
No financial statement schedules are filed herewith because (1) such schedules are not required or (2) the information has been presented in the aforementioned financial statements.
172
Pursuant to the requirements of Section 13 or 15(d) 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.
Date: March 4, 2024
/s/ Robert T. Ladd
Robert T. Ladd
Chief Executive Officer and President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated.
Chief Executive Officer, President andChairman of the Board of Directors
/s/ W. Todd Huskinson
W. Todd Huskinson
Chief Financial Officer, Chief Compliance Officerand Secretary
(Principal Accounting and Financial Officer)
/s/ Dean D’Angelo
Dean D’Angelo
Director
/s/ J. Tim Arnoult
J. Tim Arnoult
/s/ Bruce R. Bilger
Bruce R. Bilger
/s/ William C. Repko
William C. Repko