Item 1. Business
ITEM 1.
BUSINESS
Overview
Organization
Gladstone Capital Corporation was incorporated under the Maryland General Corporation Law on May 30, 2001 and completed an initial public offering on
August 24, 2001. We are an externally managed, closed-end, non-diversified management investment company that has elected to be treated as a BDC under the 1940 Act.
In addition, we have elected to be treated for tax purposes as a RIC under the Code. We were established for the purpose of investing in debt and equity securities of established private businesses operating in the United States (U.S.).
As of September 30, 2020, shares of our common stock, our 6.125% Notes due 2023 (the 2023 Notes) and our 5.375% Notes due 2024 (the
2024 Notes) trade on the Nasdaq Global Select Market (Nasdaq) under the trading symbols GLAD, GLADD and GLADL, respectively.
Investment Adviser and Administrator
We are
externally managed by the Adviser, an investment adviser registered with the SEC and an affiliate of ours, pursuant to an investment advisory and management agreement (as amended and / or restated from time to time, the Advisory
Agreement). The Adviser manages our investment activities. We have also entered into an administration agreement with Gladstone Administration, LLC (the Administrator), an affiliate of ours and the Adviser, whereby we pay
separately for administrative services (the Administration Agreement). Each of the Adviser and the Administrator are privately-held companies that are indirectly owned and controlled by David Gladstone, our chairman and chief executive
officer. Mr. Gladstone and Terry Lee Brubaker, our vice chairman and chief operating officer, also serve on the board of directors of the Adviser, the board of managers of the Administrator, and serve as executive officers of the Adviser and
the Administrator. The Administrator employs, among others, our chief financial officer and treasurer, chief valuation officer, chief compliance officer, general counsel and secretary (who also serves as the president of the Administrator) and their
respective staffs. The Adviser and Administrator have extensive experience in our lines of business and also provide investment advisory and administrative services, respectively, to our affiliates, including: Gladstone Commercial Corporation
(Gladstone Commercial), a publicly-traded real estate investment trust; Gladstone Investment Corporation (Gladstone Investment), a publicly-traded BDC and RIC; and Gladstone Land Corporation, a publicly-traded real estate
investment trust (Gladstone Land, with Gladstone Commercial, and Gladstone Investment, collectively the Affiliated Public Funds). In the future, the Adviser and Administrator may provide investment
advisory and administrative services, respectively, to other funds and companies, both public and private.
The Adviser was organized as a corporation
under the laws of the State of Delaware on July 2, 2002, and is an SEC registered investment adviser under the Investment Advisors Act of 1940, as amended. The Administrator was organized as a limited liability company under the laws of the
State of Delaware on March 18, 2005. The Adviser and Administrator are headquartered in McLean, Virginia, a suburb of Washington, D.C., at 1521 Westbranch Drive, McLean, Virginia 22102. The Adviser also has offices in other states.
Investment Objectives and Strategy
Our investment
objectives are to: (1) achieve and grow current income by investing in debt securities of established lower middle market companies (which we generally define as companies with annual earnings
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before interest, taxes, depreciation and amortization (EBITDA) of $3 million to $15 million) in the U.S. 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 stockholders; and (2) provide our stockholders with long-term capital appreciation in the value of our assets by investing in equity
securities, in connection with our debt investments, that we believe can grow over time to permit us to sell our equity investments for capital gains. To achieve our objectives, our primary investment strategy is to invest in several categories of
debt and equity securities, with each investment generally ranging from $8 million to $30 million, although investment size may vary, depending upon our total assets or available capital at the time of investment. We lend to borrowers that
need funds for growth capital, to finance acquisitions, or to recapitalize or refinance their existing debt facilities. We seek to avoid investing in high-risk, early-stage enterprises. Our targeted portfolio companies are generally considered too
small for the larger capital marketplace. We intend for our investment portfolio to consist of approximately 90.0% debt investments and 10.0% equity investments, at cost. As of September 30, 2020, our investment portfolio was made up of
approximately 91.3% debt investments and 8.7% equity investments, at cost.
We invest by ourselves or jointly with other funds and/or management of the
portfolio company, depending on the opportunity. In July 2012, the SEC granted us an exemptive order (the Co-Investment Order) that expanded our ability to
co-invest, under certain circumstances, with certain of our affiliates, including Gladstone Investment and any future BDC or closed-end management investment company
that is advised (or sub-advised if it controls the fund) by the Adviser, or any combination of the foregoing, subject to the conditions in 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. Since 2012, we have opportunistically made several co-investments with Gladstone Investment pursuant to the Co-Investment Order. 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.
In general, our investments in debt securities have a term of no more than seven years, accrue interest at variable rates (generally based on the 30-day London Interbank Offered Rate (LIBOR)) and, to a lesser extent, at fixed rates. We seek debt instruments that pay interest monthly or, at a minimum, quarterly, may have a success fee or deferred
interest provision and are primarily interest only, with all principal and any accrued but unpaid interest due at maturity. Generally, success fees accrue at a set rate and are contractually due upon a change of control of a portfolio company,
typically from an exit or sale. Some debt securities have deferred interest whereby some portion of the interest payment is added to the principal balance so that the interest is paid, together with the principal, at maturity. This form of deferred
interest is often called paid-in-kind (PIK) interest.
Typically, our equity investments consist of common stock, preferred stock, limited liability company interests, or warrants to purchase the foregoing. Often,
these equity investments occur in connection with our original investment, recapitalizing a business, or refinancing existing debt.
Since our initial
public offering in 2001 and through September 30, 2020, we have invested in over 240 different companies, while making 212 consecutive monthly or quarterly cash distributions to common stockholders. We expect that our investment portfolio will
primarily include the following three categories of investments in private companies operating in the U.S.:
Secured First Lien Debt Securities: We seek to invest a portion of our assets in first lien secured debt
securities also known as senior loans, senior term loans, lines of credit and senior notes. Using its assets as collateral, the borrower typically uses first lien debt to cover a substantial portion of the funding needs of the business. These debt
securities usually take the form of first priority liens on all, or substantially all, of the assets of the business. First lien debt securities may include investments sourced from the syndicated loan market.
Secured Second Lien Debt Securities: We seek to invest a portion of our assets in second lien secured debt
securities, also known as subordinated loans, subordinated notes and mezzanine loans. These
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second lien secured debt securities rank junior to the borrowers first lien secured debt securities and may be secured by second priority liens on all or a portion of the assets of the
business. Additionally, we may receive other yield enhancements in addition to or in lieu of success fees such as warrants to buy common and preferred stock or limited liability interests in connection with these second lien secured debt securities.
Second lien debt securities may include investments sourced from the syndicated loan market.
Preferred and Common Equity/Equivalents: In some cases we will purchase equity securities which
consist of preferred and common equity or limited liability company interests, or warrants or options to acquire such securities, and are in combination with our debt investment in a business. Additionally, we may receive equity investments derived
from restructurings on some of our existing debt investments. In some cases, we will own a significant portion of the equity and in other cases we may have voting control of the businesses in which we invest.
Under the 1940 Act, we may not acquire any asset other than assets of the type listed in Section 55 of the 1940 Act, which are referred to as
qualifying assets and generally include each of the investment types listed above, unless, at the time the acquisition is made, qualifying assets (other than certain assets related to our operations) represent at least 70.0% of our total
assets. See Regulation as a BDC Qualifying Assets for a discussion of the types of qualifying assets in which we are permitted to invest pursuant to Section 55(a) of the 1940 Act.
Because the majority of the loans in our portfolio consist of term debt in private companies that typically cannot or will not expend the resources to have
their debt securities rated by a credit rating agency, we expect that most, if not all, of the debt securities we acquire will be unrated. Investors should assume that these loans would be rated below what is today considered investment
grade quality. Investments rated below investment grade are often referred to as high yield securities or junk bonds and may be considered higher risk, as compared to investment-grade debt instruments. In addition, many of the debt securities
we hold may not amortize prior to maturity.
Investment Policies
We seek to achieve a high level of current income and capital gains through investments in debt securities and preferred or common stock that we generally
acquire in connection with buyouts and other recapitalizations. The following investment policies, along with these investment objectives, may not be changed without the approval of our board of directors (the Board of Directors):
We will at all times conduct our business so as to retain our status as a BDC. In order to retain that status, we
must operate for the purpose of investing in certain categories of qualifying assets. In addition, we may not acquire any assets (other than non-investment assets necessary and appropriate to our operations as
a BDC or qualifying assets) if, after giving effect to such acquisition, the value of our qualifying assets is less than 70.0% of the value of our total assets. We anticipate that the securities we seek to acquire will generally be
qualifying assets.
We will at all times endeavor to conduct our business so as to retain our status as a RIC under the Code. To do
so, we must meet income source, asset diversification and annual distribution requirements. We may issue senior securities, such as debt or preferred stock, to the extent permitted by the 1940 Act for the purpose of making investments, to fund share
repurchases, or for temporary emergency or other purposes.
With the exception of our policy to conduct our business as a BDC, these
policies are not fundamental and may be changed without stockholder approval.
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Investment Concentrations
As of September 30, 2020, our investment portfolio consisted of investments in 48 companies located in 25 states across 18 different industries, with an
aggregate fair value of $450.4 million. The five largest investments at fair value as of September 30, 2020, totaled $130.3 million, or 28.9% of our total investment portfolio.
The following table outlines our investments by security type as of September 30, 2020 and 2019:
September 30, 2020
September 30, 2019
Cost
Fair Value
Cost
Fair Value
Secured first lien debt
$
241,008
48.7
%
$
213,468
47.4
%
$
196,833
45.9
%
$
178,213
44.2
%
Secured second lien debt
205,841
41.6
196,986
43.7
187,569
43.8
181,541
45.1
Unsecured debt
4,708
1.0
4,299
1.0
4,088
1.0
3,933
1.0
Total debt investments
451,557
91.3
414,753
92.1
388,490
90.7
363,687
90.3
Preferred equity
18,932
3.8
7,000
1.5
16,360
3.8
9,854
2.4
Common equity/equivalents
24,158
4.9
28,647
6.4
23,602
5.5
29,334
7.3
Total equity investments
43,090
8.7
35,647
7.9
39,962
9.3
39,188
9.7
Total Investments
$
494,647
100.0
%
$
450,400
100.0
%
$
428,452
100.0
%
$
402,875
100.0
%
Our investments at fair value consisted of the following industry classifications as of September 30, 2020 and 2019:
September 30, 2020
September 30, 2019
Industry Classification
Fair Value
Percentage
of Total
Investments
Fair Value
Percentage
of Total
Investments
Diversified/Conglomerate Service
$
92,960
20.6
%
$
116,923
29.0
%
Healthcare, Education, and Childcare
64,155
14.3
39,515
9.8
Diversified/Conglomerate Manufacturing
43,995
9.8
17,923
4.4
Aerospace and Defense
37,460
8.3
15,164
3.8
Cargo Transportation
34,542
7.7
15,225
3.8
Beverage, Food, and Tobacco
29,171
6.5
12,486
3.1
Telecommunications
27,994
6.2
46,111
11.4
Oil and Gas
24,725
5.5
35,051
8.7
Diversified Natural Resources, Precious Metals, and Minerals
24,014
5.3
22,839
5.7
Automobile
18,149
4.0
23,529
5.8
Chemicals, Plastics, and Rubber
13,715
3.0
11,448
2.8
Machinery
10,264
2.3
10,724
2.7
Home and Office Furnishings, Housewares, and Durable Consumer Products
9,675
2.2
9,800
2.4
Hotels, Motels, Inns, and Gaming
8,052
1.8
7,209
1.8
Textiles and Leather
5,905
1.3
6,104
1.5
Buildings and Real Estate
3,110
0.7
3,410
0.9
Personal and Non-Durable Consumer Products
555
0.1
4,747
1.2
Other, < 2.0%
1,959
0.4
4,667
1.2
Total Investments
$
450,400
100.0
%
$
402,875
100.0
%
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Our investments at fair value were included in the following U.S. geographic regions and Canada as of
September 30, 2020 and 2019:
September 30, 2020
September 30, 2019
Location
Fair Value
Percentage
of Total
Investments
Fair Value
Percentage
of Total
Investments
South
$
214,808
47.7
%
$
171,985
42.7
%
West
138,746
30.8
118,078
29.3
Midwest
56,106
12.5
56,149
13.9
Northeast
40,740
9.0
49,914
12.4
Canada
6,749
1.7
Total Investments
$
450,400
100.0
%
$
402,875
100.0
%
The geographic composition indicates the location of the headquarters for our portfolio companies. A portfolio company may
have additional locations in other geographic regions.
Investment Process
Overview of Investment and Approval Process
To
originate investments, the Advisers investment professionals use an extensive referral network comprised primarily of private equity sponsors, leveraged buyout funds, investment bankers, attorneys, accountants, commercial bankers, and business
brokers. The Advisers investment professionals review information received from these and other sources in search of potential financing opportunities. If a potential opportunity matches our investment objectives, the investment professionals
will seek an initial screening of the opportunity with our president, Robert L. Marcotte, to authorize the submission of an indication of interest (IOI) to the prospective portfolio company. If the prospective portfolio company passes
this initial screening and the IOI is accepted by the prospective company, the investment professionals will seek approval to issue a letter of intent (LOI) to the prospective company from the Advisers investment committee, which
is composed of Messrs. Gladstone, Brubaker and Marcotte. If this LOI is issued, then the Adviser and Gladstone Securities, LLC (Gladstone Securities) (collectively, the Due Diligence Team) will conduct a due diligence
investigation and create a detailed profile summarizing the prospective portfolio companys historical financial statements, industry, competitive position and management team, analyzing its conformity to our general investment criteria. The
investment professionals then present this profile to the Advisers investment committee, which must approve each investment.
Prospective
Portfolio Company Characteristics
We have identified certain characteristics that we believe are important in identifying and investing in
prospective portfolio companies. The criteria listed below provide general guidelines for our investment decisions, although not all of these criteria may be met by each portfolio company.
Growth-and-Income Orientation
and Positive Cash Flow. Our investment philosophy places a premium on fundamental analysis from an investors perspective and has a distinct growth-and-income
orientation. We typically invest in companies that generate growing sales and cash flow to provide some assurance that they will be able to service their debt and deleverage over time. We do not expect to invest in
start-up companies or companies with what we believe to be cyclical industries or speculative business plans.
Experienced Management. We typically require that the businesses in which we invest have experienced
management teams. We also require the businesses to have proper incentives in place to induce management teams to succeed and align with our interests as an investor, including having significant equity or other interests in the financial
performance of their respective companies.
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Strong Competitive Position in an Industry . We seek to invest in businesses that have developed strong
market positions within their respective markets and that we believe are well-positioned to capitalize on growth opportunities. We seek businesses that demonstrate significant competitive advantages versus their competitors, which we believe will
help to protect their market positions and profitability.
Enterprise Collateral Value . The projected enterprise valuation of the business, based on market based
comparable cash flow multiples, is an important factor in our investment analysis in determining the collateral coverage of our debt securities.
Extensive Due Diligence
The Due Diligence Team
conducts what we believe are extensive due diligence investigations of our prospective portfolio companies and investment opportunities. The due diligence investigation may begin with a review of publicly available information followed by in depth
business analysis, including any of the following:
a review of the prospective portfolio companys historical and projected financial information, including a
quality of earnings analysis;
detailed review of the track record of the private equity firm or ownership group acquiring or controlling any
prospective borrower;
visits to the prospective portfolio companys business site(s);
interviews with the prospective portfolio companys management, employees, customers, and vendors;
review of loan documents and material contracts;
background checks and a management capabilities assessment on the prospective portfolio companys management
team and controlling shareholders; and
research on the prospective portfolio companys products, services or particular industry and its
competitive position therein.
Upon completion of a due diligence investigation and a decision to proceed with an investment, the
Advisers investment professionals who have primary responsibility for the investment present the investment opportunity to the Advisers investment committee. The investment committee then determines whether to pursue the potential
investment. Prior to the closing of an investment, additional due diligence may be conducted on our behalf by attorneys, independent accountants, and other outside advisers, as appropriate.
We also rely on the long-term relationships that the Advisers investment professionals have with leveraged buyout funds, investment bankers, commercial
bankers, private equity sponsors, attorneys, accountants, and business brokers. In addition, the extensive direct experiences of our executive officers and managing directors in the operations of lower middle market companies and providing debt and
equity capital to lower middle market companies plays a significant role in our investment evaluation and assessment of risk.
Investment Structure
Once the Adviser has determined that an investment meets our standards and investment criteria, the Adviser works with the management of that
company, the private equity firm or ownership group controlling any prospective borrower, and other capital providers to structure the transaction in a way that we believe will provide us with the greatest opportunity to maximize our return on the
investment, while providing appropriate incentives to the shareholders and management of the company. As discussed above, the capital classes through which we typically structure a deal include first lien secured debt, second lien secured debt, and
preferred and common equity or equivalents. Through its risk management process, the Adviser seeks to limit the downside risk of our investments by:
seeking collateral or superior positions in the portfolio companys capital structure where possible;
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negotiating covenants in connection with our investments that afford our portfolio companies as much flexibility
as possible in managing their businesses, consistent with preserving our capital;
securing board observation rights at the portfolio company;
incorporating call protection into the investment structure where possible; and
making investments with an expected total return (including both interest and potential equity appreciation) that
it believes compensates us appropriately for the credit risk of the investment.
We expect to hold most of our debt investments until
maturity or repayment, but may sell our investments (including our equity investments) earlier if a liquidity event takes place, such as the sale or recapitalization of a portfolio company. Occasionally, we may sell some or all of our investment
interests in a portfolio company to a third party in a privately negotiated transaction to manage our credit or sector exposures or to enhance our portfolio yield.
Competitive Advantages
A large number of entities
compete with us and make the types of investments that we seek to make in lower middle market privately-owned businesses. Such competitors include other BDCs, non-equity based investment funds, and other
financing sources, including traditional financial services companies such as commercial banks. Many of our competitors are substantially larger than we are and have considerably greater funding sources or are able to access capital more cost
effectively. In addition, certain of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments, serve a broader customer base, and establish a greater market
share. Furthermore, many of these competitors are not subject to the regulatory restrictions that the 1940 Act imposes on us as a BDC or the regulatory requirements we must comply with as a publicly traded company. However, we believe that we have
the following competitive advantages over many other providers of financing to lower middle market companies.
Management Expertise
Our Adviser has a separate investment committee for the Company and each of the Affiliated Public Funds. The Advisers investment committee for the
Company is comprised of Messrs. Gladstone, Brubaker and Marcotte, each of whom have a wealth of experience in our area of operation. Mr. Gladstone and Mr. Brubaker also serve on the Advisers investment committee for the other
Affiliated Public Funds. Mr. Gladstone and Mr. Marcotte both have over 25 years of experience in investing in middle market companies and with operating in the BDC marketplace in general. Messrs. Gladstone and Brubaker also have principal
management responsibility for the Adviser as its executive officers, and have worked together at the Gladstone Companies for more than 15 years. Mr. Brubaker has over 25 years of experience in acquisitions and operations of companies. These
three individuals dedicate a significant portion of their time to managing our investment portfolio. Our senior management has extensive experience providing capital to lower middle market companies. In addition, we have access to the resources and
expertise of the Advisers investment professionals and support staff who possess a broad range of transactional, financial, managerial, and investment skills. See the additional discussion regarding management of portfolio companies by our
Adviser below under Ongoing Management of Investments and Portfolio Company Relationships.
Increased Access to Investment
Opportunities Developed Through Extensive Research Capability and Network of Contacts
The Adviser seeks to identify potential investments through
active origination and due diligence and through its dialogue with numerous private equity firms and other members of the financial community with whom the Advisers investment professionals have long-term relationships. We believe that the
Advisers investment professionals have developed a broad network of contacts within the investment, commercial banking, private
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equity and investment management communities, and that their reputation, experience and focus on investing in lower middle market companies enables us to source and identify well-positioned
prospective portfolio companies that provide attractive investment opportunities. Additionally, the Adviser expects to generate information from its professionals network of accountants, consultants, lawyers and management teams of portfolio
companies and other contacts to support the Advisers investment activities.
Disciplined, Value and Income-Oriented Investment Philosophy with a
Focus on Preservation of Capital
In making its investment decisions, the Adviser focuses on the risk and reward profile of each prospective portfolio
company, seeking to minimize the risk of capital loss without foregoing the potential for capital appreciation. We expect the Adviser to use the same investment philosophy that its professionals use in the management of the other Affiliated Public
Funds and to commit resources to manage downside exposure. The Advisers approach seeks to reduce our risk in investments by using some or all of the following approaches:
focusing on companies with sustainable market positions and cash flow;
investing in businesses with experienced and established management teams;
engaging in extensive due diligence from the perspective of a long-term investor;
investing in businesses backed by successful private equity sponsors or owner operators; and
adopting flexible transaction structures by drawing on the experience of the investment professionals of the
Adviser and its affiliates.
Longer Investment Horizon
Unlike private equity and private credit funds that are typically organized as finite-life partnerships (generally seven to ten years), we are not subject to
standard periodic capital return requirements. These structures often force private equity and private credit funds to seek returns on their investments by causing their portfolio companies to pursue mergers, public equity offerings, or other
liquidity events more quickly than might otherwise be optimal or desirable, potentially resulting in a lower overall return to investors and/or an adverse impact on their portfolio companies. In contrast, we are an exchange-traded corporation of
perpetual duration. We believe that our flexibility to make investments with a long-term view and without the capital return requirements of traditional private investment vehicles provides us with the opportunity to achieve greater long-term
returns on invested capital.
Flexible Transaction Structuring
We believe our management teams broad expertise and years of combined experience enable the Adviser to identify, assess, and structure investments
successfully across all levels of a companys capital structure and manage potential risk and return at all stages of the economic cycle. We are not subject to many of the regulatory limitations that govern traditional lending institutions,
such as banks. As a result, we are flexible in selecting and structuring investments, adjusting investment criteria and transaction structures and, in some cases, the types of securities in which we invest. We believe that this approach enables the
Adviser to craft a financing structure which best fits the investment and growth profile of the underlying business and yields attractive investment opportunities that will continue to generate current income and capital gain potential throughout
the economic cycle, including during turbulent periods in the capital markets, such as the current COVID-19 pandemic.
Ongoing Management of Investments and Portfolio Company Relationships
The Advisers investment professionals actively oversee each investment by continuously evaluating the portfolio companys performance and typically
working collaboratively with the portfolio companys management to identify and incorporate best resources and practices that help us achieve our projected investment performance.
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Monitoring
The Advisers investment professionals monitor the financial performance, trends, and changing risks of each portfolio company on an ongoing basis to
determine if each company is performing within expectations and to guide the portfolio companys management in taking the appropriate courses of action. In addition, the Adviser has closely monitored our portfolio companies in connection with
the COVID-19 pandemic to help them navigate the significant challenges posed by the pandemic. The Adviser employs various methods of evaluating and monitoring the performance of our investments in portfolio
companies, which can include the following:
monthly analysis of financial and operating performance;
frequent assessment of the portfolio companys performance against its business plan and our investment
expectations;
attendance at and/or participation in the portfolio companys board of directors or management meetings;
assessment of portfolio company management, sponsor, governance, and strategic direction;
assessment of the portfolio companys industry and competitive environment; and
review and assessment of the portfolio companys operating outlook and financial projections.
Relationship Management
The Advisers investment professionals interact with various parties involved with a portfolio company, or investment, by actively engaging with internal
and external constituents, including:
management;
boards of directors;
private equity sponsors;
capital partners; and
advisers and consultants.
Managerial Assistance and Services
As a BDC, we
make available significant managerial assistance, as defined in the 1940 Act, to our portfolio companies and provide other services (other than such managerial assistance) to such portfolio companies. Neither we, nor the Adviser, currently receive
fees in connection with the managerial assistance we make available. At times, the Adviser may also provide other services to our portfolio companies under certain agreements and may receive fees for services other than managerial assistance. Such
services may include: (i) assistance obtaining, sourcing or structuring credit facilities, long term loans or additional equity from unaffiliated third parties; (ii) negotiating important contractual financial relationships;
(iii) consulting services regarding restructuring of the portfolio company and financial modeling as it relates to raising additional debt and equity capital from unaffiliated third parties; and (iv) taking a primary role in interviewing,
vetting and negotiating employment contracts with candidates in connection with adding and retaining key portfolio company management team members. The Adviser non-contractually, unconditionally, and
irrevocably credits 100% of any fees received for such services against the base management fee that we would otherwise be required to pay to the Adviser as discussed below in Transactions with Related Parties Investment
Advisory and Management Agreement Base Management Fee. However, pursuant to the terms of the Advisory Agreement, a small percentage of certain of such fees is retained by the Adviser in the form of reimbursement, at cost, for tasks
completed by personnel of the Adviser, primarily for the valuation of portfolio companies.
Gladstone Securities also provides other services (such as
investment banking and due diligence services) to certain of our portfolio companies and receives fees for the provision of such services; see Transactions with Related Parties Other Transactions below.
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Valuation Process
The following is a general description of the investment valuation policy (the Policy) (which has been approved by our Board of Directors) that the
professionals of the Adviser and Administrator, with oversight and direction from our chief valuation officer, an employee of the Administrator who reports directly to our Board of Directors (collectively, the Valuation Team), use each
quarter to determine the value of our investment portfolio. In accordance with the 1940 Act, our Board of Directors has the ultimate responsibility for reviewing and determining, in good faith, the fair value of our investments for which market
quotations are not readily available, based on the Policy. The Adviser values our investments in accordance with the requirements of the 1940 Act and accounting principles generally accepted in the U.S. (GAAP). There is no single
standard for determining fair value (especially for privately-held businesses), as fair value depends upon the specific facts and circumstances of each individual investment. Each quarter, our Board of Directors reviews the Policy to determine if
changes thereto are advisable and assesses whether the Valuation Team has applied the Policy consistently. With respect to the valuation of our investment portfolio, the Valuation Team performs the following steps each quarter:
Each investment is initially assessed by the Valuation Team using the Policy, which may include:
obtaining fair value quotes or utilizing input from third party valuation firms; and
using techniques, such as total enterprise value, yield analysis, market quotes and other factors, including but
not limited to: the nature and realizable value of the collateral, including external parties guaranties; any relevant offers or letters of intent to acquire the portfolio company; and the markets in which the portfolio company operates.
Preliminary valuation conclusions are then discussed amongst the Valuation Team and with our management and
documented for review by our Board of Directors. Written valuation recommendations and supporting material are sent to the Board of Directors in advance of its quarterly meetings.
The Valuation Committee of the Board of Directors (comprised entirely of independent directors) meets to review
this documentation and discusses the information provided by our Valuation Team, and determines whether the Valuation Team has followed the Policy, determines whether the Valuation Teams recommended fair value is reasonable in light of the
Policy and reviews other facts and circumstances. Then, the Valuation Committee and chief valuation officer present the Valuation Committees findings to the entire Board of Directors, so that the full Board of Directors may review and approve,
with a vote, to accept or reject the fair value recommendations in accordance with the Policy.
Fair value measurements of our
investments may involve subjective judgment and estimates. Due to the inherent uncertainty of determining these fair values, the fair value of our investments may fluctuate, from period to period. Our valuation policies, procedures and processes are
more fully described in Note 2 Summary of Significant Accounting Policies in our accompanying Notes to Consolidated Financial Statements included elsewhere in this Annual Report.
Transactions with Related Parties
Investment Advisory and Management Agreement
In
2006, we entered into the Advisory Agreement, which was subsequently amended in October 2015 and amended and restated in April 2020. In accordance with the Advisory Agreement, we pay the Adviser fees as compensation for its services, consisting of a
base management fee and an incentive fee. On July 14, 2020, our Board of Directors, including a majority of the directors who are not parties to the Advisory Agreement or interested persons of such party, unanimously approved the renewal of the
Advisory Agreement through August 31, 2021. Mr. Gladstone, our chairman and chief executive officer, controls the Adviser. The Board of
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Directors considered the following factors as the basis for its decision to renew the Advisory Agreement: (1) the nature, extent and quality of services provided by the Adviser to our
shareholders; (2) the investment performance of the Company and the Adviser; (3) the costs of the services to be provided and profits to be realized by the Adviser and its affiliates from the relationship with the Company; (4) the
extent to which economies of scale will be realized as the Company and the Affiliated Public Funds grow and whether the fee level under the Advisory Agreement reflects the economies of scale for the Companys investors; (5) the fee
structure of the advisory and administrative agreements of comparable funds; (6) indirect profits to the Adviser created through the Company; and (7) in light of the foregoing considerations, the overall fairness of the advisory fees paid
under the Advisory Agreement.
Based on the information reviewed and the considerations detailed above, our Board of Directors, including all of the
directors who are not interested persons as that term is defined in the 1940 Act, concluded that the investment advisory fee rates and terms are fair and reasonable in relation to the services provided and approved the Advisory
Agreement, as being in the best interests of our stockholders.
Base Management Fee
The base management fee is payable quarterly to the Adviser pursuant to our Advisory Agreement and is assessed at an annual rate of 1.75%, computed on the
basis of the value of our average total assets at the end of the two most recently-completed quarters (inclusive of the current quarter), which are total assets, including investments made with proceeds of borrowings, less any uninvested cash or
cash equivalents resulting from borrowings and adjusted appropriately for any share issuances or repurchases during the period. Our Board of Directors may (as it has for the years ended September 30, 2020, 2019, and 2018) accept a non-contractual, unconditional and irrevocable credit from the Adviser to reduce the annual 1.75% base management fee on syndicated loan participations to 0.5%, to the extent that proceeds resulting from borrowings
were used to purchase such syndicated loan participations.
Additionally, pursuant to the requirements of the 1940 Act, the Adviser makes available
significant managerial assistance to our portfolio companies. The Adviser may also provide other services to our portfolio companies under certain agreements and may receive fees for services other than managerial assistance. The Adviser non-contractually, unconditionally, and irrevocably credits 100% of these fees against the base management fee that we would otherwise be required to pay to the Adviser; however, pursuant to the terms of the
Advisory Agreement, a small percentage of certain of such fees is retained by the Adviser in the form of reimbursement, at cost, for tasks completed by personnel of the Adviser, primarily for the valuation of portfolio companies. Loan servicing fees
that are payable to the Adviser pursuant to our Fifth Amended and Restated Credit Agreement, with KeyBank National Association (KeyBank), as administrative agent, lead arranger and lender, as amended (our Credit Facility),
are also 100% credited against the base management fee as discussed below, Loan Servicing Fee Pursuant to Credit Agreement.
Incentive Fee
The incentive fee consists of two parts:
an income-based incentive fee and a capital gains-based incentive fee. The income-based incentive fee rewards the Adviser if our quarterly net investment income (before giving effect to any incentive fee) exceeds 1.75% of our net assets (2.0% during
the one year period from April 1, 2020 through March 31, 2021), which we define as total assets less indebtedness and before taking into account any incentive fees payable or contractually due but not payable during the period, at the end
of the immediately preceding calendar quarter, adjusted appropriately for any share issuances or repurchases during the period (the hurdle rate). The income-based incentive fee with respect to our
pre-incentive fee net investment income is generally payable quarterly to the Adviser and is computed as follows:
no incentive fee in any calendar quarter in which our pre-incentive fee
net investment income does not exceed the hurdle rate;
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100.0% of our pre-incentive fee net investment income with respect to
that portion of such pre-incentive fee net investment income, if any, that exceeds the hurdle rate but is less than 2.1875% (2.4375% during the one year period from April 1, 2020 through March 31,
2021) of our net assets, adjusted appropriately for any share issuances or repurchases during the period, in any calendar quarter; and
20.0% of the amount of our pre-incentive fee net investment income, if
any, that exceeds 2.1875% (2.4375% during the one year period from April 1, 2020 through March 31, 2021) of our net assets, adjusted appropriately for any share issuances or repurchases during the period, in any calendar quarter.
Quarterly Incentive Fee Based on Net Investment Income for the Year Period Ending March 31, 2021 (A)
Pre-incentive fee net investment
income
(expressed as a percentage of the value of net assets)
Percentage of pre-incentive fee net investment income
allocated to income-related portion of incentive fee
(A)
After March 31, 2021, the 2.00% quarterly hurdle rate will revert back to 1.75% and the 2.4375% quarterly
excess incentive fee hurdle rate will revert back to 2.1875%.
The second part of the incentive fee is a capital gains-based incentive
fee that is determined and payable in arrears as of the end of each fiscal year (or upon termination of the Advisory Agreement, as of the termination date) and equals 20.0% of our net realized capital gains (as defined below) as of the
end of the fiscal year. In determining the capital gains-based incentive fee payable to the Adviser, we calculate net realized capital gains at the end of each applicable year by subtracting the sum of our cumulative aggregate realized
capital losses and our entire portfolios aggregate unrealized capital depreciation from our cumulative aggregate realized capital gains. For this purpose, cumulative aggregate realized capital gains, if any, equals the sum of the differences
between the net sales price of each investment, when sold, and the original cost of such investment since inception. Cumulative aggregate realized capital losses equals the sum of the amounts by which the net sales price of each investment, when
sold, is less than the original cost of such investment since inception. The entire portfolios aggregate unrealized capital depreciation, if any, equals the sum of the difference between the valuation of each investment as of the applicable
calculation date and the original cost of such investment. At the end of the applicable fiscal year, the amount of capital gains that serves as the basis for our calculation of the capital gains-based incentive fee equals the cumulative aggregate
realized capital gains less cumulative aggregate realized capital losses, less the entire portfolios aggregate unrealized capital depreciation, if any. If this number is positive at the end of such fiscal year, then the capital gains-based
incentive fee for such year equals 20.0% of such amount, less the aggregate amount of any capital gains-based incentive fees paid in respect of our portfolio in all prior years. No capital gains-based incentive fee has been recorded or paid since
our inception through September 30, 2020, as cumulative unrealized capital depreciation has exceeded cumulative realized capital gains net of cumulative realized capital losses.
In accordance with GAAP, a capital gains-based incentive fee accrual is calculated using the aggregate cumulative realized capital gains and losses and
aggregate cumulative unrealized capital appreciation and depreciation. If such amount is positive at the end of a period, then GAAP requires us to record a capital gains-based incentive fee equal to 20.0% of such amount, less the aggregate amount of
actual capital gains-based
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incentive fees paid in all prior years. If such amount is negative, then there is no accrual for such period. GAAP requires that the capital gains-based incentive fee accrual consider the
cumulative aggregate unrealized capital appreciation in the calculation, as a capital gains-based incentive fee would be payable if such unrealized capital appreciation were realized. There can be no assurance that such unrealized capital
appreciation will be realized in the future. No GAAP accrual for a capital gains-based incentive fee has been recorded from our inception through September 30, 2020.
Our Board of Directors accepted non-contractual, unconditional and irrevocable credits from the Adviser to reduce the
income-based incentive fee to the extent net investment income did not cover 100.0% of distributions to common stockholders for the years ended September 30, 2020, 2019, and 2018, which credits totaled $3.0 million, $1.5 million, and
$1.7 million, respectively.
Loan Servicing Fee Pursuant to Credit Agreement
The Adviser also services the loans held by our wholly-owned subsidiary, Gladstone Business Loan, LLC (Business Loan) (the borrower under our
Credit Facility), in return for which the Adviser receives a 1.5% annual fee payable monthly based on the monthly aggregate outstanding balance of loans pledged under our Credit Facility. Since Business Loan is a consolidated subsidiary of ours, and
the total base management fee paid to the Adviser pursuant to the Advisory Agreement cannot exceed 1.75% of total assets (less any uninvested cash or cash equivalents resulting from borrowings and adjusted appropriately for any share issuances or
repurchases during the period) during any given calendar year, we treat payment of the loan servicing fee pursuant to our line of credit as a pre-payment of the base management fee under the Advisory
Agreement. Accordingly, these loan servicing fees are 100% non-contractually, unconditionally, and irrevocably credited back to us by the Adviser.
Administration Agreement
We reimburse the
Administrator pursuant to the Administration Agreement for our allocable portion of the Administrators expenses incurred while performing services to us, which are primarily rent and salaries and benefits expenses of the Administrators
employees, including our chief financial officer and treasurer, chief compliance officer, chief valuation officer and general counsel and secretary (who also serves as the Administrators president), and their respective staffs.
Our allocable portion of the Administrators expenses are generally derived by multiplying the Administrators total expenses by the approximate
percentage of time during the current quarter the Administrators employees performed services for us in relation to their time spent performing services for all companies serviced by the Administrator. On July 14, 2020, our Board of
Directors, including a majority of the directors who are not parties to the Administration Agreement or interested persons of either party, approved the renewal of the Administration Agreement through August 31, 2021.
Other Transactions
Mr. Gladstone also serves
on the board of managers of our affiliate, Gladstone Securities, a privately-held broker-dealer registered with the Financial Industry Regulatory Authority and insured by the Securities Investor Protection Corporation. Gladstone Securities is 100%
indirectly owned and controlled by Mr. Gladstone and has provided other services, such as investment banking and due diligence services, to certain of our portfolio companies, for which Gladstone Securities receives a fee. Any such fees paid by
portfolio companies to Gladstone Securities do not impact the fees we pay to the Adviser or the non-contractual, unconditional, and irrevocable credits against the base management fee or incentive fee. For
additional information refer to Note 4 Related Party Transactions of our accompanying Notes to Consolidated Financial Statements .
Material U.S. Federal Income Tax Considerations
This is a general summary of certain material U.S. federal income tax considerations applicable to us, to our qualification and taxation as a RIC for U.S.
federal income tax purposes under Subchapter M of the Code and to
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the ownership and disposition of our shares. This summary does not purport to be a complete description of all of the tax considerations relating thereto. In particular, we have not described
certain considerations that may be relevant to certain types of stockholders subject to special treatment under U.S. federal income tax laws. This summary does not discuss any aspect of state, local or foreign tax laws, or the U.S. estate or gift
tax.
RIC Status
To qualify for treatment as
a RIC under Subchapter M of the Code, we must generally distribute to our stockholders, for each taxable year, at least 90.0% of our taxable ordinary income plus the excess of our realized net short-term capital gains over our realized net long-term
capital losses (Investment Company Taxable Income). We refer to this as the annual distribution requirement. We must also meet several additional requirements, including:
Business Development Company status . At all times during the taxable year, we must maintain our status as
a BDC.
Income source requirements . At least 90.0% of our gross income for each taxable year must be from
dividends, interest, payments with respect to securities, loans, gains from sales or other dispositions of securities or other income (including certain deemed inclusions) derived with respect to our business of investing in securities, and net
income derived from an interest in a qualified publicly traded partnership.
Asset diversification requirements . As of the close of each quarter of our taxable year: (1) at least
50% of the value of our assets must consist of cash, cash items, U.S. government securities, the securities of other regulated investment companies and other securities to the extent that (a) we do not hold more than 10% of the outstanding
voting securities of an issuer of such other securities and (b) such other securities of any one issuer do not represent more than 5% of our total assets, and (2) no more than 25% of the value of our total assets may be invested in the
securities (other than U.S. government securities or the securities of other regulated investment companies) of (i) one issuer, (ii) two or more issuers that are controlled by us and are engaged in the same or similar or related trades or
businesses, and (iii) one or more qualified publicly-traded partnerships.
Failure to Qualify as a RIC
If we are unable to qualify for treatment as a RIC, we would be subject to U.S. federal income tax on all of our taxable income at the regular corporate income
tax rate and would be subject to any applicable state and local taxes, even if we distributed all of our Investment Company Taxable Income to our stockholders. We would not be able to deduct distributions to our stockholders, nor would we be
required to make such distributions for U.S. federal income tax purposes. Distributions would be taxable to our stockholders as ordinary dividend income and, subject to certain limitations under the Code, would be eligible for the current maximum
rate applicable to qualifying dividend income of individuals and other non-corporate U.S. stockholders to the extent of our current or accumulated earnings and profits. Subject to certain limitations under the
Code, corporate distributees would be eligible for the dividends received deduction, if applicable. Distributions in excess of our current and accumulated earnings and profits would be treated first as a return of capital to the extent of the
stockholders adjusted tax basis, and then as capital gain. If we fail to meet the RIC requirements for more than two consecutive years and then seek to requalify as a RIC, we generally would be subject to corporate-level U.S. federal income
tax on any unrealized appreciation with respect to our assets unless we make a special election to pay corporate-level U.S. federal income tax on any such unrealized appreciation during the succeeding five-year period.
Qualification as a RIC
If we qualify as a RIC and
meet the annual distribution requirement, we will not be subject to U.S. federal income tax on the portion of our Investment Company Taxable Income and net capital gain (realized net long
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term capital gain in excess of realized net short term capital loss) that we timely distribute (or are deemed to timely distribute) to our stockholders. If we fail to distribute in a timely
manner an amount at least equal to the sum of (1) 98.0% of our ordinary income for the calendar year, (2) 98.2% of our net capital gains 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 (together, the excise tax distribution requirements),
we will be subject to a 4% nondeductible federal excise tax on the portion of the undistributed amounts of such income that are less than the amounts required to be distributed based on the excise tax distribution requirements. For the calendar
years ended December 31, 2019, 2018, and 2017, we did not incur any excise taxes. As of September 30, 2020, our capital loss carryforward was $72.4 million.
If we acquire debt obligations that (i) were originally issued at a discount, (ii) bear interest at rates that are not either fixed rates or certain
qualified variable rates, or (iii) are not unconditionally payable at least annually over the life of the obligation, we will be required to include in taxable income each year a portion of the original issue discount (OID) that
accrues over the life of the obligation. Additionally, PIK interest, which is computed at the contractual rate specified in a loan agreement and is added to the principal balance of a loan, is also a non-cash
source of income that we are required to include in taxable income each year. Both OID and PIK income will be included in our Investment Company Taxable Income even though we receive no cash corresponding to such amounts. As a result, we may be
required to make additional distributions corresponding to such OID and PIK amounts in order to satisfy the annual distribution requirement and to continue to qualify as a RIC or to avoid the imposition of federal income and excise taxes. In this
event, we may be required to sell investments or other assets to meet the RIC distribution requirements. For the year ended September 30, 2020, we recorded $0.3 million of OID income and the unamortized balance of OID investments (which
are primarily all syndicated loans) as of September 30, 2020 totaled $0.6 million. As of September 30, 2020, we had seven investments which had a PIK interest component and we recorded PIK interest income of $2.6 million during
the year ended September 30, 2020.
Taxation of Our U.S. Stockholders
Distributions
For any period during which we
qualify as a RIC for U.S. federal income tax purposes, distributions to our stockholders attributable to our Investment Company Taxable Income generally will be taxable as ordinary income to our stockholders to the extent of our current or
accumulated earnings and profits. We first allocate our earnings and profits to distributions to our preferred stockholders, if any, and then to distributions to our common stockholders based on priority in our capital structure. Any distributions
in excess of our earnings and profits will first be treated as a return of capital to the extent of the stockholders adjusted basis in his or her shares of stock and thereafter as capital gain. Distributions of our long-term capital gains,
reported by us as such, will be taxable to our stockholders as long-term capital gains regardless of the stockholders holding period of the stock and whether the distributions are paid in cash or invested in additional stock. Corporate U.S.
stockholders generally are eligible for the 50% dividends received deduction with respect to ordinary income dividends received from us, but only to the extent such amount is attributable to dividends received by us from taxable domestic
corporations.
A RIC that has two or more classes of stock generally is required to allocate to each class proportionate amounts of each type of its
income (such as ordinary income, capital gains, qualified dividend income and dividends qualifying for the dividends-received deduction) based upon the percentage of total distributions paid to each class for the tax year. Accordingly, for any tax
year in which we have common shares and preferred shares, we intend to allocate capital gain distributions, distributions of qualified dividend income, and distributions qualifying for the dividends-received deduction, if any, between our common
shares and preferred shares in proportion to the total distributions paid to each class with respect to such tax year.
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Any distribution declared by us in October, November or December of any calendar year, payable to our
stockholders of record on a specified date in such a month and actually paid during January of the following year, will be treated as if it were paid by us and received by our stockholders on December 31 of the previous year. In addition, we
may elect (in accordance with Section 855(a) of the Code) to relate a distribution back to the prior taxable year if we (1) declare such distribution prior to the later of the extended due date for filing our return for that taxable year
or the 15 th day of the ninth month following the close of the taxable year, (2) make the election in that return, and (3) distribute the amount in
the 12-month period following the close of the taxable year but not later than the first regular distribution payment of the same type following the declaration. Any such election will not alter the
general rule that a stockholder will be treated as receiving a distribution in the taxable year in which the distribution is made, subject to the October, November, December rule described above.
If a common stockholder participates in our opt in dividend reinvestment plan, then the common stockholder will have their cash dividends and
distributions automatically reinvested in additional shares of our common stock, rather than receiving cash dividends and distributions. Any distributions reinvested under the plan will be taxable to the 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 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, unless we were to issue new shares that are trading at or above net asset value, in which case, the U.S. stockholders basis in the new shares would
generally be equal to their fair market value. The additional common shares will have a new holding period commencing on the day following the day on which the shares are credited to the common stockholders account. The plan agent purchases
shares in the open market in connection with the obligations under the plan.
Sale of Our Shares
A U.S. stockholder generally will recognize taxable gain or loss if the U.S. stockholder sells or otherwise disposes of the shares of our common stock. Any
gain arising from such sale or disposition generally will be treated as long-term capital gain or loss if the U.S. stockholder has held the shares for more than one year. Otherwise, it will be classified as short-term capital gain or loss. However,
any capital loss arising from the sale or disposition of shares of our stock held for six months or less will be treated as long-term capital loss to the extent of the amount of capital gain dividends received, or undistributed capital gain deemed
received, with respect to such shares. Under the tax laws in effect as of the date of this filing, individual U.S. stockholders are subject to a maximum federal income tax rate of 20% on their net capital gain (i.e. the excess of realized net
long-term capital gain over realized net short-term capital loss for a taxable year) including any long-term capital gain derived from an investment in our shares. Such rate is lower than the maximum rate on ordinary income currently payable by
individuals. Corporate U.S. stockholders currently are subject to federal income tax on net capital gain at the same rates applied to their ordinary income. Capital losses are subject to limitations on use for both corporate
and non-corporate stockholders. Certain U.S. stockholders who are individuals, estates or trusts generally are also subject to a 3.8% Medicare tax on, among other things, dividends on and capital gain from the sale or other disposition of
shares of our stock.
Backup Withholding and Other Required Withholding
We may be required to withhold U.S. federal income tax (i.e. backup withholding) from all taxable distributions to
any non-corporate U.S. stockholder (i) who fails to furnish us with a correct taxpayer identification number or a certificate that such stockholder is exempt from backup withholding, or
(ii) with respect to whom the Internal Revenue Service (IRS) notifies us that such stockholder has failed to properly report certain interest and dividend income to the IRS and to respond to notices to that effect. An
individuals taxpayer identification number is generally his or her social security number. Any amount withheld under backup withholding is allowed as a credit against the U.S. stockholders federal income tax liability, provided that
proper information is timely provided to the IRS.
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The Foreign Account Tax Compliance Act imposes a U.S. federal withholding tax on certain types of payments made
to foreign financial institutions and certain other non-U.S. entities unless certain due diligence, reporting, withholding, and certification obligation requirements are satisfied.
Information Reporting
We will send to each of our
U.S. stockholders, after the end of each calendar year, a notice providing, on a per share and per distribution basis, the amounts includible in the U.S. stockholders taxable income for such year as ordinary income and as long-term capital
gain, if any. In addition, the U.S. federal tax status of each years distributions will generally be reported to the IRS (including the amount of dividends, if any, eligible for the preferential rates applicable to long-term capital gains).
Regulation as a BDC
We are a closed-end, non-diversified management investment company that has elected to be regulated as a BDC under Section 54 of the 1940 Act. As such, we are subject to
regulation under the 1940 Act. The 1940 Act contains prohibitions and restrictions relating to transactions between BDCs and their affiliates, principal underwriters and affiliates of those affiliates or underwriters and requires that a majority of
the directors be persons other than interested persons, as defined in the 1940 Act. In addition, the 1940 Act provides that we may not change the nature of our business so as to cease to be, or to withdraw our election as, a BDC unless
approved by a majority of our outstanding voting securities, as defined in the 1940 Act.
We intend to conduct our business so as to retain
our status as a BDC. A BDC may use capital provided by public stockholders and from other sources to make long-term investments in private companies. A BDC provides stockholders the ability to retain the liquidity of a publicly traded stock while
sharing in the possible benefits, if any, of investing in primarily privately owned companies. In general, a BDC must have been organized and have its principal place of business in the U.S. and must be operated for the purpose of making investments
in qualifying assets, as described in Sections 55(a)(1) through (a)(3) of the 1940 Act.
Qualifying Assets
Under the 1940 Act, a BDC may not acquire any asset other than assets of the type listed in Section 55(a) of the 1940 Act, which are referred to as
qualifying assets, unless, at the time the acquisition is made, qualifying assets, other than certain interests in furniture, equipment, real estate, or leasehold improvements (Operating Assets) represent at least 70.0% of total assets,
exclusive of Operating Assets. The types of qualifying assets in which we may invest under the 1940 Act include the following:
(1)
Securities purchased in transactions not involving any public offering from the issuer of such securities, which issuer is an eligible portfolio company. An eligible portfolio company is generally defined in the 1940 Act as any issuer which:
(a)
is organized under the laws of, and has its principal place of business in, any state or states in the U.S.;
(b)
is not an investment company (other than a small business investment company wholly owned by the BDC or
otherwise excluded from the definition of investment company); and
(c) satisfies one of the following:
(i)
it does not have any class of securities with respect to which a broker or dealer may extend margin credit;
(ii)
it is controlled by the BDC and for which an affiliate of the BDC serves as a director;
(iii)
it has total assets of not more than $4.0 million and capital and surplus of not less than
$2 million;
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(iv)
it does not have any class of securities listed on a national securities exchange; or
(v)
it has a class of securities listed on a national securities exchange, with an aggregate market value of
outstanding voting and non-voting equity of less than $250.0 million.
(2)
Securities received in exchange for or distributed on or with respect to securities described in
(1) above, or pursuant to the exercise of options, warrants or rights relating to such securities.
(3)
Cash, cash items, government securities or high quality debt securities maturing in one year or less from the
time of investment.
As of September 30, 2020, 98.8% of our assets were qualifying assets.
Asset Coverage
Pursuant to Section 61(a)(3)
of the 1940 Act, we are permitted to issue multiple classes of senior securities representing indebtedness. However, pursuant to Section 18(c) of the 1940 Act, we are permitted to issue only one class of senior securities that
is stock. In either case, we may only issue such senior securities if such class of senior securities, after such issuance, has an asset coverage, as defined in Section 18(h) of the 1940 Act of at least 150%.
In addition, our ability to pay dividends or distributions (other than dividends payable in our common stock) to holders of any class of our capital stock
would be restricted if our senior securities representing indebtedness fail to have an asset coverage of at least 150% (measured at the time of declaration of such distribution and accounting for such distribution). The 1940 Act does not
apply this limitation to privately arranged debt that is not intended to be publicly distributed, unless this limitation is specifically negotiated by the lender. In addition, our ability to pay dividends or distributions (other than dividends
payable in our common stock) to our common stockholders would be restricted if our senior securities that are stock fail to have an asset coverage of at least 150% (measured at the time of declaration of such distribution and accounting
for such distribution). If the value of our assets declines, we might be unable to satisfy these asset coverage requirements. To satisfy the 150% asset coverage requirement in the event that we are seeking to pay a distribution, we might either have
to (i) liquidate a portion of our portfolio to repay a portion of our indebtedness or (ii) issue common stock. This may occur at a time when a sale of a portfolio asset may be disadvantageous, or when we have limited access to capital
markets on agreeable terms. In addition, any amounts that we use to service our indebtedness or for offering costs will not be available for distributions to our stockholders. If we are unable to regain the requisite asset coverage through these
methods, we may be forced to suspend the payment of such dividends or distributions.
Significant Managerial Assistance
A BDC generally must make available significant managerial assistance to issuers of certain of its portfolio securities that the BDC counts as a qualifying
asset for the 70.0% test described above. Making available significant managerial assistance means, among other things, any arrangement whereby the BDC, through its directors, officers or employees, offers to provide, and, if accepted, does so
provide, significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company. Significant managerial assistance also includes the exercise of a controlling influence over the management
and policies of the portfolio company. However, with respect to certain, but not all such securities, where the BDC purchases such securities in conjunction with one or more other persons acting together, one of the other persons in the group may
make available such managerial assistance, or the BDC may exercise such control jointly.
Summary Risk Factors
Below is a summary of the principal risk factors associated with an investment in our securities. In addition to the below, you should carefully consider the
information included in Risk Factors beginning on page 24 of this
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Annual Report together with all of the other information included in this Annual Report and the other reports and documents filed or furnished by us with the SEC for a more detailed discussion of
the principal risks as well as certain other risks that you should carefully consider before deciding to invest in our securities.
Market conditions could negatively impact our business, results of operations, cash flows and financial
condition.
Volatility in the capital markets may make it more difficult to raise capital and may adversely affect the
valuations of our investments.
Our business may be adversely affected by the current coronavirus pandemic and related government actions.
Changes in interest rates may negatively impact our investments and have an adverse effect on our business,
financial condition, results of operations, and cash flows.
We typically invest in transactions involving acquisitions, buyouts and recapitalizations of companies, which
will subject us to the risks associated with change in control transactions.
Our investments in lower middle market companies are extremely risky and could cause you to lose all or a part
of your investment.
The lack of liquidity of our privately held investments may adversely affect our business.
Our portfolio is concentrated in a limited number of companies and industries, which subjects us to an
increased risk of significant loss if any one of these companies does not repay us or if the industries experience downturns.
Any inability to renew, extend or replace our Credit Facility on terms favorable to us, or at all, could
adversely impact our liquidity and ability to fund new investments or maintain distributions to our stockholders.
Changes in laws or regulations governing our operations, or changes in the interpretation thereof, and any
failure by us to comply with laws or regulations governing our operations may adversely affect our business.
We are subject to restrictions that may discourage a change of control. Certain provisions contained in our
articles of incorporation and Maryland law may prohibit or restrict a change of control and adversely impact the price of our common stock.
Our success depends on the Advisers ability to attract and retain qualified personnel in a competitive
environment.
Our incentive fee may induce the Adviser to make certain investments, including speculative investments.
We may be obligated to pay the Adviser incentive compensation even if we incur a loss.
The Adviser is not obligated to provide a credit of the base management fee or incentive fee, which could
negatively impact our earnings and our ability to maintain our current level of distributions to our stockholders.
There is a risk that you may not receive distributions or that distributions may not grow over time
Investing in our securities may involve an above average degree of risk.
Common shares of closed-end investment companies frequently trade at a
discount to the net asset value of our common stock (NAV).
We may choose to redeem the 2023 Notes or 2024 Notes when prevailing interest rates are relatively low.
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Cybersecurity risks and cyber incidents may adversely affect our business by causing a disruption to our
operations, or the operations of businesses in which we invest, a compromise or corruption of our confidential information and/or damage to our business relationships, all of which could negatively impact our business, financial
condition and operating results.
Code of Ethics
We, and all of the Gladstone Companies, have adopted a code of ethics and business conduct applicable to all of the officers, directors and personnel of such
companies that complies with the guidelines set forth in Item 406 of Regulation S-K of the Securities Act and Rule 17j-1 of the 1940 Act. As required by the 1940 Act,
this code establishes procedures for personal investments, restricts certain transactions by such personnel and requires the reporting of certain transactions and holdings by such personnel. This code of ethics and business conduct is publicly
available on the Investors section of our website under Governance Governance Documents at www.GladstoneCapital.com . We intend to provide any required disclosure of any amendments to or waivers of the provisions of this
code by posting information regarding any such amendment or waiver to our website or in a Current Report on Form 8-K.
Compliance Policies and Procedures
We and the
Adviser have adopted and implemented written policies and procedures reasonably designed to prevent violation of the federal securities laws, and our Board of Directors is required to review these compliance policies and procedures annually to
assess their adequacy and the effectiveness of their implementation. We have designated a chief compliance officer, John Dellafiora, Jr., who also serves as chief compliance officer for all of the Gladstone Companies.
Staffing
We do not currently have any employees
and do not expect to have any employees in the foreseeable future. Currently, services necessary for our business are provided by individuals who are employees of the Adviser and the Administrator pursuant to the terms of the Advisory Agreement and
the Administration Agreement, respectively. We expect that 25 to 30 full time employees of the Adviser and the Administrator will spend substantial time on our matters during the remainder of calendar year 2020 and all of calendar year 2021. As of
September 30, 2020, the Adviser and the Administrator collectively had 68 full-time employees. A breakdown of these employees is summarized by functional area in the table below:
Number of Individuals
Functional Area
12
Executive management
20
Accounting, administration, compliance, human resources, legal and treasury
36
Investment management, portfolio management and due diligence
The Adviser and the Administrator aim to attract and retain capable advisory and administrative personnel, respectively, by
offering competitive base salaries and bonus structure and by providing employees with appropriate opportunities for professional growth.
Available
Information
We file with or furnish to the SEC copies of our annual report on Form 10-K, quarterly
reports on Form 10-Q, current reports on Form 8-K, proxy statements and other information meeting the information requirements of Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended (the Exchange Act), and make such reports and any amendments thereto available free of charge through the Investors section of our website at www.GladstoneCapital.com
as soon as reasonably practicable after such materials are electronically filed with or
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furnished to the SEC. Information contained on our website is not incorporated by reference into this Annual Report. The SEC also maintains a website that contains reports, proxy and information
statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov .
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