Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The information contained in this section should be read in conjunction with our consolidated financial statements and related notes thereto appearing elsewhere in this annual report on Form 10-K.
COVID-19
Governments around the world remain highly focused on mitigating the risk of further spread of COVID-19 and continue to manage their response to the crisis, which has included measures such as quarantines, travel restrictions and business curtailments. COVID-19 has created economic and financial disruptions that have adversely affected, and are likely to continue to adversely affect, our business, financial condition, liquidity and our portfolio companies’ results of operations and by extension our operating results. The extent to which the COVID-19 pandemic will continue to affect our business, financial condition, liquidity, our portfolio companies’ results of operations and by extension our operating results will depend on future developments, which are highly uncertain and cannot be predicteds as of the filing of this Form 10-K.
Forward-looking statements
This annual report on Form 10-K, including the Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains statements that constitute forward-looking statements, which relate to future events or our future performance or financial condition. These forward-looking statements are not historical facts, but rather are based on current expectations, estimates and projections about our industry, our beliefs and our assumptions. The forward-looking statements contained in this annual report on Form 10-K involve risks and uncertainties, including statements as to:
● our future operating results, including the performance of our existing debt investments, warrants and other investments;
● the introduction, withdrawal, success and timing of business initiatives and strategies;
● general economic and political trends and other external factors, including the current COVID-19 pandemic;
● the relative and absolute investment performance and operations of our Advisor;
● the impact of increased competition;
● the impact of investments we intend to make and future acquisitions and divestitures;
● the unfavorable resolution of legal proceedings;
● our business prospects and the prospects of our portfolio companies, including our and their ability to achieve our respective objectives as a result of the current COVID-19 pandemic;
● the impact, extent and timing of technological changes and the adequacy of intellectual property protection;
● our regulatory structure and tax status;
● our ability to qualify and maintain qualification as a RIC and as a BDC;
● the adequacy of our cash resources and working capital;
● the timing of cash flows, if any, from the operations of our portfolio companies;
● the impact of interest rate volatility on our results, particularly if we use leverage as part of our investment strategy;
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● the ability of our portfolio companies to achieve their objective;
● the impact of legislative and regulatory actions and reforms and regulatory supervisory or enforcement actions of government agencies relating to us or our Advisor;
● our contractual arrangements and relationships with third parties;
● our ability to access capital and any future financings by us;
● the ability of our Advisor to attract and retain highly talented professionals;
● the impact of changes to tax legislation and, generally, our tax position; and
● our ability to fund unfunded commitments.
We use words such as “anticipates,” “believes,” “expects,” “intends,” “seeks” and similar expressions to identify forward-looking statements. Undue influence should not be placed on the forward looking statements as our actual results could differ materially from those projected in the forward-looking statements for any reason, including the factors in “Item 1A – Risk Factors” and elsewhere in our annual report on Form 10-K.
We have based the forward-looking statements included in this report on information available to us on the date of this report, and we assume no obligation to update any such forward-looking statements. Although we undertake no obligation to revise or update any forward-looking statements in this annual report on Form 10-K, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that we may make directly to you or through reports that we in the future may file with the SEC, including periodic reports on Form 10-Q and current reports on Form 8-K.
You should understand that under Sections 27A(b)(2)(B) and (D) of the Securities Act and Sections 21E(b)(2)(B) and (D) of the Exchange Act, the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 do not apply to statements made in connection with this annual report on Form 10-K or any quarterly reports we file under the Exchange Act.
Overview
We are a specialty finance company that lends to and invests in development-stage companies in our Target Industries. Our investment objective is to maximize our investment portfolio’s total return by generating current income from the debt investments we make and capital appreciation from the warrants we receive when making such debt investments. We are focused on making Venture Loans to venture capital and private equity backed companies and publicly traded companies in our Target Industries, which we refer to as “Venture Lending.” Our debt investments are typically secured by first liens or first liens behind a secured revolving line of credit, or Senior Term Loans. As of December 31, 2020, 100%, or $333.5 million, of our debt investment portfolio at fair value consisted of Senior Term Loans. Venture Lending is typically characterized by (1) the making of a secured debt investment after a venture capital or equity investment in the portfolio company has been made, which investment provides a source of cash to fund the portfolio company’s debt service obligations under the Venture Loan, (2) the senior priority of the Venture Loan which requires repayment of the Venture Loan prior to the equity investors realizing a return on their capital, (3) the relatively rapid amortization of the Venture Loan and (4) the lender’s receipt of warrants or other success fees with the making of the Venture Loan.
We are an externally managed, closed-end, non-diversified management investment company that has elected to be regulated as a BDC under the 1940 Act. In addition, for U.S. federal income tax purposes, we have elected to be treated as a RIC under Subchapter M of the Code. As a BDC, we are required to comply with regulatory requirements, including limitations on our use of debt. We are permitted to, and expect to, finance our investments through borrowings. Section 61(a) of the 1940 Act added to Section 61(a)(2) of the 1940 Act enables BDCs to reduce their asset coverage requirements from 200% to 150% as a result of the enactment of the SBCAA. This provision permits a BDC to double the maximum amount of leverage that it is permitted to incur. As defined in the 1940 Act, asset coverage of 150% means that for every $100 of net assets a BDC holds, it may raise up to $200 from borrowing and issuing senior securities. We received approval
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from our stockholders to reduce our asset coverage requirement from 200% to 150% on October 30, 2018. The amount of leverage that we may employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing. As a RIC, we generally are not subject to corporate-level income taxes on our investment company taxable income, determined without regard to any deductions for dividends paid, and our net capital gain that we distribute as dividends for U.S. federal income tax purposes to our stockholders as long as we meet certain source-of-income, distribution, asset diversification and other requirements.
Compass Horizon, our predecessor company, commenced operations in March 2008. We were formed in March 2010 for the purpose of acquiring Compass Horizon and continuing its business as a public entity.
Our investment activities, and our day-to-day operations, are managed by our Advisor and supervised by our Board, of which a majority of the members are independent of us. Under the Investment Management Agreement, we have agreed to pay our Advisor a base management fee and an incentive fee for its advisory services to us. We have also entered into the Administration Agreement with our Advisor under which we have agreed to reimburse our Advisor for our allocable portion of overhead and other expenses incurred by our Advisor in performing its obligations under the Administration Agreement.
Portfolio composition and investment activity
The following table shows our portfolio by type of investment as of December 31, 2020 and 2019:
December 31, 2020
December 31, 2019
Percentage of
Percentage of
Number of
Fair
Total
Number of
Fair
Total
Investments
Value
Portfolio
Investments
Value
Portfolio
(Dollars in thousands)
Debt investments
34
$
333,495
94.6
%
35
$
288,355
90.2
%
Warrants
60
14,031
4.0
66
10,829
3.4
Other investments
2
1,700
0.5
1
500
0.2
Equity
8
3,319
0.9
9
3,217
1.0
Equity interest in HSLFI
—
—
—
1
16,650
5.2
Total
$
352,545
100.0
%
$
319,551
100.0
%
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The following table shows total portfolio investment activity as of and for the years ended December 31, 2020 and 2019:
For the year ended
December 31,
2020
2019
Beginning portfolio
$
319,551
$
248,441
New debt investments
198,561
200,832
Less refinanced debt investments
—
(17,500)
Net new debt investments
198,561
183,332
Investment in controlled affiliate investment
—
1,900
Principal payments received on investments
(24,829)
(17,369)
Early pay-offs
(121,429)
(94,321)
Accretion of debt investment fees
3,895
3,865
New debt investment fees
(2,353)
(2,669)
New equity
—
240
Warrants received in settlement of fee income
978
—
Proceeds from sale of investments
(8,335)
(4,548)
Dividend income from controlled affiliate investment
118
2,236
Distributions from controlled affiliate investment
—
(715)
Net realized loss on investments
(13,727)
(4,192)
Net unrealized appreciation on investments
313
3,201
Other
(198)
150
Ending portfolio
$
352,545
$
319,551
We receive payments on our debt investments based on scheduled amortization of the outstanding balances. In addition, we receive repayments of some of our debt investments prior to their scheduled maturity date. The frequency or volume of these repayments may fluctuate significantly from period to period.
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The following table shows our debt investments by industry sector as of December 31, 2020 and 2019:
December 31, 2020
December 31, 2019
Debt
Percentage of
Debt
Percentage of
Investments at
Total
Investments at
Total
Fair Value
Portfolio
Fair Value
Portfolio
(Dollars in thousands)
Life Science
Biotechnology
$
44,121
13.2
%
$
41,789
14.5
%
Drug Delivery
—
—
1,533
0.6
Medical Device
107,726
32.3
59,477
20.6
Technology
Communications
—
—
1,500
0.5
Consumer-Related
59,022
17.7
42,779
14.8
Data Storage
22,953
7.0
24,452
8.5
Internet and Media
7,089
2.1
22,504
7.8
Materials
1,737
0.5
8,410
2.9
Networking
9,738
2.9
—
—
Power Management
—
—
11,207
3.9
Software
56,535
17.0
51,069
17.7
Healthcare Information and Services
Diagnostics
9,760
2.9
—
—
Other Healthcare
14,814
4.4
9,771
3.4
Software
—
—
13,864
4.8
Total
$
333,495
100.0
%
$
288,355
100.0
%
The largest debt investments in our portfolio may vary from year to year as new debt investments are originated and existing debt investments are repaid. Our five largest debt investments represented 28% of total debt investments outstanding as of December 31, 2020 and 2019. No single debt investment represented more than 10% of our total debt investments as of December 31, 2020 or 2019.
Debt investment asset quality
We use an internal credit rating system which rates each debt investment on a scale of 4 to 1, with 4 being the highest credit quality rating and 3 being the rating for a standard level of risk. A rating of 2 represents an increased level of risk and, while no loss is currently anticipated for a 2-rated debt investment, there is potential for future loss of principal. A rating of 1 represents a deteriorating credit quality and a high degree of risk of loss of principal. Our internal credit rating system is not a national credit rating system. See “Item 1 – Business” for a more detailed description of the internal credit rating system. As of December 31, 2020 and 2019, our debt investments had a weighted average credit rating of 3.2 and 3.1, respectively. The following table shows the classification of our debt investment portfolio by credit rating as of December 31, 2020 and 2019:
December 31, 2020
December 31, 2019
Debt
Percentage
Debt
Percentage
Number of
Investments at
of Debt
Number of
Investments at
of Debt
Investments
Fair Value
Investments
Investments
Fair Value
Investments
(Dollars in thousands)
Credit Rating
4
6
$
77,950
23.4
%
4
$
45,339
15.7
%
3
24
240,933
72.2
26
216,128
75.0
2
3
12,875
3.9
3
24,888
8.6
1
1
1,737
0.5
2
2,000
0.7
Total
34
$
333,495
100.0
%
35
$
288,355
100.0
%
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As of December 31, 2020, there was one debt investment with an internal credit rating of 1, with an aggregate cost of $6.8 million and an aggregate fair value of $1.7 million. As of December 31, 2019, there were two debt investments with an internal credit rating of 1, with an aggregate cost of $5.7 million and an aggregate fair value of $2.0 million.
Horizon Secured Loan Fund I LLC
On June 1, 2018, we and Arena Sunset SPV, LLC, or Arena, formed a joint venture, Horizon Secured Loan Fund I, or HSLFI, to make investments, either directly or indirectly through subsidiaries, primarily in the form of secured loans to development-stage companies in the technology, life science, healthcare information and services and sustainability industries. HSLFI was formed as a Delaware limited liability company and was not consolidated by either us or Arena for financial reporting purposes. On April 21, 2020, we purchased all of the limited liability company interests of Arena in HSLFI, including, without limitation, undistributed amounts owed to Arena and interest accrued and unpaid on the debt investments of HSLFI through the date of purchase, for $17.1 million. In addition, Arena received 50% of the warrants held by HSLFI or Horizon Funding I, LLC, or HFI, at closing. As of April 21, 2020, HSLFI is wholly-owned by us and the assets and liabilities of HSLFI and HFI is consolidated with the assets and liabilities by us.
Investments held by HSLFI were measured at fair value. As of December 31, 2019, HSLFI had total assets of $48.3 million. HSLFI’s portfolio consisted of debt investments in eight portfolio companies as of December 31, 2019. As of December 31, 2019, the largest investment in a single portfolio company in the HSLFI’s portfolio in aggregate principal amount was $11.3 million and the five largest investments in portfolio companies in the HSLFI totaled $30.3 million. As of December 31, 2019, HSLFI had no investments on non-accrual status. HSLFI invested in portfolio companies in the same industries in which we may directly invest.
We invested cash or securities in portfolio companies in HSLFI in exchange for limited liability company equity interests in HSLFI. As of December 31, 2019, we and Arena each owned 50.0% of the equity interests of HSLFI. We had an original commitment to fund $25.0 million of equity interests in HSLFI. As of December 31, 2019, $9.8 million was unfunded. Our investment in HSLFI consisted of an equity contribution of $15.2 million as of December 31, 2019. During the period January 1, 2020 through April 21, 2020, there were no distributions from HSLFI. For the year ended December 31, 2019, HSLFI distributed $1.4 million.
In addition, on June 1, 2018, HSLFI entered into the Sale and Servicing Agreement. HFI entered into the NYL Facility with several entities owned or affiliated with the NYL Noteholders for an aggregate purchase price of up to $100.0 million, with an accordion feature of up to $200.0 million at the mutual discretion and agreement of HSLFI and the NYL Noteholders. The notes issued by HFI were collateralized by all investments held by HFI and permitted an advance rate of up to 67% of the aggregate principal amount of eligible debt investments. The notes were issued pursuant to the Indenture. Prior to June 5, 2020, the interest rate on the notes issued under the NYL Facility was based on the three year USD mid-market swap rate plus a margin of between 2.75% and 3.25% depending on the rating of such notes at the time of issuance. There were $15.0 million in advances made by the NYL Noteholders as of December 31, 2019 at an interest rate of 4.98%.
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The following table shows a summary of HSLFI’s investment portfolio for the period January 1, 2020 through April 21, 2020, for the year ended December 31, 2019 and for the period June 1, 2018 through December 31, 2018:
For the period
For the period
January 1, 2020
For the year
June 1, 2018
through
ended
through
April 21, 2020
December 31, 2019
December 31, 2018
(Dollars in thousands)
Total investments at fair value
$
—
$
34,829
$
24,734
Dollar-weighted annualized yield on average debt investments (1)
14.3
%
15.8
%
12.9
%
Number of portfolio companies in HSLFI
—
10
4
Largest portfolio company investment at fair value
$
—
$
11,186
$
8,154
(1) HSLFI calculates the yield on dollar-weighted average debt investments for any period measured as (1) total investment income during the period divided by (2) the average of the fair value of debt investments outstanding on (a) the last day of the calendar month immediately preceding the first day of the period and (b) the last day of each calendar month during the period. The yield on dollar-weighted average debt investments represents the portfolio yield and does not reflect HSLFI’s expenses.
The following table shows HSLFI’s total portfolio investment activity as of and for the year ended December 31, 2019:
For the year ended
December 31,
2019
(In thousands)
Beginning portfolio
$
24,734
New debt investments
19,727
Early pay-offs
(9,727)
Accretion of debt investment fees
311
New debt investment fees
(188)
Net unrealized depreciation on investments
(28)
Ending portfolio
$
34,829
The following table shows HSLFI’s investments as of December 31, 2019:
Principal
Cost of
Fair
Portfolio Company (1)
Sector
Type of Investment (2)(3)(4)
Amount
Investments (5)
Value
(Dollars in thousands)
Debt Investments — Life science
Celsion Corporation (6)(7)(8)
Biotechnology
Term Loan (9.63% cash (Libor + 7.63%; Floor 9.63%), 4.00% ETP, Due 7/1/22)
$
2,500
$
2,464
$
2,464
Term Loan (9.63% cash (Libor + 7.63%; Floor 9.63%), 4.00% ETP, Due 7/1/22)
2,500
2,464
2,464
Encore Dermatology, Inc. (6)(7)
Biotechnology
Term Loan (10.00% cash (Libor + 7.50%; Floor 10.00%), 3.00% ETP, Due 4/1/23)
5,000
4,929
4,929
Mustang Bio, Inc. (6)(7)(8)
Biotechnology
Term Loan (9.00% cash (Libor + 6.50%; Floor 9.00%), 5.00% ETP, Due 10/1/22)
5,000
4,924
4,924
Total Debt Investments — Life science
14,781
14,781
Debt Investments — Technology
Bridge2 Solutions, LLC (6)(7)
Software
Term Loan (11.00% cash (Libor + 8.4%; Floor 11.00%), 2.00% ETP, Due 9/1/23)
500
481
481
New Signature US, Inc. (6)(7)(9)
Software
Term Loan (10.50% cash (Libor + 8.50%; Floor 10.50%), 3.50% ETP, Due 7/1/22)
8,250
8,163
8,163
Term Loan (10.50% cash (Libor + 8.50%; Floor 10.50%), 3.50% ETP, Due 2/1/23)
3,000
2,961
2,961
OutboundEngine, Inc. (6)(7)
Software
Term Loan (11.15% cash (Libor + 8.40%; Floor 11.15%), 3.00% ETP, Due 7/1/23)
500
491
491
Revinate, Inc. (6)(7)
Software
Term Loan (9.50% cash (Libor + 7.00%; Floor 9.50%), 3.00% ETP, Due 6/1/23)
4,000
3,952
3,952
Total Debt Investments — Technology
16,048
16,048
Debt Investments — Healthcare information and services
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HealthEdge Software, Inc. (6)(7)
Software
Term Loan (9.94% cash (Libor + 8.25%; Floor 9.25%), 3.00% ETP, Due 10/1/23)
3,750
3,709
3,709
Total Debt Investments — Healthcare information and services
3,709
3,709
Total Debt Investments
34,538
34,538
Warrant Investments — Life science
Celsion Corporation (6)(7)(8)
Biotechnology
95,057 Common Stock Warrants
58
6
Encore Dermatology, Inc. (6)(7)
Biotechnology
503,626 Preferred Stock Warrants
38
—
Mustang Bio, Inc. (6)(7)(8)
Biotechnology
72,046 Common Stock Warrants
45
74
CSA Medical, Inc. (6)(7)
Medical Device
17,751 Preferred Stock Warrants
2
2
Total Warrant Investments — Life science
143
82
Warrant Investments — Technology
Intelepeer Holdings, Inc. (6)(7)
Communications
2,081,934 Preferred Stock Warrants
82
72
Bridge2 Solutions, LLC (6)(7)
Software
2,500 Common Stock Warrants
18
34
BSI Platform Holdings, LLC (6)(7)(9)
Software
562,500 Preferred Stock Warrants
77
62
OutboundEngine, Inc. (6)(7)
Software
40,000 Preferred Stock Warrants
5
6
Revinate Inc. (6)(7)
Software
216,362 Preferred Stock Warrants
16
18
Total Warrant Investments — Technology
198
192
Warrant Investments — Healthcare information and services
HealthEdge Software, Inc. (6)(7)
Software
47,418 Preferred Stock Warrants
16
17
Total Warrant Investments — Healthcare information and services
16
17
Total Warrant Investments
357
291
Total Portfolio Investment Assets
$
34,895
$
34,829
Short Term Investments — Unrestricted Investments
US Bank Money Market Deposit Account (6)
$
11,201
$
11,201
Total Short Term Investments — Unrestricted Investments
$
11,201
$
11,201
Short Term Investments — Restricted Money Market Funds
US Bank Money Market Deposit Account (6)
$
138
$
138
Total Short Term Investments — Restricted Money Market Funds
$
138
$
138
(1) All investments of HSLFI are in entities which are organized under the laws of the United States and have a principal place of business in the United States.
(2) All interest is payable in cash due monthly in arrears, unless otherwise indicated, and applies only to HSLFI’s debt investments. Interest rate is the annual interest rate on the debt investment and does not include end-of-term payments, or ETPs, and any additional fees related to the investments, such as deferred interest, commitment fees or prepayment fees. Debt investments are at variable rates for the term of the debt investment, unless otherwise indicated. All debt investments based on the London InterBank Offered Rate, or LIBOR, are based on one-month LIBOR. For each debt investment, the current interest rate in effect as of December 31, 2019 is provided.
(3) ETPs are contractual fixed-interest payments due in cash at the maturity date of the applicable debt investment, including upon any prepayment, and are a fixed percentage of the original principal balance of the debt investments unless otherwise noted. Interest will accrue during the life of the debt investment on each ETP and will be recognized as non-cash income until it is actually paid.
(4) Warrants are non-income producing.
(5) For debt investments, represents principal balance less unearned income.
(6) Has been pledged as collateral under the NYL Facility.
(7) The fair value of the investment was valued using significant unobservable inputs.
(8) Portfolio company is a public company.
(9) New Signature US, Inc. is a subsidiary of BSI Platform Holdings, LLC.
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The following tables show certain summarized financial information for HSLFI as of December 31, 2019 and for the period January 1, 2020 through April 21, 2010, for the year ended December 31, 2019 and for the period June 1, 2018 through December 31, 2018:
December 31,
2019
(In thousands)
Selected Statement of Assets and Liabilities Information
Total investments at fair value (cost of $34,895)
$
34,829
Cash and cash equivalents
503
Investments in money market funds
11,201
Restricted investments in money market funds
138
Interest receivable
477
Other assets
1,109
Total assets
$
48,257
Borrowings
$
14,955
Other liabilities
126
Total liabilities
15,081
Members’ equity
33,176
Total liabilities and members’ equity
$
48,257
For the period
For the period
January 1, 2020
For the year
June 1, 2018
through
ended
through
April 21, 2020
December 31, 2019
December 31, 2018
(In thousands)
Selected Statements of Operations Information
Interest income on investments
$
1,353
$
5,291
$
689
Total investment income
$
1,465
$
5,699
$
689
Total expenses
$
1,229
$
1,227
$
180
Net investment income
$
236
$
4,472
$
509
Net realized gain on investments
$
120
—
$
—
Net unrealized depreciation on investments
$
(392)
$
(28)
$
(37)
Net (decrease) increase in net assets resulting from operations
$
(36)
$
4,444
$
472
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Consolidated results of operations of Horizon Technology Finance Corporation
As a BDC and a RIC, we are subject to certain constraints on our operations, including limitations imposed by the 1940 Act and the Code. The consolidated results of operations described below may not be indicative of the results we report in future periods.
The following table shows consolidated results of operations for the years ended December 31, 2020, 2019 and 2018:
For the year ended
December 31,
2020
2019
2018
(In thousands)
Total investment income
46,035
$
43,125
$
31,090
Total expenses
25,064
24,264
18,374
Performance based incentive fee waived
—
(1,848)
(1,184)
Net expenses
25,064
22,416
17,190
Net investment income before excise tax
20,971
20,709
13,900
Provision for excise tax
222
239
34
Net investment income
20,749
20,470
13,866
Net realized (loss) gain on investments
(14,698)
(4,173)
645
Net unrealized appreciation (depreciation) on investments
313
3,201
(1,501)
Net increase in net assets resulting from operations
$
6,364
$
19,498
$
13,010
Average debt investments, at fair value
$
313,478
$
244,940
$
200,911
Average borrowings outstanding
$
174,876
$
135,419
$
99,415
Net increase in net assets resulting from operations can vary substantially from period to period for various reasons, including the recognition of realized gains and losses and unrealized appreciation and depreciation on investments. As a result, annual comparisons of net increase in net assets resulting from operations may not be meaningful.
Investment income
Total investment income increased by $2.9 million, or 6.7%, to $46.0 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019. For the year ended December 31, 2020, total investment income consisted primarily of $42.2 million in interest income from investments, which included $10.3 million in income from the accretion of origination fees and ETP, $3.7 million in fee income and $0.1 million in dividend income. Interest income on debt investments increased by $5.1 million, or 13.8%, to $42.2 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019. Interest income on investments for the year ended December 31, 2020 as compared to the year ended December 31, 2019 increased primarily due to an increase of $68.5 million, or 28.0%, in the average size of our debt investment portfolio partially offset by a decrease in one-month LIBOR which is the base rate for many of our variable rate debt investments. Fee income, which includes success fee, other fee and prepayment fee income on debt investments, decreased by $0.1 million, or 2.1%, to $3.7 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to a decrease in fees earned on principal prepayments received.
Total investment income increased by $12.0 million, or 38.7%, to $43.1 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. For the year ended December 31, 2019, total investment income consisted primarily of $37.1 million in interest income from investments, which included $10.4 million in income from the accretion of origination fees and ETP, $3.8 million in fee income and $2.2 million in dividend income. Interest income on debt investments increased by $8.3 million, or 28.8%, to $37.1 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. Interest income on investments for the year ended December 31, 2019 as compared to the year ended December 31, 2018 increased primarily due to an increase of $44.0 million, or 21.9%, in the average size of our debt investment portfolio and an increase in accelerated fees earned on higher principal prepayments received. Fee income, which includes success fee, other fee and prepayment fee income on debt investments, increased by $1.8 million, or 85.6%, to $3.8 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to an increase in fees earned on higher principal prepayments received.
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The following table shows our dollar-weighted annualized yield for the years ended December 31, 2020, 2019 and 2018:
For the year ended
December 31,
Investment type:
2020
2019
2018
Debt investments (1)(2)
14.6
%
16.7
%
15.3
%
Equity interest in HSLFI and debt investments (1)(3)
14.5
%
16.7
%
15.2
%
Equity interest in HSLFI (1)(4)
—
%
16.2
%
9.0
All investments (1)(5)
13.9
%
15.7
%
13.9
%
(1) We calculate the dollar-weighted annualized yield on average investment type for any period as (1) total related investment income during the period divided by (2) the average of the fair value of the investment type outstanding on (a) the last day of the calendar month immediately preceding the first day of the period and (b) the last day of each calendar month during the period. The dollar-weighted annualized yield on average investment type is higher than what investors will realize because it does not reflect our expenses or any sales load paid by investors.
(2) Excludes any yield from equity interest in HSLFI through April 21, 2020, warrants, equity and other investments. Related investment income includes interest income and fee income from debt investments.
(3) Excludes any yield from warrants, equity and other investments. Related investment income includes dividend income from equity interest in HSLFI through April 21, 2020, interest income and fee income from debt investments.
(4) Excludes any yield from debt investments, warrants, equity and other investments. Related investment income includes dividend income from equity interest in HSLFI through April 21, 2020.
(5) Includes any yield from equity interest in HSFLI through April 21, 2020, debt investments, warrants, equity and other investments. Related investment income includes interest income, fee income and dividend income.
Investment income, consisting of interest income and fees on debt investments, can fluctuate significantly upon repayment of large debt investments. Interest income from the five largest debt investments in the aggregate accounted for 23%, 17% and 25% of investment income for the years ended December 31, 2020, 2019 and 2018, respectively.
Expenses
Net expenses increased by $2.6 million, or 11.8%, to $25.1 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019. Net expenses increased by $5.2 million, or 30.4%, to $22.4 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. Total expenses for each period consisted of interest expense, base management fee, incentive and administrative fees, professional fees and general and administrative expenses.
Interest expense increased by $1.3 million, or 16.1%, to $9.7 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019. Interest expense, which includes the amortization of debt issuance costs, increased primarily due to an increase in average borrowings of $39.5 million, or 29.1%, offset by a reduction in our effective cost of debt. Interest expense increased by $2.0 million, or 30.9%, to $8.3 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. Interest expense, which includes the amortization of debt issuance costs, increased primarily due to an increase in average borrowings of $36.0 million, or 36.2%, which was partially offset by a decrease in LIBOR.
Base management fee expense increased by $0.9 million, or 16.2%, to $6.5 million for the December 31, 2020 as compared to the year ended December 31, 2019 primarily due to an increase of $56.4 million, or 19.8%, in average gross assets less cash for the year ended December 31, 2020 as compared to the year ended December 31, 2019. Base management fee expense increased by $1.0 million, or 21.4%, to $5.6 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018 primarily due to an increase of $44.0 million, or 21.9%, in the average size of our investment portfolio for the year ended December 31, 2019 as compared to the year ended December 31, 2018.
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On March 5, 2019, our Advisor irrevocably waived the receipt of incentive fees related to the amounts previously deferred that it may be entitled to receive under the Investment Management Agreement for the period commencing on January 1, 2019 and ending on December 31, 2019. Such waived incentive fees will not be subject to recoupment. During the year ended December 31, 2019, our Advisor waived performance based incentive fees of $1.8 million which our Advisor would have otherwise been paid. This resulted in $1.8 million of reduced expense and additional net investment income for the year ended December 31, 2019.
On March 6, 2018, our Advisor irrevocably waived the receipt of incentive fees related to the amounts previously deferred that it may be entitled to receive under the Investment Management Agreement for the period commencing on January 1, 2018 and ending on December 31, 2018. Such waived incentive fees will not be subject to recoupment. During the year ended December 31, 2018, our Advisor waived performance based incentive fees of $1.2 million which our Advisor would have otherwise earned. This resulted in $1.2 million of reduced expense and additional net investment income for the year ended December 31, 2018.
Performance based incentive fee expense increased by $0.1 million, or 1.3%, to $5.2 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019. This increase was due to an increase of $0.3 million, or 1.3%, in Pre-Incentive Fee Net Investment Income for the year ended December 31, 2020 compared to the year ended December 31, 2019. Performance based incentive fee expense, net of the waiver above, increased by $1.9 million, or 59.5%, to $5.1 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. This increase was due to (i) an increase of $8.5 million, or 49.9%, in Pre-Incentive Fee Net Investment Income for the year ended December 31, 2019 compared to the year ended December 31, 2018 and (ii) an increase in the Incentive Fee Cap calculated based on the incentive fee cap and deferral mechanism in our Investment Management Agreement for the year ended December 31, 2019 compared to the year ended December 31, 2018. The incentive fee on pre-incentive fee net investment income was subject to the Incentive Fee Cap for the year ended December 31, 2018 due to the cumulative incentive fees paid exceeding 20% of cumulative pre-incentive fee net return during the applicable quarter and the 11 preceding full calendar quarters.
In 2020 and 2019, we elected to carry forward taxable income in excess of current year distributions into the next tax year and pay a 4% excise tax on such income. For the years ended December 31, 2020 and 2019, we elected to carry forward taxable income in excess of current year distributions of $6.2 million and $6.5 million, respectively. At December 31, 2020 and 2019, excise tax payable of $0.2 million was recorded.
Administrative fee expense, professional fees and general and administrative expenses were $3.7 million, $3.4 million and $3.0 million for the years ended December 31, 2020, 2019 and 2018, respectively.
Net realized gains and losses and net unrealized appreciation and depreciation
Realized gains or losses on investments are measured by the difference between the net proceeds from the repayment or sale and the cost basis of our investments without regard to unrealized appreciation or depreciation previously recognized. Realized gains or losses on investments include investments charged off during the period, net of recoveries. The net change in unrealized appreciation or depreciation on investments primarily reflects the change in portfolio investment fair values during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.
During the year ended December 31, 2020, we realized net losses totaling $14.7 million primarily due to the realized loss on the settlement of five of our debt investments partially offset by the realized gain from the consideration we received from the exercise and sale of warrants in six portfolio companies. During the year ended December 31, 2019, we realized net losses totaling $4.2 million primarily due to the expiration of one of our royalty agreements and the sale of one of our license agreements, which were included in other investments, which was partially offset by a gain on the sale of our equity investment in one portfolio company and from the consideration we received from the termination of warrants upon the sale of three portfolio companies. During the year ended December 31, 2018, we realized net gains totaling $0.6 million primarily due to gains realized on the sale of equity received upon the exercise of warrants.
During the year ended December 31, 2020, we recorded net unrealized appreciation on investments totaling $0.3 million due to the unrealized appreciation on our warrant investments offset by the unrealized depreciation on our debt
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and equity investments. During the year ended December 31, 2019, we recorded net unrealized appreciation on investments totaling $3.2 million due to the unrealized appreciation on one of our equity investments and the reversal of previously recorded unrealized depreciation from the expiration of one of our royalty agreements, which was included in other investments, partially offset by the unrealized depreciation on one of our debt investments. During the year ended December 31, 2018, we recorded net unrealized depreciation on investments totaling $1.5 million due to the unrealized depreciation on our warrant and equity investments in public companies.
Liquidity and capital resources
As of December 31, 2020 and 2019, we had cash and investments in money market funds of $46.7 million and $16.3 million, respectively. Cash and investments in money market funds are available to fund new investments, reduce borrowings, pay expenses, repurchase common stock and pay distributions. In addition, as of December 31, 2020 and 2019, we had $1.1 million of restricted investments in money market funds. Restricted investments in money market funds may be used to make monthly interest and principal payments on our Asset-Backed Notes or our NYL Facility. Our primary sources of capital have been from our public and private equity offerings, use of our Credit Facilities and issuance of our public debt offerings.
On March 26, 2019, we completed a follow-on public offering of 2,000,000 shares of our common stock at a public offering price of $12.14 per share, for total net proceeds to us of $23.1 million, after deducting underwriting commission and discounts and other offering expenses.
On August 2, 2019 we entered into an At-The-Market (“ATM”), sales agreement (the “Prior Equity Distribution Agreement”), with Goldman Sachs & Co. LLC and B. Riley FBR, Inc (each a “Sales Agent” and, collectively, the “Sales Agents”). The Prior Equity Distribution Agreement provided that we may offer and sell shares of common stock from time to time through the Sales Agents representing up to $50.0 million worth of our common stock, in amounts and at times to be determined by us.
On July 30, 2020, we terminated the Prior Equity Distribution Agreement and entered into a new ATM sales agreement (the “Equity Distribution Agreement”) with the Sales Agents. The remaining shares available under the Prior Equity Distribution Agreement are no longer available for issuance. The Equity Distribution Agreement provides that we may offer and sell our shares from time to time through the Sales Agents up to $100.0 million worth of our common stock, in amounts and at times to be determined by us. Sales of our common stock, if any, may be made in negotiated transactions or transactions that are deemed to be “at-the-market,” as defined in Rule 415 under the Securities Act, including sales made directly on the NASDAQ or similar securities exchange or sales made to or through a market maker other than on an exchange, at prices related to the prevailing market prices or at negotiated prices
During the year ended December 31, 2020, we sold 3,702,500 shares of common stock under the Prior Equity Distribution Agreement and the Equity Distribution Agreement. For the same period, we received total accumulated net proceeds of approximately $44.6 million, including $1.0 million of offering expenses, from these sales. During the year ended December 31, 2019, we sold 2,012,844 shares of common stock under the Prior Equity Distribution Agreement. For the same period, we received total accumulated net proceeds of approximately $24.0 million, including $0.6 million of offering expenses, from these sales.
On April 24, 2020, our Board extended a previously authorized stock repurchase program which allows us to repurchase up to $5.0 million of our common stock at prices below our NAV per share as reported in our most recent consolidated financial statements. Under the repurchase program, we may, but are not obligated to, repurchase shares of our outstanding common stock in the open market or in privately negotiated transactions from time to time. Any repurchases by us will comply with the requirements of Rule 10b-18 under the Exchange Act and any applicable requirements of the 1940 Act. Unless extended by our Board, the repurchase program will terminate on the earlier of June 30, 2021 or the repurchase of $5.0 million of our common stock. During the years ended December 31, 2020, 2019 and 2018, we did not make any repurchases of our common stock. From the inception of the stock repurchase program through December 31, 2020, we repurchased 167,465 shares of our common stock at an average price of $11.22 on the open market at a total cost of $1.9 million.
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At December 31, 2020 and 2019, the outstanding principal balance under the Key Facility was $28.0 million and $17.0 million, respectively. As of December 31, 2020 and 2019, we had borrowing capacity under the Key Facility of $97.0 million and $108.0 million, respectively. At December 31, 2020 and 2019, $24.8 million and $24.2 million, respectively, were available for borrowing, subject to existing terms and advance rates.
At December 31, 2020, the outstanding principal balance under the NYL Facility was $22.3 million. As of December 31, 2020, we had borrowing capacity under the NYL Facility of $77.7 million. At December 31, 2020, $0.9 million was available for borrowing, subject to existing terms and advance rates.
Our operating activities used cash of $25.3 million for the year ended December 31, 2020, and our financing activities provided cash of $55.7 million for the same period. Our operating activities used cash primarily to purchase investments in portfolio companies partially offset by principal payments received on our debt investments. Our financing activities provided cash primarily from advances on our credit facilities and the sale of shares through our ATM for net proceeds of $44.6 million, after deducting underwriting commission and discounts and other offering expenses, partially offset by the use of cash to repay our Key Facility and to pay distributions to our stockholders.
Our operating activities used cash of $51.4 million for the year ended December 31, 2019, and our financing activities provided cash of $56.2 million for the same period. Our operating activities used cash primarily to purchase investments in portfolio companies partially offset by principal payments received on our debt investments. Our financing activities provided cash primarily from the sale of shares through a follow-on public offering and our ATM for net proceeds of $47.1 million, after deducting underwriting commission and discounts and other offering expenses and the completion of our Asset-Backed Notes, partially offset by the use of cash to pay distributions to our stockholders.
Our operating activities used cash of $12.1 million for the year ended December 31, 2018, and our financing activities provided cash of $18.1 million for the same period. Our operating activities used cash primarily for investments made in portfolio companies and HSLFI, partially offset by principal payments received on our debt investments. Our financing activities provided cash primarily from advances on our Key Facility partially offset by repayment of our Key Facility and payment of distributions to our stockholders.
Our primary use of available funds is to make debt investments in portfolio companies and for general corporate purposes. We expect to raise additional equity and debt capital opportunistically, as needed, and subject to market conditions, to support our future growth to the extent permitted by the 1940 Act.
In order to remain subject to taxation as a RIC, we intend to distribute to our stockholders all or substantially all of our investment company taxable income. In addition, as a BDC, we are required to maintain asset coverage of at least 150%. This requirement limits the amount that we may borrow.
We believe that our current cash, cash generated from operations, and funds available from our Credit Facilities will be sufficient to meet our working capital and capital expenditure commitments for at least the next 12 months.
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Current borrowings
The following table shows our borrowings as of December 31, 2020 and 2019:
December 31, 2020
December 31, 2019
Total
Balance
Unused
Total
Balance
Unused
Commitment
Outstanding
Commitment
Commitment
Outstanding
Commitment
(In thousands)
Key Facility
$
125,000
$
28,000
$
97,000
$
125,000
$
17,000
$
108,000
NYL Facility
100,000
22,250
77,750
—
—
—
Asset-Backed Notes
100,000
100,000
—
100,000
100,000
—
2022 Notes
37,375
37,375
—
37,375
37,375
—
Total before debt issuance costs
362,375
187,625
174,750
262,375
154,375
108,000
Unamortized debt issuance costs attributable to term borrowings
—
(1,806)
—
—
(2,325)
—
Total borrowings outstanding, net
$
362,375
$
185,819
$
174,750
$
262,375
$
152,050
$
108,000
We entered into the Key Facility effective November 4, 2013. The interest rate on the Key Facility is based upon the one-month LIBOR plus a spread of 3.25%, with a LIBOR floor of 1.00%. The LIBOR rate was 0.14% and 1.76% as of December 31, 2020 and 2019, respectively. The interest rates in effect were 4.25% and 4.94% as of December 31, 2020 and 2019, respectively. The Key Facility requires the payment of an unused line fee in an amount equal to 0.50% of any unborrowed amount available under the facility annually.
The Key Facility has an accordion feature which allows for an increase in the total loan commitment to $150 million. On June 29, 2020, we amended the Key Facility, among other things, to amend the LIBOR floor from 0.75% to 1.00% and to extend the period during which we may request advances under the Key Facility (the “Revolving Period”) to September 30, 2021. The Key Facility is collateralized by debt investments held by Credit II and permits an advance rate of up to fifty percent (50%) of eligible debt investments held by Credit II. The Key Facility contains covenants that, among other things, require us to maintain a minimum net worth, to restrict the debt investments securing the Key Facility to certain criteria for qualified debt investments and to comply with portfolio company concentration limits as defined in the related loan agreement. After the Revolving Period, we may not request new advances, and we must repay the outstanding advances under the Key Facility as of such date, at such times and in such amounts as are necessary to maintain compliance with the terms and conditions of the Key Facility, particularly the condition that the principal balance of the Key Facility not exceed fifty percent (50%) of the aggregate principal balance of our eligible debt investments to our portfolio companies. The maturity of the Key Facility, the date on which all outstanding advances under the Key Facility are due and payable, is on April 6, 2023.
On September 29, 2017, we issued and sold an aggregate principal amount of $32.5 million 2022 Notes, and on October 11, 2017, pursuant to the underwriters’ 30-day option to purchase additional notes, we sold an additional $4.9 million of the 2022 Notes. The 2022 Notes have a stated maturity of September 15, 2022 and may be redeemed in whole or in part at our option at any time or from time to time on or after September 15, 2019 at a redemption price of $25 per security plus accrued and unpaid interest. The 2022 Notes bear interest at a rate of 6.25% per year payable quarterly on March 15, June 15, September 15 and December 15 of each year. The 2022 Notes are our direct, unsecured obligations and (1) rank equally in right of payment with our current and future unsecured indebtedness; (2) are senior in right of payment to any of our future indebtedness that expressly provides it is subordinated to the 2022 Notes; (3) are effectively subordinated to all of our existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness and (4) are structurally subordinated to all existing and future indebtedness and other obligations of any of our subsidiaries. As of December 31, 2020, we were in material compliance with the terms of the 2022 Notes. The 2022 Notes are listed on the New York Stock Exchange under the symbol “HTFA”.
On August 13, 2019, the Asset-Backed Notes were issued by the 2019-1 Trust pursuant to a note purchase agreement, dated as of August 13, 2019, by and among us and Keybanc Capital Markets Inc. as Initial Purchaser, and are backed by a pool of loans made to certain portfolio companies of ours and secured by certain assets of those portfolio companies and are to be serviced by us. Interest on the Asset-Backed Notes will be paid, to the extent of funds available, at a fixed rate of
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4.21% per annum. The Asset-Backed Notes have a two-year reinvestment period and a stated maturity of September 15, 2027. The Asset-Backed Notes were rated A+(sf) by Morningstar Credit Ratings, LLC on August 13, 2019. There has been no change in the rating since August 13, 2019.
At December 31, 2020 and 2019, the Asset-Backed Notes had an outstanding principal balance of $100.0 million.
Under the terms of the Asset-Backed Notes, we are required to maintain a reserve cash balance, funded through proceeds from the sale of the Asset-Backed Notes, which may be used to pay monthly interest and principal payments on the Asset-Backed Notes. The Company has segregated these funds and classified them as restricted investments in money market funds. At December 31, 2020 and 2019, there was approximately $1.0 million and $1.1 million, respectively, of restricted investments.
On April 21, 2020, we purchased all of the limited liability company interests of Arena in HSLFI. HFI is a wholly-owned subsidiary of HSLFI. HFI entered into the NYL Facility with the NYL Noteholders for an aggregate purchase price of up to $100.0 million, with an accordion feature of up to $200.0 million at the mutual discretion and agreement of HSLFI and the NYL Noteholders. On June 1, 2018, HSLFI sold or contributed to HFI certain secured loans made to certain portfolio companies pursuant to the Sale and Servicing Agreement. Any notes issued by HFI are collateralized by all investments held by HFI and permit an advance rate of up to 67% of the aggregate principal amount of eligible debt investments.
On June 5, 2020, HFI amended the NYL Facility to extend the investment period to June 5, 2022. The investment period will be followed by a five year amortization period. The stated final payment date was extended to June 15, 2027, subject to any extension of the investment period. The interest rate on the notes issued under the NYL Facility is based on the three year USD mid-market swap rate plus a margin of between 3.55% and 5.15% with an interest rate floor, depending on the rating of such notes at the time of issuance. Any obligation to make additional advances was conditioned on the occurrence of certain conditions, which were satisfied June 26, 2020. There were $22.3 million in notes issued to the Noteholders as of December 31, 2020 at an interest rate of 4.60%.
Other assets
As of December 31, 2020 and 2019, other assets were $1.9 million and $1.5 million, respectively, which is primarily comprised of debt issuance costs and prepaid expenses.
Contractual obligations and off-balance sheet arrangements
The following table shows our significant contractual payment obligations and off-balance sheet arrangements as of December 31, 2020:
Payments due by period
Less than
1 – 3
3 – 5
After 5
Total
1 year
Years
Years
years
(In thousands)
Borrowings
$
187,625
$
9,716
$
142,097
$
35,812
$
—
Unfunded commitments
91,500
68,000
23,500
—
—
Total
$
279,125
$
77,716
$
165,597
$
35,812
$
—
In the normal course of business, we are party to financial instruments with off-balance sheet risk. These consist primarily of unfunded commitments to extend credit, in the form of loans, to our portfolio companies. Unfunded commitments to provide funds to portfolio companies are not reflected on our balance sheet. Our unfunded commitments may be significant from time to time. As of December 31, 2020, we had such unfunded commitments of $91.5 million. This includes no undrawn revolver commitments. These commitments are subject to the same underwriting and ongoing portfolio maintenance requirements as are the financial instruments that we hold on our balance sheet. In addition, these commitments are often subject to financial or non-financial milestones and other conditions to borrowing that must be achieved before the commitment can be drawn. Since these commitments may expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. We regularly monitor our unfunded commitments and anticipated refinancings, maturities and capital raising, to ensure that we have sufficient liquidity to
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fund such unfunded commitments. As of December 31, 2020, we reasonably believed that our assets would provide adequate financial resources to satisfy all of our unfunded commitments.
In addition to the Credit Facilities, we have certain commitments pursuant to our Investment Management Agreement entered into with our Advisor. We have agreed to pay a fee for investment advisory and management services consisting of two components (1) a base management fee equal to a percentage of the value of our gross assets less cash or cash equivalents, and (2) a two-part incentive fee. We have also entered into a contract with our Advisor to serve as our administrator. Payments under the Administration Agreement are equal to an amount based upon our allocable portion of our Advisor’s overhead in performing its obligations under the agreement, including rent, fees and other expenses inclusive of our allocable portion of the compensation of our Chief Financial Officer and Chief Compliance Officer and their respective staffs. See Note 3 to our consolidated financial statements for additional information regarding our Investment Management Agreement and our Administration Agreement.
Distributions
In order to qualify and be subject to tax as a RIC, we must meet certain source-of-income, asset diversification and annual distribution requirements. Generally, in order to qualify as a RIC, we must derive at least 90% of our gross income for each tax year from dividends, interest, payments with respect to certain securities, loans, gains from the sale or other disposition of stock, securities or foreign currencies, income derived from certain publicly traded partnerships, or other income derived with respect to its business of investing in stock or other securities. We must also meet certain asset diversification requirements at the end of each quarter of each tax year. Failure to meet these diversification requirements on the last day of a quarter may result in us having to dispose of certain investments quickly in order to prevent the loss of RIC status. Any such dispositions could be made at disadvantageous prices or times, and may cause us to incur substantial losses.
In addition, in order to be subject to tax as a RIC and to avoid the imposition of corporate-level tax on the income and gains we distribute to our stockholders in respect of any tax year, we are required under the Code to distribute as dividends to our stockholders out of assets legally available for distribution each tax year an amount generally at least equal to 90% of the sum of our net ordinary income and net short-term capital gains in excess of net long-term capital losses, if any. Additionally, in order to avoid the imposition of a U.S. federal excise tax, we are required to distribute, in respect of each calendar year, dividends to our stockholders of an amount at least equal to the sum of 98% of our calendar year net ordinary income (taking into account certain deferrals and elections); 98.2% of our capital gain net income (adjusted for certain ordinary losses) for the one year period ending on October 31 of such calendar year; and any net ordinary income and capital gain net income for preceding calendar years that were not distributed during such calendar years and on which we previously did not incur any U.S. federal income tax. If we fail to qualify as a RIC for any reason and become subject to corporate tax, the resulting corporate taxes could substantially reduce our net assets, the amount of income available for distribution and the amount of our distributions. Such a failure would have a material adverse effect on us and our stockholders. In addition, we could be required to recognize unrealized gains, incur substantial taxes and interest and make substantial distributions in order to re-qualify as a RIC. We cannot assure stockholders that they will receive any distributions.
To the extent our taxable earnings in a tax year fall below the total amount of our distributions made to stockholders in respect of such tax year, a portion of those distributions may be deemed a return of capital to our stockholders for U.S. federal income tax purposes. Thus, the source of a distribution to our stockholders may be the original capital invested by the stockholder rather than our income or gains. Stockholders should review any written disclosure accompanying a distribution payment carefully and should not assume that the source of any distribution is our ordinary income or gains.
We have adopted an “opt out” DRIP for our common stockholders. As a result, if we declare a distribution, then stockholders’ cash distributions will be automatically reinvested in additional shares of our common stock unless a stockholder specifically “opts out” of our DRIP. If a stockholder opts out, that stockholder will receive cash distributions. Although distributions paid in the form of additional shares of our common stock will generally be subject to U.S. federal, state and local taxes, stockholders participating in our DRIP will not receive any corresponding cash distributions with which to pay any such applicable taxes. If our common stock is trading above NAV, a stockholder receiving distributions in the form of additional shares of our common stock will be treated as receiving a distribution of an amount equal to the
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fair market value of such shares of our common stock. We may use newly issued shares to implement the DRIP, or we may purchase shares in the open market in connection with our obligations under the DRIP.
Related party transactions
We have entered into the Investment Management Agreement with the Advisor. The Advisor is registered as an investment adviser under the Investment Advisers Act of 1940, as amended. Our investment activities are managed by the Advisor and supervised by the Board, the majority of whom are independent directors. Under the Investment Management Agreement, we have agreed to pay the Advisor a base management fee as well as an incentive fee. During the years ended December 31, 2020, 2019 and 2018, the Advisor earned $11.6 million, $10.7 million and $7.8 million, respectively, pursuant to the Investment Management Agreement.
Horizon Technology Finance Principals LLC f/k/a Horizon Technology Finance, LLC (“HTF Principals”) owns more than seventy percent (70%) of the Advisor. Our Chief Executive Officer, Robert D. Pomeroy, Jr. and our President, Gerald A. Michaud own one hundred percent (100%) of HTF Principals. By virtue of their ownership interest in HTF Principals, Mr. Pomeroy and Mr. Michaud control our Advisor.
We have also entered into the Administration Agreement with the Advisor. Under the Administration Agreement, we have agreed to reimburse the Advisor for our allocable portion of overhead and other expenses incurred by the Advisor in performing its obligations under the Administration Agreement, including rent and our allocable portion of the costs of compensation and related expenses of our Chief Financial Officer and Chief Compliance Officer and their respective staffs. In addition, pursuant to the terms of the Administration Agreement the Advisor provides us with the office facilities and administrative services necessary to conduct our day-to-day operations. During the years ended December 31, 2020, 2019 and 2018, the Advisor earned $1.0 million, $0.9 million and $0.7 million, respectively, pursuant to the Administration Agreement.
HTF Principals has granted the Company a non-exclusive, royalty-free license to use the name “Horizon Technology Finance.”
We believe that we derive substantial benefits from our relationship with our Advisor. Our Advisor may manage other investment vehicles, or Advisor Funds, with the same investment strategy as us. The Advisor may provide us an opportunity to co-invest with the Advisor Funds. Under the 1940 Act, absent receipt of exemptive relief from the SEC, we and our affiliates are precluded from co-investing in negotiated investments. On November 27, 2017, we were granted exemptive relief from the SEC which permits us to co-invest with Advisor Funds, subject to certain conditions.
Critical accounting policies
The discussion of our financial condition and results of operation is based upon our financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Changes in the economic environment, financial markets and any other parameters used in determining such estimates could cause actual results to differ. In addition to the discussion below, we describe our significant accounting policies in the notes to our consolidated financial statements.
We have identified the following items as critical accounting policies.
Valuation of investments
Investments are recorded at fair value. Our Board determines the fair value of our portfolio investments. We apply fair value to substantially all of our investments in accordance with Topic 820, Fair Value Measurement , of the Financial Accounting Standards Board’s, or FASB’s, Accounting Standards Codification as amended, or ASC, which establishes a framework used to measure fair value and requires disclosures for fair value measurements. We have categorized our investments carried at fair value, based on the priority of the valuation technique, into a three-level fair value hierarchy. Fair value is a market-based measure considered from the perspective of the market participant who holds the financial instrument rather than an entity specific measure. Therefore, when market assumptions are not readily available, our own
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assumptions are set to reflect those that management believes market participants would use in pricing the financial instrument at the measurement date.
The availability of observable inputs can vary depending on the financial instrument and is affected by a wide variety of factors, including, for example, the type of product, whether the product is new, whether the product is traded on an active exchange or in the secondary market and the current market conditions. To the extent that the valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. The three categories within the hierarchy are as follows:
Level 1
Quoted prices in active markets for identical assets and liabilities.
Level 2
Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active and model-based valuation techniques for which all significant inputs are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3
Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.
Our Board determines the fair value of investments in good faith, based on the input of management, the audit committee and independent valuation firms that have been engaged at the direction of our Board to assist in the valuation of each portfolio investment without a readily available market quotation at least once during a trailing twelve-month period under our valuation policy and a consistently applied valuation process. The Board conducts this valuation process at the end of each fiscal quarter, with 25% (based on fair value) of our valuation of portfolio companies that do not have a readily available market quotations subject to review by an independent valuation firm.
Income recognition
Interest on debt investments is accrued and included in income based on contractual rates applied to principal amounts outstanding. Interest income is determined using a method that results in a level rate of return on principal amounts outstanding. Generally, when a debt investment becomes 90 days or more past due, or if we otherwise do not expect to receive interest and principal repayments, the debt investment is placed on non-accrual status and the recognition of interest income may be discontinued. Interest payments received on non-accrual debt investments may be recognized as income, on a cash basis, or applied to principal depending upon management’s judgment at the time the debt investment is placed on non-accrual status. For the year ended December 31, 2020, we recognized as interest income interest payments of $0.03 million received from one portfolio company whose debt investment was on non-accrual status. For the year ended December 31, 2019 and 2018, we did not recognize any interest income from debt investments on non-accrual status.
We receive a variety of fees from borrowers in the ordinary course of conducting our business, including advisory fees, commitment fees, amendment fees, non-utilization fees, success fees and prepayment fees. In a limited number of cases, we may also receive a non-refundable deposit earned upon the termination of a transaction. Debt investment origination fees, net of certain direct origination costs, are deferred, and along with unearned income, are amortized as a level yield adjustment over the respective term of the debt investment. All other income is recorded into income when earned. Fees for counterparty debt investment commitments with multiple debt investments are allocated to each debt investment based upon each debt investment’s relative fair value. When a debt investment is placed on non-accrual status, the amortization of the related fees and unearned income is discontinued until the debt investment is returned to accrual status.
Certain debt investment agreements also require the borrower to make an ETP that is accrued into income over the life of the debt investment to the extent such amounts are expected to be collected. We will generally cease accruing the income if there is insufficient value to support the accrual or if we do not expect the borrower to be able to pay all principal and interest due.
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In connection with substantially all lending arrangements, we receive warrants to purchase shares of stock from the borrower. We record the warrants as assets at estimated fair value on the grant date using the Black-Scholes valuation model. We consider the warrants as loan fees and record them as unearned income on the grant date. The unearned income is recognized as interest income over the contractual life of the related debt investment in accordance with our income recognition policy. Subsequent to origination, the warrants are also measured at fair value using the Black-Scholes valuation model. Any adjustment to fair value is recorded through earnings as net unrealized gain or loss on investments. Gains and losses from the disposition of the warrants or stock acquired from the exercise of warrants are recognized as realized gains and losses on investments.
Prior to consolidating the investment of HSLFI on and after April 21, 2020, distributions from HSLFI were evaluated at the time of distribution to determine if the distribution should be recorded as dividend income or a return of capital. Generally, we did not record distributions from HSLFI as dividend income unless there were sufficient accumulated tax-basis earnings and profit in HSLFI prior to distribution. Distributions that were classified as a return of capital were recorded as a reduction in the cost basis of the investment. For the period January 1, 2020 through April 21, 2020, there were no distributions from HSLFI. For the year ended December 31, 2019, HSLFI distributed $0.7 million classified as dividend income to us. For the period June 1, 2018 (the commencement of HSLFI’s operations) through December 31, 2018, HSLFI distributed $0.3 million classified as dividend income to us.
Realized gains or losses on the sale of investments, or upon the determination that an investment balance, or portion thereof, is not recoverable, are calculated using the specific identification method. We measure realized gains or losses by calculating the difference between the net proceeds from the repayment or sale and the amortized cost basis of the investment. Net change in unrealized appreciation or depreciation reflects the change in the fair values of our portfolio investments during the reporting period, including any reversal of previously recorded unrealized appreciation or depreciation, when gains or losses are realized.
Income taxes
We have elected to be treated as a RIC under Subchapter M of the Code and operate in a manner so as to qualify for the tax treatment applicable to RICs. In order to qualify as a RIC and to avoid the imposition of corporate-level U.S. federal income tax on the amounts we distribute to our stockholders, among other things, we are required to meet certain source of income and asset diversification requirements, and we must timely distribute dividends to our stockholders out of assets legally available for distribution each tax year of an amount generally at least equal to 90% of our investment company taxable income, as defined by the Code and determined without regard to any deduction for dividends paid. We, among other things, have made and intend to continue to make the requisite distributions to our stockholders, which will generally relieve us from incurring any material liability for U.S. federal income taxes.
Depending on the level of taxable income earned in a tax year, we may choose to carry forward taxable income in excess of current year distributions into the next tax year and incur a 4% excise tax on such income, as required. To the extent that we determine that our estimated current year annual taxable income will be in excess of estimated current year distributions, we will accrue excise tax, if any, on estimated excess taxable income as taxable income is earned.
We evaluate tax positions taken in the course of preparing our tax returns to determine whether the tax positions are “more-likely-than-not” to be sustained by the applicable tax authority in accordance with ASC Topic 740, Income Taxes , as modified by ASC Topic 946, Financial Services – Investment Companies . Tax benefits of positions not deemed to meet the more-likely-than-not threshold, or uncertain tax positions, are recorded as a tax expense in the current year. It is our policy to recognize accrued interest and penalties related to uncertain tax benefits in income tax expense. We had no material uncertain tax positions at December 31, 2020 and 2019.
Recently issued accounting pronouncement
In March 2020, the Financial Accounting Standards Board issued Accounting Standards Update No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, or ASU 2020-04. ASU 2020-04 provides optional expedients and exceptions for applying GAAP to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another rate that is expected to be discontinued. The amendments in ASU 2020-04 are effective for all entities as of March 12, 2020 through December 31,
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2022. We are currently assessing the impact of ASU 2020-04 and the LIBOR transition on our consolidated financial statements.
Recent developments
Subsequent to December 31, 2020 pursuant to private foreclosure sales, we received net proceeds of approximately $1.7 million from the sale of substantially all of the assets of The NanoSteel Company, Inc. (“NanoSteel”), which assets collateralized our debt investment in NanoSteel. We do not expect to receive any additional material proceeds from the sale of additional assets of NanoSteel.
On January 14, 2021, we funded a $5.0 million debt investment to a new portfolio company, Clara Foods Co.
On January 15, 2021, we funded a $7.0 million debt investment to a new portfolio company, Supply Network Visibility Holdings LLC.
On February 23, 2021, we funded a $7.0 million debt investment to an existing portfolio company, Getaround, Inc.
On February 25, 2021, we funded a $6.0 million debt investment to a new portfolio company, Primary Kids, Inc.
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.