What changed in this filing

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Item 7. Management’s Discussion and Analysis

2021-03-04 compared with 2020-03-03 · 215 added, 203 removed, 286 unchanged (59% of the section changed)

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Some of the statements in this Annual Report on Form 10-K constitute forward-looking statements, which relate to future events or our future performance or financial condition.

The forward-looking statements contained in this annual report on Form 10-K involve risks and uncertainties, including statements as to:

The forward-looking statements contained in this Annual Report on Form 10-K involve risks and uncertainties, related to the COVID-19 pandemic and otherwise, including statements as to:

our future operating results;

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the ability of Stellus Capital Management to attract and retain highly talented professionals;

our ability to maintain our qualification as a RIC and as a BDC;

the effect of future changes in laws or regulations (including the interpretation of these laws and regulations by regulatory authorities) and conditions in our operating areas, particularly with respect to business development companies or RICs.

our ability to maintain our qualification as a registered investment company (“RIC”) and as a business development company (“BDC”);

Such forward-looking statements may include statements preceded by, followed by or that otherwise include the words “may,” “might,” “will,” “intend,” “should,” “could,” “can,” “would,” “expect,” “believe,” “estimate,” “anticipate,” “predict,” “potential,” “plan” or similar words.

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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 annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.

We are an externally managed, non-diversified, closed-end investment company that has elected to be regulated as a BDC under the 1940 Act.

Our investment activities are managed by our investment adviser, Stellus Capital Management.

We were organized as a Maryland corporation on May 18, 2012 and formally commenced operations on November 7, 2012.

Our investment objective is to maximize the total return to our stockholders in the form of current income and capital appreciation through debt and related equity investments in middle-market companies.

We are an externally managed, non-diversified, closed-end investment company that has elected to be regulated as a BDC under the 1940 Act.

Our investment activities are managed by our investment adviser, Stellus Capital Management.

As a BDC, we are required to comply with certain regulatory requirements.

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federal income taxes on any income we distribute to our stockholders.

Prior to June 28, 2018, we were only allowed to employ leverage to the extent that our asset coverage, as defined in the 1940 Act, was equal to at least 200% after giving effect to such leverage.

On March 23, 2018, the Small Business Credit Availability Act (the “SBCAA”) was signed into law, which included various changes to regulations under the federal securities laws that impact BDCs.

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On April 4, 2018, the Board, including a “required majority” (as such term is defined in Section 57(o) of the Investment Company Act of 1940, as amended (the “1940 Act”)) of the Board, approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act.

The Board also approved the submission of a proposal to stockholders to approve the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act, which was approved by stockholders at our 2018 annual meeting of stockholders.

At our 2018 annual meeting of stockholders our stockholders also approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act.

As a result, the asset coverage ratio applicable to us was decreased from 200% to 150%, effective June 29, 2018, which effectively increased the amount of leverage we may incur.

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The amount of leverage that we employ at any time depends on our assessment of the market and other factors at the time of any proposed borrowing.

COVID-19 Developments

On March 11, 2020, the World Health Organization declared COVID-19 a pandemic and recommended containment and mitigation measures worldwide.

During the year ended December 31, 2020, and subsequent to December 31, 2020, the COVID-19 pandemic has had a significant impact on the U.S.

and global economy.

Each portfolio company has been assessed on an individual basis to identify the impact of the COVID-19 pandemic on the valuation of our investments in such company.

We believe that any such COVID-19 pandemic impacts have been reflected in the valuation of our investments.

The global impact of the outbreak continues to evolve, and many countries have reacted by instituting quarantines, prohibitions on travel and the closure of offices, businesses, schools, retail stores and other public venues.

Businesses are also implementing similar precautionary measures.

Such measures, as well as the general uncertainty surrounding the dangers and impact of the COVID-19 pandemic, have created significant disruption in supply chains and economic activity.

While several countries, as well as certain states in the United States, have begun to lift public health restrictions with the view to reopening their economies, recurring COVID-19 outbreaks have led to the re-introduction of such restrictions in certain states in the United States and globally and could continue to lead to the re-introduction of such restrictions elsewhere.

The Federal Food and Drug Administration authorized vaccines produced for emergency use starting in December 2020, it remains unclear how quickly the vaccines will be distributed nationwide and globally or when “herd immunity” will be achieved and the restrictions that were imposed to slow the spread of the virus will be lifted entirely.

The delay in distributing the vaccines could lead people to continue to self-isolate and not participate in the economy at pre-pandemic levels for a prolonged period of time.

Even after the COVID-19 pandemic subsides, the U.S.

economy and most other major global economies may continue to experience a recession, and we anticipate our business and operations could be materially adversely affected by a prolonged recession in the United States and other major markets.

As COVID-19 continues to spread, the potential impacts, including a global, regional, or other economic recession, remain uncertain and difficult to assess.

The extent of the impact of the COVID-19

pandemic on the financial performance of our current and future investments will depend on future developments, including the duration and spread of the virus, related advisories and restrictions, and the health of the financial markets and economy, all of which are highly uncertain and cannot be predicted.

To the extent our portfolio companies are adversely impacted by the effects of the COVID-19 pandemic, it may have a material adverse impact on our future net investment income, the fair value of our portfolio investments and our financial condition.

Economic outlook

The delay in distributing the vaccines could lead people to continue to self-isolate and not participate in the economy at pre-pandemic levels for a prolonged period.

The COVID-19 pandemic could have a continued adverse impact on economic and market conditions and trigger a period of global economic slowdown.

The COVID-19 pandemic presents material uncertainty and risks with respect to the underlying value of our portfolio companies and with respect to our business, financial condition, results of operations, and cash flows, such as the potential negative impact to financing arrangements, increased costs of operations, changes in law and/or regulation, and uncertainty regarding government and regulatory policy.

All partners and employees of Stellus Capital have been operating remotely since March 16, 2020 without disruption to its operations and are prepared to continue working remotely as long as is necessary for the health and safety of all personnel.

Our COVID-19 response

Since the onset of the COVID-19 pandemic, we have been in regular contact with all our portfolio companies and/or their sponsors to assess among other things their ability to function in the new environment.

Discussions have addressed the portfolio companies’ liquidity position, expected covenant compliance, and the health of their workforce and customers.

Financial impact

We will continue to closely monitor the financial condition of our portfolio companies as part of our efforts to mitigate the impact of the COVID-19 pandemic.

Historical information may be relatively less significant.

Portfolio Composition and Investment Activity

Portfolio Composition

We originate and invest primarily in privately-held middle-market companies (typically those with $5.0 million to $50.0 million of EBITDA) through first lien (including unitranche), second lien, and unsecured debt financing, often times with a corresponding equity investment.

We originate and invest primarily in privately-held middle-market companies (typically those with $5.0 million to $50.0 million of EBITDA (earnings before interest, taxes, depreciation and amortization)) through first lien (including unitranche), second lien, and unsecured debt financing, often times with a corresponding equity investment.

As of December 31, 2020, we had $ 653.4 million (at fair value) invested in 66 companies.

As of December 31, 2019, our portfolio included approximately 72% of first lien debt, 18% of second lien debt, 4% of unsecured debt and 6% of equity investments at fair value.

As of December 31, 2020, our portfolio included approximately 78% of first lien debt (including unitranche investments), 11% of second lien debt, 3% of unsecured debt and 8% of equity investments at fair value.

The composition of our investments at cost and fair value as of December 31, 2020 was as follows:

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Includes unitranche investments, which account for 13.0% of our portfolio at fair value.

Unitranche structures may combine characteristics of first lien senior secured as well as second lien and/or subordinated loans and our unitranche loans will expose us to the risks associated with the second lien and subordinated loans to the extent we invest in the “last-out” tranche.

Unitranche structures may combine characteristics of first lien senior secured as well as second lien and/or subordinated loans.

Our unitranche loans will expose us to the risks associated with the second lien and subordinated loans to the extent we invest in the “last-out” tranche.

As of December 31, 2019, we had $628.9 million (at fair value) invested in 63 companies.

As of December 31, 2018, our portfolio included approximately 58% of first lien debt, 30% of second lien debt, 5% of unsecured debt and 7% of equity investments at fair value.

As of December 31, 2019, our portfolio included approximately 72% of first lien debt (including unitranche investments), 18% of second lien debt, 4% of unsecured debt and 6% of equity investments at fair value.

The composition of our investments at cost and fair value as of December 31, 2019 was as follows:

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Includes unitranche investments, which account for 14.4% of our portfolio at December 31, 2019 fair value.

Unitranche structures may combine characteristics of first lien senior secured as well as second lien and/or subordinated loans.

Our unitranche loans will expose us to the risks associated with the second lien and subordinated loans to the extent we invest in the “last-out” tranche.

Our investment portfolio may contain loans that are in the form of lines of credit or revolving credit facilities, which require us to provide funding when requested by portfolio companies in accordance with the terms and conditions of the underlying loan agreements.

As of December 31, 2019 and December 31, 2018, we had unfunded commitments of $37.5 million and $21.2 million, respectively, to provide debt financing for seventeen and eleven portfolio companies, respectively.

As of December 31, 2019, the Company had sufficient liquidity to fund such unfunded commitments should the need arise.

As of December 31, 2020 and December 31, 2019, we had unfunded commitments of $28.9 million and $37.5 million, respectively, to provide debt financing for 19 and 17 portfolio companies, respectively.

As of December 31, 2020, we had sufficient liquidity (through cash on hand and available borrowings under the Credit Facility (as defined below)) to fund such unfunded commitments should the need arise.

The following is a summary of geographical concentration of our investment portfolio as of December 31, 2020:

at fair value

United Kingdom

South Carolina

Washington, D.C.

North Carolina

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The following is a summary of geographical concentration of our investment portfolio as of December 31, 2019:

at Fair Value

United Kingdom

South Carolina

at Fair Value

North Carolina

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Aerospace & Defense

Consumer Goods:

Beverage, Food, & Tobacco

Broadcasting & Subscription

Advertising, Printing & Publishing

High Tech Industries

Consumer Goods:

Environmental Industries

Advertising, Printing & Publishing

Capital Equipment

Metals & Mining

Transportation & Logistics

Containers, Packaging, & Glass

Environmental Industries

Chemicals, Plastics, & Rubber

Metals & Mining

Consumer goods:

Construction & Building

Chemicals, Plastics, & Rubber

Hotel, Gaming, & Leisure

The following is a summary of industry concentration of our investment portfolio as of December 31, 2019:

at Fair Value

Healthcare & Pharmaceuticals

Broadcasting & Subscription

Aerospace & Defense

Consumer Goods:

High Tech Industries

Beverage, Food, & Tobacco

Broadcasting & Subscription

Advertising, Printing & Publishing

High Tech Industries

Capital Equipment

Metals & Mining

Consumer goods:

Transportation & Logistics

Containers, Packaging, & Glass

Environmental Industries

Chemicals, Plastics, & Rubber

Containers, Packaging, & Glass

Aerospace & Defense

Consumer goods:

Construction & Building

Capital Equipment

Advertising, Printing & Publishing

Transportation:

Hotel, Gaming, & Leisure

Certain portfolio company classifications were updated to more adequately align to the risks of the portfolio investments with other companies in such industries.

Industry classification for the prior year financial statements included above were reclassified to the current presentation.

The following changes and their December 31, 2018 cost and fair value, respectively, were made:

1) Consumer Goods:

Durable to Metals & Mining;

$17,237,500 for both cost and fair value, 2) Media:

Broadcasting & Subscription to Media:

Advertising, Printing & Publishing;

$7,058,675 and $6,875,625, 3) Services:

Business to Aerospace & Defense;

$10,777,822 for both cost and value, 4) Services:

Business to Environmental Industries;

$13,058,543 and $12,505,509, 5) Services:

Business to Software;

$14,005,369 and $13,432,500.

At December 31, 2020, our average portfolio company investment at amortized cost and fair value was approximately $10.0 million and $9.9 million, respectively, and our largest portfolio company investment at amortized cost and fair value was approximately $21.4 million and $21.6 million, respectively.

At December 31, 2018, our average portfolio company investment at both amortized cost and fair value was approximately $8.9 million, and our largest portfolio company investment at amortized cost and fair value was approximately $21.6 million and $22.3 million, respectively.

At December 31, 2019, 93% of our debt investments bore interest based on floating rates (subject to interest rate floors), such as LIBOR, and 7% bore interest at fixed rates.

At December 31, 2019, our average portfolio company investment at amortized cost and fair value was approximately $10.2 million and $10.0 million, respectively, and our largest portfolio company investment at amortized cost and fair value was approximately $21.6 million and $21.3 million, respectively.

At December 31, 2020, 93% of our debt investments bore interest based on floating rates (subject to interest rate floors), such as London Interbank Offered Rate (“LIBOR”), and 7% bore interest at fixed rates.

At December 31, 2019, 93% of our debt investments bore interest based on floating rates (subject to interest rate floors), such as LIBOR, and 7% bore interest at fixed rates.

The weighted average yield on all of our debt investments as of December 31, 2020 and December 31, 2019 was approximately 8.3% and 9.2%, respectively.

The weighted average yield on all of our investments, including non-income producing equity positions, as of December 31, 2020 and December 31, 2019 was approximately 7.9% and 8.8%, respectively.

The weighted average yield was computed using the effective interest rates for all of our debt investments, including accretion of original issue discount.

The weighted average yield of our debt investments is not the same as a return on investment for our stockholders, but, rather relates to a portion of our investment portfolio and is calculated before the payment of all of our subsidiaries’ fees and expenses.

average yield of our debt investments is not the same as a return on investment for our stockholders, but, rather relates to a portion of our investment portfolio and is calculated before the payment of all of our subsidiaries’ fees and expenses.

As of December 31, 2020 and December 31, 2019, we had cash and cash equivalents of $18.5 million and $16.1 million, respectively.

Investment Activity

During the year ended December 31, 2019, we made $246.5 million of investments in seventeen new portfolio companies and twelve existing portfolio companies.

During the year ended December 31, 2020, we made $152.0 million of investments in ten new portfolio companies and twenty existing portfolio companies.

During the year ended December 31, 2020, we received $128.8 million in proceeds principally from prepayments of our investments, including $38.3 million from amortization of certain other investments.

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Our level of investment activity can vary substantially from period to period depending on many factors, including the amount of debt and equity capital to middle market companies, the level of merger and acquisition activity, the general economic environment and the competitive environment for the types of investments we make.

For example, during the twelve months ended December 31, 2020, the uncertainty and economic ramifications of the rapid spread of COVID-19 led to a general slowing of investment activity in the U.S.

lower middle market.

As a result, we did not make any investments in new portfolio companies from March 13, 2020 until July 17, 2020.

Since then, the investment activity has increased and we have invested $76.7 million (net of fees) in seven new portfolio companies.

See Note 15 to the Consolidated Financial Statements for information on investments made subsequent to quarter end.

Asset Quality

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Investments with a rating of 5 are those for which some loss of return and principal is expected.

(dollars in millions)

As of December 31, 2020

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Companies (1)

(dollars in millions)

One portfolio company appears in two categories as of December 31, 2019 and December 31, 2018.

One portfolio company appears in two categories as of December 31, 2019.

Loans and Debt Securities on Non-Accrual Status

We will not accrue interest on loans and debt securities if we have reason to doubt our ability to collect such interest.

As of December 31, 2019, we had loans to 2 portfolio companies that were on non-accrual status, which represented approximately 3.6% of our loan portfolio at cost and 0.9% at fair value.

As of December 31, 2018, we had loans to four portfolio companies that were on non-accrual status, which represented approximately 3.9% of our loan portfolio at cost and 2.8% at fair value.

As of December 31, 2020, we had loans to three portfolio companies that were on non-accrual status, which represented approximately 4.3% of our loan portfolio at cost and 1.0% at fair value.

As of December 31, 2019, we had loans to two portfolio companies that were on non-accrual status, which represented approximately 3.6% of our loan portfolio at cost and 0.9% at fair value.

As of December 31, 2020 and December 31, 2019, $7.1 million and $3.8 million of income from investments on non-accrual has not been accrued, respectively.

Results of Operations

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Non-recurring income was related to early repayments, the recognition of previously reserved income from a prior period, and amendments to specific loan positions.

The increase in interest income from the respective periods were due primarily to growth in the overall investment portfolio.

The decrease in interest income from the year ended December 31, 2019 to the year ended December 31, 2020 was due primarily to a decline in the market indices that are used for the floating rate loans, subject to interest rate floors.

The increase in interest income from the year ended December 31, 2018 to the year ended December 31, 2019 was due primarily to growth in the overall investment portfolio.

Our primary operating expenses include the payment of fees to Stellus Capital Management under the investment advisory agreement, our allocable portion of overhead expenses under the administration agreement and other operating costs described below.

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Income incentive fees

Capital gain incentive fees

Capital gain incentive (reversal) fees

Professional fees

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Total Operating Expenses

Loss on extinguishment of debt

Total Expenses

The increase in operating expenses for the respective periods was primarily due to 1) an increase in management fees, directly related to the growth of our portfolio, 2) increased interest expense due to the higher balances on the Credit Facility and SBA-guaranteed debentures outstanding during the period, 3) excise taxes as a result of capital gains on certain equity positions, and 4) higher income incentive fees and capital gains incentive fees due to performance of the portfolio.

The decrease in operating expenses for the respective periods was primarily due to lower income incentive fees, as a result of pre-incentive fee net investment income being lower than the hurdle rate, mainly due to lower LIBOR rates over the period;

and the reversal of a previously accrued capital gains incentive fee, which resulted from realized losses incurred over the period.

The decrease was offset by an increase in management fees, directly related to the growth of our portfolio and an increase in interest expense due to the higher balances on the Credit Facility and SBA-guaranteed debentures (as defined below) outstanding during the period.

Net Investment Income

Net investment income was $22.4 million, or $1.23 per common share based on 18,275,696 weighted-average common shares outstanding at December 31, 2019.

Net investment income was $22.6 million, or $1.42 per common share based on 15,953,571 weighted-average common shares outstanding at December 31, 2018.

Net investment income was $18.0 million, or $1.21 per common share based on 14,870,981 weighted-average common shares outstanding at December 31, 2017.

For the year ended December 31, 2020, net investment income was $22.0 million, or $1.13 per common share based on 19,471,500 weighted-average common shares outstanding.

For the year ended December 31, 2019, net investment income was $22.4 million, or $1.23 per common share based on 18,275,696 weighted-average common shares outstanding.

For the year ended December 31, 2018, net investment income was $22.6 million, or $1.42 per common share based on 15,953,571 weighted-average common shares outstanding.

Net investment income for the year ended December 31, 2020 decreased compared to the year ended December 31, 2019 as a result of lower interest income due to a decline in the market indices that are used for our floating rate loans, subject to interest rate floors;

offset by lower operating expenses as explained in the “Expenses” section above.

Net investment income for the year ended December 31, 2019 decreased compared to the year ended December 31, 2018 as a result of an increase in accrued capital gains incentive fees and excise taxes generated by realized gains on certain equity positions and higher interest expense from larger amounts outstanding under the Credit Facility and SBA-guaranteed debentures;

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We measure realized gains or losses by the difference between the net proceeds from the repayment, sale or other disposition and the amortized cost basis of the investment, using the specific identification method, without regard to unrealized appreciation or depreciation previously recognized.

Proceeds from repayments of investments and amortization of certain other investments for the year ended December 31, 2020 totaled $128.6 million and net realized losses totaled ($10.1) million.

Proceeds from repayments of investments and amortization of certain other investments for the year ended December 31, 2019 totaled $128.2 million and net realized gains totaled $19.6 million.

Proceeds from repayments of investments and amortization of certain other investments for the year ended December 31, 2018 totaled $147.5 million and net realized gain totaled $5.5 million.

Proceeds from the sales and repayments of investments and amortization of certain other investments for the year ended December 31, 2018 totaled $147.5 million and net realized gains totaled $5.5 million.

Net realized gains in all periods presented resulted from the realization of our equity investments in certain portfolio companies.

Net realized losses during the year ended December 31, 2020 resulted primarily from the disposition of a loan in our portfolio, partially offset by gains from the realization of our equity investments in certain portfolio companies.

Net realized gains for the years ended December 31, 2019 and 2018 resulted primarily from the realization of our equity investments in certain portfolio companies.

Net Change in Unrealized Appreciation (Depreciation) of Investments

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Net change in unrealized appreciation (depreciation) on investments and cash equivalents for the year ended December 31, 2020, 2019 and 2018 totaled $8.6 million, ($15.5) million, and ($1.6) million, respectively.

The change in unrealized appreciation in 2020 was primarily due to portfolio company specific performance on several of our equity investments.

The change in unrealized depreciation in 2019 was primarily due to write downs on specific investments.

The change in unrealized depreciation in 2018 was due to a significant widening of spreads during the fourth quarter, offset by the write up of a specific equity investment.

There was relatively no change in unrealized appreciation in 2017.

The change in unrealized depreciation in 2018 was due to a significant widening of spreads right at year end, offset by the write up of a specific equity investment.

Provision for Taxes on Unrealized Appreciation on Investments

We have direct wholly owned subsidiaries that have elected to be taxable entities (the “Taxable Subsidiaries”).

The Taxable Subsidiaries permit us to hold equity investments in portfolio companies which are “pass through” entities for tax purposes and continue to comply with the “source-of-income” requirements contained in RIC tax provisions of the Code.

The Taxable Subsidiaries are not consolidated with us for income tax filing purposes and may generate income tax expense, benefit, and the related tax assets and liabilities, as a result of their ownership of certain portfolio investments.

The income tax expense, or benefit, if any, and related tax assets and liabilities are reflected in our consolidated financial statements.

For the year ended December 31, 2019, 2018 and 2017, we recognized a deferred tax benefit (provision) related to unrealized appreciation on certain equity investments for income tax at our Taxable Subsidiaries of $(66.8) thousand, $(68.0) thousand and $9.0 thousand, respectively.

As of December 31, 2019 and 2018, a deferred tax liabilities of $134.7 thousand and $68.0 thousand, respectively, were included on the Consolidated Statement of Assets and Liabilities.

The Taxable Subsidiaries permit us to hold equity investments in portfolio companies which are “pass through” entities for U.S.

federal income tax purposes and continue to comply with the “source income” requirements contained in RIC tax provisions of the Code.

The Taxable Subsidiaries are not consolidated with us for U.S.

federal income tax purposes and may generate U.S.

federal income tax expense, benefit, and the related tax assets and liabilities, as a result of their ownership of certain portfolio investments.

federal income tax expense, or benefit, if any, and related tax assets and liabilities are reflected in our consolidated financial statements.

For the year ended December 31, 2020, 2019 and 2018, we recognized a deferred tax provision related to unrealized appreciation on certain equity investments for income tax at our Taxable Subsidiaries of $224.9 thousand, $66.8 thousand and $68.0 thousand, respectively.

As of December 31, 2020 and 2019, deferred tax liabilities of $359.6 thousand and $134.7 thousand, respectively, were included on the Consolidated Statement of Assets and Liabilities.

For the year ended December 31, 2018, we recognized tax expense related to the realized gains on certain equity investments at our taxable subsidiaries of $267.0 thousand.

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Net Increase in Net Assets Resulting from Operations

Net increase in net assets resulting from operations totaled $26.4 million, or $1.45 per common share based on weighted-average shares of 18,275,696 for the year ended December 31, 2019, as compared to $26.2 million, or $1.64 per common share based on weighted-average shares of 15,953,571 common shares outstanding for the year ended December 31, 2018, as compared to $22.6 million, or $1.52 per common share based on weighted-average shares of 14,870,981 common shares outstanding for the year ended December 31, 2017.

The increase in net assets resulting from operations for the year ended December 31, 2019 as compared to the year ended December 31, 2018 was higher due primarily to a larger amount of realized gains, offset by unrealized depreciation.

The increase in net assets resulting from operations for the year ended December 31, 2018 as compared to the year ended December 31, 2017 was higher due primarily to a higher net investment income as a result of portfolio growth, as well as a larger amount of realized gains.

Net increase in net assets resulting from operations totaled $20.2 million, or $1.04 per common share based on weighted-average shares of 19,471,500 for the year ended December 31, 2020, as compared to $26.4 million, or $1.45 per common share based on weighted-average shares of 18,275,696 common shares

outstanding for the year ended December 31, 2019, as compared to $26.2 million, or $1.64 per common share based on weighted-average shares of 15,953,571 common shares outstanding for the year ended December 31, 2018.

The decrease in net increase in net assets for the year ended December 31, 2020 was primarily due to net realized losses, offset by net unrealized gains.

The net increase in net assets resulting from operations for the year ended December 31, 2019 as compared to the year ended December 31, 2018 was higher due primarily to a larger amount of realized gains, offset by unrealized depreciation.

Financial condition, liquidity and capital resources

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Our operating activities used net cash of $3.5 million for the year ended December 31, 2020, primarily in connection with the purchase of portfolio investments, offset by sales and repayments of portfolio investments.

The decrease in net cash used in operating activities over the period is because we did not make any new investments during the first half of 2020, primarily due to the COVID-19 pandemic.

Our financing activities for the year ended December 31, 2020 provided cash of $5.8 million primarily from proceeds from SBA-guaranteed debentures, net borrowings on our Credit Facility, and proceeds from the issuance of common stock.

Our operating activities used net cash of $93.3 million for the year ended December 31, 2019, primarily in connection with the purchase of portfolio investments, offset by sales and repayments of portfolio investments.

Our financing activities for the year ended December 31, 2019 provided cash of $92.0 million primarily from proceeds from the issuance of common stock, proceeds from SBA-guaranteed debentures and net borrowings on our Credit Facility.

Our operating activities used net cash of $102.4 million for the year ended December 31, 2018, primarily in connection with the purchase of portfolio investments, offset by sales and repayments of portfolio investments.

Our financing activities for the year ended December 31, 2018 provided cash of $94.8 million primarily from proceeds from SBA-guaranteed debentures and net borrowings on our credit facility

Our operating activities provided net cash of $18.9 million for the year ended December 31, 2017, primarily in connection with income earned on our portfolio investments, offset by the purchase and origination of portfolio investments.

Our financing activities for the year ended December 31, 2017 used cash of ($2.9) million, primarily from net repayments on our credit facility.

Our financing activities for the year ended December 31, 2018 used cash of $94.8 million, primarily from proceeds from SBA-guaranteed debentures and net borrowings on our Credit Facility.

Liquidity and Capital Resources

Our liquidity and capital resources are derived from the Credit Facility, the 2022 Notes, SBA-guaranteed debentures and cash flows from operations, including investment sales and repayments, and income earned.

Our liquidity and capital resources are derived from the Credit Facility, the 2022 Notes (as defined below), SBA-guaranteed debentures and cash flows from operations, including investment sales and repayments, and income earned.

Our primary use of funds from operations includes investments in portfolio companies and other operating expenses we incur, as well as the payment of dividends to the holders of our common stock.

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A proposal, approved by our stockholders at our 2020 annual stockholders meeting, authorizes us to sell up to 25% of our outstanding common shares at a price equal to or below the then current net asset value per share in one or more offerings.

This approval will expire on the earlier of our 2020 annual stockholder meeting or July 22, 2020, the one-year anniversary of our 2019 annual stockholders meeting.

This authorization will expire on June 25, 2021, the one-year anniversary of our 2020 annual stockholders meeting.

We would need similar future approval from our stockholders to issue shares below the then current net asset value per share any time after the expiration of the current approval.

In addition, we intend to distribute between 90% and 100% of our taxable income to our stockholders in order to satisfy the requirements applicable to RICs under Subchapter M of the Code.

Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio companies or to repay borrowings.

Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio

companies or to repay borrowings.

In addition, the illiquidity of our portfolio investments may make it difficult for us to sell these investments when desired and, if we are required to sell these investments, we may realize significantly less than their recorded value.

Also, as a BDC, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, to total senior securities, which include all of our borrowings and any outstanding preferred stock, of at least 150% effective June 28, 2018 (at least 200% prior to June 28, 2018).

Also, as a BDC, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, over the aggregate amount of the senior securities, which include all of our borrowings and any outstanding preferred stock, of at least 150% effective June 29, 2018 (at least 200% prior to June 29, 2018).

This requirement limits the amount that we may borrow.

We have received exemptive relief from the SEC to permit us to exclude the debt of our SBIC subsidiaries guaranteed by the SBA from the definition of senior securities in the asset coverage test under the 1940 Act.

We have received exemptive relief from the SEC to permit us to exclude the debt of Stellus Capital SBIC, LP (“SBIC subsidiary”) and Stellus Capital SBIC II, LP (“SBIC II subsidiary”) (together, “the SBIC subsidiaries”) guaranteed by the Small Business Administration (“SBA”) from the definition of senior securities in the asset coverage test under the 1940 Act.

We were in compliance with the asset coverage ratios at all times.

As of December 31, 2020 and December 31, 2019, our asset coverage ratio was 223% and 229%, respectively.

The amount of leverage that we employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing, such as the maturity,

covenant package and rate structure of the proposed borrowings, our ability to raise funds through the issuance of shares of our common stock and the risks of such borrowings within the context of our investment outlook.

The amount of leverage that we employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing, such as the maturity, covenant package and rate structure of the proposed borrowings, our ability to raise funds through the issuance of shares of our common stock and the risks of such borrowings within the context of our investment outlook.

Ultimately, we only intend to use leverage if the expected returns from borrowing to make investments will exceed the cost of such borrowing.

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Credit Facility

On November 7, 2012, we entered into a revolving credit facility (the “Original Facility”) with various lenders.

SunTrust Bank, one of the lenders, served as administrative agent under the Original Facility.

We terminated the Original Facility on October 11, 2017, in conjunction with securing and entering into a new senior secured revolving credit agreement, dated as of October 10, 2017, as amended on March 28, 2018, August 2, 2018, September 13, 2019, and December 27, 2019, with ZB, N.A., dba Amegy Bank and various other lenders (the “Credit Facility”).

The Credit Facility, as amended, provides for borrowings up to a maximum of $220.0 million on a committed basis with an accordion feature that allows the Company to increase the aggregate commitments up to $250.0 million, subject to new or existing lenders agreeing to participate in the increase and other customary conditions.

Borrowings under the Credit Facility bear interest, subject to our election, on a per annum basis equal to (i) LIBOR plus 2.50% (or 2.75% during certain periods in which the our asset coverage ratio is equal to or below 1.90 to 1.00) with no LIBOR floor, or (ii) 1.50% (or 1.75% during certain periods in which our asset coverage ratio is equal to or below 1.90 to 1.00) plus an alternate base rate based on the highest of the Prime Rate, Federal Funds Rate plus 0.5% or one month LIBOR plus 1.0%.

On October 11, 2017, we entered a senior secured revolving credit agreement, dated as of October 10, 2017, as amended, that was amended and restated on September 18, 2020 with ZB, N.A., dba Amegy Bank and various other lenders (the “Credit Facility”).

The key changes in the amended and restated Credit Facility are as follows:

Prior agreement

As amended and restated

Maturity Date

October 10, 2021

September 18, 2025

Commitment termination date

March 10, 2021

September 18, 2024

Prime rate floor

Asset coverage ratio

Minimum of 1.75 to 1.00 (maximum leverage of 1.33x)

Minimum of 1.67 to 1.00 (maximum leverage of 1.5x)

Refinancing of 2022 Notes (1)

Required by March 15, 2022

See subsequent events section below for discussion on activity related to the 2022 Notes subsequent to December 31, 2020.

The Credit Facility, as amended and restated, provides for borrowings up to a maximum of $230.0 million on a committed basis with an accordion feature that allows us to increase the aggregate commitments up to $280.0 million, subject to new or existing lenders agreeing to participate in the increase and other customary conditions.

Borrowings under the Credit Facility bear interest, subject to our election, on a per annum basis equal to (i) LIBOR plus 2.50% (or 2.75% during certain periods in which our asset coverage ratio is equal to or below 1.90 to 1.00) with a 0.25% LIBOR floor, or (ii) 1.50% (or 1.75% during certain periods in which our asset coverage ratio is equal to or below 1.90 to 1.00) plus an alternate base rate based on the highest of the Prime Rate, Federal Funds Rate plus 0.5% or one month LIBOR plus 1.0%.

We pay unused commitment fees of 0.50% per annum on the unused lender commitments under the Credit Facility.

Interest is payable quarterly in arrears.

The commitment to fund the revolver expires on October 10, 2020, after which we may no longer borrow under the Credit Facility.

We must begin repaying principal equal to 1/12 of the aggregate amount outstanding under the Credit Facility beginning October 15, 2020.

Any amounts borrowed under the Credit Facility will mature, and all accrued and unpaid interest thereunder will be due and payable, on October 10, 2021.

Our obligations to the lenders are secured by a first priority security interest in its portfolio of securities and cash not held at the SBIC subsidiaries, but excluding short term investments.

The commitment to fund the revolver expires on September 18, 2024, after which we may no longer borrow under the Credit Facility and must begin repaying principal equal to 1/12 of the aggregate amount outstanding under the Credit Facility.

Any amounts borrowed under the Credit Facility will mature, and all accrued and unpaid interest thereunder will be due and payable, on September 18, 2025.

Our obligations to the lenders are secured by a first priority security interest in our portfolio of securities and cash not held at the SBIC subsidiaries but excluding short term investments.

The Credit Facility contains certain covenants, including but not limited to:

(i) maintaining a minimum liquidity test of at least $10.0 million, including cash, liquid investments and undrawn availability, (ii) maintaining an asset coverage ratio of at least 1.75 to 1.0, and (iii) maintaining a minimum shareholder’s equity.

As of December 31, 2019, we were in compliance with these covenants.

(i) maintaining a minimum liquidity test of at least $10,000,000, including cash, liquid investments and undrawn availability, (ii) maintaining an asset coverage ratio of at least 1.67 to 1.0, (iii) maintaining a minimum shareholder’s equity, and (iv) maintaining a minimum interest coverage ratio of at least 2.00 to 1.00.

As of December 31, 2020 and December 31, 2019, the outstanding balance under the Credit Facility was $174.0 million and $161.6 million, respectively.

The carrying amount of the amount outstanding under the Credit Facility approximates its fair value.

The fair values of the Credit Facility is determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions.

The fair value of the Credit Facility is determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions.

The fair value of the Credit Facility is estimated based upon market interest rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any.

We have incurred costs of $1.8 million in connection with the current Credit Facility, which are being amortized over the life of the facility.

Additionally, $0.3 million of costs from the Original Facility will continue to be amortized over the remaining life of the Credit Facility.

We have incurred costs of $3.6 million in connection with the current Credit Facility, which were capitalized and are being amortized over the life of the facility.

Additionally, $0.3 million of costs from a prior credit facility will continue to be amortized over the life of the Credit Facility.

As of December 31, 2020 and 2019, $2.3 million and $1.0 million of such prepaid loan structure fees and administration fees had yet to be amortized, respectively.

These prepaid loan fees are presented on our consolidated statement of assets and liabilities as a deduction from the debt liability attributable to the Credit Facility.

Interest is paid quarterly in arrears.

Interest is paid monthly or quarterly in arrears.

The following table summarizes the interest expense and amortized loan fees on the Credit Facility for the years ended December 31, 2020, 2019, and 2018 (dollars in millions):

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Administration fees

Total interest expense and other fees

Loss on extinguishment of debt

Total interest and financing expenses

Weighted average interest rate

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SBA-guaranteed debentures

Due to the SBIC subsidiaries’ status as licensed SBICs, we can issue debentures guaranteed by the SBA at favorable interest rates.

Under the regulations applicable to SBIC funds, a single licensee can have outstanding debentures guaranteed by the SBA subject to a regulatory leverage limit, up to two times the amount of regulatory capital.

Due to the SBIC subsidiaries’ status as licensed SBICs, we can issue debentures guaranteed by the SBA at favorable interest rates (“SBA-guaranteed debentures”).

Under the regulations applicable to SBIC funds, a single licensee can have outstanding SBA-guaranteed debentures, subject to a regulatory leverage limit, up to two times the amount of regulatory capital.

As of both December 31, 2020 and 2019, the SBIC subsidiary had $75.0 million in “regulatory capital”, as such term is defined by the SBA.

As of December 31, 2019, the year ending the first year of operations, the SBIC II subsidiary had $20.0 million in regulatory capital, as such term is defined by the SBA.

On August 12, 2014, we obtained exemptive relief from the SEC to permit us to exclude the debt of the SBIC subsidiaries guaranteed by the SBA from our asset coverage test under the 1940 Act.

As of December 31, 2020 and 2019, the SBIC II subsidiary had $40.0 million and $20.0 million in regulatory capital, respectively.

On August 12, 2014, we obtained exemptive relief from the SEC to permit us to exclude the SBA-guaranteed debentures from our asset coverage test under the 1940 Act.

The exemptive relief provides us with increased flexibility under the asset coverage test by permitting us to borrow up to $325.0 million more than we would otherwise be able to absent the receipt of this exemptive relief.

On a stand-alone basis, the SBIC subsidiaries held $277.3 million and $240.1 million in assets at December 31, 2020 and 2019, respectively, which accounted for approximately 41.1% and 37.0% of our total consolidated assets at December 31, 2020 and 2019, respectively.

Debentures guaranteed by the SBA have fixed interest rates that equal prevailing 10-year Treasury Note rates plus a market spread and have a maturity of ten years with interest payable semi-annually.

The principal amount of the debentures is not required to be paid before maturity, but may be pre-paid at any time with no prepayment penalty.

As of December 31, 2019 and 2018, the SBIC subsidiaries had $161.0 million and $150.0 million of the SBA-guaranteed debentures outstanding, respectively.

SBA-guaranteed debentures have fixed interest rates that equal prevailing 10-year Treasury Note rates plus a market spread and have a maturity of ten years with interest payable semi-annually.

The principal amount of the SBA-guaranteed debentures is not required to be paid before maturity but may be pre-paid at any time with no prepayment penalty.

As of December 31, 2020 and 2019, the SBIC subsidiaries had $176.5 million and $161.00 of the SBA-guaranteed debentures outstanding, respectively.

SBA-guaranteed debentures drawn before October 1, 2019 incur upfront fees of 3.425%, which consists of a 1.00% commitment fee and a 2.425% issuance discount, which are amortized over the life of the SBA-guaranteed debentures.

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As of December 31, 2020 and 2019, the carrying amount of the SBA-guaranteed debentures approximated their fair value.

The fair values of the SBA-guaranteed debentures are determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions.

The fair value of the SBA-guaranteed debentures are estimated based upon market interest

rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any.

The fair value of the SBA-guaranteed debentures is determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions.

The fair value of the SBA-guaranteed debentures is estimated based upon market interest rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any.

At December 31, 2020 and 2019, the SBA-guaranteed debentures would be deemed to be Level 3, as defined in Note 6.

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The following table summarizes the interest expense and amortized fees on the SBA-guaranteed debentures for the years ended December 31, 2020, 2019 and 2018 (dollars in millions):

averages for periods outstanding):

For the years ended

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Debenture fee amortization

Total interest expense and other fees

Weighted average interest rate

Effective interest rate (including fee amortization)

Average debt outstanding

Cash paid for interest

On May 5, 2014, we closed a public offering of $25.0 million aggregate principal amount of 6.50% notes (the “2019 Notes”) due April 30, 2019.

We redeemed all $25.0 million in aggregate principal amount of the 2019 Notes on September 20, 2017.

As a result of the redemption, we recognized a loss on the extinguishment of debt of $0.3 million for the year ended December 31, 2017, due to the write off of the remaining deferred financing costs on the 2019 Notes.

The following table summarizes the interest expense and deferred financing costs on the 2019 Notes for the years ended December 31, 2019, 2018, and 2017 (dollars in millions;

averages for period outstanding):

For the year ended

Interest expense

Deferred financing costs

Total interest expense and other fees

Loss on extinguishment of debt

Total interest and financing expenses

Weighted average interest rate

2 unchanged sentences

Cash paid for interest

Notes Offering

On August 21, 2017, we issued $42.5 million in aggregate principal amount of 5.75% fixed-rate notes due 2022 (the “2022 Notes”).

On September 8, 2017, we issued an additional $6.4 million in aggregate principal amount of the 2022 Notes pursuant to a full exercise of the underwriters’ overallotment option.

The 2022 Notes will mature on September 15, 2022, and may be redeemed in whole or in part at any time or

from time to time at the Company’s option on or after September 15, 2019 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest.

The 2022 Notes will mature on September 15, 2022, and may be redeemed in whole or in part at any time or from time to time at our option on or after September 15, 2019 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest.

Interest is payable quarterly.

We used all of the net proceeds from this offering to fully redeem the 2019 Notes and a portion of the amount outstanding under the Original Facility.

We used all of the net proceeds from this offering to fully redeem notes issued in a prior public offering and a portion of the amount outstanding under our prior credit facility.

As of both December 31, 2020 and 2019, the aggregate carrying amount of all Notes was $48.9 million and the fair value of the Notes was approximately $49.2 million and $49.7 million, respectively.

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The following table summarizes the interest expense and deferred financing costs on the 2022 Notes for the years ended December 31, 2020, 2019, 2018 (in millions):

For the year ended

For the years ended

Interest expense

Deferred financing costs

Total interest expense and other fees

Total interest and financing expenses

Weighted average interest rate

2 unchanged sentences

Cash paid for interest

for the period outstanding

Contractual Obligations

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SBA-guaranteed debentures

We must begin repaying principal equal to 1/12 of the aggregate amount outstanding under the Credit Facility beginning October 15, 2020.

See Note 9 for further discussion.

See Note 15 for the discussion regarding the 2022 Notes subsequent to December 31, 2020

Off-Balance Sheet Arrangements

We may be a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our portfolio companies.

As of December 31, 2019, our only off-balance sheet arrangements consisted of $37.5 million of unfunded commitments to provide debt financing to seventeen of our portfolio companies.

As of December 31, 2018, our only off-balance sheet arrangements consisted of a $21.2 million unfunded commitments to provide debt financing to eleven of our portfolio companies.

As of December 31, 2020, our only off-balance sheet arrangements consisted of $28.9 million of unfunded commitments to provide debt financing to 19 of our portfolio companies.

As of December 31, 2019, our only off-balance sheet arrangements consisted of $37.5 million unfunded commitments to provide debt financing to 17 of our portfolio companies.

As of December 31, 2020, we had sufficient liquidity (through cash on hand and available borrowings under the Credit Facility to fund such unfunded commitments should the need arise.

Regulated Investment Company Status and Dividends

We have elected to be treated as a RIC under Subchapter M of the Code.

So long as we maintain our status as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders as dividends on a timely basis.

So long as we maintain our qualification as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders as dividends on a timely basis.

Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation until realized.

Distributions declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year.

Distributions declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable

income or the distribution of prior year taxable income carried forward into and distributed in the current year.

Distributions also may include returns of capital.

To qualify for RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company net taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any).

If we maintain our qualification as a RIC, we must also satisfy certain distribution requirements each calendar year in order to avoid a federal excise tax on our undistributed earnings of a RIC.

If we maintain our qualification as a RIC, we must also satisfy certain distribution requirements each calendar year to avoid a U.S.

federal excise tax on our undistributed earnings of a RIC.

As of December 31, 2020, we had $21,051,549 of undistributed taxable income that will be carried forward toward distributions paid during the year ending December 31, 2021.

We intend to distribute to our stockholders between 90% and 100% of our annual taxable income (which includes our taxable interest and fee income).

However, the covenants contained in the Credit Facility may prohibit us from making distributions to our stockholders, and, as a result, could hinder our ability to satisfy the distribution requirement.

In addition, we may retain for investment some or all of our net taxable capital gains (i.e., realized net long-term capital gains in excess of realized net short-term capital losses) and treat such amounts as deemed distributions to our stockholders.

If we do this, our stockholders will be treated as if they received actual distributions of the capital gains we retained and then reinvested the net after-tax proceeds in our common stock.

In addition, we may retain for investment some or all our net taxable capital gains (i.e., realized net long-term capital gains in excess of realized net short-term capital losses) and treat such amounts as deemed distributions to our stockholders.

If we do this, our stockholders will be treated as if they received actual distributions of the capital gains we retained and then reinvested the net after-tax proceeds in shares of our common stock.

Our stockholders also may be eligible to claim tax credits (or, in certain circumstances, tax refunds) equal to their allocable share of the tax we paid on the capital gains deemed distributed to them.

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We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time.

In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a business development company under the 1940 Act and due to provisions in Credit Facility.

In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a BDC under the 1940 Act and due to provisions in the Credit Facility.

We cannot assure stockholders that they will receive any distributions or distributions at a particular level.

In accordance with certain applicable Treasury regulations and private letter rulings issued by the Internal Revenue Service, a RIC may treat a distribution of its own stock as fulfilling its RIC distribution requirements if each stockholder may elect to receive his or her entire distribution in either cash or stock of the RIC, subject to a limitation that the aggregate amount of cash to be distributed to all stockholders must be at least 20% of the aggregate declared distribution.

If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a pro rata amount of cash (with the balance of the distribution paid in stock).

In no event will any stockholder, electing to receive cash, receive less than 20% of his or her entire distribution in cash.

In accordance with certain applicable U.S.

Treasury regulations and private letter rulings issued by the Internal Revenue Service (the “IRS”), a RIC may treat a distribution of its own stock as fulfilling its RIC distribution requirements if each stockholder may elect to receive his or her entire distribution in either cash or stock of the RIC, subject to a limitation that the aggregate amount of cash to be distributed to all stockholders must be at least 20% of the aggregate declared distribution.

If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a pro rata amount of cash (with the balance of the distribution paid in shares of our common stock).

In no event will any stockholder, electing to receive cash, receive less than 20% of his or her entire distribution in cash, except as described below.

Recently, in recognition of the need for enhanced liquidity during the current period of economic disruption, the IRS temporarily reduced the minimum required aggregate amount of cash that shareholders may receive in such a distribution from 20% down to 10% percent of the aggregate declared distribution.

This temporary modification was effective solely with respect to distributions declared on or after April 1, 2020, and on or before December 31, 2020.

If these and certain other requirements are met, for U.S.

federal income tax purposes, the amount of the dividend paid in stock will be equal to the amount of cash that could have been received instead of stock.

We have no current intention of paying dividends in shares of our stock in accordance with these Treasury regulations or private letter rulings.

federal income tax purposes, the amount of the dividend paid in shares of our common stock will be equal to the amount of cash that could have been received instead of stock.

We have no current intention of paying dividends in shares of our common stock in accordance with these U.S.

Treasury regulations or private letter rulings.

However, we continue to monitor the Company’s liquidity position and the overall economy and will continue to assess whether it would be in our and our shareholders best interest to take advantage of the IRS rulings.

Recent Accounting Pronouncements

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Critical Accounting Policies

The preparation of our 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, our significant accounting policies are further described in the notes to the financial statements.

Valuation of portfolio investments

As a business development company, we generally invest in illiquid loans and securities including debt and equity securities of middle-market companies.

Under procedures established by our Board, we may value investments for which market quotations are readily available at such market quotations.

We obtain these market values from an independent pricing service or at the mean between the bid and ask prices obtained from at least two brokers or dealers (if available, otherwise by a principal market maker or a primary market dealer).

Debt and equity securities that are not publicly traded or whose market prices are not readily available are valued at fair value as determined in good faith by our Board.

Such determination of fair values may involve subjective judgments and estimates, although we engage independent valuation providers to review the valuation of each portfolio investment that does not have a readily available market quotation at least twice each year.

Investments purchased within 90 days of maturity are valued at cost plus accreted discount, or minus amortized premium, which approximates value.

With respect to unquoted securities, our Board, together with our independent valuation advisors, values each investment considering, among other measures, discounted cash flow models, comparisons of financial ratios of peer companies that are public and other factors.

When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, our Board uses the pricing indicated by the external event to corroborate and/or assist us in our valuation.

Because there is not a readily available market for substantially all of the investments in our portfolio, we value most of our portfolio investments at fair value as determined in good faith by our Board using a documented valuation policy and a consistently applied valuation process.

Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ significantly from the values that would have been used had a readily available market value existed for such investments, and the differences could be material.

With respect to investments for which market quotations are not readily available, our Board undertakes a multi-step valuation process each quarter, as described below:

Our quarterly valuation process begins with each portfolio company or investment being initially valued by the investment professionals of Stellus Capital Management responsible for the portfolio investment;

Preliminary valuation conclusions are then documented and discussed with our senior management and Stellus Capital Management;

At least twice annually, the valuation for each portfolio investment is reviewed by an independent valuation firm;

The audit committee of our Board then reviews these preliminary valuations;

The Board then discusses valuations and determines the fair value of each investment in our portfolio in good faith, based on the input of Stellus Capital Management, the independent valuation firm and the audit committee.

Revenue recognition

We record interest income on an accrual basis to the extent that we expect to collect such amounts.

For loans and debt securities with contractual PIK interest, which represents contractual interest accrued and added to the loan balance that generally becomes due at maturity, we do not accrue PIK interest if the portfolio company valuation indicates that such PIK interest is not collectible.

We will not accrue interest on loans and debt securities if we have reason to doubt our ability to collect such interest.

Loan origination fees, original issue discount and market discount or premium are capitalized, and we then accrete or amortize such amounts using the effective interest method as interest income.

Upon the prepayment of a loan or

debt security, any unamortized loan origination is recorded as interest income.

We record prepayment premiums on loans and debt securities as interest income.

Dividend income, if any, will be recognized on the ex-dividend date.

We have investments in our portfolio that contain a PIK interest provision.

Any PIK interest is added to the principal balance of such investments and is recorded as income, if the portfolio company valuation indicates that such PIK interest is collectible.

In order to maintain our status as a RIC, substantially all of this income must be paid out to stockholders in the form of dividends, even if we have not collected any cash.

Net realized gains or losses and net change in unrealized appreciation or depreciation

We measure realized gains or losses by the difference between the net proceeds from the repayment, sale, or other disposition and the amortized cost basis of the investment, without regard to unrealized appreciation or depreciation previously recognized.

Net change in unrealized appreciation or depreciation reflects the change in portfolio investment values during the reporting period, including any reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.

Capital Gains Incentive Fee

Under GAAP, the Company calculates the capital gains incentive fee payable to the Advisor as if the Company had realized all investments at their fair values as of the reporting date.

Accordingly, the Company accrues a provisional capital gains incentive fee taking into account any unrealized gains or losses.

As the provisional incentive fee is subject to the performance of investments until there is a realization event, the amount of provisional capital gains incentive fee accrued at a reporting date may vary from the incentive fee that is ultimately realized and the differences could be material.

Recent Developments

See Note 1 to the Consolidated Financial Statements contained herein for a description of critical accounting policies.

Subsequent Events

Investment Portfolio

On January 3, we received full repayment on the first lien term loan of APG Intermediate Sub 2 Corp.

for total proceeds of $10 million, including a $0.1 million prepayment fee.

We also received $2.4 million in full realization on the equity of the company, resulting in a $1.3 million gain.

On January 7, 2020, we invested $14.4 million in the first lien term loan of Sales Benchmark Index, LLC, $1.3 million in the unfunded revolver, and $3.3 million in the unfunded delayed draw term loan of Sales Benchmark, LLC, a provider of revenue growth management consulting services for private equity-owned and large enterprise clients.

Additionally, we invested $0.7 million in the preferred equity of the company.

On January 15, 2020, Apex Environmental Resources Holdings, LLC was merged with a provider of non-hazardous waste management, collection, and recycling services, creating Interstate Waste Services, Inc.

Our common and preferred ownership positions in Apex Environmental Resources Holdings, LLC was rolled into the combined entity.

On January 31, 2020, we invested $18.9 million in the first lien term loan and $2.7 million in the unfunded revolver of Elliott Aviation, LLC, a provider of maintenance, repair, and overhaul and fixed-base operator services to the business aviation sector.

Additionally, we invested $0.9 million in the preferred equity of the company.

On January 14, 2021, we received full repayment on the first lien term loan and revolver of BFC Solmetex, LLC.

for total proceeds of $13.6 million.

We also received full repayment on the first lien term loan of Bonded Filter Co.

LLC, a subsidiary of BFC Solmetex, LLC, for total proceeds of $1.2 million.

On January 29, 2021, we invested $11.3 million in the first lien term loan of NuSource Financial, LLC, a provider of technology integration and installation of Automated Teller Machines / Integrated Teller Machines (“ATM” / “ITM”), maintenance services, and security solutions.

Additionally, we invested $4.8 million in the subordinated debt and warrants of the company.

On February 1, 2021, we invested $0.4 million in the equity of Tailwind Core Investor, LLC, an existing portfolio company.

On February 11, 2021, we invested $7.2 million in the first lien term loan of Time Manufacturing Acquisition, LLC, an existing portfolio company.

Additionally, we invested $0.1 million in the equity of the company.

On February 19, 2021, we invested $13.5 million in the first lien term loan and committed $0.1 million in the unfunded revolver of CEATI International, Inc., a provider of intellectual content, technical trade programs, research groups, and conferences for utility companies.

Additionally, we invested $0.3 million in the equity of the company.

On March 1, 2021, we invested $10.8 million in the first lien term loan and committed $0.1 million in the unfunded revolver of TAC LifePort Purchaser, LLC, a provider of aerospace products for the U.S.

military / government, air medical, and high-end VIP aircraft end markets.

Additionally, we invested $0.5 million in the equity of the company.

On March 2, 2021, we invested $10.0 million in the first lien term loan and $0.1 million in the unfunded revolver of TradePending, LLC, a provider of vehicle trade-in and merchandising intelligence solutions for auto dealerships, primarily flagship dealerships.

Additionally, we invested $0.8 million in the equity of the company.

On January 14, 2021, we issued $100.0 million in aggregate principal amount of 4.875% fixed-rate notes due 2026 (the “2026 Notes”).

The 2026 Notes will mature on March 30, 2026, and may be redeemed in whole or in part at any time or from time to time at our option on or after December 31, 2025 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest.

Interest is payable semi-annually beginning September 30, 2021.

We used all of the net proceeds from this offering to fully redeem the 2022 Notes and repay a portion of the outstanding amount under the Credit Facility.

Redemption of the 2022 Notes

On February 12, 2021, we redeemed all $48.875 million in aggregate principal amount of the 2022 Notes.

The 2022 Notes were redeemed at 100% of their principal amount, plus the accrued and unpaid interest thereon through the redemption date.

Credit Facility

The outstanding balance under the Credit Facility as of February 28, 2020 was $175.3 million.

Since December 31, 2019, we issued 332,591 shares under the At-the-Market (“ATM”) Program, for gross proceeds of $4.8 million.

The average per share offering price of shares issued in the ATM Program was $14.42.

The outstanding balance under the Credit Facility as of March 3, 2021 was $164.5 million.

TABLE OF CONTENTS

SBA-guaranteed Debentures

The outstanding balance under SBA-guaranteed Debentures as of February 28, 2020 was $161.0 million.

The outstanding balance under SBA-guaranteed debentures as of March 3, 2021 was $210.0 million.

SBIC II Subsidiary

On January 21, 2021, we contributed $15.0 million to the SBIC II subsidiary, bring total contributed capital to $35.0 million.

On January 25, 2021, we increased committed capital to $60.0 million.

Dividend Declared

On January 10, 2020, the Company’s Board declared a regular monthly dividend for each of January, February and March 2020.

Ex-Dividend Date

Amount per Share

On January 15, 2021, our Board changed the frequency of distributions from quarterly to monthly and declared a regular monthly dividend for each of January, February and March 2021 as follows:

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7. Management’s Discussion and Analysis