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Logan Ridge Finance Corp. - Quarter Report: 2018 March (Form 10-Q)

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended March 31, 2018

 

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

 

Commission
File Number
  Exact name of registrant as specified in its charter, 
address of principal executive office, telephone number and
state or other jurisdiction 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, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

 

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

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act.           ¨

 

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 May 7, 2018 was 15,981,224.

 

 

   

 

 

TABLE OF CONTENTS

 

      Page
       
PART I. FINANCIAL INFORMATION   3
       
Item 1. Consolidated Financial Statements   3
       
  Consolidated Statements of Assets and Liabilities as of March 31, 2018 (unaudited) and December 31, 2017   3
       
  Consolidated Statements of Operations for the three months ended March 31, 2018 and 2017 (unaudited)   4
       
  Consolidated Statements of Changes in Net Assets for the three months ended March 31, 2018 and 2017 (unaudited)   5
       
  Consolidated Statements of Cash Flows for the three months ended March 31, 2018 and 2017 (unaudited)   6
       
  Consolidated Schedules of Investments as of March 31, 2018 (unaudited) and December 31, 2017   7
       
  Notes to Consolidated Financial Statements as of March 31, 2018 (unaudited)   23
       
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations   49
       
Item 3. Quantitative and Qualitative Disclosures About Market Risk   68
       
Item 4. Controls and Procedures   70
       
PART II.    OTHER INFORMATION   71
       
Item 1. Legal Proceedings   71
       
Item 1A. Risk Factors   71
       
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   72
       
Item 3. Defaults Upon Senior Securities   72
       
Item 4. Mine Safety Disclosures   72
       
Item 5. Other Information   72
       
Item 6. Exhibits   73
     
Signatures   74

 

 2 

 

 

PART I. FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements

 

Capitala Finance Corp.

 

Consolidated Statements of Assets and Liabilities

(in thousands, except share and per share data)

 

   As of 
   March 31, 2018   December 31, 2017 
   (unaudited)     
ASSETS        
Investments at fair value          
Non-control/non-affiliate investments (amortized cost of $278,716 and $298,132, respectively)  $271,092   $288,374 
Affiliate investments (amortized cost of $99,167 and $77,336, respectively)   125,012    103,957 
Control investments (amortized cost of $91,319 and $89,559, respectively)   107,618    107,608 
Total investments at fair value (amortized cost of $469,202 and $465,027, respectively)   503,722    499,939 
Cash and cash equivalents   25,720    31,221 
Interest and dividend receivable   3,090    2,976 
Due from related parties   -    95 
Prepaid expenses   275    309 
Other assets   57    55 
Total assets  $532,864   $534,595 
           
LIABILITIES          
SBA debentures (net of deferred financing costs of $2,146 and $2,300, respectively)  $168,554   $168,400 
2022 Notes (net of deferred financing costs of $2,371 and $2,496, respectively)   72,629    72,504 
2022 Convertible Notes (net of deferred financing costs of $1,504 and $1,583, respectively)   50,584    50,505 
Credit Facility (net of deferred financing costs of $1,186 and $1,293, respectively)   10,814    7,707 
Management and incentive fees payable   2,446    2,172 
Interest and financing fees payable   1,479    3,141 
Trade settlement payable   -    175 
Deferred tax liability, net   1,339    1,289 
Written call option at fair value (proceeds of $20 and $20, respectively)   6,815    6,815 
Total liabilities  $314,660   $312,708 
           
Commitments and contingencies (Note 2)          
           
NET ASSETS          
Common stock, par value $.01, 100,000,000 common shares authorized, 15,974,218 and 15,951,231 common shares  issued and outstanding, respectively  $160   $160 
Additional paid in capital   241,191    241,027 
Undistributed net investment income   16,304    15,854 
Accumulated net realized losses from investments   (65,837)   (61,982)
Net unrealized appreciation on investments, net of deferred taxes   33,181    33,623 
Net unrealized depreciation on written call option   (6,795)   (6,795)
Total net assets  $218,204   $221,887 
Total liabilities and net assets  $532,864   $534,595 
           
Net asset value per share  $13.66   $13.91 

 

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 March 31 
   2018   2017 
INVESTMENT INCOME          
Interest and fee income:          
Non-control/non-affiliate investments  $7,356   $9,638 
Affiliate investments   1,941    1,044 
Control investments   1,849    1,988 
Total interest and fee income   11,146    12,670 
Payment-in-kind interest and dividend income:          
Non-control/non-affiliate investments   705    1,178 
Affiliate investments   486    231 
Control investments   166    246 
Total payment-in-kind interest and dividend income   1,357    1,655 
Dividend income:          
Non-control/non-affiliate investments   -    168 
Affiliate investments   29    29 
Control investments   25    280 
Total dividend income   54    477 
Interest income from cash and cash equivalents   15    13 
Total investment income   12,572    14,815 
           
EXPENSES          
Interest and financing expenses   4,364    4,653 
Base management fee   2,303    2,514 
Incentive fees   244    1,308 
General and administrative expenses   1,223    1,107 
Expenses before incentive fee waiver   8,134    9,582 
Incentive fee waiver (See Note 6)   -    (958)
Total expenses, net of fee waivers   8,134    8,624 
           
NET INVESTMENT INCOME   4,438    6,191 
           
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS AND WRITTEN CALL OPTION:          
Net realized gain (loss) from investments:          
Non-control/non-affiliate investments   (4,579)   4,831 
Affiliate investments   724    15 
Net realized gain (loss) from investments   (3,855)   4,846 
Net unrealized appreciation (depreciation) on investments:          
Non-control/non-affiliate investments   2,134    (6,395)
Affiliate investments   (776)   225 
Control investments   (1,750)   1,499 
Net unrealized depreciation from investments   (392)   (4,671)
Net unrealized depreciation on written call option   -    (1,485)
Net loss on investments and written call option   (4,247)   (1,310)
Tax provision   (50)   - 
Total net realized and unrealized loss on investments and written call option, net of taxes   (4,297)   (1,310)
           
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS  $141   $4,881 
           
NET INCREASE IN NET ASSETS PER SHARE RESULTING FROM OPERATIONS – BASIC AND DILUTED  $0.01   $0.31 
           
WEIGHTED AVERAGE COMMON STOCK OUTSTANDING - BASIC AND DILUTED   15,959,215    15,873,655 
           
DISTRIBUTIONS PAID PER SHARE  $0.25   $0.39 

 

See accompanying notes to consolidated financial statements.

 

 4 

 

 

Capitala Finance Corp.

 

Consolidated Statements of Changes in Net Assets

(in thousands, except share data)

(unaudited)

 

   Common Stock   Additional Paid  

Undistributed Net

   Accumulated Net
Realized Gains
   Net Unrealized
Appreciation (Depreciation)
on Investments,
net of Deferred
   Net Unrealized
Depreciation on
     
   Number of Shares   Par Value   in Capital  

Investment Income

  (Losses)   Taxes   Written Call Option   Total 
                                 
BALANCE, December 31, 2016   15,868,045   $159   $240,184   $22,973   $(37,881)  $27,863   $(2,716)  $     250,582 
Net investment income   -    -    -    6,191    -    -    -    6,191 
Net realized gain from investments   -    -    -    -    4,846    -    -    4,846 
Net change in unrealized depreciation on investments   -    -    -    -    -    (4,671)   -    (4,671)
Net change in unrealized depreciation on written call option   -    -    -    -    -    -    (1,485)   (1,485)
Distributions to Shareholders:                                        
Stock issued under dividend reinvestment plan   15,447    -    207    -    -    -    -    207 
Distributions declared   -    -    -    (6,191)   -    -    -    (6,191)
BALANCE, March 31, 2017  15,883,492   $159   $240,391   $22,973   $(33,035)  $23,192   $(4,201)  $249,479 
                                         
BALANCE, December 31, 2017   15,951,231   $160   $241,027   $15,854   $(61,982)  $33,623   $(6,795)  $221,887 
Net investment income   -    -    -    4,438    -    -    -    4,438 
Net realized loss from investments   -    -    -    -    (3,855)   -    -    (3,855)
Net change in unrealized depreciation on investments   -    -    -    -    -    (392)   -    (392)
Tax provision   -    -    -    -    -    (50)   -    (50)
Distributions to Shareholders:                                        
Stock issued under dividend reinvestment plan   22,987    -    164    -    -    -    -    164 
Distributions declared   -    -    -    (3,988)   -    -    -    (3,988)
BALANCE, March 31, 2018   15,974,218   $160   $241,191   $16,304   $(65,837)  $33,181   $(6,795)  $218,204 

  

See accompanying notes to consolidated financial statements.

 

 5 

 

 

Capitala Finance Corp.

 

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

 

   For the Three Months Ended March 31 
   2018   2017 
CASH FLOWS FROM OPERATING ACTIVITIES          
Net increase in net assets resulting from operations  $141   $4,881 
Adjustments to reconcile net increase in net assets resulting from operations to net cash provided by (used in) operating activities:          
Purchase of investments   (27,800)   (21,708)
Repayments and sales of investments   21,400    33,049 
Net realized (gain) loss on investments   3,855    (4,846)
Net unrealized depreciation on investments   392    4,671 
Payment-in-kind interest and dividends   (1,357)   (1,655)
Accretion of original issue discount on investments   (273)   (350)
Net unrealized depreciation on written call option   -    1,485 
Amortization of deferred financing fees   465    534 
Tax provision   50    - 
Changes in assets and liabilities:          
Interest and dividend receivable   (114)   (259)
Due from related parties   95    39 
Trade settlement receivable   -    (990)
Prepaid expenses   34    65 
Other assets   (2)   5 
Due to related parties   -    (35)
Management and incentive fees payable   274    (2,539)
Interest and financing fees payable   (1,662)   (1,691)
Accounts payable and accrued expenses   -    (389)
Trade settlement payable   (175)   - 
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES   (4,677)   10,267 
           
CASH FLOWS FROM FINANCING ACTIVITIES          
Proceeds from Credit Facility   16,000    - 
Payments to Credit Facility   (13,000)   - 
Distributions paid to shareholders   (3,824)   (5,984)
NET CASH USED IN FINANCING ACTIVITIES   (824)   (5,984)
           
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS   (5,501)   4,283 
CASH AND CASH EQUIVALENTS, beginning of period   31,221    36,281 
CASH AND CASH EQUIVALENTS, end of period  $25,720   $40,564 
           
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION          
Cash paid for interest  $5,196   $5,582 
           
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING TRANSACTIONS          
Distributions paid through dividend reinvestment plan share issuances  $164   $207 

 

See accompanying notes to consolidated financial statements.

 

 6 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

March 31, 2018

(unaudited)

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Non-control/non-affiliated investments - 124.2%                          
                           
Non-control/non-affiliated investments - United States                          
                           
3 Bridge Solutions, LLC  IT Consulting  First Lien Debt (10.67% Cash (1 month LIBOR + 9.0%, 1% Floor), Due 12/4/22)  $11,180   $11,180   $11,180    5.1%
                           
3 Bridge Solutions, LLC  IT Consulting  Preferred Units (965,250 units, 8% PIK) (5)        990    990    0.4%
                           
3 Bridge Solutions, LLC  IT Consulting  Membership Units (39,000 units)        10    147    0.1%
                           
               12,180    12,317    5.6%
                           
Alternative Biomedical Solutions, LLC  Healthcare  First Lien Debt (11.91% Cash, Due 12/18/22) (6)   13,000    13,000    13,000    6.0%
                           
Alternative Biomedical Solutions, LLC  Healthcare  Membership Units (20,092 units)        800    410    0.2%
                           
               13,800    13,410    6.2%
                           
American Clinical Solutions, LLC  Healthcare  First Lien Debt (10.5% Cash, 1% PIK, Due 6/11/20)   9,091    9,091    6,731    3.1%
                           
               9,091    6,731    3.1%
                           
AmeriMark Direct, LLC  Consumer Products  First Lien Debt (12.75% Cash, Due 9/8/21)   18,950    18,590    18,950    8.7%
                           
               18,590    18,950    8.7%
                           
B&W Quality Growers, LLC  Farming  Membership Unit Warrants (91,739 Units)        -    5,609    2.6%
                           
               -    5,609    2.6%
                           
BigMouth, Inc.  Consumer Products  First Lien Debt (13.6% Cash, Due 11/14/21) (6)   9,616    9,616    9,616    4.4%
                           
BigMouth, Inc.  Consumer Products  Series A Preferred Stock (350,000 shares, 8% PIK) (5)        389    727    0.3%
                           
               10,005    10,343    4.7%
                           
Bluestem Brands, Inc.  Online Merchandise Retailer  First Lien Debt (9.38% Cash (1 month LIBOR + 7.5%, 1% Floor), Due 11/7/20)   3,967    3,915    3,615    1.7%
                           
               3,915    3,615    1.7%
                           
Burke America Parts Group, LLC  Home Repair Parts Manufacturer  Membership Units (14 units)        5    2,767    1.3%
                           
               5    2,767    1.3%

 

 7 

 

  

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

March 31, 2018

(unaudited)

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
California Pizza Kitchen, Inc.  Restaurant  Second Lien Debt (11.88% Cash (1 month LIBOR + 10%, 1% Floor), Due 8/23/23)   5,000   4,886   4,886   2.2%
                           
               4,886    4,886    2.2%
                           
Caregiver Services, Inc.  In-Home Healthcare Services  Common Stock (293,186 shares)        258    80    0.0%
                           
Caregiver Services, Inc.  In-Home Healthcare Services  Common Stock Warrants (655,908 units) (7)        264    178    0.1%
                           
               522    258    0.1%
                           
Cedar Electronics Holding Corp.  Consumer Electronics  Subordinated Debt (12% Cash, Due 12/26/20) (8)(9)   21,550    21,550    958    0.4%
                           
               21,550    958    0.4%
                           
CIS Secure Computing, Inc.  Government Services  First Lien Debt (10.17% Cash (1 month LIBOR + 8.5%, 1% Floor), 1% PIK, Due 9/14/22) (10)   9,015    9,015    9,015    4.1%
                           
CIS Secure Computing, Inc.  Government Services  Common Stock (46,163 shares)        1,000    1,541    0.7%
                           
               10,015    10,556    4.8%
                           
Corporate Visions, Inc.  Sales & Marketing Services  Subordinated Debt (9% Cash, 2% PIK, Due 11/29/21)   18,250    18,250    17,431    8.0%
                           
Corporate Visions, Inc.  Sales & Marketing Services  Common Stock (15,750 shares)        1,575    640    0.3%
                           
               19,825    18,071    8.3%
                           
Currency Capital, LLC  Financial Services  First Lien Debt (12.67% Cash (1 month LIBOR + 11%, 0.50% Floor) Due 1/20/22) (11)   17,000    17,000    17,000    7.8%
                           
Currency Capital, LLC  Financial Services  Class A Preferred Units (2,000,000 units) (11)        2,000    2,000    0.9%
                           
               19,000    19,000    8.7%
                           
Flavors Holdings, Inc.  Food Product Manufacturer  First Lien Debt (8.05% Cash (3 month LIBOR + 5.75%, 1% Floor), Due 4/3/20)   6,600    6,503    6,023    2.8%
                           
Flavors Holdings, Inc.  Food Product Manufacturer  Second Lien Debt (12.30% Cash (3 month LIBOR + 10%, 1% Floor), Due 10/3/21)   12,000    11,757    10,923    5.0%
                           
               18,260    16,946    7.8%
                           
MC Sign Lessor Corp.  Advertising & Marketing Services  First Lien Debt (8.66% Cash (1 month LIBOR + 7.0%, 1% Floor), Due 12/22/22)(12)   3,935    3,935    3,935    1.8%

 

 8 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

March 31, 2018

(unaudited)

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
MC Sign Lessor Corp.  Advertising & Marketing Services  First Lien Debt (8.66% Cash (1 month LIBOR + 7.0%, 1% Floor), Due 12/22/22)(13)   -   -   -   0.0%
                           
               3,935    3,935    1.8%
                           
Nth Degree, Inc.  Business Services  First Lien Debt (13.19% Cash (1 month LIBOR + 11.5%, 1% Floor), 2% PIK, Due 12/14/20)   7,236    7,236    7,236    3.3%
                           
Nth Degree, Inc.  Business Services  Preferred Stock (2,400 Units, 10% PIK dividend) (5)        3,011    11,401    5.2%
                           
               10,247    18,637    8.5%
                           
Sequoia Healthcare Management, LLC  Healthcare Management  First Lien Debt (12% Cash, 4% PIK, Due 7/17/19)   8,706    8,668    8,706    4.0%
                           
               8,668    8,706    4.0%
                           
Spectra Services Holdings, LLC  Refrigeration / HVAC services  First Lien Debt (10% Cash, 4% PIK, Due 12/27/22)   7,525    7,525    7,525    3.4%
                           
Spectra Services Holdings, LLC  Refrigeration / HVAC services  Class A Units (1,283,824 units, 4% Cash dividend, 11% PIK dividend) (5)        1,321    1,560    0.7%
                           
Spectra Services Holdings, LLC  Refrigeration / HVAC services  Class B Units (257 units)        -    -    0.0%
                           
               8,846    9,085    4.1%
                           
Sur La Table, Inc.  Retail  First Lien Debt (12% Cash, Due 7/28/20)   15,000    15,000    15,000    6.9%
                           
               15,000    15,000    6.9%
                           
Taylor Precision Products, Inc.  Household Product Manufacturer  Series C Preferred Stock (379 shares)        758    758    0.3%
                           
               758    758    0.3%
                           
Vintage Stock, Inc.  Specialty Retail  First Lien Debt (14.16% Cash (1 month LIBOR + 12.5%, 0.5% floor), 3% PIK, Due 11/3/21)   19,494    19,494    19,494    8.9%
                           
               19,494    19,494    8.9%
                           
Vology, Inc.  Information Technology  Subordinated Debt (15% Cash (3 month LIBOR + 14%, 1% Ceiling), 4% PIK Due 6/30/20)   8,458    8,458    8,458    3.9%
                           
               8,458    8,458    3.9%
                           
Western Windows Systems, LLC  Building Products  First Lien Debt (12.5% Cash, Due 7/31/20) (6)   10,500    10,500    10,500    4.8%

 

 9 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

March 31, 2018

(unaudited)

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Western Windows Systems, LLC  Building Products  Membership Units (39,860 units)       3,000   8,209   3.8%
                           
               13,500    18,709    8.6%
                           
Xirgo Technologies, LLC  Information Technology  Subordinated Debt (11.5% Cash, Due 3/1/22)   15,750    15,750    15,750    7.2%
                           
Xirgo Technologies, LLC  Information Technology  Membership Units (600,000 units)        600    569    0.3%
                           
               16,350    16,319    7.5%
                           
Sub Total Non-control/non-affiliated investments - United States              266,900    263,518    120.7%
                           
Non-control/non-affiliated investments - Brazil                          
Velum Global Credit Management, LLC  Financial Services  First Lien Debt (15% PIK, Due 12/31/17) (8) (11) (14) (15)   12,741    11,816    7,574    3.5%
                           
               11,816    7,574    3.5%
                           
Sub Total Non-control/non-affiliated investments - Brazil              11,816    7,574    3.5%
                           
Sub Total Non-control/non-affiliated investments             $278,716   $271,092    124.2%
                           
Affiliate investments - 57.3%                          
                           
Affiliate investments - United States                          
AAE Acquisition, LLC  Industrial Equipment Rental  Second Lien Debt (8% Cash, 4% PIK, Due 8/24/19) (14)  $16,004   $16,004   $15,952    7.3%
                           
AAE Acquisition, LLC  Industrial Equipment Rental  Membership Units (2.19% fully diluted)        17    -    0.0%
                           
AAE Acquisition, LLC  Industrial Equipment Rental  Warrants (37.78% fully diluted)        -    -    0.0%
                           
               16,021    15,952    7.3%
                           
Burgaflex Holdings, LLC  Automobile Part Manufacturer  First Lien Debt (12% Cash, 1% PIK, Due 3/23/21)   14,688    14,688    14,688    6.7%
                           
Burgaflex Holdings, LLC  Automobile Part Manufacturer  Common Stock Class A (1,253,198 shares)        1,504    -    0.0%
                           
Burgaflex Holdings, LLC  Automobile Part Manufacturer  Common Stock Class B (900,000 shares)        300    300    0.1%
                           
               16,492    14,988    6.8%
                           
City Gear, LLC  Footwear Retail  Subordinated Debt (13% Cash, Due 10/20/19) (14)   8,231    8,231    8,231    3.8%

 

 10 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

March 31, 2018

(unaudited)

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
City Gear, LLC  Footwear Retail  Preferred Membership Units (2.78% fully diluted, 9% Cash Dividend) (5)       1,269   1,269   0.6%
                           
City Gear, LLC  Footwear Retail  Membership Unit Warrants (11.38% fully diluted)        -    7,631    3.5%
                           
               9,500    17,131    7.9%
                           
GA Communications, Inc.  Advertising & Marketing Services  Series A-1 Preferred Stock (1,998 shares, 8% PIK Dividend) (5)        2,968    3,286    1.5%
                           
GA Communications, Inc.  Advertising & Marketing Services  Series B-1 Common Stock (200,000 shares)        2    1,678    0.8%
                           
               2,970    4,964    2.3%
                           
J&J Produce Holdings, Inc.  Produce Distribution  Subordinated Debt (13% Cash, Due 6/16/19) (14)   6,406    6,406    6,313    2.9%
                           
J&J Produce Holdings, Inc.  Produce Distribution  Common Stock (8,182 shares)        818    -    0.0%
                           
J&J Produce Holdings, Inc.  Produce Distribution  Common Stock Warrants (6,369 shares)        -    -    0.0%
                           
               7,224    6,313    2.9%
                           
LJS Partners, LLC  QSR Franchisor  Common Stock (1,500,000 shares)        896    7,662    3.5%
                           
               896    7,662    3.5%
                           
MMI Holdings, LLC  Medical Device Distributor  First Lien Debt (12% Cash, Due 1/31/19) (14)   2,600    2,600    2,600    1.2%
                           
MMI Holdings, LLC  Medical Device Distributor  Subordinated Debt (6% Cash, Due 1/31/19) (14)   400    388    400    0.2%
                           
MMI Holdings, LLC  Medical Device Distributor  Preferred Units (1,000 units, 6% PIK Dividend) (5)        1,405    1,542    0.7%
                           
MMI Holdings, LLC  Medical Device Distributor  Common Membership Units (45 units)        -    174    0.1%
                           
               4,393    4,716    2.2%
                           
MTI Holdings, LLC  Retail Display & Security Services  Membership Units (2,000,000 units) (16)        -    100    0.0%
                           
               -    100    0.0%
                           
Sierra Hamilton Holdings Corporation  Oil & Gas Engineering and Consulting Services  Common Stock (15,068,000 shares)        6,958    8,891    4.1%
                           
               6,958    8,891    4.1%

 

 11 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

March 31, 2018

(unaudited)

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Source Capital Penray, LLC  Automotive Chemicals & Lubricants  Membership Units (11.3% ownership) (16)       -   101   0.0%
                           
               -    101    0.0%
                           
US Bath Group, LLC  Building Products  First Lien Debt (10.67% Cash (1 month LIBOR + 9.0%, 1% Floor), Due 1/2/23)   14,688    14,688    14,688    6.7%
                           
US Bath Group, LLC  Building Products  Membership Units (500,000 units)        500    500    0.2%
                           
               15,188    15,188    6.9%
                           
U.S. Well Services, LLC  Oil & Gas Services  First Lien Debt (7.65% Cash (1 month LIBOR + 6%, 1% floor), Due 2/2/22) (17)   2,299    2,299    2,299    1.1%
                           
U.S. Well Services, LLC  Oil & Gas Services  First Lien Debt (10.65% Cash (1 month LIBOR + 9%, 1% floor), Due 2/2/22)   9,713    9,713    9,713    4.5%
                           
U.S. Well Services, LLC  Oil & Gas Services  Class A Units (5,680,688 Units)        6,259    15,004    6.9%
                           
U.S. Well Services, LLC  Oil & Gas Services  Class B Units (2,076,298 Units)        441    955    0.4%
                           
               18,712    27,971    12.9%
                           
V12 Holdings, Inc.  Data Processing & Digital Marketing  Subordinated Debt (18)        813    1,035    0.5%
                           
               813    1,035    0.5%
                           
Sub Total Affiliate investments - United States             $99,167   $125,012    57.3%
                           
Control investments- 49.3%                          
                           
Control investments - United States                          
CableOrganizer Acquisition, LLC  Computer Supply Retail  First Lien Debt (12% Cash, 4% PIK, Due 5/24/18)  $12,497   $12,497   $11,306    5.2%
                           
CableOrganizer Acquisition, LLC  Computer Supply Retail  Common Stock (21.3% fully diluted)        1,394    -    0.0%
                           
CableOrganizer Acquisition, LLC  Computer Supply Retail  Common Stock Warrants (10% fully diluted )        -    -    0.0%
                           
               13,891    11,306    5.2%
                           
Eastport Holdings, LLC  Business Services  Subordinated Debt (15.02% Cash (3 month LIBOR + 13%, 0.5% Floor), Due 4/29/20)   16,500    14,926    16,500    7.6%

 

 12 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

March 31, 2018

(unaudited)

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Eastport Holdings, LLC  Business Services  Membership Units (33.3% ownership) (19)       4,733   26,449   12.1%
                           
               19,659    42,949    19.7%
                           
Kelle's Transport Service, LLC  Transportation  First Lien Debt (4% Cash, Due 2/15/20) (20)   2,227    2,227    2,227    1.0%
                           
Kelle's Transport Service, LLC  Transportation  First Lien Debt (1.46% Cash, Due 2/15/20) (14)   13,674    13,669    9,933    4.6%
                           
Kelle's Transport Service, LLC  Transportation  Membership Units (27.5% fully diluted)        -    -    0.0%
                           
               15,896    12,160    5.6%
                           
Micro Precision, LLC  Conglomerate  Subordinated Debt (10% Cash, Due 9/15/18) (14)   1,862    1,862    1,862    0.9%
                           
Micro Precision, LLC  Conglomerate  Subordinated Debt (14% Cash, 4% PIK, Due 9/15/18) (14)   4,195    4,195    4,195    1.9%
                           
Micro Precision, LLC  Conglomerate  Series A Preferred Units (47 units)        1,629    1,177    0.5%
                           
               7,686    7,234    3.3%
                           
Navis Holdings, Inc.  Textile Equipment Manufacturer  First Lien Debt (15% Cash, Due 10/30/20) (14)   7,500    7,500    7,500    3.4%
                           
Navis Holdings, Inc.  Textile Equipment Manufacturer  Class A Preferred Stock (1,000 shares, 10% Cash Dividend) (5)        1,000    1,000    0.5%
                           
Navis Holdings, Inc.  Textile Equipment Manufacturer  Common Stock (300,000 shares)        1    5,258    2.4%
                           
               8,501    13,758    6.3%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Subordinated Debt (18% Cash, Due 12/19/18) (8) (14)   14,778    11,020    11,647    5.3%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Series A Preferred Stock (32,782 shares)        3,278    -    0.0%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Series B Preferred Stock (23,648 shares)        2,365    -    0.0%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Common Stock (33,058 shares)        33    -    0.0%
                           
               16,696    11,647    5.3%
                           
Portrait Studio, LLC  Professional and Personal Digital Imaging  First Lien Debt (8.69% Cash (1 month LIBOR + 7%, 1% floor, 2% ceiling), Due 12/31/22) (21)   2,040    2,040    2,040    0.9%

 

 13 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

March 31, 2018

(unaudited)

 

Portfolio Company, Country (1), (2), (3), (4)  Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Portrait Studio, LLC  Professional and Personal Digital Imaging  First Lien Debt (8.69% Cash (1 month LIBOR + 7%, 1% floor, 5% ceiling), Due 12/31/22)   4,500    4,500    4,500    2.1%
                           
Portrait Studio, LLC  Professional and Personal Digital Imaging  Preferred Units (4,350,000 Units)        2,450    2,024    0.9%
                           
Portrait Studio, LLC  Professional and Personal Digital Imaging  Membership Units (150,000 Units)        -    -    0.0%
                           
               8,990    8,564    3.9%
                           
Sub Total Control investments - United States             $91,319   $107,618    49.3%
                           
TOTAL INVESTMENTS - 230.8%             $469,202   $503,722    230.8%
                         
Derivatives - (3.1)%                          
                           
Derivatives - United States                          
Eastport Holdings, LLC  Business Services  Written Call Option (19)       $(20)  $(6,815)   (3.1%)
                           
Sub Total Derivatives - United States             $(20)  $(6,815)   (3.1%)
                           
TOTAL DERIVATIVES- (3.1)%             $(20)  $(6,815)   (3.1%)

 

(1) All investments valued using unobservable inputs (Level 3).

(2) All investments valued by the Board of Directors.

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

(4) Percentages are based on net assets of $218,204 as of March 31, 2018.

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

(6) The cash rate equals the approximate current yield on our last-out portion of the unitranche facility.

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

(8) Non-accrual investment.

(9) On April 2, 2018, the debt investment was converted to equity as part of a restructuring. The investment was valued based on the new capital structure of the company.

(10) The investment has a $2.0 million unfunded commitment.

(11) Indicates assets that the Company believes do not represent “qualifying assets” under Section 55(a) of the Investment Company Act of 1940, as amended. Qualifying assets must represent at least 70% of the Company's total assets at the time of acquisition of any additional non-qualifying assets. As of March 31, 2018, 5.0% of the Company's total assets were non-qualifying assets.

(12) The investment has a $0.6 million unfunded commitment.

(13) The investment has a $0.5 million unfunded commitment.

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

(15) The company is headquartered in Brazil.

(16) The company has been exited. The residual value reflects estimated escrow to be settled post-closing.

(17) The investment has a $0.7 million unfunded commitment.

(18) The investment has been exited. The residual value reflects estimated escrow and earnout to be settled post-closing.

(19) The Company has written a call option that enables CapitalSouth Partners Florida Sidecar Fund II, L.P. to purchase up to 31.25% of the Company's interest at a strike price of $1.5 million. As of March 31, 2018, the fair value of the written call option is approximately $6.8 million. See Note 4 to the consolidated financial statements for further detail on the written call option transaction.

(20) The investment has a $0.8 million unfunded commitment.

(21) The investment has a $3.0 million unfunded commitment.

 

See accompanying notes to consolidated financial statements. 

 

 14 

 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

December 31, 2017

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Non-control/non-affiliated investments - 130.0%                          
                           
Non-control/non-affiliated investments - United States                          
                           
3 Bridge Solutions, LLC  IT Consulting  First Lien Debt (10.38% Cash (1 month LIBOR + 9.0%, 1% Floor), Due 12/4/22)  $11,250   $11,250   $11,250   5.1%
                           
3 Bridge Solutions, LLC  IT Consulting  Preferred Units (965,250 units, 8% PIK) (5)        971    971    0.4%
                           
3 Bridge Solutions, LLC  IT Consulting  Membership Units (39,000 units)        10    10    0.0%
                           
               12,231    12,231    5.5%
                           
Alternative Biomedical Solutions, LLC  Healthcare  First Lien Debt (11.74% Cash, Due 12/18/22) (6)   13,000    13,000    13,000    5.9%
                           
Alternative Biomedical Solutions, LLC  Healthcare  Membership Units (20,092 units)        800    800    0.4%
                           
               13,800    13,800    6.3%
                           
American Clinical Solutions, LLC  Healthcare  First Lien Debt (10.5% Cash, 1% PIK, Due 6/11/20)   9,068    9,068    7,568    3.4%
                           
               9,068    7,568    3.4%
                           
American Exteriors, LLC  Replacement Window Manufacturer  First Lien Debt (10% PIK, Due 1/1/19) (7)(8)   8,287    5,679    1,880    0.8%
                           
American Exteriors, LLC  Replacement Window Manufacturer  Common Stock Warrants (10% fully diluted)        -    -    0.0%
                           
               5,679    1,880    0.8%
                           
AmeriMark Direct, LLC  Consumer Products  First Lien Debt (12.75% Cash, Due 9/8/21)   19,100    18,713    19,100    8.6%
                           
               18,713    19,100    8.6%
                           
B&W Quality Growers, LLC  Farming  Membership Unit Warrants (91,739 Units)        -    5,581    2.5%
                           
               -    5,581    2.5%
                           
BigMouth, Inc.  Consumer Products  First Lien Debt (13.3% Cash, Due 11/14/21) (6)   9,790    9,790    9,790    4.4%
                           
BigMouth, Inc.  Consumer Products  Series A Preferred Stock (350,000 shares, 8% PIK) (5)        382    722    0.3%
                           
               10,172    10,512    4.7%

 

 15 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

December 31, 2017

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Bluestem Brands, Inc.  Online Merchandise Retailer  First Lien Debt (9.07% Cash (1 month LIBOR + 7.5%, 1% Floor), Due 11/7/20)   4,029   3,965   3,755   1.7%
                           
               3,965    3,755    1.7%
                           
Brunswick Bowling Products, Inc.  Bowling Products  First Lien Debt (8% Cash (1 month LIBOR + 6%, 2% Floor), Due 5/22/20)   1,600    1,600    1,600    0.7%
                           
Brunswick Bowling Products, Inc.  Bowling Products  First Lien Debt (16.25% Cash (1 month LIBOR + 14.25%, 2% Floor), Due 5/22/20)   5,586    5,586    5,586    2.5%
                           
               7,186    7,186    3.2%
                           
Burke America Parts Group, LLC  Home Repair Parts Manufacturer  Membership Units (14 units)        5    2,767    1.2%
                           
               5    2,767    1.2%
                           
California Pizza Kitchen, Inc.  Restaurant  Second Lien Debt (11.57% Cash (1 month LIBOR + 10%, 1% Floor), Due 8/23/23)   5,000    4,880    4,880    2.2%
                           
               4,880    4,880    2.2%
                           
Caregiver Services, Inc.  In-Home Healthcare Services  Common Stock (293,186 shares)        258    54    0.0%
                           
Caregiver Services, Inc.  In-Home Healthcare Services  Common Stock Warrants (655,908 units) (9)        264    120    0.1%
                           
               522    174    0.1%
                           
Cedar Electronics Holding Corp.  Consumer Electronics  Subordinated Debt (12% Cash, Due 12/26/20) (7)   21,550    21,550    3,498    1.6%
                           
               21,550    3,498    1.6%
                           
CIS Secure Computing, Inc.  Government Services  First Lien Debt (9.88% Cash (1 month LIBOR + 8.5%, 1% Floor), 1% PIK, Due 9/14/22) (10)   9,116    9,116    9,116    4.1%
                           
CIS Secure Computing, Inc.  Government Services  Common Stock (46,163 shares)        1,000    1,204    0.5%
                           
               10,116    10,320    4.6%
                           
Corporate Visions, Inc.  Sales & Marketing Services  Subordinated Debt (9% Cash, 2% PIK, Due 11/29/21)   18,159    18,159    16,995    7.7%
                           
Corporate Visions, Inc.  Sales & Marketing Services  Common Stock (15,750 shares)        1,575    393    0.2%
                           
               19,734    17,388    7.9%
                           
Currency Capital, LLC  Financial Services  First Lien Debt (12.38% Cash (1 month LIBOR + 11%, 0.50% Floor) Due 1/20/22) (11)   17,000    17,000    17,000    7.7%

 

 16 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

December 31, 2017

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Currency Capital, LLC  Financial Services  Class A Preferred Units (2,000,000 units) (11)       2,000   1,905   0.9%
                           
               19,000    18,905    8.6%
                           
Flavors Holdings, Inc.  Food Product Manufacturer  First Lien Debt (7.44% Cash (3 month LIBOR + 5.75%, 1% Floor), Due 4/3/20)   6,700    6,589    5,911    2.7%
                           
Flavors Holdings, Inc.  Food Product Manufacturer  Second Lien Debt (11.69% Cash (3 month LIBOR + 10%, 1% Floor), Due 10/3/21)   12,000    11,740    10,311    4.6%
                           
               18,329    16,222    7.3%
                           
Nth Degree, Inc.  Business Services  First Lien Debt (8.38% Cash (1 month LIBOR + 7%, 1% Floor), 1% PIK, Due 12/14/20)   8,833    8,833    8,833    4.0%
                           
Nth Degree, Inc.  Business Services  First Lien Debt (12.88% Cash (1 month LIBOR + 11.5%, 1% Floor), 2% PIK, Due 12/14/20)   7,200    7,200    7,200    3.2%
                           
Nth Degree, Inc.  Business Services  Preferred Stock (2,400 Units, 10% PIK dividend) (5)        2,938    11,140    5.0%
                           
               18,971    27,173    12.2%
                           
Sequoia Healthcare Management, LLC  Healthcare Management  First Lien Debt (12% Cash, 4% PIK, Due 7/17/19)   9,014    8,964    9,014    4.1%
                           
               8,964    9,014    4.1%
                           
Spectra Services Holdings, LLC  Refrigeration / HVAC services  First Lien Debt (10% Cash, 4% PIK, Due 12/27/22)   7,450    7,450    7,450    3.4%
                           
Spectra Services Holdings, LLC  Refrigeration / HVAC services  Class A Units (1,283,824 units, 4% Cash dividend, 11% PIK dividend) (5)        1,286    1,286    0.6%
                           
Spectra Services Holdings, LLC  Refrigeration / HVAC services  Class B Units (257 units)        -    -    0.0%
                           
               8,736    8,736    4.0%
                           
Sur La Table, Inc.  Retail  First Lien Debt (12% Cash, Due 7/28/20)   15,000    15,000    15,000    6.8%
                           
               15,000    15,000    6.8%
                           
Taylor Precision Products, Inc.  Household Product Manufacturer  Series C Preferred Stock (379 shares)        758    1,316    0.6%
                           
               758    1,316    0.6%
                           
Vintage Stock, Inc.  Specialty Retail  First Lien Debt (13.86% Cash (1 month LIBOR + 12.5%, 0.5% floor), 3% PIK, Due 11/3/21)   20,713    20,713    20,713    9.3%
                           
               20,713    20,713    9.3%

 

 17 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

December 31, 2017

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Vology, Inc.  Information Technology  Subordinated Debt (15% Cash (3 month LIBOR + 14%, 1% Ceiling), 4% PIK Due 6/30/20)   8,374   8,374   8,374   3.8%
                           
               8,374    8,374    3.8%
                           
Western Windows Systems, LLC  Building Products  First Lien Debt (11.9% Cash, Due 7/31/20) (6)   10,500    10,500    10,500    4.7%
                           
Western Windows Systems, LLC  Building Products  Membership Units (39,860 units)        3,000    7,379    3.3%
                           
               13,500    17,879    8.0%
                           
Xirgo Technologies, LLC  Information Technology  Subordinated Debt (11.5% Cash, Due 3/1/22)   15,750    15,750    15,750    7.1%
                           
Xirgo Technologies, LLC  Information Technology  Membership Units (600,000 units)        600    637    0.3%
                           
               16,350    16,387    7.4%
                           
Sub Total Non-control/non-affiliated investments - United States              286,316    280,359    126.4%
                           
Non-control/non-affiliated investments - Brazil                          
Velum Global Credit Management, LLC  Financial Services  First Lien Debt (15% PIK, Due 12/31/17) (7) (8) (11) (12)   12,275    11,816    8,015    3.6%
                           
               11,816    8,015    3.6%
                           
Sub Total Non-control/non-affiliated investments - Brazil              11,816    8,015    3.6%
                           
Sub Total Non-control/non-affiliated investments             $298,132   $288,374    130.0%
                           
Affiliate investments - 46.8%                          
                           
Affiliate investments - United States                          
AAE Acquisition, LLC  Industrial Equipment Rental  Second Lien Debt (8% Cash, 4% PIK, Due 8/24/19) (8)  $15,846   $15,846   $15,603    7.0%
                           
AAE Acquisition, LLC  Industrial Equipment Rental  Membership Units (2.19% fully diluted)        17    -    0.0%
                           
AAE Acquisition, LLC  Industrial Equipment Rental  Warrants (37.78% fully diluted)        -    -    0.0%
                           
               15,863    15,603    7.0%
                           
Burgaflex Holdings, LLC  Automobile Part Manufacturer  Subordinated Debt (14% Cash, Due 8/9/19) (13)   3,000    3,000    3,000    1.4%

 

 18 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

December 31, 2017

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Burgaflex Holdings, LLC  Automobile Part Manufacturer  Subordinated Debt (12% Cash, Due 8/9/19) (13)   5,828   5,828   5,828   2.6%
                           
Burgaflex Holdings, LLC  Automobile Part Manufacturer  Common Stock (1,253,198 shares)        1,504    457    0.2%
                           
               10,332    9,285    4.2%
                           
City Gear, LLC  Footwear Retail  Subordinated Debt (13% Cash, Due 10/20/19) (8)   8,231    8,231    8,231    3.7%
                           
City Gear, LLC  Footwear Retail  Preferred Membership Units (2.78% fully diluted, 9% Cash Dividend) (5)        1,269    1,269    0.6%
                           
City Gear, LLC  Footwear Retail  Membership Unit Warrants (11.38% fully diluted)        -    8,248    3.7%
                           
               9,500    17,748    8.0%
                           
GA Communications, Inc.  Advertising & Marketing Services  Series A-1 Preferred Stock (1,998 shares, 8% PIK Dividend) (5)        2,902    3,225    1.5%
                           
GA Communications, Inc.  Advertising & Marketing Services  Series B-1 Common Stock (200,000 shares)        2    1,932    0.9%
                           
               2,904    5,157    2.4%
                           
J&J Produce Holdings, Inc.  Produce Distribution  Subordinated Debt (6% Cash, 7% PIK, Due 6/16/19) (8)   6,368    6,368    6,170    2.8%
                           
J&J Produce Holdings, Inc.  Produce Distribution  Common Stock (8,182 shares)        818    -    0.0%
                           
J&J Produce Holdings, Inc.  Produce Distribution  Common Stock Warrants (6,369 shares)        -    -    0.0%
                           
               7,186    6,170    2.8%
                           
LJS Partners, LLC  QSR Franchisor  Common Stock (1,500,000 shares)        896    7,650    3.4%
                           
               896    7,650    3.4%
                           
MMI Holdings, LLC  Medical Device Distributor  First Lien Debt (12% Cash, Due 1/31/19) (8)   2,600    2,600    2,600    1.2%
                           
MMI Holdings, LLC  Medical Device Distributor  Subordinated Debt (6% Cash, Due 1/31/19) (8)   400    388    400    0.2%
                           
MMI Holdings, LLC  Medical Device Distributor  Preferred Units (1,000 units, 6% PIK dividend) (5)        1,381    1,520    0.7%
                           
MMI Holdings, LLC  Medical Device Distributor  Common Membership Units (45 units)        -    193    0.1%
                           
               4,369    4,713    2.2%

 

 19 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

December 31, 2017

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
MTI Holdings, LLC  Retail Display & Security Services  Membership Units (2,000,000 units) (14)       -   100   0.0%
                           
               -    100    0.0%
                           
Sierra Hamilton Holdings Corporation  Oil & Gas Engineering and Consulting Services  Common Stock (15,068,000 shares)        6,958    8,528    3.8%
                           
               6,958    8,528    3.8%
                           
Source Capital Penray, LLC  Automotive Chemicals & Lubricants  Membership Units (11.3% ownership) (14)        -    101    0.0%
                           
               -    101    0.0%
                           
STX Healthcare Management Services, Inc.  Dental Practice Management  Common Stock (1,200,000 shares) (14)        -    93    0.0%
                           
               -    93    0.0%
                           
U.S. Well Services, LLC  Oil & Gas Services  First Lien Debt (7.35% Cash (1 month LIBOR + 6%, 1% floor), Due 2/2/22) (15)   2,299    2,299    2,299    1.0%
                           
U.S. Well Services, LLC  Oil & Gas Services  First Lien Debt (12.35% PIK (1 month LIBOR + 11%, 1% floor), Due 2/2/22)   9,516    9,516    9,516    4.3%
                           
U.S. Well Services, LLC  Oil & Gas Services  Class A Units (5,680,688 Units)        6,259    15,004    6.8%
                           
U.S. Well Services, LLC  Oil & Gas Services  Class B Units (2,076,298 Units)        441    955    0.4%
                           
               18,515    27,774    12.5%
                           
V12 Holdings, Inc.  Data Processing & Digital Marketing  Subordinated Debt (19)        813    1,035    0.5%
                           
               813    1,035    0.5%
                           
Sub Total Affiliate investments - United States             $77,336   $103,957    46.8%
                           
Control investments- 48.5%                          
                           
Control investments - United States                          
CableOrganizer Acquisition, LLC  Computer Supply Retail  First Lien Debt (12% Cash, 4% PIK, Due 5/24/18)  $12,373    12,373    12,373    5.6%
                           
CableOrganizer Acquisition, LLC  Computer Supply Retail  Common Stock (21.3% fully diluted)        1,394    118    0.1%

 

 20 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

December 31, 2017

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
CableOrganizer Acquisition, LLC  Computer Supply Retail  Common Stock Warrants (10% fully diluted )       -   60   0.0%
                           
               13,767    12,551    5.7%
                           
Eastport Holdings, LLC  Business Services  Subordinated Debt (14.49% Cash (3 month LIBOR + 13%, 0.5% Floor), Due 4/29/20)   16,500    14,738    16,500    7.4%
                           
Eastport Holdings, LLC  Business Services  Membership Units (33.3% ownership) (16)        4,733    26,449    11.9%
                           
               19,471    42,949    19.3%
                           
Kelle's Transport Service, LLC  Transportation  First Lien Debt (4% Cash, Due 2/15/20) (17)   2,000    2,000    2,000    0.9%
                           
Kelle's Transport Service, LLC  Transportation  First Lien Debt (1.46% Cash, Due 2/15/20) (8)   13,674    13,669    9,560    4.3%
                           
Kelle's Transport Service, LLC  Transportation  Membership Units (27.5% fully diluted)        -    -    0.0%
                           
               15,669    11,560    5.2%
                           
Micro Precision, LLC  Conglomerate  Subordinated Debt (10% Cash, Due 9/15/18) (8)   1,862    1,862    1,862    0.8%
                           
Micro Precision, LLC  Conglomerate  Subordinated Debt (14% Cash, 4% PIK, Due 9/15/18) (8)   4,154    4,154    4,154    1.9%
                           
Micro Precision, LLC  Conglomerate  Series A Preferred Units (47 units)        1,629    1,629    0.7%
                           
               7,645    7,645    3.4%
                           
Navis Holdings, Inc.  Textile Equipment Manufacturer  First Lien Debt (15% Cash, Due 10/30/20) (8)   6,500    6,500    6,500    2.9%
                           
Navis Holdings, Inc.  Textile Equipment Manufacturer  Class A Preferred Stock (1,000 shares, 10% Cash Dividend) (5)        1,000    1,000    0.5%
                           
Navis Holdings, Inc.  Textile Equipment Manufacturer  Common Stock (300,000 shares)        1    5,005    2.3%
                           
               7,501    12,505    5.7%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Subordinated Debt (18% Cash, Due 12/19/18) (7) (8)   14,072    11,020    11,588    5.2%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Series A Preferred Stock (32,782 shares)        3,278    -    0.0%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Series B Preferred Stock (23,648 shares)        2,365    -    0.0%
                           
On-Site Fuel Services, Inc.  Fuel Transportation Services  Common Stock (33,058 shares)        33    -    0.0%
                           
               16,696    11,588    5.2%

 

 21 

 

 

Capitala Finance Corp.

 

Consolidated Schedule of Investments

(in thousands, except for units/shares)

December 31, 2017

 

Portfolio Company, Country (1), (2), (3), (4)   Industry  Type of Investment  Principal
Amount
   Cost   Fair Value   % of
Net Assets
 
                       
Portrait Studio, LLC  Professional and Personal Digital Imaging  First Lien Debt (8.56% Cash (1 month LIBOR + 7%, 1% floor, 2% ceiling), Due 12/31/22) (18)   1,860    1,860    1,860   0.9%
                           
Portrait Studio, LLC  Professional and Personal Digital Imaging  First Lien Debt (8.56% Cash (1 month LIBOR + 7%, 1% floor, 5% ceiling), Due 12/31/22)   4,500    4,500    4,500    2.0%
                           
Portrait Studio, LLC  Professional and Personal Digital Imaging  Preferred Units (4,350,000 Units)        2,450    2,450    1.1%
                           
Portrait Studio, LLC  Professional and Personal Digital Imaging  Membership Units (150,000 Units)        -    -    0.0%
                           
               8,810    8,810    4.0%
                           
Sub Total Control investments - United States             $89,559   $107,608    48.5%
                           
TOTAL INVESTMENTS - 225.3%             $465,027   $499,939    225.3%
                         
Derivatives - (3.1)%                          
                           
Derivatives - United States                          
Eastport Holdings, LLC  Business Services  Written Call Option (16)       $(20)  $(6,815)   (3.1)%
                           
Sub Total Derivatives - United States             $(20)  $(6,815)   (3.1)%
                           
TOTAL DERIVATIVES- (3.1)%             $(20)  $(6,815)   (3.1)%

 

(1) All investments valued using unobservable inputs (Level 3).

(2) All investments valued by the Board of Directors.

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

(4) Percentages are based on net assets of $221,887 as of December 31, 2017.

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

(6) The cash rate equals the approximate current yield on our last-out portion of the unitranche facility.

(7) Non-accrual investment.

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

(9) The equity investment has an excercisable put option.

(10) The investment has a $2.0 million unfunded commitment.

(11) Indicates assets that the Company believes do not represent “qualifying assets” under Section 55(a) of the Investment Company Act of 1940, as amended. Qualifying assets must represent at least 70% of the Company's total assets at the time of acquisition of any additional non-qualifying assets. As of December 31, 2017, 5.0% of the Company's total assets were non-qualifying assets.

(12) The company is headquartered in Brazil.

(13) In addition to the stated rate, the Company is charging 3% default interest on the investment.

(14) The investment has been exited. The residual value reflects estimated escrow to be settled post-closing.

(15) The investment has a $0.7 million unfunded commitment.

(16) The Company has written a call option that enables CapitalSouth Partners Florida Sidecar Fund II, L.P. to purchase up to 31.25% of the Company's interest at a strike price of $1.5 million. As of December 31, 2017, the fair value of the written call option is approximately $6.8 million. See Note 4 to the consolidated financial statements for further detail on the written call option transaction.

(17) The investment has a $1.0 million unfunded commitment.

(18) The investment has a $3.1 million unfunded commitment.

(19) The investment has been exited. The residual value reflects estimated escrow and earnout to be settled post-closing.

 

See accompanying notes to consolidated financial statements.

 

 

 22 

 

 

CAPITALA FINANCE CORP.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

March 31, 2018

 

(Unaudited)

 

Note 1. Organization

 

Capitala Finance Corp. (the ‘‘Company’’, ‘‘we’’, ‘‘us’’, and ‘‘our’’) is an 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’’). The Company is an ‘‘emerging growth company’’ within the meaning of the Jumpstart Our Business Startups Act of 2012 (the ‘‘JOBS Act’’), and as such, is subject to reduced public company reporting requirements. The Company commenced operations on May 24, 2013 and completed its 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 ‘‘Advisors Act’’), and Capitala Advisors Corp. (the ‘‘Administrator’’) provides the administrative services necessary for the Company to operate. For United States (“U.S.”) federal income tax purposes, the Company has elected to be treated, and intends to comply with the requirements to continue to qualify annually, as a regulated investment company (‘‘RIC’’) under subchapter M of the Internal Revenue Code of 1986, as amended (the ‘‘Code’’).

 

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, the Company offers customized financing to business owners, management teams and financial sponsors for change of ownership transactions, recapitalizations, strategic acquisitions, business expansion and other growth initiatives. The Company invests in first lien loans, second lien loans, subordinated loans, and, to a lesser extent, equity securities issued by lower middle-market companies and traditional middle-market companies.

 

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 lower middle-market and traditional 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, continued to hold their existing investments at the time of the IPO and have continued 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.

 

During the fourth quarter of 2017, Florida Sidecar transferred all of its assets to Capitala Finance Corp. and was legally dissolved as a standalone partnership.

 

The Company has formed and expects to continue to form certain consolidated taxable subsidiaries (the ‘‘Taxable Subsidiaries’’), which are taxed as corporations for income tax purposes. These Taxable Subsidiaries allow the Company to make equity investments in companies organized as pass-through entities while continuing to satisfy the requirements of a RIC under the Code.

 

Note 2. Summary of Significant Accounting Policies

 

Basis of Presentation

 

The Company is considered an investment company as defined in Accounting Standards Codification (‘‘ASC’’) Topic 946 — Financial Services — Investment Companies (‘‘ASC 946’’). The accompanying unaudited consolidated financial statements have been prepared on the accrual basis of accounting in conformity with U.S. generally accepted accounting principles (‘‘U.S. GAAP’’) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 6 and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying our annual consolidated financial statements prepared in accordance with U.S. GAAP have been omitted. The consolidated financial statements of the Company include the accounts of the Company and its wholly owned subsidiaries, including Fund II, Fund III, Florida Sidecar, and the Taxable Subsidiaries.

 

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The Company’s financial statements as of March 31, 2018 and December 31, 2017 are presented on a consolidated basis. The effects of all intercompany transactions between the Company and its subsidiaries (Fund II, Fund III, Florida Sidecar, and the Taxable Subsidiaries) 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.

 

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 year ended December 31, 2017, filed with the U.S. Securities and Exchange Commission (“SEC”) on February 27, 2018.

 

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 under different assumptions and conditions. The most significant estimates in the preparation of the consolidated financial statements are investment valuation, revenue recognition, and income taxes.

 

Consolidation

 

As provided under Regulation S-X and ASC 946, the Company will generally not consolidate its investment in a company other than a substantially wholly owned investment company subsidiary or a controlled operating company whose business consists of providing services to the Company. Accordingly, the Company consolidated the results of the Company’s wholly owned investment company subsidiaries (Fund II, Fund III, Florida Sidecar, and the Taxable Subsidiaries) in its consolidated financial statements.

 

Segments

 

In accordance with ASC Topic 280 — Segment Reporting (‘‘ASC 280’’), the Company has determined that it has a single reporting segment and operating unit structure. While the Company invests in several industries and geographic locations, all investments share similar business and economic risks. As such, all investment activities have been aggregated into a single segment.

 

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. The Company deposits its cash in financial institutions and, at times, such balances may be in excess of the Federal Deposit Insurance Corporation insurance limits.

 

Investment Classification

 

In accordance with the provisions of the 1940 Act, the Company classifies its investments 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.

 

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, the Company’s board of directors (the ‘‘Board’’) uses various valuation approaches, and engages a third-party valuation firm, which provides an independent valuation of certain investments it reviews. 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.

 

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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 Board’s 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. 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. The Company uses 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.

 

In estimating the fair value of portfolio investments, the Company starts with the cost basis of the investment, which includes original issue discount and payment-in-kind (‘‘PIK’’) income, 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 valuation methodologies summarized below are utilized by the Company in estimating fair value.

 

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, but not limited to, 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. In certain instances, the Company may also utilize revenue multiples to determine enterprise value. 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 or offers to purchase the 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.

 

The enterprise value waterfall approach is primarily utilized to value the Company’s equity securities, including warrants. However, the Company may utilize the enterprise value waterfall approach to value certain debt securities.

 

Income Approach

 

The income approach utilizes a discounted cash flow methodology in which the Company estimates fair value based on the present value 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. Because the majority of the Company’s portfolio companies do not have a public credit rating, determining a discount rate often involves assigning an implied credit rating based on the portfolio company’s operating metrics compared to average metrics of similar publicly rated debt. Operating metrics include, but are not limited to, EBITDA, interest coverage, leverage ratios, return on capital, and debt to equity ratios. The implied credit rating is used to assign a base discount rate range based on publicly available yields on similarly rated debt securities. The Company may apply a premium to the discount rate utilized in determining fair value when performance metrics and other qualitative information indicate that there is an additional level of uncertainty about collectability of cash flows.

 

Asset Approach

 

The asset approach values an investment based on the value of the underlying collateral securing the investment. This approach is used 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.

 

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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 interest (‘‘PIK interest’’) provision. The PIK interest, which represents contractually deferred interest added to the loan balance that is generally due at maturity, is recorded on an 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 investments: Management reviews all loans that become 90 days or more past due, or when there is reasonable doubt that principal or interest will be collected, for possible placement on non-accrual status. When 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 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.

 

Original issue discount: Discounts received to par on loans purchased are capitalized and accreted into income over the life of the loan. Any remaining discount is accreted into income upon prepayment of the loan.

 

Other income: Origination fees (to the extent services are performed to earn such income), amendment fees, consent fees, and other 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.

 

Loan Sales

 

The Company follows the guidance in ASC Topic 860 — Transfers and Servicing (‘‘ASC 860’’) when accounting for loan participations and partial loan sales as it relates to concluding on sales accounting treatment for such transactions. Based on the Company’s analysis of all loan participations and partial sales completed, the Company believes that all such transactions meet the criterion required by ASC 860 to qualify for sales accounting treatment.

 

General and Administrative Expenses

 

General and administrative expenses are paid as incurred. The Company’s administrative expenses include personnel and overhead expenses allocable to the Company paid by and reimbursed to the Administrator under an administration agreement between the Company and the Administrator (the ‘‘Administration Agreement’’). Other operating expenses such as legal and audit fees, director fees, and director and officer insurance are generally paid directly by the Company.

 

Deferred Financing Fees

 

Costs incurred to issue the Company’s debt obligations are capitalized and are amortized over the term of the debt agreements under the effective interest method.

 

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Commitments and Contingencies

 

As of March 31, 2018, the Company had outstanding unfunded commitments related to debt investments in existing portfolio companies of $3.0 million (Portrait Studio, LLC), $2.0 million (CIS Secure Computing, Inc.), $1.1 million (MC Sign Lessor Corp), $0.8 million (Kelle’s Transport Service, LLC) and $0.7 million (U.S. Well Services, LLC). As of December 31, 2017, the Company had outstanding unfunded commitments related to debt investments in existing portfolio companies of $3.1 million (Portrait Studio, LLC), $2.0 million (CIS Secure Computing, Inc.), $1.0 million (Kelle’s Transport Service, LLC), and $0.7 million (U.S. Well Services, LLC).

 

In addition to unfunded commitments related to debt investments, the Company also has extended a guaranty on behalf of one of our portfolio companies, whereby we have guaranteed $1.9 million of obligations of Kelle’s Transport Service, LLC. As of March 31, 2018 we have not been required to make payments on this or any previous guaranties, and we consider the credit risks to be remote and the fair value of this guaranty to be immaterial.

 

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

 

On December 28, 2017, an alleged stockholder filed a putative class action lawsuit complaint, Paskowitz v. Capitala Finance Corp., et al., in the United States District Court for the Central District of California (case number 2:17-cv-09251-MWF-AS) (the “Paskowitz Action”), against the Company and certain of its current officers on behalf of all persons who purchased or otherwise acquired the Company’s common stock between January 4, 2016 and August 7, 2017. On January 3, 2018, another alleged stockholder filed a putative class action complaint, Sandifer v. Capitala Finance Corp., et al., in the United States District Court for the Central District of California (case number 2:18-cv-00052-MWF-AS) (the “Sandifer Action”), asserting substantially similar claims on behalf of the same putative class and against the same defendants. The complaints in the Paskowitz Action and the Sandifer Action allege certain violations of the securities laws, including, inter alia, that the defendants made certain materially false and misleading statements and omissions regarding the Company’s business, operations, and prospects. On February 2, 2018, the Sandifer Action was transferred, on stipulation of the parties, to the United States District Court for the Western District of North Carolina. The Sandifer Action was voluntarily dismissed on February 28, 2018. On March 1, 2018, the Paskowitz Action was transferred, on stipulation of the parties, to the United States District Court for the Western District of North Carolina (case number 3:18-cv-00096-RJC-DSC). While the Company intends to vigorously defend itself in this litigation, the outcome of these legal proceedings cannot be predicted with certainty.

 

Estimating an amount or range of possible losses resulting from litigation proceedings is inherently difficult and requires an extensive degree of judgment, particularly where the matters involve indeterminate claims for monetary damages, are in the early stages of the proceedings, and are subject to appeal. In addition, because most legal proceedings are resolved over extended periods of time, potential losses are subject to change due to, among other things, new developments, changes in legal strategy, the outcome of intermediate procedural and substantive rulings and other parties’ settlement posture and their evaluation of the strength or weakness of their case against us. For these reasons, we are currently unable to predict the ultimate timing or outcome of, or reasonably estimate the possible losses or a range of possible losses resulting from, the matters described above. Based on information currently available, the Company does not believe that any reasonably possible losses arising from the currently pending legal matters described above will be material to the Company’s results of operations or financial condition. However, in light of the inherent uncertainties involved in such matters, an adverse outcome in this litigation could materially and adversely affect the Company’s financial condition, results of operations or cash flows in any particular reporting period.

 

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 or result in direct losses to the Company. In management’s opinion, no direct losses with respect to litigation contingencies were probable as of March 31, 2018 and December 31, 2017. Management is of the opinion that the ultimate resolution of such claims, if any, will not materially affect the Company’s business, financial position, results of operations or liquidity. Furthermore, in management’s opinion, it is not possible to estimate a range of reasonably possible losses with respect to litigation contingencies.

 

Income Taxes

 

The Company has elected to be treated for U.S. federal income tax purposes, and intends to comply with the requirements to qualify annually 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 U.S. 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.

 

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Depending on the level of taxable income earned in an excise tax year, the Company may choose to carry forward taxable income in excess of current year dividend distributions into the next excise 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. Since the Company’s IPO, the Company has not accrued or paid excise tax.

 

For U.S. federal income tax purposes, as of March 31, 2018, the aggregate net unrealized appreciation for all securities was $27.7 million. As of March 31, 2018, gross unrealized appreciation was $82.0 million and gross unrealized depreciation was $54.3 million. The aggregate cost of securities for U.S. federal income tax purposes was $476.0 million.

 

The Company’s Taxable Subsidiaries record deferred tax assets or liabilities related to temporary book versus tax differences on the income or loss generated by the underlying equity investments held by the Taxable Subsidiaries. As of March 31, 2018 and December 31, 2017, the Company recorded a net deferred tax liability of $1.3 million and $1.3 million, respectively. For the three months ended March 31, 2018, the Company recorded a tax provision of $50 thousand. For the three months ended March 31, 2017, no tax provision was recorded.

 

In accordance with certain applicable U.S. Treasury regulations and guidance 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 its 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, the cash available for distribution must be allocated among the stockholders electing to receive cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive the lesser of (a) the portion of the distribution such stockholder has elected to receive in cash or (b) an amount equal to his or her entire distribution times the percentage limitation on cash available for distribution. If these and certain other requirements are met, for U.S. federal income tax purposes, the amount of the dividend paid in stock will be equal to the amount of cash that could have been received instead of stock. For income tax purposes, the Company has paid distributions on its common stock from ordinary income in the amount of $25.2 million, $24.5 million, and $25.1 million during the tax years ended August 31, 2017, 2016 and 2015, respectively.

 

ASC Topic 740 — Income Taxes (‘‘ASC 740’’), provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the 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’’ to be 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 March 31, 2018 and December 31, 2017, 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 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 tax years ended August 31, 2017, 2016 and 2015 remain subject to examination by U.S. federal, state, and local tax authorities. No interest expense or penalties have been assessed for the three months ended March 31, 2018 and March 31, 2017. If the Company was required to recognize interest and penalties, if any, related to unrecognized tax benefits this would be recognized as income tax expense in the consolidated statements of operations.

 

The Company has elected to amend its tax year end from August 31 to December 31 and will file a tax return for the four months ended December 31, 2017. The election to change the tax year end is not expected to have a material impact on the Company’s consolidated statements of operations, the Company’s tax status as a RIC, or the nature of distributions paid to our stockholders. 

 

On December 22, 2017, the United States enacted tax reform legislation through the Tax Cuts and Jobs Act, which significantly changes the existing U.S. tax laws, including a reduction in the corporate tax rate from 35% to 21%, a move from a worldwide tax system to a territorial system, as well as other changes. The Taxable Subsidiaries’ provisional tax is based on the new lower blended federal and state corporate tax rate of 25%. This estimate incorporates assumptions made based on the Taxable Subsidiaries’ current interpretation of the Tax Act and may change, possibly materially, as we complete our analysis and receive additional clarification and implementation guidance.

 

Distributions

 

Distributions to common stockholders are recorded as payable on the declaration date. The amount to be paid out as a dividend is determined 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.

 

The Company has adopted an ‘‘opt out’’ dividend reinvestment plan (‘‘DRIP’’) for the Company’s common stockholders. As a result, if the Company declares a distribution, then stockholders’ cash distributions will be automatically reinvested in additional shares of the Company’s common stock unless a stockholder specifically ‘‘opts out’’ of our DRIP. 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 the Company’s DRIP will not receive any corresponding cash distributions with which to pay any such applicable taxes.

 

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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.

 

The value of the Company’s investments 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 debt-to-liquidation values with each debt investment and the collateral underlying the debt investment.

 

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 October 2016, the SEC adopted new rules and amended existing rules (together, ‘‘final rules’’) intended to modernize the reporting and disclosure of information by registered investment companies. In part, the final rules amend Regulation S-X and require standardized, enhanced disclosures about derivatives in investment company financial statements, as well as other amendments. The compliance date for the amendments to Regulation S-X was August 1, 2017. Management has adopted the amendments to Regulation S-X and included required disclosures in the Company’s consolidated financial statements and related disclosures.

 

In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (ASC Topic 606) (“ASU 2014-09”). ASU 2014-09 supersedes the revenue recognition requirements under ASC Topic 605, Revenue Recognition, and most industry-specific guidance throughout the ASC. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. The new guidance significantly enhances comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets. Additionally, the guidance requires improved disclosures as to the nature, amount, timing and uncertainty of revenue that is recognized. The new guidance became effective for the annual reporting period beginning January 1, 2018, including interim periods within that reporting period. The Company completed its assessment in evaluating the potential impact on its consolidated financial statements and based on its assessment, determined that its financial contracts are excluded from the scope of ASU 2014-09. As a result of the scope exception for financial contracts, the Company’s management has determined that there will be no material changes to the recognition timing and classification of revenues and expenses; additionally, the Company’s management determined that the adoption of ASU 2014-09 does not have a significant impact on its consolidated financial statement disclosures.

 

Note 4. Investments and Fair Value Measurements

 

The Company’s investment objective is to generate both current income and capital appreciation through debt and equity investments. Both directly and through the Company’s subsidiaries that are licensed by the SBA under the SBIC Act, the Company offers customized financing to business owners, management teams and financial sponsors for change of ownership transactions, recapitalizations, strategic acquisitions, business expansion and other growth initiatives. The Company invests in first lien loans, second lien loans, and subordinated loans. Most of the Company’s 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 of March 31, 2018, our portfolio consisted of investments in 46 portfolio companies with a fair value of approximately $503.7 million.

 

Most of the Company’s debt investments are structured as first lien loans. First lien loans may contain some minimum amount of principal amortization, excess cash flow sweep feature, prepayment penalties, or any combination of the foregoing. First lien loans are secured by a first priority lien in existing and future assets of the borrower and may take the form of term loans or delayed draw facilities. Unitranche debt, a form of first lien loan, typically involves issuing one debt security that blends the risk and return profiles of both senior secured and subordinated debt in one debt security, bifurcating the loan into a first-out tranche and last-out tranche. As of March 31, 2018, 12.9% of the fair value of our first lien loans consisted of last-out loans. In some cases, first lien loans may be subordinated, solely with respect to the payment of cash interest, to an asset based revolving credit facility.

 

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The Company also invests in debt instruments structured as second lien loans. Second lien loans are loans which have a second priority security interest in all or substantially all of the borrower’s assets, and which are not subject to the blockage of cash interest payments to the Company at the first lien lender’s discretion.

 

In addition to first and second lien loans, the Company may also invest in subordinated loans. Subordinated loans typically have a second lien on all or substantially all of the borrower’s assets, and unlike second lien loans, may be subject to the interruption of cash interest payments upon certain events of default, at the discretion of the first lien lender.

 

During the three months ended March 31, 2018, the Company made approximately $27.8 million of investments and had approximately $21.4 million in repayments and sales resulting in net investments of approximately $6.4 million for the period. During the three months ended March 31, 2017, the Company made approximately $21.7 million of investments and had approximately $33.0 million in repayments and sales resulting in net repayments and sales of approximately $11.3 million for the period.

 

During the three months ended March 31, 2018, the Company funded $1.0 million of previously committed capital to existing portfolio companies. During the three months ended March 31, 2018, the Company funded $26.8 million of investments in portfolio companies for which it was not previously committed to fund. During the three months ended March 31, 2017, the Company funded $1.2 million of previously committed capital to existing portfolio companies. During the three months ended March 31, 2017, the Company funded $20.5 million of investments in portfolio companies for which it was not previously committed to fund. 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 three months ended March 31, 2018 and March 31, 2017, the Company did not lead any syndicates and did not assist any portfolio companies in obtaining indirect financing.

 

On August 31, 2016, the Company sold a portion of 14 securities across 10 portfolio companies to CapitalSouth Partners Florida Sidecar Fund II, L.P. (‘‘FSC II’’), including granting an option to acquire a portion of the Company’s equity investment in Eastport Holdings, LLC (the ‘‘Written Call Option’’), in exchange for 100% of the partnership interests in FSC II. Concurrent with the sale of these assets to FSC II, the Company received cash consideration of $47.6 million from an affiliated third-party purchaser in exchange for 100% of the partnership interests of FSC II. These assets were sold to FSC II at their June 30, 2016 fair market values, resulting in a net realized gain of $0.1 million. The Company’s Board pre-approved this transaction pursuant to Section 57(f) of the 1940 Act.

 

The Company collected and will periodically collect principal and interest payments related to certain of the securities purchased by FSC II. Such principal and interest payments will be remitted timely to FSC II based on its proportionate share of the security. FSC II does not have any recourse to the Company related to the non-payment of principal or interest by the underlying issuers of the securities.

 

The Written Call Option granted FSC II the right to purchase up to 31.25% of the Company’s equity investment in Eastport Holdings, LLC. The Written Call Option has a strike price of $1.5 million and a termination date of August 31, 2018. The fair value of the Written Call Option, which has been treated as a derivative liability and is recorded in the financial statement line item Written Call Option at fair value in the Company’s consolidated statements of assets and liabilities, was approximately $6.8 million and $6.8 million as of March 31, 2018 and December 31, 2017, respectively. For purposes of determining the fair value of the Written Call Option, the Company calculated the difference in the fair value of the underlying equity investment in Eastport Holdings, LLC and the strike price of the Written Call Option, or intrinsic value. The time value of the Written Call Option as of March 31, 2018 was determined to be insignificant. The Written Call Option is classified as a Level 3 financial instrument.

 

The composition of our investments as of March 31, 2018, at amortized cost and fair value was 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
 
First Lien Debt  $268,504    57.2%  $256,594    51.0%
Second Lien Debt   32,647    7.0    31,761    6.3 
Subordinated Debt   111,849    23.8    92,780    18.4 
Equity and Warrants   56,202    12.0    122,587    24.3 
Total  $469,202    100.0%  $503,722    100.0%

 

 30 

 

 

The composition of our investments as of December 31, 2017, at amortized cost and fair value was 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
 
First Lien Debt  $257,147    55.3%  $243,489    48.7%
Second Lien Debt   32,465    7.0    30,794    6.1 
Subordinated Debt   120,235    25.8    103,385    20.7 
Equity and Warrants   55,180    11.9    122,271    24.5 
Total  $465,027    100.0%  $499,939    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.

 

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 the Company’s valuation policy, the Company evaluates the source of inputs, including any markets in which its 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 income, 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 table presents the fair value measurements of investments, by major class, as of March 31, 2018 (dollars in thousands), according to the fair value hierarchy:

 

   Fair Value Measurements 
   Level 1   Level 2   Level 3   Total 
First Lien Debt  $   $   $256,594   $256,594 
Second Lien Debt           31,761    31,761 
Subordinated Debt           92,780    92,780 
Equity and Warrants           122,587    122,587 
Total  $   $   $503,722   $503,722 

 

The following table presents fair value measurements of the Written Call Option as of March 31, 2018 (dollars in thousands), according to the fair value hierarchy:

 

   Fair Value Measurements 
   Level 1   Level 2   Level 3   Total 
Written Call Option  $   $   $(6,815)  $(6,815)
Total  $   $   $(6,815)  $(6,815)

 

 31 

 

 

The following table presents fair value measurements of investments, by major class, as of December 31, 2017 (dollars in thousands), according to the fair value hierarchy:

 

   Fair Value Measurements 
   Level 1   Level 2   Level 3   Total 
First Lien Debt  $   $   $243,489   $243,489 
Second Lien Debt           30,794    30,794 
Subordinated Debt           103,385    103,385 
Equity and Warrants           122,271    122,271 
Total  $   $   $499,939   $499,939 

 

The following table presents fair value measurements of the Written Call Option as of December 31, 2017 (dollars in thousands), according to the fair value hierarchy:

 

   Fair Value Measurements 
   Level 1   Level 2   Level 3   Total 
Written Call Option  $   $   $(6,815)  $(6,815)
Total  $   $   $(6,815)  $(6,815)

 

 The following table provides a reconciliation of the beginning and ending balances for investments that use Level 3 inputs for the three months ended March 31, 2018 (dollars in thousands):

 

   First Lien
Debt
   Second Lien
Debt
   Subordinated
Debt
   Equity
and Warrants
   Total 
Balance as of January 1, 2018  $243,489   $30,794   $103,385   $122,271   $499,939 
Reclassifications   8,828        (8,828)        
Repayments/sales   (20,676)           (724)   (21,400)
Purchases   27,000            800    27,800 
Payment in-kind interest and dividends accrued   722    159    255    221    1,357 
Accretion of original issue discount   64    23    186        273 
Realized gain (loss) from investments   (4,579)           724    (3,855)
Net unrealized appreciation (depreciation) on investments   1,746    785    (2,218)   (705)   (392)
Balance as of March 31, 2018  $256,594   $31,761   $92,780   $122,587   $503,722 

 

The following table provides a reconciliation of the beginning and ending balances for the Written Call Option that use Level 3 inputs for the three months ended March 31, 2018 (dollars in thousands):

 

   Written
Call Option
 
Balance as of January 1, 2018  $(6,815)
Net unrealized depreciation on Written Call Option    
Balance as of March 31, 2018  $(6,815)

 

The following table provides a reconciliation of the beginning and ending balances for investments that use Level 3 inputs for the three months ended March 31, 2017 (dollars in thousands):

 

   First Lien
Debt
   Second Lien
Debt
   Subordinated
Debt
   Equity
and Warrants
   Total 
Balance as of January 1, 2017  $226,578   $71,483   $150,232   $93,346   $541,639 
Reclassifications   (6,701)           6,701     
Repayments/sales   (1,273)   (10,790)   (14,667)   (6,319)   (33,049)
Purchases   18,526        1,182    2,000    21,708 
Payment in-kind interest and dividends accrued   1,277        164    214    1,655 
Accretion of original issue discount   66    100    184        350 
Realized gain (loss) from investments       (140)       4,986    4,846 
Net unrealized appreciation (depreciation) on investments   (2,609)   8    (1,489)   (581)   (4,671)
Balance as of March 31, 2017  $235,864   $60,661   $135,606   $100,347   $532,478 

 

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The following table provides a reconciliation of the beginning and ending balances for the Written Call Option that use Level 3 inputs for the three months ended March 31, 2017 (dollars in thousands):

 

   Written Call Option 
Balance as of January 1, 2017  $(2,736)
Net unrealized depreciation on Written Call Option   (1,485)
Balance as of March 31, 2017  $(4,221)

 

The net change in unrealized depreciation on investments held as of March 31, 2018 and March 31, 2017, was $(4.1) million and $(4.8) million, respectively, and is included in net unrealized appreciation (depreciation) on investments in the consolidated statements of operations.

 

The valuation techniques and significant unobservable inputs used in recurring Level 3 fair value measurements of assets and (liabilities) as of March 31, 2018 were as follows:

 

  Fair Value
(in millions)
  

Valuation

Approach

  Unobservable Input  Range (Weighted Average)
First lien debt  $218.9   Income  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  8.9% – 20.0% (13.2%)
1.8x – 6.2x (3.5x)
$1.7 million – $122.2 million
($21.4 million)
First lien debt  $37.7   Enterprise Value Waterfall  EBITDA Multiple
Adjusted EBITDA

Revenue Multiple
Revenue
  3.5x – 6.0x (5.2x)
$1.3 million – $3.2 million ($2.1 million)
0.2x – 0.2x (0.2x)
$51.5 million – $51.5 million
($51.5 million)
Second lien debt  $31.8   Income  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  11.9% – 17.6% (14.5%)
4.9x – 7.1x (6.0x)
$7.3 million – $78.5 million ($41.5 million)
Subordinated debt  $56.2   Income  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  11.5% – 19.5% (13.9%)
3.1x – 8.5x (5.6x)
$2.0 million – $14.6 million ($9.6 million)
Subordinated debt  $36.6   Enterprise Value Waterfall and Asset (1)  EBITDA Multiple
Adjusted EBITDA
  4.5x – 7.4x (6.7x)
$1.7 million – $32.9 million ($24.0 million)
           Revenue Multiple   0.2x – 0.2x (0.2x)
           Revenue  $158.7 million – $158.7 million ($158.7 million)
Equity and warrants  $122.6   Enterprise Value Waterfall  EBITDA Multiple
Adjusted EBITDA

Revenue Multiple
Revenue
  3.2x – 14.5x (7.8x)
$1.7 million – $82.1 million (27.2 million)
0.5x – 0.5x (0.5x)
$156.1 million – $156.1 million ($156.1 million)
Written Call Option  $(6.8)  Enterprise Value Waterfall  EBITDA Multiple
Adjusted EBITDA
  7.4x – 7.4x (7.4x)
$32.9 million – $32.9 million ($32.9 million)

 

  (1) $1.0 million in subordinated debt was valued using the asset approach.

 

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The valuation techniques and significant unobservable inputs used in recurring Level 3 fair value measurements of assets and (liabilities) as of December 31, 2017 were as follows:

 

  Fair Value
(in millions)
  

Valuation

Approach

  Unobservable Input  Range (Weighted Average)
First lien debt  $211.2   Income  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  8.6% – 21.2% (13.5%)
1.7x – 7.0x (3.6x)
$1.8 million – $131.2 million
($21.1 million)
First lien debt  $32.3   Enterprise Value Waterfall and Asset (1)  EBITDA Multiple
Adjusted EBITDA

  4.0x – 7.0x (5.5x)
$2.1 million – $3.1 million
($2.6 million)
Second lien debt  $30.8   Income  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  11.6% – 17.6% (14.4%)
4.9x – 7.0x (6.0x)
$7.3 million – $78.5 million
($41.1 million)
Subordinated debt  $64.4   Income  Required Rate of Return
Leverage Ratio
Adjusted EBITDA
  11.5% – 19.0% (14.2%)
3.2x – 8.1x (5.6x)
3.2 million – $15.1 million ($9.7 million)
Subordinated debt  $39.0   Enterprise Value Waterfall and Asset (1)  EBITDA Multiple
Adjusted EBITDA
 
Revenue Multiple
Revenue
  6.0x – 7.5x (7.2x)
$1.8 million – $30.1 million ($21.2 million)
0.2x – 0.2x (0.2x)
$150.7 million – $150.7 million ($150.7 million)
Equity and warrants  $122.3   Enterprise Value Waterfall  EBITDA Multiple
Adjusted EBITDA
  3.5x – 14.5x (7.9x)
$1.8 million – $77.6 million ($24.3 million)
Written Call Option  $(6.8)  Enterprise Value Waterfall  EBITDA Multiple
Adjusted EBITDA
  7.25x – 7.25x (7.25x)
$30.1 million – $30.1 million ($30.1 million)

 

  (1) $1.0 million in subordinated debt and $1.9 million in first lien debt were valued using the asset approach

 

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

 

 34 

 

 

Note 5. Transactions With Affiliated Companies

 

        During the three months ended March 31, 2018, the Company had investments in portfolio companies designated as affiliates under the 1940 Act. Transactions with affiliates were as follows (dollars in thousands):

 

Company (4)  Type of Investment  Principal Amount   Amount of Interest, Fees
or Dividends
Credited to
Income (1)
   December 31, 2017
Fair Value
   Gross
Additions (2)
   Gross
Reductions (3)
   Realized
Gain/(Loss)
   Unrealized
Gain/(Loss)
   March 31, 2018
Fair Value
 
                                    
Affiliate investments                                           
                                            
AAE Acquisition, LLC  Second Lien Debt (8% Cash, 4% PIK, Due 8/24/19)  $16,004   $318   $15,603   $160   $-   $-   $189   $15,952 
                                            
AAE Acquisition, LLC  Membership Units (2.19% fully diluted)   -    -    -    -    -    -    -    - 
                                            
AAE Acquisition, LLC  Warrants (37.78% fully diluted)   -   -   -   -   -   -   -   - 
                                            
            318    15,603    160    -    -    189    15,952 
                                            
Burgaflex Holdings, LLC  First Lien Debt (12% Cash, 1% PIK, Due 3/23/21)   14,688    39    -    14,688    -    -    -    14,688 
                                            
Burgaflex Holdings, LLC  Subordinated Debt (14% Cash, Due 8/9/19)   -    116    3,000    -    (3,000)   -    -    - 
                                            
Burgaflex Holdings, LLC  Subordinated Debt (12% Cash, Due 8/9/19)   -    199    5,828    -    (5,828)   -    -    - 
                                            
Burgaflex Holdings, LLC  Common Stock Class A (1,253,198 shares)   -    -    457    -    -    -    (457)   - 
                                            
Burgaflex Holdings, LLC  Common Stock Class B (900,000 shares)   -    -    -    300         -    -    300 
                                            
            354    9,285    14,988    (8,828)   -    (457)   14,988 
                                            
Chef'n Corporation  Series A Preferred Stock (1,000,000 shares)   -    -    -    -    (644)   644    -    - 
                                            
            -    -    -    (644)   644    -    - 
                                            
City Gear, LLC  Subordinated Debt (13% Cash, Due 10/20/19)   8,231    268    8,231    -    -    -    -    8,231 
                                            
City Gear, LLC (5)  Preferred Membership Units (2.78% fully diluted, 9% Cash Dividend)   -    29    1,269    -    -    -    -    1,269 
                                            
City Gear, LLC  Membership Unit Warrants (11.38% fully diluted)   -    -    8,248    -    -    -    (617)   7,631 
                                            
            297    17,748    -    -    -    (617)   17,131 
                                            
GA Communications, Inc. (5)  Series A-1 Preferred Stock (1,998 shares, 8% PIK Dividend)   -    -    3,225    66    -    -    (5)   3,286 
                                            
GA Communications, Inc.  Series B-1 Common Stock (200,000 shares)   -    -    1,932    -    -    -    (254)   1,678 
                                            
            -    5,157    66    -    -    (259)   4,964 
                                            
J&J Produce Holdings, Inc.  Subordinated Debt (13% Cash, Due 6/16/19)   6,406    169    6,170    38    -    -    105    6,313 
                                            
J&J Produce Holdings, Inc.  Common Stock (8,182 shares)   -    -    -    -    -    -    -    - 
                                            
J&J Produce Holdings, Inc.  Common Stock Warrants (6,369 shares)   -    -    -    -    -    -    -    - 
                                            
            169    6,170    38    -    -    105    6,313 
                                            
LJS Partners, LLC  Common Stock (1,500,000 shares)   -    -    7,650    -    -    -    12    7,662 
                                            
            -    7,650    -    -    -    12    7,662 
                                            
MMI Holdings, LLC  First Lien Debt (12% Cash, Due 1/31/19)   2,600    79    2,600    -    -    -    -    2,600 
                                            
MMI Holdings, LLC  Subordinated Debt (6% Cash, Due 1/31/19)   400    6    400    -    -    -    -    400 
                                            
MMI Holdings, LLC (5)  Preferred Units (1,000 units, 6% PIK Dividend)   -    -    1,520    23    -    -    (1)   1,542 
                                            
MMI Holdings, LLC  Common Membership Units (45 units)   -    -    193    -    -    -    (19)   174 
                                            
            85    4,713    23    -    -    (20)   4,716 
                                            
MTI Holdings, LLC  Membership Units (2,000,000 units)   -    -    100    -    -    -    -    100 
                                            
            -    100    -    -    -    -    100 
                                            
Sierra Hamilton Holdings Corporation  Common Stock (15,068,000 shares)   -    -    8,528    -    -    -    363    8,891 
                                            
            -    8,528    -    -    -    363    8,891 
                                            
Source Capital Penray, LLC  Membership Units (11.3% ownership)   -    -    101    -    -    -    -    101 
                                            
            -    101    -    -    -    -    101 
                                            
STX Healthcare Management Services, Inc.  Common Stock (1,200,000 shares)   -    -    93    -    (80)   80    (93)   - 
                                            
            -    93    -    (80)   80    (93)   - 
                                            
US Bath Group, LLC  First Lien Debt (10.67% Cash (1 month LIBOR + 9.0%, 1% Floor), Due 1/2/23)   14,688    614    -    15,000    (313)   -    1    14,688 
                                            
US Bath Group, LLC  Membership Units (500,000 units)   -    -    -    500    -    -    -    500 
                                            
            614    -    15,500    (313)   -    1    15,188 
                                            
U.S. Well Services, LLC  First Lien Debt (7.65% Cash (1 month LIBOR + 6%, 1% floor), Due 2/2/22)   2,299    44    2,299    -    -    -    -    2,299 
                                            
U.S. Well Services, LLC  First Lien Debt (10.65% Cash (1 month LIBOR + 9%, 1% floor), Due 2/2/22)   9,713    89    9,516    197    -    -    -    9,713 
                                            
U.S. Well Services, LLC  Class A Units (5,680,688 Units)   -    -    15,004    -    -    -    -    15,004 
                                            
U.S. Well Services, LLC  Class B Units (2,076,298 Units)   -    -    955    -    -    -    -    955 
                                            
            133    27,774    197    -    -    -    27,971 
                                            
V12 Holdings, Inc.  Subordinated Debt   -    -    1,035    -    -    -    -    1,035 
                                            
            -    1,035    -    -    -    -    1,035 
                                            
Total Affiliate investments          $1,970   $103,957   $30,972   $(9,865)  $724   $(776)  $125,012 

 

 35 

 

  

Company (4)  Type of Investment  Principal Amount   Amount of Interest, Fees
or Dividends
Credited to
Income (1)
   December 31, 2017
Fair Value
   Gross
Additions (2)
   Gross
Reductions (3)
   Realized
Gain/(Loss)
   Unrealized
Gain/(Loss)
  

March 31, 2018

Fair Value

 
                                    
Control investments                                           
                                            
CableOrganizer Acquisition, LLC  First Lien Debt (12% Cash, 4% PIK, Due 5/24/18)  $12,497   $372   $12,373   $124   $-   $-   $(1,191)  $11,306 
                                            
CableOrganizer Acquisition, LLC  Common Stock (21.3% fully diluted)   -    -    118    -    -    -    (118)   - 
                                            
CableOrganizer Acquisition, LLC  Common Stock Warrants (10% fully diluted)   -    -    60    -    -    -    (60)   - 
                                            
            372    12,551    124    -    -    (1,369)   11,306 
                                            
Eastport Holdings, LLC  Subordinated Debt (15.02% Cash (3 month LIBOR + 13%, 0.5% Floor), Due 4/29/20)   16,500    799    16,500    187    -    -    (187)   16,500 
                                            
Eastport Holdings, LLC  Membership Units (33.3% ownership)   -    -    26,449    -    -    -    -    26,449 
                                            
            799    42,949    187    -    -    (187)   42,949 
                                            
Kelle's Transport Service, LLC  First Lien Debt (4% Cash, Due 2/15/20)   2,227    21    2,000    227    -    -    -    2,227 
                                            
Kelle's Transport Service, LLC  First Lien Debt (1.46% Cash, Due 2/15/20)   13,674    50    9,560    -    -    -    373    9,933 
                                            
Kelle's Transport Service, LLC  Membership Units (27.5% fully diluted)   -    -    -    -    -    -    -    - 
                                            
            71    11,560    227    -    -    373    12,160 
Micro Precision, LLC  Subordinated Debt (10% Cash, Due 9/15/18)   1,862    47    1,862    -    -    -    -    1,862 
                                            
Micro Precision, LLC  Subordinated Debt (14% Cash, 4% PIK, Due 9/15/18)   4,195    146    4,154    42    -    -    (1)   4,195 
                                            
Micro Precision, LLC  Series A Preferred Units (47 units)   -    -    1,629    -    -    -    (452)   1,177 
                                            
            193    7,645    42    -    -    (453)   7,234 
                                            
Navis Holdings, Inc.  First Lien Debt (15% Cash, Due 10/30/20)   7,500    264    6,500    1,000    -    -    -    7,500 
                                            
Navis Holdings, Inc. (5)  Class A Preferred Stock (1,000 shares, 10% Cash Dividend)   -    25    1,000    -    -    -    -    1,000 
                                            
Navis Holdings, Inc.  Common Stock (300,000 shares)   -    -    5,005    -    -    -    253    5,258 
                                            
            289    12,505    1,000    -    -    253    13,758 
                                            
On-Site Fuel Services, Inc.  Subordinated Debt (18% Cash, Due 12/19/18) (6)   14,778    -    11,588    -    -    -    59    11,647 
                                            
On-Site Fuel Services, Inc.  Series A Preferred Stock (32,782 shares)   -    -    -    -    -    -    -    - 
                                            
On-Site Fuel Services, Inc.  Series B Preferred Stock (23,648 shares)   -    -    -    -    -    -    -    - 
                                            
On-Site Fuel Services, Inc.  Common Stock (33,058 shares)   -    -    -    -    -    -    -    - 
                                            
            -    11,588    -    -    -    59    11,647 
                                            
Portrait Studio, LLC  First Lien Debt (8.69% Cash (1 month LIBOR + 7%, 1% floor, 2% ceiling), Due 12/31/22)   2,040    53    1,860    780    (600)   -    -    2,040 
                                            
Portrait Studio, LLC  First Lien Debt (8.69% Cash (1 month LIBOR + 7%, 1% floor, 5% ceiling), Due 12/31/22)   4,500    97    4,500    -    -    -    -    4,500 
                                            
Portrait Studio, LLC  Preferred Units (4,350,000 Units)   -    -    2,450    -    -    -    (426)   2,024 
                                            
Portrait Studio, LLC  Membership Units (150,000 Units)   -    -    -    -    -    -    -    - 
                                            
            150    8,810    780    (600)   -    (426)   8,564 
                                            
Total Control investments          $1,874   $107,608   $2,360   $(600)  $-   $(1,750)  $107,618 

 

(1) Represents the total amount of interest, fees or dividends credited to income for the portion of the year an investment was included in Control or Affiliate categories, respectively.

(2) Gross additions include increases in the cost basis of investments resulting from new portfolio investment, follow-on investments, accrued PIK and accretion of OID. Gross Additions also include transfers into affiliate or control classification.

(3) Gross reductions include decreases in the total cost basis of investments resulting from principal or PIK repayments and sales.

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

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

(6) Non-accrual investment.

 

 36 

 

 

 

Note 6. Agreements

 

On September 24, 2013, the Company entered into an investment advisory agreement (the ‘‘Investment Advisory Agreement’’) with our Investment Advisor, which was initially approved by the Board on June 10, 2013. Unless earlier terminated in accordance with its terms, the Investment Advisory Agreement will remain in effect if approved annually by the Board or by a majority of our outstanding voting securities, including, in either case, by a majority of our non-interested directors. The Investment Advisory Agreement was most recently re-approved by the Board, including a majority of our non-interested directors, at an in-person meeting on August 3, 2017. Subject to the overall supervision of the Board, the Investment Advisor manages our day-to-day operations, and provides investment advisory and management services to us. Under the terms of the 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.

 

The Investment Advisory 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, the Investment Advisor 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 Investment Advisor’s services under the Investment Advisory Agreement or otherwise as Investment Advisor for the Company.

 

Pursuant to the Investment Advisory Agreement, the Company has 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 the gross assets, which are the total assets reflected on the consolidated statements of assets and liabilities and includes any borrowings for investment purposes. Although the Company does 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 the 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 was initially calculated based on the value of the gross assets at the end of the first calendar quarter subsequent to the IPO, and thereafter based on the average value of the 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.

 

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 the 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). The net investment income used to calculate this part of the incentive fee is also included in the amount of the gross assets used to calculate the 1.75% base management fee. The Company pays the Investment Advisor an incentive fee with respect to the pre-incentive fee net investment income in each calendar quarter as follows:

 

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

 

•  100% of the 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). The Company refers to this portion of the pre-incentive fee net investment income (which exceeds the hurdle but is less than 2.5%) as the ‘‘catch-up.’’ The ‘‘catch-up’’ is meant to provide the Investment Advisor with 20% of the 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

 

 37 

 

 

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

 

The Investment Advisor has voluntarily agreed to waive all or such portion of the quarterly incentive fees earned by the Investment Advisor that would otherwise cause the Company’s quarterly net investment income to be less than the distribution payments declared by the Board. Quarterly incentive fees are earned by the Investment Advisor pursuant to the Investment Advisory Agreement. Incentive fees subject to the waiver cannot exceed the amount of incentive fees earned during the period, as calculated on a quarterly basis. The Investment Advisor will not be entitled to recoup any amount of incentive fees that it waives. The waiver was effective in the fourth quarter of 2015 and will continue unless otherwise publicly disclosed by the Company.

 

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.

 

The Company will defer cash payment of the portion of any incentive fee otherwise earned by the Investment Advisor that would, when taken together with all other incentive fees paid to the 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) the pre-incentive fee net investment income during such period, (b) the net unrealized appreciation or depreciation during such period and (c) the 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. As of March 31, 2018 and December 31, 2017, the Company had incentive fees payable to the Investment Advisor of $2.4 million and $2.2 million, respectively.

 

For the three months ended March 31, 2018 and 2017, the Company incurred $2.3 million and $2.5 million in base management fees, respectively. The Company incurred $0.2 million and $1.3 million in incentive fees related to pre-incentive fee net investment income for the three months ended March 31, 2018 and 2017, respectively. For the three months ended March 31, 2018 and 2017, our Investment Advisor waived incentive fees of $0.0 million and $1.0 million, respectively.

 

On September 24, 2013, the Company entered into the Administration Agreement, pursuant to which the Administrator has agreed to furnish the Company with office facilities, equipment and clerical, bookkeeping and record keeping services at such facilities. The Administrator also performs, or oversees the performance of the required administrative services, which include, among other things, being responsible for the financial records that the Company is required to maintain and preparing reports to our stockholders. In addition, the Administrator assists in determining and publishing the net asset value, oversees the preparation and filing of the tax returns and the printing and dissemination of reports to the stockholders, and generally oversees the payment of the expenses and the performance of administrative and professional services rendered to the Company by others.

 

Payments under the Administration Agreement are equal to an amount based upon the allocable portion of the Administrator’s overhead in performing its obligations under the Administration Agreement, including rent, the fees and expenses associated with performing compliance functions and the allocable portion of the compensation of the chief financial officer and the chief compliance officer, and their respective administrative support staff. Under the Administration Agreement, the Administrator will also provide, on the Company’s behalf, managerial assistance to those portfolio companies that request such assistance. Unless terminated earlier in accordance with its terms, the Administration Agreement will remain in effect if approved annually by the Board. The Board most recently approved the renewal of the Administration Agreement on August 3, 2017. To the extent that the Administrator outsources any of its functions, the Company 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.

 

For the three months ended March 31, 2018 and 2017, the Company paid the Administrator $0.4 million and $0.3 million, respectively, for the Company’s allocable portion of the Administrator’s overhead.

 

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.

 

 38 

 

 

Note 7. Related Party Transactions

 

At March 31, 2018 and December 31, 2017, the Company had the following receivables from (payables to) related parties relating to certain management fees, incentive fees, reimbursable expenses, and other payments owed to related parties (dollars in thousands):

 

   March 31,
2018
   December 31,
2017
 
CapitalSouth Corporation  $   $74 
CapitalSouth Partners Florida Sidecar Fund II, L.P.       21 
Capitala Investment Advisors, LLC   (2,446)   (2,172)
Total  $(2,446)  $(2,077)

 

These amounts are reflected in the accompanying consolidated statements of assets and liabilities under the captions, “Due from related parties”, “Management and incentive fee payable” and “Due to related parties.”

 

On August 31, 2016, the Company sold assets to FSC II in exchange for 100% of the partnership interests in FSC II. Concurrent with the sale of these assets to FSC II, the Company received cash consideration of $47.6 million from an affiliated third-party purchaser in exchange for 100% of the partnership interests of FSC II. The Company’s Board pre-approved this transaction pursuant to Section 57(f) of the 1940 Act. The Administrator also serves as the administrator to FSC II. See Note 4 for a further description of this transaction.

 

Note 8. 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 March 31, 2018 and December 31, 2017 the Company had $170.7 million of SBA-guaranteed debentures outstanding. 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 March 31, 2018 and December 31, 2017, Fund II and Fund III had total assets of approximately $340.1 million and $341.5 million, respectively. 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 (the ‘‘1934 Act’’), with respect to Fund II and Fund III. The Company intends to comply with the conditions of the order.

 

The following table summarizes the interest expense and annual charges, deferred financing costs, average balance outstanding, and average stated interest and annual charge rate on the SBA-guaranteed debentures for the three months ended March 31, 2018 and 2017 (dollars in thousands):

 

   For the three months ended 
   March 31, 2018   March 31, 2017 
Interest expense and annual charges  $1,562   $1,562 
Deferred financing costs   154    151 
Total interest and financing expenses  $1,716   $1,713 
Average outstanding balance  $170,700   $170,700 
Average stated interest and annual charge rate   3.71%   3.71%

 

As of March 31, 2018 and December 31, 2017, the Company’s issued and outstanding SBA-guaranteed debentures mature as follows (dollars in thousands):

 

Fixed Maturity Date  Interest Rate   SBA Annual
Charge
   March 31,
2018
   December 31,
2017
 
March 1, 2019   4.620%   0.941%   5,000    5,000 
September 1, 2020   3.215%   0.285%   19,000    19,000 
March 1, 2021   4.084%   0.515%   15,700    15,700 
March 1, 2021   4.084%   0.285%   46,000    46,000 
March 1, 2022   2.766%   0.285%   10,000    10,000 
March 1, 2022   2.766%   0.515%   50,000    50,000 
March 1, 2023   2.351%   0.515%   25,000    25,000 
             $170,700   $170,700 

 

 39 

 

 

2021 Notes

 

On June 16, 2014, the Company issued $113.4 million in aggregate principal amount of 7.125% fixed-rate notes due 2021 (the “2021 Notes”). On May 26, 2017, the Company caused notices to be issued to the holders of its 2021 Notes regarding the Company’s exercise of its option to redeem all of the issued and outstanding 2021 Notes. The Company redeemed all $113.4 million in aggregate principal amount of the 2021 Notes on June 25, 2017. The Notes were redeemed at 100% of their principal amount ($25 per Note), plus the accrued and unpaid interest thereon from June 16, 2017, through, but excluding, June 25, 2017.

 

The following table summarizes the interest expense, deferred financing costs, average outstanding balance and average stated interest rate on the 2021 Notes for the three months ended March 31, 2018 and 2017 (dollars in thousands):

 

   For the three months ended 
   March 31, 2018   March 31, 2017 
Interest expense  $   $2,022 
Deferred financing costs       145 
Total interest and financing expenses  $   $2,167 
Average outstanding balance  $   $113,348 
Average stated interest rate   %   7.13%

 

2022 Notes

 

On May 16, 2017, the Company issued $70.0 million in aggregate principal amount of 6.0% fixed-rate notes due May 31, 2022 (the ‘‘2022 Notes’’). On May 25, 2017, the Company issued an additional $5.0 million in aggregate principal amount of the 2022 Notes pursuant to a partial exercise of the underwriters’ overallotment option. The 2022 Notes will mature on May 31, 2022, 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 May 31, 2019 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest. Interest was payable quarterly beginning August 31, 2017.

  

The following table summarizes the interest expense and deferred financing costs on the 2022 Notes for the three months ended March 31, 2018 and 2017 (dollars in thousands):

 

   For the three months ended 
   March 31, 2018   March 31, 2017 
Interest expense  $1,125   $ 
Deferred financing costs   124     
Total interest and financing expenses  $1,249   $ 
Average outstanding balance  $75,000   $ 
Average stated interest rate   6.0%    

 

2022 Convertible Notes

 

On May 26, 2017, the Company issued $50.0 million in aggregate principal amount of 5.75% fixed-rate convertible notes due on May 31, 2022 (the ‘‘2022 Convertible Notes’’). On June 26, 2017, the Company issued an additional $2.1 million in aggregate principal amount of the 2022 Convertible Notes pursuant to a partial exercise of the underwriters’ overallotment option. Interest was payable quarterly beginning August 31, 2017.

 

The 2022 Convertible Notes are convertible, at the holder’s option, into shares of the Company’s common stock at any time on or prior to the close of business on the business day immediately preceding the maturity date. The conversion rate for the 2022 Convertible Notes is initially 1.5913 shares per $25.00 principal amount of 2022 Convertible Notes (equivalent to an initial conversion price of approximately $15.71 per share of common stock). The initial conversion premium is approximately 14.0%. Upon conversion, the Company will deliver shares of its common stock (and cash in lieu of fractional shares). The conversion rate is subject to adjustment if certain events occur as outlined in the supplemental indenture relating to the 2022 Convertible Notes. The Company has determined that the embedded conversion option in the 2022 Convertible Notes is not required to be separately accounted for as a derivative under GAAP.

 

In addition, pursuant to a ‘‘fundamental change’’ as defined in the supplemental indenture relating to the 2022 Convertible Notes, holders of the 2022 Convertible Notes may require the Company to repurchase for cash all or part of their 2022 Convertible Notes at a repurchase price equal to 100.0% of the principal amount of the 2022 Convertible Notes to be repurchased, plus accrued and unpaid interest through, but excluding, the repurchase date. The 2022 Convertible Notes are not redeemable prior to maturity and no ‘‘sinking fund’’ is provided for the 2022 Convertible Notes.

 

 40 

 

 

The following table summarizes the interest expense and deferred financing costs on the 2022 Convertible Notes for the three months ended March 31, 2018 and 2017 (dollars in thousands):

 

   For the three months ended 
   March 31, 2018   March 31, 2017 
Interest expense  $749   $ 
Deferred financing costs   79     
Total interest and financing expenses  $828   $ 
Average outstanding balance  $52,088   $ 
Average stated interest rate   5.75%    

 

Credit Facility

 

On October 17, 2014, the Company entered into a senior secured revolving credit agreement (the “Credit Facility”) with ING Capital, LLC, as administrative agent, arranger, and bookrunner, and the lenders party thereto. On June 16, 2017, the Company entered into an amendment to its Credit Facility with ING Capital, LLC (the ‘‘Amendment’’). Pursuant to the Amendment, the Credit Facility currently provides for borrowings up to $114.5 million and may be increased up to $200.0 million pursuant to its ‘‘accordion’’ feature. The Credit Facility matures on June 16, 2021.

 

Borrowings under the Credit Facility bear interest, at the Company’s election, at a rate per annum equal to (i) the one, two, three or six month LIBOR, as applicable, plus 3.00% or (ii) 2.00% plus the highest of (A) a prime rate, (B) the Federal Funds rate plus 0.5% and (C) three month LIBOR plus 1.0%. The Company’s ability to elect LIBOR indices with various tenors (e.g., one, two, three or six month LIBOR) on which the interest rates for borrowings under the Credit Facility are based, provides the company with increased flexibility to manage interest rate risks as compared to a borrowing arrangement that does not provide for such optionality. Once a particular LIBOR rate has been selected, the interest rate on the applicable amount borrowed will reset after the applicable tenor period and be based on the then applicable selected LIBOR rate (e.g., borrowings for which the Company has elected the one month LIBOR rate will reset on the one month anniversary of the period based on the then selected LIBOR rate). For any given borrowing under the Credit Facility, the Company intends to elect what it believes to be an appropriate LIBOR rate taking into account the Company’s needs at the time as well as the Company’s view of future interest rate movements. The Amendment provides for the ability to step-down the pricing of the Credit Facility from LIBOR plus 3.00% to LIBOR plus 2.75% when certain conditions are met. The Company will also pay an unused commitment fee at a rate of 2.50% per annum on the amount (if positive) by which 40% of the aggregate commitments under the Credit Facility exceeds the outstanding amount of loans under the Credit Facility and 0.50% per annum on any remaining unused portion of the Credit Facility.

 

The following table summarizes the interest expense, deferred financing costs, unused commitment fees, average outstanding balance, and average stated interest rate on the Credit Facility for the three months ended March 31, 2018 and 2017 (dollars in thousands):

 

   For the three months ended 
   March 31, 2018   March 31, 2017 
Interest expense  $189   $420 
Deferred financing costs   107    237 
Unused commitment fees   275    116 
Total interest and financing expenses  $571   $773 
Average outstanding balance  $16,344   $44,000 
Average stated interest and annual charge rate   4.63%   3.44%

 

As of March 31, 2018 and December 31, 2017, the Company had $12.0 million and $9.0 million, respectively, outstanding under the Credit Facility. The Credit Facility is secured by investments and cash held by the Company, exclusive of assets held at our two SBIC subsidiaries. Assets pledged to secure the Credit Facility had a carrying value of $192.2 million and $192.4 million, respectively, at March 31, 2018 and December 31, 2017. As part of the terms of the Credit Facility, the Company may not make cash distributions with respect to any taxable year that exceed 110% (125% if the Company is not in default and our covered debt does not exceed 85% of the borrowing base) of the amounts required to be distributed to maintain eligibility as a RIC and to reduce our tax liability to zero for taxes imposed on our investment company taxable income and net capital gains.

 

 41 

 

 

The following table presents the carrying value and fair value of the Company’s financial liabilities disclosed, but not carried, at fair value as of March 31, 2018, and the level of each financial liability within the fair value hierarchy (dollars in thousands):

 

   Carrying
Value (1)
   Fair Value   Level 1   Level 2   Level 3 
SBA debentures  $170,700   $171,182   $   $   $171,182 
2022 Notes   75,000    74,700    74,700         
2022 Convertible Notes   52,088    51,150    51,150         
Credit Facility   12,000    12,047            12,047 
Total  $309,788   $309,079   $125,850   $   $183,229 

 

(1)Carrying value equals the gross principal outstanding at period end.

 

The following table presents the carrying value and fair value of the Company’s financial liabilities disclosed, but not carried, at fair value as of December 31, 2017, and the level of each financial liability within the fair value hierarchy (dollars in thousands):

 

   Carrying
Value (1)
   Fair Value   Level 1   Level 2   Level 3 
SBA debentures  $170,700   $173,373   $   $   $173,373 
2022 Notes   75,000    75,600    75,600         
2022 Convertible Notes   52,088    51,775    51,775         
Credit Facility   9,000    9,038            9,038 
Total  $306,788   $309,786   $127,375   $   $182,411 

 

(1)Carrying value equals the gross principal outstanding at period end.

 

The estimated fair value of the Company’s SBA debentures was based on future contractual cash payments discounted at market interest rates to borrow from the SBA as of the measurement date.

 

The estimated fair value of the 2022 Notes and 2022 Convertible Notes was based on their respective closing prices as of the measurement date as they are traded on the NASDAQ Global Select Market under the ticker ‘‘CPTAL’’ (2022 Notes) and on the NASDAQ Capital Market under the ticker ‘‘CPTAG’’ (2022 Convertible Notes).

 

The estimated fair value of the Credit Facility was based on future contractual cash payments discounted at estimated market interest rates for similar debt.

 

Note 9. 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 $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 months ended March 31, 2018, and 2017, the Company recognized directors fees expense of $0.1 million. 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 10. Summarized Financial Information of Our Unconsolidated Subsidiaries

 

The Company holds a control interest, as defined by the 1940 Act, in seven portfolio companies that are considered significant subsidiaries under the guidance in Regulation S-X, but are not consolidated in the Company’s consolidated financial statements. Below is a brief description of each such portfolio company, along with summarized financial information as of March 31, 2018 and December 31, 2017, and for the three months ended March 31, 2018 and March 31, 2017.

 

CableOrganizer Acquisition, LLC

 

CableOrganizer Acquisition, LLC, a Delaware limited liability company that began operations on April 23, 2013, is a leading online provider of cable and wire management products. The income (loss) the Company generated from CableOrganizer Acquisition, LLC, which includes all interest, dividends, PIK interest and PIK dividends, fees, and unrealized appreciation (depreciation), was $(0.9) million and $0.2 million for the three months ended March 31, 2018 and March 31, 2017, respectively.

 

Eastport Holdings, LLC

 

Eastport Holdings, LLC, an Ohio limited liability company organized on November 1, 2011, is a holding company consisting of marketing and advertising companies located across the U.S. The income the Company generated from Eastport Holdings, LLC, which includes all interest, dividends, PIK interest and PIK dividends, fees, and unrealized appreciation, was $0.6 million and $1.7 million for the three months ended March 31, 2018 and March 31, 2017, respectively.

 

 42 

 

 

Kelle’s Transport Service, LLC

 

Kelle’s Transport Service, LLC, a Delaware limited liability company organized on March 28, 2014, provides temperature sensitive transportation services throughout North America. The income (loss) the Company generated from Kelle’s Transport Service, LLC, which includes all interest, dividends, PIK interest and PIK dividends, fees, realized losses, and unrealized appreciation (depreciation), was $0.4 million and $(3.4) million for the three months ended March 31, 2018 and March 31, 2017, respectively.

 

Micro Precision, LLC

 

Micro Precision, LLC, formed on August 5, 2011 as a Delaware limited liability company, is a prime contractor supplying critical parts and mechanical assemblies to the U.S. Department of Defense as well as designer and manufacturer of locomotive air horns. The income (loss) the Company generated from Micro Precision, LLC, which includes all interest, dividends, PIK interest and PIK dividends, fees, and unrealized appreciation (depreciation), was $(0.2) million and $0.3 million for the three months ended March 31, 2018 and March 31, 2017, 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 PIK dividends, fees, and unrealized appreciation was $0.5 million and $0.4 million for the three months ended March 31, 2018 and March 31, 2017.

 

On-Site Fuel Services, Inc.

 

On-Site Fuel Services, Inc. is a 100% owned subsidiary of On-Site Fuel Holdings, Inc., which was incorporated in Delaware on December 19, 2011. On-Site Fuel Services, Inc. provides fueling services for commercial and government vehicle fleets throughout the southeast U.S. The income the Company generated from On-Site Fuel Services, Inc., which includes all interest, dividends, PIK interest and PIK dividends, fees, and unrealized appreciation, was $0.1 million and $0.0 million for the three months ended March 31, 2018 and March 31, 2017, respectively.

 

Portrait Studio, LLC

 

Portrait Studio, LLC, formed on December 12, 2017 as a Delaware limited liability company, is a professional and personal imaging platform, operating retail studios throughout the U.S. and an ecommerce virtual studio web portal. The loss the Company generated from Portrait Studio, LLC, which includes all interest, dividends, PIK interest, and PIK dividends, fees, and unrealized depreciation, was $(0.3) million for the three months ended March 31, 2018. The company was not formed until December, 2017. As such, comparative financial information for the prior period statement of operations is not presented.

 

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

 

   As of 
Balance Sheet – CableOrganizer Acquisition, LLC  March 31,
2018
   December 31,
2017
 
Current assets  $5,074   $5,211 
Noncurrent assets   8,356    8,380 
Total assets  $13,430   $13,591 
           
Current liabilities  $5,449   $5,233 
Noncurrent liabilities   12,497    12,373 
Total liabilities  $17,946   $17,606 
           
Total deficit  $(4,516)  $(4,015)
           
   For the three months ended 
Statements of Operations – CableOrganizer Acquisition, LLC  March 31,
2018
   March 31,
2017
 
Net sales  $4,926   $6,343 
Cost of goods sold   3,411    4,491 
Gross profit  $1,515   $1,852 
           
Other expenses  $2,015   $2,152 
Loss before income taxes   (500)   (300)
Income tax benefit        
Net loss  $(500)  $(300)

 

 43 

 

 

   As of 
Balance Sheet – Eastport Holdings, LLC(1)  December 31,
2017
   September 30,
2017
 
Current assets  $94,186   $93,749 
Noncurrent assets   185,087    150,772 
Total assets  $279,273   $244,521 
           
Current liabilities  $142,250   $153,294 
Noncurrent liabilities   70,765    44,558 
Total liabilities  $213,015   $197,852 
           
Total equity  $66,258   $46,669 
           
   For the three months ended 

Statements of Operations – Eastport Holdings, LLC(1)

  December 31,
2017
   December 31,
2016
 
Net sales  $141,438   $160,257 
Cost of goods sold   102,735    121,233 
Gross profit  $38,703   $39,024 
           
Other expenses  $31,945   $33,124 
Income before income taxes   6,758    5,900 
Income tax benefit   22    1,188 
Net income  $6,780   $7,088 
             
(1) March 31, 2018 financial statements are not available. As such, the most recent comparable period is presented.
   As of 
Balance Sheet – Kelle’s Transport Services, LLC  March 31,
2018
   December 31,
2017
 
Current assets  $6,973   $6,344 
Noncurrent assets   1,080    738 
Total assets  $8,053   $7,082 
           
Current liabilities  $14,307   $10,512 
Noncurrent liabilities   15,016    17,923 
Total liabilities  $29,323   $28,435 
           
Total deficit  $(21,270)  $(21,353)
           
   For the three months ended 
Statements of Operations – Kelle’s Transport Services, LLC  March 31,
2018
   March 31,
2017
 
Net sales  $14,748   $14,214 
Cost of goods sold   12,129    13,864 
Gross profit  $2,619   $350 
           
Other expenses  $2,535   $3,250 
Income (loss) before income taxes   84    (2,900)
Income tax provision       (3)
Net income (loss)  $84   $(2,903)

 

 44 

 

 

   As of 
Balance Sheet – Micro Precision, LLC  March 31,
2018
   December 31,
2017
 
Current assets  $6,277   $6,187 
Noncurrent assets   19,644    19,707 
Total assets  $25,921   $25,894 
           
Current liabilities  $7,395   $7,210 
Noncurrent liabilities   13,951    13,951 
Total liabilities  $21,346   $21,161 
           
Total equity  $4,575   $4,733 
           
   For the three months ended 
Statements of Operations – Micro Precision, LLC  March 31,
2018
   March 31,
2017
 
Net sales  $2,367   $1,947 
Cost of goods sold   1,308    1,039 
Gross profit  $1,059   $908 
           
Other expenses  $1,216   $1,135 
Loss before income taxes   (157)   (227)
Income tax provision        
Net loss  $(157)  $(227)
           
   As of 
   March 31,   December 31, 
Balance Sheet - Navis Holdings, Inc.  2018   2017 
Current assets  $4,158   $4,721 
Noncurrent assets   3,776    2,950 
Total assets  $7,934   $7,671 
           
Current liabilities  $2,294   $1,941 
Noncurrent liabilities   7,956    6,973 
Total liabilities  $10,250   $8,914 
           
Total deficit  $(2,316)  $(1,243)
           
   March 31,   March 31, 
Statement of Operations - Navis Holdings, Inc.  2018   2017 
Net sales  $3,364   $3,324 
Cost of goods sold   2,025    2,047 
Gross profit  $1,339   $1,277 
           
Other expenses  $1,336   $1,271 
Income before income taxes   3    6 
Income tax provision   (2)   (3)
Net income  $1   $3 
           
   As of 
   March 31,   December 31, 
Balance Sheet - On-Site Fuel Services, Inc.  2018   2017 
Current assets  $18,477   $28,064 
Noncurrent assets   22,548    26,807 
Total assets  $41,025   $54,871 
           
Current liabilities  $24,032   $32,626 
Noncurrent liabilities   31,273    34,515 
Total liabilities  $55,305   $67,141 
           
Total deficit  $(14,280)  $(12,270)

 

 45 

 

 

   For the three months ended 
   March 31,   March 31, 
Statement of Operations - On-Site Fuel Services, Inc.  2018   2017 
Net sales  $41,726   $36,894 
Cost of goods sold   40,295    35,400 
Gross profit  $1,431   $1,494 
           
Other expenses  $3,360   $3,268 
Loss before income taxes   (1,929)   (1,774)
Income tax provision        
Net loss  $(1,929)  $(1,774)
     
   As of 
   March 31,   December 31, 
Balance Sheet – Portrait Studio, LLC  2018   2017 
Current assets  $4,324   $6,354 
Noncurrent assets   15,737    8,055 
Total assets  $20,061   $14,409 
           
Current liabilities  $6,380   $10,123 
Noncurrent liabilities   7,500    15,728 
Total liabilities  $13,800   $25,851 
           
Total equity/(deficit)  $6,181   $(11,442)
             
   For the three
months ended
         
   March 31,         
Statement of Operations – Portrait Studio, LLC  2018         
Net sales  $8,759         
Cost of goods sold   1,170         
Gross profit  $7,589         
              
Other expenses  $7,144         
Income before income taxes   445         
Income tax provision            
Net income  $445         

 

Note 11. Earnings Per Share

 

In accordance with the provisions of ASC Topic 260 - Earnings per Share (‘‘ASC 260’’), basic earnings per share is computed by dividing earnings available to common stockholders 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 March 31, 2018, all convertible shares related to the 2022 Convertible Notes, which would be approximately 3.3 million shares if converted, were considered anti-dilutive. As of March 31, 2018 and March 31, 2017, there were no dilutive shares.

 

The following information sets forth the computation of the weighted average basic and diluted net increase in net assets per share resulting from operations for the three months ended March 31, 2018 and March 31, 2017 (dollars in thousands, except share and per share data):

 

   For the three months ended 
   March 31,   March 31, 
Basic and diluted  2018   2017 
Net increase in net assets resulting from operations  $141   $4,881 
Weighted average common stock outstanding – basic and diluted   15,959,215    15,873,655 
Net increase in net assets per share resulting from operations – basic and diluted  $0.01   $0.31 

 

 46 

 

 

Note 12. Distributions

 

The Company’s distributions are recorded as payable on the declaration date. Stockholders have the option to receive payment of the distribution in cash, shares of common stock, or a combination of cash and common stock.

 

The following table summarizes the Company’s distribution declarations for the three months ended March 31, 2018 (dollars in thousands, except share and per share data):

 

Date Declared  Record Date  Payment Date  Amount
Per Share
   Cash
Distribution
   DRIP
Shares
Issued
   DRIP
Share
Value
 
January 2, 2018  January 22, 2018  January 30, 2018  $0.0833   $1,275    7,280   $54 
January 2, 2018  February 20, 2018  February 27, 2018   0.0833    1,275    8,076    54 
January 2, 2018  March 23, 2018  March 29, 2018   0.0833    1,274    7,631    56 
Total Distributions Declared and Distributed  $0.25   $3,824    22,987   $164 

 

The following table summarizes the Company’s distribution declarations for the three months ended March 31, 2017 (dollars in thousands, except share and per share data):

 

Date Declared  Record Date  Payment Date  Amount
Per Share
   Cash
Distribution
   DRIP
Shares
Issued
   DRIP
Share
Value
 
January 3, 2017  January 20, 2017  January 30, 2017  $0.13   $1,993    5,304   $70 
January 3, 2017  February 20, 2017  February 27, 2017   0.13    1,993    5,195    70 
January 3, 2017  March 23, 2017  March 30, 2017   0.13    1,998    4,948    67 
Total Distributions Declared and Distributed  $0.39   $5,984    15,447   $207 

 

Note 13. Financial Highlights

 

The following is a schedule of financial highlights for the three months ended March 31, 2018 and 2017 (dollars in thousands, except share and per share data):

 

   March 31, 2018   March 31, 2017 
Per share data:          
Net asset value at beginning of period  $13.91   $15.79 
Net investment income(1)   0.28    0.39 
Net realized gain (loss) on investments(1)   (0.24)   0.31 
Net unrealized depreciation on investments(1)   (0.02)   (0.29)
Net unrealized depreciation on Written Call Option(1)       (0.09)
Tax provision(1)   (0.01)    
Distributions declared from net investment income   (0.25)   (0.39)
Other(7)   (0.01)   (0.01)
Net asset value at end of period  $13.66   $15.71 
Net assets at end of period  $218,204   $249,479 
Shares outstanding at end of period   15,974,218    15,883,492 
Per share market value at end of period  $7.72   $14.36 
Total return based on market value(2)   9.80%   11.23%
Ratio/Supplemental data:          
Ratio of net investment income to average net assets(9)   8.43%   10.47%
Ratio of incentive fee, net of incentive fee waiver, to average net assets(6)(10)   0.11%   0.14%
Ratio of interest and financing expenses to average net assets(8)   8.04%   7.55%
Ratio of tax provision to average net assets (8)   0.09%    
Ratio of other operating expenses to average net assets (8)   6.51%   5.87%
Ratio of total expenses including tax provision, net of fee waivers to average net assets(6)(9)   14.75%   13.56%
Portfolio turnover rate(3)   4.26%   4.04%
Average debt outstanding(4)   $314,132   $328,138 
Average debt outstanding per common share  $19.66   $20.67 
Asset coverage ratio per unit(5)  $2,569   $2,585 

 

 47 

 

 

(1)Based on daily weighted average balance of 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 DRIP. 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. Portfolio turnover rates that cover less than a full period are not annualized.
(4)Based on daily weighted average balance of debt outstanding during the period.
(5)Asset coverage per unit is the ratio of the carrying value of our total consolidated assets, less all liabilities and indebtedness not represented by senior securities, to the aggregate amount of senior securities representing indebtedness. We have excluded our SBA-guaranteed debentures from the asset coverage calculation as of March 31, 2018 and March 31, 2017 pursuant to the exemptive relief granted by the SEC in June 2014 that permits us to exclude such debentures from the definition of senior securities in the 200% asset coverage ratio we are required to maintain under the 1940 Act. Asset coverage per unit is expressed in terms of dollar amounts per $1,000 of indebtedness.
(6)The ratio of waived incentive fees to average net assets was 0.00% and 0.38%, for the three months ended March 31, 2018 and March 31, 2017.
(7)Includes the impact of different share amounts used in calculating per share data as a result of calculating certain per share data based on weighted average shares outstanding during the period and certain per share data based on shares outstanding as of a period end or transaction date.
(8)Ratios are annualized.
(9)Ratios are annualized. Incentive fees, net of incentive fees waiver, included within the ratio are not annualized.
(10)Ratio is not annualized.

 

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 March 31, 2018.

 

Distributions

 

On April 2, 2018, the Company’s Board declared normal monthly distributions for April, May, and June of 2018 as set forth below:

 

Date Declared  Record Date  Payment Date  Distributions per Share 
April 2, 2018  April 19, 2018  April 27, 2018  $0.0833 
April 2, 2018  May 22, 2018  May 30, 2018  $0.0833 
April 2, 2018  June 20, 2018  June 28, 2018  $0.0833 

 

Portfolio Activity

 

On April 2, 2018, the Company restructured its investment in Cedar Electronics Holdings Corp., exchanging its $21.6 million subordinated debt investment for 4,759,250 Class C Preferred Units, 16,562,190 Class D Preferred Units, and 19.04% of the Class E Common Units of Cedar Ultimate Parent, LLC.

 

 48 

 

 

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.

 

Some of the statements in the Quarterly Report on Form 10-Q constitute forward-looking statements, which relate to future events or our performance or financial condition. 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 our Annual Report on Form 10-K.

 

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” and elsewhere in our Annual Report on Form 10-K for the fiscal year ended December 31, 2017. 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.

 

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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 as amended (the ‘‘1940 Act’’). We are an ‘‘emerging growth company’’ within the meaning of the Jumpstart Our Business Startups Act of 2012, 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 lower and traditional middle-market companies in the United States (‘‘U.S.’’), 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, products or services with competitive advantages and industry-appropriate margins. We primarily invest in companies with between $4.5 million and $30 million in trailing twelve-month earnings before interest, tax, depreciation, and amortization (‘‘EBITDA’’).

 

We invest in first lien loans, second lien loans, and subordinated loans. 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 must 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% (or 150%, if certain requirements are met) after such borrowing, with certain limited exceptions. On March 23, 2018, the Small Business Credit Availability Act (the “SBCA”) was signed into law, which included various changes to regulations under the federal securities laws that impact BDCs. The SBCA included changes to the 1940 Act to allow BDCs to decrease their asset coverage requirement from 200% to 150% (i.e. the amount of debt may not exceed 66.7% of the value of our total assets), if certain requirements are met. 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 of the Internal Revenue Code of 1986, as amended (the ‘‘Code’’) 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 lower middle-market and traditional 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 continued to hold their existing investments at the time of IPO and have continued to make new investments after the IPO. 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.

 

At the time of the Formation Transactions, our portfolio consisted of: (1) approximately $326.3 million in investments; (2) an aggregate of approximately $67.1 million in cash, interest receivable and other assets; and (3) liabilities of approximately $202.2 million of U.S. Small Business Administration (‘‘SBA’’) guaranteed debt payable. We have two subsidiaries licensed under the Small Business Investment Company (‘‘SBIC’’) Act that have elected to be regulated as BDCs under the 1940 Act.

 

During the fourth quarter of 2017, Florida Sidecar transferred all of its assets to Capitala Finance Corp. and was legally dissolved as a standalone partnership.

 

The Company has formed and expects to continue to form certain consolidated taxable subsidiaries (the ‘‘Taxable Subsidiaries’’), which are taxed as corporations for income tax purposes. These Taxable Subsidiaries allow the Company to make equity investments in companies organized as pass-through entities while continuing to satisfy the requirements of a RIC under the Code.

 

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Basis of Presentation

 

The Company is considered an investment company as defined in Accounting Standards Codification (‘‘ASC’’) Topic 946 — Financial Services Investment Companies (‘‘ASC 946’’). The accompanying unaudited consolidated financial statements have been prepared on the accrual basis of accounting in conformity with U.S. generally accepted accounting principles (‘‘U.S. GAAP’’) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 6 and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying our annual consolidated financial statements prepared in accordance with U.S. GAAP have been omitted. The consolidated financial statements of the Company include the accounts of the Company and its wholly owned subsidiaries, including Fund II, Fund III, Florida Sidecar, and the Taxable Subsidiaries.

 

The Company’s financial statements as of March 31, 2018 and December 31, 2017 are presented on a consolidated basis. The effects of all intercompany transactions between the Company and its subsidiaries (Fund II, Fund III, Florida Sidecar, and the Taxable Subsidiaries) 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.

 

Consolidation

 

As provided under Regulation S-X and ASC 946, the Company will generally not consolidate its investment in a company other than an investment company subsidiary or a controlled operating company whose business consists of providing services to the Company. Accordingly, the Company consolidated the results of the Company’s wholly owned investment company subsidiaries (Fund II, Fund III, Florida Sidecar, and the Taxable Subsidiaries) in its consolidated financial statements.

 

Revenues

 

We generate revenue primarily from the periodic cash interest we 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, amendment, 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 Advisor, our allocable portion of overhead and other expenses incurred by our Administrator in performing its obligations under an administration agreement between us and the Administrator (the ‘‘Administration Agreement’’) and other operating expenses as detailed below. Our investment advisory fee will compensate our Investment Advisor 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;

 

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 (such as legal, accounting, and travel expenses incurred in connection 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, as amended (the “1934 Act”), other applicable federal and state securities laws and ongoing stock exchange listing fees;

  

federal, state and local taxes;

 

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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 their respective 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 the consolidated financial statements. While all of these policies are important to understanding our 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 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 judgments 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.

 

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 it reviews. 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 Board’s 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.

 

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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.

 

In estimating the fair value of portfolio investments, the Company starts with the cost basis of the investment, which includes original issue discount and payment-in-kind income (“PIK income”), 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.

 

Valuation Techniques

 

Enterprise Value Waterfall Approach

 

The enterprise value waterfall approach determines an enterprise value based on 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, but not limited to, 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. In certain instances, the Company may also utilize revenue multiples to determine enterprise value. 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 or offers to purchase the 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.

 

The enterprise value waterfall approach is primarily utilized to value the Company’s equity securities, including warrants. However, the Company may utilize the enterprise value waterfall approach to value certain debt securities.

 

Income Approach

 

The income approach utilizes a discounted cash flow methodology in which the Company estimates fair value based on the present value 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. Because the majority of the Company’s portfolio companies do not have a public credit rating, determining a discount rate often involves assigning an implied credit rating based on the portfolio company’s operating metrics compared to average metrics of similar publicly rated debt. Operating metrics include, but are not limited to, EBITDA, interest coverage, leverage ratio, return on capital, and debt to equity ratios. The implied credit rating is used to assign a base discount rate range based on publicly available yields on similarly rated debt securities. The Company may apply a premium to the discount rate utilized in determining fair value when performance metrics and other qualitative information indicate that there is an additional level of uncertainty about collectability of cash flows.

 

Asset Approach

 

The asset approach values an investment based on the value of the underlying collateral securing the investment. This approach is used 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.

 

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 interest (‘‘PIK interest’’) 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.

 

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Non-accrual investments: Management reviews all loans that become 90 days or more past due, or when there is reasonable doubt that principal or interest will be collected, for possible placement on non-accrual status. When 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 cash 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 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.

 

Original issue discount: Discounts received to par on loans purchased are capitalized and accreted into income over the life of the loan. Any remaining discount is accreted into income upon prepayment of the loan.

 

Other income: Origination fees (to the extent services are performed to earn such income), amendment fees, consent fees, and other 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 the 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-1 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 has elected to be treated for U.S. federal income tax purposes, and intends to comply with the requirement to qualify annually 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 U.S. 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 an excise tax year, the Company may choose to carry forward taxable income in excess of current year dividend distributions into the next excise 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. Since the Company’s IPO, the Company has not accrued or paid excise tax.

 

For U.S. federal income tax purposes, as of March 31, 2018, the aggregate net unrealized appreciation for all securities was $27.7 million. As of March 31, 2018, gross unrealized appreciation was $82.0 million and gross unrealized depreciation was $54.3 million. The aggregate cost of securities for U.S. federal income tax purposes was $476.0 million.

 

The Company’s Taxable Subsidiaries record deferred tax assets or liabilities related to temporary book versus tax differences on the income or loss generated by the underlying equity investments held by the Taxable Subsidiaries. As of March 31, 2018 and December 31, 2017, the Company recorded a net deferred tax liability of $1.3 million and $1.3 million, respectively. For the three months ended March 31, 2018, the Company recorded a tax provision of $50 thousand. For the three months ended March 31, 2017, no tax provision was recorded.

 

In accordance with certain applicable U.S. 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 its 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 its 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 March 31, 2018 and December 31, 2017, 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 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 March 31, 2018 and December 31, 2017. 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 tax years ended August 31, 2017, 2016, 2015, and 2014 remain subject to examination by U.S. federal, state, and local tax authorities. No interest expense or penalties have been assessed for the periods ended March 31, 2018 and March 31, 2017. If the Company was required to recognize interest and penalties, if any, related to unrecognized tax benefits this would be recognized as income tax expense in the consolidated statements of operations.

 

The Company has elected to amend its tax year end from August 31 to December 31 and expects to file a tax return for the four months ended December 31, 2017. The election to change tax year end is not expected to have a material impact on the Company’s consolidated statements of operations, the Company’s tax status as a RIC, or the nature of distributions paid to our stockholders.

 

On December 22, 2017, the United States enacted tax reform legislation through the Tax Cuts and Jobs Act, which significantly changes the existing U.S. tax laws, including a reduction in the corporate tax rate from 35% to 21%, a move from a worldwide tax system to a territorial system, as well as other changes. The Taxable Subsidiaries’ provisional tax is based on the new lower blended federal and state corporate tax rate of 25%. This estimate incorporates assumptions made based on the Taxable Subsidiaries’ current interpretation of the Tax Act and may change, possibly materially, as we complete our analysis and receive additional clarification and implementation guidance.

 

Portfolio and Investment Activity

 

The Company’s investment objective is to generate both current income and capital appreciation through debt and equity investments. Both directly and through the Company’s subsidiaries that are licensed by the SBA under the SBIC Act, the Company offers customized financing to business owners, management teams and financial sponsors for change of ownership transactions, recapitalizations, strategic acquisitions, business expansion and other growth initiatives. The Company invests in first lien loans, second lien loans, and subordinated loans. Most of the Company’s 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 of March 31, 2018, our portfolio consisted of investments in 46 portfolio companies with a fair value of approximately $503.7 million.

 

Most of the Company’s debt investments are structured as first lien loans. First lien loans may contain some minimum amount of principal amortization, excess cash flow sweep feature, prepayment penalties, or any combination of the foregoing. First lien loans are secured by a first priority lien in existing and future assets of the borrower and may take the form of term loans or delayed draw facilities. Unitranche debt, a form of first lien loan, typically involves issuing one debt security that blends the risk and return profiles of both senior secured and subordinated debt in one debt security, bifurcating the loan into a first-out tranche and last-out tranche. As of March 31, 2018, 12.9% of the fair value of our first lien loans consisted of last-out loans. In some cases, first lien loans may be subordinated, solely with respect to the payment of cash interest, to an asset based revolving credit facility.

 

The Company also invests in debt instruments structured as second lien loans. Second lien loans are loans which have a second priority security interest in all or substantially all of the borrower’s assets, and which are not subject to the blockage of cash interest payments to the Company at the first lien lender’s discretion.

 

In addition to first and second lien loans, the Company may also invest in subordinated loans. Subordinated loans typically have a second lien on all or substantially all of the borrower’s assets, and unlike second lien loans, may be subject to the interruption of cash interest payments upon certain events of default, at the discretion of the first lien lender.

 

During the three months ended March 31, 2018, we made approximately $27.8 million of investments and had approximately $21.4 million in repayments and sales of investments resulting in net investments of approximately $6.4 million for the period. During the three months ended March 31, 2017, we made approximately $21.7 million of investments and had approximately $33.0 million in repayments and sales resulting in net repayments and sales of approximately $11.3 million for the period.

 

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On August 31, 2016, we sold a portion of 14 securities across 10 portfolio companies to CapitalSouth Partners Florida Sidecar Fund II, L.P. (‘‘FSC II’’), including granting an option to acquire a portion of our equity investment in Eastport Holdings, LLC (the ‘‘Written Call Option’’), in exchange for 100% of the partnership interests in FSC II. Concurrent with the sale of these assets to FSC II, we received cash consideration of $47.6 million from an affiliated third-party purchaser in exchange for 100% of the partnership interests of FSC II. These assets were sold to FSC II at their June 30, 2016 fair market values, resulting in a net realized gain of $0.1 million. Our Board pre-approved this transaction pursuant to Section 57(f) of the 1940 Act.

 

The Company collected and will periodically collect principal and interest payments related to certain of the securities purchased by FSC II. Such principal and interest payments will be remitted timely to FSC II based on its proportionate share of the security. FSC II does not have any recourse to the Company related to the non-payment of principal or interest by the underlying issuers of the securities.

 

The Written Call Option granted FSC II the right to purchase up to 31.25% of our equity investment in Eastport Holdings, LLC. The Written Call Option has a strike price of $1.5 million and a termination date of August 31, 2018. The fair value of the Written Call Option, which has been treated as a derivative liability and is recorded in the financial statement line item Written Call Option at fair value in our consolidated statements of assets and liabilities, was approximately $6.8 million and $6.8 million as of March 31, 2018 and December 31, 2017, respectively. For purposes of determining the fair value of the Written Call Option, we calculated the difference in the fair value of the underlying equity investment in Eastport Holdings, LLC and the strike price of the Written Call Option, or intrinsic value. The time value of the Written Call Option as of March 31, 2018 and December 31, 2017 was determined to be insignificant. The Written Call Option is classified as a Level 3 financial instrument. The Written Call Option remained outstanding as of March 31, 2018 and December 31, 2017.

 

As of March 31, 2018, our average portfolio company investment and our largest portfolio company investment at amortized cost and fair value was approximately $10.2 million and $11.0 million, and $21.6 million and $42.9 million, respectively. As of March 31, 2018, the Company had approximately $25.7 million of cash and cash equivalents. As of December 31, 2017, our average portfolio company investment and our largest portfolio company investment at amortized cost and fair value was approximately $9.9 million and $10.6 million, and $21.6 million and $42.9 million, respectively. As of December 31, 2017, the Company had approximately $31.2 million of cash and cash equivalents.

 

As of March 31, 2018, our debt investment portfolio, which represented 75.7% of our total portfolio, had a weighted average annualized yield of approximately 12.0%. As of March 31, 2018, 51.6% of our debt investment portfolio was bearing a fixed rate of interest. As of December 31, 2017, our debt investment portfolio, which represented 75.5% of our total portfolio, had a weighted average annualized yield of approximately 11.9%. As of December 31, 2017, 51.7% of our debt investment portfolio was bearing a fixed rate of interest.

 

The weighted annualized yield is calculated based on the effective interest rate as of period end, divided by the fair value of our debt investments. The weighted average annualized yield of our debt investments is not the same as a return on investment for our stockholders but, rather, relates to a portion of our investment portfolio and is calculated before the payment of all of our fees and expenses. There can be no assurance that the weighted average yield will remain at its current level.

 

The following table summarizes the amortized cost and the fair value of investments and cash and cash equivalents as of March 31, 2018 (dollars in thousands):

 

   Investments
at
Amortized Cost
   Percentage of
Total
   Investments
at
Fair Value
   Percentage of
Total
 
First Lien Debt  $268,504    54.2%  $256,594    48.4%
Second Lien Debt   32,647    6.6    31,761    6.0 
Subordinated Debt   111,849    22.6    92,780    17.5 
Equity and Warrants   56,202    11.4    122,587    23.2 
Cash and Cash Equivalents   25,720    5.2    25,720    4.9 
Total  $494,922    100.0%  $529,442    100.0%

 

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The following table summarizes the amortized cost and the fair value of investments and cash and cash equivalents as of December 31, 2017 (dollars in thousands):

 

   Investments
at
Amortized Cost
   Percentage of
Total
   Investments
at
Fair Value
   Percentage of
Total
 
First Lien Debt  $257,147    51.8%  $243,489    45.8%
Second Lien Debt   32,465    6.6    30,794    5.8 
Subordinated Debt   120,235    24.2    103,385    19.5 
Equity and Warrants   55,180    11.1    122,271    23.0 
Cash and Cash Equivalents   31,221    6.3    31,221    5.9 
Total  $496,248    100.0%  $531,160    100.0%

 

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

 

   March 31, 2018   December 31, 2017 
   Investments at
Fair Value
   Percentage of
Total Portfolio
   Investments at
Fair Value
   Percentage of
Total Portfolio
 
Business Services  $61,586    12.2%  $70,122    14.0%
Building Products   33,897    6.7    17,879    3.6 
Consumer Products   29,293    5.8    29,612    5.9 
Oil & Gas Services   27,971    5.6    27,774    5.6 
Financial Services   26,574    5.3    26,920    5.4 
Information Technology   24,777    4.9    24,761    5.0 
Healthcare   20,141    4.0    21,368    4.3 
Specialty Retail   19,494    3.9    20,713    4.1 
Sales & Marketing Services   18,071    3.6    17,388    3.5 
Footwear Retail   17,131    3.4    17,748    3.6 
Food Product Manufacturer   16,946    3.4    16,222    3.2 
Industrial Equipment Rental   15,952    3.2    15,603    3.1 
Retail   15,000    3.0    15,000    3.0 
Automobile Part Manufacturer   14,988    3.0    9,285    1.9 
Textile Equipment Manufacturer   13,758    2.7    12,505    2.5 
IT Consulting   12,317    2.4    12,231    2.4 
Transportation   12,160    2.4    11,560    2.3 
Fuel Transportation Services   11,647    2.3    11,588    2.3 
Computer Supply Retail   11,306    2.2    12,551    2.5 
Government Services   10,556    2.1    10,320    2.1 
Refrigeration/HVAC Services   9,085    1.8    8,736    1.7 
Advertising & Marketing Services   8,899    1.8    5,157    1.0 
Oil & Gas Engineering and Consulting Services   8,891    1.8    8,528    1.7 
Healthcare Management   8,706    1.7    9,014    1.8 
Professional and Personal Digital Imaging   8,564    1.7    8,810    1.8 
QSR Franchisor   7,662    1.5    7,650    1.5 
Conglomerate   7,234    1.4    7,645    1.5 
Produce Distribution   6,313    1.3    6,170    1.2 
Farming   5,609    1.1    5,581    1.1 
Restaurant   4,886    1.0    4,880    1.0 
Medical Device Distributor   4,716    0.9    4,713    0.9 
Online Merchandise Retailer   3,615    0.7    3,755    0.8 
Home Repair Parts Manufacturer   2,767    0.5    2,767    0.6 
Data Processing & Digital Marketing   1,035    0.2    1,035    0.2 
Consumer Electronics   958    0.2    3,498    0.7 
Household Product Manufacturer   758    0.2    1,316    0.3 
In-Home Healthcare Services   258    0.1    174    0.1 
Automotive Chemicals & Lubricants   101    0.0    101    0.0 
Retail Display & Security Services   100    0.0    100    0.0 
Bowling Products           7,186    1.4 
Replacement Window Manufacturer           1,880    0.4 
Dental Practice Management           93    0.0 
Total  $503,722    100.0%  $499,939    100.0%

 

With the exception of the international investment holdings noted below, all investments made by the Company as of March 31, 2018 and December 31, 2017 were made in portfolio companies located in the U.S. 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 March 31, 2018 and December 31, 2017 (dollars in thousands):

 

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   March 31, 2018   December 31, 2017 
   Investments at
Fair Value
   Percentage of
Total Portfolio
   Investments at
Fair Value
   Percentage of
Total Portfolio
 
South  $245,483    48.7%  $254,829    51.0%
West   108,444    21.5    107,835    21.5 
Midwest   97,957    19.5    84,832    17.0 
Northeast   44,264    8.8    44,428    8.9 
International   7,574    1.5    8,015    1.6 
Total  $503,722    100.0%  $499,939    100.0%

 

In addition to various risk management tools, our Investment Advisor uses an investment rating system to characterize and monitor our expected level of return on each investment in our portfolio.

 

As part of our valuation procedures, we risk rate all of our investments. In general, our investment rating system uses a scale of 1 to 5, with 1 being the lowest probability of default and principal loss. Our internal rating is not an exact system, but it is used internally to estimate the probability of: (i) default on our debt securities and (ii) loss of our debt principal, in the event of a default. In general, our internal rating system may also assist our valuation team in its determination of the estimated fair value of equity securities or equity-like securities. Our internal risk rating system generally encompasses both qualitative and quantitative aspects of our portfolio companies.

 

Our internal investment rating system incorporates the following five categories:

 

Investment
Rating
  Definition
1   In general, the investment may be performing above our internal expectations. Full return of principal and interest is expected. Capital gain is expected.
     
2   In general, the investment may be performing within our internal expectations, and potential risks to the applicable investment are considered to be neutral or favorable compared to any potential risks at the time of the original investment. All new investments are initially given this rating.
     
3   In general, the investment may be performing below our internal expectations and therefore, investments in this category may require closer internal monitoring; however, the valuation team believes that no loss of investment return (interest and/or dividends) or principal is expected. The investment also may be out of compliance with certain financial covenants.
     
4   In general, the investment may be performing below internal expectations and quantitative or qualitative risks may have increased substantially since the original investment. Loss of some or all principal is expected.
     
5   In general, the investment may be performing substantially below our internal expectations and a number of quantitative or qualitative risks may have increased substantially since the original investment. Loss of some or all principal is expected.

 

Our Investment Advisor will monitor and, when appropriate, change the investment ratings assigned to each investment in our portfolio. In connection with our valuation process, our Investment Advisor will review these investment ratings on a quarterly basis. The investment rating of a particular investment should not, however, be deemed to be a guarantee of the investment’s future performance.

 

The following table shows the distribution of our investments on the 1 to 5 investment rating scale at fair value as of March 31, 2018 and December 31, 2017 (dollars in thousands):

 

   As of March 31, 2018   As of December 31, 2017 
Investment Rating  Investments
at
Fair Value
   Percentage of
Total
Investments
   Investments
at
Fair Value
   Percentage of
Total
Investments
 
1  $186,731    37.1%  $191,204    38.2%
2   194,269    38.6    186,445    37.3 
3   102,543    20.3    97,309    19.5 
4   20,179    4.0    24,981    5.0 
5                
Total  $503,722    100.0%  $499,939    100.0%

 

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As of March 31, 2018, we had debt investments in three portfolio companies on non-accrual status with an amortized cost of $44.4 million and a fair value of $20.2 million, which represented 9.5% and 4.0% of the investment portfolio, respectively. As of December 31, 2017, we had debt investments in four portfolio companies on non-accrual status with amortized cost of $50.1 million and a fair value of $25.0 million, which represented 10.8% and 5.0% of the investment portfolio, respectively.

 

Results of Operations

 

Operating results for the three months ended March 31, 2018 and 2017 were as follows (dollars in thousands):

 

   For the Three Months Ended 
   March 31, 2018   March 31, 2017 
Total investment income  $12,572   $14,815 
Total expenses, net of fee waivers   8,134    8,624 
Net investment income   4,438    6,191 
Net realized gain (loss) from investments   (3,855)   4,846 
Net unrealized depreciation on investments   (392)   (4,671)
Net unrealized depreciation on written call option       (1,485)
Tax provision   (50)    
Net increase in net assets resulting from operations  $141   $4,881 

 

Investment income

 

The composition of our investment income for the three months ended March 31, 2018 and 2017 was as follows (dollars in thousands):

 

   For the Three Months Ended 
   March 31, 2018   March 31, 2017 
Interest income  $10,659   $11,998 
Fee income   487    672 
Payment-in-kind interest and dividend income   1,357    1,655 
Dividend income   54    477 
Interest from cash and cash equivalents   15    13 
Total investment income  $12,572   $14,815 

 

The income reported as interest income and PIK interest and PIK dividend income is generally based on the stated rates as disclosed in our consolidated schedule of investments. Accretion of discounts paid for purchased loans are included in interest income as an adjustment to yield. As a general rule, our interest income and PIK interest and PIK dividend income are recurring in nature.

 

We also generate fee income primarily through origination fees charged for new investments, and secondarily via amendment fees, consent fees, prepayment penalties, and other fees. While fee income is typically non-recurring for each investment, most of our new investments include an origination fee; as such, fee income is dependent upon our volume of directly originated investments and the fee structure associated with those investments.

 

We earn dividends on certain equity investments within our investment portfolio. As noted in our consolidated schedule of investments, some investments are scheduled to pay a periodic dividend, though these recurring dividends do not make up a significant portion of our total investment income. We may, and have received, more substantial one-time dividends from our equity investments.

 

For the three months ended March 31, 2018, total investment income decreased by $2.2 million, or 15.1%, compared to the three months ended March 31, 2017. The decrease from the prior year was driven primarily by a $1.3 million decline in interest income, from $12.0 million for the three months ended March 31, 2017, to $10.7 million for the three months ended March 31, 2018. The decline in interest income was caused by a decline in average outstanding debt investments, and an increase in average non-accrual debt investments. Fee income declined by $0.2 million compared to the prior year, from $0.7 million for the three months ended March 31, 2017 to $0.5 million for the three months ended March 31, 2018. For the three months ended March 31, 2018, we generated $0.3 million in origination fees from new deployments and $0.2 million in other fees. Comparatively, for the three months ended March 31, 2017, we generated $0.4 million in origination fees from new deployments and $0.3 million in other fees. Dividend income decreased from $0.5 million for the three months ended March 31, 2017 to $0.1 million for the three months ended March 31, 2018, mostly driven by a one-time dividend paid during the three months ended March 31, 2017. PIK income decreased $0.3 million compared to the prior year, from $1.7 million for the three months ended March 31, 2017 to $1.4 million for the three months ended March 31, 2018. The decrease in PIK income was primarily due to an increase in average non-accrual investments.

 

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Operating expenses

 

The composition of our expenses for the three months ended March 31, 2018 and March 31, 2017 was as follows (dollars in thousands):

 

   For the Three Months Ended 
   March 31, 2018   March 31, 2017 
Interest and financing expenses  $4,364   $4,653 
Base management fee   2,303    2,514 
Incentive fees, net of incentive fee waiver   244    350 
General and administrative expenses   1,223    1,107 
Total expenses, net of fee waivers  $8,134   $8,624 

 

For the three months ended March 31, 2018, operating expenses decreased $0.5 million, or 5.7%, compared to the three months ended March 31, 2017. For the three months ended March 31, 2018, interest and financing expenses decreased $0.3 million compared to the three months ended March 31, 2017, due primarily to lower Credit Facility utilization during the period. Management fees declined by $0.2 million, from $2.5 million for the three months ended March 31, 2017 to $2.3 million for the three months ended March 31, 2018, due to lower average assets under management. Incentive fees, net of incentive fee waiver, declined by $0.1 million for the three months ended March 31, 2018 compared to the three months ended March 31, 2017, due to lower pre-incentive fee net investment income.

  

Net realized gains (losses) on sales of investments

 

During the three months ended March 31, 2018 and March 31, 2017 we recognized $(3.9) million and $4.8 million, respectively, of net realized gains (losses) on our portfolio investments.

 

Net unrealized appreciation (depreciation) on investments

 

Net change in unrealized appreciation (depreciation) on investments reflects the net change in the fair value of our investment portfolio. For the three months ended March 31, 2018 and 2017, we had net unrealized appreciation (depreciation) of $(0.4) million and $(4.7) million, respectively.

 

Net unrealized appreciation (depreciation) on Written Call option

 

For the three months ended March 31, 2018 and 2017 we had net unrealized appreciation (depreciation) on the Written Call Option of $0.0 million and $(1.5) million, respectively.

 

Tax provision

 

For the three months ended March 31, 2018 and 2017, we recorded a tax provision of $0.1 million and $0.0 million, respectively.

 

Changes in net assets resulting from operations

 

For the three months ended March 31, 2018 and 2017 we recorded a net increase in net assets resulting from operations of $0.1 million and $4.9 million, respectively. Based on the weighted average shares of common stock outstanding for the three months ended March 31, 2018 and 2017, our per share net increase in net assets resulting from operations was $0.01 and $0.31, respectively.

 

Summarized Financial Information of Our Unconsolidated Subsidiaries

 

The Company holds a control interest, as defined by the 1940 Act, in seven portfolio companies that are considered significant subsidiaries under the guidance in Regulation S-X, but are not consolidated in the Company’s consolidated financial statements. Below is a brief description of each such portfolio company, along with summarized financial information as of March 31, 2018 and December 31, 2017, and for the three months ended March 31, 2018 and March 31, 2017.

 

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CableOrganizer Acquisition, LLC

 

CableOrganizer Acquisition, LLC, a Delaware limited liability company that began operations on April 23, 2013, is a leading online provider of cable and wire management products. The income (loss) the Company generated from CableOrganizer Acquisition, LLC, which includes all interest, dividends, PIK interest and PIK dividends, fees, and unrealized appreciation (depreciation), was $(0.9) million and $0.2 million for the three months ended March 31, 2018 and March 31, 2017, respectively.

 

Eastport Holdings, LLC

 

Eastport Holdings, LLC, an Ohio limited liability company organized on November 1, 2011, is a holding company consisting of marketing and advertising companies located across the U.S. The income the Company generated from Eastport Holdings, LLC, which includes all interest, dividends, PIK interest and PIK dividends, fees, and unrealized appreciation, was $0.6 million and $1.7 million for the three months ended March 31, 2018 and March 31, 2017, respectively.

 

Kelle’s Transport Service, LLC

 

Kelle’s Transport Service, LLC, a Delaware limited liability company organized on March 28, 2014, provides temperature sensitive transportation services throughout North America. The income (loss) the Company generated from Kelle’s Transport Service, LLC, which includes all interest, dividends, PIK interest and PIK dividends, fees, realized losses, and unrealized appreciation (depreciation), was $0.4 million and $(3.4) million for the three months ended March 31, 2018 and March 31, 2017, respectively.

 

Micro Precision, LLC

 

Micro Precision, LLC, formed on August 5, 2011 as a Delaware limited liability company, is a prime contractor supplying critical parts and mechanical assemblies to the U.S. Department of Defense as well as designer and manufacturer of locomotive air horns. The income (loss) the Company generated from Micro Precision, LLC, which includes all interest, dividends, PIK interest and PIK dividends, fees, and unrealized appreciation (depreciation), was $(0.2) million and $0.3 million for the three months ended March 31, 2018 and March 31, 2017, 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 PIK dividends, fees, and unrealized appreciation was $0.5 million and $0.4 million for the three months ended March 31, 2018 and March 31, 2017.

 

On-Site Fuel Services, Inc.

 

On-Site Fuel Services, Inc. is a 100% owned subsidiary of On-Site Fuel Holdings, Inc., which was incorporated in Delaware on December 19, 2011. On-Site Fuel Services, Inc. provides fueling services for commercial and government vehicle fleets throughout the southeast U.S. The income the Company generated from On-Site Fuel Services, Inc., which includes all interest, dividends, PIK interest and PIK dividends, fees, and unrealized appreciation, was $0.1 million and $0.0 million for the three months ended March 31, 2018 and March 31, 2017, respectively. 

 

Portrait Studio, LLC

 

Portrait Studio, LLC, formed on December 12, 2017 as a Delaware limited liability company, is a professional and personal imaging platform, operating retail studios throughout the U.S. and an ecommerce virtual studio web portal. The loss the Company generated from Portrait Studio, LLC, which includes all interest, dividends, PIK interest, and PIK dividends, fees, and unrealized depreciation, was $(0.3) million for the three months ended March 31, 2018. The company was not formed until December, 2017. As such, comparative financial information for the prior period statement of operations is not presented.

 

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

 

   As of 
Balance Sheet – CableOrganizer Acquisition, LLC  March 31,
2018
   December 31,
2017
 
Current assets  $5,074   $5,211 
Noncurrent assets   8,356    8,380 
Total assets  $13,430   $13,591 
           
Current liabilities  $5,449   $5,233 
Noncurrent liabilities   12,497    12,373 
Total liabilities  $17,946   $17,606 
           
Total deficit  $(4,516)  $(4,015)

 

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   For the three months ended 
Statements of Operations – CableOrganizer Acquisition, LLC  March 31,
2018
   March 31,
2017
 
Net sales  $4,926   $6,343 
Cost of goods sold   3,411    4,491 
Gross profit  $1,515   $1,852 
           
Other expenses  $2,015   $2,152 
Loss before income taxes   (500)   (300)
Income tax benefit        
Net loss  $(500)  $(300)
           
   As of 
Balance Sheet – Eastport Holdings, LLC(1)  December 31,
2017
   September 30,
2017
 
Current assets  $94,186   $93,749 
Noncurrent assets   185,087    150,772 
Total assets  $279,273   $244,521 
           
Current liabilities  $142,250   $153,294 
Noncurrent liabilities   70,765    44,558 
Total liabilities  $213,015   $197,852 
           
Total equity  $66,258   $46,669 
           
   For the three months ended 
Statements of Operations – Eastport Holdings, LLC(1)  December 31,
2017
   December 31,
2016
 
Net sales  $141,438   $160,257 
Cost of goods sold   102,735    121,233 
Gross profit  $38,703   $39,024 
           
Other expenses  $31,945   $33,124 
Income before income taxes   6,758    5,900 
Income tax benefit    22    1,188 
Net income  $6,780   $7,088 
           
   As of 
Balance Sheet – Kelle’s Transport Services, LLC  March 31,
2018
   December 31,
2017
 
Current assets  $6,973   $6,344 
Noncurrent assets   1,080    738 
Total assets  $8,053   $7,082 
           
Current liabilities  $14,307   $10,512 
Noncurrent liabilities   15,016    17,923 
Total liabilities  $29,323   $28,435 
           
Total deficit  $(21,270)  $(21,353)
             
(1) March 31, 2018 financial statements are not available. As such, the most recent comparable period is presented.

 

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   For the three months ended 
Statements of Operations – Kelle’s Transport Services, LLC  March 31,
2018
   March 31,
2017
 
Net sales  $14,748   $14,214 
Cost of goods sold   12,129    13,864 
Gross profit  $2,619   $350 
           
Other expenses  $2,535   $3,250 
Income (loss) before income taxes   84    (2,900)
Income tax provision       (3)
Net income (loss)  $84   $(2,903)

 

   As of 
Balance Sheet – Micro Precision, LLC  March 31,
2018
   December 31,
2017
 
Current assets  $6,277   $6,187 
Noncurrent assets   19,644    19,707 
Total assets  $25,921   $25,894 
           
Current liabilities  $7,395   $7,210 
Noncurrent liabilities   13,951    13,951 
Total liabilities  $21,346   $21,161 
           
Total equity  $4,575   $4,733 

 

   For the three months ended 
Statements of Operations – Micro Precision, LLC  March 31,
2018
   March 31,
2017
 
Net sales  $2,367   $1,947 
Cost of goods sold   1,308    1,039 
Gross profit  $1,059   $908 
           
Other expenses  $1,216   $1,135 
Loss before income taxes   (157)   (227)
Income tax provision        
Net loss  $(157)  $(227)

 

   As of 
   March 31,   December 31, 
Balance Sheet - Navis Holdings, Inc.  2018   2017 
Current assets  $4,158   $4,721 
Noncurrent assets   3,776    2,950 
Total assets  $7,934   $7,671 
           
Current liabilities  $2,294   $1,941 
Noncurrent liabilities   7,956    6,973 
Total liabilities  $10,250   $8,914 
           
Total deficit  $(2,316)  $(1,243)

  

   For the three months ended 
   March 31,   March 31, 
Statement of Operations - Navis Holdings, Inc.  2018   2017 
Net sales  $3,364   $3,324 
Cost of goods sold   2,025    2,047 
Gross profit  $1,339   $1,277 
           
Other expenses  $1,336   $1,271 
Income before income taxes   3    6 
Income tax provision   (2)   (3)
Net income  $1   $3 

 

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   As of 
   March 31,   December 31, 
Balance Sheet - On-Site Fuel Services, Inc.  2018   2017 
Current assets  $18,477  $28,064 
Noncurrent assets   22,548   26,807
Total assets  $41,025  $54,871 
           
Current liabilities  $24,032  $32,626
Noncurrent liabilities   31,273   34,515 
Total liabilities  $55,305  $67,141 
           
Total deficit  $(14,280)  $(12,270)

 

   For the three months ended 
   March 31,   March 31, 
Statement of Operations - On-Site Fuel Services, Inc.  2018   2017 
Net sales  $41,726   $36,894 
Cost of goods sold   40,295    35,400 
Gross profit  $1,431   $1,494 
           
Other expenses  $3,360   $3,268 
Loss before income taxes   (1,929)  (1,774 )
Income tax provision        
Net loss  $(1,929)  $(1,774)

  

   As of 
   March 31,   December 31, 
Balance Sheet – Portrait Studio, LLC  2018   2017 
Current assets  $4,324  $6,354 
Noncurrent assets   15,737   8,055 
Total assets  $20,061  $14,409 
           
Current liabilities  $6,380  $10,123
Noncurrent liabilities   7,500   15,728 
Total liabilities  $13,800  $25,851
           
Total equity/deficit  $6,181  $(11,442)
             
   For the three
months ended
         
   March 31,         
Statement of Operations – Portrait Studio, LLC  2018         
Net sales  $8,759         
Cost of goods sold   1,170         
Gross profit  $7,589         
              
Other expenses  $7,144         
Income before income taxes   445         
Income tax provision            
Net income  $445         

 

Financial Condition, Liquidity and Capital Resources

 

We use and intend to use existing cash primarily to originate investments in new and existing portfolio companies, pay distributions to our stockholders, and repay indebtedness.

 

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On September 30, 2013, we issued 4,000,000 shares at $20.00 per share in our IPO, yielding net proceeds of $74.25 million.

 

On October 17, 2014, we entered into the Credit Facility. On June 16, 2017, we entered into an amendment to our Credit Facility with ING Capital, LLC (the ‘‘Amendment’’). Pursuant to the Amendment, the Credit Facility currently provides for borrowings up to $114.5 million and may be increased up to $200.0 million pursuant to its ‘‘accordion’’ feature. The Credit Facility matures on June 16, 2021. As of March 31, 2018, we had $12.0 million outstanding and $102.5 million available under the Credit Facility.

 

On April 13, 2015, we completed an underwritten offering of 3,500,000 shares of our common stock at a public offering price of $18.32 per share. The total proceeds received in the offering net of underwriting discounts and offering costs were approximately $61.7 million.

 

On May 16, 2017, we issued $70.0 million in aggregate principal amount of 6.0% fixed-rate notes due May 31, 2022 (the ‘‘2022 Notes’’). On May 25, 2017, we issued an additional $5.0 million in aggregate principal amount of the 2022 Notes pursuant to a partial exercise of the underwriters’ overallotment option. The 2022 Notes will mature on May 31, 2022, and may be redeemed in whole or in part at any time or from time to time at our option on or after May 31, 2019 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest. Interest is payable quarterly beginning August 31, 2017. The 2022 Notes are listed on the NASDAQ Global Select Market under the trading symbol ‘‘CPTAL’’ with a par value $25.00 per share.

 

On May 26, 2017, we issued $50.0 million in aggregate principal amount of 5.75% fixed-rate convertible notes due on May 31, 2022 (the ‘‘2022 Convertible Notes’’). On June 26, 2017, we issued an additional $2.1 million in aggregate principal amount of the 2022 Convertible Notes pursuant to a partial exercise of the underwriters’ overallotment option. Interest is payable quarterly beginning August 31, 2017. The 2022 Convertible Notes are listed on the NASDAQ Capital Market under the trading symbol ‘‘CPTAG’’ with a par value $25.00 per share.

 

As of March 31, 2018, Fund II had $26.2 million in regulatory capital and $20.7 million in SBA-guaranteed debentures outstanding and Fund III had $75.0 million in regulatory capital and $150.0 million in SBA-guaranteed debentures outstanding. 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 1934 Act, with respect to Fund II and Fund III. We intend to comply with the conditions of the order.

 

As of March 31, 2018, we had $25.7 million in cash and cash equivalents, and our net assets totaled $218.2 million.

 

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.

 

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 our significant contractual payment obligations as of March 31, 2018 are 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 Debentures  $5,000   $80,700   $85,000   $   $170,700 
2022 Notes           75,000        75,000 
2022 Convertible Notes           52,088        52,088 
Credit Facility           12,000        12,000 
Total Contractual Obligations  $5,000   $80,700   $224,088   $   $309,788 

 

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Distributions

 

In order to qualify as a RIC and to avoid corporate-level U.S. federal 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. We made quarterly distributions to our stockholders for the first four full quarters subsequent to our IPO. To the extent we have income available, we have made and intend to 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, and from time to time we may decrease the amount of our distributions. 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 (‘‘DRIP’’) 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 DRIP. 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 DRIP will not receive any corresponding cash distributions with which to pay any such applicable taxes.

 

 The following tables summarize our distributions declared from January 4, 2016 through March 31, 2018:

 

Date Declared   Record Date   Payment Date   Amount
Per Share
 
January 2, 2018   January 22, 2018   January 30, 2018   $ 0.0833  
January 2, 2018   February 20, 2018   February 27, 2018     0.0833  
January 2, 2018   March 23, 2018   March 29, 2018     0.0833  
Total Distributions Declared and Distributed for 2018   $ 0.25  

 

Date Declared   Record Date   Payment Date   Amount
Per Share
 
January 3, 2017   January 20, 2017   January 30, 2017   $ 0.1300  
January 3, 2017   February 20, 2017   February 27, 2017     0.1300  
January 3, 2017   March 23, 2017   March 30, 2017     0.1300  
April 3, 2017   April 19, 2017   April 27, 2017     0.1300  
April 3, 2017   May 23, 2017   May 29, 2017     0.1300  
April 3, 2017   June 24, 2017   June 29, 2017     0.1300  
July 3, 2017   July 21, 2017   July 28, 2017     0.1300  
July 3, 2017   August 23, 2017   August 30, 2017     0.1300  
July 3, 2017   September 20, 2017   September 28, 2017     0.1300  
October 2, 2017   October 23, 2017   October 30, 2017     0.0833  
October 2, 2017   November 21, 2017   November 29, 2017     0.0833  
October 2, 2017   December 20, 2017   December 28, 2017     0.0833  
Total Distributions Declared and Distributed for 2017   $ 1.42  

 

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Date Declared   Record Date   Payment Date   Amount
Per Share
 
January 4, 2016   January 22, 2016   January 28, 2016   $ 0.1567  
January 4, 2016   February 19, 2016   February 26, 2016     0.1567  
January 4, 2016   March 22, 2016   March 30, 2016     0.1567  
April 1, 2016   April 22, 2016   April 28, 2016     0.1567  
April 1, 2016   May 23, 2016   May 30, 2016     0.1567  
April 1, 2016   June 21, 2016   June 29, 2016     0.1567  
July 1, 2016   July 22, 2016   July 29, 2016     0.1567  
July 1, 2016   August 22, 2016   August 30, 2016     0.1567  
July 1, 2016   September 22, 2016   September 29, 2016     0.1567  
September 22, 2016   October 21, 2016   October 28, 2016     0.1300  
September 22, 2016   November 21, 2016   November 29, 2016     0.1300  
September 22, 2016   December 21, 2016   December 29, 2016     0.1300  
Total Distributions Declared and Distributed for 2016   $ 1.80  

 

Related Parties

 

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

 

In addition, an affiliate of the Investment Advisor also manages CapitalSouth Partners SBIC Fund IV, L.P. (‘‘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 the opportunity to co-invest with Fund IV in portfolio investments. An affiliate of the Investment Advisor also manages Capitala Private Credit Fund V, L.P. (‘‘Fund V’’), a private investment limited partnership and a private investment vehicle (referred to herein as “Capitala Specialty Lending Corp.” or “CSLC”), both of which provide financing solutions to lower middle-market and traditional middle-market companies. 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. To the extent permitted by the 1940 Act and interpretation of the SEC staff, 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. However, we do expect to make, and have made, co-investments with Fund V and/or CSLC given their similar investment strategies.

 

On September 10, 2015, we, Fund II, Fund III, Fund V, and the Investment Advisor filed an application for exemptive relief with the SEC to permit an investment fund and one or more other affiliated investment funds, including future affiliated investment funds, to participate in the same investment opportunities through a proposed co-investment program where such participation would otherwise be prohibited under the 1940 Act. On June 1, 2016, the SEC issued an order (the ‘‘Order’’) permitting this relief. Pursuant to the Order, we are permitted to co-invest in such investment opportunities with our affiliates if a ‘‘required majority’’ (as defined in Section 57(o) of the 1940 Act) of our independent directors make certain conclusions in connection with a co-investment transaction, including, but not limited to, that (1) the terms of the potential co-investment transaction, including the consideration to be paid, are reasonable and fair to us and our stockholders and do not involve overreaching in respect of us or our stockholders on the part of any person concerned, and (2) the potential co-investment transaction is consistent with the interests of our stockholders and is consistent with our then-current investment objective and strategies.

 

On August 31, 2016, the Company sold assets to FSC II in exchange for 100% of the partnership interests in FSC II. Concurrent with the sale of these assets to FSC II, the Company received cash consideration of $47.6 million from an affiliated third-party purchaser in exchange for 100% of the partnership interests of FSC II. The Company’s Board pre-approved this transaction pursuant to Section 57(f) of the 1940 Act. Capitala Advisors Corp., the Company’s Administrator, also serves as the administrator to FSC II.

 

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, and chairman of our Board, is the chief executive officer, president and a director of our Administrator.

 

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Off-Balance Sheet Arrangements

 

As of March 31, 2018, the Company had outstanding unfunded commitments related to debt investments in existing portfolio companies of $3.0 million (Portrait Studio, LLC), $2.0 million (CIS Secure Computing, Inc.), $1.1 million (MC Sign Lessor, Corp), $0.8 million (Kelle’s Transport Service LLC), and $0.7 million (U.S. Well Services, LLC). As of December 31, 2017, the Company had outstanding unfunded commitments related to debt investments in existing portfolio companies of $3.1 million (Portrait Studio, LLC), $2.0 million (CIS Secure Computing, Inc.), $1.0 million (Kelle’s Transport Service, LLC), and $0.7 million (U.S. Well Services, LLC).

 

In addition to unfunded commitments related to debt investments, the Company also has extended a guaranty on behalf of one of our portfolio companies, whereby we have guaranteed $1.9 million of obligations of Kelle’s Transport Service, LLC. As of March 31, 2018 we have not been required to make payments on this or any previous guaranties, and we consider the credit risks to be remote and the fair value of this guaranty to be immaterial.

 

We have no other 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

 

Distributions

 

On April 2, 2018 our Board declared the following distributions:

 

Date Declared   Record Date   Payment Date   Distributions per Share  
April 2, 2018   April 19, 2018   April 27, 2018   $ 0.0833  
April 2, 2018   May 22, 2018   May 30, 2018   $ 0.0833  
April 2, 2018   June 20, 2018   June 28, 2018   $ 0.0833  

 

Portfolio Activity

 

On April 2, 2018, the Company restructured its investment in Cedar Electronics Holdings Corp., exchanging its $21.6 million subordinated debt investment for 4,759,250 Class C Preferred Units, 16,562,190 Class D Preferred Units, and 19.04% of the Class E Common Units of Cedar Ultimate Parent, LLC.

  

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 months ended March 31, 2018, we did not engage in hedging activities.

 

As of March 31, 2018, we held 21 securities bearing a variable rate of interest. Our variable rate investments represent approximately 48.4% of the fair value of total debt investments. As of March 31, 2018, 4.6% of variable rate securities were yielding interest at a rate equal to the established interest rate floor or interest rate ceiling and 95.4% of variable rate securities were yielding interest at a rate above its interest rate floor, below its interest rate ceiling, or were not subject to an interest rate floor. As of March 31, 2018, we had $12.0 million outstanding on our Credit Facility, which has a variable rate of interest at one-month LIBOR + 3.0%. As of March 31, 2018, all of our other interest paying liabilities, consisting of $170.7 million in SBA-guaranteed debentures, $75.0 million in 2022 Notes, and $52.1 million in 2022 Convertible Notes, were bearing interest at a fixed rate.

 

Interest rate sensitivity refers to the change in earnings that may result from changes in the level of interest rates. Because we fund a portion of our investments with borrowings, our net investment income is affected by the difference between the rate at which we invest and the rate at which we borrow. As a result, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income.

 

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Based on our March 31, 2018 consolidated statements of assets and liabilities, the following table shows the annual impact on net income (excluding the potential related incentive fee impact) of base rate changes in interest rates (considering interest rate floors for variable rate securities) assuming no changes in our investment and borrowing structure (dollars in thousands):

  

Basis Point Change   Increase
(decrease)
in interest
income
    (Increase)
decrease in
interest
expense
    Increase
(decrease)
in net income
 
Up 300 basis points   $ 5,300     $ (360   $ 4,940  
Up 200 basis points   $ 3,534     $ (240 )   $ 3,294  
Up 100 basis points   $ 1,768     $ (120 )   $ 1,648  
Down 100 basis points   $ (1,685 )   $ 120     $ (1,565 )
Down 200 basis points   $ (2,014 )   $ 226     $ (1,788 )
Down 300 basis points   $ (2,014 )   $ 226     $ (1,788 )

 

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Item 4. Controls and Procedures

 

  (a) Evaluation of Disclosure Controls and Procedures

 

As of March 31, 2018 (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 financial reporting that occurred during the first quarter of 2018 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

Other than as described below, we and our subsidiaries are not currently subject to any material legal proceedings, nor, to our knowledge, is any material legal proceeding threatened against us or our subsidiaries. From time to time, we, or our subsidiaries 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, if any, 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.

 

On December 28, 2017, an alleged stockholder filed a putative class action lawsuit complaint, Paskowitz v. Capitala Finance Corp., et al., in the United States District Court for the Central District of California (case number 2:17-cv-09251-MWF-AS) (the ‘‘Paskowitz Action’’), against the Company and certain of its current officers on behalf of all persons who purchased or otherwise acquired the Company’s common stock between January 4, 2016 and August 7, 2017. On January 3, 2018, another alleged stockholder filed a putative class action complaint, Sandifer v. Capitala Finance Corp., et al., in the United States District Court for the Central District of California (case number 2:18-cv-00052-MWF-AS) (the ‘‘Sandifer Action’’), asserting substantially similar claims on behalf of the same putative class and against the same defendants. The complaints in the Paskowitz Action and the Sandifer Action allege certain violations of the securities laws, including, inter alia, that the defendants made certain materially false and misleading statements and omissions regarding the Company’s business, operations, and prospects. On February 2, 2018, the Sandifer Action was transferred, on stipulation of the parties, to the United States District Court for the Western District of North Carolina. The Sandifer Action was voluntarily dismissed on February 28, 2018. On March 1, 2018, the Paskowitz Action was transferred, on stipulation of the parties, to the United States District Court for the Western District of North Carolina (case number 3:18-cv-00096-RJC-DSC). While the Company intends to vigorously defend itself in this litigation, the outcome of these legal proceedings cannot be predicted with certainty.

 

Estimating an amount or range of possible losses resulting from litigation proceedings is inherently difficult and requires an extensive degree of judgment, particularly where the matters involve indeterminate claims for monetary damages, are in the early stages of the proceedings, and are subject to appeal. In addition, because most legal proceedings are resolved over extended periods of time, potential losses are subject to change due to, among other things, new developments, changes in legal strategy, the outcome of intermediate procedural and substantive rulings and other parties’ settlement posture and their evaluation of the strength or weakness of their case against us. For these reasons, we are currently unable to predict the ultimate timing or outcome of, or reasonably estimate the possible losses or a range of possible losses resulting from, the matters described above. Based on information currently available, the Company does not believe that any reasonably possible losses arising from the currently pending legal matters described above will be material to the Company’s results of operations or financial condition. However, in light of the inherent uncertainties involved in such matters, an adverse outcome in this litigation could materially adversely affect the Company’s financial condition, results of operations or cash flows in any particular reporting period.

 

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, 2017, 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 that 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. During the three months ended March 31, 2018, 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, 2017 except for the following:

 

Recent legislation may allow us to incur additional leverage.

 

The 1940 Act generally prohibits us from incurring indebtedness unless immediately after such borrowing we have an asset coverage for total borrowings of at least 200% (i.e., the amount of debt may not exceed 50% of the value of our total assets). However, on March 23, 2018, the Small Business Credit Availability Act (the “SBCA”) was signed into law, which included various changes to regulations under the federal securities laws that impact BDCs. The SBCA included changes to the 1940 Act to allow BDCs to decrease their asset coverage requirement from 200% to 150% (i.e. the amount of debt may not exceed 66.7% of the value of our total assets), if certain requirements are met. Under the SBCA, we are allowed to reduce our asset coverage requirement to 150%, and thereby increase our leverage capacity, if shareholders representing at least a majority of the votes cast, when quorum is met, approve a proposal to do so. If we receive shareholder approval, we would be allowed to reduce our asset coverage requirement to 150% on the first day after such approval. Alternatively, the SBCA allows the majority of our independent directors to approve the reduction in our asset coverage requirement to 150%, and such approval would become effective after one year. In either case, we would be required to make certain disclosures on our website and in SEC filings regarding, among other things, the receipt of approval to reduce our asset coverage requirement to 150%, our leverage capacity and usage, and risks related to leverage.

 

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As a result of the SBCA, if we obtain the necessary approval, we may be able to increase our leverage up to an amount that reduces our asset coverage ratio from 200% to 150%. Leverage magnifies the potential for loss on investments in our indebtedness and on invested equity capital. As we use leverage to partially finance our investments, you will experience increased risks of investing in our securities. If the value of our assets increases, then leveraging would cause the net asset value attributable to our common stock to increase more sharply than it would have had we not leveraged. Conversely, if the value of our assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged our business. Similarly, any increase in our income in excess of interest payable on the borrowed funds would cause our net investment income to increase more than it would without the leverage, while any decrease in our income would cause net investment income to decline more sharply than it would have had we not borrowed. Such a decline could negatively affect our ability to pay common stock dividends, scheduled debt payments or other payments related to our securities. Leverage is generally considered a speculative investment technique.

 

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

 

During the quarter ended March 31, 2018, we issued 22,987 shares of common stock under our DRIP. The issuances were not subject to the registration requirements under the Securities Act of 1933, as amended. The cash paid for shares of common stock issued under our DRIP during the quarter ended March 31, 2018 was approximately $0.2 million. Other than the shares issued under our DRIP during the quarter ended March 31, 2018, we did not sell any unregistered equity securities.

 

Item 3. Defaults Upon Senior Securities

 

None.

 

Item 4. Mine Safety Disclosures

 

Not applicable.

 

Item 5. Other Information

 

None. 

 

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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)
     
3.2   Certificate of Limited Partnership of CapitalSouth Partners Fund II Limited Partnership (2)
     
3.3   Certificate of Limited Partnership of CapitalSouth Partners SBIC Fund III, L.P. (2)
     
3.4   Bylaws (1)
     
3.5   Form of Amended and Restated Limited Partnership Agreement of CapitalSouth Partners Fund II Limited Partnership (3)
     
3.6   Form of Amended and Restated Agreement of Limited Partnership of CapitalSouth Partners SBIC Fund III, L.P. (3)
     
4.1   Form of Common Stock Certificate (1)

 

11.1   Computation of Per Share Earnings (included in the notes to the consolidated financial statements contained in this report)
     
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. 333-188956) filed on September 16, 2013.
     
(3)   Previously filed in connection with Pre-Effective Amendment No. 5 to Capitala Finance Corp.’s registration statement on Form N-2 (File No. 333-188956) filed on September 24, 2013.

 

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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: May 7, 2018 By /s/ Joseph B. Alala III 
    Joseph B. Alala III
    Chief Executive Officer
    (Principal Executive Officer)
    Capitala Finance Corp.
     
Date: May 7, 2018 By /s/ Stephen A. Arnall
    Stephen A. Arnall
    Chief Financial Officer
    (Principal Financial and Accounting Officer)
    Capitala Finance Corp.

  

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