Stellus Capital Investment (SCM) - 2020 Q4 - Annual Report

PART I ITEM 1. BUSINESS Stellus Capital is an externally managed BDC investing in middle-market companies, aiming for total stockholder return under BDC/RIC regulations and SBIC leverage, while managing COVID-19 impacts - Stellus Capital Investment Corporation is an externally managed BDC, organized on May 8, 2012, and commenced operations on November 7, 2012. It invests primarily in private middle-market companies (typically $5.0 million to $50.0 million EBITDA) through first lien, unitranche, second lien, and unsecured debt, often with equity co-investments[14] - The company's investment objective is to maximize total return to stockholders through current income and capital appreciation, achieved by accessing extensive origination channels, investing in companies with strong fundamentals across diverse sectors (business services, energy, healthcare, software, specialty finance), focusing on directly originated transactions, applying disciplined underwriting, and actively monitoring investments[15][16] - The company has elected to be treated as a Regulated Investment Company (RIC) for U.S. federal income tax purposes, requiring compliance with source-of-income and asset diversification rules to avoid corporate-level taxes on timely distributed income[20] - Effective June 29, 2018, the company's asset coverage ratio requirement decreased from 200% to 150% following approval by its board and stockholders, allowing it to borrow $2.00 for every $1.00 of investor equity. As of December 31, 2020, the asset coverage ratio was 223%[21][22] - Two wholly-owned subsidiaries hold Small Business Investment Company (SBIC) licenses, enabling them to obtain SBA-guaranteed debentures up to $175.0 million (subject to capitalization and approval) with fixed, attractive interest rates and ten-year maturities. Exemptive relief from the SEC allows these debentures to be excluded from the company's asset coverage test, providing increased borrowing flexibility[24][25] - The COVID-19 pandemic has severely impacted global economic activity and financial markets, creating disruption in supply chains and adversely affecting industries. The company is actively monitoring portfolio companies' liquidity, covenant compliance, and workforce health to mitigate impacts, acknowledging that historical information may be less significant[26][28][29] Portfolio Investments Summary (December 31, 2020) | Category | Fair Value ($ millions) | % of Portfolio at Fair Value | | :------------------------- | :---------------------- | :--------------------------- | | First Lien Debt | $508.67 | 77.8% | | Second Lien Debt | $70.72 | 10.8% | | Unsecured Debt | $21.19 | 3.3% | | Equity | $52.84 | 8.1% | | Total | $653.42 | 100.0% | - Stellus Capital Management, the investment adviser, is responsible for managing investment activities, including opportunity analysis, due diligence, structuring, origination, and monitoring. Its senior investment professionals have an average of over 31 years of experience and maintain extensive networks for sourcing investments[39][40][41] - The company identifies attractive market opportunities in middle-market lending due to robust demand for debt capital from private equity firms, a strong U.S. economy supporting middle-market companies, attractive deal pricing and structures with stronger covenant packages and higher interest rates, and specialized lending requirements that favor experienced lenders[43][44][45][46] - Competitive strengths include an experienced investment team, a rigorous investment and monitoring process, demonstrated ability to structure investments creatively (e.g., commitment fees, OID, PIK interest, equity participation), and access to the broad resources and relationships of the Stellus Capital Management platform[48][49][50][51] - The investment strategy is opportunistic and flexible, focusing on direct origination of first lien (including unitranche), second lien, and unsecured debt, often with equity co-investments, in middle-market companies with $5.0 million to $50.0 million EBITDA. The strategy emphasizes capital preservation, downside protection through conservative structures, and diversification across industries[52][53][54][56] - Transaction sourcing relies on the senior investment team's long-standing relationships with private equity firms, investment banks, senior lenders, management teams, and other intermediaries, providing a continuous flow of investment opportunities and market intelligence[58][59][61] - Investment structuring involves tailoring terms based on the portfolio company's business, credit profile, industry outlook, and management. Investments typically include high cash pay interest, with potential return-enhancing mechanisms like commitment fees, OID, early redemption premiums, PIK interest, and equity participation (preferred/common stock, warrants). Debt investments usually have a 5-7 year term[62][63] - The investment process is highly involved and interactive, designed to identify attractive risk/reward characteristics. It includes initial informal review, weekly senior investment professional meetings, detailed due diligence (financials, industry, management, sponsor track record), and a multi-stage approval process by the investment committee, requiring unanimous approval for new and follow-on investments[73][74][75][76][77] - Investment monitoring is active, involving quarterly financial performance reviews, regular discussions with management, periodic written updates, and a comprehensive quarterly portfolio review by the Chief Investment Officer and Chief Compliance Officer. Valuations of non-publicly traded investments are reviewed by an independent third-party firm at least twice annually and determined in good faith by the Board[80][81][82] - The company uses a five-level numeric investment ranking system to monitor credit profile and expected returns: Category 1 (above expectations), Category 2 (within expectations, initial rating for new loans), Category 3 (below expectations, closer monitoring, no loss expected), Category 4 (substantially below expectations, work out, some return loss expected), and Category 5 (substantially below expectations, work out, some principal loss expected)[84][85][86][87][88] - Net asset value (NAV) per share is determined quarterly by dividing total assets minus liabilities by outstanding shares. Investments with readily available market quotations are valued at market prices; others are valued at fair value by the Board, with independent firm review at least twice annually. Valuation factors include market data, yields, multiples, collateral, cash flow, and peer comparisons[90][91][92][94] - The company's primary competitors include public and private funds, other BDCs, commercial and investment banks, commercial financing companies, and private equity/hedge funds. Many competitors are larger, have greater resources, and are not subject to the same regulatory restrictions as BDCs or RICs[98] - The company has no direct employees; day-to-day operations are managed by Stellus Capital Management. Officers are employees of Stellus Capital Management, and their allocable costs are reimbursed under an administration agreement[100] - Under the investment advisory agreement, Stellus Capital Management determines portfolio composition, identifies/evaluates investments, executes transactions, and monitors the portfolio. The company pays a base management fee (1.75% of gross assets, excluding cash) and an incentive fee (20.0% of pre-incentive fee net investment income above an 8.0% annualized hurdle, subject to a total return requirement and capital gains component)[102][103][104][105][111] - The administration agreement outlines services provided by Stellus Capital Management, including office facilities, clerical, bookkeeping, and other administrative functions, for which the company pays an allocable portion of overhead and expenses. A license agreement grants the company non-exclusive, royalty-free use of the 'Stellus Capital' name[131][132][134] - As a BDC, the company must invest at least 70% of its total assets in 'qualifying assets,' primarily private operating companies or certain public companies with market capitalization under $250 million. It also offers managerial assistance to portfolio companies to meet regulatory requirements[19][139][142] - To maintain RIC status, the company must meet a 90% income test (at least 90% gross income from investments) and diversification tests (at least 50% of assets in cash, government securities, other RICs, and other securities not exceeding 5% of assets or 10% of issuer's voting securities; no more than 25% of assets in one issuer or related businesses)[168] - The company's SBIC licenses allow its subsidiaries to issue SBA-guaranteed debentures, which are non-recourse, interest-only, ten-year maturity debentures with fixed interest rates. SBICs are subject to SBA regulations regarding investment limitations (e.g., maximum 30% of regulatory capital in one company), eligible small business criteria (tangible net worth < $19.5 million, avg. net income < $6.5 million), and prohibitions on certain industries[179][180][181] SBIC Regulatory Capital and Debentures (December 31, 2020) | Subsidiary | Regulatory Capital ($) | SBA-Guaranteed Debentures Outstanding ($) | | :------------------- | :--------------------- | :---------------------------------------- | | SBIC subsidiary | $75,000,000 | $150,000,000 | | SBIC II subsidiary | $40,000,000 | $26,500,000 | ITEM 1A. RISK FACTORS Investing in the company's securities involves significant risks from business structure, operations, economic conditions, and specific investments, including personnel dependence, conflicts of interest, leverage, COVID-19, and regulatory compliance Risks Relating to our Business and Structure The company faces risks from economic uncertainty, COVID-19, dependence on Stellus Capital Management personnel, conflicts of interest from fees, BDC/RIC regulatory compliance, and potential cybersecurity failures - Political, social, and economic uncertainty, including the COVID-19 pandemic, creates and exacerbates risks such as increased market volatility, difficulty in valuing assets, higher default risks for obligors, and potential for global economic slowdowns. The pandemic has led to business disruptions, increased draws on credit lines, and requests for loan amendments, impacting the company's ability to originate loans and achieve investment objectives[188][190][191][192] - The company is highly dependent on the diligence, skill, and network of Stellus Capital Management's senior investment professionals. The loss of key personnel, including members of the investment committee, could significantly harm the company's ability to achieve its investment objective and operate effectively[204][205] - Significant potential conflicts of interest exist due to Stellus Capital Management's multiple roles (officers, directors, managers of other funds with similar strategies) and its incentive fee structure. The base management fee, calculated on gross assets, may incentivize the use of additional leverage, potentially leading to more speculative investments. The incentive fee on net investment income, subject to a hurdle, and the capital gains incentive fee, without a hurdle, could also encourage riskier investment decisions[209][212][213][215][216] - Maintaining RIC tax treatment requires distributing at least 90% of net ordinary income and net short-term capital gains annually. Debt covenants and asset coverage ratios under the 1940 Act can restrict distributions, potentially leading to corporate-level income tax or default under credit facilities. Recognizing income before receiving cash (e.g., PIK interest) can also create distribution difficulties[220][222][223] - The company's use of leverage magnifies potential gains and losses. As a BDC, it must maintain a 150% asset coverage ratio (down from 200% since June 2018). Failure to meet this or other debt covenants could restrict additional borrowing, limit distributions, or lead to default and foreclosure on assets, which are substantially pledged as collateral[227][229][232][235] - Most portfolio investments are illiquid and valued at fair value by the Board, which involves significant management judgment and unobservable inputs (Level 3 under ASC Topic 820). This introduces uncertainty, and actual realized values may differ materially from recorded fair values, potentially impacting net asset value[249] - The company is highly dependent on information systems and faces cybersecurity risks, including cyber-attacks, system failures, and data breaches. Such incidents could disrupt business, lead to financial losses, litigation, regulatory penalties, and reputational damage, with heightened risks in remote working environments[290][291][292][293][295][296][298] - Non-compliance with SBA regulations for its SBIC subsidiaries could lead to limitations on debenture use, acceleration of outstanding debentures, or license revocation, negatively impacting the company's operations and financial condition[263][264][265] Risks Related to Our Operations Operational risks include capital raising challenges due to RIC rules, affiliate transaction restrictions, conflicts of interest in valuation, reliance on Stellus Capital Management, fluctuating results, strategy changes, and anti-takeover provisions - The company requires additional capital for growth but is limited by RIC distribution requirements (90-100% taxable income) and BDC asset coverage tests (150%). If common stock trades below NAV, raising equity capital is restricted without stockholder approval, potentially impairing growth or forcing disadvantageous asset sales[266][267] - SBIC subsidiaries' ability to make distributions to the company may be limited by SBA regulations, potentially hindering the company's ability to maintain RIC tax treatment and leading to entity-level taxes[268] - Restrictions under the 1940 Act limit transactions with affiliates, including co-investments, which may narrow investment opportunities. The involvement of interested directors and Stellus Capital Management's investment professionals in the valuation process creates potential conflicts of interest, as management fees are tied to gross assets and incentive fees to realized/unrealized gains[269][270][271][272] - The investment advisory and administration agreements were not negotiated at arm's length, potentially making terms less favorable. Stellus Capital Management and its affiliates are not prohibited from managing other entities with similar investment strategies, which could divert resources and create competition for investment opportunities[274][275] - Stellus Capital Management can resign as investment adviser or administrator with 60 days' notice, and finding a suitable replacement quickly may be difficult, leading to operational disruption and adverse effects on financial condition and stock price[278] - Failure to maintain BDC status or invest a sufficient portion of assets in qualifying assets would subject the company to greater regulatory restrictions, significantly reducing operating flexibility and potentially preventing follow-on investments[279][280][281][282] Risks Related to Economic Conditions Global economic, political, and market conditions, including Brexit and U.S. policy changes, can adversely affect the company's business, liquidity, and earnings, increasing volatility and hindering attractive returns - Global economic, political, and market conditions, including Brexit and U.S. policy changes, can adversely affect the company's business. Downgrades to the U.S. credit rating, government shutdowns, or geopolitical unrest could negatively impact liquidity, financial condition, and earnings, increasing market volatility and economic uncertainty[300][301][304][305] Risks Related to our Investments Investment risks include economic recessions, illiquidity, non-diversification, lack of control, defaults, prepayments, interest rate changes (LIBOR transition), industry-specific regulations, and subordination in bankruptcy - Economic recessions or downturns can impair portfolio companies, increasing non-performing assets and decreasing portfolio value. Leveraged, private, and middle-market companies are particularly susceptible due to limited financial resources, unpredictable operating results, and reliance on a small management team, increasing the risk of losing all or part of the investment[306][308][309][311] - Most assets are illiquid loans and securities, making them difficult to sell quickly and potentially leading to significant losses if liquidation is required. Price declines and illiquidity in corporate debt markets can result in substantial net unrealized depreciation, reducing net asset value[312][313][314] - As a non-diversified investment company, the company is not limited in the proportion of assets invested in a single issuer, increasing exposure to individual company or industry-specific risks[315] - The company generally does not hold controlling equity interests, limiting its ability to influence portfolio company decisions and prevent actions adverse to its interests. Defaults by portfolio companies can trigger cross-defaults and jeopardize obligations, while prepayments of debt investments can reduce net investment income and ability to make distributions[319][320][321] - Floating-rate loans are subject to interest rate changes, which could increase borrowing costs, reduce net investment income, or cause portfolio companies to default. The planned phase-out of LIBOR by the end of 2021 introduces uncertainty regarding alternative reference rates and potential market disruptions[322][323][324][325][326][327] - Investments in subordinated loans carry greater default risk. Portfolio companies may incur debt ranking equally with or senior to the company's investments, meaning senior creditors would be repaid first in insolvency, potentially leaving no assets for the company. Intercreditor agreements may also limit the company's control over collateral enforcement[330][331][332][333][335][340] - Industry-specific risks, such as changes in healthcare laws and regulations or technological developments in business services, can adversely affect portfolio companies' ability to offer products/services, increase costs, or render offerings obsolete, impacting investment value[344][345][346][347] Risks Relating to Our Common Stock Common stock risks include distribution uncertainty, dilution from DRIP non-participation, trading at a NAV discount, and significant market price fluctuations due to speculative investments and external factors - There is no assurance of specific cash distribution levels or year-to-year increases, as distributions depend on earnings, financial condition, RIC status, and BDC/SBA compliance. A portion of distributions may be a non-taxable return of capital[350][351][352] - Stockholders not participating in the dividend reinvestment plan may experience dilution over time. Shares may trade at unsustainable premiums or discounts from net asset value, a risk distinct from NAV decline, particularly for short-term investors[353][354][355][356] - Investing in the company's securities involves an above-average degree of risk due to speculative investments. The market price and liquidity of securities can fluctuate significantly due to factors like volatility in BDC sector, regulatory changes, operating performance, and general economic trends[357][358] Risks Relating to Our Debt Securities Debt securities risks include subordination, limited indenture protection, illiquidity, default on other debt, optional redemption, credit rating downgrades, and inability to repurchase upon change of control - The 2026 Notes are unsecured and effectively subordinated to secured indebtedness and structurally subordinated to all indebtedness and liabilities of the company's subsidiaries. This means that in liquidation, secured creditors and subsidiary creditors have priority claims over 2026 Note holders[359][360] - The indenture for the 2026 Notes provides limited protection, not restricting the company's ability to incur additional debt (including secured or structurally senior debt), pay dividends on junior securities (subject to 1940 Act and specific exceptions), sell assets, or enter into affiliate transactions. This lack of covenants could adversely affect the 2026 Notes' value[361][362][363][364][365] - There is no active trading market for the 2026 Notes, and the company does not intend to list them. This illiquidity means holders may not be able to sell them at a favorable price or at all, and their market value could decline based on interest rates, credit ratings, and economic conditions[367] - Default on other indebtedness (e.g., Credit Facility) could prevent payments on the 2026 Notes, leading to acceleration of all debt and potential bankruptcy. The company may also redeem the 2026 Notes at its option when prevailing interest rates are low, forcing reinvestment at lower rates[368][369] - A downgrade, suspension, or withdrawal of the credit rating for the company or the 2026 Notes, or changes in debt markets, could significantly reduce their liquidity or market value. The company may not be able to repurchase the 2026 Notes upon a Change of Control Repurchase Event due to insufficient funds or restrictions in other debt agreements[370][371][372][373] ITEM 1B. UNRESOLVED STAFF COMMENTS There are no unresolved staff comments from the SEC - No unresolved staff comments are applicable to the registrant[374] ITEM 2. PROPERTIES The company does not own any material real estate or physical properties. Its headquarters are in Houston, TX, with additional offices in Charlotte, NC, and the Washington, D.C. area, all provided by Stellus Capital Management under an administration agreement - The company does not own any material real estate or physical properties. Its headquarters are in Houston, TX, with additional offices in Charlotte, NC, and the Washington, D.C. area, all provided by Stellus Capital Management under the administration agreement[375] ITEM 3. LEGAL PROCEEDINGS Neither the company, Stellus Capital Management, nor its subsidiaries are currently subject to any material legal proceedings, nor are any threatened. The company may be involved in ordinary course legal proceedings, but these are not expected to materially affect its financial condition or results of operations - Neither the company, Stellus Capital Management, nor its subsidiaries are currently subject to any material legal proceedings, nor are any material legal proceedings threatened against them. Any ordinary course legal proceedings are not expected to have a material effect on financial condition or results of operations[376] ITEM 4. MINE SAFETY DISCLOSURES Mine Safety Disclosures are not applicable to the company - Mine Safety Disclosures are not applicable[377] PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES The company's common stock (SCM) trades on the NYSE, with nine stockholders of record as of January 31, 2021, and a history of monthly/quarterly distributions. In 2020, it issued shares via DRIP and ATM for $4.77 million, while its stock often traded at a discount to NAV with high volatility - The company's common stock is traded on the New York Stock Exchange (NYSE) under the symbol 'SCM'. As of January 31, 2021, there were nine stockholders of record[379] - The company generally intends to pay distributions to stockholders. From January 2014 through March 2020, monthly distributions were $0.1133 per share. For April-December 2020, quarterly distributions were $0.25 per share[380] Equity Securities Activity (Year Ended December 31, 2020) | Activity | Shares | Proceeds/Cost ($) | | :-------------------------------- | :------- | :------------------ | | DRIP Issuances (unregistered) | 21,666 | $228,943 | | ATM Program Sales (registered) | 332,591 | $4,771,144 | | DRIP Purchases (open market) | 117,687 | $1,127,500 (Avg. $9.58/share) | - The company's common stock has historically traded at times at a discount to its net asset value (NAV) per share, a risk distinct from NAV decrease[388] Common Stock Price Range and NAV (Fiscal Year Ended December 31, 2020) | Quarter | NAV Per Share ($) | High Sales Price ($) | Low Sales Price ($) | Premium or Discount of High Sales NAV (%) | Premium or Discount of Low Sales NAV (%) | | :---------------- | :------------------ | :------------------- | :------------------ | :---------------------------------------- | :--------------------------------------- | | Fourth quarter | 14.03 | 12.07 | 8.04 | -13.97 | -42.69 | | Third quarter | 13.17 | 8.94 | 7.22 | -32.12 | -45.18 | | Second quarter | 13.34 | 8.75 | 5.58 | -34.41 | -58.17 | | First quarter | 11.55 | 15.03 | 5.06 | 30.13 | -56.19 | ITEM 6. SELECTED FINANCIAL DATA This section provides a five-year financial overview (2016-2020), highlighting fluctuating investment income, stable net investment income, increasing portfolio fair value, and a downward trend in weighted average debt investment yield from 11.0% to 8.3% Selected Financial Data (2016-2020) | Metric | 2020 ($) | 2019 ($) | 2018 ($) | 2017 ($) | 2016 ($) | | :------------------------------------ | :--------- | :--------- | :--------- | :--------- | :--------- | | Statement of Operations Data: | | | | | | | Total investment income | 56,658,314 | 58,911,889 | 53,266,338 | 39,648,193 | 39,490,197 | | Total expenses, net of fee waiver | 34,666,411 | 36,473,080 | 30,629,801 | 21,677,433 | 22,177,996 | | Net investment income | 21,991,903 | 22,438,809 | 22,636,537 | 17,970,760 | 17,312,201 | | Net increase in net assets from operations | 20,192,441 | 26,438,186 | 26,194,578 | 22,613,257 | 23,199,062 | | Per Share Data: | | | | | | | Net asset value | 14.03 | 14.14 | 14.09 | 13.81 | 13.69 | | Net investment income | 1.13 | 1.23 | 1.42 | 1.21 | 1.39 | | Net increase in net assets from operations | 1.04 | 1.45 | 1.64 | 1.52 | 1.86 | | Distributions declared | 1.15 | 1.36 | 1.36 | 1.36 | 1.36 | | Balance Sheet Data (as of Dec 31):| | | | | | | Investments at fair value | 653,424,495| 628,948,077| 504,483,668| 371,839,772| 365,625,891| | Cash and cash equivalents | 18,477,602 | 16,133,315 | 17,467,146 | 25,110,718 | 9,194,129 | | Total assets | 674,910,157| 648,513,227| 526,287,251| 400,260,855| 379,878,729| | Total liabilities | 401,549,508| 377,942,054| 301,442,244| 180,013,613| 208,996,944| | Total net assets | 273,360,649| 270,571,173| 224,845,007| 220,247,242| 170,881,785| | Other Data: | | | | | | | Number of portfolio companies | 66 | 63 | 57 | 48 | 45 | | Weighted average yield on debt investments | 8.3% | 9.2% | 10.9% | 10.8% | 11.0% | ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This section analyzes the company's financial condition, liquidity, and operations for 2020, covering COVID-19 impacts, portfolio, investment activity, asset quality, revenues, expenses, debt, RIC status, and subsequent events Forward-Looking Statements This section notes the report contains forward-looking statements about future operations, investments, and regulatory compliance, which involve COVID-19 related risks and uncertainties, with no obligation to update unless legally required - The report contains forward-looking statements about future operating results, business prospects, investment effects, contractual arrangements, conflicts of interest, economic dependence, portfolio company objectives, use of borrowed money, financing adequacy, cash flow timing, Stellus Capital Management's ability to locate and monitor investments, RIC/BDC qualification, and regulatory changes[395] - Forward-looking statements involve risks and uncertainties, including those related to the COVID-19 pandemic, and actual results could differ materially from anticipated outcomes. The company does not undertake to revise or update these statements unless required by law[395][397] Overview Stellus Capital, an externally managed BDC formed in 2012, aims to maximize stockholder returns through middle-market debt and equity, complying with 70% qualifying asset rules and RIC status, with a 150% asset coverage ratio, while navigating COVID-19 impacts - Stellus Capital Investment Corporation, organized on May 18, 2012, and commenced operations on November 7, 2012, is an externally managed, non-diversified, closed-end investment company regulated as a BDC and treated as a RIC[398][399] - The company's investment objective is to maximize total return to stockholders through current income and capital appreciation from debt and related equity investments in middle-market companies[398] - As a BDC, the company must ensure at least 70% of its total assets are 'qualifying assets' (investments in eligible portfolio companies). It also maintains RIC tax status, requiring compliance with source-of-income and asset diversification rules to avoid corporate-level taxes on distributed income[400][401] - Following stockholder approval in 2018, the company's asset coverage ratio requirement decreased from 200% to 150%, increasing its leverage capacity. As of December 31, 2020, the asset coverage ratio was 223%[402][403] COVID-19 Developments The COVID-19 pandemic, declared in March 2020, has significantly impacted the economy and portfolio valuations, with ongoing uncertainty regarding vaccine distribution and potential recession posing material risks to future net investment income and financial condition - The COVID-19 pandemic, declared in March 2020, has significantly impacted the U.S. and global economy, leading to widespread disruptions, quarantines, and business closures. The company has assessed the pandemic's impact on each portfolio company's valuation[404][405] - Uncertainty regarding vaccine distribution and the timeline for achieving 'herd immunity' means a prolonged period of self-isolation and reduced economic participation is possible. This could lead to a sustained recession, materially adversely affecting the company's business, operations, net investment income, portfolio fair value, and financial condition[405][406][407] Economic outlook The economic outlook remains uncertain due to the COVID-19 pandemic, posing material risks to portfolio company values, financing, operational costs, and regulatory policy, potentially triggering a global economic slowdown - The economic outlook is uncertain due to the COVID-19 pandemic, with potential for prolonged self-isolation and reduced economic participation despite vaccine authorizations. This presents material uncertainty and risks to portfolio company values, financing arrangements, operational costs, and regulatory policy, potentially triggering a global economic slowdown[408] Operations Stellus Capital Management's partners and employees have operated remotely since March 16, 2020, without disruption, prepared to continue as needed for safety - All partners and employees of Stellus Capital Management have been operating remotely since March 16, 2020, without disruption, and are prepared to continue as long as necessary for health and safety[409] Our COVID-19 response Since the pandemic's onset, the company has maintained regular contact with portfolio companies and sponsors to assess liquidity, covenant compliance, and workforce/customer health - Since the onset of the COVID-19 pandemic, the company has been in regular contact with all portfolio companies and/or their sponsors to assess liquidity, expected covenant compliance, and the health of their workforce and customers[410] Financial impact The company will closely monitor portfolio companies' financial condition to mitigate COVID-19 impacts, noting historical data may be less relevant - The company will continue to closely monitor the financial condition of its portfolio companies to mitigate the impact of the COVID-19 pandemic, with historical information being relatively less significant[411] Portfolio Composition and Investment Activity As of December 31, 2020, the portfolio held $653.4 million across 66 companies, primarily 78% first lien debt with an 8.3% weighted average yield, concentrated in Texas, California, Business Services, and Healthcare, with $28.9 million unfunded commitments and $152.0 million in 2020 investments - As of December 31, 2020, the company had $653.4 million (fair value) invested in 66 companies. The portfolio was composed of approximately 78% first lien debt (including unitranche), 11% second lien debt, 3% unsecured debt, and 8% equity investments at fair value[413] - As of December 31, 2020, 93% of debt investments bore interest based on floating rates (subject to interest rate floors), and 7% bore interest at fixed rates. The weighted average yield on all debt investments was approximately 8.3% (down from 9.2% in 2019), and on all investments (including non-income producing equity) was approximately 7.9% (down from 8.8% in 2019)[420][421] Portfolio Composition by Investment Type (Fair Value) | Investment Type | Dec 31, 2020 ($) | Dec 31, 2020 (%) | Dec 31, 2019 ($) | Dec 31, 2019 (%) | | :------------------------ | :--------------- | :--------------- | :--------------- | :--------------- | | Senior Secured – First Lien | $508,673,064 | 77.8% | $455,169,878 | 72.4% | | Senior Secured – Second Lien| $70,720,186 | 10.8% | $111,961,013 | 17.8% | | Unsecured Debt | $21,191,245 | 3.3% | $22,137,186 | 3.5% | | Equity | $52,840,000 | 8.1% | $39,680,000 | 6.3% | | Total Investments | $653,424,495 | 100.0% | $628,948,077 | 100.0% | Top Geographical Concentrations (Fair Value, Dec 31, 2020) | Geography | Fair Value ($) | % of Total Investments | | :---------- | :------------- | :--------------------- | | Texas | $135,146,776 | 20.68% | | California | $92,069,851 | 14.09% | | Illinois | $57,535,404 | 8.81% | | Arizona | $52,015,600 | 7.96% | | New Jersey | $37,765,139 | 5.78% | Top Industry Concentrations (Fair Value, Dec 31, 2020) | Industry | Fair Value ($) | % of Total Investments | | :---------------------------- | :------------- | :--------------------- | | Services: Business | $109,873,364 | 16.82% | | Healthcare & Pharmaceuticals | $82,945,887 | 12.69% | | Aerospace & Defense | $52,184,338 | 7.99% | | Beverage, Food, & Tobacco | $41,012,620 | 6.28% | | Media: Broadcasting & Subscription | $34,418,869 | 5.27% | - As of December 31, 2020, unfunded commitments to 19 portfolio companies totaled $28.9 million, a decrease from $37.5 million across 17 companies in 2019. The company had sufficient liquidity to fund these commitments[415] - In 2020, the company made $152.0 million in investments (ten new, twenty existing portfolio companies) and received $128.8 million in proceeds from prepayments and amortizations. Investment activity slowed in early 2020 due to COVID-19 but increased later in the year, with $76.7 million invested in seven new companies since July 2020[423][426] Asset Quality The company uses a five-level investment rating system; as of December 31, 2020, 76% of the portfolio was Category 2 (within expectations), 14% Category 1 (above expectations), and only 1% Category 5 (expected loss) - The company uses a five-level numeric investment rating system to characterize and monitor the credit profile and expected returns of each investment. Category 1 indicates performance above expectations, Category 2 is within expectations (initial rating for new loans), Category 3 is below expectations but no loss of return/principal expected, Category 4 is substantially below expectations with some return loss expected, and Category 5 is substantially below expectations with some loss of return and principal expected[427] Investment Category Summary (Fair Value) | Investment Category | Dec 31, 2020 ($ millions) | Dec 31, 2020 (%) | Dec 31, 2019 ($ millions) | Dec 31, 2019 (%) | | :------------------ | :------------------------ | :--------------- | :------------------------ | :--------------- | | 1 | $87.3 | 14% | $70.4 | 11% | | 2 | $496.5 | 76% | $492.2 | 78% | | 3 | $61.3 | 9% | $49.3 | 8% | | 4 | — | —% | $12.0 | 2% | | 5 | $8.3 | 1% | $5.0 | 1% | | Total | $653.4 | 100% | $628.9 | 100% | Loans and Debt Securities on Non-Accrual Status As of December 31, 2020, three loans were on non-accrual status, representing 4.3% of the loan portfolio at cost and 1.0% at fair value, with $7.1 million in unaccrued income Loans on Non-Accrual Status | Metric | Dec 31, 2020 | Dec 31, 2019 | | :-------------------------------- | :----------- | :----------- | | Number of portfolio companies | 3 | 2 | | % of loan portfolio at cost | 4.3% | 3.6% | | % of loan portfolio at fair value | 1.0% | 0.9% | | Unaccrued income ($) | $7.1 million | $3.8 million | Results of Operations In 2020, net investment income was $22.0 million ($1.13 per share), down from $22.4 million in 2019, driven by lower interest income and operating expenses, with net realized losses of $10.1 million and $8.6 million in unrealized appreciation, resulting in a $20.2 million net increase in net assets from operations Investment Income Breakdown ($ millions) | Income Type | 2020 | 2019 | 2018 | | :---------------- | :---- | :---- | :---- | | Interest Income | $54.7 | $56.5 | $49.6 | | PIK Income | $0.7 | $0.4 | $1.9 | | Miscellaneous fees| $1.3 | $2.0 | $1.8 | | Total | $56.7 | $58.9 | $53.3 | - Interest income decreased from 2019 to 2020 primarily due to a decline in market indices for floating rate loans, subject to interest rate floors. Non-recurring income from early repayments, previously reserved income, and loan amendments was $2.1 million in 2020, $2.8 million in 2019, and $3.4 million in 2018[433][434] Operating Expenses Breakdown ($ millions) | Expense Type | 2020 | 2019 | 2018 | | :-------------------------------- | :---- | :---- | :---- | | Management Fees | $11.1 | $9.7 | $8.2 | | Valuation Fees | $0.3 | $0.3 | $0.3 | | Administrative services expenses | $1.8 | $1.7 | $1.4 | | Income incentive fees | $2.5 | $5.8 | $5.5 | | Capital gain incentive (reversal) fees | ($0.4)| $0.8 | $0.1 | | Professional fees | $1.0 | $1.0 | $1.2 | | Directors' fees | $0.4 | $0.4 | $0.3 | | Insurance expense | $0.3 | $0.3 | $0.3 | | Interest expense and other fees | $16.0 | $15.0 | $12.3 | | Income tax expense | $0.8 | $0.9 | $0.3 | | Other general and administrative | $0.9 | $0.6 | $0.7 | | Total Operating Expenses | $34.7 | $36.5 | $30.6 | - Operating expenses decreased in 2020 primarily due to lower income incentive fees (due to lower LIBOR rates) and a reversal of capital gains incentive fees from realized losses. This was partially offset by increased management fees (due to portfolio growth) and higher interest expense (due to increased debt balances)[438] Net Investment Income and Net Assets from Operations | Metric | 2020 ($) | 2019 ($) | 2018 ($) | | :---------------------------------------- | :---------- | :---------- | :---------- | | Net investment income | $21,991,903 | $22,438,809 | $22,636,537 | | Net investment income per common share | $1.13 | $1.23 | $1.42 | | Net increase in net assets from operations| $20,192,441 | $26,438,186 | $26,194,578 | | Net increase in net assets from operations per common share | $1.04 | $1.45 | $1.64 | - Net investment income decreased in 2020 compared to 2019 due to lower interest income, offset by lower operating expenses. Net realized losses totaled ($10.1 million) in 2020, primarily from a loan disposition, partially offset by equity investment gains. This contrasts with net realized gains of $19.6 million in 2019 and $5.5 million in 2018[440][443] - Net change in unrealized appreciation was $8.6 million in 2020, primarily due to portfolio company-specific performance on equity investments. This is a reversal from net unrealized depreciation of ($15.5 million) in 2019 and ($1.6 million) in 2018[445][446] - A deferred tax provision of $224.9 thousand was recognized in 2020 (vs. $66.8 thousand in 2019 and $68.0 thousand in 2018) related to unrealized appreciation on equity investments in Taxable Subsidiaries[448] Financial condition, liquidity and capital resources Liquidity stems from the Credit Facility, SBA debentures, and operations; 2020 saw $3.5 million net cash used in operations and $5.8 million provided by financing. The Credit Facility was amended in September 2020, lowering the asset coverage ratio to 1.67 to 1.0, with $174.0 million outstanding on the Credit Facility and $176.5 million on SBA debentures, and $48.9 million in 5.75% notes due 2022 Cash Flows Summary ($ millions) | Activity | 2020 | 2019 | 2018 | | :------------------------------------ | :----- | :----- | :----- | | Net Cash Used In Operating Activities | ($3.5) | ($93.3)| ($102.4)| | Net Cash Provided by Financing Activities | $5.8 | $92.0 | $94.8 | - The decrease in net cash used in operating activities in 2020 was primarily due to reduced new investments during the first half of the year, influenced by the COVID-19 pandemic[453] - Liquidity and capital resources are derived from the Credit Facility, 2022 Notes, SBA-guaranteed debentures, and cash flows from operations. The company expects to fund growth through future equity offerings and senior securities issuances, but faces limitations if common stock trades below NAV[456][457] - As of December 31, 2020, the company's asset coverage ratio was 223% (vs. 229% in 2019), well above the 150% requirement, providing flexibility for leverage. Cash and cash equivalents were $18.5 million in 2020 (vs. $16.1 million in 2019)[459] - The Credit Facility was amended and restated on September 18, 2020, extending the maturity to September 18, 2025, and the commitment termination date to September 18, 2024. It includes a LIBOR floor of 0.25% and a minimum asset coverage ratio of 1.67 to 1.0 (maximum leverage of 1.5x)[460] Credit Facility Key Terms (Amended and Restated) | Feature | Prior Agreement | As Amended and Restated | | :------------------------ | :-------------- | :---------------------- | | Maturity Date | Oct 10, 2021 | Sep 18, 2025 | | Commitment Termination Date | Mar 10, 2021 | Sep 18, 2024 | | LIBOR Floor | None | 0.25% | | Prime Rate Floor | None | 3.00% | | Asset Coverage Ratio | Min 1.75 to 1.00| Min 1.67 to 1.00 | - As of December 31, 2020, the outstanding balance under the Credit Facility was $174.0 million (vs. $161.6 million in 2019). The weighted average interest rate was 3.2% in 2020 (vs. 4.8% in 2019)[464][465] - SBA-guaranteed debentures outstanding were $176.5 million in 2020 (vs. $161.0 million in 2019). These debentures have fixed interest rates (10-year Treasury + spread) and a ten-year maturity, with no prepayment penalty. The SBIC subsidiaries held 41.1% of total consolidated assets in 2020[469][470] - The company issued $48.9 million in 5.75% fixed-rate notes due September 15, 2022 (the '2022 Notes'). As of December 31, 2020, the carrying amount was $48.9 million, with a fair value of approximately $49.2 million. The weighted average interest rate was 5.7% in 2020[474][475][477] Contractual Obligations (Principal Amounts, as of Dec 31, 2020) | Obligation | Total ($ thousands) | 2021 ($ thousands) | 2022 ($ thousands) | 2023 ($ thousands) | 2024 ($ thousands) | 2025 ($ thousands) | 2026 and thereafter ($ thousands) | | :------------------------ | :------------------ | :----------------- | :----------------- | :----------------- | :----------------- | :----------------- | :-------------------------------- | | Credit Facility payable | $174,000 | — | — | — | $58,000 | $116,000 | — | | Notes payable | $48,875 | — | $48,875 | — | — | — | — | | SBA-guaranteed debentures | $176,500 | — | — | — | — | — | $176,500 | | Total | $399,375 | $— | $48,875 | $— | $58,000 | $116,000 | $176,500 | Off-Balance Sheet Arrangements As of December 31, 2020, off-balance sheet arrangements included $28.9 million in unfunded commitments to 19 portfolio companies, a decrease from $37.5 million for 17 companies in 2019, with sufficient liquidity maintained - As of December 31, 2020, the company had $28.9 million in unfunded commitments to 19 portfolio companies, down from $37.5 million for 17 companies in 2019. The company maintains sufficient liquidity to fund these commitments[479] Regulated Investment Company Status and Dividends The company maintains RIC status by distributing at least 90% of taxable income, carrying forward $21.1 million to 2021, and aims for 90-100% annual distribution, though debt covenants may restrict it; the IRS temporarily reduced the cash distribution requirement to 10% in 2020 - The company maintains RIC tax status by distributing at least 90% of its investment company taxable income to stockholders, avoiding corporate-level taxes. As of December 31, 2020, $21.1 million of undistributed taxable income was carried forward for 2021 distributions[480][483] - The company intends to distribute 90-100% of its annual taxable income, but Credit Facility covenants may restrict distributions. Stockholders are not assured of specific distribution levels[484][485] - In 2020, the IRS temporarily reduced the minimum cash distribution requirement for stock dividends to 10% (from 20%) for distributions declared between April 1 and December 31, 2020, to enhance liquidity during economic disruption. The company has no current intention to pay dividends in stock but continues to assess its liquidity and the economic environment[486][487][488] Recent Accounting Pronouncements FASB issued ASU 2020-04, Reference Rate Reform, in March 2020, offering optional expedients for contracts and hedging relationships through December 31, 2022, which the company is evaluating but did not use in 2020; other pronouncements are not expected to materially impact financials - In March 2020, FASB issued ASU 2020-04, Reference Rate Reform, offering optional expedients for contracts and hedging relationships affected by reference rate reform, effective through December 31, 2022. The company is evaluating its impact but did not use these expedients in 2020[606] - Other new accounting pronouncements are not expected to have a material impact on the company's consolidated financial statements upon adoption[609] Critical Accounting Policies Critical accounting policies are detailed in Note 1 to the Consolidated Financial Statements - Critical accounting policies are described in Note 1 to the Consolidated Financial Statements[490] Subsequent Events Post-December 31, 2020, the company received $14.8 million in repayments, made $48.8 million in new investments, issued $100.0 million in 4.875% notes due 2026 to redeem 2022 Notes and repay Credit Facility, increased SBIC II capital by $15.0 million, and declared $0.0833 per share monthly dividends - On January 14, 2021, the company received full repayment of $13.6 million on the first lien term loan and revolver of BFC Solmetex, LLC, and $1.2 million from its subsidiary, Bonded Filter Co. LLC[491][719] - New investments post-year-end include $11.3 million in first lien term loan and $4.8 million in subordinated debt/warrants of NuSource Financial, LLC (Jan 29, 2021); $0.4 million in equity of Tailwind Core Investor, LLC (Feb 1, 2021); $7.2 million in first lien term loan and $0.1 million in equity of Time Manufacturing Acquisition, LLC (Feb 11, 2021); $13.5 million in first lien term loan, $0.1 million unfunded revolver, and $0.3 million equity of CEATI International, Inc. (Feb 19, 2021); $10.8 million in first lien term loan, $0.1 million unfunded revolver, and $0.5 million equity of TAC LifePort Purchaser, LLC (Mar 1, 2021); and $10.0 million in first lien term loan, $0.1 million unfunded revolver, and $0.8 million equity of TradePending, LLC (Mar 2, 2021)[492][493][494][495][496][720][721][722][723][724] - On January 14, 2021, the company issued $100.0 million in 4.875% fixed-rate notes due 2026. Proceeds were used to fully redeem the 2022 Notes ($48.875 million) on February 12, 2021, and repay a portion of the Credit Facility[497][498][725][727] - As of March 3, 2021, the outstanding balance under the Credit Facility was $164.5 million, and SBA-guaranteed debentures totaled $210.0 million[499][500][728][729] - On January 21, 2021, the company contributed an additional $15.0 million to the SBIC II subsidiary, bringing total contributed capital to $35.0 million. Committed capital was increased to $60.0 million on January 25, 2021[501][730] - On January 15, 2021, the Board changed the distribution frequency from quarterly to monthly and declared a regular monthly dividend of $0.0833 per share for January, February, and March 2021[502][731] ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The company faces interest rate risk; 93% of loans are floating-rate with a 1.21% weighted average LIBOR floor in 2020, where a 50 basis point increase could decrease net interest income by $0.4 million, though hedging was not used in 2019 or 2020 - The company is subject to financial market risks, including changes in interest rates. A prolonged low interest rate environment, particularly with reduced LIBOR, could compress net interest income and adversely affect operating results[503] - As of December 31, 2020 and 2019, 93% of the company's loan portfolio bore interest at floating rates (typically LIBOR-indexed with floors). The weighted average interest rate floor on floating rate loans was 1.21% in 2020 (vs. 1.13% in 2019)[503] Annual Impact on Net Interest Income from Interest Rate Changes (Dec 31, 2020) | Change in Basis Points | Interest Income ($ millions) | Interest Expense ($ millions) | Net Interest Income ($ millions) | | :--------------------- | :--------------------------- | :---------------------------- | :------------------------------- | | Up 200 | $11.4 | ($3.5) | $7.9 | | Up 150 | $7.6 | ($2.6) | $5.0 | | Up 100 | $2.9 | ($1.7) | $1.2 | | Up 50 | $0.5 | ($0.9) | ($0.4) | | Down 25 | — | — | — | - The company may hedge against interest rate fluctuations using instruments like futures, options, and forward contracts, but did not engage in hedging activities for the years ended December 31, 2020 and 2019[505] ITEM 8. AUDITED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA This section presents the audited consolidated financial statements for 2018-2020, including the independent auditor's report, primary financial statements, schedule of investments, and comprehensive notes detailing operations, accounting policies, related parties, distributions, equity, NAV, fair value, commitments, financial highlights, debt, taxes, senior securities, and subsequent events Report of Independent Registered Public Accounting Firm Grant Thornton LLP issued an unqualified opinion on the company's 2019-2020 consolidated financial statements, confirming U.S. GAAP conformity, with the critical audit matter being the fair value of Level 3 investments due to unobservable inputs and management judgment - Grant Thornton LLP issued an unqualified opinion on the company's consolidated financial statements for the periods ended December 31, 2020 and 2019, confirming fair presentation in conformity with U.S. GAAP[508] - The critical audit matter identified was the fair value of investments, specifically Level 3 assets, due to the use of significant unobservable inputs and high management judgment in valuation. Audit procedures included testing controls over management's valuation process and evaluating data, methods, and assumptions with internal valuation specialists[513][514][515] Statements of Assets and Liabilities As of December 31, 2020, total assets we