Item 7. Management’s Discussion and Analysis
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following analysis of our financial condition and results of operations should be read in conjunction with our accompanying Consolidated Financial Statements and the notes thereto contained elsewhere in this Annual Report. Historical financial condition and results of operations and percentage relationships among any amounts in the financial statements are not necessarily indicative of financial condition, results of operations or percentage relationships for any future periods. Except per share amounts, dollar amounts included herein are in thousands unless otherwise indicated.
OVERVIEW
General
We were incorporated under the General Corporation Law of the State of Delaware on February 18, 2005. On June 22, 2005, we completed our initial public offering and commenced operations. We operate as an externally managed, closed-end, non-diversified management investment company and have elected to be treated as a BDC under the 1940 Act. For U.S. federal income tax purposes, we have elected to be treated as a RIC under Subchapter M of the Code. To continue to qualify as a RIC for U.S. federal income tax purposes and obtain favorable RIC tax treatment, we must meet certain requirements, including certain minimum distribution requirements.
We were established for the purpose of investing in debt and equity securities of established private businesses operating in the U.S. Our investment objectives are to: (i) achieve and grow current income by investing in debt securities of established businesses that we believe will provide stable earnings and cash flow to pay expenses, make principal and interest payments on our outstanding indebtedness, and make distributions to our stockholders that grow over time; and (ii) provide our stockholders with long-term capital appreciation in the value of our assets by investing in equity securities of established businesses, generally, in combination with the aforementioned debt securities, that we believe can grow over time to permit us to sell our equity investments for capital gains. To achieve our objectives, our investment strategy is to invest in several categories of debt and equity securities, with individual investments generally totaling up to $75 million, although investment size may vary, depending upon our total assets or available capital at the time of investment. We expect that our investment portfolio over time will consist of approximately 75% in debt securities and 25% in equity securities, at cost. As of March 31, 2023, our investment portfolio was comprised of 77.1% in debt securities and 22.9% in equity securities, at cost.
We focus on investing in Lower Middle Market businesses in the U.S. that meet certain criteria, including: the sustainability of the business’ free cash flow and its ability to grow it over time, adequate assets for loan collateral, experienced management teams with a significant ownership interest in the portfolio company, reasonable capitalization of the portfolio company, including an ample equity contribution or cushion based on prevailing enterprise valuation multiples, and the potential to realize appreciation and gain liquidity in our equity position, if any. We anticipate that liquidity in our equity position will be achieved through a merger or acquisition of the portfolio company, a public offering of the portfolio company’s stock or, to a lesser extent, by exercising our right to require the portfolio company to repurchase our warrants, though there can be no assurance that we will always have these rights. We invest in portfolio companies that need funds for management buyouts and/or growth capital to finance acquisitions, recapitalize or, to a lesser extent, refinance their existing debt facilities. We seek to avoid investing in high-risk, early-stage enterprises.
We invest by ourselves or jointly with other funds and/or management of the portfolio company, depending on the opportunity, and have opportunistically made several co-investments with Gladstone Capital pursuant to the Co-Investment Order. We believe the Co-Investment Order has enhanced and will continue to enhance our ability to further our investment objectives and strategies. If we are participating in an investment with one or more co-investors, whether or not an affiliate of ours, our investment is likely to be smaller than if we were investing alone.
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Business
Portfolio Activity
While the business environment remains competitive, we continue to see new investment opportunities consistent with our investment strategy of providing a combination of debt and equity in support of management and independent sponsor-led buyouts of Lower Middle Market companies in the U.S. During the year ended March 31, 2023, we invested in one new portfolio company and exited two portfolio companies. From our initial public offering in June 2005 through March 31, 2023, we invested in 56 companies, excluding investments in syndicated loans, for a total of approximately $1.6 billion, before giving effect to principal repayments and divestitures.
The majority of the debt securities in our portfolio have a success fee component, which enhances the yield on our debt investments. Unlike PIK income, we generally do not recognize success fees as income until payment has been received. Due to the contingent nature of success fees, there are no guarantees that we will be able to collect any or all of these success fees or know the timing of any such collections. As a result, as of March 31, 2023, we had unrecognized, contractual success fees of $53.6 million, or $1.60 per common share. Consistent with GAAP, we generally have not recognized success fee receivables and related income in our accompanying Consolidated Financial Statements until earned.
From inception through March 31, 2023 , we exited our investments in 29 portfolio companies that we acquired under our buyout strategy (which excludes investments in syndicated loans). In the aggregate, these sales have generated $260.2 million in net realized gains and $40.4 million in other income upon exit, for a total increase to our net assets of $300.7 million. We believe, in aggregate, these transactions were equity-oriented investment successes and exemplify our investment strategy of striving to achieve returns through current income on the debt portion of our investments and capital gains from the equity portion. The 29 liquidity events have offset any realized losses since inception, which were primarily incurred during the 2008-2009 recession in connection with the sale of performing syndicated loans at a realized loss to pay off a former lender. The successful exits, in part, enabled us to increase the monthly distribution by 100.0% from March 2011 through March 31, 2023 and allowed us to declare and pay 18 supplemental distributions to common stockholders through March 31, 2023 .
Capital Raising Efforts
We have been able to meet our capital needs through extensions of and increases to the Credit Facility and by accessing the capital markets in the form of public offerings of unsecured notes, as well as common and preferred stock. We have successfully extended the Credit Facility’s revolving period multiple times, most recently to February 2024, and currently have a total commitment amount of $180.0 million (with a potential total commitment of $300.0 million through additional commitments from new or existing lenders). During the year ended March 31, 2023, we sold 386,482 shares of our common stock under our "at-the-market" program (the "Common Stock ATM Program") for gross proceeds of approximately $5.5 million. During the year ended March 31, 2022, we issued our 2028 Notes for gross proceeds of $134.6 million. Refer to “ Liquidity and Capital Resources.”
Although we have been able to access the capital markets historically, market conditions may continue to affect the trading price of our common stock and thus our ability to finance new investments through the issuance of common equity. On March 31, 2023, the closing market price of our common stock was $ 13.25 per share, representing a 1.2 % premium to our NAV of $ 13.09 per share as of March 31, 2023. When our common stock trades below NAV, our ability to issue additional equity is constrained by provisions of the 1940 Act, which generally prohibits the issuance and sale of our common stock at an issuance price below the then current NAV per share without stockholder approval, other than through sales to our then existing stockholders pursuant to a rights offering.
Regulatory Compliance
Our ability to seek external debt financing, to the extent that it is available under current market conditions, is further subject to the asset coverage limitations of the 1940 Act, which require us to have asset coverage (as defined in Sections 18 and 61 of the 1940 Act) of at least 150% on each of our senior securities representing indebtedness and our senior securities that are stock (such as our previously outstanding series of term preferred stock).
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On April 10, 2018, our Board of Directors, including a “required majority” (as such term is defined in Section 57(o) of the 1940 Act) thereof, approved the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. As a result, our asset coverage requirements for senior securities changed from 200% to 150%, effective as of April 10, 2019, one year after the date of the Board of Directors’ approval.
As of March 31, 2023, our asset coverage ratio on our senior securities representing indebtedness was 244.7%.
Investment Highlights
Investment Activity
During the fiscal year ended March 31, 2023, the following significant transactions occurred:
• In May 2022, we invested an additional $6.4 million in the form of secured first lien debt in Nocturne to fund an add-on acquisition.
• In June 2022, we exited our investment in Bassett Creek Services, Inc. ("Bassett Creek"), which resulted in success fee income of $3.0 million and a realized gain on preferred equity of $4.7 million. In connection with the sale, we received net cash proceeds of $57.6 million, including the repayment of our debt investment of $48.0 million at par.
• In June 2022, we invested $21.0 million in a new portfolio company, Dema/Mai, in the form of preferred equity to acquire Mai Mechanical, LLC, a leading provider of plumbing and mechanical services focused on multi-family residential construction headquartered in Denver, Colorado, from J.R. Hobbs Co. - Atlanta, LLC ("J.R. Hobbs"), an existing portfolio company. In July 2022, we invested an additional $39.1 million in the form of secured first lien debt in Dema/Mai to fund the acquisition of Dema Plumbing, a plumbing and mechanical systems installation and service provider to single-family residential homebuilders.
• In July 2022, we recapitalized our investment in Horizon and invested an additional $30.0 million in the form of secured first lien debt. In connection with this investment, we received equity proceeds of $12.3 million, which were recognized as a $10.1 million return of preferred equity cost basis and a realized gain of $2.2 million, as well as dividend income of $3.1 million and success fee income of $1.7 million.
• In August 2022, in conjunction with a refinancing at Ginsey, our $13.3 million secured second lien debt investment was reduced to $12.2 million and converted to secured first lien debt. The reduction in our cost basis was the result of a $5.1 million payment made by Ginsey to extinguish our secured borrowing liability, which was partially offset by an additional investment in Ginsey of $4.0 million.
• In October 2022, we invested an additional $8.4 million in the form of secured first lien debt in Nocturne to fund an add-on acquisition.
• In November 2022, our $1.5 million secured second lien debt investment in Country Club Enterprises, LLC ("CCE") was repaid at par. In connection with the repayment, we received success fee income of $1.1 million and our $1.0 million guaranty was released.
• In December 2022, we recapitalized our investment in Old World and invested an additional $15.5 million in the form of secured first lien debt. In connection with this investment, we received proceeds of $17.9 million, of which $13.4 million was recognized as a realized gain and $4.5 million was recognized as dividend income.
• In December 2022, we replaced our previously outstanding secured second lien term loan and secured second lien delayed draw term loan to The Mountain with a total aggregate cost basis of $13.2 million with a new $3.2 million secured second lien term loan, which resulted in a realized loss of $10.0 million.
• In February 2023, we replaced our two previously outstanding secured first lien revolving lines of credit to The Mountain with an aggregate cost basis of $4.3 million with a new secured first lien revolving line of credit with a $4.7 million commitment.
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Recent Developments
Distributions and Dividends
In April 2023, our Board of Directors declared the following monthly and supplemental cash distributions to common stockholders:
Record Date Payment Date Distribution per Common Share
April 21, 2023 April 28, 2023 $ 0.080
May 23, 2023 May 31, 2023 0.080
June 5, 2023 June 15, 2023 0.120 (A)
June 21, 2023 June 30, 2023 0.080
Total for the Quarter: $ 0.360
(A) Represents a supplemental distribution to common stockholders.
LIBOR Transition
In general, our investments in debt securities have a term of five years, accrue interest at variable rates (based on the one-month LIBOR) and, to a lesser extent, at fixed rates. Most U.S. dollar LIBOR are currently anticipated to be phased out in June 2023. We have amended all outstanding loan agreements with our portfolio companies to include fallback language providing a mechanism for the parties to negotiate a new reference interest rate in the event that LIBOR ceases to exist . Assuming that SOFR replaces LIBOR and is appropriately adjusted to equate to one-month LIBOR, we expect that there should be minimal impact on our operations. Subsequent to March 31, 2023, certain of our existing investments have been transitioned from LIBOR to SOFR.
Revolving Line of Credit
On April 10, 2023, we, through Business Investment, entered into Amendment No. 7 to the Fifth Amended and Restated Credit Agreement, originally entered into on April 30, 2013, with KeyBank National Association (“KeyBank”) as administrative agent, lead arranger, managing agent and lender, the Adviser, as servicer, and certain other lenders party thereto, to update the reference rate from LIBOR to Term SOFR plus an 11 basis point credit spread adjustment.
Impact of Inflation
We believe the effects of inflation, on our historical results of operations and financial condition have not been significant. During the fiscal year ended March 31, 2023, general inflationary pressures and certain commodity price volatility have impacted our portfolio companies to varying degrees; however, the broad based impact of these pricing changes have largely been mitigated by price adjustments without adverse sales implications, and thus, have not materially impacted our portfolio companies’ ability to service their indebtedness, including our loans. Notwithstanding the results to date, we do expect that the cumulative effect of these inflationary pressures may impact the profit margins or sales of certain portfolio companies and their ability to service their debts. We continue to monitor the current inflationary environment to anticipate any impact on our portfolio companies including their availability to pay interest on our loans. We cannot assure you that our results of operations and financial condition or that of our portfolio companies will not be materially impacted by inflation in the future. Refer to “Risk Factors — Risks Related to the Economy — We may experience fluctuations in our quarterly and annual results based on the impact of inflation in the U.S.”
Director Activity
Terry Lee Brubaker resigned from our Board of Directors, effective April 14, 2023. Mr. Brubaker's resignation was not a result of any disagreement with the Company on any matters relating to the Company's operations, policies, or practices.
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RESULTS OF OPERATIONS
Comparison of the Fiscal Year Ended March 31, 2023 to the Fiscal Year Ended March 31, 2022
For the Fiscal Years Ended March 31,
2023 2022 $ Change % Change
INVESTMENT INCOME
Interest income $ 60,276 $ 59,649 $ 627 1.1 %
Dividend and success fee income 21,267 12,903 8,364 64.8 %
Total investment income 81,543 72,552 8,991 12.4 %
EXPENSES
Base management fee 14,798 14,113 685 4.9 %
Loan servicing fee 7,880 7,178 702 9.8 %
Incentive fee 8,880 26,360 (17,480) (66.3) %
Administration fee 1,811 1,806 5 0.3 %
Interest and dividend expense 15,877 15,384 493 3.2 %
Amortization of deferred financing costs and discounts 1,802 1,803 (1) (0.1) %
Other 5,186 4,593 593 12.9 %
Expenses before credits from Adviser 56,234 71,237 (15,003) (21.1) %
Credits to fees from Adviser (11,691) (13,675) 1,984 (14.5) %
Total expenses, net of credits to fees 44,543 57,562 (13,019) (22.6) %
NET INVESTMENT INCOME 37,000 14,990 22,010 146.8 %
REALIZED AND UNREALIZED GAIN (LOSS), NET OF TAXES
Net realized gain on investments 10,753 14,442 (3,689) (25.5) %
Net realized loss on other — (1,998) 1,998 100.0 %
Net unrealized (depreciation) appreciation of investments (12,235) 74,882 (87,117) (116.3) %
Net unrealized depreciation of other 29 — 29 NM
Net realized and unrealized (loss) gain, net of taxes on deemed distribution of long-term capital gains (1,453) 87,326 (88,779) (101.7) %
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS $ 35,547 $ 102,316 $ (66,769) (65.3) %
WEIGHTED-AVERAGE SHARES OF COMMON STOCK OUTSTANDING
Basic and diluted 33,311,785 33,205,023 106,762 0.3 %
BASIC AND DILUTED PER COMMON SHARE:
Net investment income $ 1.11 $ 0.45 $ 0.66 146.7 %
Net increase in net assets resulting from operations $ 1.07 $ 3.08 $ (2.01) (65.3) %
NM = Not Meaningful
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Investment Income
Total investment income increased by 12.4% for the year ended March 31, 2023, as compared to the prior year. This increase was primarily due to an increase in dividend and success fee income, as well as an increase in interest income.
Interest income from our investments in debt securities increased 1.1% for the year ended March 31, 2023, as compared to the prior year . Excluding the collection of $7.3 million of past due interest during the year ended March 31, 2022 from certain loans that were previously on non-accrual status, of which no such collection took place in the current fiscal year, interest income from our investments in debt securities would have increased 14.9% for the year ended March 31, 2023, as compared to the prior year. Generally, the level of interest income from investments is directly related to the principal balance of our interest-bearing investment portfolio outstanding during the period, multiplied by the weighted-average yield.
The weighted-average principal balance of our interest-bearing investment portfolio during the year ended March 31, 2023 was $464.4 million, compared to $442.8 million during the prior year. This increase was primarily due to the origination of $60.7 million of new debt investments, $118.3 million of follow-on debt investments to existing portfolio companies, and $14.9 million of loans placed back on accrual status, partially offset by the pay-off, restructuring, or write-off of $108.8 million of debt investments and $73.4 million of existing loans placed on non-accrual status after March 31, 2021, and their respective impact on the weighted-average principal balance when considering the timing of new investments, pay-offs, restructurings, write-offs, and accrual status changes, as applicable.
The weighted-average yield on our interest-bearing investments, excluding cash and cash equivalents and receipts recorded as other income, was 13.0% and 13.5% for the years ended March 31, 2023 and 2022, respectively. The weighted-average yield may vary from period to period, based on the current stated interest rate on interest-bearing investments, coupled with any collection of past due interest during the period. During the year ended March 31, 2023, we had no collections of past due interest. During the year ended March 31, 2022, we collected $7.3 million in past due interest from portfolio companies that were previously on non-accrual status, including $3.4 million from Horizon, $2.8 million from B+T Group Acquisition, Inc. (“B+T”), $1.0 million from SOG Speciality Knives & Tools, LLC and $0.1 million from PSI Molded Plastics, Inc. Excluding this collection of past due interest, the weighted-average yield on our interest-bearing investments, excluding cash and cash equivalents and receipts recorded as other income, for the year ended March 31, 2022 would have been 11.8%.
As of March 31, 2023, our loans to Edge Adhesives Holdings, Inc. ("Edge"), J.R. Hobbs, and The Mountain were on non-accrual status, with an aggregate debt cost basis of $66.9 million. As of March 31, 2022, our loans to J.R. Hobbs, The Mountain, and SFEG Holdings, Inc. ("SFEG") were on non-accrual status, with an aggregate debt cost basis of $77.2 million.
Dividend and success fee income for the year ended March 31, 2023 increased 64.8% from the prior year. During the year ended March 31, 2023, dividend and success fee income consisted of $10.9 million of dividend income and $10.4 million of success fee income. During the year ended March 31, 2022, dividend and success fee income consisted of $10.3 million of success fee income and $2.6 million of dividend income.
As of March 31, 2023 and 2022, no single investment represented greater than 10% of our total investment portfolio at fair value.
Expenses
Total expenses, net of any non-contractual, unconditional, and irrevocable credits from the Adviser, decreased 22.6% for the year ended March 31, 2023, as compared to the prior year, primarily due to a decrease in the capital gains-based incentive fee, partially offset by a decrease in credits to fees from Adviser, an increase in income-based incentive fee, base management fee, and interest and dividend expense.
In accordance with GAAP, we recorded a reversal of capital gains-based incentive fee of $0.3 million during the year ended March 31, 2023, compared to a capital gains-based incentive fee of $18.3 million during the year ended March 31, 2022. The capital gains-based incentive fee is a result of the net impact of net realized gains (losses) and net unrealized appreciation (depreciation) on investments during the respective periods. The income-based incentive fee increased during the year ended March 31, 2023, as compared to the prior year, as the increase in pre-incentive fee net investment income more than offset the increase in net assets, which drives the hurdle rate.
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The base management fee, loan servicing fee, incentive fee, and their related non-contractual, unconditional, and irrevocable credits are computed quarterly, as described under “ Transactions with the Adviser ” in Note 4 – Related Party Transactions in the accompanying Notes to Consolidated Financial Statements and are summarized in the following table:
Year Ended March 31,
2023 2022
Average total assets subject to base management fee (A)
$ 739,900 $ 705,650
Multiplied by annual base management fee of 2.0%
2.0 % 2.0 %
Base management fee (B)
14,798 14,113
Credits to fees from Adviser - other (B)
(3,811) (6,497)
Net base management fee
$ 10,987 $ 7,616
Loan servicing fee (B)
$ 7,880 $ 7,178
Credits to base management fee - loan servicing fee (B)
(7,880) (7,178)
Net loan servicing fee $ — $ —
Incentive fee – income-based $ 9,176 $ 8,074
Incentive fee – capital gains-based (C)
(296) 18,286
Total incentive fee (B)
8,880 26,360
Credits to fees from Adviser - other (B)
— —
Net total incentive fee $ 8,880 $ 26,360
(A) Average total assets subject to the base management fee is defined in the Advisory Agreement as total assets, including investments made with proceeds of borrowings, less any uninvested cash or cash equivalents resulting from borrowings, valued at the end of the applicable quarters within the respective periods and adjusted appropriately for any share issuances or repurchases during the periods.
(B) Reflected as a line item on our accompanying Consolidated Statement of Operations .
(C) The capital gains-based incentive fees are recorded in accordance with GAAP and do not necessarily reflect amounts contractually due under the terms of the Advisory Agreement.
Interest and dividend expense increased 3.2% during the year ended March 31, 2023, as compared to the prior year, primarily due to the issuance of the 2028 Notes in August 2021 and an increase in LIBOR, partially offset by the redemption of our then outstanding 6.375% Series E Cumulative Term Preferred Stock ("Series E Term Preferred Stock") and a lower weighted-average balance outstanding on the Credit Facility during the year ended March 31, 2023. The weighted-average balance outstanding on the Credit Facility during the year ended March 31, 2023 was $16.2 million, as compared to $18.1 million in the prior year. The effective interest rate on the Credit Facility, excluding the impact of deferred financing costs, during the year ended March 31, 2023 was 17.3%, as compared to 12.5% in the prior year. This increase in the effective interest rate on the Credit Facility was primarily a result of the increase in LIBOR as well as the unused commitment fee on the higher undrawn portion of the Credit Facility.
Other expenses increased 12.9% during the year ended March 31, 2023, as compared to the prior year, primarily due to an increase in tax expense and professional expenses, partially offset by a decrease in bad debt expense.
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Realized and Unrealized Gain (Loss), net of Taxes
The realized gains (losses) and unrealized appreciation (depreciation) across our investments for the years ended March 31, 2023 and 2022 were as follows:
Year Ended March 31, 2023
Portfolio Company Realized
Gain (Loss) on Investments Unrealized
Appreciation
(Depreciation) Reversal of
Unrealized
(Appreciation)
Depreciation Net Gain
(Loss)
Nth Degree Investment Group, LLC $ — $ 14,732 $ — $ 14,732
Brunswick Bowling Products, Inc. — 12,484 — 12,484
Old World Christmas, Inc. 13,371 (3,852) — 9,519
Horizon Facilities Services, Inc. 2,218 4,618 — 6,836
Nocturne Luxury Villas, Inc. — 6,040 — 6,040
SFEG Holdings, Inc. — 5,485 — 5,485
Mason West, LLC — 3,387 — 3,387
Counsel Press, Inc. — 2,511 — 2,511
Utah Pacific Bridge & Steel, Ltd. — 1,748 — 1,748
Dema/Mai Holdings, Inc. — 1,321 — 1,321
Schylling, Inc. — 1,102 — 1,102
PSI Molded Plastics, Inc. — (1,726) — (1,726)
Educators Resource, Inc. — (1,807) — (1,807)
Galaxy Technologies Holdings, Inc. — (3,481) — (3,481)
Ginsey Home Solutions, Inc. — (4,787) — (4,787)
Edge Adhesives Holdings, Inc. — (4,817) — (4,817)
ImageWorks Display and Marketing Group, Inc. — (5,479) — (5,479)
The Mountain Corporation (10,000) (5,590) 10,000 (5,590)
Bassett Creek Services, Inc. 5,188 — (12,250) (7,062)
B+T Group Acquisition, Inc. — (13,480) — (13,480)
J.R. Hobbs Co. - Atlanta, LLC — (18,510) — (18,510)
Other, net (<$1.0 million, net ) (24) 130 (14) 92
Total $ 10,753 $ (9,971) $ (2,264) $ (1,482)
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Year Ended March 31, 2022
Portfolio Company Realized
Gain (Loss) on Investments Unrealized
Appreciation
(Depreciation) Reversal of
Unrealized
(Appreciation)
Depreciation Net Gain
(Loss)
Brunswick Bowling Products, Inc. $ — $ 20,470 $ — $ 20,470
Bassett Creek Services, Inc. — 17,994 — 17,994
Old World Christmas, Inc. — 17,594 — 17,594
B+T Group Acquisition, Inc. — 16,885 — 16,885
Horizon Facilities Services, Inc. — 14,144 — 14,144
Schylling, Inc. — 9,883 — 9,883
SOG Specialty Knives & Tools, LLC — 8,197 — 8,197
Educators Resource, Inc. — 8,058 — 8,058
ImageWorks Display and Marketing Group, Inc. — 6,586 — 6,586
Counsel Press, Inc. — 4,027 — 4,027
PSI Molded Plastics, Inc. — 3,633 — 3,633
Nocturne Luxury Villas, Inc. — 3,623 — 3,623
Head Country, Inc. 3,627 — (2,469) 1,158
Channel Technologies Group, LLC (1,841) — 1,841 —
The Maids International, LLC — (881) — (881)
The Mountain Corporation — (1,045) — (1,045)
Mason West, LLC — (2,221) — (2,221)
Pioneer Square Brands, Inc. 21,939 (1,245) (25,425) (4,731)
Ginsey Home Solutions, Inc. — (5,287) — (5,287)
SFEG Holdings, Inc. (A)
— (5,376) — (5,376)
Galaxy Technologies Holdings, Inc. (B)
— (9,587) — (9,587)
J.R. Hobbs Co. - Atlanta, LLC (10,000) (4,709) 800 (13,909)
Other, net (<$1.0 million, net ) 717 (661) 53 109
Total $ 14,442 $ 100,082 $ (25,200) $ 89,324
(A) In January 2022, SBS Industries Holdings, Inc. was renamed SFEG Holdings, Inc.
(B) In conjunction with the September 2021 merger of Danco and Galaxy into the newly formed Galaxy Technologies Holdings, total unrealized depreciation for the year ended March 31, 2022 includes the net unrealized appreciation (depreciation) for Danco and Galaxy prior to the merger.
Net Realized Gain (Loss) on Investments
During the year ended March 31, 2023, we recorded net realized gains on investments of $10.8 million, primarily due to a $13.4 million realized gain from the recapitalization of Old World, $5.2 million of realized gains from the exit of Bassett Creek, and a $2.2 million realized gain from the recapitalization of Horizon. These amounts were partially offset by the $10.0 million realized loss recognized in conjunction with the replacement of our existing investment in The Mountain. During the year ended March 31, 2022, we recorded net realized gains on investments of $14.4 million, primarily due to a $21.9 million realized gain from the exit of Pioneer Square Brands, Inc., a $3.6 million realized gain from the exit of Head Country, Inc. and $0.7 million in realized gains related to prior period exits, partially offset by a $10.0 million realized loss recognized on the restructuring of the first lien term loan to J.R. Hobbs and a $1.8 million realized loss from the dissolution of Channel Technologies Group, LLC.
Net Realized Gain (Loss) on Other
During the year ended March 31, 2023, there were no realized gains or losses on other. During the year ended March 31, 2022, we recorded a net realized loss on other of $2.0 million which primarily related to unamortized deferred issuance costs written off upon the redemption of our then outstanding Series E Term Preferred Stock in August 2021.
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Net Unrealized Appreciation (Depreciation) of Investments
Net unrealized depreciation of investments of $12.2 million for the year ended March 31, 2023 was primarily due to the net unrealized depreciation across our portfolio, as well as the reversal of unrealized appreciation of our investment in Bassett Creek upon its exit, partially offset by the reversal of unrealized depreciation of our investment in The Mountain upon the replacement of our existing investment. The net depreciation was driven primarily by decreased performance of certain of our other portfolio companies and decreased comparable transaction multiples used to estimate the fair value of certain of our portfolio companies. These decreases were partially offset by increased performance of certain of our portfolio companies, driven partially by the reversal of the impact of COVID-19 on certain of our portfolio companies and the markets in which they operate.
Net unrealized appreciation of investments of $74.9 million for the year ended March 31, 2022 was primarily due to increased performance of certain of our portfolio companies, driven partially by the reversal of the impact of COVID-19 on certain of our portfolio companies and the markets in which they operate, increased comparable multiples used to estimate the fair value of certain of our portfolio companies and the reversal of previously recorded unrealized depreciation of our investments in CTG upon its dissolution. These amounts were partially offset by the reversal of previously recorded unrealized appreciation of our investment in Pioneer and Head Country upon exit and the decreased performance of certain of our portfolio companies. In part, the performance of certain of our portfolio companies was driven by the impact COVID-19, and its variants, has had or is expected to have on our portfolio companies and the markets in which they operate, including government restrictions on the portfolio companies’ ability to operate under historical conditions, current and future shutdowns and reopening restrictions, operating challenges, including but not limited to, labor shortages, supply chain delays, increased material costs and demand for their products, and general economic outlook, or the reversal of such impact towards pre-COVID-19 levels.
Across our entire investment portfolio, we recorded $24.8 million of net unrealized depreciation on our debt investments and $12.6 million of net unrealized appreciation on our equity investments for the year ended March 31, 2023. At March 31, 2023, the fair value of our investment portfolio was more than our cost basis by $32.9 million, compared to March 31, 2022, when the fair value of our investment portfolio was more than our cost basis by $45.1 million. This resulted in net unrealized depreciation of $12.2 million for the year ended March 31, 2023. Our entire portfolio was fair valued at 104.6% of cost as of March 31, 2023.
The comparison of the fiscal year ended March 31, 2022 to the fiscal year ended March 31, 2021 can be found in our Annual Report on Form 10-K for the fiscal year ended March 31, 2022 located within Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations .
LIQUIDITY AND CAPITAL RESOURCES
Operating Activities
Cash inflows from operating activities are primarily generated from cash collections of interest and other income from our portfolio companies, as well as from cash proceeds received from repayments of debt investments and from sales of equity investments. These cash collections are principally used to fund new investments, pay distributions to our common stockholders, make interest payments on our Credit Facility, 2026 Notes and 2028 Notes, pay management and incentive fees to the Adviser and other operating expenses. We may also use cash inflows from operating activities to repay outstanding borrowings under the Credit Facility.
Net cash used in operating activities for the year ended March 31, 2023 was $4.5 million, as compared to net cash provided by operating activities of $36.6 million for the year ended March 31, 2022. This change was primarily due to an increase in purchases of investments, partially offset by decreases in net proceeds from the sale of investments and principal repayments of investments. Purchases of investments totaled $133.8 million during the year ended March 31, 2023, compared to $92.7 million during the year ended March 31, 2022. Net proceeds from the sale of investments and principal repayments of investments totaled $87.8 million during the year ended March 31, 2023, compared to $101.4 million during the year ended March 31, 2022.
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Net cash provided by operating activities for the year ended March 31, 2022 was $36.6 million , as compared to net cash used in operating activities of $29.7 million for the year ended March 31, 2021. This change was primarily due to increases in principal repayments of investments and net proceeds from the sale of investments and a decline in purchase of new investments. Purchases of investments totaled $92.7 million during the year ended March 31, 2022 , compared to $95.3 million during the year ended March 31, 2021. Repayments and net proceeds from the sale of investments totaled $101.4 million during the year ended March 31, 2022 , compared to $51.8 million during the year ended March 31, 2021.
As of March 31, 2023, we had equity investments in, or loans to, 25 companies with an aggregate cost basis of $720.6 million. As of March 31, 2022, we had equity investments in, or loans to, 26 companies with an aggregate cost basis of $669.2 million. The following table summarizes our total portfolio investment activity for the years ended March 31, 2023 and 2022:
Years Ended March 31,
2023 2022
Beginning investment portfolio, at fair value $ 714,396 $ 633,829
New investments 60,050 34,200
Disbursements to existing portfolio companies 73,706 58,538
Unscheduled principal repayments (A)
(57,398) (51,398)
Net proceeds from sales of investments (35,533) (49,419)
Net realized gain on investments 10,545 13,746
Net unrealized appreciation (depreciation) of investments (9,971) 100,083
Reversal of net unrealized appreciation of investments (2,264) (25,201)
Amortization of premiums, discounts, and acquisition costs, net 12 18
Ending investment portfolio, at fair value $ 753,543 $ 714,396
(A) The year ended March 31, 2023 includes $5.1 million of non-cash principal repayments related to the August 2022 refinancing at Ginsey.
The following table summarizes the contractual principal repayment and maturity of our investment portfolio by fiscal year, assuming no voluntary prepayments, as of March 31, 2023:
Amount
For the fiscal years ending March 31:
2024 $ 81,218
2025 89,614
2026 202,419
2027 144,096
2028 38,250
Thereafter —
Total contractual repayments $ 555,597
Investments in equity securities 165,033
Total cost basis of investments held as of March 31, 2023: $ 720,630
Financing Activities
Net cash used in financing activities for the year ended March 31, 2023 was $6.7 million, which consisted primarily of $47.1 million in distributions to common stockholders and $0.3 million of deferred financing and offering costs, partially offset by $35.2 million of net borrowings on our Credit Facility and $5.4 million of proceeds from the issuance of common stock under the Common Stock ATM Program, net of discounts, commissions, and offering costs.
Net cash used in financing activities for the year ended March 31, 2022 was $24.5 million, which consisted primarily of the redemption of our Series E Term Preferred Stock of $94.4 million, $38.9 million in distributions to common stockholders, $22.4 million of net repayments on our Credit Facility, and $3.4 million of deferred financing and offering costs, partially offset by $134.6 million in gross proceeds from the issuance of our 2028 Notes.
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Distributions and Dividends to Stockholders
Common Stock Distributions
To qualify to be taxed as a RIC and thus avoid corporate level federal income tax on the income we distribute to our stockholders, we are required, among other requirements, to distribute to our stockholders on an annual basis at least 90% of our Investment Company Taxable Income, determined without regard to the dividends paid deduction. Additionally, the Credit Facility generally restricts the amount of distributions to stockholders that we can pay out to be no greater than the sum of certain amounts, including our net investment income, plus net capital gains, plus amounts elected by the Company to be considered as having been paid during the prior fiscal year in accordance with Section 855(a) of the Code. In accordance with these requirements, our Board of Directors declared, and we paid, monthly cash distributions of $0.075 per common share for each of the six months from April 2022 through September 2022, monthly cash distributions of $0.08 per common share for each of the six months from October 2022 through March 2023, and supplemental distributions of $0.12, $0.12, and $0.24 per common share in June 2022, December 2022 and March 2023, respectively. See also “ Recent Developments - Distributions and Dividends ” for a discussion of cash distributions to common stockholders declared by our Board of Directors in April 2023.
For each of the fiscal years ended March 31, 2023 and 2022, Investment Company Taxable Income exceeded distributions declared and paid, and, in accordance with Section 855(a) of the Code, we elected to treat $21.4 million and $13.9 million, respectively, of the first distributions paid subsequent to fiscal year-end as having been paid in the prior year. In addition, for each of the fiscal years ended March 31, 2023 and 2022, net capital gains exceeded distributions declared and paid, and, in accordance with Section 855(a) of the Code, we elected to treat $10.6 million and $15.7 million, respectively, of the first distributions paid subsequent to fiscal year-end as having been paid in the prior year. For the year ended March 31, 2023, we recorded $1.6 million of net adjustments for estimated permanent book-tax differences to reflect tax character, which decreased Capital in excess of par value and increased Overdistributed net investment income and Accumulated net realized gain in excess of distributions. For the year ended March 31, 2022, we recorded $2.8 million of net adjustments for estimated permanent book-tax differences to reflect tax character, which decreased Capital in excess of par value and Underdistributed net investment income and increased Accumulated net realized gain in excess of distributions.
Preferred Stock Dividends
Our Board of Directors declared and we paid monthly cash dividends of $0.1328125 per share to holders of our Series E Term Preferred Stock per month from April 2021 through July 2021 and $0.07968750 per share of our Series E Term Preferred Stock for the period from August 1, 2021 up to, but excluding, the redemption date of August 19, 2021. In accordance with GAAP, we treated these monthly dividends as an operating expense.
Dividend Reinvestment Plan
Our common stockholders who hold their shares through our transfer agent, Computershare, Inc. (“Computershare”), have the option to participate in a dividend reinvestment plan offered by Computershare, as the plan agent. This is an “opt in” dividend reinvestment plan, meaning that common stockholders may elect to have their cash distributions automatically reinvested in additional shares of our common stock. Common stockholders who do not make such election will receive their distributions in cash. Any distributions reinvested under the plan will be taxable to a common stockholder to the same extent, and with the same character, as if the common stockholder had received the distribution in cash. The common stockholder generally will have an adjusted basis in the additional common shares purchased through the plan equal to the dollar amount that would have been received if the U.S. stockholder had received the dividend or distribution in cash. The additional common shares will have a new holding period commencing on the day following the date on which the shares are credited to the common stockholder’s account. Computershare purchases shares in the open market in connection with the obligations under the plan.
Registration Statement
On September 3, 2021, we filed a registration statement on Form N-2 (File No. 333-259302), which the SEC declared effective on October 15, 2021. The registration statement permits us to issue, through one or more transactions, up to an aggregate of $300.0 million in securities, consisting of common stock, preferred stock, subscription rights, debt securities, and warrants to purchase common stock, preferred stock, or debt securities, including through concurrent, separate offerings of such securities. As of the date of this report, we have the ability to issue up to $294.5 million of the securities registered under the registration statement.
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Equity
Common Stock
In August 2022, we entered into equity distribution agreements with Oppenheimer & Co. and Virtu Americas LLC (each a “Sales Agent”), under which we have the ability to issue and sell shares of our common stock, from time to time, through the Sales Agents, up to an aggregate offering price of $50.0 million in our Common Stock ATM Program. As of March 31, 2023, we had remaining capacity to sell up to an additional $44.5 million of common stock under the Common Stock ATM Program.
During the year ended March 31, 2023, we sold 386,482 shares of our common stock under the Common Stock ATM Program at a weighted-average gross price of $14.21 per share and raised approximately $5.5 million of gross proceeds. The weighted-average net price per share, after deducting commissions and offering costs borne by us, was $14.01 and resulted in total net proceeds of approximately $5.4 million. These sales were above our then current NAV per share.
In December 2019, we entered into equity distribution agreements with Wedbush Securities, Inc., Cantor Fitzgerald & Co., and Ladenburg Thalmann & Co., Inc. (each, a “2019 Sales Agent”), under which we had the ability to issue and sell shares of our common stock, from time to time, through the 2019 Sales Agents, up to an aggregate offering price of $35.0 million in an at-the-market program (the "2019 Common Stock ATM Program"). On August 11, 2021, we terminated the equity distribution agreements with each of the 2019 Sales Agents. We did not sell any shares of our common stock under the 2019 Common Stock ATM Program during the year ended March 31, 2022.
We anticipate issuing equity securities to obtain additional capital in the future. However, we cannot determine the timing or terms of any future equity issuances or whether we will be able to issue equity on terms favorable to us, or at all. When our common stock is trading at a price below NAV per share, the 1940 Act places regulatory constraints on our ability to obtain additional capital by issuing common stock. Generally, the 1940 Act provides that we may not issue and sell our common stock at a price below our NAV per common share, other than to our then existing common stockholders pursuant to a rights offering, without first obtaining approval from our stockholders and our independent directors and meeting other stated requirements. On March 31, 2023, the closing market price of our common stock was $13.25 per share, representing a 1.2% premium to our NAV of $13.09 per share as of March 31, 2023.
Term Preferred Stock
In August 2018, we completed a public offering of 2,990,000 shares of our Series E Term Preferred Stock at a public offering price of $25.00 per share. Gross proceeds totaled $74.8 million and net proceeds, after deducting underwriting discounts and offering costs borne by us, were $72.1 million. Total underwriting discounts and offering costs related to this offering were $2.7 million, which have been recorded as discounts to the liquidation value on our accompanying Consolidated Statements of Assets and Liabilities and were amortized over the period ending August 31, 2025, the mandatory redemption date, prior to redemption in August 2021. Prior to actual redemption in August 2021, the Series E Term Preferred Stock provided for a fixed dividend equal to 6.375% per year, payable monthly.
In August 2021, we used a portion of the proceeds from the issuance of our 2028 Notes to voluntarily redeem all outstanding shares of our Series E Term Preferred Stock, which had a liquidation preference of $25.00 per share. In connection with the voluntary redemption, we incurred a loss on extinguishment of debt of $2.0 million, which was recorded in Realized loss on other in our accompanying Consolidated Statements of Operations and which was primarily comprised of unamortized deferred issuance costs at the time of redemption.
Revolving Line of Credit
On March 8, 2021, we, through our wholly-owned subsidiary, Business Investment, entered into Amendment No. 6 to the Credit Facility, to extend the revolving period to February 29, 2024, and if not renewed or extended by such date, all principal and interest will be due and payable on February 28, 2026.
On August 10, 2020, we, through Business Investment, entered into Amendment No. 5 to the Credit Facility to, among other things, (i) add LIBOR replacement language; (ii) implement a 0.50% LIBOR floor; (iii) reduce the facility size from $200.0 million to $180.0 million, which may be expanded to $300.0 million through additional commitments; and (iv) provide certain other changes to existing terms and covenants.
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Advances under the Credit Facility generally bear interest at 30-day LIBOR, subject to a floor of 0.50%, plus 2.85% per annum until February 29, 2024, with the margin then increasing to 3.10% for the period from February 29, 2024 to February 28, 2025, and increasing further to 3.35% thereafter. The Credit Facility has an unused commitment fee on the daily unused commitment amount of 0.50% per annum if the average unused commitment amount for the period is less than or equal to 50% of the total commitment amount, 0.75% per annum if the average unused commitment amount for the period is greater than 50% but less than or equal to 65% of the total commitment amount, and 1.00% per annum if the average unused commitment amount for the period is greater than 65% of the total commitment amount.
Subsequent to March 31, 2023, on April 10, 2023, we, through Business Investment, entered into Amendment No. 7 to the Credit Facility to update the reference rate from LIBOR to Term SOFR plus an 11 basis point credit spread adjustment.
Interest is payable monthly during the term of the Credit Facility. Available borrowings are subject to various constraints and applicable advance rates, which are generally based on the size, characteristics, and quality of the collateral pledged by Business Investment. The Credit Facility also requires that any interest and principal payments on pledged loans be remitted directly by the borrower into a lockbox account with KeyBank. KeyBank is also the trustee of the account and generally remits the collected funds to us once a month.
Among other things, the Credit Facility contains covenants that require Business Investment to maintain its status as a separate legal entity, prohibit certain significant corporate transactions (such as mergers, consolidations, liquidations or dissolutions) and restrict certain material changes to our credit and collection policies without the lenders’ consent. The Credit Facility also generally seeks to restrict distributions to stockholders to the sum of (i) our net investment income, (ii) net capital gains, and (iii) amounts deemed by the Company to be considered as having been paid during the prior fiscal year in accordance with Section 855(a) of the Code. Loans eligible to be pledged as collateral are subject to certain limitations, including, among other things, restrictions on geographic concentrations, industry concentrations, loan size, payment frequency and status, average life, portfolio company leverage, and lien property. The Credit Facility also requires Business Investment to comply with other financial and operational covenants, which obligate Business Investment to, among other things, maintain certain financial ratios, including asset and interest coverage and a minimum number of obligors required in the borrowing base. Additionally, the Credit Facility contains a performance guaranty that requires the Company to maintain (i) a minimum net worth (defined in our Credit Facility to include any outstanding mandatorily redeemable preferred stock) of the greater of $ 210.0 million or $ 210.0 million plus 50 % of all equity and subordinated debt raised minus 50 % of any equity or subordinated debt redeemed or retired after November 16, 2016, which equated to $ 289.0 million as of March 31, 2023, (ii) asset coverage with respect to senior securities representing indebtedness of at least 150 % (or such percentage as may be set forth in Section 18 of the 1940 Act, as modified by Section 61 of the 1940 Act); and (iii) our status as a BDC under the 1940 Act and as a RIC under the Code. As of March 31, 2023, and as defined in the performance guaranty of the Credit Facility, we had a net worth of $ 696.7 million, asset coverage on our senior securities representing indebtedness of 244.7 %, calculated in compliance with the requirements of Sections 18 and 61 of the 1940 Act, and an active status as a BDC and RIC. As of March 31, 2023, we had availability, after adjustments for various constraints based on collateral quality, of $ 144.8 million under the Credit Facility and were in compliance with all covenants under the Credit Facility.
Notes Payable
5.00% Notes due 2026
In March 2021, we completed a public offering of the 2026 Notes with an aggregate principal amount of $127.9 million, which resulted in net proceeds of approximately $123.8 million after deducting underwriting discounts, commissions and offering costs borne by us. The 2026 Notes are traded under the ticker symbol “GAINN” on Nasdaq. The 2026 Notes will mature on May 1, 2026 and may be redeemed in whole or in part at any time or from time to time at the Company’s option on or after May 1, 2023. The 2026 Notes bear interest at a rate of 5.00% per year (which equates to $6.4 million per year), payable quarterly in arrears.
The indenture relating to the 2026 Notes contains certain covenants, including (i) an inability to incur additional debt or issue additional debt or preferred securities unless the Company’s asset coverage meets the threshold specified in the 1940 Act after such borrowing, (ii) an inability to declare any dividend or distribution (except a dividend payable in our stock) on a class of our capital stock or to purchase shares of our capital stock unless the Company’s asset coverage meets the threshold specified in the 1940 Act at the time of (and giving effect to) such declaration or purchase, and (iii) if, at any time, we are not subject to the reporting requirements of the Exchange Act, we will provide the holders of the 2026 Notes,
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as applicable, and the trustee with audited annual consolidated financial statements and unaudited interim consolidated financial statements.
The 2026 Notes are recorded at the aggregate principal amount, less underwriting discounts, commissions, and offering costs, on our accompanying Consolidated Statements of Assets and Liabilities . Total underwriting discounts, commissions, and offering costs related to this offering were $4.1 million, which have been recorded as discounts to the aggregate principal amount on our accompanying Consolidated Statements of Assets and Liabilities and are being amortized over the period ending May 1, 2026, the maturity date.
4.875% Notes due 2028
In August 2021, we completed a public offering of the 2028 Notes with an aggregate principal amount of $134.6 million, which resulted in net proceeds of approximately $131.3 million after deducting underwriting discounts, commissions and offering costs borne by us. The 2028 Notes are traded under the ticker symbol “GAINZ” on Nasdaq. The 2028 Notes will mature on November 1, 2028 and may be redeemed in whole or in part at any time or from time to time at the Company’s option on or after November 1, 2023. The 2028 Notes bear interest at a rate of 4.875% per year (which equates to $6.6 million per year), payable quarterly in arrears.
The indenture relating to the 2028 Notes contains certain covenants, including (i) an inability to incur additional debt or issue additional debt or preferred securities unless the Company’s asset coverage meets the threshold specified in the 1940 Act after such borrowing, (ii) an inability to declare any dividend or distribution (except a dividend payable in our stock) on a class of our capital stock or to purchase shares of our capital stock unless the Company’s asset coverage meets the threshold specified in the 1940 Act at the time of (and giving effect to) such declaration or purchase, and (iii) if, at any time, we are not subject to the reporting requirements of the Exchange Act, we will provide the holders of the 2028 Notes, as applicable, and the trustee with audited annual consolidated financial statements and unaudited interim consolidated financial statements.
The 2028 Notes are recorded at the aggregate principal amount, less underwriting discounts, commissions, and offering costs, on our accompanying Consolidated Statements of Assets and Liabilities . Total underwriting discounts, commissions, and offering costs related to this offering were $3.3 million , which have been recorded as discounts to the aggregate principal amount on our accompanying Consolidated Statements of Assets and Liabilities and are being amortized over the period ending November 1, 2028, the maturity date.
OFF-BALANCE SHEET ARRANGEMENTS
Unlike PIK income, we generally do not recognize success fees as income until payment has been received. Due to the contingent nature of success fees, there are no guarantees that we will be able to collect any or all of these success fees or know the timing of any such collections. As a result, as of March 31, 2023 and 2022, we had unrecognized, contractual off-balance sheet success fee receivables of $53.6 million and $50.5 million (or approximately $1.60 and $1.52 per common share), respectively, on our debt investments. Consistent with GAAP, we have not recognized success fee receivables and related income in our accompanying Consolidated Financial Statements until earned.
CONTRACTUAL OBLIGATIONS
We have line of credit commitments to certain of our portfolio companies that have not been fully drawn. Since these line of credit commitments have expiration dates and we expect many will never be fully drawn, the total line of credit commitment amounts do not necessarily represent future cash requirements. We estimate the fair value of the combined unused line of credit commitments as of March 31, 2023 to be insignificant.
In conjunction with the term loan repayment by CCE in November 2022, our previously outstanding $1.0 million guaranty was released and terminated. We were not required to make any payments on this guaranty, or any guaranties that existed in previous periods.
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The following table shows our contractual obligations as of March 31, 2023, at cost:
Payments Due by Period
Contractual Obligations (A)
Total Less than
1 Year 1-3 Years 3-5 Years More than
5 Years
Credit Facility (B)
$ 35,200 $ — $ 35,200 $ — $ —
Notes payable 262,488 — — 127,938 134,550
Interest payments on obligations (C)
68,657 17,187 33,992 13,652 3,826
Total $ 366,345 $ 17,187 $ 69,192 $ 141,590 $ 138,376
(A) Excludes unused line of credit commitments to our portfolio companies in the aggregate principal amount of $2.2 million.
(B) Principal balance of borrowings outstanding under the Credit Facility, based on the maturity date following the current contractual revolving period end date.
(C) Includes interest payments due on the Credit Facility, 2026 Notes, and 2028 Notes, as applicable. The amount of interest payments calculated for purposes of this table was based upon rates and outstanding balances as of March 31, 2023.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported consolidated amounts of assets and liabilities, including disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the period reported. Actual results could differ materially from those estimates under different assumptions or conditions. We have identified our investment valuation policy (which has been approved by our Board of Directors) as our most critical accounting policy, which is described in Note 2— Summary of Significant Accounting Policies in the accompanying Notes to Consolidated Financial Statements included elsewhere in this Annual Report. Additionally, refer to Note 3 — Investments in the accompanying Notes to Consolidated Financial Statements included elsewhere in this Annual Report for additional information regarding fair value measurements and our application of Financial Accounting Standards Board Accounting Standards Codification Topic 820, “ Fair Value Measurements and Disclosures.” We have also identified our revenue recognition policy as a critical accounting policy, which is described in Note 2— Summary of Significant Accounting Policies in the accompanying Notes to Consolidated Financial Statements included elsewhere in this Annual Report.
Investment Valuation
Credit Monitoring and Risk Rating
The Adviser monitors a wide variety of key credit statistics that provide information regarding our portfolio companies to help us assess credit quality and portfolio performance and, in some instances, are used as inputs in our valuation techniques. Generally, we, through the Adviser, participate in periodic board meetings of our portfolio companies in which we hold board seats and also require them to provide annual audited and monthly unaudited financial statements. Using these statements or comparable information and board discussions, the Adviser calculates and evaluates certain credit statistics.
The Adviser risk rates all of our investments in debt securities. The Adviser does not risk rate equity securities. For loans that have been rated by a SEC-registered Nationally Recognized Statistical Rating Organization (“NRSRO”), the Adviser generally uses the average of two corporate level NRSRO’s risk ratings for such security. For all other debt securities, the Adviser uses a proprietary risk rating system. While the Adviser seeks to mirror the NRSRO systems, we cannot provide any assurance that the Adviser’s risk rating system will provide the same risk rating as an NRSRO for these securities. The Adviser’s risk rating system is used to estimate the probability of default on debt securities and the expected loss, if there is a default. The Adviser’s risk rating system uses a scale of 0 to >10, with >10 being the lowest probability of default. It is the Adviser’s understanding that most debt securities of Lower Middle Market companies do not exceed the grade of BBB on an NRSRO scale, so there would be no debt securities in the Lower Middle Market that would meet the definition of AAA, AA or A. Therefore, the Adviser’s scale begins with the designation >10 as the best risk rating which may be equivalent to a BBB from an NRSRO; however, no assurance can be given that a >10 on the Adviser’s scale is equal to a BBB or Baa2 on an NRSRO scale. The Adviser’s risk rating system covers both qualitative and quantitative aspects of the business and the securities we hold.
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The following table reflects risk ratings for all loans in our portfolio as of March 31, 2023 and 2022:
As of March 31,
Rating 2023 2022
Highest 9.0 9.0
Average 6.4 6.5
Weighted-average 7.3 7.0
Lowest 1.0 3.0
Tax Status
We intend to continue to maintain our qualification as a RIC under Subchapter M of the Code for U.S. federal income tax purposes. As a RIC, we generally are not subject to U.S. federal income tax on the portion of our taxable income and gains distributed to our stockholders. To maintain our qualification as a RIC, we must maintain our status as a BDC and meet certain source-of-income and asset diversification requirements. In addition, to qualify to be taxed as a RIC, we must distribute to stockholders at least 90% of our Investment Company Taxable Income, determined without regard to the dividends paid deduction. Our policy generally is to make distributions to our stockholders in an amount up to 100% of Investment Company Taxable Income. We may retain some or all of our net long-term capital gains, if any, and designate them as deemed distributions, or distribute such gains to stockholders in cash. See “Business — Material U.S. Federal Income Tax Considerations” and “ — Liquidity and Capital Resources — Distributions and Dividends to Stockholders . ”
In an effort to limit federal excise taxes, we have to distribute to stockholders, during each calendar year, an amount close to the sum of: (1) 98% of our ordinary income for the calendar year, (2) 98.2% of our net capital gains (both long-term and short-term), if any, for the one-year period ending on October 31 of the calendar year, and (3) any income realized, but not distributed, in the preceding period (to the extent that income tax was not imposed on such amounts), less certain reductions, as applicable. Under the RIC Modernization Act, we are permitted to carryforward any capital losses that we may incur for an unlimited period, and such capital loss carryforwards will retain their character as either short-term or long-term capital losses. Our capital loss carryforward balance was $0 as of both March 31, 2023 and 2022 .
Recent Accounting Pronouncements
Refer to Note 2 — Summary of Significant Accounting Policies in the accompanying Notes to Consolidated Financial Statements included elsewhere in this Annual Report for a description of recent accounting pronouncements.