Stellus Capital Investment (SCM) - 2021 Q1 - Quarterly Report

PART I. FINANCIAL INFORMATION Item 1. Financial Statements This section includes Stellus Capital Investment Corporation's unaudited consolidated statements of assets and liabilities, operations, changes in net assets, cash flows, and schedules of investments as of March 31, 2021, and December 31, 2020, with detailed notes covering operations, accounting policies, related party transactions, dividends, equity offerings, investment portfolio and fair value, commitments and contingencies, financial highlights, credit facilities, and SBA debentures Consolidated Statements of Assets and Liabilities As of March 31, 2021, total assets increased significantly to $747.8 million, up 10.8% from $674.9 million on December 31, 2020, driven by increases in non-controlled, non-affiliated investments and cash, with total liabilities rising to $474.3 million, while net assets remained stable at $273.4 million, and NAV per share at $14.03 Consolidated Statements of Assets and Liabilities | Metric | March 31, 2021 (Unaudited) | December 31, 2020 | Change | | :----------------------------------- | :------------------------- | :---------------- | :------- | | Total Assets | $747,758,576 | $674,910,157 | +10.8% | | Non-controlled, non-affiliated investments (fair value) | $714,464,472 | $653,424,495 | +9.3% | | Cash and cash equivalents | $30,449,635 | $18,477,602 | +64.8% | | Total Liabilities | $474,329,691 | $401,549,508 | +18.1% | | Notes payable | $97,765,674 | $48,307,518 | +102.4% | | SBA-guaranteed debentures | $205,285,585 | $173,167,496 | +18.5% | | Net Assets | $273,428,885 | $273,360,649 | +0.02% | | Net Asset Value Per Share | $14.03 | $14.03 | 0% | Consolidated Statements of Operations For the three months ended March 31, 2021, net investment income decreased by 19.0% to $5.06 million from $6.24 million in the prior year, primarily due to lower interest income, while the net increase in net assets from operations significantly improved to $4.94 million, compared to a $43.94 million decrease in the prior year, driven by unrealized appreciation Consolidated Statements of Operations | Metric | Three months ended March 31, 2021 (Unaudited) | Three months ended March 31, 2020 (Unaudited) | Change | | :------------------------------------------------- | :-------------------------------------------- | :-------------------------------------------- | :------- | | Total Investment Income | $13,987,864 | $15,261,045 | -8.3% | | Total Operating Expenses | $8,927,233 | $9,021,583 | -1.0% | | Net Investment Income | $5,060,631 | $6,239,462 | -19.0% | | Net realized gain on investments | $462,228 | $1,296,793 | -64.3% | | Loss on debt extinguishment | $(539,250) | $0 | N/A | | Net change in unrealized appreciation (depreciation) | $121,983 | $(51,504,946) | N/A | | Net Increase (Decrease) in Net Assets from Operations | $4,937,788 | $(43,939,732) | N/A | | Net Investment Income Per Share | $0.26 | $0.32 | -18.8% | | Net Increase (Decrease) in Net Assets from Operations Per Share | $0.25 | $(2.26) | N/A | | Distributions Per Share | $0.25 | $0.34 | -26.4% | Consolidated Statements of Changes in Net Assets For the three months ended March 31, 2021, net assets increased by $68,236 to $273.4 million, a significant improvement compared to a $45.65 million decrease in the prior year, primarily due to the net increase in net assets from operations offsetting distributions to shareholders Consolidated Statements of Changes in Net Assets | Metric | Three months ended March 31, 2021 (Unaudited) | Three months ended March 31, 2020 (Unaudited) | Change | | :------------------------------------------------- | :-------------------------------------------- | :-------------------------------------------- | :------- | | Net Increase (Decrease) in Net Assets from Operations | $4,937,788 | $(43,939,732) | N/A | | Total Distributions | $(4,869,552) | $(6,619,297) | -26.4% | | Net Increase in Net Assets from Capital Share Transactions | $0 | $4,906,521 | N/A | | Total Increase (Decrease) in Net Assets | $68,236 | $(45,652,508) | N/A | | Net Assets at End of Period | $273,428,885 | $224,918,665 | +21.6% | Consolidated Statements of Cash Flows For the three months ended March 31, 2021, operating activities used $57.1 million in cash, primarily for investment purchases, while financing activities provided $69.0 million, mainly from new notes and SBA debentures, resulting in a $12.0 million net increase in cash Consolidated Statements of Cash Flows | Metric | Three months ended March 31, 2021 (Unaudited) | Three months ended March 31, 2020 (Unaudited) | Change | | :------------------------------------------------- | :-------------------------------------------- | :-------------------------------------------- | :------- | | Net Cash Used in Operating Activities | $(57,052,324) | $(27,884,098) | +104.6% | | Net Cash Provided by Financing Activities | $69,024,357 | $46,776,029 | +47.6% | | Net Increase in Cash and Cash Equivalents | $11,972,033 | $18,891,931 | -36.6% | | Cash and Cash Equivalents Balance at End of Period | $30,449,635 | $35,025,246 | -13.1% | | Cash paid for interest expense | $4,166,438 | $5,291,684 | -21.3% | Consolidated Schedules of Investments As of March 31, 2021, the fair value of the investment portfolio increased to $714.5 million across 70 portfolio companies, up from $653.4 million (66 companies) on December 31, 2020, primarily comprising senior secured first lien debt (79%) and concentrated in business services, healthcare, and aerospace & defense, with unfunded commitments decreasing to $22.8 million Total Investments | Metric | March 31, 2021 (Fair Value) | December 31, 2020 (Fair Value) | Change | | :----------------------------------- | :---------------------------- | :----------------------------- | :------- | | Total Investments | $714,464,472 | $653,424,495 | +9.3% | | Number of Portfolio Companies | 70 | 66 | +4 | | Senior Secured – First Lien | $564,335,624 (79%) | $508,673,064 (78%) | +10.9% | | Senior Secured – Second Lien | $61,483,486 (9%) | $70,720,186 (11%) | -13.0% | | Unsecured Debt | $32,155,362 (4%) | $21,191,245 (3%) | +51.7% | | Equity | $56,490,000 (8%) | $52,840,000 (8%) | +6.9% | - Geographical Concentration (March 31, 2021): Primarily concentrated in Texas (19.69%), California (13.00%), and Illinois (8.88%)[160][247] - Industry Concentration (March 31, 2021): Primarily concentrated in Business Services (22.74%), Healthcare & Pharmaceuticals (11.60%), and Aerospace & Defense (9.09%)[170][249] - Unfunded Commitments: Decreased from $28.9 million (19 companies) on December 31, 2020, to $22.8 million (22 companies) on March 31, 2021[174][251] Notes to Unaudited Financial Statements This section details the company's operations, significant accounting policies, related party transactions, dividends, equity offerings, investment portfolio and fair value measurement, commitments and contingencies, financial highlights, credit facilities, SBA debentures, and the potential impact of COVID-19 on operations and investments NOTE 1 — NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES Stellus Capital Investment Corporation operates as an externally managed BDC and RIC, focusing on debt and equity investments in middle-market companies, utilizing wholly-owned taxable subsidiaries and SBIC subsidiaries for investments and leverage, with its asset coverage ratio reduced to 150% in 2018, and continuously assessing COVID-19 impacts - Company Status: An externally managed, closed-end, non-diversified investment management company, regulated as a Business Development Company (BDC) under the 1940 Act and treated as a Regulated Investment Company (RIC) under the Internal Revenue Code of 1986, as amended[55][58] - Investment Objective: To maximize total shareholder return through current income and capital appreciation by investing in debt and related equity of middle-market companies, typically with EBITDA between $5 million and $50 million[59] - SBIC Subsidiaries: Stellus Capital SBIC, LP ("SBIC Subsidiary") was formed in 2013, and Stellus Capital SBIC II, LP ("SBIC II Subsidiary") in 2018, both licensed by the U.S. Small Business Administration (SBA) to operate as Small Business Investment Companies (SBICs) and issue SBA-guaranteed debentures[60][65] - Asset Coverage Ratio: The company's applicable asset coverage ratio test was reduced from 200% to 150% on June 29, 2018, following board and shareholder approval, with the ratio standing at 203% as of March 31, 2021[66][67] - COVID-19 Impact: The company is assessing the impact of the COVID-19 pandemic on investment valuations and portfolio company liquidity, anticipating that the pandemic may have a significant adverse effect on future net investment income, fair value of investments, and financial condition[72][74] SBIC Regulatory Capital and Debentures | Metric | March 31, 2021 | December 31, 2020 | | :------------------------------------------------- | :------------- | :---------------- | | SBIC I Regulatory Capital | $75,000,000 | $75,000,000 | | SBIC II Regulatory Capital | $60,000,000 | $40,000,000 | | SBIC I SBA-guaranteed debentures outstanding | $150,000,000 | $150,000,000 | | SBIC II SBA-guaranteed debentures outstanding | $60,000,000 | $26,500,000 | NOTE 2 — RELATED PARTY ARRANGEMENTS The company has agreements with its investment adviser, Stellus Capital, including an investment advisory agreement with a 1.75% base management fee and incentive fees (subject to a 2.0% hurdle and total return requirements for investment income, and 20% of cumulative realized capital gains), an administration agreement, and a name license agreement, also engaging in co-investments with affiliated funds under an SEC exemptive order Related Party Fees and Expenses | Fee Type | Three Months Ended March 31, 2021 | Three Months Ended March 31, 2020 | | :--------------------------------- | :-------------------------------- | :-------------------------------- | | Base Management Fees | $2,963,861 | $2,719,054 | | Investment Income Incentive Fees | $0 | $1,339,637 | | Capital Gains Incentive Fee (reversed) | $83,281 | $(880,913) | | Total Incentive Fee Expense | $83,281 | $458,724 | | Administrative Services Expenses | $381,050 | $399,599 | | Director Fees | $91,500 | $132,250 | - Investment Income Incentive Fees: Based on net investment income before incentive fees, subject to a 2.0% (8.0% annualized) hurdle rate and a cumulative total return requirement, with no incentive fee paid if net investment income before incentive fees does not exceed the hurdle[118][119] - Capital Gains Incentive Fee: Equal to 20.0% of cumulative realized capital gains since inception, less cumulative realized capital losses and cumulative unrealized capital depreciation[123] - Co-Investments: Under an SEC exemptive order, the company can co-invest with private funds managed by Stellus Capital or its affiliates to access more investment opportunities and achieve greater diversification[129] NOTE 3 — DISTRIBUTIONS The company typically declares quarterly dividends and plans to distribute at least its net realized income annually to maintain RIC qualification, with total common stock dividends declared since inception reaching $11.16 per share as of March 31, 2021, operating an "opt-out" dividend reinvestment plan that may increase total assets and associated management fees - Dividend Policy: Dividends are typically declared quarterly, with plans to distribute at least its net realized income annually to maintain RIC qualification[137] - Dividend Reinvestment Plan (DRIP): Operates an "opt-out" DRIP where shareholders receive dividends in company common stock unless they elect to receive cash, with participation increasing total assets and consequently impacting base management and incentive fee calculations[141] Total Distributions Per Share | Fiscal Year | Total Distributions Per Share | | :---------- | :---------------------------- | | 2012 | $0.18 | | 2013 | $1.36 | | 2014 | $1.42 | | 2015 | $1.36 | | 2016 | $1.36 | | 2017 | $1.36 | | 2018 | $1.36 | | 2019 | $1.36 | | 2020 | $1.15 | | 2021 (Q1) | $0.25 (3 x $0.0833) | | Total (Inception - Mar 31, 2021) | $11.16 | NOTE 4 — EQUITY OFFERINGS AND RELATED EXPENSES Since inception, the company has issued 19,486,003 shares of common stock, raising $286.6 million in gross proceeds, with no shares issued in Q1 2021, but 332,591 shares issued in Q1 2020 through an ATM Program for $4.795 million Equity Offerings (Inception) | Metric | Total (Inception) | | :--------------------------------- | :---------------- | | Number of Shares Issued | 19,486,003 | | Gross Proceeds | $286,629,818 | | Underwriting Fees | $7,414,918 | | Offering Expenses | $1,712,309 | | Net Proceeds | $277,502,591 | - Q1 2021 Issuance: No shares were issued[148] - Q1 2020 ATM Program: 332,591 shares were issued, generating $4,794,995 in gross proceeds at an average price of $14.42 per share[149] - DRIP Issuance: 0 shares issued in Q1 2021, compared to 9,910 shares in Q1 2020[149] NOTE 5 — NET INCREASE (DECREASE) IN NET ASSETS PER COMMON SHARE For the three months ended March 31, 2021, the net increase in net assets per share was $0.25, a significant improvement compared to a $2.26 decrease per share in the prior year Net Increase (Decrease) in Net Assets Per Common Share | Metric | Three Months Ended March 31, 2021 | Three Months Ended March 31, 2020 | | :------------------------------------------------- | :-------------------------------- | :-------------------------------- | | Net increase (decrease) in net assets from operations | $4,937,788 | $(43,939,732) | | Weighted average common shares | 19,486,003 | 19,429,480 | | Net increase (decrease) in net assets from operations per share | $0.25 | $(2.26) | NOTE 6 — PORTFOLIO INVESTMENTS AND FAIR VALUE As of March 31, 2021, the fair value of the investment portfolio increased to $714.5 million across 70 companies, up from $653.4 million (66 companies) on December 31, 2020, primarily comprising senior secured first lien debt (79%) with equity investments at 8%, all classified as Level 3 fair value, and unfunded commitments decreasing to $22.8 million Total Investments | Metric | March 31, 2021 (Fair Value) | December 31, 2020 (Fair Value) | Change | | :----------------------------------- | :---------------------------- | :----------------------------- | :------- | | Total Investments | $714,464,472 | $653,424,495 | +9.3% | | Number of Portfolio Companies | 70 | 66 | +4 | | Senior Secured – First Lien | $564,335,624 (79%) | $508,673,064 (78%) | +10.9% | | Senior Secured – Second Lien | $61,483,486 (9%) | $70,720,186 (11%) | -13.0% | | Unsecured Debt | $32,155,362 (4%) | $21,191,245 (3%) | +51.7% | | Equity | $56,490,000 (8%) | $52,840,000 (8%) | +6.9% | - Fair Value Hierarchy: All investments are classified as Level 3, indicating their valuation relies on significant unobservable inputs[153] - Unfunded Commitments: Decreased from $28.9 million (19 companies) on December 31, 2020, to $22.8 million (22 companies) on March 31, 2021[160] - Geographical Concentration (March 31, 2021): Primarily concentrated in Texas (19.69%), California (13.00%), and Illinois (8.88%)[170] - Industry Concentration (March 31, 2021): Primarily concentrated in Business Services (22.74%), Healthcare & Pharmaceuticals (11.60%), and Aerospace & Defense (9.09%)[174] Aggregate Portfolio Value | Metric | March 31, 2021 | December 31, 2020 | | :--------------------------------------- | :------------- | :---------------- | | Aggregate cost of portfolio securities | $719,546,960 | $658,628,966 | | Gross unrealized appreciation | $29,436,962 | $28,143,621 | | Gross unrealized depreciation | $(34,519,450) | $(33,348,092) | | Aggregate fair value | $714,464,472 | $653,424,495 | NOTE 7 — COMMITMENTS AND CONTINGENCIES The company is not currently involved in any material legal proceedings, and unfunded commitments for debt financing to portfolio companies decreased to $22.8 million as of March 31, 2021, from $28.9 million on December 31, 2020, with sufficient liquidity maintained to meet these obligations - Legal Proceedings: The company is not currently involved in any material legal proceedings, nor has it received any threats of such[183] - Unfunded Commitments: As of March 31, 2021, the company had $22,838,727 in unfunded commitments to 22 existing portfolio companies, down from $28,865,202 to 19 companies on December 31, 2020[185] - Liquidity: The company maintains sufficient liquidity through cash on hand and available borrowings under its credit facility to address unfunded loan commitments[185] NOTE 8 — FINANCIAL HIGHLIGHTS Net asset value per share remained stable at $14.03, while net investment income per share decreased to $0.26 from $0.32 year-over-year, but total return based on market value significantly improved to 19.1% from (47.8)%, reflecting recovery from COVID-19 impacts, and the asset coverage ratio increased from 1.87x to 2.03x Financial Highlights | Metric | March 31, 2021 | March 31, 2020 | Change | | :------------------------------------------------- | :------------- | :------------- | :------- | | Net asset value at beginning of period | $14.03 | $14.14 | -0.8% | | Net investment income per share | $0.26 | $0.32 | -18.8% | | Net increase (decrease) in net assets from operations per share | $0.25 | $(2.26) | N/A | | Net asset value at end of period | $14.03 | $11.55 | +21.5% | | Per share market value at end of period | $12.70 | $7.29 | +74.2% | | Total return based on market value | 19.1% | (47.8)% | N/A | | Weighted average shares outstanding | 19,486,003 | 19,429,480 | +0.3% | | Asset coverage ratio | 2.03x | 1.87x | +8.6% | | Annualized ratio of net investment income to net assets | 7.45% | 9.28% | -19.7% | | Portfolio Turnover | 4.91% | 5.14% | -4.5% | NOTE 9 — CREDIT FACILITY The company's senior secured revolving credit facility, with a maximum of $230 million (expandable to $280 million) and maturing on September 18, 2025, had an outstanding balance of $165.5 million as of March 31, 2021, down from $174 million, bearing interest at LIBOR plus 2.50% (or 2.75% under certain conditions) with a 0.25% LIBOR floor, and the company remains compliant with all covenants, including the 1.67:1 asset coverage requirement - Credit Facility Terms: Senior secured revolving credit agreement with a maximum borrowing amount of $230 million, expandable to $280 million, with the commitment period expiring on September 18, 2024, and all borrowings due on September 18, 2025[189] - Interest Rate: Borrowings bear interest at LIBOR plus 2.50% (or 2.75% during certain periods if the asset coverage ratio is less than or equal to 1.90:1.00), with a 0.25% LIBOR floor, and an unfunded commitment fee of 0.50% per annum[192] - Covenants: Includes covenants to maintain minimum liquidity of at least $10 million, an asset coverage ratio of at least 1.67:1, and minimum shareholder equity, all of which the company was in compliance with as of March 31, 2021[193] Credit Facility Outstanding Balance | Metric | March 31, 2021 | December 31, 2020 | Change | | :----------------------------------- | :------------- | :---------------- | :------- | | Outstanding Balance | $165,500,000 | $174,000,000 | -4.9% | | Credit facility payable, net of prepaid loan structure fees | $163,342,988 | $171,728,405 | -4.9% | Credit Facility Interest and Debt | Metric | Three months ended March 31, 2021 | Three months ended March 31, 2020 | | :---------------------------------- | :-------------------------------- | :-------------------------------- | | Total interest and financing expenses | $1,209,600 | $1,993,793 | | Weighted average interest rate | 2.8% | 4.1% | | Effective interest rate | 3.5% | 4.5% | | Average debt outstanding | $140,666,667 | $175,812,088 | NOTE 10 — SBA-GUARANTEED DEBENTURES SBIC subsidiaries (SBIC I and SBIC II) issue SBA-guaranteed debentures, benefiting from an SEC exemption that excludes this debt from the 1940 Act's asset coverage test, with $150 million outstanding for SBIC I and $60 million for SBIC II as of March 31, 2021, these debentures feature fixed rates (10-year Treasury plus market spread) and 10-year terms, with upfront fees amortized over their life - Exemptive Relief: The company obtained SEC exemptive relief allowing SBA-guaranteed debt issued by its SBIC subsidiaries to be excluded from the 1940 Act's asset coverage test, increasing flexibility[198] - Debenture Terms: SBA-guaranteed debentures have fixed interest rates (equal to the prevailing 10-year U.S. Treasury rate plus a market spread), a ten-year maturity, and interest paid semi-annually, with principal not due until maturity but prepayable at any time without penalty, and upfront fees (3.425% or 3.435%) amortized over the debentures' life[199][200] - Regulatory Capital: As of March 31, 2021, the SBIC Subsidiary had $75 million in regulatory capital, and the SBIC II Subsidiary had $60 million in regulatory capital[202] SBA-Guaranteed Debentures Outstanding | Metric | March 31, 2021 | December 31, 2020 | Change | | :----------------------------------- | :------------- | :---------------- | :------- | | Total SBA-guaranteed debentures outstanding | $210,000,000 | $176,500,000 | +18.9% | | SBA Debentures, net of prepaid loan fees | $205,285,585 | $173,167,496 | +18.5% | SBA-Guaranteed Debentures Interest and Debt | Metric | Three months ended March 31, 2021 | Three months ended March 31, 2020 | | :---------------------------------- | :-------------------------------- | :-------------------------------- | | Total interest and financing expenses | $1,619,647 | $1,512,958 | | Weighted average interest rate | 3.0% | 3.3% | | Effective interest rate | 3.5% | 3.8% | | Average debt outstanding | $190,211,111 | $161,000,000 | NOTE 11 — NOTES The company redeemed all $48.875 million of its 5.75% fixed-rate 2022 Notes on February 12, 2021, recognizing a $539,250 loss on debt extinguishment, while simultaneously issuing $100 million of 4.875% fixed-rate 2026 Notes on January 14, 2021, with proceeds used to redeem the 2022 Notes and repay a portion of the credit facility - 2022 Notes Redemption: The company redeemed all $48,875,000 of its 5.75% fixed-rate 2022 Notes on February 12, 2021, resulting in a $539,250 loss on debt extinguishment[209][210] - 2026 Notes Issuance: The company issued $100,000,000 of 4.875% fixed-rate 2026 Notes on January 14, 2021[212] - Use of Proceeds: Net proceeds from the 2026 Notes were used to fully redeem the 2022 Notes and repay a portion of the outstanding amount under the credit facility[213] Notes Interest and Debt | Metric | Three months ended March 31, 2021 | Three months ended March 31, 2020 | | :---------------------------------- | :-------------------------------- | :-------------------------------- | | 2022 Notes: | | | | Total interest and financing expenses | $357,295 | $785,452 | | Loss on debt extinguishment | $539,250 | $0 | | Weighted average interest rate | 5.7% | 5.8% | | Average debt outstanding | $48,875,000 | $48,875,000 | | 2026 Notes: | | | | Total interest and financing expenses | $1,136,936 | $0 | | Weighted average interest rate | 4.9% | 0% | | Average debt outstanding | $100,000,000 | $0 | NOTE 12 — SUBSEQUENT EVENTS Subsequent to March 31, 2021, the company received a $14 million term loan repayment, made new investments totaling $18.3 million in two new portfolio companies (HVAC/plumbing and catalyst products), committed an additional $2.1 million in unfunded revolving credit/delayed draw term loans, increased its credit facility balance to $186 million and SBA debentures to $220 million, made an additional $15 million capital contribution to SBIC II, and declared regular monthly dividends of $0.0833 per share for April, May, and June 2021 - Investment Repayment: On April 22, 2021, the company received a $14 million full repayment of an unsecured term loan from Skopos Financial, LLC[219] - New Investments: On April 26, 2021, the company invested $10.8 million in a first lien term loan and committed $0.1 million in unfunded revolving credit and delayed draw term loans to an HVAC and plumbing design, installation, and service provider[319] On April 28, 2021, the company invested $7.5 million in a first lien term loan and committed $2 million in unfunded revolving credit, along with a $0.8 million equity investment, in Unicat Catalyst, LLC[320] - Credit Facility: As of May 6, 2021, the outstanding balance on the credit facility was $186 million[321] - SBA-Guaranteed Debentures: As of May 6, 2021, the total outstanding balance of SBA-guaranteed debentures was $220 million[322] - SBIC II Subsidiary: On April 13, 2021, the company made an additional $15 million capital contribution to its SBIC II Subsidiary, bringing its total contributed capital to $50 million[323] - Dividend Declaration: On April 19, 2021, the Board of Directors declared regular monthly dividends of $0.0833 per share for April, May, and June 2021[323] Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This section discusses Stellus Capital Investment Corporation's financial condition and operating results as of March 31, 2021, covering the company overview, COVID-19 impact, portfolio composition and activities, asset quality, operating results, financial condition, liquidity and capital resources, off-balance sheet arrangements, RIC status and dividend policy, recent accounting pronouncements, and critical accounting policies Overview Stellus Capital Investment Corporation, established in 2012, is an externally managed BDC and RIC aiming to maximize total returns through debt and equity investments in U.S. middle-market companies, adhering to BDC regulations including maintaining at least 70% qualified assets and RIC tax requirements, with its asset coverage ratio reduced to 150% in 2018 and standing at 203% as of March 31, 2021 - Company Formation: Formed on May 18, 2012, and commenced operations on November 7, 2012[229] - Investment Objective: To maximize total shareholder return through current income and capital appreciation by investing in debt and related equity of middle-market companies[230] - Regulatory Status: Elected to be regulated as a BDC under the 1940 Act and treated as a RIC under Subchapter M of the Code[231] - Qualified Assets: As a BDC, it is required to have at least 70% of its total assets at the time of acquisition as "qualifying assets"[232] - Asset Coverage Ratio: The company's applicable asset coverage ratio was reduced from 200% to 150% on June 28, 2019, following board and shareholder approval, with the ratio standing at 203% as of March 31, 2021[234] COVID-19 Developments The COVID-19 pandemic has significantly impacted the U.S. and global economies, causing widespread market disruptions, and while the company has assessed its investment valuations to reflect these impacts, uncertainties regarding vaccine distribution and economic recovery persist, potentially leading to significant adverse effects on future net investment income, portfolio fair value, and financial condition - Economic Impact: COVID-19 was declared a pandemic on March 11, 2020, causing significant disruptions in global supply chains and economic activity[235] - Valuation Impact: Each portfolio company has been individually assessed, and the pandemic's effects are reflected in investment valuations[236] - Future Uncertainty: The extent of the pandemic's impact on financial performance remains uncertain, depending on the duration, spread, related recommendations and restrictions, and the health of financial markets and the economy, with a prolonged recession potentially having a significant adverse effect on the company's net investment income, fair value of investments, and financial condition[237] Economic outlook The economic outlook remains uncertain due to the evolving COVID-19 pandemic, particularly regarding vaccine distribution and the timeline for achieving "herd immunity," with prolonged self-isolation and reduced economic participation potentially leading to continued adverse economic and market conditions, posing significant risks to the company's business, financial condition, and cash flows - Vaccine Distribution Uncertainty: The pace of vaccine distribution nationally and globally, and when "herd immunity" will be achieved, remains unclear[238] - Prolonged Economic Slowdown: Delays in vaccine distribution could lead to continued self-isolation and prolonged non-participation in economic activity, resulting in a sustained global economic slowdown[238] - Significant Risks: The COVID-19 pandemic presents significant uncertainties and risks to the potential value of portfolio companies and the company's business, financial condition, operating results, and cash flows[238] Operations Since March 16, 2020, Stellus Capital's partners and employees have primarily worked remotely without operational disruption and are prepared to continue remote work as necessary to ensure the health and safety of all personnel - Remote Operations: Since March 16, 2020, Stellus Capital's partners and employees have primarily worked remotely, with no disruption to operations[240] - Preparedness: Partners and employees are prepared to continue remote work as necessary to ensure the health and safety of all personnel[240] Our COVID-19 response Since the pandemic's onset, the company has maintained regular contact with all portfolio companies and their sponsors to assess operational capabilities, liquidity, covenant compliance, and employee/customer health in the new environment, aiming to mitigate COVID-19 impacts - Continuous Monitoring: Regular contact is maintained with all portfolio companies and their sponsors to assess their operational capabilities, liquidity positions, anticipated covenant compliance, and the health of their employees and customers in the new environment[241] - Mitigation Efforts: Ongoing efforts are in place to mitigate the impact of the COVID-19 pandemic[241] Financial impact The company will continue to closely monitor the financial condition of its portfolio companies to mitigate the impact of the COVID-19 pandemic, recognizing that historical financial information may no longer adequately reflect future performance - Continuous Monitoring: The financial condition of portfolio companies will continue to be closely monitored[242] - Historical Data Relevance: Historical information may be relatively less relevant[242] Portfolio Composition and Investment Activity As of March 31, 2021, the investment portfolio's fair value increased to $714.5 million across 70 companies, primarily comprising first lien debt (79%), with key industries including business services, healthcare, and aerospace & defense, unfunded commitments decreased to $22.8 million, and in Q1 2021, the company invested $93.4 million in new and existing portfolio companies while receiving $33.6 million in investment repayments Portfolio Composition | Metric | March 31, 2021 (Fair Value) | December 31, 2020 (Fair Value) | Change | | :----------------------------------- | :---------------------------- | :----------------------------- | :------- | | Total Investments | $714.5 million | $653.4 million | +9.3% | | Number of Portfolio Companies | 70 | 66 | +4 | | Senior Secured – First Lien | 79% | 78% | +1% | | Senior Secured – Second Lien | 9% | 11% | -2% | | Unsecured Debt | 4% | 3% | +1% | | Equity | 8% | 8% | 0% | - Unfunded Commitments: Decreased from $28.9 million (19 companies) on December 31, 2020, to $22.8 million (22 companies) on March 31, 2021[247] - Q1 2021 Investment Activity: Total investments of $93.4 million (3 new companies, 11 existing companies) and investment repayments of $33.6 million[253] - Debt Investment Interest Rates: As of March 31, 2021, and December 31, 2020, 93% of debt investments were at floating rates (subject to interest rate floors), and 7% were at fixed rates[254] - Weighted Average Yield: As of March 31, 2021, the weighted average yield on all debt investments was 8.3%, and approximately 7.8% on all investments, including non-income producing equity positions[256] Asset Quality The company employs a five-tier numerical rating system to monitor the credit quality and expected return levels of its investments, with 92% of the portfolio (by fair value) rated 1 or 2 (performing as expected or better) as of March 31, 2021, and five loans on non-accrual status, representing 5.3% of the loan portfolio at cost and 1.8% at fair value, an increase from three loans on non-accrual as of December 31, 2020 - Investment Rating System: A five-tier numerical rating system (1-5) is used to assess and monitor the credit quality and expected return levels of each investment in the portfolio, where 1 indicates performance exceeding expectations; 2 indicates performance meeting expectations (all new loans are initially rated 2); 3 indicates performance below expectations, requiring close monitoring but no expected loss of return or principal; 4 indicates performance significantly below expectations with substantially increased risk, expecting some loss of return but no principal; and 5 indicates performance significantly below expectations with substantially increased risk, expecting some loss of return and principal[258] - Non-Accrual Loans (March 31, 2021): Five loans were on non-accrual status, representing 5.3% of the loan portfolio at cost and 1.8% at fair value[260] - Non-Accrual Loans (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[262] - Unaccrued Income: Unaccrued income on non-accrual investments was $8.2 million as of March 31, 2021, and $7.1 million as of December 31, 2020[262] Investment Category by Fair Value | Investment Category | March 31, 2021 (Fair Value) | % of Total Portfolio | Number of Portfolio Companies | December 31, 2020 (Fair Value) | % of Total Portfolio | Number of Portfolio Companies | | :------------------ | :---------------------------- | :------------------- | :---------------------------- | :----------------------------- | :------------------- | :---------------------------- | | 1 | $119.4 million | 17% | 14 | $87.3 million | 14% | 12 | | 2 | $538.8 million | 75% | 48 | $496.5 million | 76% | 45 | | 3 | $44.6 million | 6% | 4 | $61.3 million | 9% | 6 | | 4 | $3.6 million | 1% | 1 | $0 | 0% | 0 | | 5 | $8.1 million | 1% | 3 | $8.3 million | 1% | 3 | | Total | $714.5 million | 100% | 70 | $653.4 million | 100% | 66 | Results of Operations Net investment income for Q1 2021 decreased by 19.0% to $5.1 million year-over-year, primarily due to lower LIBOR rates, while total operating expenses remained stable, and the net increase in net assets from operations significantly improved to $4.9 million compared to a $43.9 million decrease in Q1 2020, largely driven by a positive change in unrealized appreciation versus a significant depreciation in the prior year Results of Operations | Metric | Three months ended March 31, 2021 | Three months ended March 31, 2020 | Change | | :------------------------------------------------- | :-------------------------------- | :-------------------------------- | :------- | | Total Investment Income | $14.0 million | $15.3 million | -8.5% | | Total Operating Expenses | $8.9 million | $9.0 million | -1.1% | | Net Investment Income | $5.1 million | $6.2 million | -18.0% | | Net Realized Gain | $0.5 million | $1.3 million | -61.5% | | Net Change in Unrealized Appreciation (Depreciation) | $0.1 million | $(51.5) million | N/A | | Provision for Taxes on Unrealized Appreciation | $(0.2) million | $0.03 million | N/A | | Net Increase (Decrease) in Net Assets from Operations | $4.9 million | $(43.9) million | N/A | - Decrease in Interest Income: Primarily due to lower LIBOR rates and the recognition of previously reserved interest in Q1 2020[266] - Decrease in Operating Expenses: Primarily due to lower income incentive fees, partially offset by an increase in capital gains incentive fees[269] - Change in Unrealized Appreciation: A significant improvement compared to the unrealized depreciation in Q1 2020, which was primarily due to the onset of the COVID-19 pandemic[276][279] Financial condition, liquidity and capital resources The company's liquidity is derived from its credit facility, 2026 Notes, SBA debentures, and operating cash flow, with Q1 2021 operating activities using $57.1 million while financing activities provided $69.0 million, primarily from the issuance of 2026 Notes and SBA debentures, offsetting the redemption of 2022 Notes and credit facility repayments, maintaining a 150% asset coverage ratio (203% as of March 31, 2021) and benefiting from an SEC exemption for SBA debt - Cash Flow (Q1 2021): Operating activities used $57.1 million in net cash; financing activities provided $69.0 million in net cash[280] - Liquidity Sources: Credit facility, 2022 Notes, 2026 Notes, SBA-guaranteed debentures, and cash flow from operations[282] - Capital Raising: Anticipates funding portfolio growth through future public and private equity offerings and senior securities or future borrowings, which may be limited if common stock trades below net asset value per share (equity offerings below NAV require shareholder approval, with current approval expiring June 25, 2021)[283][284] - Asset Coverage Ratio: Stood at 203% as of March 31, 2021, well above the 150% requirement, with the company having obtained SEC exemptive relief to exclude SBA-guaranteed debentures from the asset coverage test[289] - Credit Facility: As of March 31, 2021, the credit facility had an outstanding balance of $165.5 million, with a maximum capacity of $230 million and an incremental feature to increase it to $280 million[292] - SBA-Guaranteed Debentures: As of March 31, 2021, $210 million of SBA-guaranteed debentures were outstanding[293] - 2026 Notes: $100 million of 2026 Notes were issued in January 2021, used to redeem the 2022 Notes and repay a portion of the credit facility[303] Off-Balance Sheet Arrangements As of March 31, 2021, the company's off-balance sheet arrangements included $22.8 million in unfunded commitments to 22 portfolio companies, a decrease from $28.9 million on December 31, 2020, with sufficient liquidity maintained to meet these commitments - Unfunded Commitments: As of March 31, 2021, the company had $22.8 million in unfunded commitments to 22 portfolio companies, down from $28.9 million to 19 companies on December 31, 2020[307] - Liquidity: The company maintains sufficient liquidity through cash on hand and available borrowings under its credit facility to meet unfunded commitments[307] Regulated Investment Company Status and Dividends The company maintains RIC status by distributing at least 90% of its taxable income, thereby avoiding corporate-level federal income tax, with $21.1 million in undistributed taxable income carried forward to 2021, though covenants in the credit facility may restrict dividend distributions, potentially impacting RIC compliance, and the company may retain net taxable capital gains as deemed distributions, allowing shareholders to claim tax credits - RIC Qualification: The company maintains RIC qualification by distributing at least 90% of its investment company net taxable income annually[308] - Undistributed Taxable Income: As of December 31, 2020, the company had $21,051,549 of undistributed taxable income carried forward to 2021[310] - Distribution Restrictions: Covenants in the credit facility may prohibit the company from making distributions to shareholders, potentially hindering its ability to meet distribution requirements[311] - Deemed Distributions: The company may retain a portion of its net taxable capital gains and treat them as deemed distributions to shareholders, who may be eligible for a tax credit equal to the tax paid by the company[314] - Dividend Policy: The company currently has no intention to pay dividends in stock form under U.S. Treasury Regulations or private letter rulings but continuously monitors its liquidity position and the overall economy to assess what is in the best interest of the company and its shareholders[314] Recent Accounting Pronouncements The company refers to Note 1 of the consolidated financial statements for recent accounting pronouncements, including ASU 2020-04 (reference rate reform), and believes these standards will not materially impact the consolidated financial statements upon adoption - ASU 2020-04 (Reference Rate Reform): This standard provides optional practical expedients and exceptions for contracts, hedging relationships, and other transactions affected by reference rate reform, effective through December 31, 2022, which the company did not elect to adopt during the quarter ended March 31, 2021[113][114] - Impact: Management believes that recently issued pronouncements will not have a material impact on the company's consolidated financial statements upon adoption[315] Critical Accounting Policies The company refers to Note 1 of the consolidated financial statements for a description of its critical accounting policies - Reference: Critical accounting policies are described in Note 1 to the consolidated financial statements[316] Subsequent Events Subsequent to March 31, 2021, the company received a $14 million term loan repayment, made new investments totaling $18.3 million in two new portfolio companies (HVAC/plumbing and catalyst products), committed an additional $2.1 million in unfunded revolving credit/delayed draw term loans, increased its credit facility balance to $186 million and SBA debentures to $220 million, made an additional $15 million capital contribution to SBIC II, and declared regular monthly dividends of $0.0833 per share for April, May, and June 2021 - Investment Repayment: On April 22, 2021, the company received a $14 million full repayment of an unsecured term loan from Skopos Financial, LLC[318] - New Investments: On April 26, 2021, the company invested $10.8 million in a first lien term loan and committed $0.1 million in unfunded revolving credit and delayed draw term loans to an HVAC and plumbing design, installation, and service provider[319] On April 28, 2021, the company invested $7.5 million in a first lien term loan and committed $2 million in unfunded revolving credit, along with a $0.8 million equity investment, in Unicat Catalyst, LLC[320] - Credit Facility: As of May 6, 2021, the outstanding balance on the credit facility was $186 million[321] - SBA-Guaranteed Debentures: As of May 6, 2021, the total outstanding balance of SBA-guaranteed debentures was $220 million[322] - SBIC II Subsidiary: On April 13, 2021, the company made an additional $15 million capital contribution to its SBIC II Subsidiary, bringing its total contributed capital to $50 million[323] - Dividend Declaration: On April 19, 2021, the Board of Directors declared regular monthly dividends of $0.0833 per share for April, May, and June 2021[323] Item 3. Quantitative and Qualitative Disclosures About Market Risk The company faces interest rate market risk, with 93% of its loan portfolio at floating rates (subject to LIBOR floors), where a 200 basis point increase in interest rates would annually increase net interest income by $3.5 million, while a 100 basis point increase would decrease it by $0.2 million, primarily due to interest expense impacts, and no hedging activities were undertaken in Q1 2021 or Q1 2020 - Interest Rate Risk Exposure: As of March 31, 2021, and December 31, 2020, 93% of the company's loan portfolio was at floating rates (referencing LIBOR and subject to interest rate floors)[324] - Weighted Average Interest Rate Floor: Stood at 1.19% as of March 31, 2021, and 1.21% as of December 31, 2020[326] - Hedging Activities: No hedging activities were undertaken during the three months ended March 31, 2021, or March 31, 2020[326] Annual Impact on Net Interest Income | Change in Basis Points | Annual Impact on Net Interest Income ($ in millions) | | :------------------- | :------------------------------------------------- | | Up 200 | $3.5 | | Up 150 | $1.3 | | Up 100 | $(0.2) | | Up 50 | $(0.3) | | Down 25 | $0.0 | Item 4. Controls and Procedures The CEO and CFO affirm the effectiveness of the company's disclosure controls and procedures as of March 31, 2021, with no material changes to internal controls over financial reporting identified during the quarter - Disclosure Controls: The Chief Executive Officer and Chief Financial Officer concluded that the company's disclosure controls and procedures were effective as of March 31, 2021[327] - Internal Controls over Financial Reporting: No changes in internal control over financial reporting that materially affected, or are reasonably likely to materially affect, the company's internal control over financial reporting were identified during the quarter ended March 31, 2021[328] PART II. OTHER INFORMATION Item 1. Legal Proceedings The company is not currently involved in any material legal proceedings, nor has it received any threats of such, and routine legal actions that may arise in the ordinary course of business are not expected to materially impact its financial condition or operating results - Current Status: The company is not currently involved in any material legal proceedings, nor has it received any threats of such[330] - Expected Impact: Routine legal actions that may arise in the ordinary course of business are not expected to materially impact the company's financial condition or operating results[330] Item 1A. Risk Factors No material changes have occurred in the risk factors disclosed in the company's annual report on Form 10-K for December 31, 2020, beyond the information provided in this report - No Material Changes: No material changes have occurred in the risk factors disclosed in the company's annual report on Form 10-K for December 31, 2020, beyond the information provided in this report[331] Item 2. Unregistered Sales of Equity Securities and Use of Proceeds For the three months ended March 31, 2021, the company did not issue any shares through its dividend reinvestment plan (DRIP), whereas in the prior year period, 9,910 shares of common stock were issued under DRIP, totaling approximately $135,472 - Q1 2021 DRIP: No shares were issued through the dividend reinvestment plan (DRIP)[332] - Q1 2020 DRIP: 9,910 shares of common stock were issued through the DRIP, totaling approximately $135,472[332] Item 3. Defaults Upon Senior Securities This item is not applicable for the reporting period - Status: Not applicable[333] Item 4. Mine Safety Disclosures This item is not applicable for the reporting period - Status: Not applicable[333] Item 5. Other Information No other information is disclosed for this reporting period - Status: None[334] Item 6. Exhibits This report includes certifications from the Chief Executive Officer and Chief Financial Officer as exhibits - Exhibits: Includes certifications from the Chief Executive Officer and Chief Financial Officer (31.1, 31.2, 32.1, 32.2) filed with this report[335]