Great Elm Capital Corp. - Quarter Report: 2023 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2023

or

 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 814-01211

Great Elm Capital Corp.

(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code: (617) 375-3006

Securities registered pursuant to Section 12(b) of the Act:

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.

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 is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  No ☒

As of October 26, 2023, the registrant had 7,601,958 shares of common stock, $0.01 par value per share, outstanding.

Table of Contents

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PART I—FINANCIAL INFORMATION

Unless the context otherwise requires, all references to “GECC,” “we,” “us,” “our,” the “Company” and words of similar import are to Great Elm Capital Corp. and/or its subsidiaries. We reference materials on our website, www.greatelmcc.com, but nothing on our website shall be deemed incorporated by reference or otherwise contained in this report.

Cautionary Note Regarding Forward-Looking Information

Some of the statements in this report (including in the following discussion) constitute forward-looking statements, which relate to future events or our future performance or financial conditions. The forward-looking statements contained in this report involve a number of risks and uncertainties, including statements concerning:

We use words such as “anticipate,” “believe,” “expect,” “intend,” “will,” “should,” “could,” “may,” “plan” and similar words to identify forward-looking statements. The forward-looking statements contained in this report involve risks and uncertainties. Our actual results could differ materially from those implied or expressed in the forward-looking statements for any reason, including the factors set forth under “Item 1A. Risk Factors,” herein and in our Annual Report on Form 10-K for the fiscal year ended December 31, 2022.

We have based the forward-looking statements included in this report on information available to us on the date of this report, and we assume no obligation to update any such forward-looking statements. Although we undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that we may make directly to you or through reports that we have filed or in the future may file with the Securities and Exchange Commission (the “SEC”).

Item 1. Financial Statements.

The financial statements listed in the index to consolidated financial statements immediately following the signature page to this report are incorporated herein by reference.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview

On September 1, 2023, the Company contributed investments in certain of its operating company subsidiaries and other specialty finance assets to its wholly owned subsidiary, Great Elm Specialty Finance, LLC (“GESF”) in exchange for equity and subordinated indebtedness in GESF. In connection with this contribution, a strategic investor purchased approximately 12.5% of the equity interests and subordinated indebtedness in GESF. Through its subsidiaries, GESF provides a variety of financing options along a "continuum of lending" to middle-market borrowers including, receivables factoring, asset-based and asset-backed lending, lender finance, and equipment financing. GESF expects to generate both revenue and cost synergies across its specialty finance company subsidiaries.

On September 27, 2016, we and Great Elm Capital Management, Inc. (“GECM”), our external investment manager, entered into an investment management agreement (the “Investment Management Agreement”) and an administration agreement (the “Administration Agreement”), and we began to accrue obligations to our external investment manager under those agreements. On August 1, 2022, upon receiving our stockholders’ approval, we and GECM entered into an amendment to the Investment Management Agreement to reset the capital gains incentive fee to begin on April 1, 2022, which eliminated $163.2 million of realized and unrealized losses incurred prior to April 1, 2022 in calculating future incentive fees. In addition, the incentive fee based on income was amended to reset the mandatory deferral commencement date used in calculating deferred incentive fees to April 1, 2022. The Investment Management Agreement renews for successive annual periods, subject to requisite approvals from our board of directors (our “Board”) and/or stockholders.

We have elected to be treated as a RIC for U.S. federal income tax purposes. As a RIC, we will not be taxed on our income to the extent that we distribute such income each year and satisfy other applicable income tax requirements. To qualify as a RIC, we must, among other things, meet source-of-income and asset diversification requirements and annually distribute to our stockholders generally at least 90% of our investment company taxable income on a timely basis. If we qualify as a RIC, we generally will not have to pay corporate level taxes on any income that we distribute to our stockholders.

Investments

Our level of investment activity can and does vary substantially from period to period depending on many factors, including, among others, the amount of debt and equity capital available from other sources to middle-market companies, the level of merger and acquisition activity, pricing in the high yield and leveraged loan credit markets, our expectations of future investment opportunities, the general economic environment as well as the competitive environment for the types of investments we make.

As a BDC, our investments and the composition of our portfolio are required to comply with regulatory requirements.

Revenues

We generate revenue primarily from interest on the debt investments that we hold. We may also generate revenue from dividends on the equity investments that we hold, capital gains on the disposition of investments, and lease, fee, and other income. Our investments in fixed income instruments generally have an expected maturity of three to five years, although we have no lower or upper constraint on maturity. Our debt investments generally pay interest quarterly or semi-annually. Payments of principal of 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 and preferred stock investments may defer payments of cash interest or dividends or payment-in-kind (“PIK”). In addition, we may generate revenue in the form of prepayment fees, commitment, origination, due diligence fees, end-of-term or exit fees, fees for providing significant managerial assistance, consulting fees and other investment-related income.

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Expenses

Our primary operating expenses include the payment of a base management fee, administration fees (including the allocable portion of overhead under the Administration Agreement), and, depending on our operating results, an incentive fee. The base management fee and incentive fee remunerates GECM for work in identifying, evaluating, negotiating, closing and monitoring our investments. The Administration Agreement provides for reimbursement of costs and expenses incurred for office space rental, office equipment and utilities allocable to us under the Administration Agreement, as well as certain costs and expenses incurred relating to non-investment advisory, administrative or operating services provided by GECM or its affiliates to us. We also bear all other costs and expenses of our operations and transactions. In addition, our expenses include interest on our outstanding indebtedness.

Critical Accounting Policies

Valuation of Portfolio Investments

We value our portfolio investments at fair value based upon the principles and methods of valuation set forth in policies adopted by our Board. Fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Market participants are buyers and sellers in the principal (or most advantageous) market for the asset that (1) are independent of us; (2) are knowledgeable, having a reasonable understanding about the asset based on all available information (including information that might be obtained through due diligence efforts that are usual and customary); (3) are able to transact for the asset; and (4) are willing to transact for the asset (that is, they are motivated but not forced or otherwise compelled to do so).

Investments for which market quotations are readily available are valued at such market quotations unless the quotations are deemed not to represent fair value. Debt and equity securities for which market quotations are not readily available or for which market quotations are deemed not to represent fair value, are valued at fair value using a valuation process consistent with our Board-approved policy.

Our Board approves in good faith the valuation of our portfolio as of the end of each quarter. Due to the inherent uncertainty and subjectivity 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 may differ materially from the values that we may ultimately realize. In addition, changes in the market environment and other events may impact the market quotations used to value some of our investments.

Those investments for which market quotations are not readily available or for which market quotations are deemed not to represent fair value are valued utilizing a market approach, an income approach, or both approaches, as appropriate. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts. In following these approaches, the types of factors that we may take into account in determining the fair value of our investments include, as relevant and among other factors: available current market data, including relevant and applicable market trading and transaction comparables; applicable market yields and multiples, security covenants, call protection provisions, information rights and the nature and realizable value of any collateral, the portfolio company’s ability to make payments, its earnings and discounted cash flows, the markets in which the portfolio company does business, comparisons of financial ratios of peer companies that are public, and merger and acquisition comparables; and enterprise values.

We prefer the use of observable inputs and minimize the use of unobservable inputs in our valuation process. Inputs refer broadly to the assumptions that market participants would use in pricing an asset. Observable inputs are inputs that reflect the assumptions market participants would use in pricing an asset developed based on market data obtained from sources independent of us. Unobservable inputs are inputs that reflect our assumptions about the assumptions market participants would use in pricing an asset developed based on the best information available in the circumstances.

Both observable and unobservable inputs are subject to some level of uncertainty and assumptions used bear the risk of change in the future. We utilize the best information available to us, including the factors listed above, in preparing the fair valuations. In determining the fair value of any individual investment, we may use multiple inputs or utilize more than one approach to calculate the fair value to assess the sensitivity to change and determine a reasonable range of fair value. In addition, our valuation procedures include an assessment of the current valuation as compared to the previous valuation for each investment and where differences are material understanding the primary drivers of those changes, incorporating updates to our current valuation inputs and approaches as appropriate.

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Revenue Recognition

Interest and dividend income, including PIK income, is recorded on an accrual basis. Origination, structuring, closing, commitment and other upfront fees, including original issue discounts (“OID”), earned with respect to capital commitments are generally amortized or accreted into interest income over the life of the respective debt investment, as are end-of-term or exit fees receivable upon repayment of a debt investment if such fees are fixed in nature. Other fees, including certain amendment fees, prepayment fees and commitment fees on broken deals, and end-of-term or exit fees that have a contingency feature or are variable in nature are recognized as earned. Prepayment fees and similar income due upon the early repayment of a loan or debt security are recognized when earned and are included in interest income.

We may purchase debt investments at a discount to their face value. Discounts on the acquisition of corporate debt instruments are generally amortized using the effective-interest or constant-yield method unless there are material questions as to collectability.

We assess the outstanding accrued income receivables for collectability at least quarterly, or more frequently if there is an event that indicates the underlying portfolio company may not be able to make the expected payments. If it is determined that amounts are not likely to be paid we may establish a reserve against or reverse the income and put the investment on non-accrual status.

Net Realized Gains (Losses) and Net Change in Unrealized Appreciation (Depreciation)

We measure realized gains or losses by the difference between the net proceeds from the repayment or sale of an investment and the amortized cost basis of the investment, without regard to unrealized appreciation or depreciation previously recognized. Realized gains and losses are computed using the specific identification method.

Net change in unrealized appreciation or depreciation reflects the net change in portfolio investment fair values and portfolio investment cost bases during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.

Portfolio and Investment Activity

The following is a summary of our investment activity for the year ended December 31, 2022 and the nine months ended September 30, 2023:

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Portfolio Reconciliation

The following is a reconciliation of the investment portfolio for the nine months ended September 30, 2023 and the year ended December 31, 2022. Investments in short-term securities, including U.S. Treasury Bills and money market mutual funds, are excluded from the table below.

Portfolio Classification

The following table shows the fair value of our portfolio of investments by industry as of September 30, 2023 and December 31, 2022 (in thousands):

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Results of Operations

Investment Income

Investment income consists of interest income, including net amortization of premium and accretion of discount on loans and debt securities, dividend income and other income, which primarily consists of amendment fees, commitment fees and funding fees on loans.

Interest income increased for the three and nine months ended September 30, 2023 as compared to the corresponding periods in the prior year primarily due to growth of the portfolio and rising interest rates. As of September 30, 2023, the debt investment portfolio had an average coupon rate of 12.5% on approximately $217.8 million of principal as compared to 11.0% on approximately $182.3 million of principal as of September 30, 2022, excluding positions on non-accrual in each period.

Dividend income for the three months ended September 30, 2023 increased as compared to the three months ended September 30, 2022 primarily due to higher distributions from our investments in specialty finance portfolio companies. Dividend income for the nine months ended September 30, 2023 decreased as compared to the nine months ended September 30, 2022 due to exits from certain preferred equity positions and lower distributions from our investments in specialty finance portfolio companies.

The increase in other income for the three and nine months ended September 30, 2023 as compared to the corresponding periods in the prior year is attributable to fees in connection with the extensions of certain revolver commitments.
 

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Expenses

Expenses are largely comprised of advisory fees and administration fees paid to GECM and interest expense on our outstanding notes payable. See “—Liquidity and Capital Resources.” Advisory fees include management fees and incentive fees calculated in accordance with the Investment Management Agreement, and administration fees include direct costs reimbursable to GECM under the Administration Agreement and fees paid for sub-administration services.

Incentive fees increased for the three and nine months ended September 30, 2023 as compared to the three and nine months ended September 30, 2022 due to increased pre-incentive net investment income over the same periods. In addition, GECM waived all accrued and unpaid incentive fees pursuant to the Investment Management Agreement as of March 31, 2022. As of March 31, 2022, there were approximately $4.9 million of accrued and unpaid incentive fees held on our balance sheet. In connection with the incentive fee waiver, we recognized the reversal of these accrued and unpaid incentive fees during the period ended March 31, 2022, resulting in a corresponding increase in net asset value (“NAV”) in such period. The incentive fee waiver is not subject to recapture.

Professional services costs decreased for the three and nine months ended September 30, 2023 as compared to the corresponding periods in the prior year, primarily due to decreased legal expenses associated with specific transaction matters which have been partially offset by general rate increases for professional services including legal and accounting costs.

Interest expense increased for the three and nine months ended September 30, 2023 as compared to the corresponding periods in the prior year as a result of double-carry of interest expense plus the write off of deferred offering costs associated with the refinancing of the 6.50% Notes due 2024 (the “GECCN Notes”) in September 2023, and corresponding issuance of the $40.0 million in aggregate principal amount of the 8.75% Notes due 2028 (the “GECCZ Notes”) in August 2023.

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Realized Gains (Losses)

Realized gain for the three and nine months ended September 30, 2023 includes $5.7 million in gains on the realization of our investment in Prestige Capital Finance, LLC (“Prestige”) common equity in connection with the in-kind contribution to Great Elm Specialty Finance, LLC (“GESF”) and $0.7 million in gains from the sale of our investment in Crestwood Equity Partners, LP (“Crestwood”). Realized losses for the three and nine months ended September 30, 2023 includes $7.0 million in loss on the sale of Lenders Funding, LLC (“Lenders Funding”) common equity and $2.1 million in loss on the realization of our investment in Sterling Commercial Credit, LLC (“Sterling”) in connection with the in-kind contribution to GESF.

During the three months ended September 30, 2022, net realized gains were primarily driven by the sale of our investment in Crestwood resulting in realized gain of $0.7 million, the paydown of our investment in Altus Midstream LP resulting in realized gain of $0.2 million and the sale of our investment in Microstrategy Incorporated resulting in realized gain of $0.1 million.

During the nine months ended September 30, 2022, gross realized losses included $110 million in previously recognized unrealized losses recognized as a result of the restructuring of Avanti Communications Group plc (“Avanti Communications”) in April 2022, along with additional losses of $15.9 million and $4.2 million recognized on the sales of our positions in Tru (UK) Asia Limited (“Tru Taj”) common stock and California Pizza Kitchen, Inc. (“CPK”) common stock, respectively.

Change in Unrealized Appreciation (Depreciation) on Investments

For the three months ended September 30, 2023, unrealized appreciation was primarily driven by reversal of approximately $7.0 million in previously recognized unrealized depreciation on our investment in Lenders Funding common equity which was reclassified to realized loss upon the sale of our position and $2.0 million in the reversal of previously recognized unrealized depreciation on our investment in Sterling equity which was reclassified to realized loss upon the in-kind contribution to GESF. Unrealized depreciation for the three months ended September 30, 2023 was primarily driven by the reversal of approximately $3.9 million in previously recognized unrealized appreciation on our investment in Prestige common equity which was reclassified to realized gain upon the in-kind contribution to GESF.

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Net unrealized depreciation for the three months ended September 30, 2022, is primarily due to the decrease of $1.3 million in fair value of our investment in Lenders Funding equity and $0.7 million in the reversal of previously recognized unrealized gains related to the sale of a portion of our Crestwood preferred equity investment. These losses were partially offset by unrealized gains of $0.6 million and $0.3 million due to the increase in fair value of our investments in the Universal Fiber Systems warrants and First Brands, Inc. second lien secured loans, respectively.

For the nine months ended September 30, 2023, unrealized appreciation was primarily driven by an increase in the fair value of our investment in American Coastal Insurance Corp. (formerly, United Insurance Holding Corp.) unsecured bonds of approximately $5.0 million. Unrealized appreciation also includes approximately $5.0 million and $1.6 million in the reversal of previously recognized unrealized depreciation on our investments in Lenders Funding equity and Sterling equity, respectively. Unrealized depreciation for the nine months ended September 30, 2023, was primarily driven by the reversal of approximately $3.9 million in previously recognized unrealized appreciation on our investment in Prestige common equity which was reclassified to realized gain upon the in-kind contribution to GESF.

For the nine months ended September 30, 2022, unrealized appreciation also includes approximately $15.3 million and $4.2 million in reversals of previously recognized unrealized depreciation resulting from the sales of our investments in Tru Taj common equity and CPK common equity, in addition to the $110 million reversal of previously recognized unrealized losses on our investments in Avanti Communications as a result of the restructuring in April 2022. Unrealized depreciation for the nine months ended September 30, 2022 includes approximately $7.0 million of loss on our investments in Avanti Space Limited E2, F and G junior priority notes along with losses of $1.0 million and $0.9 million on our investments in Lenders Funding equity and Research Now Group, Inc. second lien secured loan, respectively, each due to decreases in fair value.

Liquidity and Capital Resources

We generate liquidity through our operations with cash received from investment income and sales and paydowns on investments. Such proceeds are generally reinvested in new investment opportunities, distributed to shareholders in the form of dividends, or used to pay operating expenses. We also receive proceeds from our issuances of notes payable and our revolving credit facility and from time to time may raise additional equity capital. See “—Revolver” and “—Notes Payable” below for more information regarding our outstanding credit facility and notes.

At September 30, 2023, we had approximately $1.8 million of cash and cash equivalents and approximately $1.0 million of money market fund investments at fair value. At September 30, 2023, we had investments in 46 debt instruments across 38 companies, with an aggregate fair value of approximately $204.3 million and 11 equity investments in 11 companies, with an aggregate fair value of approximately $31.1 million excluding SPAC and de-SPAC securities. SPAC and de-SPAC securities consist of 43 investments in 43 companies, with an aggregate fair value of approximately $35 thousand.

In the normal course of business, we may enter into investment agreements under which we commit to make an investment in a portfolio company at some future date or over a specified period of time. As of September 30, 2023, we had approximately $20.3 million in unfunded loan commitments, subject to our approval in certain instances, to provide debt financing to certain of our portfolio companies. We had sufficient cash and other liquid assets on our September 30, 2023 balance sheet to satisfy the unfunded commitments.

For the nine months ended September 30, 2023, net cash provided by operating activities was approximately $23.6 million, reflecting the purchases and repayments of investments offset by net investment income, including non-cash income related to accretion of discount and PIK income and proceeds from sales of investments and principal payments received. Net cash provided by purchases and proceeds from sales of investments was approximately $5.5 million, reflecting payments for additional investments of $151.3 million, offset by proceeds from principal repayments and sales of $156.8 million. Such amounts include draws and repayments on investments in revolving credit facilities.

For the nine months ended September 30, 2023, net cash used in financing activities was $22.4 million, consisting of $38.4 million in net proceeds from the issuance of the GECCZ Notes which was offset by $42.8 million in payments to retire the GECCN Notes, $10.0 million in net repayments on the revolving credit facility and $8.0 million in distributions to stockholders.

We believe we have sufficient liquidity available to meet our short-term and long-term obligations for at least the next 12 months and for the foreseeable future thereafter.

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Contractual Obligations and Cash Requirements

A summary of our material contractual payment and other cash obligations as of September 30, 2023 is as follows:

See “—Revolver” and “—Notes Payable” below for more information regarding our outstanding credit facility and notes.

We have certain contracts under which we have material future commitments. Under the Investment Management Agreement, GECM provides investment advisory services to us. For providing these services, we pay GECM a fee, consisting of two components: (1) a base management fee based on the average value of our total assets and (2) an incentive fee based on our performance. On August 1, 2022, our stockholders approved an amendment to the Investment Management Agreement to eliminate $163.2 million of realized and unrealized losses incurred prior to April 1, 2022 from the calculation of future capital gains incentive fees and reset the capital gain incentive fee and mandatory deferral periods in Sections 4.4 and 4.5, respectively, of the Investment Management Agreement to begin on April 1, 2022.

We are also party to the Administration Agreement with GECM. Under the Administration Agreement, GECM furnishes us with, or otherwise arranges for the provision of, office facilities, equipment, clerical, bookkeeping, finance, accounting, compliance and record keeping services at such office facilities and other such services as our administrator.

If any of the contractual obligations discussed above are terminated, our costs under any new agreements that we enter into may increase. In addition, we would likely incur significant time and expense in locating alternative parties to provide the services we expect to receive under our Investment Management Agreement and our Administration Agreement. Any new investment management agreement would also be subject to approval by our stockholders.

Both the Investment Management Agreement and the Administration Agreement may be terminated by either party without penalty upon no fewer than 60 days’ written notice to the other.

Revolver

On May 5, 2021, we entered into a Loan, Guarantee and Security Agreement (the “Loan Agreement”) with City National Bank (“CNB”). The Loan Agreement provides for a senior secured revolving line of credit of up to $25 million (subject to a borrowing base as defined in the Loan Agreement). We may request to increase the revolving line in an aggregate amount not to exceed $25 million, which increase is subject to the sole discretion of CNB. The maturity date of the revolving line is May 5, 2024. Borrowings under the revolving line bear interest at a rate equal to (i) the secured overnight financing rate (“SOFR”) plus 3.50%, (ii) a base rate plus 2.00% or (iii) a combination thereof, as determined by us. As of September 30, 2023, there were no borrowings outstanding under the revolving line.

Borrowings under the revolving line are secured by a first priority security interest in substantially all of our assets, subject to certain specified exceptions. We have made customary representations and warranties and are required to comply with various affirmative and negative covenants, reporting requirements and other customary requirements for similar loan agreements. In addition, the Loan Agreement contains financial covenants requiring (i) net assets of not less than $65 million, (ii) asset coverage equal to or greater than 150% and (iii) bank asset coverage equal to or greater than 300%, in each case tested as of the last day of each fiscal quarter of the Company. Borrowings are also subject to the leverage restrictions contained in the Investment Company Act of 1940, as amended (the “Investment Company Act”). In May 2022, the Loan Agreement was amended to require an asset coverage equal to or greater than 150% as of the last day of each fiscal quarter except for the fiscal quarters ending March 31, 2022 and June 30, 2022. In addition, the interest rate was amended to replace the London Interbank Offered Rate with SOFR.

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Distributions

The following table summarizes our distributions declared for record dates since January 1, 2021: