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Logan Ridge Finance Corp. - Quarter Report: 2014 June (Form 10-Q)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

  

xQuarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the Quarter Ended June 30, 2014

 

¨Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

Commission
File Number
 

Exact name of registrants as specified in their charters, addresses of principal  executive

offices, telephone numbers and states or other jurisdictions of incorporation or organization

 

I.R.S. Employer

Identification Number

814-01022  

Capitala Finance Corp.

4201 Congress St., Suite 360

Charlotte, North Carolina

Telephone: (704) 376-5502

State of Incorporation: Maryland

  90-0945675

 

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.

 

Capitala Finance Corp. Yes  x            No  ¨  

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

Capitala Finance Corp. Yes  ¨            No  ¨  

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one):

 

Capitala Finance Corp. Large accelerated filer ¨ Accelerated filer ¨
         
  Non-accelerated filer x Smaller reporting company ¨

 

 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Capitala Finance Corp. Yes  ¨            No  x  

 

The number of shares of Capitala Finance Corp.’s common stock, $0.01 par value, outstanding as of August 11, 2014 was 12,974,420.

 

 

 

 
 

  

TABLE OF CONTENTS

 

    Page
     
PART I FINANCIAL INFORMATION 3
     
Item 1. Financial Statements 3
     
  Consolidated Statements of Assets and Liabilities as of June 30, 2014 (unaudited) and December 31, 2013 3
     
  Consolidated Statements of Operations for the three and six months ended June 30, 2014 (unaudited) and June 30, 2013 (unaudited) 4
     
  Consolidated Statements of Changes in Net Assets for the six months ended June 30, 2014 (unaudited) and June 30, 2013 (unaudited) 5
     
  Consolidated Statements of Cash Flows for the six months ended June 30, 2014 (unaudited) and June 30, 2013 (unaudited) 6
     
  Consolidated Schedules of Investments as of June 30, 2014 (unaudited) and December 31, 2013 7
     
  Notes to Consolidated Financial Statements as of June 30, 2014 (unaudited) 15
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 35
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk 50
     
Item 4. Controls and Procedures 50
     
PART II OTHER INFORMATION 50
     
Item 1. Legal Proceedings 50
     
Item 1A. Risk Factors 51
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 51
     
Item 3. Defaults upon Senior Securities 51
     
Item 4. Mine Safety Disclosures 51
     
Item 5. Other Information 51
     
Item 6. Exhibits 51
   
Signatures 53

 

2
 

  

PART I FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Capitala Finance Corp.

 

Consolidated Statements of Assets and Liabilities

(in thousands, except share and per share data)

 

   As of 
   June 30, 2014   December 31, 2013 
   (unaudited)     
ASSETS          
           
Investments at fair value          
Non-control/non-affiliate investments (amortized cost of $116,776 and $84,138, respectively)  $133,176   $99,140 
Affiliate investments (amortized cost of $163,896 and $159,104, respectively)   190,892    189,098 
Control investments (amortized cost of $67,074 and $58,057, respectively)   81,491    76,481 
Total investments at fair value (amortized cost of $347,746 and $301,299, respectively)   405,559    364,719 
Cash and cash equivalents   166,503    101,622 
Interest and dividend receivable   2,934    2,917 
Due from related parties   541    1,645 
Deferred financing fees (net of accumulated amortization of $2,585 and $2,216, respectively)   8,703    4,871 
Prepaid expenses   229    654 
Total assets  $584,469   $476,428 
           
LIABILITIES          
SBA debentures payable  $192,200   $202,200 
Notes payable   113,438    - 
Due to related parties   474    1,153 
Incentive fee payable   1,408    1,525 
Interest payable   2,875    2,723 
Trade settlement payable   9,959    - 
Accounts payable and accrued expenses   211    157 
Total liabilities  $320,565   $207,758 
           
NET ASSETS          
Common stock, par value $.01, 100,000,000 common shares authorized, 12,974,420 common shares issued and outstanding  $130   $130 
Additional paid in capital   188,408    188,408 
Accumulated undistributed net investment income   15,919    16,760 
Accumulated undistributed net realized gain (loss) from investments   1,634    (48)
Net unrealized appreciation on investments   57,813    63,420 
Total net assets   263,904    268,670 
           
Total liabilities and net assets  $584,469   $476,428 
           
Net asset value per share  $20.34   $20.71 

 

See accompanying notes to consolidated financial statements.

 

3
 

  

Capitala Finance Corp.

 

Consolidated Statements of Operations

(in thousands, except share and per share data)

(unaudited)

 

   For the three months ended June 30,   For the six months ended June 30, 
   2014   2013   2014   2013 
       (combined)       (combined) 
INVESTMENT INCOME                    
Interest and fee income:                    
Non-control/Non-affiliate investments  $3,125   $2,314   $6,066   $4,405 
Affiliate investments   3,884    3,385    7,625    5,829 
Control investments   1,504    862    2,837    1,631 
Total interest and fee income   8,513    6,561    16,528    11,865 
Payment-in-kind interest and dividend income:                    
Non-control/Non-affiliate investments   251    44    424    86 
Affiliate investments   330    102    623    154 
Control investments   163    229    287    428 
Total payment-in-kind interest and dividend income   744    375    1,334    668 
Dividend income:                    
Non-control/Non-affiliate investments   1,351    -    1,514    - 
Affiliate investments   687    29    716    58 
Control investments   1,225    414    4,795    459 
Total dividend income   3,263    443    7,025    517 
Other income   -    789    -    1,361 
Interest income from cash and cash equivalents   6    48    14    76 
Total investment income   12,526    8,216    24,901    14,487 
                     
EXPENSES                    
Interest expense and amortization of deferred financing fees   2,401    2,226    4,601    4,291 
Management fees   2,276    1,230    4,294    2,014 
Incentive fees   1,408    -    2,838    - 
General and administrative expenses   883    102    2,013    234 
Expenses before management fee waiver   6,968    3,558    13,746    6,539 
Management fee waiver (See Note 5)   (76)   -    (200)   - 
Total expenses net of management fee waiver   6,892    3,558    13,546    6,539 
                     
NET INVESTMENT INCOME   5,634    4,658    11,355    7,948 
                     
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:                    
Net realized gain from investments:                    
Non-control/Non-affiliate investments   -    -    1,158    - 
Affiliate investments   351    -    351    - 
Control investments   111    365    173    365 
Total realized gain from investments   462    365    1,682    365 
Net unrealized appreciation (depreciation) on investments   116    6,560    (5,607)   5,839 
Net gain/(loss) on investments   578    6,925    (3,925)   6,204 
                     
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS  $6,212   $11,583   $7,430   $14,152 
                     
NET INCREASE IN NET ASSETS PER SHARE RESULTING FROM OPERATIONS – BASIC AND DILUTED  $0.48    N/A   $0.57    N/A 
                     
WEIGHTED AVERAGE COMMON STOCK OUTSTANDING - BASIC AND DILUTED   12,974,420    N/A    12,974,420    N/A 

 

N/A – Not Applicable

 

4
 

  

Capitala Finance Corp.

 

Consolidated Statements of Changes in Net Assets

(in thousands except share and per share data)

(unaudited)

 

           Common Stock   Additional   Accumulated   Accumulated   Net Unrealized     
   General   Limited   Number of   Par   Paid in   Undistributed Net   Undistributed Net   Appreciation on     
   Partner   Partners   Shares   Value   Capital   Investment Income   Realized Gains   Investments   Total 
                                     
BALANCE, December 31, 2012  $282   $77,358   -   $-   $-   $8,560   $-   $56,233   $142,433 
Partners' capital contributions   -    24,852    -    -    -    -    -    -    24,852 
Net investment income   -    -    -    -    -    7,948    -    -    7,948 
Net realized gain on portfolio investments   -    -    -    -    -    -    365    -    365 
Net change in unrealized appreciation on portfolio investments   -    -    -    -    -    -    -    5,839    5,839 
BALANCE, June 30, 2013  $282   $102,210   -   $-   $-   $16,508   $365   $62,072   $181,437 
                                              
BALANCE, December 31, 2013  $-   $-   12,974,420   $130   $188,408   $16,760   $(48)  $63,420   $268,670 
Net investment income   -    -    -    -    -    11,355    -    -    11,355 
Net realized gain on portfolio investments   -    -    -    -    -    -    1,682         1,682 
Net change in unrealized appreciation on portfolio investments   -    -    -    -    -    -         (5,607)   (5,607)
Dividends declared and paid   -    -    -    -    -    (12,196)   -    -    (12,196)
BALANCE, June 30, 2014  $-   $-   12,974,420   $130   $188,408   $15,919   $1,634   $57,813   $263,904 

 

See accompanying notes to consolidated financial statements.

 

5
 

  

Capitala Finance Corp.

 

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

 

   For the six months ended June 30, 
   2014   2013 
       (combined) 
CASH FLOWS FROM OPERATING ACTIVITIES          
Net increase in net assets resulting from operations  $7,430   $14,152 
Adjustments to reconcile net increase in net assets resulting from operations to net cash used in operating activities:          
Purchase of portfolio investments   (63,584)   (41,380)
Repayments of portfolio investments   20,160    28,721 
Net realized gain on portfolio investments   (1,682)   (365)
(Increase) Decrease in net unrealized appreciation on portfolio investments   5,607    (5,839)
Payment-in-kind interest accrued, net of payments received   (1,334)   (565)
Accretion of original issue discount on portfolio investments   (7)   (34)
Amortization of deferred financing fees   369    344 
Changes in assets and liabilities:          
Interest and dividend receivable   (17)   (302)
Due from related parties   1,104    (2,699)
Prepaid expenses   425    - 
Due to related parties   (679)   2,128 
Incentive fee payable   (117)   - 
Interest payable   152    209 
Trade settlement payable   9,959    - 
Accounts payable and accrued expenses   54    26 
NET CASH USED IN OPERATING ACTIVITIES   (22,160)   (5,604)
           
CASH FLOWS FROM FINANCING ACTIVITIES          
Proceeds from issuance of SBA-guaranteed debentures   -    25,000 
Partners' capital contributions   -    24,852 
Paydowns on SBA-guaranteed debentures   (10,000)   - 
Issuance of notes   113,438    - 
Dividends declared and paid   (12,196)   - 
Deferred financing fees paid   (4,201)   (606)
NET CASH PROVIDED BY FINANCING ACTIVITIES   87,041    49,246 
           
NET INCREASE IN CASH AND CASH EQUIVALENTS   64,881    43,642 
CASH AND CASH EQUIVALENTS, beginning of period   101,622    30,467 
CASH AND CASH EQUIVALENTS, end of period  $166,503   $74,109 
           
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION          
Cash paid for interest  $4,075   $3,735 

 

See accompanying notes to consolidated financial statements.

 

6
 

  

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units)

June 30, 2014

(unaudited)

 

Company (4, 5)  Industry  Investment Interest Rate / Maturity  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Non-control/Non-affiliated investments - 50.7%     
                           
AAE Acquisition, LLC  Industrial Equipment Rental  Senior Secured Term Debt (12% Cash, Due 5/6/15)  $11,000   $10,996   $11,000    4.2%
                           
AAE Acquisition, LLC  Industrial Equipment Rental  Membership Units (14% fully diluted)   -    17    2,333    0.9%
                           
               11,013    13,333    5.1%
                           
American Exteriors, LLC (1)  Replacement Window Manufacturer  Senior Secured Debt (14.0% Cash, Due 6/30/15)   4,404    3,204    4,404    1.7%
                           
American Exteriors, LLC (1)  Replacement Window Manufacturer  Jr. Convertible Note (10.0% Cash, Due 6/30/16)   500    416    638    0.2%
                           
American Exteriors, LLC (8)  Replacement Window Manufacturer  Common Stock Warrants (15% fully diluted)   -    -    -    0.0%
                           
               3,620    5,042    1.9%
                           
Boot Barn Holding Corporation  Western Wear Retail  Common Stock (2,400 shares)   -    2,400    7,177    2.7%
                           
               2,400    7,177    2.7%
                           
Caregiver Services, Inc.  In-Home Healthcare Services  Common Stock (293,186 shares)   -    258    188    0.1%
                           
Caregiver Services, Inc. (8)  In-Home Healthcare Services  Common Stock Warrants (655,908 units)   -    264    421    0.1%
                           
               522    609    0.2%
                           
Crowley Holdings, Inc. (6)  Transportation  Series A Income Preferred Shares (6,000 shares, 10% cash, 2% PIK dividend)   -    6,082    6,082    2.3%
                           
               6,082    6,082    2.3%
                           
Immersive Media Tactical Solutions, LLC  Specialty Defense Contractor  Senior Secured Term Debt (13% Cash, Due 10/6/16)   2,000    2,000    2,000    0.8%
                           
Immersive Media Tactical Solutions, LLC  Specialty Defense Contractor  Common Unit Warrants (12% fully diluted)   -    -    541    0.2%
                           
               2,000    2,541    1.0%
                           
Kelle's Transport Service, LLC  Transportation  Senior Secured Debt (14% Cash, Due 3/31/19)   15,800    15,783    15,800    6.0%
                           
Kelle's Transport Service, LLC (6)  Transportation  Preferred Units (1,000 units, 10% PIK Dividend)   -    2,663    2,600    1.0%
                           
Kelle's Transport Service, LLC  Transportation  Common Stock Warrants (15% fully diluted)   -    22    -    0.0%
                           
               18,468    18,400    7.0%
                           
Medical Depot, Inc. (1)  Medical Device Distributor  Subordinated Debt (14% Cash, Due 9/27/20)   4,667    4,667    4,667    1.8%
                           
Medical Depot, Inc.  Medical Device Distributor  Series C Convertible Preferred Stock (740 shares)   -    1,333    3,424    1.3%
                           
               6,000    8,091    3.1%
                           
Naples Lumber & Supply Co (1)  Building Supplies  Subordinated Debt (7% cash, Due 6/30/15)   2,109    1,309    2,109    0.8%
                           
Naples Lumber & Supply Co  Building Supplies  Common Stock Warrants (10% fully diluted)   -    -    777    0.3%
                           
               1,309    2,886    1.1%
                           
Pickaway Plains Ambulance Services, Inc. (1) (2)  Medical Transportation Services  Senior Secured Term Debt (13% Cash, Due 12/31/15)   1,548    -    -    0.0%
                           
Pickaway Plains Ambulance Services, Inc.  Medical Transportation Services  Common Stock Warrants (5% fully diluted)   -    -    -    0.0%
                           
               -    -    0.0%
                           
Precision Manufacturing, LLC  Industrial Boiler Manufacturer  Subordinated Debt (14% PIK, Due 2/13/15)   211    211    183    0.1%
                           
Precision Manufacturing, LLC (3)  Industrial Boiler Manufacturer  Subordinated Debt (6.5% Cash, 6.5% PIK, Due 2/10/17)   2,568    2,568    1,732    0.7%
                           
Precision Manufacturing, LLC  Industrial Boiler Manufacturer  Membership Unit Warrants (6.5% fully diluted)   -    -    -    0.0%
                           
               2,779    1,915    0.8%
                           
Sierra Hamilton, LLC  Oil & Gas Engineering and Consulting Services  Senior Secured Debt (12.25% Cash, Due 12/15/18)   15,000    15,000    15,491    5.9%
                           
               15,000    15,491    5.9%
                           
Southern Pump & Tank Company, LLC (1)  Petroleum Equipment Supplier  Senior Secured Term Debt (13% Cash, 6% PIK, Due 1/15/15)   4,195    3,379    3,680    1.4%
                           
Southern Pump & Tank Company, LLC  Petroleum Equipment Supplier  Common Stock Warrants (10% fully diluted)   -    -    -    0.0%
                           
               3,379    3,680    1.4%
                           
Stoddard Hill Media Holdings, LLC  IT Hosting Services  Class D Preferred Units (132,159 shares)   -    300    415    0.2%
                           
               300    415    0.2%
                           
Tenere, Inc.  Industrial Manufacturing  Senior Secured Term Debt (11% Cash, 2% PIK, Due 12/15/17)   3,469    3,469    3,469    1.3%
                           
               3,469    3,469    1.3%
                           
TGI Friday's, Inc.  Restaurant  Subordinated Debt (L+8.25%, 1% Floor, Due 7/15/21)   10,000    9,959    10,000    3.8%
                           
               9,959    10,000    3.8%
                           
U.S. Well Services, LLC  Oil & Gas Services  Senior Secured Debt (L+11.50%, 0.5% floor, Due 5/2/19)   4,376    4,270    4,376    1.7%
                           
               4,270    4,376    1.7%
                           
Velum Global Credit Management, LLC  Financial Services  Senior Secured Debt (15% Cash, Due 12/31/15)   8,300    8,300    8,300    3.1%
                           
               8,300    8,300    3.1%
                           
Worklife America, Inc.  Professional Employer Organization  Senior Secured Debt (12% Cash, Due 12/28/16)   17,906    17,906    17,906    6.8%
                           
Worklife America, Inc.  Professional Employer Organization  Common Unit Warrants (3.8% ownership)   -    -    2,964    1.1%
                           
Worklife America, Inc.  Professional Employer Organization  Preferred Unit Warrants (3.8% ownership)   -    -    499    0.2%
                           
               17,906    21,369    8.1%
                           
Sub Total Non-control/Non-affiliated investments      $116,776   $133,176    50.7%

 

7
 

  

Affiliate investments - 72.2%                          
                           
Chef'N Corporation  Culinary Products  Subordinated Debt (13%, 2% PIK at company's option, Due 5/16/18)  $6,300   $6,300   $6,300    2.4%
                           
Chef'N Corporation  Culinary Products  Series A Preferred Stock (1,000,000 shares)   -    1,000    4,342    1.6%
                           
               7,300    10,642    4.0%
                           
City Gear, LLC  Footwear Retail  Subordinated Debt (13% Cash, Due 9/28/16)   8,231    8,231    8,231    3.1%
                           
City Gear, LLC (6)  Footwear Retail  Preferred Membership Units (9% cash dividend)   -    1,269    1,269    0.5%
                           
City Gear, LLC  Footwear Retail  Membership Unit Warrants (14.15% fully diluted)   -    -    6,042    2.3%
                           
               9,500    15,542    5.9%
                           
Corporate Visions, Inc.  Sales & Marketing Services  Subordinated Debt (14% Cash, 2% PIK, Due 3/22/18)   11,286    11,286    11,286    4.3%
                           
Corporate Visions, Inc.  Sales & Marketing Services  Common Stock (2,216,463 shares)   -    2,576    9,797    3.7%
                           
Corporate Visions, Inc.  Sales & Marketing Services  Common Stock Warrant (403,257 shares)   -    -    1,782    0.7%
                           
               13,862    22,865    8.7%
                           
GA Communications, Inc. (6)  Advertising & Marketing Services  Series A-1 Preferred Stock (1,998 shares, 8% PIK dividend)   -    2,094    2,471    0.9%
                           
GA Communications, Inc.  Advertising & Marketing Services  Series B-1 Common Stock (200,000 shares)   -    2    2,685    1.0%
                           
               2,096    5,156    1.9%
                           
Impresa Aerospace Holdings, LLC (3)  Aerospace Parts Manufacturer  Subordinated Debt (4.1% Cash, Due 4/28/16)   14,028    12,258    9,934    3.8%
                           
Impresa Aerospace Holdings, LLC  Aerospace Parts Manufacturer  Class A Membership Units (1,006,621 units)   -    900    -    0.0%
                           
Impresa Aerospace Holdings, LLC  Aerospace Parts Manufacturer  Class C Membership Units (362,416 units)   -    362    -    0.0%
                           
Impresa Aerospace Holdings, LLC  Aerospace Parts Manufacturer  Class F Membership Units (604,504 units)   -    605    -    0.0%
                           
               14,125    9,934    3.8%
                           
J&J Produce Holdings, Inc.  Produce Distribution  Subordinated Debt (13% Cash, Due 7/16/18)   5,182    5,182    5,182    2.0%
                           
J&J Produce Holdings, Inc.  Produce Distribution  Common Stock (8,182 shares)   -    818    598    0.2%
                           
J&J Produce Holdings, Inc.  Produce Distribution  Common Stock Warrants (4,506 shares)   -    -    329    0.1%
                           
               6,000    6,109    2.3%
                           
LJS Partners, LLC  QSR Franchisor  Common Stock (1,500,000 shares)   -    1,500    11,188    4.2%
                           
               1,500    11,188    4.2%
                           
MJC Holdings, LLC  Specialty Clothing  Subordinated Debt (14%, 2% PIK at Company's option, Due 1/16/18)   7,500    7,500    7,500    2.9%
                           
MJC Holdings, LLC  Specialty Clothing  Series A Preferred Units (2,000,000 units)   -    2,000    4,874    1.8%
                           
               9,500    12,374    4.7%
                           
MMI Holdings, LLC  Medical Device Distributor  Senior Secured Debt (12% Cash, Due 10/17/14)   2,600    2,600    2,600    1.0%
                           
MMI Holdings, LLC  Medical Device Distributor  Subordinated Debt (6% Cash, Due 8/15/15)   400    389    400    0.2%
                           
MMI Holdings, LLC (6)  Medical Device Distributor  Preferred Units (1,000 units, 6% PIK dividend)   -    1,097    1,235    0.4%
                           
MMI Holdings, LLC  Medical Device Distributor  Common Units (45 units)   -    -    106    0.0%
                           
               4,086    4,341    1.6%
                           
MTI Holdings, LLC  Retail Display & Security Services  Subordinated Debt (12% Cash, Due 11/1/18)   8,000    8,000    8,000    3.0%
                           
MTI Holdings, LLC  Retail Display & Security Services  Capital Units (2,000,000 units)   -    2,000    3,910    1.5%
                           
               10,000    11,910    4.5%
                           
Source Capital ABUTEC, LLC  Environmental Services Products  Senior Secured Debt (12% Cash, 3% PIK, Due 12/28/17)   5,203    5,203    5,203    2.0%
                           
Source Capital ABUTEC, LLC  Environmental Services Products  Preferred Membership Units (10.8% fully diluted)   -    1,240    27    0.0%
                           
               6,443    5,230    2.0%
                           
Source Capital Penray, LLC  Automotive Chemicals & Lubricants  Subordinated Debt (13% Cash, Due 2/17/17)   2,500    2,500    2,500    0.9%
                           
Source Capital Penray, LLC  Automotive Chemicals & Lubricants  Common Stock Warrants (6.65% ownership)   -    -    546    0.2%
                           
Source Capital Penray, LLC  Automotive Chemicals & Lubricants  Membership Units (11.3% ownership)   -    750    771    0.3%
                           
               3,250    3,817    1.4%
                           
Source Capital SSCR, LLC  Personal Product Manufacturer  Subordinated Debt (14% Cash, Due 9/15/17)   17,125    17,125    15,389    5.8%
                           
Source Capital SSCR, LLC  Personal Product Manufacturer  Senior Secured Term Debt (10% Cash, Due 6/12/17)   3,000    3,000    2,768    1.1%
                           
Source Capital SSCR, LLC  Personal Product Manufacturer  Preferred Membership Units (15.8% ownership)   -    1,878    -    0.0%
                           
Source Capital SSCR, LLC  Personal Product Manufacturer  Membership Unit Warrant (0.31% ownership)   -    10    -    0.0%
                           
               22,013    18,157    6.9%
                           
Source Recycling, LLC (2)  Metal Recycler  Subordinated Debt (13% Cash, Due 9/2/16)   5,000    5,000    3,950    1.5%
                           
Source Recycling, LLC  Metal Recycler  Membership Units (68,656 units)   -    1,590    -    0.0%
                           
Source Recycling, LLC  Metal Recycler  Membership Unit Warrants (1% fully diluted)   -    -    -    0.0%
                           
               6,590    3,950    1.5%
                           
Sparus Holdings, Inc. (1)  Energy Services  Subordinated Debt (13% Cash, 2% PIK, Due 3/21/16)   8,025    8,025    8,025    3.0%
                           
Sparus Holdings, Inc.  Energy Services  Series B Preferred Stock (5,703 shares)   -    1,173    -    0.0%

 

8
 

  

Sparus Holdings, Inc.  Energy Services  Common Stock Warrants (3,491 shares)   -    -    -    0.0%
                           
               9,198    8,025    3.0%
                           
STX Healthcare Management Services, Inc. (1)  Dental Practice Management  Subordinated Debt (14% Cash, Due 7/31/15)   7,425    7,425    7,425    2.8%
                           
STX Healthcare Management Services, Inc.  Dental Practice Management  Common Stock (1,200,000 shares)   -    1,200    766    0.3%
                           
STX Healthcare Management Services, Inc.  Dental Practice Management  Common Stock Warrants (1,154,254 shares)   -    218    813    0.3%
                           
               8,843    9,004    3.4%
                           
Take 5 Oil Change, Inc.  Quick Lube Services  Common Stock (10,692 shares)   -    1,069    2,047    0.8%
                           
               1,069    2,047    0.8%
                           
TCE Holdings, Inc.  Oil & Gas Services  Subordinated Debt (12% Cash, 2% PIK, Due 11/22/18)   12,210    12,210    12,210    4.6%
                           
TCE Holdings, Inc.  Oil & Gas Services  Subordinated Debt (12% Cash, 2% PIK, Due 2/1/19)   9,730    9,730    9,730    3.7%
                           
TCE Holdings, Inc.  Oil & Gas Services  Class A Common Stock (3,600 shares)   -    3,600    3,600    1.4%
                           
               25,540    25,540    9.7%
                           
V12 Holdings, Inc. (1)  Data Processing & Digital Marketing  Bridge Note (0% Cash, Due 12/31/14)   663    361    663    0.2%
                           
V12 Holdings, Inc. (1)  Data Processing & Digital Marketing  Tier 2 Note (0% Cash, Due 12/31/14)   81    44    81    0.0%
                           
V12 Holdings, Inc. (1)  Data Processing & Digital Marketing  Senior Subordinated Note (0% Cash, Due 12/31/14)   3,563    2,369    3,563    1.4%
                           
V12 Holdings, Inc. (1)  Data Processing & Digital Marketing  Tier 3 Note (0% Cash, Due 12/31/14)   299    207    299    0.1%
                           
V12 Holdings, Inc. (1)  Data Processing & Digital Marketing  Jr. Subordinated Note (0% Cash, Due 12/31/14)   2,750    -    455    0.2%
                           
V12 Holdings, Inc. (1)  Data Processing & Digital Marketing  Tier 4 Note (0% Cash, Due 12/31/14)   243    -    -    0.0%
                           
V12 Holdings, Inc.  Data Processing & Digital Marketing  Series A-1 Preferred Stock (255,102 shares)   -    -    -    0.0%
                           
V12 Holdings, Inc.  Data Processing & Digital Marketing  Series A-3 Preferred Stock (88,194 shares)   -    -    -    0.0%
                           
V12 Holdings, Inc.  Data Processing & Digital Marketing  Series A-5 Preferred Stock (20,530 shares)   -    -    -    0.0%
                           
V12 Holdings, Inc.  Data Processing & Digital Marketing  Common Stock Warrants (2,063,629 warrants)   -    -    -    0.0%
                           
               2,981    5,061    1.9%
                           
Sub Total Affiliate investments             $163,896   $190,892    72.2%
                           
Control investments - 30.9%                          
                           
CableOrganizer Acquisition, LLC  Computer Supply Retail  Senior Secured Term Debt (12% Cash, 4% PIK, Due 5/24/18)  $10,606   $10,606   $10,606    4.0%
                           
CableOrganizer Acquisition, LLC  Computer Supply Retail  Common Stock (1,125,000 shares)   -    1,125    -    0.0%
                           
               11,731    10,606    4.0%
                           
KBP Investments, LLC (6) (7)  QSR Franchisee  Class A Preferred Stock (8,270 shares, 10% Cash Dividend)   -    8,269    8,269    3.1%
                           
KBP Investments, LLC  QSR Franchisee  Class A Common Stock (380,413 shares)   -    -    15,830    6.0%
                           
               8,269    24,099    9.1%
                           
Market E's, LLC (2)  Online Travel Sales & Marketing  Senior Secured Debt (10% Cash, Due 5/1/15)   810    810    810    0.3%
                           
Market E's, LLC (1) (2)  Online Travel Sales & Marketing  Subordinated Debt (14% Cash, 3% PIK, Due 12/31/14)   2,897    2,833    800    0.3%
                           
Market E's, LLC  Online Travel Sales & Marketing  Class A Preferred Stock (600 shares)   -    240    -    0.0%
                           
Market E's, LLC  Online Travel Sales & Marketing  Class B Preferred Stock (2,411 shares)   -    965    -    0.0%
                           
Market E's, LLC  Online Travel Sales & Marketing  Class A Common Stock (600 shares)   -    -    -    0.0%
                           
               4,848    1,610    0.6%
                           
Micro Precision, LLC  Conglomerate  Subordinated Debt (10% Cash, Due 9/16/16)   1,862    1,862    1,862    0.7%
                           
Micro Precision, LLC  Conglomerate  Subordinated Debt (14% Cash, 4% PIK, Due 9/16/16)   3,623    3,623    3,623    1.4%
                           
Micro Precision, LLC  Conglomerate  Series A Preferred Units (47 units)   -    1,628    1,740    0.7%
                           
               7,113    7,225    2.8%
                           
Navis Holdings, Inc.  Textile Equipment Manufacturer  Senior Secured Term Debt (17%, 3% PIK at Company's option, Due 2/1/16)   6,500    6,500    6,500    2.5%
                           
Navis Holdings, Inc. (6)  Textile Equipment Manufacturer  Class A Preferred Stock (1,000 shares, 10% Cash Dividend)   -    1,000    1,000    0.3%
                           
Navis Holdings, Inc.  Textile Equipment Manufacturer  Common Stock (300,000 shares)   -    1    2,286    0.9%
                           
               7,501    9,786    3.7%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Subordinated Debt (14% Cash, 4% PIK, Due 12/19/16)   4,946    4,946    4,946    1.9%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Series A Preferred Stock (32,782 shares)   -    3,278    -    0.0%
                           
On-Site Fuel Services, Inc. (6)  Fuel Transportation Services  Series B Preferred Stock (14% scheduled cash dividend, 4% PIK dividend)   -    2,365    2,676    1.0%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Common Stock (33,107 shares)   -    33    -    0.0%
                           
               10,622    7,622    2.9%
                           
                           
Print Direction, Inc.  Printing Services  Senior Secured Term Debt (15% Cash, Due 2/24/19)   14,000    14,000    14,000    5.3%
                           
Print Direction, Inc.  Printing Services  Common Stock (19,363 shares)   -    2,990    6,266    2.4%
                           
Print Direction, Inc.  Printing Services  Common Stock Warrants (3% fully diluted)   -    -    277    0.1%
                           
               16,990    20,543    7.8%
                           
Sub Total Control investments             $67,074   $81,491    30.9%
                           
TOTAL INVESTMENTS - 153.8%          $347,746   $405,559    153.8%

 

(1) The maturity date of the original investment has been extended.

(2) Due to deterioration in credit quality, this investment is on non- accrual status.

(3) The debt investment is accruing interest based on the terms of the forebearance agreement.

(4) All debt investments are income producing. Equity and warrant investments are non-income producing, unless otherwise noted.

(5) Percentages are based on net assets of $263,904 as of June 30, 2014.

(6) The equity investment is income producing, based on rate disclosed.

(7) During the fourth quarter of 2013, the Company accepted a consent fee that waives its right to dividends through September 30, 2014.

(8) The equity investment has an exercisable put option.

 

See accompanying notes to consolidated financial statements.

 

9
 

  

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units)

December 31, 2013

 

Company (4, 5)  Industry  Investment Interest Rate /
Maturity
  Principal
Amount
   Cost   Fair
Value
   % of
Net
Assets
 
Non-control/Non-affiliated investments - 36.9%                          
AAE Acquisition, LLC  Industrial Equipment Rental  Senior Secured Term Debt (12% Cash, Due 5/6/15)  $19,000   $18,992   $19,000    7.1%
AAE Acquisition, LLC  Industrial Equipment Rental  Membership Units (21% fully diluted)   -    25    3,500    1.3%
               19,017    22,500    8.4%
American Exteriors, LLC(1)  Replacement Window Manufacturer  Senior Secured Debt (14.0% Cash, Due 6/30/14)   4,565    3,365    4,565    1.7%
American Exteriors, LLC (1)  Replacement Window Manufacturer  Jr. Convertible Note (10.0% Cash, Due 6/30/15)   500    416    612    0.2%
American Exteriors, LLC (8)  Replacement Window Manufacturer  Common Stock Warrants (15% fully diluted)   -    -    1,106    0.4%
               3,781    6,283    2.3%
Boot Barn Holding Corporation  Western Wear Retail  Common Stock (2,400 shares)   -    2,400    4,774    1.8%
               2,400    4,774    1.8%
Caregiver Services, Inc.  In-Home Healthcare Services  Common Stock (293,186 shares)   -    258    231    0.1%
Caregiver Services, Inc. (8)  In-Home Healthcare Services  Common Stock Warrants (655,908 units)   -    264    517    0.2%
               522    748    0.3%
Crowley Holdings, Inc. (6)  Transportation  Series A Income Preferred Shares (6,000 shares, 10% cash, 2% PIK dividend)   -    6,000    6,000    2.2%
               6,000    6,000    2.2%
Immersive Media Tactical Solutions, LLC  Specialty Defense Contractor  Senior Secured Term Debt (13% Cash, Due 10/6/16)   2,000    2,000    2,000    0.7%
Immersive Media Tactical Solutions, LLC  Specialty Defense Contractor  Common Unit Warrants (12% fully diluted)   -    -    800    0.3%
               2,000    2,800    1.0%
Medical Depot, Inc.  Medical Device Distributor  Subordinated Debt (14% Cash, Due 10/11/16)   4,667    4,667    4,667    1.7%
Medical Depot, Inc.  Medical Device Distributor  Series C Convertible Preferred Stock (740 shares)   -    1,333    2,129    0.8%
   `                       
               6,000    6,796    2.5%
Naples Lumber & Supply Co (1)  Building Supplies  Subordinated Debt (6% cash, Due 2/15/14)   2,109    1,309    2,109    0.8%
Naples Lumber & Supply Co  Building Supplies  Common Stock Warrants (10% fully diluted)   -    -    400    0.1%
               1,309    2,509    0.9%
Pickaway Plains Ambulance Services, Inc. (1, 2)  Medical Transportation Services  Senior Secured Term Debt (13% Cash, Due 12/31/15)   1,548    -    -    0.0%
Pickaway Plains Ambulance Services, Inc.  Medical Transportation Services  Common Stock Warrants (5% fully diluted)   -    -    -    0.0%
               -    -    0.0%
Precision Manufacturing, LLC (2)  Industrial Boiler Manufacturer  Subordinated Debt (13% Cash, Due 2/10/17)   2,500    2,500    1,536    0.6%
Precision Manufacturing, LLC  Industrial Boiler Manufacturer  Membership Unit Warrants (70,000 units)   -    -    -    0.0%
               2,500    1,536    0.6%
Sierra Hamilton, LLC  Oil & Gas Engineering and Consulting Services  Senior Secured Debt (12.25% Cash, 12/15/18)   15,000    15,000    15,000    5.6%
               15,000    15,000    5.6%

 

10
 

 

Southern Pump & Tank Company, LLC (1)  Petroleum Equipment Supplier  Senior Secured Term Debt (13% Cash, 6% PIK, Due 6/15/14)   3,633    3,213    3,624    1.3%
Southern Pump & Tank Company, LLC  Petroleum Equipment Supplier  Common Stock Warrants (10% fully diluted)   -    -    -    0.0%
               3,213    3,624    1.3%
Stoddard Hill Media Holdings, LLC  IT Hosting Services  Class D Preferred Units (132,159 shares)   -    300    453    0.2%
               300    453    0.2%
Tenere, Inc.  Industrial Manufacturing  Senior Secured Term Debt (11% Cash, 2% PIK, Due 12/17/17)   3,440    3,440    3,440    1.3%
               3,440    3,440    1.3%
Worklife America, Inc.  Professional Employer Organization  Senior Secured Debt (12% Cash, Due 12/28/16)   18,656    18,656    18,656    7.0%
Worklife America, Inc.  Professional Employer Organization  Common Unit Warrants (3.84% ownership)   -    -    3,441    1.3%
Worklife America, Inc.  Professional Employer Organization  Preferred Unit Warrants (3.84% ownership)   -    -    580    0.2%
               18,656    22,677    8.5%
Sub Total Non-control/Non-affiliated investments             $84,138   $99,140    36.9%
Affiliate investments - 70.4%                          
Chef'N Corporation  Culinary Products  Subordinated Debt (15%, 3% PIK at company's option, Due 5/16/18)  $6,300   $6,300   $6,300    2.3%
Chef'N Corporation  Culinary Products  Series A Preferred Stock (1,000,000 shares)   -    1,000    4,002    1.5%
               7,300    10,302    3.8%
City Gear, LLC  Footwear Retail  Subordinated Debt (13% Cash, Due 9/28/16)   8,231    8,231    8,231    3.1%
City Gear, LLC (6)  Footwear Retail  Preferred Membership Units (2.78% fully diluted, 9% dividend)   -    1,269    1,269    0.5%
City Gear, LLC  Footwear Retail  Membership Unit Warrants (11.37% fully diluted)   -    -    5,307    2.0%
               9,500    14,807    5.6%
Corporate Visions, Inc.  Sales & Marketing Services  Subordinated Debt (14% Cash, 2% PIK, Due 3/22/18)   11,174    11,174    11,174    4.2%
Corporate Visions, Inc.  Sales & Marketing Services  Common Stock (2,216,463 shares)   -    2,576    9,797    3.6%
Corporate Visions, Inc.  Sales & Marketing Services  Common Stock Warrant (403,257 shares)   -    -    1,782    0.7%
               13,750    22,753    8.5%
GA Communications, Inc.  Advertising & Marketing Services  Series A-1 Preferred Stock (1,998 shares)   -    1,998    2,370    0.9%
GA Communications, Inc.  Advertising & Marketing Services  Series B-1 Common Stock (200,000 shares)   -    2    2,541    0.9%
               2,000    4,911    1.8%
Impresa Aerospace Holdings, LLC (3)  Aerospace Parts Manufacturer  Subordinated Debt (4.1% Cash, Due 4/28/16)   13,274    12,258    10,064    3.7%
Impresa Aerospace Holdings, LLC  Aerospace Parts Manufacturer  Class A Membership Units (1,006,621 units)   -    900    -    0.0%
Impresa Aerospace Holdings, LLC  Aerospace Parts Manufacturer  Class C Membership Units (362,416 units)   -    362    -    0.0%
Impresa Aerospace Holdings, LLC  Aerospace Parts Manufacturer  Class F Membership Units (604,504 units)   -    604    -    0.0%
               14,124    10,064    3.7%

 

11
 

  

Company (4, 5)  Industry  Investment Interest Rate /
Maturity
  Principal
Amount
   Cost   Fair
Value
   % of
Net
Assets
 
J&J Produce Holdings, Inc.  Produce Distribution  Subordinated Debt (13% Cash, Due 7/16/18)   5,182    5,182    5,182    2.0%
J&J Produce Holdings, Inc.  Produce Distribution  Common Stock (8,182 Shares)   -    818    934    0.3%
J&J Produce Holdings, Inc.  Produce Distribution  Common Stock Warrants (4,506 shares)   -    -    515    0.2%
               6,000    6,631    2.5%
LJS Partners, LLC  QSR Franchisor  Common Stock (1,500,000 shares)   -    1,500    14,622    5.4%
               1,500    14,622    5.4%
MJC Holdings, LLC  Specialty Clothing  Subordinated Debt (14%, 2% PIK at company's option, Due 1/16/18)   7,500    7,500    7,500    2.8%
MJC Holdings, LLC  Specialty Clothing  Series A Preferred Units (2,000,000 units)   -    2,000    5,224    1.9%
               9,500    12,724    4.7%
MMI Holdings, LLC  Medical Device Distributor  Senior Secured Debt (12% Cash, Due 10/17/14)   2,600    2,600    2,600    1.1%
MMI Holdings, LLC  Medical Device Distributor  Subordinated Debt (6% Cash, Due 8/15/15)   400    388    400    0.1%
MMI Holdings, LLC  Medical Device Distributor  Preferred Units (1,000 units)   -    1,052    1,200    0.4%
MMI Holdings, LLC  Medical Device Distributor  Common Units (45 units)   -    -    125    0.0%
               4,040    4,325    1.6%
MTI Holdings, LLC  Retail Display & Security Services  Subordinated Debt (12% Cash, Due 11/1/18)   8,000    8,000    8,000    3.0%
MTI Holdings, LLC  Retail Display & Security Services  Capital Units (2,000,000 units)   -    2,000    2,823    1.1%
               10,000    10,823    4.1%
Source Capital ABUTEC, LLC  Environmental Services Products  Senior Secured Debt (12% Cash, 3% PIK, Due 12/28/17)   5,125    5,125    5,125    1.9%
Source Capital ABUTEC, LLC  Environmental Services Products  Preferred Membership Units (15.5% fully diluted)   -    1,240    60    0.0%
               6,365    5,185    1.9%
Source Capital Penray, LLC  Automotive Chemicals & Lubricants  Subordinated Debt (13% Cash, Due 2/17/17)   2,500    2,500    2,500    0.9%
Source Capital Penray, LLC  Automotive Chemicals & Lubricants  Membership Units  (11.3% fully diluted)   -    750    810    0.3%
Source Capital Penray, LLC  Automotive Chemicals & Lubricants  Common Stock Warrants (6.65% fully diluted)   -    -    576    0.2%
               3,250    3,886    1.4%
Source Capital SSCR, LLC  Personal Product Manufacturer  Senior Secured Term Debt (14% Cash, Due 7/6/17)   15,000    15,000    12,115    4.5%
Source Capital SSCR, LLC  Personal Product Manufacturer  Senior Secured Term Debt (14% Cash, 5% PIK, Due 3/28/14)   2,079    2,079    1,958    0.7%
Source Capital SSCR, LLC  Personal Product Manufacturer  Preferred Membership Units (14,718 units)   -    1,720    -    0.0%
Source Capital SSCR, LLC  Personal Product Manufacturer  Membership Unit Warrants (0.987% fully diluted)   -    -    -    0.0%
               18,799    14,073    5.2%
Source Recycling, LLC (2)  Metal Recycler  Subordinated Debt (13% Cash, Due 9/2/16)   5,000    5,000    3,950    1.5%
Source Recycling, LLC  Metal Recycler  Membership Units (68,658 units)   -    1,590    -    0.0%
Source Recycling, LLC  Metal Recycler  Membership Unit Warrants (1% fully diluted)   -    -    -    0.0%
               6,590    3,950    1.5%
Sparus Holdings, Inc.(1)  Energy Services  Subordinated Debt (12% Cash, Due 3/21/16)   7,000    7,000    7,000    2.6%

 

12
 

  

Sparus Holdings, Inc.  Energy Services  Series B Preferred Stock (5,703 shares)   -    1,173    1,479    0.6%
Sparus Holdings, Inc.  Energy Services  Common Stock Warrants (3,491 shares)   -    -    304    0.1%
               8,173    8,783    3.3%
STX Healthcare Management Services, Inc. (1)  Dental Practice Management  Subordinated Debt (14% Cash, Due 7/31/15)   7,425    7,425    7,425    2.8%
STX Healthcare Management Services, Inc.  Dental Practice Management  Common Stock (1,200,000 shares)   -    1,200    942    0.4%
STX Healthcare Management Services, Inc.  Dental Practice Management  Common Stock Warrants (1,154,254 shares)   -    218    906    0.3%
               8,843    9,273    3.5%
Take 5 Oil Change, LLC  Quick Lube Services  Common Stock (10,692 shares)   -    1,069    1,604    0.6%
               1,069    1,604    0.6%
TCE Holdings, Inc.  Oil & Gas Services  Subordinated Debt (12% Cash, 2% PIK, Due 11/22/18)   12,088    12,088    12,088    4.5%
TCE Holdings, Inc.  Oil & Gas Services  Subordinated Debt (12% Cash, 2% PIK, Due 2/1/19)   9,633    9,633    9,633    3.6%
TCE Holdings, Inc.  Oil & Gas Services  Class A Common Stock (3,600 shares)   -    3,600    3,600    1.3%
               25,321    25,321    9.4%
V12 Holdings(1)  Data Processing & Digital Marketing  Bridge Note (0% Cash, Due 12/31/14)   663    361    663    0.3%
V12 Holdings(1)  Data Processing & Digital Marketing  Tier 2 Note (0% Cash, Due 12/31/14)   81    44    81    0.0%
V12 Holdings(1)  Data Processing & Digital Marketing  Senior Subordinated Note (0% Cash, Due 12/31/14)   3,563    2,369    3,598    1.3%
V12 Holdings(1)  Data Processing & Digital Marketing  Tier 3 Note (0% Cash, Due 12/31/14)   299    206    314    0.1%
V12 Holdings(1)  Data Processing & Digital Marketing  Jr. Subordinated Note (0% Cash, Due 12/31/14)   2,750    -    405    0.2%
V12 Holdings(1)  Data Processing & Digital Marketing  Tier 4 Note (0% Cash, Due 12/31/14)   243    -    -    0.0%
V12 Holdings  Data Processing & Digital Marketing  Series A-1 Preferred Stock (255,102 shares)   -    -    -    0.0%
V12 Holdings  Data Processing & Digital Marketing  Series A-3 Preferred Stock (88,194 shares)   -    -    -    0.0%
V12 Holdings  Data Processing & Digital Marketing  Series A-5 Preferred Stock (20,530 shares)   -    -    -    0.0%
V12 Holdings  Data Processing & Digital Marketing  Common Stock Warrants (2,063,629 warrants)   -    -    -    0.0%
               2,980    5,061    1.9%
Sub Total Affiliate investments             $159,104   $189,098    70.4%
Control investments - 28.4%                          
CableOrganizer Acquisition, LLC  Computer Supply Retail  Senior Secured Debt (12% Cash, 4% PIK, Due 5/24/18)  $6,585   $6,585   $6,585    2.5%
CableOrganizer Acquisition, LLC  Computer Supply Retail  Common Stock (1,125,000 shares)   -    1,125    88    0.0%
               7,710    6,673    2.5%
KBP Investments, LLC (6) (7)  QSR Franchisee  Class A Preferred Stock (8,270 shares, 10% Dividend)   -    8,269    8,269    3.1%
KBP Investments, LLC  QSR Franchisee  Class A Common Stock (380,413 shares)   -    -    16,518    6.1%
               8,269    24,787    9.2%
Market E’s, LLC  Online Travel Sales & Marketing  Senior Secured Debt (10% Cash, Due 12/31/14)   650    650    650    0.2%
Market E’s, LLC (1)(2)  Online Travel Sales & Marketing  Senior Subordinated Debt (14% Cash, 3% PIK, Due 12/31/14)   3,014    2,832    988    0.4%
Market E’s, LLC  Online Travel Sales & Marketing  Class A Preferred Stock (600 shares)   -    240    -    0.0%
Market E’s, LLC  Online Travel Sales & Marketing  Class B Preferred Stock (2,411 shares)   -    965    -    0.0%
Market E’s, LLC  Online Travel Sales & Marketing  Class A Common Stock (600 shares)   -    -    -    0.0%
               4,687    1,638    0.6%

 

13
 

  

Micro Precision, LLC  Conglomerate  Subordinated Debt (10% Cash, Due 9/16/16)   1,862    1,862    1,862    0.7%
Micro Precision, LLC  Conglomerate  Subordinated Debt (14% Cash, 4% PIK, Due 9/16/16)   3,557    3,557    3,557    1.3%
Micro Precision, LLC  Conglomerate  Common Stock (47 units)   -    1,629    2,210    0.8%
               7,048    7,629    2.8%
Navis Holdings, Inc.  Textile Equipment Manufacturer  Senior Secured Term Debt (17%, 3% PIK at company's option, Due 2/1/16)   6,753    6,753    6,753    2.5%
Navis Holdings, Inc.  Textile Equipment Manufacturer  Class A Preferred Stock (1,000 shares)   -    1,000    1,200    0.5%
Navis Holdings, Inc.  Textile Equipment Manufacturer  Common Stock (300,000 shares)   -    1    1,079    0.4%
               7,754    9,032    3.4%
On-Site Fuel Services, Inc.  Fuel Transportation Services  Subordinated Debt (14% Cash, 4% PIK, Due 12/19/16)   4,848    4,848    4,848    1.8%
On-Site Fuel Services, Inc.  Fuel Transportation Services  Series A Preferred Stock (32,782 shares)   -    3,278    2,719    1.0%
On-Site Fuel Services, Inc. (6)  Fuel Transportation Services  Series B Preferred Stock (23,648 shares)   -    2,451    2,707    1.0%
On-Site Fuel Services, Inc.  Fuel Transportation Services  Common Stock (33,107 shares)   -    33    -    0.0%
               10,610    10,274    3.8%
Print Direction, Inc. (1)  Printing Services  Subordinated Debt (12% Cash, 6% PIK, Due 7/25/2018)   4,424    4,389    4,424    1.6%
Print Direction, Inc. (1)  Printing Services  Subordinated Debt (14% Cash, Due 7/31/18)   4,600    4,600    4,600    1.7%
Print Direction, Inc.  Printing Services  Common Stock (19,363 shares)   -    2,990    7,110    2.7%
Print Direction, Inc.  Printing Services  Common Stock Warrants (3% fully diluted)   -    -    314    0.1%
               11,979    16,448    6.1%
Sub Total Control investments             $58,057   $76,481    28.4%
TOTAL INVESTMENTS - 135.7%             $301,299   $364,719    135.7%

 

(1) The maturity date of the original investment has been extended.

(2) Due to deterioration in credit quality, this investment is on non- accrual status.

(3) The debt investment is accruing interest based on the terms of the forebearance agreement.

(4) All debt investments are income producing. Equity and warrant investments are non-income producing, unless otherwise noted.

(5) Percentages are based on net assets of $268,670 as of December 31, 2013.

(6) The equity investment is income producing, based on cash rate disclosed.

(7) During the fourth quarter of 2013, the Company accepted a consent fee that waives its right to dividends through September 30, 2014.

(8) The equity investment has an exercisable put option.

 

See accompanying notes to consolidated financial statements.

 

14
 

 

CAPITALA FINANCE CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

June 30, 2014

 

(unaudited)

 

Note 1. Organization

 

Capitala Finance Corp. (the “Company”, “we”, “us”, and “our”) is a newly formed, externally managed non-diversified closed-end management investment company incorporated in Maryland 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 are an “emerging growth company” within the meaning of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and as such, are subject to reduced public company reporting requirements. We commenced operations on May 24, 2013 and completed our initial public offering (“IPO”) on September 30, 2013. The Company is managed by Capitala Investment Advisors, LLC (the “Investment Advisor”), an investment adviser that is registered as an investment adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and Capitala Advisors Corp. (the “Administrator”) provides the administrative services necessary for us to operate. In addition, for U.S. federal income tax purposes, the Company intends to elect to be treated as a regulated investment company (“RIC”), under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”) commencing with our tax year ending August 31, 2014.

 

The Company was formed for the purpose of: (i) acquiring, through a series of transactions, an investment portfolio from the following entities: CapitalSouth Partners Fund I Limited Partnership (“Fund I”); CapitalSouth Partners Fund II Limited Partnership (“Fund II”); CapitalSouth Partners Fund III, L.P. (“Fund III Parent”); CapitalSouth Partners SBIC Fund III, L.P. (“Fund III”) and CapitalSouth Partners Florida Sidecar Fund I, L.P. (“Florida Sidecar” and, collectively with Fund I, Fund II, Fund III and Fund III Parent, the “Legacy Funds”); (ii) raising capital in the IPO; and (iii) continuing and expanding the business of the Legacy Funds by making additional debt and equity investments in smaller and lower middle market companies.

 

The Company’s investment objective is to generate both current income and capital appreciation through debt and equity investments. Both directly and through our subsidiaries that are licensed by the U.S. Small Business Administration (“SBA”) under the Small Business Investment Company (“SBIC”) Act, we offer customized financing to business owners, management teams and financial sponsors for change of ownership transactions, recapitalizations, strategic acquisitions, business expansion and other growth initiatives. We invest primarily in traditional mezzanine, senior subordinated and unitranche debt, as well as senior and second-lien loans and, to a lesser extent, equity securities issued by smaller and lower middle-market companies.

 

On September 24, 2013, the Company acquired 100% of the limited partnership interests in Fund II, Fund III and Florida Sidecar and each of their respective general partners, as well as certain assets from Fund I and Fund III Parent, in exchange for an aggregate of 8,974,420 shares of the Company’s common stock (the “Formation Transactions”). Fund II, Fund III and Florida Sidecar became the Company’s wholly-owned subsidiaries. Fund II and Fund III retained their SBIC licenses and continue to hold their existing investments and continue to make new investments. The IPO consisted of the sale of 4,000,000 shares of the Company’s common stock at a price of $20.00 per share resulting in net proceeds to the Company of $74.25 million, after deducting underwriting fees and commissions totaling $4.0 million and offering expenses totaling $1.75 million. The other costs of the IPO were borne by the limited partners of the Legacy Funds. As of June 30, 2014, the Company had 12,974,420 shares of common stock outstanding.

 

15
 

  

Note 2. Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying unaudited financial statements are presented in conformity with United States generally accepted accounting principles (“U.S. GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with U.S. GAAP are omitted. In the opinion of management, all adjustments, consisting solely of normal recurring adjustments necessary for the fair presentation of financial statements for the interim period, have been reflected in the unaudited consolidated financial statements. The current period’s results of operations are not necessarily indicative of results that ultimately may be achieved for the year. Additionally, the unaudited consolidated financial statements and notes should be read in conjunction with the audited consolidated financial statements and notes thereto appearing in the Company’s annual report on Form 10-K for the period ended December 31, 2013, filed with the U.S Securities and Exchange Commission (“SEC”) on March 28, 2014. Financial statements prepared on a U.S. GAAP basis require management to make estimates and assumptions that affect the amounts and disclosures reported in the consolidated financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.

 

The consolidated financial statements of the Company include the accounts of the Company and its wholly-owned subsidiaries as described in the Formation Transactions presented in Note 1. The transactions related to Fund II, Fund III, and the Florida Sidecar constitute an exchange of shares between entities under common control and will be accounted for in accordance with the Accounting Standards Codification (“ASC”), Topic 805, Business Combinations (“ASC 805”). As such, the results of the Company’s operations and cash flows for the three and six months ended June 30, 2013 have been presented on a combined basis in order to provide comparative information with respect to prior periods. The Formation Transactions also included an asset acquisition of certain assets in Fund I and Fund III Parent. In accordance with ASC 805, the assets acquired were recorded at fair value at the date of acquisition, September 24, 2013.

 

The Company’s financial position as of June 30, 2014 is presented on a consolidated basis. The effects of all intercompany transactions between the Company and its subsidiaries (Fund II, Fund III, and the Florida Sidecar) have been eliminated in consolidation. All financial data and information included in these consolidated financial statements have been presented on the basis described above. In the opinion of management, the consolidated financial statements reflect all adjustments that are necessary for the fair presentation of financial results as of and for the periods presented.

 

Use of Estimates in the Preparation of Financial Statements

 

The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

 

Segments

 

In accordance with ASC Topic 280 - Segment Reporting, the Company has determined that it has a single reporting segment and operating unit structure.

 

Cash and Cash Equivalents

 

The Company considers cash equivalents to be highly liquid investments with original maturities of three months or less at the date of purchase. Cash and cash equivalents include deposits in money market accounts. The Company deposits its cash in financial institutions and, at times, such balances may be in excess of the Federal Deposit Insurance Corporation (“FDIC”) insurance limits.

 

Investment Classification

 

In accordance with the provisions of the 1940 Act, the Company classifies investment by level of control. As defined in the 1940 Act, “Control Investments” are investments in those companies that the Company is deemed to “Control.” “Affiliate Investments” are investments in those companies that are “Affiliated Companies” of the Company, as defined in the 1940 Act, other than Control Investments. “Non-Control/Non-Affiliate Investments” are those investments that are neither Control Investments nor Affiliate Investments. Generally under the 1940 Act, the Company is deemed to control a company in which it has invested if the Company owns more than 25% of the voting securities of such company and/or has greater than 50% representation on its board or has the power to exercise control over management or policies of such portfolio company. The Company is deemed to be an affiliate of a company in which the Company has invested if it owns between 5% and 25% of the voting securities of such company.

 

16
 

  

Valuation of Investments

 

The Company applies fair value accounting to all of its financial instruments in accordance with the 1940 Act and ASC Topic 820 - Fair Value Measurements and Disclosures (“ASC 820”). ASC 820 defines fair value, establishes a framework used to measure fair value and requires disclosures for fair value measurements. In accordance with ASC 820, the Company has categorized its financial instruments carried at fair value, based on the priority of the valuation technique, into a three-level fair value hierarchy as discussed in Note 4.

 

In determining fair value, our board of directors (the “Board”) uses various valuation approaches, and engages a third-party valuation firm, which provides an independent review of certain investments. In accordance with U.S. GAAP, a fair value hierarchy for inputs is used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available.

 

Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Board. Unobservable inputs reflect the Boards’ assumptions about the inputs market participants would use in pricing the asset or liability developed based upon the best information available in the circumstances.

 

The availability of valuation techniques and observable inputs can vary from security to security and is affected by a wide variety of factors including, the type of security, whether the security is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Those estimated values do not necessarily represent the amounts that may be ultimately realized due to the occurrence of future circumstances that cannot be reasonably determined. Because of the inherent uncertainty of valuation, those estimated values may be materially higher or lower than the values that would have been used had a market for the securities existed. Accordingly, the degree of judgment exercised by the Board in determining fair value is greatest for securities categorized in Level 3 (as defined below). In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls, is determined based on the lowest level input that is significant to the fair value measurement.

 

Fair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the Company’s own assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date. We use prices and inputs that are current as of the measurement date, including periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many securities. This condition could cause a security to be reclassified to a lower level within the fair value hierarchy.

 

Valuation Techniques

 

Senior and Subordinated Secured Loans

 

The Company’s portfolio primarily consists of private debt instruments (“Level 3 debt”). We consider our Level 3 debt to be performing loans if the borrower is not in default, the borrower is remitting payments in a timely manner, the loan is in covenant compliance or is otherwise not deemed to be impaired. In determining the fair value of the performing Level 3 debt, the Company’s Board considers fluctuations in current interest rates, the trends in yields of debt instruments with similar credit ratings (if applicable), the financial condition of the borrower, economic conditions and other relevant factors, both qualitative and quantitative. In the event that a Level 3 debt instrument is not performing, as defined above, the Board will evaluate the value of the collateral utilizing the same framework described above for a performing loan to determine the value of the Level 3 debt instrument.

 

17
 

  

This evaluation will be updated no less than quarterly for Level 3 debt instruments that are not performing, and more frequently for time periods where there are significant changes in the collateral or significant changes in the perceived performance of the underlying portfolio company. The collateral value will be analyzed on an ongoing basis using internal metrics, appraisals, third-party valuation agents and other data as may be acquired and analyzed by our management and Board.

 

Equity Investments in Private Companies

 

Our Board determines the fair value of its investments in private companies by incorporating valuations that consider the evaluation of financing and sale transactions with third-parties, expected cash flows and market-based information, including comparable transactions, and performance multiples, among other factors, and may use third-party valuation agents. Such non-public investments are included in Level 3 of the fair value hierarchy.

 

Warrants

 

Our Board will ascribe value to warrants based on the fair value of holdings to which they are associated that can include discounted cash flow analyses, option pricing models, comparable analyses and other techniques as deemed appropriate. Such warrants are included in Level 3 of the fair value hierarchy to the extent issued by non-public companies.

 

Revenue Recognition

 

The Company’s revenue recognition policies are as follows:

 

Interest Income and Paid-in Kind Interest Income: Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. The company has loans in the portfolio that contain a payment-in-kind (“PIK”) provision. The PIK interest, which represents contractually deferred interest added to the loan balance that is generally due at maturity, is recorded on the accrual basis to the extent that such amounts are expected to be collected. PIK interest is not accrued if the Company does not expect the issuer to be able to pay all principal and interest when due.

 

Non-accrual income: Generally, when interest and/or principal payments on a loan become materially past due, or if the Company otherwise does not expect the borrower to be able to service its debt and other obligations, the Company will place the loan on non-accrual status, and will generally cease recognizing interest income and PIK interest on that loan for financial reporting purposes. Interest payments received on non-accrual loans may be recognized as income or applied to principal depending upon management’s judgment. The Company writes off any previously accrued and uncollected interest when it is determined that interest is no longer considered collectible. The company may elect to cease accruing PIK interest and continue accruing interest income in cases where a loan is currently paying its interest income but, in management’s judgment, there is a reasonable likelihood of principal loss on the loan. Non-accrual loans are returned to accrual status when the borrower’s financial condition improves such that management believes current interest and principal payments are expected to be collected.

 

Gains and Losses on investment sales and paydowns: Realized gains and losses on investments are recognized using the specific identification method.

 

Dividend Income and Paid-in-kind Dividends: Dividend income is recognized on the date dividends are declared. The Company holds preferred equity investments in the portfolio that contain a payment-in-kind dividend (“PIK dividends”) provision. PIK dividends, which represent contractually deferred dividends added to the equity balance, are recorded on the accrual basis to the extent that such amounts are expected to be collected. The Company will typically cease accrual of PIK dividends when the fair value of the equity investment is less than the cost basis of the investment or when it is otherwise determined by management that collection of PIK dividends are unlikely to be collected. If management determines that a decline in fair value is temporary in nature and the PIK dividends are more likely than not to be collected, management may elect to continue accruing PIK dividends.

 

18
 

  

Other Income: Origination, amendment, consent, closing and/or commitment fees associated with investments in portfolio companies are recognized as income when the investment transaction closes. Prepayment penalties received by the Company for debt instruments repaid prior to maturity date are recorded as income upon receipt.

 

General and Administrative Expenses

 

General and administrative expenses are accrued as incurred. The Company’s general and administrative expenses include personnel expenses allocable to the Company under the Administration Agreement, legal and audit fees, director fees, director and officer insurance, and other expenses payable under the Administration Agreement.

 

Deferred Financing Fees

 

Costs incurred to issue the SBA-guaranteed debentures and notes payable are capitalized and are amortized over the term of the debt agreements under the effective interest method.

 

Commitments and Contingencies

 

As of June 30, 2014 and December 31, 2013, the Company had $1.3 million and $0 of outstanding unfunded commitments, respectively. The Company’s unfunded commitments are comprised solely of unused lines of credit of existing portfolio companies.

 

In the ordinary course of its business, the Company may enter into contracts or agreements that contain indemnifications or warranties. Future events could occur that lead to the execution of these provisions against the Company. Based on its history and experience, management feels that the likelihood of such an event is remote.

 

In the ordinary course of business, the Company may directly or indirectly be a defendant or plaintiff in legal actions with respect to bankruptcy, insolvency or other types of proceedings. Such lawsuits may involve claims that could adversely affect the value of certain financial instruments owned by the Company. As of June 30, 2014, resolution of any outstanding claims is not expected to materially affect the Company’s business, financial position, results of operation, or liquidity.

 

Income Taxes

 

The Company intends to elect to be treated for federal income tax purposes, and intends to qualify annually thereafter, as a RIC under Subchapter M of the Code and, among other things, intends to make the requisite distributions to its stockholders which will relieve the Company from federal income taxes. Therefore, no provision has been recorded for federal income taxes.

 

In order to qualify as a RIC, among other requirements, the Company is required to timely distribute to its stockholders at least 90.0% of its investment company taxable income, as defined by the Code, for each fiscal tax year. The Company will be subject to a nondeductible U.S. federal excise tax of 4.0% on undistributed income if it does not distribute at least 98.0% of its ordinary income in any calendar year and 98.2% of its capital gain net income for each one-year period ending on October 31.

 

Depending on the level of taxable income earned in a tax year, the Company may choose to carry forward taxable income in excess of current year dividend distributions into the next tax year and pay a 4.0% excise tax on such income, as required. 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 for excise tax purposes, the Company accrues excise tax, if any, on estimated excess taxable income as taxable income is earned.

 

In accordance with certain applicable Treasury regulations and private letter rulings issued by the Internal Revenue Service, a 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 on the aggregate amount of cash to be distributed to all stockholders, which limitation must be at least 20.0% of the aggregate declared distribution. If too many stockholders elect to receive cash, each stockholder electing to receive cash will receive a pro rata amount of cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive less than 20.0% of his or her entire distribution in cash. 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.

 

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 ASC Topic 740, Income Taxes (“ASC 740”), provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the consolidated financial statements. ASC 740 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s 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 current period. The Company recognizes interest and penalties, if any, related to unrecognized tax benefits as income tax expense in the consolidated statements of operations. As of June 30, 2014 and December 31, 2013, there were no uncertain tax positions.

 

The Company is required to determine whether a tax position of the Company is more likely-than-not to be sustained upon examination by the applicable taxing authority, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The tax benefit to be recognized is measured as the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. De-recognition of a tax benefit previously recognized could result in the Company recording a tax liability that could have negatively impact the Company’s net assets.

 

U.S. GAAP provides guidance on thresholds, measurement, de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition that is intended to provide better financial statement comparability among different entities.

 

The Company has concluded that it was not necessary to record a liability for any such tax positions as of June 30, 2014 and December 31, 2013. However, the Company’s conclusions regarding this policy may be subject to review and adjustment at a later date based on factors including, but not limited to, ongoing analyses of, and changes to, tax laws, regulations and interpretations thereof.

 

The Company’s activities from commencement of operations remain subject to examination by U.S. federal, state, and local tax authorities. No interest expense or penalties have been assessed for the three and six month periods ended June 30, 2014 and June 30, 2013. If the Company were required to recognize interest and penalties, if any, related to unrecognized tax benefits this would be recognized as income tax expense in the consolidated statement of operations.

 

Dividends

 

Dividends to common stockholders are recorded on the ex-dividend date. The amount to be paid out as a dividend is approved by the Board. Net capital gains, if any, are generally distributed at least annually, although we may decide to retain such capital gains for reinvestment.

 

We have adopted an “opt out” dividend reinvestment plan for our common stockholders. As a result, if we declare a cash dividend or other distribution, each stockholder that has not “opted out” of our dividend reinvestment plan will have his/her dividends automatically reinvested in additional shares of our common stock rather than receiving cash dividends. Stockholders who receive distributions in the form of shares of common stock will be subject to the same federal, state and local tax consequences as if they received cash distributions.

 

Company Investment Risk, Concentration of Credit Risk, and Liquidity Risk

 

The Investment Advisor has broad discretion in making investments for the Company. Investments will generally consist of debt and equity instruments that may be affected by business, financial market or legal uncertainties. Prices of investments may be volatile, and a variety of factors that are inherently difficult to predict, such as domestic or international economic and political developments, may significantly affect the results of the Company’s activities and the value of its investments. In addition, the value of the Company’s portfolio may fluctuate as the general level of interest rates fluctuate.

 

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The value of the Company’s investments in loans may be detrimentally affected to the extent, among other things, that a borrower defaults on its obligations, there is insufficient collateral and/or there are extensive legal and other costs incurred in collecting on a defaulted loan, observable secondary or primary market yields for similar instruments issued by comparable companies increase materially or risk premiums required in the market between smaller companies, such as our borrowers, and those for which market yields are observable increase materially.

 

The Investment Advisor may attempt to minimize this risk by maintaining low loan-to-liquidation values with each loan and the collateral underlying the loan.

 

The Company’s assets may, at any time, include securities and other financial instruments or obligations that are illiquid or thinly traded, making purchase or sale of such securities and financial instruments at desired prices or in desired quantities difficult. Furthermore, the sale of any such investments may be possible only at substantial discounts, and it may be extremely difficult to value any such investments accurately.

 

Note 3. Recent Accounting Pronouncements

 

In June, 2013 the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No 2013-08, “Financial Services – Investment Companies (Topic 946), Amendments to the Scope, Measurement, and Disclosure Requirements. The amendments in this accounting standards update affect the scope, measurement, and disclosure requirements for investment companies under U.S. GAAP, and clarify the characteristics of an investment company, provide comprehensive guidance for assessing whether an entity is an investment company, require that an investment company measure non-controlling ownership interests in other investment companies at fair value rather than using the equity method of accounting, and require additional disclosures. This standard is effective for interim and annual reporting periods in fiscal years that begin after December 15, 2013. The Company has adopted this standard and the required disclosures are presented in the consolidated financial statements.

 

Note 4. Investments

 

The Company’s investment objective is to generate both current income and capital appreciation through debt and equity investments. Both directly and through our subsidiaries that are licensed by the SBA under the SBIC Act, we offer customized financing to business owners, management teams and financial sponsors for change of ownership transactions, recapitalizations, strategic acquisitions, business expansion and other growth initiatives. We invest primarily in traditional mezzanine, senior subordinated and unitranche debt, as well as senior and second-lien loans and, to a lesser extent, equity securities issued by smaller and lower middle-market companies. As of June 30, 2014, our portfolio consisted of investments in 45 portfolio companies with a fair value of approximately $405.6 million.

 

During the three months ended June 30, 2014, the Company made approximately $22.6 million of investments in new or existing portfolio companies and had approximately $9.4 million in exits and repayments resulting in net investments of approximately $13.2 million for the period. During the three months ended June 30, 2013, the Company made approximately $20.2 million of investments in new or existing portfolio companies and had approximately $15.7 million in exits and repayments resulting in net investments of approximately $4.5 million for the period.

 

During the six months ended June 30, 2014, the Company made approximately $63.6 million of investments in new or existing portfolio companies and had approximately $20.2 million in exits and repayments resulting in net investments of approximately $43.4 million for the period. During the six months ended June 30, 2013, the Company made approximately $41.4 million of investments in new or existing portfolio companies and had approximately $28.7 million in exits and repayments resulting in net investments of approximately $12.7 million for the period.

 

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During the three and six month periods ended June 30, 2014, all investments were made to portfolio companies in which the Company was not previously contractually obligated to provide financial support. In addition to investing directly in portfolio companies, the Company may assist portfolio companies in securing financing from other sources by introducing portfolio companies to sponsors or by leading a syndicate of investors to provide the portfolio companies with financing. During the six month period ended June 30, 2014, the Company did not lead any syndicates. During the three months ended June 30, 2014 the Company did not assist any portfolio companies in obtaining financing. During the six month periods ended June 30, 2014, the Company helped Print Direction, Inc. obtain a $3.5 million senior revolving credit facility.

 

The composition of our investments as of June 30, 2014, at amortized cost and fair value were as follows (dollars in thousands):

 

   Investments at
Amortized Cost
   Amortized Cost
Percentage of
Total Portfolio
   Investments at
Fair Value
   Fair Value
Percentage of
Total Portfolio
 
Senior Secured Debt  $127,026    36.5%  $128,913    31.8%
Subordinated Debt   156,534    45.0    151,683    37.4 
Equity and Warrants   64,186    18.5    124,963    30.8 
Total  $347,746    100.0%  $405,559    100.0%

 

The composition of our investments as of December 31, 2013, at amortized cost and fair value were as follows (dollars in thousands):

 

   Investments at
Amortized Cost
   Amortized Cost
Percentage of
Total Portfolio
   Investments at
Fair Value
   Fair Value
Percentage of
Total Portfolio
 
Senior Secured Debt  $103,457    34.3%  $102,071    28.0%
Subordinated Debt   136,638    45.4    133,710    36.7 
Equity and Warrants   61,204    20.3    128,938    35.3 
Total  $301,299    100.0%  $364,719    100.0%

 

As noted above, the Company values all investments in accordance with ASC 820. ASC 820 requires enhanced disclosures about assets and liabilities that are measured and reported at fair value. As defined in ASC 820, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

 

ASC 820 establishes a hierarchal disclosure framework which prioritizes and ranks the level of market price observability of inputs used in measuring investments at fair value. Market price observability is affected by a number of factors, including the type of investment and the characteristics specific to the investment. Investments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value.

 

Based on the observability of the inputs used in the valuation techniques, the Company is required to provide disclosures on fair value measurements according to the fair value hierarchy. The fair value hierarchy ranks the observability of the inputs used to determine fair values. Investments carried at fair value are classified and disclosed in one of the following three categories:

 

  Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.

 

  Level 2—Valuations based on inputs other than quoted prices in active markets, which are either directly or indirectly observable.

 

  Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

 

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In addition to using the above inputs in investment valuations, the Company continues to employ the valuation policy approved by the Board that is consistent with ASC 820 (See Note 2). Consistent with our Company’s valuation policy, we evaluate the source of inputs, including any markets in which our investments are trading, in determining fair value.

 

In estimating fair value of portfolio investments, the Company starts with the cost basis of the investment, which includes amortized original issue discount and PIK interest and dividends, if any. The transaction price is typically the best estimate of fair value at inception. When evidence supports a subsequent change to the carrying value from the original transaction price, adjustments are made to reflect the expected fair values.

 

The following valuation methodologies are utilized by the company in estimating fair value and are summarized as follows:

 

Enterprise Value Waterfall Approach

 

The enterprise value waterfall approach determines an enterprise value based on earnings before interest, tax, depreciation and amortization (“EBITDA”) multiples of publicly traded companies that are considered similar to the subject portfolio company. The Company considers a variety of items in determining a reasonable pricing multiple, including operating results, budgeted projections, growth, size, risk, profitability, leverage, management depth, diversification, market position, supplier or customer dependence, asset utilization, liquidity metrics, and access to capital markets. EBITDA of the portfolio company is adjusted for non-recurring items in order to reflect a normalized level of earnings that is representative of future earnings. When available, the Company may assign a pricing multiple or value its equity investments based on the value of recent investment transactions in the subject portfolio company. The enterprise value is adjusted for financial instruments with seniority to the Company’s ownership and for the effect of any instrument which may dilute the Company’s investment in the portfolio company. The adjusted enterprise value is then apportioned based on the seniority and privileges of the Company’s investments within the portfolio company.

 

Income Approach

 

The income approach utilizes a discounted cash flow methodology in which the Company estimates fair value based on the present value of a stream of expected cash flows discounted at a market rate of interest. The determination of a discount rate, or required rate of return, takes into account the portfolio company’s fundamentals and perceived credit risk.

 

Asset Approach

 

The asset approach values an investment based on the greater of the enterprise value or the underlying collateral securing the investment. See discussion of determining enterprise value above. This approach is used when the debt is not performing in accordance with its contractual terms or when the Company has reason to believe that it will not collect all principal and interest in accordance with the contractual terms of the debt agreement.

 

The following table presents fair value measurements of investments, by major class, as of June 30, 2014 (dollars in thousands), according to the fair value hierarchy:

 

   Fair Value Measurements 
   Level 1   Level 2   Level 3   Total 
Senior Secured Debt  $   $   $128,913   $128,913 
Subordinated Debt           151,683    151,683 
Equity and Warrants           124,963    124,963 
Total  $   $   $405,559   $405,559 

 

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The following table presents fair value measurements of investments, by major class, as of December 31, 2013 (dollars in thousands), according to the fair value hierarchy:

 

   Fair Value Measurements 
   Level 1   Level 2   Level 3   Total 
Senior Secured Debt  $   $   $102,071   $102,071 
Subordinated Debt           133,710    133,710 
Equity and Warrants           128,938    128,938 
Total  $   $   $364,719   $364,719 

 

The following table provides a reconciliation of the beginning and ending balances for investments that use Level 3 inputs for the six months ended June 30, 2014 (dollars in thousands):

 

   Senior
Secured
Debt
   Subordinated
Debt
   Equity
and
Warrants
   Total 
Balance as of January 1, 2014  $102,071   $133,710   $128,938   $364,719 
Change in classification due to restructure   (14,073)   14,073         
Repayments   (9,401)   (9,100)   (1,659)   (20,160)
Purchases   49,657    11,159    2,768    63,584 
Payment in-kind interest and dividends, net of payments received   404    642    288    1,334 
Accretion of original issue discount   7            7 
Realized gain from investments       55    1,627    1,682 
Increase/(decrease) in net unrealized appreciation   248    1,144    (6,999)   (5,607)
Balance as of June 30, 2014  $128,913   $151,683   $124,963   $405,559 

 

The following table provides a reconciliation of the beginning and ending balances for investments that use Level 3 inputs for the three months ended June 30, 2013 (dollars in thousands):

 

   Senior
Secured
Debt
   Subordinated
Debt
   Equity
and
Warrants
   Total 
Balance as of January 1, 2013  $73,638   $101,659   $108,634   $283,931 
Repayments   (375)   (27,981)   (365)   (28,721)
Purchases   23,855    15,050    2,475    41,380 
Payment in-kind interest and dividends, net of payments received   230    335        565 
Accretion of original issue discount   3    31        34 
Realized gain from investments           365    365 
Increase/(decrease) in net unrealized appreciation   545    (1,211)   6,505    5,839 
Balance as of June 30, 2013  $97,896   $87,883   $117,614   $303,393 

 

The net change in unrealized depreciation on investments held as of June 30, 2014 was $5.6 million and is included in net unrealized depreciation on investments in the consolidated statements of operations for the six months ended June 30, 2014. The net change in unrealized appreciation on investments held as of June 30, 2013 was $6.1 million and is included in net unrealized appreciation on investments in the consolidated statements of operations for the six months ended June 30, 2014.

 

 The valuation techniques and significant unobservable inputs used in recurring Level 3 fair value measurements of assets as of June 30, 2014 were as follows (dollars in thousands, except EBITDA amounts):

 

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   Fair Value   Valuation Approach  Level 3 Input  Range of Inputs  Weighted
Average
 
                  
Subordinated debt and second lien notes   $128,792   Income  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  9.0% - 25.0%
1.4x – 6.8x
$1.2 million-$109.0 million
   14.5%
4.1x
$18.6 million
 
                    
Subordinated debt and second lien notes   $22,891   Enterprise Value
Waterfall and Asset (1)
  Adjusted EBITDA Multiple
Adjusted EBITDA
  5.0x – 5.0x
$1.3 million - $2.8 million
   5.0x
$2.3 million
 
                    
Senior debt and first lien notes   $128,913   Income and Asset (1)  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  11.9% - 22.0%
0.7x – 6.8x
$1.3 million- $36.6 million
   13.8%
3.3x
$10.6 million
 
                    
Equity shares and warrants   $124,963   Enterprise Value
Waterfall
  Adjusted EBITDA Multiple
Adjusted EBITDA
  2.5x – 9.5x
$1.5 million -$229.0 million
   7.2x
$24.9 million
 

 

  (1) $19.7 million in subordinated notes and $9.1 million senior notes were valued using the asset approach.

 

The valuation techniques and significant unobservable inputs used in recurring Level 3 fair value measurements of assets as of December 31, 2013 were as follows (dollars in thousands, except EBITDA amounts):

 

   Fair Value   Valuation Approach  Level 3 Input  Range of Inputs  Weighted
Average
                 
Subordinated debt and second lien notes   $111,711   Income  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  7.0% - 18.0%
1.2x – 4.6x
$2.3 million-$25.8 million
  14.1%
3.1x
$11.2 million
                  
Subordinated debt and second lien notes    21,999   Enterprise Value
Waterfall and Asset (1)
  Adjusted EBITDA Multiple
Adjusted EBITDA
  4.3x – 11.5x
$1.3 million - $2.2 million
  9.5x
$2.0 million
                  
Senior debt and first lien notes    102,071   Income and Asset (1)  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  10.0% - 24.5%
1.2x – 9.9x
$0.6 million- $29.7 million
  15.2%
3.8x
$11.2 million
                  
Equity shares and warrants    128,938   Enterprise Value
Waterfall
  Adjusted EBITDA Multiple
Adjusted EBITDA
Transaction Price
  1.6x – 9.5x
$1.4 million -$229.0 million
n/a
  7.1x
$23.8 million
n/a

 

  (1) $15.0 million in subordinated notes and $3.6 million in senior notes were valued using the asset approach.

 

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The significant unobservable inputs used in the valuation of the Company’s debt and equity investments are required rate of return, adjusted EBITDA, EBITDA multiples, leverage and transaction prices. Changes in any of these unobservable inputs could have a significant impact on the Company’s estimate of fair value. An increase (decrease) in required rate of return or leverage will result in a lower (higher) estimate of fair value while an increase (decrease) in adjusted EBITDA, EBITDA multiples, or transaction prices will result in a higher (lower) estimate of fair value.

 

Note 5. Agreements

 

On September 24, 2013, the Company entered into an investment advisory agreement (the “Investment Advisory Agreement”) with our Investment Advisor, which was approved by the Board of the Company on June 10, 2013. The initial term of the Investment Advisory Agreement is two years, with automatic, one-year renewals at the end of each year subject to certain approvals by our Board and/or our stockholders. Subject to the overall supervision of our Board, our investment adviser manages our day-to-day operations, and provides investment advisory and management services to us. Under the terms of our Investment Advisory Agreement, The Investment Advisor:

 

  determines the composition of our portfolio, the nature and timing of the changes to our portfolio and the manner of implementing such changes;

 

  identifies, evaluates and negotiates the structure of the investments we make (including performing due diligence on our prospective portfolio companies);

 

  closes and monitors the investments we make; and

 

  provides us with other investment advisory, research and related services as we may from time to time require.

 

The Investment Advisor’s services under the Investment Advisory Agreement are not exclusive, and it is free to furnish similar services to other entities so long as its services to us are not impaired.

 

Pursuant to the Investment Advisory Agreement, we have agreed to pay the Investment Advisor a fee for investment advisory and management services consisting of two components — a base management fee and an incentive fee.

 

The base management fee is calculated at an annual rate of 1.75% of our gross assets, which is our total assets as reflected on our Statements of Assets and Liabilities and includes any borrowings for investment purposes. Although we do not anticipate making significant investments in derivative financial instruments, the fair value of any such investments, which will not necessarily equal their notional value, will be included in our calculation of gross assets. For services rendered under the Investment Advisory Agreement, the base management fee is payable quarterly in arrears. The base management fee will initially be calculated based on the value of our gross assets at the end of the first calendar quarter subsequent to our IPO, and thereafter based on the average value of our gross assets at the end of the two most recently completed calendar quarters, and appropriately adjusted for any share issuances or repurchases during the current calendar quarter. For the first twelve months following our IPO, the Investment Advisor has agreed to waive the portion of the base management fee payable on cash and cash equivalents held at the Company level, excluding cash and cash equivalents held by the Legacy Funds that were acquired by the Company in connection with the Formation Transactions.

 

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Prior to the Formation Transactions, the management fee charged by each Legacy Fund for each fiscal quarter was the lesser of (a) an amount equal to an annual rate of .625% of the sum of (i) the Legacy Funds’ regulatory capital and (ii) the amount of an assumed two tiers of outstanding leverage based on such regulatory capital, or (b) an amount negotiated between the general partner and the management company. The management fee was reduced by certain fees ultimately received by the Investment Advisor to the Legacy Funds from the portfolio companies. Payments of the management fee were made quarterly in advance. Certain direct expenses such as legal, audit, tax, and limited partner expense were the responsibility of the Legacy Fund.

 

The incentive fee consists of the following two parts:

 

The first part of the incentive fee is calculated and payable quarterly in arrears based on our pre-incentive fee net investment income for the immediately preceding calendar quarter. For this purpose, pre-incentive fee net investment income means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence 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 to our Administrator, and any interest expense and dividends 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, debt instruments with PIK interest and zero coupon securities), accrued income that we have not yet received in cash. Pre-incentive fee net investment income does not include any realized capital gains, computed net of all realized capital losses or unrealized capital appreciation or depreciation. Pre-incentive fee net investment income, expressed as a rate of return on the value of our net assets at the end of the immediately preceding calendar quarter, is compared to a hurdle of 2.0% per quarter (8.0% annualized). Our net investment income used to calculate this part of the incentive fee is also included in the amount of our gross assets used to calculate the 1.75% base management fee. We pay the Investment Advisor an incentive fee with respect to our pre-incentive fee net investment income in each calendar quarter as follows:

 

  no incentive fee in any calendar quarter in which our pre-incentive fee net investment income does not exceed the hurdle of 2.0%;

 

  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 but is less than 2.5% in any calendar quarter (10.0% annualized). We refer to this portion of our pre-incentive fee net investment income (which exceeds the hurdle but is less than 2.5%) as the “catch-up.” The “catchup” is meant to provide our Investment Advisor with 20% of our pre-incentive fee net investment income as if a hurdle did not apply if this net investment income exceeds 2.5% in any calendar quarter; and

 

  20% of the amount of our pre-incentive fee net investment income, if any, that exceeds 2.5% in any calendar quarter (10.0% annualized) is payable to our Investment Advisor (once the hurdle is reached and the catch-up is achieved, 20% of all preincentive fee investment income thereafter is allocated to the Investment Advisor).

 

The second part 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 will equal 20% of our realized capital gains, if any, on a cumulative basis from inception through the end of each calendar year, computed net of all realized capital losses and unrealized capital depreciation on a cumulative basis, less the aggregate amount of any previously paid capital gain incentive fees with respect to each of the investments in our portfolio.

 

We will defer cash payment of the portion of any incentive fee otherwise earned by our Investment Advisor that would, when taken together with all other incentive fees paid to our Investment Advisor during the most recent 12 full calendar month period ending on or prior to the date such payment is to be made, exceed 20% of the sum of (a) our pre-incentive fee net investment income during such period, (b) our net unrealized appreciation or depreciation during such period and (c) our net realized capital gains or losses during such period. Any deferred incentive fees will be carried over for payment in subsequent calculation periods to the extent such payment is payable under the Investment Advisory Agreement. Such deferred amounts will be calculated using a period of shorter than 12 full calendar months until 12 full calendar months have passed since completion of our IPO.

 

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For the three months ended June 30, 2014 and 2013 we incurred $2.3 million and $1.2 million in base management fees, respectively. For the three months ended June 30, 2014 and 2013, our Investment Advisor waived $0.1 million and $0, respectively. For the three months ended June 30, 2014 and 2013, we incurred $1.4 million and $0, respectively, in incentive fees related to pre-incentive fee net investment income.

 

For the six months ended June 30, 2014 and 2013 we incurred $4.3 million and $2.0 million in base management fees, respectively. For the six months ended June 30, 2014 and 2013, our Investment Advisor waived $0.2 million and $0, respectively. For the six months ended June 30, 2014 and 2013, we incurred $2.8 million and $0, respectively, in incentive fees related to pre-incentive fee net investment income.

 

On September 24, 2013, the Company entered into a separate administration agreement (the “Administration Agreement”) with Capitala Advisors Corp., our Administrator, pursuant to which our Administrator has agreed to furnish us with office facilities, equipment and clerical, bookkeeping and record keeping services at such facilities. Our Administrator also performs, or oversees the performance of, our required administrative services, which include, among other things, being responsible for the financial records that we are required to maintain and preparing reports to our stockholders. In addition, our Administrator 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 to our stockholders, and generally oversees the payment of our expenses and the performance of administrative and professional services rendered to us by others.

 

Payments under the Administration Agreement are equal to an amount based upon our allocable portion of our Administrator’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 compensation of our chief financial officer, chief compliance officer and our allocable portion of the compensation of any administrative support staff. Under the Administration Agreement, our Administrator will also provide on our behalf managerial assistance to those portfolio companies that request such assistance. The Administration Agreement will have 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 our Administrator outsources any of its functions, we will pay the fees associated with such functions on a direct basis without any incremental profit to our Administrator. Stockholder approval is not required to amend the Administration Agreement.

 

The Administration Agreement provides that, absent willful misfeasance, bad faith or negligence in the performance of its duties or by reason of the reckless disregard of its duties and obligations, our Administrator and its officers, managers, partners, agents, employees, controlling persons, 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 our Administrator’s services under the Administration Agreement or otherwise as Administrator for the Company.

 

Note 6. Related Party Transactions

 

At June 30, 2014 and December 31, 2013, the Company had the following receivables from (payables to) related parties relating to certain capital contributions, management fees, incentive fees, and reimbursable expenses (dollars in thousands):

 

   June 30,
2014
   December 31,
2013
 
CapitalSouth Corporation  $252   $252 
Shareholders/Limited Partners   270    267 
CapitalSouth Fund III, L.P.       1,118 
Capitala Investment Advisors, LLC   (1,863)   (2,670)
Total  $(1,341)  $(1,033)

 

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These amounts are reflected in the accompanying statements of financial position under the captions, “Due from related parties”, “Incentive fee payable” and “Due to related parties.”

 

At times, the Company maintains deposit accounts and certificates of deposit with financial institutions that are shareholders of the Company. Total deposits with these financial institutions were approximately $2 thousand and $2.8 million at June 30, 2014 and December 31, 2013, respectively.

 

Note 7. Borrowings

 

SBA Debentures

 

The Company, through its two wholly-owned subsidiaries, uses debenture leverage provided through the SBA to fund a portion of its investment portfolio. As of June 30, 2014, the Company has issued $192.2 million of SBA-guaranteed debentures. The Company has issued all SBA-guaranteed debentures that were permitted under each of the Legacy Funds’ respective SBIC licenses (as applicable), and there are no unused SBA debenture commitments remaining. SBA-guaranteed debentures are secured by a lien on all assets of Fund II and Fund III. As of June 30, 2014, Fund II and Fund III had total assets of approximately $377.8 million. On June 10, 2014, the Company received an exemptive order from the SEC exempting the Company, Fund II and Fund III from certain provisions of the 1940 Act (including an exemptive order granting relief from the asset coverage requirements for certain indebtedness issued by Fund II and Fund III as SBICs) and from certain reporting requirements mandated by the Securities Exchange Act of 1934, as amended, with respect to Fund II and Fund III. The Company intends to comply with the conditions of the order.

 

 For the three months ended June 30, 2014 and June 30, 2013 we recorded $2.1 million and $2.2 million, respectively, of interest, annual charges, and financing expenses related to the SBA guaranteed debentures, of which $1.9 million and $2.0 million, respectively, was attributable to interest expense and annual charges, and $0.2 million and $0.2 million, respectively, was attributable to amortization of commitment and upfront fees. For the six months ended June 30, 2014 and June 30, 2013 we recorded $4.3 million and $4.3 million, respectively, of interest, annual charges, and financing expenses related to the SBA guaranteed debentures, of which $3.9 million and $4.0 million, respectively, was attributable to interest expense and annual charges, and $0.4 million and $0.3 million, respectively, was attributable to amortization of commitment and upfront fees. The weighted average interest rate for all SBA-guaranteed debentures as of June 30, 2014 and December 31, 2013 was 3.51% and 3.57%, respectively. In addition to the stated interest rate, the SBA also charges an annual fee on all SBA-guaranteed debentures issued, which is included in the Company’s interest expense. The weighted average annual fee for all SBA-guaranteed debentures as of June 30, 2014 and December 31, 2013 was 0.48% and 0.50%, respectively.

 

As of June 30, 2014 and December 31, 2013, the Company’s issued and outstanding SBA-guaranteed debentures mature as follows (dollars in thousands):

 

Date of Pooling  Fixed Maturity Date  Interest Rate   SBA Annual Charge   June 30,
2014
   December 31,
2013
 
March 1, 2004  March 1, 2014   4.120%   0.855%  $   $2,000 
September 1, 2004  September 1, 2014   4.684%   0.855%       8,000 
September 1, 2005  September 1, 2015   4.941%   0.871%   8,000    8,000 
March 1, 2006  March 1, 2016   5.524%   0.871%   2,000    2,000 
September 1, 2006  September 1, 2016   5.535%   0.941%   11,500    11,500 
March 1, 2009  March 1, 2019   4.620%   0.941%   5,000    5,000 
September 1, 2010  September 1, 2020   3.215%   0.285%   19,000    19,000 
March 1, 2011  March 1, 2021   4.084%   0.515%   15,700    15,700 
March 1, 2011  March 1, 2021   4.084%   0.285%   46,000    46,000 
March 1, 2012  March 1, 2022   2.766%   0.285%   10,000    10,000 
March 1, 2012  March 1, 2022   2.766%   0.515%   50,000    50,000 
March 1, 2013  March 1, 2023   2.351%   0.515%   25,000    25,000 
                $192,200   $202,200 

 

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ASC Topic 820 requires disclosure of the fair value of financial instruments for which it is practical to estimate such value. The Company estimates that the fair value of its SBA-guaranteed debentures is approximately $193.4 million and $200.7 million as of June 30, 2014 and December 31, 2013, respectively. The fair value estimate was based on future contractual cash payments discounted at market interest rates to borrow from the SBA as of the measurement date. Because the market interest rate is considered an unobservable input, SBA-guaranteed debentures are considered a level 3 financial instrument in the fair value hierarchy.

 

Notes

 

In June 2014, the Company issued $113.4 million in aggregate principal amount of 7.125% fixed-rate notes due 2021 (the “Notes”). The Notes will mature on June 16, 2021, and may be redeemed in whole or in part at any time or from time to time at the Company’s option on or after June 16, 2017 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest. Interest will be payable quarterly beginning September 16, 2014.

 

As of June 30, 2014, the carrying amount and fair value of the Notes was $113.4 million and $114.6 million, respectively. The fair value of the Notes, which are publicly traded, is based upon closing market quotes as of the measurement date. Because the fair value is determined by quoted prices for the Notes, the Notes are considered a level 1 financial instrument in the fair value hierarchy. As of June 30, 2014, $4.2 million of financing costs related to the Notes have been capitalized and are being amortized over the term of the Notes. For the three and six months ended June 30, 2014, the Company has recorded $0.3 million of interest expense and $0.02 million of amortization of deferred financing costs related to the Notes.

 

Note 8. Directors Fees

 

Our independent directors receive an annual fee of $50,000. They also receive $5,000 plus reimbursement of reasonable out-of-pocket expenses incurred in connection with attending each board meeting, and also receive $5,000 plus reimbursement of reasonable out-of-pocket expenses incurred in connection with attending each committee meeting. In addition, the chairman of the audit committee receives an annual fee of $10,000 and each chairman of any other committee receives an annual fee of $5,000 for their additional services, if any, in these capacities. For the three and six months ended June 30, 2014, the Company recognized director fee expense of $86,250 and $188,250, respectively. For the three and six months ended June 30, 2013, the Company recognized director fee expense of $0 and $0, respectively. No compensation is expected to be paid to directors who are “interested persons” of the Company, as such term is defined in Section 2(a)(19) of the 1940 Act.

 

Note 9. Stockholders’ Equity

 

On September 24, 2013, we issued 8,974,420 shares of common stock to the limited partners of the Legacy Funds, in exchange for 100% of their membership interests or certain investment assets of such Legacy Fund, as the case may be. On September 30, 2013, we issued 4,000,000 shares of common stock in connection with the closing of our IPO. The shares issued in the IPO were priced at $20.00 per share. We received proceeds of $74.25 million in the IPO, net of underwriters’ discounts and commissions totaling $4.0 million and offering expenses totaling $1.75 million. The Legacy Funds bore the other expenses associated with the offering. As of June 30, 2014, the Company had 12,974,420 shares of common stock outstanding.

 

Note 10. Summarized Financial Information of Our Unconsolidated Subsidiaries

 

The Company holds a control interest, as defined by the 1940 Act, in three majority owned portfolio companies that are not consolidated in the Company’s consolidated financial statements. Below is a brief description of each portfolio company, along with summarized financial information as of June 30, 2014 and December 31, 2013, and for the six month period ended June 30, 2014 and June 30, 2013.

 

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Print Direction, Inc. 

Print Direction, Inc., incorporated in Georgia on May 11, 2006, is a professional printing services firm serving customers, particular fast food, retail, and other similar chains, through the United States. Print Direction, Inc. also provides warehousing and distribution services for these customers. The income the Company generated from Print Direction, Inc., which includes all interest, dividends, PIK interest and dividends, fees, and unrealized depreciation, was $3.6 million and $1.5 million for the six months ended June 30, 2014 and June 30, 2013, respectively.

 

Navis Holdings, Inc.

Navis Holdings, Inc. incorporated in Delaware on December 21, 2010, designs and manufactures leading machinery for the global knit and woven finishing textile industries. The income the Company generated from Navis Holdings, Inc., which includes all interest, dividends, PIK interest and dividends, fees, and unrealized appreciation, was $2.8 million and $1.5 million for the six months ended June 30, 2014 and June 30, 2013, respectively.

 

On-Site Fuel Service, Inc.

On-Site Fuel Service, Inc. is a 100% owned subsidiary of On-Site Fuel Holdings, Inc., which was incorporated in Delaware on December 19, 2011. On-Site Fuel Service, Inc. provides fueling services for commercial and government vehicle fleets throughout the southeast United States. The loss the Company generated from On-Site Fuel Service, Inc., which includes all interest, dividends, PIK interest and dividends, fees, and unrealized depreciation, was $2.2 million for the six months ended June 30, 2014. The income the Company generated from On-Site Fuel Service, Inc. which includes all interest, dividends, PIK interest and dividends, fees, and unrealized appreciation was $1.5 million for the six months ended June 30, 2013.

 

The summarized financial information of our unconsolidated subsidiaries was as follows (dollars in thousands):

  

   As of 
Balance Sheet - Print Direction, Inc.  June 30,
2014
   December 31,
2013
 
Current assets  $4,946   $5,738 
Noncurrent assets   5,596    5,955 
Total assets  $10,542   $11,693 
           
Current liabilities  $3,304   $3,828 
Noncurrent liabilities   14,510    10,496 
Total liabilities  $17,814   $14,324 
           
Total equity  $(7,272)  $(2,631)

 

   Six Months Ended 
Statements of Operations - Print Direction, Inc.  June 30,
2014
   June 30,
2013
 
Net sales  $11,748   $12,513 
Cost of goods sold   4,611    5,609 
Gross profit  $7,137   $6,904 
           
Other expenses  $6,977   $6,039 
Income before income taxes   160    865 
Income tax provision   67    380 
Net income  $93   $485 

 

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   As of 
Balance Sheet - Navis Holdings, Inc.  June 30,
2014
   December 31,
2013
 
Current assets  $5,315   $5,216 
Noncurrent assets   5,707    5,333 
Total assets  $11,022   $10,549 
           
Current liabilities  $2,177   $1,761 
Noncurrent liabilities   6,903    7,053 
Total liabilities  $9,080   $8,814 
           
Total equity  $1,942   $1,735 

 

   Six Months Ended 
Statements of Operations - Navis Holdings, Inc.  June 30,
2014
   June 30,
2013
 
Net sales  $7,918   $8,320 
Cost of goods sold   4,691    5,737 
Gross profit  $3,227   $2,583 
           
Other expenses  $2,427   $2,368 
Income before income taxes   800    215 
Income tax provision   318    55 
Net income  $482   $160 

  

   As of 
Balance Sheet – On-Site Fuel Service, Inc.  June 30,
2014
   December 31,
2013
 
Current assets  $18,685   $15,578 
Noncurrent assets   17,938    18,124 
Total assets  $36,623   $33,702 
           
Current liabilities  $16,589   $12,666 
Noncurrent liabilities   11,343    11,442 
Total liabilities  $27,932   $24,108 
           
Total equity  $8,691   $9,594 

 

   Six Months Ended 
Statements of Operations - On-Site Fuel Service, Inc.  June 30,
2014
   June 30,
2013
 
Net sales  $110,211   $119,336 
Cost of goods sold   104,868    113,799 
Gross profit  $5,343   $5,537 
           
Other expenses  $6,247   $5,779 
Loss before income taxes   (904)   (242)
Income tax provision        
Net loss  $(904)  $(242)

 

Note 11. Earnings Per Share

 

In accordance with the provisions of ASC 260, Earnings per Share, basic earnings per share is computed by dividing earnings available to common shareholders by the weighted average number of shares outstanding during the period. Other potentially dilutive common shares, and the related impact to earnings, are considered when calculating earnings per share on a diluted basis. As of June 30, 2014, there were no dilutive shares.

 

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The following information sets forth the computation of the weighted average basic and diluted net increase in net assets per share from operations for the three and six months ended June 30, 2014 and June 30, 2013 (dollars in thousands except share and per share data):

 

   For the three months ended   For the six months ended 
Basic and diluted  June 30,
2014
   June 30,
2013
   June 30,
2014
   June 30,
2013
 
Net increase in net assets from operations  $6,212   $11,583   $7,430   $14,152 
Weighted average common shares outstanding   12,974,420    N/A    12,974,420    N/A 
Net increase in net assets per share from operations-basic and diluted  $0.48    N/A   $0.57    N/A 

 

Note 12. Dividend

 

The Company’s dividends and distributions are recorded on the record date. Shareholders have the option to receive payment of the dividend in cash, shares of common stock, or a combination of cash and common stock.

 

The following table summarizes the Company’s dividend declarations and distributions through June 30, 2014:

 

Date Declared  Record Date  Payment Date  Amount
Per Share
 
November 11, 2013  December 10, 2013  December 30, 2013  $0.47 
      Total Dividends Declared  $0.47 

 

Date Declared  Record Date  Payment Date  Amount
Per Share
 
February 27, 2014  March 14, 2014  March 26, 2014  $0.47 
May 8, 2014  June 9, 2014  June 26, 2014   0.47 
      Total Dividends Declared  $0.94 

 

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Note 13. Financial Highlights

 

The following is a schedule of financial highlights for the six months ended June 30, 2014 (dollars in thousands, except share and per share data):

   

   June
30, 2014
 
Per share data:     
Net asset value at beginning of period  $20.71 
      
Net investment income(1)   0.87 
Net realized gain on investments   0.13 
Net decrease in unrealized appreciation on investments   (0.43)
      
Net increase in stockholders’ equity   0.57 
      
Dividends declared and paid   (0.94)
      
Net asset value at end of period  $20.34 
Net assets at end of period  $263,904 
Shares outstanding at end of period   12,974,420 
Per share market value at end of period  $18.89 
Total return based on market value(2)   (0.32)%
Ratio/Supplemental data:     
Ratio of net investment income to average net assets(4)   8.63%
Ratio of incentive fee to average net assets(4)   2.16%
Ratio of debt related expenses to average net assets(4)   3.49%
Ratio of other operating expenses, net of management fee waiver to average net assets(4)(7)   4.64%
Ratio of total expenses to average net assets(4)   10.29%
Portfolio turnover rate(3)   5.21%
Average Debt Outstanding(5)  $204,063 
Average Debt Outstanding per common share  $15.73 
Asset Coverage ratio per unit(6)  $1,863 

 

(1) Net investment income per share is calculated using the weighted average shares outstanding during the period.

(2) Total investment return is calculated assuming a purchase of common shares at the current market value on the first day and a sale at the current market value on the last day of the period reported. Dividends and distributions, if any, are assumed for purposes of this calculation to be reinvested at prices obtained under the Company’s dividend reinvestment plan. Total investment return does not reflect brokerage commissions. Total investment returns covering less than a full period are not annualized.

(3) Portfolio turnover rate is calculated using the lesser of year-to-date sales or year-to-date purchases over the average of the invested assets at fair value.

(4) Ratios are annualized.

(5) Based on daily weighted average balance of debt outstanding during the period.

(6) Asset coverage per unit is the ratio of the carrying value of our total consolidated assets, less all liabilities and indebtness not represented by senior securities, to the aggregate amount of senior securities representing indebtness. Asset coverage per unit is expressed in terms of dollar amounts per $1,000 of indebtness.

(7) The ratio of waived management fees to average net assets was .15%.

 

Note 14. Subsequent Events

 

Management has evaluated subsequent events through the date of issuance of the consolidated financial statements included herein. There have been no subsequent events that occurred during such period that would be required to be recognized in the consolidated financial statements as of and for the six month period ended June 30, 2014.

 

On July 15, 2014, the Company invested approximately $7.2 million in the junior subordinated debt (12% cash interest), $5.0 million in the senior subordinated debt (14% cash interest), and $1.8 million in the common equity of Burgaflex Holdings, LLC.

 

On July 17, 2014, the Company invested approximately $12.5 million in the senior secured debt (12% cash, 4% PIK) of Sequoia Healthcare Management, LLC.

 

On July 25, 2014, the Company invested approximately $3.0 million in the subordinated debt (cash interest of LIBOR + 9.0%, 1% floor) of Meritas Schools Holdings, LLC.

 

On August 1, 2014, the Company invested $5.3 million in senior revolving debt (current contractual rate of LIBOR plus 6.75% cash interest, .25% floor) and $3.4 million in senior term debt (current contractual rate of LIBOR plus 7.75% cash interest, .25% floor) for Impresa Aerospace Holdings, LLC, an existing portfolio company.

 

On August 5, 2014, the Company invested $4.0 million in the senior secured debt (12% cash interest, 2% PIK) of Sparus Holdings, Inc., an existing portfolio company.

 

On August 7, 2014, the Company’s Board declared a quarterly dividend of $0.47 per share payable on September 26, 2014 to holders of record as of September 12, 2014.

 

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

 

The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes and other financial information appearing elsewhere in this Quarterly Report on Form 10-Q.

 

Except as otherwise specified, references to “we,” “us,” “our” or the “Company”, refer to Capitala Finance Corp.

 

This Quarterly Report, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve substantial risks and uncertainties. These forward-looking statements are not historical facts, but rather are based on current expectations, estimates and projections about the Company, our current and prospective portfolio investments, our industry, our beliefs, and our assumptions. Words such as “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” “continue,” “believes,” “seeks,” “estimates,” “would,” “could,” “should,” “targets,” “projects,” and variations of these words and similar expressions are intended to identify forward-looking statements.

 

The forward-looking statements contained in this Quarterly Report on Form 10-Q involve risks and uncertainties, including statements as to:

 

  our future operating results;

 

  our business prospects and the prospects of our portfolio companies;

 

  the impact of investments that we expect to make;

 

  our contractual arrangements and relationships with third parties;

 

  the dependence of our future success on the general economy and its impact on the industries in which we invest;

 

  the ability of our portfolio companies to achieve their objectives;

 

  our expected financings and investments;

 

  the adequacy of our cash resources and working capital; and

 

  the timing of cash flows, if any, from the operations of our portfolio companies.

 

These statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements, including without limitation:

 

  an economic downturn could impair our portfolio companies’ ability to continue to operate or repay their borrowings, which could lead to the loss of some or all of our investments in such portfolio companies;

 

  a contraction of available credit and/or an inability to access the equity markets could impair our lending and investment activities;

 

  interest rate volatility could adversely affect our results, particularly if we use leverage as part of our investment strategy; and

 

  the risks, uncertainties and other factors we identify in “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.

 

35
 

  

Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also could be inaccurate. Important assumptions include our ability to originate new loans and investments, certain margins and levels of profitability and the availability of additional capital. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this Quarterly Report on Form 10-Q should not be regarded as a representation by us that our plans and objectives will be achieved. These risks and uncertainties include those described or identified in “Risk Factors” in our Annual Report on Form 10-K. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. 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 U.S. Securities and Exchange Commission (“SEC”) rule or regulation.

 

OVERVIEW

 

We are a Maryland corporation that has elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”). We are an emerging growth company within the meaning of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), and as such, are subject to reduced public company reporting requirements. Our investment objective is to generate both current income and capital appreciation through debt and equity investments. We are managed by Capitala Investment Advisors, LLC (the “Investment Advisor”), and Capitala Advisors Corp. (the “Administrator”) provides the administrative services necessary for us to operate.

 

We provide capital to smaller and lower middle-market companies in the United States, with a non-exclusive emphasis on the Southeast, Southwest and Mid-Atlantic regions. We invest primarily in companies with a history of earnings growth and positive cash flow, proven management teams, product or service with competitive advantages and industry-appropriate margins. We primarily invest in companies with between $5 million and $30 million in trailing twelve month earnings before interest, tax, depreciation and amortization (“EBITDA”).

 

We invest in mezzanine and senior subordinated debt investments that are secured by subordinated liens on all of our borrowers’ assets and, to a lesser extent, in senior, cash flow-based “unitranche” securities. Most of our debt investments are coupled with equity interests, whether in the form of detachable “penny” warrants or equity co-investments made pari passu with our borrowers’ financial sponsors.

 

As a BDC, we are required to comply with certain regulatory requirements. For instance, we generally have to invest at least 70% of our total assets in “qualifying assets,” including securities of private or thinly traded public U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt investments that mature in one year or less. In addition, we are only allowed to borrow money such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowing, with certain limited exceptions. To maintain our regulated investment company (“RIC”) status, we must meet specified source-of-income and asset diversification requirements. To maintain our RIC tax treatment under subchapter M for U.S. federal income tax purposes, we must distribute at least 90% of our net ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, for the taxable year.

 

Corporate History

 

We commenced operations on May 24, 2013 and completed our initial public offering (“IPO”) on September 30, 2013. The Company was formed for the purpose of (i) acquiring, through a series of transactions, an investment portfolio from the following entities: CapitalSouth Partners Fund I Limited Partnership (“Fund I”); CapitalSouth Partners Fund II Limited Partnership (“Fund II”); CapitalSouth Partners Fund III, L.P. (“Fund III Parent”); CapitalSouth Partners SBIC Fund III, L.P. (“Fund III”) and CapitalSouth Partners Florida Sidecar Fund I, L.P. (“Florida Sidecar” and, collectively with Fund I, Fund II, Fund III and Fund III Parent, the “Legacy Funds”); (ii) raising capital in the IPO and (iii) continuing and expanding the business of the Legacy Funds by making additional debt and equity investments in smaller and lower middle market companies.

 

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On September 24, 2013, the Company acquired 100% of the limited partnership interests in Fund II, Fund III and Florida Sidecar and each of their respective general partners, as well as certain assets from Fund I and Fund III Parent, in exchange for an aggregate of 8,974,420 shares of the Company’s common stock (the “Formation Transactions”). Fund II, Fund III and Florida Sidecar became the Fund’s wholly-owned subsidiaries. Fund II and Fund III retained their SBIC licenses and continue to hold their existing investments and continue to make new investments. The IPO consisted of the sale of 4,000,000 shares of the Company’s common stock at a price of $20.00 per share resulting in net proceeds to the Company of $74.25 million, after deducting underwriting fees and commissions totaling $4.0 million and offering expenses totaling $1.75 million. The other costs of the IPO were borne by the limited partners of the Legacy Funds. As of June 30, 2014, the Company had 12,974,420 shares of common stock outstanding.

 

At the time of the Formation Transactions, our portfolio consisted of: (i) approximately $326.3 million in investments; (ii) an aggregate of approximately $67.1 million in cash, interest receivable and other assets; and (iii) liabilities of approximately $202.2 million of SBA-guaranteed debt payable. We have two SBIC-licensed subsidiaries that have elected to be regulated as BDCs under the 1940 Act. We may also seek other forms of leverage and borrow funds to make investments, including before we have fully invested the proceeds of this offering.

 

Basis of Presentation

 

The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”). The consolidated financial statements of the Company include the accounts of the Company and its wholly-owned subsidiaries as described in the Formation Transactions presented in Note 1 to our Consolidated Financial Statements. The transactions related to Fund II, Fund III, and the Florida Sidecar constitute an exchange of shares between entities under common control and will be accounted for in accordance with the Accounting Standards Codification (“ASC”), Topic 805, Business Combinations (“ASC 805”). As such, the results of the Company’s operations and cash flows for the six months ended June 30, 2013, have been presented on a combined basis in order to provide comparative information with respect to prior periods. The Formation Transactions also included an asset acquisition of certain assets in Fund I and Fund III Parent. In accordance with ASC 805, the assets acquired were recorded at fair value at the date of acquisition, September 24, 2013.

 

The Company’s financial position as of June 30, 2014 is presented on a consolidated basis. The effects of all intercompany transactions between the Company and its subsidiaries (Fund II, Fund III, and the Florida Sidecar) have been eliminated in consolidation. All financial data and information included in these financial statements have been presented on the basis described above. In the opinion of management, the financial statements reflect all adjustments that are necessary for the fair presentation of financial results as of and for the periods presented.

 

Revenues

 

We generate revenue primarily from the periodic cash interest we will collect on our debt investments. In addition, most of our debt investments offer the opportunity to participate in a borrower’s equity performance through warrant participation, direct equity ownership or otherwise, which we expect to result in revenue in the form of dividends and/or capital gains. Further, we may generate revenue in the form of commitment, origination, structuring or diligence fees, monitoring fees, fees for providing managerial assistance and possibly consulting fees and performance-based fees. These fees will be recognized as they are earned.

 

Expenses

 

Our primary operating expenses include the payment of investment advisory fees to our Investment Adviser, our allocable portion of overhead and other expenses incurred by our Administrator in performing its obligations under the Administration Agreement and other operating expenses as detailed below. Our investment advisory fee will compensate our Investment Adviser for its work in identifying, evaluating, negotiating, closing, monitoring and servicing our investments. We will bear all other expenses of our operations and transactions, including (without limitation):

 

  the cost of our organization;

 

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  the cost of calculating our net asset value, including the cost of any third-party valuation services;

 

  the cost of effecting sales and repurchases of our shares and other securities;

 

  interest payable on debt, if any, to finance our investments;

 

  fees payable to third parties relating to, or associated with, making investments, including fees and expenses associated with performing due diligence reviews of prospective investments and advisory fees;

 

  transfer agent and custodial fees;

 

  fees and expenses associated with marketing efforts;

 

  costs associated with our reporting and compliance obligations under the 1940 Act, the Securities Exchange Act of 1934 (the “Exchange Act”), other applicable federal and state securities laws and ongoing stock exchange listing fees;

 

  federal, state and local taxes;

 

  independent directors’ fees and expenses;

 

  brokerage commissions;

 

  costs of proxy statements, stockholders’ reports and other communications with stockholders;

 

  fidelity bond, directors’ and officers’ liability insurance, errors and omissions liability insurance and other insurance premiums;

 

  direct costs and expenses of administration, including printing, mailing, telephone and staff;

 

  fees and expenses associated with independent audits and outside legal costs; and

 

  all other expenses incurred by either our Administrator or us in connection with administering our business, including payments under the Administration Agreement that will be based upon our allocable portion of overhead and other expenses incurred by our Administrator in performing its obligations under the Administration Agreement, including rent, the fees and expenses associated with performing compliance functions, and our allocable portion of any costs of compensation and related expenses of our chief compliance officer and our chief financial officer and any administrative support staff.

 

Critical Accounting Policies and Use of Estimates

 

In the preparation of our consolidated financial statements and related disclosures, we have adopted various accounting policies that govern the application of U.S. GAAP. Our significant accounting policies are described in Note 2 to our Consolidated Financial Statements. While all of these policies are important to understanding our consolidated financial statements, certain accounting policies and estimates are considered critical due to their impact on the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses for the periods covered by such financial statements. We have identified investment valuation, revenue recognition, and income taxes as our most critical accounting estimates. We continuously evaluate our estimates, including those related to the matters described below. Because of the nature of the judgment and assumptions we make, actual results could materially differ from those estimates under different assumptions or conditions. A discussion of our critical accounting policies follows.

 

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Valuation of Investments

 

The Company applies fair value accounting to all of its financial instruments in accordance with the 1940 Act and ASC Topic 820 - Fair Value Measurements and Disclosures (“ASC 820”). ASC 820 defines fair value, establishes a framework used to measure fair value and requires disclosures for fair value measurements. In accordance with ASC 820, the Company has categorized its financial instruments carried at fair value, based on the priority of the valuation technique, into a three-level fair value hierarchy as discussed in Note 4 to our Consolidated Financial Statements.

 

In determining fair value, our board of directors (the “Board”) uses various valuation approaches, and engages a third-party independent valuation firm, which provides positive assurance on the investments they review. In accordance with U.S. GAAP, a fair value hierarchy for inputs is used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available.

 

Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Board. Unobservable inputs reflect the Boards’ assumptions about the inputs market participants would use in pricing the asset or liability developed based upon the best information available in the circumstances. The fair value hierarchy is categorized into three levels based on the inputs as follows:

 

Level 1 – Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not applied to Level 1 securities. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment.

 

Level 2 – Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.

 

Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

 

The availability of valuation techniques and observable inputs can vary from security to security and is affected by a wide variety of factors including, the type of security, whether the security is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Those estimated values do not necessarily represent the amounts that may be ultimately realized due to the occurrence of future circumstances that cannot be reasonably determined. Because of the inherent uncertainty of valuation, those estimated values may be materially higher or lower than the values that would have been used had a market for the securities existed. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for securities categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls, is determined based on the lowest level input that is significant to the fair value measurement.

 

Fair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the Company’s own assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date. We use prices and inputs that are current as of the measurement date, including periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many securities. This condition could cause a security to be reclassified to a lower level within the fair value hierarchy.

 

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Valuation Techniques

 

Senior and Subordinated Secured Loans

 

The Company’s portfolio primarily consists of private debt instruments (“Level 3 debt”). We consider our Level 3 debt to be performing loans if the borrower is not in default, the borrower is remitting payments in a timely manner, the loan is in covenant compliance or is otherwise not deemed to be impaired. In determining the fair value of the performing Level 3 debt, the Company’s Board considers fluctuations in current interest rates, the trends in yields of debt instruments with similar credit ratings (if applicable), the financial condition of the borrower, economic conditions and other relevant factors, both qualitative and quantitative. In the event that a Level 3 debt instrument is not performing, as defined above, the Board will evaluate the value of the collateral utilizing the same framework described above for a performing loan to determine the value of the Level 3 debt instrument.

 

This evaluation will be updated no less than quarterly for Level 3 debt instruments that are not performing, and more frequently for time periods where there are significant changes in the collateral or significant changes in the perceived performance of the underlying portfolio company. The collateral value will be analyzed on an ongoing basis using internal metrics, appraisals, third-party valuation agents and other data as may be acquired and analyzed by our management and Board.

 

Equity Investments in Private Companies

 

Our Board determines the fair value of its investments in private companies by incorporating valuations that consider the evaluation of financing and sale transactions with third-parties, expected cash flows and market-based information, including comparable transactions, and performance multiples, among other factors, and may use third-party valuation agents. Such non-public investments are included in Level 3 of the fair value hierarchy.

 

Warrants

 

Our Board will ascribe value to warrants based on fair value holdings that can include discounted cash flow analyses, option pricing models, comparable analyses and other techniques as deemed appropriate. Such warrants are included in Level 3 of the fair value hierarchy to the extent issued by non-public companies.

 

Revenue Recognition

 

The Company’s revenue recognition policies are as follows:

 

Interest Income and Paid-in Kind Interest Income: Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. The company has loans in the portfolio that contain a payment-in-kind (“PIK”) provision. The PIK interest, which represents contractually deferred interest added to the loan balance that is generally due at maturity, is recorded on the accrual basis to the extent that such amounts are expected to be collected. PIK interest is not accrued if the Company does not expect the issuer to be able to pay all principal and interest when due.

 

Non-accrual income: Generally, when interest and/or principal payments on a loan become materially past due, or if the Company otherwise does not expect the borrower to be able to service its debt and other obligations, the Company will place the loan on non-accrual status, and will generally cease recognizing interest income and PIK on that loan for financial reporting purposes. Interest payments received on non-accrual loans may be recognized as income or applied to principal depending upon management’s judgment. The Company writes off any previously accrued and uncollected interest when it is determined that interest is no longer considered collectible. The company may elect to cease accruing PIK and continue accruing interest income in cases where a loan is currently paying interest income but, in management’s judgment, there is a reasonable likelihood of principal loss on the loan. Non-accrual loans are returned to accrual status when the borrower’s financial condition improves such that management believes current interest and principal payments are expected to be collected.

 

Gains and Losses on investment sales and paydowns: Realized gains and losses on investments are recognized using the specific identification method.

 

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Dividend Income and Paid-in-kind Dividends: Dividend income is recognized on the date dividends are declared. The Company holds preferred equity investments in the portfolio that contain a payment-in-kind dividend (“PIK dividends”) provision. PIK dividends, which represent contractually deferred dividends added to the equity balance, are recorded on the accrual basis to the extent that such amounts are expected to be collected. The Company will typically cease accrual of PIK dividends when the fair value of the equity investment is less than the cost basis of the investment or when it is otherwise determined by management that collection of PIK dividends are unlikely to be collected. If management determines that a decline in fair value is temporary in nature and the PIK dividends are more likely than not to be collected, management may elect to continue accruing PIK dividends.

 

Other Income: Origination, amendment, consent, closing and/or commitment fees associated with investments in portfolio companies are recognized as income when the investment transaction closes. Prepayment penalties received by the Company for debt instruments repaid prior to maturity date are recorded as income upon receipt.

 

Income Taxes

 

Prior to the Formation Transactions, the Legacy Funds were treated as partnerships for U.S. federal, state and local income tax purposes and, therefore, no provision has been made in the accompanying consolidated financial statements for federal, state or local income taxes. In accordance with the partnership tax law requirements, each partner would include their respective components of the Legacy Funds' taxable profits or losses, as shown on their Schedule K-1s in their respective tax or information returns. The Legacy Funds are disregarded entities for tax purposes prior to and post the Formation Transactions.

 

The Company intends to elect to be treated for federal income tax purposes, and intends to qualify annually thereafter, as a RIC under Subchapter M of the Code and, among other things, intends to make the requisite distributions to its stockholders which will relieve the Company from federal income taxes. Therefore, no provision has been recorded for federal income taxes.

 

In order to qualify as a RIC, among other requirements, the Company is required to timely distribute to its stockholders at least 90.0% of its investment company taxable income, as defined by the Code, for each fiscal tax year. The Company will be subject to a nondeductible U.S. federal excise tax of 4.0% on undistributed income if it does not distribute at least 98.0% of its ordinary income in any calendar year and 98.2% of its capital gain net income for each one-year period ending on October 31.

 

Depending on the level of taxable income earned in a tax year, the Company may choose to carry forward taxable income in excess of current year dividend distributions into the next tax year and pay a 4.0% excise tax on such income, as required. 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 for excise tax purposes, the Company accrues excise tax, if any, on estimated excess taxable income as taxable income is earned.

 

In accordance with certain applicable treasury regulations and private letter rulings issued by the Internal Revenue Service, a 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 on the aggregate amount of cash to be distributed to all stockholders, which limitation must be at least 20.0% of the aggregate declared distribution. If too many stockholders elect to receive cash, each stockholder electing to receive cash will receive a pro rata amount of cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive less than 20.0% of his or her entire distribution in cash. 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.

 

ASC Topic 740, Income Taxes (“ASC 740”), provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the consolidated financial statements. ASC 740 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s 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 current period. The Company recognizes interest and penalties, if any, related to unrecognized tax benefits as income tax expense in the consolidated statements of operations. As of June 30, 2014 and December 31, 2013, there were no uncertain tax positions.

 

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The Company is required to determine whether a tax position of the Company is more likely-than-not to be sustained upon examination by the applicable taxing authority, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The tax benefit to be recognized is measured as the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. De-recognition of a tax benefit previously recognized could result in the Company recording a tax liability that could have a negative impact the Company’s net assets.

 

U.S. GAAP provides guidance on thresholds, measurement, de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition that is intended to provide better financial statement comparability among different entities.

 

The Company has concluded that it was not necessary to record a liability for any such tax positions as of June 30, 2014 and December 31, 2013. However, the Company’s conclusions regarding this policy may be subject to review and adjustment at a later date based on factors including, but not limited to, ongoing analyses of, and changes to, tax laws, regulations and interpretations thereof.

 

The Company’s activities from commencement of operations remain subject to examination by U.S. federal, state, and local tax authorities. No interest expense or penalties have been assessed for the three and six month periods ended June 30, 2014 and June 30, 2013. If the Company were required to recognize interest and penalties, if any, related to unrecognized tax benefits this would be recognized as income tax expense in the consolidated statement of operations.

 

Portfolio and Investment Activity

 

As of June 30, 2014, our portfolio consisted of investments in 45 portfolio companies with a fair value of approximately $405.6 million.

 

During the three months ended June 30, 2014, we made approximately $22.6 million of investments in new or existing portfolio companies and had approximately $9.4 million in exits and repayments resulting in net investments of approximately $13.2 million for the period. During the three months ended June 30, 2013, we made approximately $20.2 million of investments in new or existing portfolio companies and had approximately $15.7 million in exits and repayments resulting in net investments of approximately $4.5 million for the period.

 

During the six months ended June 30, 2014, we made approximately $63.6 million of investments in new or existing portfolio companies and had approximately $20.2 million in exits and repayments resulting in net investments of approximately $43.4 million for the period. During the six months ended June 30, 2013, we made approximately $41.4 million of investments in new or existing portfolio companies and had approximately $28.7 million in exits and repayments resulting in net investments of approximately $12.7 million for the period.

 

  As of June 30, 2014, our average portfolio company investment and our largest portfolio company investment at amortized cost and fair value was approximately $7.7 million and $9.0 million, and $25.5 million and $25.5 million, respectively. As of June 30, 2014, the Company had approximately $166.5 million of cash and cash equivalents. As of December 31, 2013, our average portfolio company investment and our largest portfolio company investment at amortized cost and fair value was approximately $7.3 million and $8.9 million, and $25.3 million and $25.3 million, respectively. As of December 31, 2013, the Company had $101.6 million of cash and cash equivalents.

 

 

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The following table summarizes the amortized cost and the fair value of investments and cash and cash equivalents as of June 30, 2014 (dollars in thousands):

 

   Investments at
Amortized Cost
   Amortized Cost
Percentage of
Total Portfolio
   Investments at
Fair Value
   Fair Value
Percentage of
Total Portfolio
 
Senior Secured Debt  $127,026    24.7%  $128,913    22.5%
Subordinated Debt   156,534    30.4%   151,683    26.5%
Equity and Warrants   64,186    12.5%   124,963    21.8%
Cash and Cash Equivalents   166,503    32.4%   166,503    29.2%
Total  $514,249    100.0%  $572,062    100.0%

 

The following table summarizes the amortized cost and the fair value of investments and cash and cash equivalents as of December 31, 2013 (dollars in thousands):

 

   Investments at
Amortized Cost
   Amortized Cost
Percentage of
Total Portfolio
   Investments at
Fair Value
   Fair Value
Percentage of
Total Portfolio
 
Senior Secured Debt  $103,457    25.7%  $102,071    21.9%
Subordinated Debt   136,638    33.9%   133,710    28.7%
Equity and Warrants   61,204    15.2%   128,938    27.6%
Cash and Cash Equivalents   101,622    25.2%   101,622    21.8%
Total  $402,921    100.0%  $466,341    100.0%

 

As of June 30, 2014, our income-bearing investment portfolio, which represented nearly 69% of our total portfolio, had a weighted average yield of approximately 13.4%. As of June 30, 2014, 95% of our income-bearing investment portfolio was bearing a fixed rate of interest. As of December 31, 2013, our income-bearing investment portfolio, which represented nearly 65% of our total portfolio, had a weighted average yield of approximately 13.7% all bearing a fixed rate of interest.

 

The following table shows the portfolio composition by industry grouping at fair value (dollars in thousands):

 

   June 30, 2014   December 31, 2013 
   Investments
at
Fair Value
   Percentage
of
Total
Portfolio
   Investments
at
Fair Value
   Percentage
of
Total
Portfolio
 
Oil & Gas Services  $29,916    7.4%  $25,321    7.0%
Transportation   24,482    6.0%   6,000    1.6%
QSR Franchisee   24,099    5.9%   24,787    6.8%
Sales & Marketing Services   22,865    5.6%   22,753    6.3%
Professional Employer Organization   21,369    5.3%   22,677    6.2%
Printing Services   20,543    5.1%   16,448    4.5%
Personal Product Manufacturer   18,157    4.5%   14,073    3.9%
Footwear Retail   15,542    3.8%   14,807    4.1%
Oil & Gas Engineering and Consulting Services   15,491    3.8%   15,000    4.1%
Industrial Equipment Rental   13,333    3.3%   22,500    6.2%
Medical Device Distributor   12,432    3.1%   11,121    3.0%
Specialty Clothing   12,374    3.1%   12,724    3.5%
Retail Display & Security Services   11,910    2.9%   10,823    3.0%
QSR Franchisor   11,188    2.8%   14,622    4.0%
Culinary Products   10,642    2.6%   10,302    2.8%
Computer Supply Retail   10,606    2.6%   6,673    1.8%
Restaurant   10,000    2.5%       %
Aerospace Parts Manufacturer   9,934    2.4%   10,064    2.8%
Textile Equipment Manufacturer   9,786    2.4%   9,031    2.5%
Dental Practice Management   9,004    2.2%   9,273    2.6%
Financial Services   8,300    2.0%       %
Energy Services   8,025    2.0%   8,783    2.4%
Fuel Transportation Services   7,622    1.9%   10,274    2.8%
Conglomerate   7,225    1.8%   7,630    2.1%
Western Wear Retail   7,177    1.8%   4,774    1.3%
Produce Distribution   6,109    1.5%   6,631    1.8%
Environmental Services Products   5,230    1.3%   5,185    1.4%
Advertising & Marketing Services   5,156    1.3%   4,911    1.3%
Data Processing & Digital Marketing   5,061    1.2%   5,061    1.4%
Replacement Window Manufacturer   5,042    1.2%   6,284    1.7%
Metal Recycler   3,950    1.0%   3,950    1.1%
Automotive Chemicals & Lubricants   3,817    0.9%   3,886    1.1%
Petroleum Equipment Supplier   3,680    0.9%   3,624    1.0%
Industrial Manufacturing   3,469    0.9%   3,440    0.9%
Building Supplies   2,886    0.7%   2,509    0.7%
Specialty Defense Contractor   2,541    0.6%   2,799    0.8%
Quick Lube Services   2,047    0.5%   1,604    0.4%
Industrial Boiler Manufacturer   1,915    0.5%   1,536    0.4%
Online Travel Sales & Marketing   1,610    0.4%   1,638    0.4%
In-Home Healthcare Services   609    0.2%   748    0.2%
IT Hosting Services   415    0.1%   453    0.1%
Total  $405,559    100.0%  $364,719    100.0%

 

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With the exception of an $8.3 million investment in an internationally headquartered company, all investments made by the Company as of June 30, 2014 and December 31, 2013 were made in portfolio companies located in the United States. The geographic composition is determined by the location of the corporate headquarters of the portfolio company, which may not be indicative of the primary source of the portfolio company’s business. The following table shows the portfolio composition by geographic region at fair value as of June 30, 2014 and December 31, 2013 (dollars in thousands):

 

   June 30, 2014   December 31, 2013 
   Investments
at
Fair Value
   Percentage
of
Total
Portfolio
   Investments
at
Fair Value
   Percentage
of
Total
Portfolio
 
South  $265,277    65.4%  $254,143    69.7%
West   87,580    21.6%   66,637    18.3%
Northeast   24,327    6.0%   23,436    6.4%
Midwest   20,075    5.0%   20,503    5.6%
International   8,300    2.0%       0.0%
Total  $405,559    100.0%  $364,719    100.0%

 

The Investment Advisor regularly assesses the risk profile of each of our investments and rates each of them based on the following categories, which we refer to as the Investment Advisor’s investment credit rating:

 

Credit Rating    Definition 
     
1   Investments that are performing above expectations.
     
2   Investments that are performing within expectations, with risks that are neutral or favorable compared to risks at the time of origination.
     
    All new loans are rated ‘2’.
     
3   Investments that are performing below expectations and that require closer monitoring, but where no loss of interest, dividend or principal is expected.
     
    Companies rated ‘3’ may be out of compliance with financial covenants, however, loan payments are generally not past due.

 

4   Investments that are performing below expectations and for which risk has increased materially since origination.
     
    Some loss of interest or dividend is expected but no loss of principal.
     
    In addition to the borrower being generally out of compliance with debt covenants, loan payments may be past due (but generally not more than 180 days past due).
     
5   Investments that are performing substantially below expectations and whose risks have increased substantially since origination.
     
    Most or all of the debt covenants are out of compliance and payments are substantially delinquent.
     
    Some loss of principal is expected.

 

 

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The following table shows the distribution of our investments on the 1 to 5 investment performance rating scale at fair value as of June 30, 2014 (dollars in thousands):

 

Investment Performance Rating  Investments
at Fair
Value
   Percentage
of Total
Investments
 
1  $199,687    49.2%
2   122,857    30.3%
3   77,455    19.1%
4   5,560    1.4%
5        
Total  $405,559    100.0%

 

The following table shows the distribution of our investments on the 1 to 5 investment performance rating scale at fair value as of December 31, 2013 (dollars in thousands):

 

Investment Performance Rating  Investments
at Fair
Value
   Percentage
of Total
Investments
 
1  $183,194    50.2%
2   129,721    35.5%
3   44,680    12.3%
4   7,124    2.0%
5        
Total  $364,719    100.0%

 

As of June 30, 2014, the Company had four portfolio investments on non-accrual status with a total principal amount of $10.3 million, amortized cost of $8.6 million and a fair value of $5.6 million, which represented 3.2%, 2.5% and 1.4% of the investment portfolio, respectively. As of December 31, 2013 the Company had four portfolio investments on non-accrual status with a total principal amount of $12.1 million, amortized cost of $10.3 million and a fair value of $6.5 million representing 3.3%, 2.8% and 1.8% of the investment portfolio, respectively.

 

Results of Operations

 

Operating results for the three and six months ended June 30, 2014 and June 30, 2013 are as follows (dollars in thousands):

 

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   For the three months ended   For the six months ended 
   June 30,
2014
   June 30,
2013
   June 30,
2014
   June 30,
2013
 
Total investment income  $12,526   $8,216   $24,901   $14,487 
Total expenses, net   6,892    3,558    13,546    6,539 
Net investment income   5,634    4,658    11,355    7,948 
Net realized gain from investments   462    365    1,682    365 
Net increase (decrease) in unrealized appreciation   116    6,560    (5,607)   5,839 
Net increase in net assets resulting from operations  $6,212   $11,583   $7,430   $14,152 

 

Investment income

 

The composition of our investment income for the three and six months ended June 30, 2014 and June 30, 2013 was as follows (dollars in thousands):

 

   For the three months ended   For the six months ended 
   June 30,
2014
   June 30,
2013
   June 30,
2014
   June 30,
2013
 
Interest and fee income  $8,513   $6,561   $16,528   $11,865 
Dividend income   3,263    443    7,025    517 
Payment-in-kind interest and dividend income   744    375    1,334    668 
Interest from cash and cash equivalents   6    48    14    76 
Other Income       789        1,361 
Total Investment Income  $12,526   $8,216   $24,901   $14,487 

 

For the three months ended June 30, 2014, total investment income increased $4.3 million, or 52.5% compared to the three months ended June 30, 2013. For the six months ended June 30, 2014, total investment income increased $10.4 million, or 71.9% compared to the six months ended June 30, 2013. The increase from the prior period relates to higher dividend income mostly from recapitalizations of control investments, and higher loan interest and fee income resulting from an increasing investment portfolio.

 

Operating expenses

 

The composition of our expenses for the three and six months ended June 30, 2014 and June 30, 2013 was as follows (dollars in thousands):

 

   For the three months ended   For the six months ended 
   June 30,
2014
   June 30,
2013
   June 30,
2014
   June 30,
2013
 
Interest expense and amortization of deferred financing fees  $2,401   $2,226   $4,601   $4,291 
Management fees, net of management fee waiver   2,200    1,230    4,094    2,014 
Incentive fees   1,408        2,838     
General and administrative expenses   883    102    2,013    234 
Total expenses  $6,892   $3,558   $13,546   $6,539 

 

For the three months ended June 30, 2014, operating expenses increased $3.3 million, or 93.7% compared to the three months ended June 30, 2013. For the six months ended June 30, 2014, operating expenses increased $7.0 million, or 107.2% compared to the six months ended June 30, 2013. The increase from the prior period is attributable to incentive and management fees under the new advisory agreement along with increased general and administrative expenses due to regulatory and reporting costs subsequent to our IPO on September 30, 2013, and an increase in interest expense as a result of our June 2014 $113.4 million offering of 7.125% fixed rate notes due 2021.

 

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Net realized gains/losses on sales of investments

 

During the three and six months ended June 30, 2014, we recognized $0.5 million and $1.7 million, respectively, of net realized gains on our portfolio investments. During the three and six months ended June 30, 2013, we recognized $0.4 million and $0.4 million, respectively, of net realized gains on portfolio investments.

 

Net unrealized appreciation/depreciation on investments

 

Net change in unrealized appreciation on investments reflects the net change in the fair value of our investment portfolio. For the three months ended June 30, 2014, we had a $0.1 million increase in unrealized appreciation on portfolio investments. For the six months ended June 30, 2014, we had a $5.6 million decrease in unrealized appreciation on portfolio investments. For the three and six months ended June 30, 2013, we had a $6.6 million and $5.8 million, respectively, increase in unrealized appreciation on portfolio investments.

 

Changes in net assets resulting from operations

 

For the three and six months ended June 30, 2014, we recorded a net increase in net assets resulting from operations of $6.2 million and $7.4 million, respectively. Based on the weighted average shares of common stock outstanding for the three and six months ended June 30, 2014 our per share net increase in net assets resulting from operations was $0.48 and $0.57, respectively. For the three and six months ended June 30, 2013, we recorded a net increase in net assets resulting from operations of $11.6 million and $14.2 million, respectively.

 

Financial Condition, Liquidity and Capital Resources

 

In addition to the $74.25 million of net proceeds from our IPO, we intend to continue to generate cash from future offerings of securities and cash flows from operations, including earnings on investments in our portfolio and future investments, as well as interest earned from the temporary investment of cash in U.S. government securities and other high-quality debt investments that mature in one year or less. In addition to our existing SBA-guaranteed debentures, we may, if permitted by regulation, seek to issue additional SBA-guaranteed debentures as well as other forms of leverage and borrow funds to make investments. On June 10, 2014, we received an exemptive order from the SEC exempting us, Fund II and Fund III from certain provisions of the 1940 Act (including an exemptive order granting relief from the asset coverage requirements for certain indebtedness issued by Fund II and Fund III as SBICs) and from certain reporting requirements mandated by the Securities Exchange Act of 1934, as amended, with respect to Fund II and Fund III. We intend to comply with the conditions of the order.

 

As of June 30, 2014, we had $166.5 million in cash and cash equivalents, and our net assets totaled $263.9 million.

 

In June 2014, we issued $113.4 million in aggregate principal amount of 7.125% fixed-rate notes due 2021 (the “Notes”). The Notes will mature on June 16, 2021, and may be redeemed in whole or in part at any time or from time to time at the Company’s option on or after June 17, 2017 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest. The notes will bear interest at a rate of 7.125% per year payable quarterly on March 16, June 16, September 16, and December 16 of each year, beginning September 16, 2014. The Notes are listed on the NYSE under the trading symbol “CLA” with a par value of $25.00 per share.

 

Contractual obligations

 

We have entered into two contracts under which we have material future commitments, the Investment Advisory Agreement, pursuant to which the Investment Advisor serves as our investment adviser, and the Administration Agreement, pursuant to which our Administrator agrees to furnish us with certain administrative services necessary to conduct our day-to-day operations. Payments under the Investment Advisory Agreement in future periods will be equal to: (1) a percentage of the value of our gross assets; and (2) an incentive fee based on our performance. Payments under the Administration Agreement will occur on an ongoing basis as expenses are incurred on our behalf by our Administrator.

 

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The Investment Advisory Agreement and the Administration Agreement are each terminable by either party without penalty upon 60 days’ written notice to the other. If either of these agreements is terminated, the costs we incur under new agreements may increase. In addition, we will likely incur significant time and expense in locating alternative parties to provide the services we expect to receive under both our Investment Advisory Agreement and our Administration Agreement. Any new Investment Advisory Agreement would also be subject to approval by our stockholders.

 

A summary of the Company’s significant contractual payment obligations as of June 30, 2014 is as follows (dollars in thousands):

 

   Contractual Obligations Payments Due by Period 
   Less Than
1 Year
   1 - 3
Years
   3 - 5
Years
   More Than
5 Years
   Total 
SBA-Guaranteed Debentures  $   $21,500   $5,000   $165,700   $192,200 
Note Obligations  $   $   $   $113,438   $113,438 
Total Contractual Obligations  $   $21,500   $5,000   $279,138   $305,638 

 

Distributions

 

In order to qualify as a RIC and to avoid U.S. federal corporate level income tax on the income we distribute to our stockholders, we are required to distribute at least 90% of our net ordinary income and our net short-term capital gains in excess of net long-term capital losses, if any, to our stockholders on an annual basis. Additionally, we must distribute an amount at least equal to the sum of 98% of our net ordinary income (during the calendar year) plus 98.2% of our net capital gain income (during each 12-month period ending on October 31) plus any net ordinary income and capital gain net income for preceding years that were not distributed during such years and on which we paid no U.S. federal income tax to avoid a U.S. federal excise tax. To the extent that we have income available, we intend to make quarterly distributions to our stockholders for the first four full quarters subsequent to our IPO and then make monthly distributions thereafter. Our monthly stockholder distributions, if any, will be determined by our Board on a quarterly basis. Any distribution to our stockholders will be declared out of assets legally available for distribution.

 

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 our distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage requirements applicable to us as a BDC under the 1940 Act. If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including the possible loss of our qualification as a RIC. We cannot assure stockholders that they will receive any distributions.

 

To the extent our taxable earnings fall below the total amount of our distributions for that fiscal year, a portion of those distributions may be deemed a return of capital to our stockholders for U.S. federal income tax purposes. Thus, the source of a distribution to our stockholders may be the original capital invested by the stockholder rather than our income or gains. Stockholders should read any written disclosure accompanying any stockholder distribution carefully and should not assume that the source of any distribution is our ordinary income or capital gains.

 

We have adopted an “opt out” dividend reinvestment plan for our common stockholders. As a result, if we declare a distribution, then stockholders’ cash distributions will be automatically reinvested in additional shares of our common stock unless a stockholder specifically “opts out” of our dividend reinvestment plan. If a stockholder opts out, that stockholder will receive cash distributions. Although distributions paid in the form of additional shares of our common stock will generally be subject to U.S. federal, state and local taxes in the same manner as cash distributions, stockholders participating in our dividend reinvestment plan will not receive any corresponding cash distributions with which to pay any such applicable taxes.

 

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Related Parties

 

We have entered into the Investment Advisory Agreement with the Investment Advisor. Mr. Alala, our chief executive officer, president and chairman of our Board, is the managing partner and chief investment officer of our Investment Advisor, and Mr. Broyhill, a member of our Board, has an indirect controlling interest in the Investment Advisor.

 

In addition, the Investment Advisor’s investment team also manages Fund IV, a private investment limited partnership providing financing solutions to smaller and lower middle-market companies that had its first closing in March 2013 and obtained SBA approval for its SBIC license in April 2013. In addition to Fund IV, affiliates of the Investment Advisor may manage several affiliated funds whereby institutional limited partners in Fund IV, have had the opportunity to co-invest with Fund IV in portfolio investments. The Investment Advisor and its affiliates may also manage other funds in the future that may have investment mandates that are similar, in whole and in part, with ours. The Investment Advisor and its affiliates may determine that an investment is appropriate for us and for one or more of those other funds. In such event, depending on the availability of such investment and other appropriate factors, the Investment Advisor or its affiliates may determine that we should invest side-by-side with one or more other funds. Any such investments will be made only to the extent permitted by applicable law and interpretive positions of the SEC and its staff, and consistent with the Investment Advisor’s allocation procedures. We do not expect to make co-investments, or otherwise compete for investment opportunities, with Fund IV because its focus and investment strategy differ from our own.

 

We have entered into a license agreement with the Investment Advisor, pursuant to which the Investment Advisor has agreed to grant us a non-exclusive, royalty-free license to use the name “Capitala.”

 

We have entered into the Administration Agreement with our Administrator. Pursuant to the terms of the Administration Agreement, our Administrator provides us with the office facilities and administrative services necessary to conduct our day-to-day operations. Mr. Alala, our chief executive officer, president and chairman of our Board, is the chief executive officer, president and a director of our Administrator, and Mr. Broyhill, a member of our Board, is the trustee of a trust that has a controlling interest in our Adminstrator.

 

 Off-balance sheet arrangements

 

We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

 

Recent Developments

 

On July 15, 2014, we invested approximately $7.2 million in the junior subordinated debt (12% cash interest), $5.0 million in the senior subordinated debt (14% cash interest), and $1.8 million in the common equity of Burgaflex Holdings, LLC.

 

On July 17, 2014, we invested approximately $12.5 million in the senior secured debt (12% cash, 4% PIK) of Sequoia Healthcare Management, LLC.

 

On July 25, 2014, we invested approximately $3.0 million in the subordinated debt (cash interest of LIBOR + 9.0%, 1% floor) of Meritas Schools Holdings, LLC.

 

On August 1, 2014, we invested $5.3 million in senior revolving debt (current contractual rate of LIBOR plus 6.75% cash interest, .25% floor) and $3.4 million in senior term debt (current contractual rate of LIBOR plus 7.75% cash interest, .25% floor) of Impresa Aerospace Holdings, LLC, an existing portfolio company.

 

On August 5, 2014, we invested $4.0 million in the senior secured debt (12% cash interest, 2% PIK) of Sparus Holdings, Inc., an existing portfolio company.

 

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On August 7, 2014, we declared a quarterly dividend of $0.47 per share payable on September 26, 2014 to holders of record as of September 12, 2014.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

We are subject to financial market risks, including changes in interest rates. Changes in interest rates may affect both our cost of funding and our interest income from portfolio investments and cash and cash equivalents. We may hedge against interest rate fluctuations by using standard hedging instruments such as futures, options and forward contracts subject to the requirements of the 1940 Act. For the three and six months ended June 30, 2014, we did not engage in hedging activities.

 

As of June 30, 2014, the Company held 2 securities at a cost of $14.4 million bearing a variable rate of interest. The Company’s variable rate investments represent approximately 5% of the fair market value of total interest earning investments. All variable rate securities are London Interbank Offered Rate-based (“LIBOR”) and are subject to interest rate floors. As of and for the three and six month periods ended June 30, 2014, all variable rate securities are yielding interest at a rate equal to the established interest rate floor. As of June 30, 2014, all of our interest paying liabilities, consisting of $192.2 million in SBA-guaranteed debentures and $113.4 million in notes payable, bear interest at a fixed rate.

 

Item 4. Controls and Procedures

 

  (a) Evaluation of Disclosure Controls and Procedures

 

As of June 30, 2014 (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 Securities Exchange Act of 1934, as amended). Based on that evaluation, our management, including the 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 such possible controls and procedures.

 

  (b) Changes in Internal Controls Over Financial Reporting

 

Management has not identified any change in the Company’s internal control over financing reporting that occurred during the second quarter of 2014 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

None of us, our Investment Advisor or Administrator or any of the Legacy Funds, is currently subject to any material legal proceedings, nor, to our knowledge, is any material legal proceeding threatened against us, or against our Investment Advisor or Administrator. From time to time, we, our Investment Advisor or Administrator, or any of the Legacy Funds 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.

 

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Item 1A. Risk Factors

 

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, which could materially affect our business, financial condition and/or operating results. The risks described in our Annual Report on Form 10-K are not the only risks we face. Additional risks and uncertainties are not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results. There have been no material changes from the risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2013.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

During the quarter ended June 30, 2014, we issued 11,812 shares of common stock under our dividend reinvestment plan. The issuances were not subject to the registration requirements under the Securities Act. The cash paid for shares of common stock issued under our dividend reinvestment plan during the quarter ended June 30, 2014 was approximately $227 thousand. Other than the shares issued under our dividend reinvestment plan during the quarter ended June 30, 2014, we did not sell any unregistered equity securities and we did not repurchase any of our equity securities.

 

Item 3. Defaults upon Senior Securities

 

None.

 

Item 4. Mine Safety Disclosures

 

None.

 

Item 5. Other Information

 

None.

 

Item 6. Exhibits

 

The following exhibits are filed as part of this report or hereby incorporated by reference to exhibits previously filed with the SEC:

 

Exhibit    
Number   Description of Document
3.1   Articles of Amendment and Restatement(1)
3.4   Bylaws(1)
4.1   Form of Common Stock Certificate(1)
4.2   Form of Base Indenture(2)
4.3   Form of First Supplemental Indenture(2)
4.4   Form of Global Note (included as Exhibit A to the Form of First Supplemental Indenture)(2)
10.1   Form of Dividend Reinvestment Plan(1)
10.2   Form of Investment Advisory Agreement by and between Registrant and Capitala Investment Advisors, LLC(1)
10.3   Form of Custodian Agreement(1)
10.4   Form of Administration Agreement by and between Registrant and Capitala Advisors Corp.(1)
10.5   Form of Indemnification Agreement by and between Registrant and each of its directors(1)
10.6   Form of Trademark License Agreement by and between Registrant and Capitala Investment Advisors, LLC(1)
11.1   Computation of Per Share Earnings (included in the notes to the consolidated financial statements contained in this report)

 

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31.1   Certification of Chief Executive Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)
31.2   Certification of Chief Financial Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)
32.1   Certification of Chief Executive Officer 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith)
32.2   Certification of Chief Financial Officer 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith)

(1)   Previously filed in connection with the Pre-Effective Amendment No. 1 to Capitala Finance Corp.’s registration statement on Form N-2 (File No. 333-188956) filed on September 9, 2013.
(2)   Previously filed in connection with Pre-Effective Amendment No. 2 to Capitala Finance Corp.’s registration statement on Form N-2 (File No. 333-193374) filed on May 21, 2014.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

Date: August 12, 2014 By /s/ Joseph B. Alala III 
    Joseph B. Alala III
    Chief Executive Officer
    (Principal Executive Officer)
    Capitala Finance Corp.
     
Date: August 12, 2014 By /s/ Stephen A. Arnall
    Stephen A. Arnall
    Chief Financial Officer
    (Principal Financial and Accounting Officer)
    Capitala Finance Corp.

 

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