Great Elm Capital (GECC) - 2020 Q3 - Quarterly Report

PART I. FINANCIAL INFORMATION Financial Statements This section incorporates by reference the detailed consolidated financial statements, which are presented at the end of the report starting from page F-1 - The financial statements listed in the index to consolidated financial statements are incorporated by reference into this item[10] Management's Discussion and Analysis of Financial Condition and Results of Operations This section provides management's perspective on the company's financial condition and results of operations for the third quarter of 2020, detailing its business as a BDC, revenue and expense structure, critical accounting policies, portfolio activity, operational results, liquidity, and the material impact of the COVID-19 pandemic Overview Great Elm Capital Corp. (GECC) is a Business Development Company (BDC) focused on generating current income and capital appreciation through debt and equity investments, primarily in middle-market companies, and is managed by Great Elm Capital Management, Inc. (GECM), having elected to be treated as a Regulated Investment Company (RIC) for tax purposes - The company's primary investment objective is to generate both current income and capital appreciation through debt and equity investments, focusing on the debt obligations of middle-market companies[11] - GECC is externally managed by Great Elm Capital Management, Inc. (GECM) under an Investment Management Agreement and an Administration Agreement established on September 27, 2016[12] - The company has elected to be treated as a Regulated Investment Company (RIC), which necessitates distributing at least 90% of its investment company taxable income to stockholders annually to avoid corporate-level taxes[13] Critical Accounting Policies The company's critical accounting policies center on the valuation of its portfolio investments at fair value, particularly for illiquid securities, which involves significant judgment and the use of market and income approaches, with revenue recognized on an accrual basis and realized/unrealized gains/losses measured based on amortized cost basis - Portfolio investments are valued at fair value, and for investments without readily available market quotations, the Board of Directors approves valuations based on market and/or income approaches, using both observable and unobservable inputs, a process with inherent uncertainty[18][19][21] - Revenue from interest and dividends, including Payment-In-Kind (PIK) income, is recorded on an accrual basis, while upfront fees and Original Issue Discounts (OID) are generally amortized over the life of the debt investment[25] - Realized gains or losses are calculated as the difference between net proceeds from a sale/repayment and the investment's amortized cost, and the net change in unrealized appreciation/depreciation reflects the change in portfolio investment fair values during the period[28][29] Portfolio and Investment Activity For the nine months ended September 30, 2020, the company's investment activity resulted in a net disposition of assets, with $82.3 million in acquisitions and $85.0 million in dispositions, leading to a decrease in the total investment portfolio's fair value from $197.6 million at year-end 2019 to $169.5 million, and a shift in industry concentration Investment Activity for the Nine Months Ended September 30, 2020 (in thousands) | Metric | Amount | | :--- | :--- | | Acquisitions | $82,290 | | Dispositions | $(84,954) | Portfolio Reconciliation (in thousands) | | For the Nine Months Ended Sep 30, 2020 | | :--- | :--- | | Beginning Investment Portfolio, at fair value | $197,615 | | Portfolio Investments acquired | $82,290 | | Portfolio Investments repaid or sold | $(84,954) | | Net change in unrealized appreciation (depreciation) | $(17,298) | | Net realized gain (loss) | $(11,750) | | Ending Investment Portfolio, at fair value | $169,486 | - As of September 30, 2020, the top three industry concentrations by fair value were Wireless Telecommunications Services (23.21%), Specialty Finance (11.46%), and Internet Media (10.71%)[35] Results of Operations For the third quarter of 2020, GECC reported a net increase in net assets of $7.7 million, a significant turnaround from a $9.6 million loss in Q3 2019, driven by net unrealized appreciation, though the nine-month period saw a net decrease of $22.3 million due to declining investment income and partially offset by lower expenses Investment Income Comparison (in thousands) | Period | Q3 2020 | Q3 2019 | 9M 2020 | 9M 2019 | | :--- | :--- | :--- | :--- | :--- | | Total Investment Income | $5,951 | $7,002 | $17,148 | $20,026 | - The decrease in interest income for 2020 periods was due to exits from high-yield positions, lower LIBOR rates, and several investments being placed on non-accrual status[41] Total Expenses Comparison (in thousands) | Period | Q3 2020 | Q3 2019 | 9M 2020 | 9M 2019 | | :--- | :--- | :--- | :--- | :--- | | Total Expenses | $4,018 | $4,383 | $11,647 | $11,628 | - For the nine months ended September 30, 2020, net realized losses were $10.5 million, primarily driven by losses on the sales of Commercial Barge ($9.8 million) and Full House Resorts, Inc. ($1.3 million)[49][51] - For the nine months ended September 30, 2020, net unrealized depreciation was $17.3 million, largely driven by valuation decreases in investments like Avanti Communications, Boardriders, and California Pizza Kitchen[53][54] Liquidity and Capital Resources As of September 30, 2020, the company had $12.6 million in cash and cash equivalents, managed its liquidity through operating cash flows and financing activities, and maintained an asset coverage ratio of 150.9%, above the required minimum of 150% - As of September 30, 2020, the company held approximately $12.6 million in cash and cash equivalents and had $46.2 million in unfunded loan commitments[61][62] Contractual Obligations as of September 30, 2020 (in thousands) | Obligation | Total | 1-3 years | 3-5 years | | :--- | :--- | :--- | :--- | | GECCL Notes (due 2022) | $30,293 | $30,293 | - | | GECCM Notes (due 2025) | $45,610 | - | $45,610 | | GECCN Notes (due 2024) | $42,823 | - | $42,823 | | Total | $118,726 | $30,293 | $88,433 | - The company's asset coverage ratio was approximately 150.9% as of September 30, 2020, satisfying the minimum requirement of 150%[76] Recent Developments and COVID-19 Subsequent to the quarter's end, the company completed a rights offering in October 2020, raising approximately $31.7 million, and the Board set a dividend of $0.10 per share for Q1 2021, while the COVID-19 pandemic has significantly impacted portfolio valuations, income, and overall financial health, with the full financial impact remaining uncertain - In October 2020, the company completed a rights offering, selling 10.8 million shares for gross proceeds of approximately $31.7 million[78] - The COVID-19 pandemic has negatively impacted the financial performance of portfolio companies, which in turn has adversely affected the valuation of GECC's investments, results of operations, and cash flows[80] - The pandemic has led to a significant reduction in the company's net asset value as of September 30, 2020, compared to December 31, 2019, primarily due to decreases in the fair value of portfolio investments and the re-pricing of credit risk[87] Quantitative and Qualitative Disclosures About Market Risk The company is primarily exposed to interest rate risk, as a significant portion of its debt portfolio consists of variable-rate investments tied to LIBOR, with an analysis showing a 1% increase in LIBOR would increase net investment income by approximately $0.8 million, while a 1% decrease would reduce it by only $39,000 due to LIBOR floors - As of September 30, 2020, the company held $142.4 million in principal of variable-rate debt investments and $95.5 million in fixed-rate debt investments[91] Interest Rate Sensitivity Analysis (in thousands) | LIBOR Change | Increase (decrease) of Net Investment Income | | :--- | :--- | | +3.00% | $2,351 | | +2.00% | $1,567 | | +1.00% | $784 | | -1.00% | $(39) | - The minimal impact of a decrease in LIBOR is due to LIBOR floors present in several of the company's variable-rate debt investments[94] Controls and Procedures Management, including the CEO and CFO, evaluated the company's disclosure controls and procedures as of September 30, 2020, concluding that these controls were effective in ensuring timely and accurate information for SEC filings, with no material changes to internal control over financial reporting during the quarter - Management concluded that as of September 30, 2020, the company's disclosure controls and procedures were effective at a reasonable assurance level[96] - No changes in internal control over financial reporting occurred during the quarter ended September 30, 2020, that have materially affected, or are reasonably likely to materially affect, these controls[98] PART II. OTHER INFORMATION Legal Proceedings The company is involved in certain legal proceedings in the ordinary course of business, with no material updates to previously disclosed cases, and more detailed descriptions available in the Notes to the Financial Statements - The company may be a party to legal proceedings in the ordinary course of business, and no material updates to previously disclosed proceedings were reported in this section[100] Risk Factors There have been no material changes to the risk factors previously disclosed in the company's Annual Report on Form 10-K for the year ended December 31, 2019, and its Quarterly Report on Form 10-Q for the six months ended June 30, 2020 - No material changes in risk factors were reported for the period covered by this report[101] Exhibits This section lists the exhibits filed with the report, including certifications from the CEO and CFO, and incorporates by reference several key agreements and documents from previous filings, such as the company's charter, bylaws, and indentures for its notes - The report includes certifications from the CEO (Exhibit 31.1) and CFO (Exhibit 31.2 and 32.1) as filed exhibits[108] Consolidated Financial Statements Consolidated Statements of Assets and Liabilities As of September 30, 2020, the company's total assets were $264.5 million and total liabilities were $204.0 million, resulting in total net assets of $60.5 million, a significant decrease from December 31, 2019, when net assets were $86.9 million, consequently reducing the net asset value (NAV) per share from $8.63 to $5.53 Consolidated Assets and Liabilities (in thousands, except per share data) | | Sep 30, 2020 | Dec 31, 2019 | | :--- | :--- | :--- | | Total investments | $244,466 | $283,348 | | Total assets | $264,505 | $291,039 | | Total liabilities | $204,041 | $204,150 | | Total net assets | $60,464 | $86,889 | | Net asset value per share | $5.53 | $8.63 | Consolidated Statements of Operations For the three months ended September 30, 2020, the company generated net investment income of $1.9 million and a net increase in net assets of $7.7 million, driven by unrealized gains, while for the nine-month period, net investment income was $5.5 million, but significant realized and unrealized losses resulted in a net decrease in net assets of $22.3 million, or ($2.17) per share Consolidated Operations Summary (in thousands) | | For the Three Months Ended Sep 30 | | For the Nine Months Ended Sep 30 | | | :--- | :--- | :--- | :--- | :--- | | | 2020 | 2019 | 2020 | 2019 | | Total investment income | $5,951 | $7,002 | $17,148 | $20,026 | | Total expenses | $4,018 | $4,383 | $11,647 | $11,628 | | Net investment income | $1,933 | $2,619 | $5,501 | $8,398 | | Net realized and unrealized gains (losses) | $5,771 | $(12,265) | $(27,824) | $(14,354) | | Net increase (decrease) in net assets | $7,704 | $(9,646) | $(22,323) | $(5,956) | Consolidated Schedule of Investments As of September 30, 2020, the company's total investments at fair value were $244.5 million, spread across debt, equity, and short-term instruments, primarily composed of debt securities (225% of net assets) and heavily concentrated in the United States (319% of net assets), with top industry exposures in Wireless Telecommunications Services, Specialty Finance, and Internet Media Portfolio Composition by Investment Type (Sep 30, 2020) | Investment Type | Fair Value (in thousands) | Percentage of Net Assets | | :--- | :--- | :--- | | Debt | $136,062 | 225.03% | | Equity/Other | $33,424 | 55.28% | | Short-Term Investments | $74,980 | 124.01% | | Total | $244,466 | 404.32% | - The top three industry concentrations by fair value as of September 30, 2020 were Wireless Telecommunications Services (65.05% of net assets), Specialty Finance (32.12%), and Internet Media (30.03%)[126] - Geographically, the portfolio was concentrated in the United States ($192.7 million) and the United Kingdom ($51.7 million) as of September 30, 2020[127] Notes to the Unaudited Consolidated Financial Statements This section provides detailed explanations of the company's accounting policies, agreements, and financial data, covering fair value measurements, including a reconciliation of Level 3 assets; specifics on outstanding debt; commitments and legal contingencies; financial highlights per share; details on affiliated and controlled investments; and significant events that occurred after the reporting period Significant Agreements and Related Parties The company is externally managed by GECM under an Investment Management Agreement, where GECM earns a base management fee of 1.50% of average adjusted gross assets and a two-part incentive fee based on income and capital gains, with the income incentive fee subject to a 7.0% annualized hurdle rate and a total return lookback provision, amounting to $1.9 million in management fees and $0.8 million in incentive fees for the nine months ended September 30, 2020 - The base management fee is 1.50% of average adjusted gross assets, which amounted to $1,898 thousand for the nine months ended September 30, 2020[164][165] - The income-based incentive fee is 20% of pre-incentive fee net investment income over a 7% annualized hurdle rate, subject to a total return requirement, amounting to $810 thousand for the nine months ended September 30, 2020[167][173] Fair Value Measurement The company categorizes its investments into a three-level fair value hierarchy, with total investments of $244.5 million as of September 30, 2020, classified as Level 1 ($87.7 million), Level 2 ($28.0 million), and Level 3 ($128.8 million), where Level 3 assets, using significant unobservable inputs, decreased from $144.0 million at the start of the year primarily due to sales, settlements, and net unrealized depreciation Reconciliation of Level 3 Assets for the Nine Months Ended Sep 30, 2020 (in thousands) | | Debt | Equity/Other | Total | | :--- | :--- | :--- | :--- | | Beginning Balance (Jan 1, 2020) | $120,431 | $23,549 | $143,980 | | Net Transfers In/Out | $(3,735) | - | $(3,735) | | Purchases | $65,342 | - | $65,342 | | Net Realized Gain (Loss) | $(1,094) | - | $(1,094) | | Net Change in Unrealized Appr. (Depr.) | $(20,737) | $(2,011) | $(22,748) | | Sales and Settlements | $(54,840) | $(824) | $(55,664) | | Ending Balance (Sep 30, 2020) | $108,061 | $20,714 | $128,775 | Debt The company has three series of unsecured notes outstanding: 6.50% Notes due 2022 (GECCL), 6.75% Notes due 2025 (GECCM), and 6.50% Notes due 2024 (GECCN), totaling $118.7 million in principal outstanding with a fair value of $107.5 million as of September 30, 2020, and was in compliance with all debt covenants, including its asset coverage ratio of 150.9% Outstanding Debt as of September 30, 2020 (in thousands) | Facility | Borrowings Outstanding | Fair Value | | :--- | :--- | :--- | | Unsecured Debt - GECCL Notes | $30,293 | $28,463 | | Unsecured Debt - GECCM Notes | $45,610 | $41,159 | | Unsecured Debt - GECCN Notes | $42,823 | $37,873 | | Total | $118,726 | $107,495 | Financial Highlights For the nine months ended September 30, 2020, the company's net asset value (NAV) per share decreased from $8.63 to $5.53, with a total return based on NAV of -25.03% and a total return based on market value of -47.85%, and the ratio of total expenses to average net assets was 27.14% on an annualized basis Financial Highlights Per Share (Nine Months Ended Sep 30, 2020) | Per Share Data | Amount | | :--- | :--- | | Net asset value, beginning of period | $8.63 | | Net increase (decrease) in net assets from operations | $(2.35) | | Distributions declared from net investment income | $(0.75) | | Net asset value, end of period | $5.53 | Key Ratios and Returns (Nine Months Ended Sep 30, 2020) | Ratio/Supplemental Data | Value | | :--- | :--- | | Total return based on net asset value | (25.03)% | | Total return based on market value | (47.85)% | | Ratio of total expenses to average net assets (annualized) | 27.14% | | Ratio of net investment income to average net assets (annualized) | 13.53% | Subsequent Events After the quarter ended, the company completed a non-transferable rights offering on October 1, 2020, raising approximately $31.7 million in gross proceeds, and the Board also declared a dividend of $0.10 per share for the quarter ending March 31, 2021, in addition to engaging in several investment purchases and sales in October and November 2020 - On October 1, 2020, the company sold 10,761,950 shares of common stock through a rights offering, generating gross proceeds of approximately $31.7 million[227] - The Board of Directors set a distribution of $0.10 per share for the quarter ending March 31, 2021[228]