UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2014
OR
For the transition period from to
Commission file number: 814-00704
GLADSTONE INVESTMENT CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
(703) 287-5800
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed from last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12 b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. The number of shares of the issuer’s Common Stock, $0.001 par value per share, outstanding as of October 27, 2014, was 26,475,958.
TABLE OF CONTENTS
Condensed Consolidated Statements of Assets and Liabilities as of September 30 and March 31, 2014
Condensed Consolidated Statements of Operations for the three and six months ended September 30, 2014 and 2013
Condensed Consolidated Statements of Changes in Net Assets for the six months ended September 30, 2014 and 2013
Condensed Consolidated Statements of Cash Flows for the six months ended September 30, 2014 and 2013
Condensed Consolidated Schedules of Investments as of September 30 and March 31, 2014
Notes to Condensed Consolidated Financial Statements
Overview
Results of Operations
Liquidity and Capital Resources
CONDENSED CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
(DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
ASSETS
Investments at fair value
Non-Control/Non-Affiliate investments (Cost of $181,693 and $233,895, respectively)
Affiliate investments (Cost of $201,605 and $120,010, respectively)
Control investments (Cost of $28,782 and $29,632 respectively)
Total investments at fair value (Cost of $412,080 and $383,537, respectively)
Cash
Restricted cash
Interest receivable
Due from custodian
Deferred financing costs
Other assets
Total assets
LIABILITIES
Borrowings:
Line of credit at fair value (Cost of $87,750 and $61,250, respectively)
Secured borrowing
Total borrowings
Mandatorily redeemable preferred stock, $0.001 par value, $25 liquidation preference; 1,610,000 shares authorized, 1,600,000shares issued and outstanding
Accounts payable and accrued expenses
Fees due to Adviser(A)
Fee due to Administrator(A)
Other liabilities
Total liabilities
Commitments and contingencies(B)
NET ASSETS
Common stock, $0.001 par value per share, 100,000,000 shares authorized, 26,475,958 shares issued and outstanding
Capital in excess of par value
Cumulative net unrealized depreciation of investments
Cumulative net unrealized depreciation of other
Net investment income in excess of distributions
Accumulated net realized loss
Total net assets
Total liabilities and net assets
NET ASSET VALUE PER SHARE AT END OF PERIOD
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.
2
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
INVESTMENT INCOME
Interest income
Non-Control/Non-Affiliate investments
Affiliate investments
Control investments
Cash and cash equivalents
Total interest income
Other income
Total other income
Total investment income
EXPENSES
Base management fee(A)
Loan servicing fee(A)
Incentive fee(A)
Administration fee(A)
Interest expense on borrowings
Dividends on mandatorily redeemable preferred stock
Amortization of deferred financing fees
Professional fees
Other general and administrative expenses
Expenses before credits from Adviser
Credit of loan servicing fee(A)
Other credits to Adviser fees(A)
Total expenses net of credits to fees
NET INVESTMENT INCOME
REALIZED AND UNREALIZED (LOSS) GAIN
Net realized (loss) gain:
Total net realized (loss) gain
Net unrealized (depreciation) appreciation:
Other
Total net unrealized (depreciation) appreciation
Net realized and unrealized (loss) gain
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS
BASIC AND DILUTED PER COMMON SHARE:
Net investment income
Net increase in net assets resulting from operations
Distributions
WEIGHTED AVERAGE SHARES OF COMMON STOCK OUTSTANDING:
Basic and diluted
3
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
(IN THOUSANDS)
OPERATIONS:
Net realized (loss) gain of investments
Net unrealized appreciation (depreciation) of investments
Net unrealized appreciation of other
Net increase in net assets from operations
DISTRIBUTIONS TO COMMON STOCKHOLDERS:
Total increase in net assets
Net assets at beginning of period
Net assets at end of period
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net increase in net assets resulting from operations to net cash (used in) provided by operating activities:
Purchase of investments
Principal repayments of investments
Increase in investment balance due to paid in kind interest
Net proceeds from the sale of investments
Net realized loss (gain) on investments
Net unrealized (appreciation) depreciation of investments
Amortization of deferred financing costs
Decrease (increase) in restricted cash
Increase in interest receivable
Decrease in due from custodian
Increase in other assets
Increase (decrease) in accounts payable and accrued expenses
Increase (decrease) in fees due to Adviser(A)
Decrease in administration fee due to Administrator(A)
(Decrease) increase in other liabilities
Net cash (used in) provided by operating activities
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from short-term loans
Repayments on short-term loans
Proceeds from line of credit
Repayments on line of credit
Proceeds from secured borrowing
Purchase of derivative
Payment of deferred financing costs
Distributions paid to common stockholders
Net cash provided by (used in) financing activities
NET DECREASE IN CASH AND CASH EQUIVALENTS
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
CASH AND CASH EQUIVALENTS, END OF PERIOD
5
CONDENSED CONSOLIDATED SCHEDULE OF INVESTMENTS
September 30, 2014
(DOLLAR AMOUNTS IN THOUSANDS)
Company(A)
Industry
Investment(B)
NON-CONTROL/NON-AFFILIATE INVESTMENTS(L):
Auto Safety House, LLC
Automobile
Line of Credit , $1,000 available (7.0%, Due 10/2018)
B-Dry, LLC
Personal, Food and Miscellaneous Services
Line of Credit, $0 available (6.5%, Due 5/2015)
Senior Term Debt (13.5%, Due 5/2015)
Common Stock Warrants (85 shares)(C)(F)
Cavert II Holding Corp.
Containers, Packaging, and Glass
Preferred Stock (18,446 shares)(C)(F)
Country Club Enterprises, LLC
Senior Subordinated Term Debt (18.6%, Due 5/2017)
Preferred Stock (7,079,792 shares)(C)(F)
Guaranty ($2,000)(D)
Guaranty ($716)(D)
Drew Foam Company, Inc.
Chemicals, Plastics, and Rubber
Senior Term Debt (13.5%, Due 8/2017)
Preferred Stock (34,045 shares)(C)(F)
Common Stock (5,372 shares)(C)(F)
Frontier Packaging, Inc.
Senior Term Debt (12.0%, Due 12/2017)
Preferred Stock (1,373 shares)(C)(F)
Common Stock (152 shares)(C)(F)
Funko, LLC(K)
Personal and Non-Durable Consumer Products (Manufacturing Only)
Senior Subordinated Term Debt (12.0% and 1.5% PIK, Due 5/2019)
Preferred Stock (1,305 shares)(C)(F)
Ginsey Home Solutions, Inc.
Home and Office Furnishings, Housewares, and Durable Consumer Products
Senior Subordinate Term Debt (13.5%, Due 1/2018)(H)
Preferred Stock (18,898 shares)(C)(F)
Common Stock (63,747 shares)(C)(F)
Jackrabbit, Inc.
Farming and Agriculture
Senior Term Debt (13.5%, Due 4/2018)
Preferred Stock (3,556 shares)(C)(F)
Common Stock (548 shares)(C)(F)
Mathey Investments, Inc.
Machinery (Nonagriculture, Nonconstruction, Nonelectronic)
Senior Term Debt (10.0%, Due 3/2016)
Senior Term Debt (12.0%, Due 3/2016)
Senior Term Debt (12.5%, Due3/2016)(E)(I)
Common Stock (29,102 shares)(C)(F)
Mitchell Rubber Products, Inc.
Subordinated Term Debt (13.0%, Due 10/2016)(I)
Subordinated Term Debt (13.0%, Due 12/2015)(I)
Diversified/Conglomerate Manufacturing
Senior Term Debt (14.0%, Due 12/2015)
Preferred Stock (19,091 shares)(C)(F)
Common Stock (90,909 shares)(C)(F)
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CONDENSED CONSOLIDATED SCHEDULE OF INVESTMENTS (Continued)
Quench Holdings Corp.
Common Stock (4,770,392 shares)(C)(F)
SBS, Industries, LLC
Senior Term Debt (14.0%, Due 8/2016)
Preferred Stock (19,935 shares)(C)(F)
Common Stock (221,500 shares)(C)(F)
Schylling Investments, LLC
Leisure, Amusement, Motion Pictures, Entertainment
Senior Term Debt (13.0%, Due 8/2017)
Preferred Stock (4,000 shares)(C)(F)
Star Seed, Inc.
Senior Term Debt (12.5%, Due 4/2018)
Preferred Stock (1,499 shares)(C)(F)
Common Stock (600 shares)(C)(F)
Total Non-Control/Non-Affiliate Investments (represents 49.9% of total investments at fair value)
AFFILIATE INVESTMENTS(M):
Acme Cryogenics, Inc.
Senior Subordinated Term Debt (11.5%, Due 3/2015)(I)
Preferred Stock (965,982 shares)(C)(F)
Common Stock (549,908 shares)(C)(F)
Common Stock Warrants (465,639 shares)(C)(F)
Alloy Die Casting Corp.(K)
Senior Term Debt (13.5%, Due 10/2018)
Preferred Stock (4,064 shares)(C)(F)
Common Stock (630 shares)(C)(F)
Behrens Manufacturing, LLC(K)
Senior Term Debt (13.0%, Due 12/2018)
Cambridge Sound Management, LLC
Home and office Furnishings, Housewares and Durable Consumer Products
Line of Credit, $325 available (13.0%, Due 9/2015)(J)
Senior Term Debt (13.0%, Due 9/2019)(J)
Preferred Stock (4,500 shares)(C)(F)(J)
Channel Technologies Group, LLC
Preferred Stock (2,279 shares)(C)(F)
Common Stock (2,279,020 shares)(C)(F)
Danco Acquisition Corp.
Line of Credit, $550 available (4.0%, Due 8/2015)
Senior Term Debt (4.0%, Due 8/2015)
Senior Term Debt (5.0%, Due 8/2015)(E)
Preferred Stock (25 shares)(C)(F)
Common Stock (1,241 shares)(C)(F)
Edge Adhesives Holdings, Inc.(K)
Line of Credit, $345 available (10.5%, Due 8/2015)
Senior Term Debt (12.5%, Due 2/2019)
Senior Term Debt (13.75%, Due11/2014)(J)
Senior Subordinated Term Debt (13.75%, Due 2/2019)
Preferred Stock (3,474 shares)(C)(F)
Head Country Food Products, Inc.
Beverage, Food and Tobacco
7
Meridian Rack & Pinion, Inc. (K)
Senior Term Debt (13.5%, Due 12/2018)
Preferred Stock (3,381 shares) (C)(F)
NDLI Inc.
Cargo Transport
Line of Credit, $0 available (10.5%, Due 1/2015)
Senior Term Debt (11.0%, Due 1/2015)
Senior Term Debt (10.5%, Due 1/2015)
Senior Term Debt (10.5%, Due 1/2015)(E)
Preferred Stock (3,600 shares)(C)(F)
Common Stock (545 shares)(C)(F)
SOG Specialty K&T, LLC
Senior Term Debt (13.3%, Due 10/2017)
Senior Term Debt (14.8%, Due 10/2017)
Preferred Stock (9,749 shares)(C)(F)
Tread Corp.
Oil and Gas
Line of Credit, $496 available (12.5%, Due 2/2015)(G)(I)
Senior Subordinated Term Debt (12.5%, Due 2/2015)(G)(I)
Senior Subordinated Term Debt (12.5%, Due on Demand)(G)(I)
Preferred Stock (3,332,765 shares)(C)(F)
Common Stock (7,716,320 shares)(C)(F)
Common Stock Warrants (2,372,727 shares)(C)(F)
Total Affiliate Investments (represents 45.1% of total investments at fair value)
CONTROL INVESTMENTS(N):
Galaxy Tool Holding Corp.
Aerospace and Defense
Senior Subordinated Term Debt (13.5%, Due 8/2017)
Preferred Stock (6,039,387 shares)(C)(F)
Common Stock (88,843 shares)(C)(F)
Tread Real Estate Corp.
Buildings and Real Estate
Common Stock (1,000 shares)(C)(F)(J)
Total Control Investments (represents 5.0% of total investments at fair value)
TOTAL INVESTMENTS
8
9
MARCH 31, 2014
Senior Subordinated Term Debt (11.5%, Due 3/2015)(K)
Preferred Stock (898,814 shares)(C)(F)
Common Stock (418,072 shares)(C)(F)
Common Stock Warrants (465,639shares)(C)(F)
Alloy Die Casting Corp.
Senior Term Debt (13.5%, Due 10/2018)(D)
Line of Credit, $1,000 available (7.0%, Due 10/2018)(D)(K)
Guaranty ($500)
Guaranty ($250)
Line of Credit, $0 available (6.5%, Due 5/2014)
Senior Term Debt (13.5%, Due 5/2014)
Senior Subordinated Term Debt (18.6%, Due 11/2014)
Guaranty ($2,000)
Guaranty ($878)
Funko, LLC
Senior Subordinated Term Debt (12.0% and 1.5% PIK, Due 5/2019)(D)
Senior Subordinate Term Debt (13.5%, Due 1/2018) (I)
Line of Credit, $3,000 available (13.5%, Due 4/2014)
Senior Term Debt (12.5%, Due3/2016)(E)(K)
10
Subordinated Term Debt (13.0%, Due 10/2016)(D)(K)
Preferred Stock (27,900 shares)(C)(F)
Common Stock (27,900 shares)(C)(F)
Noble Logistics, Inc.
Line of Credit, $0 available (10.5%, Due 1/2015)(D)
Senior Term Debt (11.0%, Due1/2015)(D)
Senior Term Debt (10.5%, Due1/2015)(D)
Senior Term Debt (10.5%, Due1/2015)(D)(E)
Precision Southeast, Inc.
Common Stock (4,770,391shares)(C)(F)
Senior Term Debt (13.0%, Due8/2017)(D)
Preferred Stock (4,000 shares) (C)(F)
Senior Term Debt (12.5%, Due4/2018)(D)
Total Non-Control/Non-Affiliate Investments (represents 65.4% of total investments at fair value)
Behrens Manufacturing, LLC
Line of Credit, $700 available (4.0%, Due 8/2015)(D)
Senior Term Debt (4.0%, Due 8/2015)(D)
Senior Term Debt (5.0%, Due8/2015)(D)(E)
Edge Adhesives Holdings, Inc.
Line of Credit, $705 available (10.5%, Due 8/2014)(H)
Senior Term Debt (12.5%, Due2/2019)(H)
Senior Subordinated Term Debt (13.5%, Due 2/2019)(H)
Preferred Stock (3,474 shares) (C)(F)(H)
Line of Credit, $500 available (10.0%, Due 8/2014)(H)
Preferred Stock (4,000 shares)(C)(F)(H)
11
Meridian Rack & Pinion, Inc.
Senior Term Debt (13.5%, Due12/2018) (D)
Senior Term Debt (13.3%, Due 8/2016)
Senior Term Debt (14.8%, Due 8/2016)
Line of Credit, $779 available (12.5%, Due 6/2014)(G)(K)
Senior Subordinated Term Debt (12.5%, Due 2/2015)(G)(K)
Senior Subordinated Term Debt (12.5%, Due on Demand)(G)(K)
Total Affiliate Investments (represents 27.9% of total investments at fair value)
Preferred Stock (2,600 shares)(C)(F)
Total Control Investments (represents 6.7% of total investments at fair value)
TOTAL INVESTMENTS(J)
12
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014
(DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA AND AS OTHERWISE INDICATED)
NOTE 1. ORGANIZATION
Gladstone Investment Corporation (“Gladstone Investment”) was incorporated under the General Corporation Law of the State of Delaware on February 18, 2005, and completed an initial public offering on June 22, 2005. The terms “the Company,” “we,” “our” and “us” all refer to Gladstone Investment and its consolidated subsidiaries. We are an externally advised, closed-end, non-diversified management investment company that has elected to be treated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). In addition, we have elected to be treated for tax purposes as a regulated investment company (“RIC”) under the Internal Revenue Code of 1986, as amended (the “Code”). We were established for the purpose of investing in debt and equity securities of established private businesses in the United States (“U.S.”). Debt investments primarily come in the form of three types of loans: senior term loans, senior subordinated loans and junior subordinated debt. Equity investments primarily take the form of preferred or common equity (or warrants or options to acquire the foregoing), often in connection with buyouts and other recapitalizations. Our investment objectives are: (a) to achieve and grow current income by investing in debt securities of established businesses that we believe will provide stable earnings and cash flow to pay expenses, make principal and interest payments on our outstanding indebtedness and make distributions to stockholders that we anticipate will grow over time, and (b) to provide our stockholders with long-term capital appreciation in the value of our assets by investing in equity securities of established businesses that we believe can grow over time to permit us to sell our equity investments for capital gains. We aim to maintain a portfolio allocation of approximately 80% debt investments and 20% equity investments, at cost.
Gladstone Business Investment, LLC (“Business Investment”), a wholly-owned subsidiary, was established on August 11, 2006 for the sole purpose of owning our portfolio of investments in connection with our line of credit. The financial statements of Business Investment are consolidated with those of Gladstone Investment. We also have significant subsidiaries whose financial statements are not consolidated with ours. Refer to Note 12—Unconsolidated Significant Subsidiaries for additional information regarding our unconsolidated significant subsidiaries.
We are externally managed by Gladstone Management Corporation (the “Adviser”), an affiliate of ours and a SEC registered investment adviser, pursuant to an investment advisory agreement and management agreement. Administrative services are provided by Gladstone Administration, LLC (the “Administrator”), an affiliate of ours and the Adviser, pursuant to an administration agreement.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Unaudited Interim Financial Statements and Basis of Presentation
We prepare our interim financial statements in accordance with accounting principles generally accepted in the U.S. (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Articles 6 and 10 of SEC Regulation S-X. Accordingly, we have omitted certain disclosures accompanying annual financial statements prepared in accordance with GAAP. The accompanying Condensed Consolidated Financial Statements include our accounts and those of our wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated. Under Article 6 of Regulation S-X, and the authoritative accounting guidance provided by the American Institute of Certified Public Accountants Audit and Accounting Guide for Investment Companies, we are not required to consolidate any portfolio company investments, including those in which we have a controlling interest. In our opinion, all adjustments, consisting solely of normal recurring accruals, necessary for the fair statement of financial statements for the interim periods have been included. The results of operations for the three and six months ended September 30, 2014, are not necessarily indicative of results that ultimately may be achieved for the year. The interim financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto included in our annual report on Form 10-K for the fiscal year ended March 31, 2014, as filed with the SEC on May 13, 2014.
Our fiscal year-end Condensed Consolidated Statement of Assets and Liabilities presented in this Form 10-Q was derived from audited financial statements, but does not include all disclosures required by GAAP.
Revisions
Certain amounts in the prior year’s consolidated financial statements have been revised to correct the presentation for the three and six months ended September 30, 2014 with no effect on our financial condition or results of operations. Certain amounts that were revised relate to our change in the classification of certain of our investments between control, affiliate and non-control/non-affiliate. The general change in the definitions from prior reported periods to the three and six months ended September 30, 2014, relate to the use of voting equity securities as the primary determinate of classification compared to the use of both voting and non-voting equity securities in prior periods.
13
Other revisions related to the net presentation of certain fees in our results of operations. The Adviser services, administers and collects on the loans held by Business Investment, in return for which the Adviser receives a 2% annual fee from Business Investment. All loan servicing fees are credited back to us by our Advisor. Previously, we incorrectly presented the loan servicing fee on a net basis, which is zero because it is 100% credited back to us. We have revised our fee presentation related to these loan servicing fees to reflect the gross fee and related gross credit amounts.
Management evaluated these errors in presentation and concluded they were not material to the previously issued financial statements for the three and six months ended September 30, 2013. The impact of the revisions are shown in the table below:
Expenses
Non-revised expenses, in aggregate
Loan servicing fee
Credit of loan servicing fee
Other credits to Adviser fees
Net unrealized (depreciation) appreciation
Total net unrealized depreciation
Investment Valuation Policy
Accounting Recognition
We record our investments at fair value in accordance with the Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification Topic 820, “Fair Value Measurements and Disclosures” (“ASC 820”) and the 1940 Act. Investment transactions are recorded on the trade date. Realized gains or losses are measured by the difference between the net proceeds from the repayment or sale and amortized cost basis of the investment, without regard to unrealized depreciation or appreciation previously recognized, and include investments charged off during the period, net of recoveries. Unrealized depreciation or appreciation primarily reflect the change in investment fair values, including the reversal of previously recorded unrealized depreciation or appreciation when gains or losses are realized.
Board Responsibility
In accordance with the 1940 Act, our board of directors (our “Board of Directors”) has the ultimate responsibility for reviewing and approving, in good faith, the fair value of our investments based on our established investment valuation policy (the “Policy”). Our Board of Directors reviews valuation recommendations that are provided by professionals of the Adviser and Administrator with oversight and direction from the Valuation Officer, employed by the Administrator (the “Valuation Team”). There is no single standard for determining fair value (especially for privately-held businesses), as fair value depends upon the specific facts and circumstances of each individual investment. In determining the fair value of our investments, the Valuation Team, led by the Valuation Officer, uses the Policy, which has been approved by our Board of Directors, and each quarter our Board of Directors reviews the Policy to determine if changes thereto are advisable and also reviews whether the Valuation Team has applied the Policy consistently.
14
Use of Third Party Valuation Firms
The Valuation Team engages third party valuation firms to provide independent assessments of the fair value of certain of our investments. Currently, the third-party service provider Standard & Poor’s Securities Evaluation, Inc. (“SPSE”) provides estimates of fair value on the majority of our debt investments.
The Valuation Team generally assigns SPSE’s estimates of fair value to our debt investments where we do not have the ability to effectuate a sale of the applicable portfolio company. The Valuation Team corroborates SPSE’s estimates of fair value using one or more of the valuation techniques discussed below. The Valuation Team’s estimates of value on a specific debt investment may significantly differ from SPSE’s. When this occurs, our Board of Directors reviews whether the Valuation Team has followed the Policy, whether the Valuation Team’s recommended value is reasonable in light of the Policy and other facts and circumstances, and in light of all relevant information, then votes to accept or reject the Valuation Team’s recommended valuation.
Valuation Techniques
In accordance with ASC 820, the Valuation Team uses the following techniques when valuing our investment portfolio:
TEV is primarily calculated using EBITDA or revenue multiples; however, TEV may also be calculated using a discounted cash flow (“DCF”) analysis whereby future expected cash flows of the portfolio company are discounted to determine a net present value using estimated risk-adjusted discount rates, which incorporate adjustments for nonperformance and liquidity risks. Generally, the Valuation Team uses the DCF to calculate the TEV to corroborate estimates of value for our equity investments, where we do not have the ability to effectuate a sale of a portfolio company or for debt of credit impaired portfolio companies.
In addition to the above valuation techniques, the Valuation Team may also consider other factors when determining fair values of our investments, including, but not limited to: the nature and realizable value of the collateral, including external parties’ guaranties; any relevant offers or letters of intent to acquire the portfolio company; and the markets in which the portfolio company operates. If applicable, new debt and equity investments made during the three months ended September 30, 2014 are generally valued at original cost basis. Fair value measurements of our investments may involve subjective judgments and estimates and due to the inherent uncertainty of determining these fair values, the fair value of our investments may fluctuate from period to period. Additionally, changes in the market environment and other events that may occur over the life of the investment may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned. Further, such investments are generally subject to legal and other restrictions on resale or otherwise are less liquid than publicly traded securities. If we were required to liquidate a portfolio investment in a forced or liquidation sale, we could realize significantly less than the value at which it is recorded.
Refer to Note 3—Investments for additional information regarding fair value measurements and our application of ASC 820.
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Interest Income Recognition
Interest income, adjusted for amortization of premiums, amendment fees and acquisition costs and the accretion of discounts, is recorded on the accrual basis to the extent that such amounts are expected to be collected. Generally, when a loan becomes 90 days or more past due, or if our qualitative assessment indicates that the debtor is unable to service its debt or other obligations, we will place the loan on non-accrual status and cease recognizing interest income on that loan until the borrower has demonstrated the ability and intent to pay contractual amounts due. However, we remain contractually entitled to this interest. Interest payments received on non-accrual loans may be recognized as income or applied to the cost basis, depending upon management’s judgment. Generally, non-accrual loans are restored to accrual status when past-due principal and interest are paid, and, in management’s judgment, are likely to remain current, or due to a restructuring, the interest income is deemed to be collectible. As of September 30, 2014, our loans to Tread Corp. (“Tread”) were on non-accrual, with an aggregate debt cost basis of $12.0 million, or 4.0% of the cost basis of all debt investments in our portfolio, and an aggregate fair value of $0. As of March 31, 2014, our loans to Tread were on non-accrual, with an aggregate debt cost basis of $11.7 million, or 4.2% of the cost basis of all debt investments in our portfolio, and an aggregate fair value of $0.
PIK interest, computed at the contractual rate specified in the loan agreement, is added to the principal balance of the loan and recorded as interest income. During the three and six months ended September 30, 2014, we recorded PIK income of $29 and $58, respectively. During the three and six months ended September 30, 2013, we recorded PIK income of $29 and $39, respectively.
Other Income Recognition
We generally record success fees upon receipt of cash. Success fees are contractually due upon a change of control in a portfolio company. We recorded $0.5 million of success fees for the three and six months ended September 30, 2014. During the three months ended September 30, 2014, we received success fees of $0.2 million from each of Auto Safety House, LLC (“ASH”) and Frontier Packaging, Inc (“Frontier”) and $0.1 million from Mathey Investments, Inc (“Mathey”). We recorded $2.1 million and $2.3 million of success fees during the three and six months ended September 30, 2013, respectively. During the three months ended September 30, 2013, we received $0.3 million in success fee prepayments from Cavert II Holding Corp. (“Cavert”) and we received $1.8 million related to the exit of Venyu Solutions, Inc. (“Venyu”).
We accrue dividend income on preferred and common equity securities to the extent that such amounts are expected to be collected and if we have the option to collect such amounts in cash or other consideration. For the three and six months ended September 30, 2014, we recorded $1.4 million of dividend income from Mathey. For the three and six months ended September 30, 2013, we recorded $1.4 million in dividend income related to the exit of Venyu.
Both dividend and success fee income are recorded in Other income in our accompanying Condensed Consolidated Statements of Operations.
Recent Accounting Pronouncements
In June 2013, the FASB issued ASU 2013-08, “Financial Services – Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements,” which amends the criteria that define an investment company and clarifies the measurement guidance and requires new disclosures for investment companies. Under ASU 2013-08, an entity already regulated under the 1940 Act is automatically an investment company under the new GAAP definition, so there was no impact from adopting this standard on our financial position or results of operations. We adopted ASU 2013-08 beginning with our quarter ended June 30, 2014, and have increased our disclosure requirements as necessary. We did not adopt any new accounting standards during the three months ending September 30, 2014.
NOTE 3. INVESTMENTS
Fair Value
In accordance with ASC 820, our investments’ fair value is determined to be the price that would be received for an investment in a current sale, which assumes an orderly transaction between market participants on the measurement date. This fair value definition focuses on exit price in the principal, or most advantageous, market and prioritizes, within a measurement of fair value, the use of market-based inputs over entity-specific inputs. ASC 820 also establishes the following three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of a financial instrument as of the measurement date.
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When a determination is made to classify our investments within Level 3 of the valuation hierarchy, such determination is based upon the significance of the unobservable factors to the overall fair value measurement. However, Level 3 financial instruments typically include, in addition to the unobservable, or Level 3, inputs, observable inputs (or, components that are actively quoted and can be validated to external sources). The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. As of September 30 and March 31, 2014, all of our investments were valued using Level 3 inputs and during the three and six months ended September 30, 2014 and 2013, there were no investments transferred in to or out of Level 1, 2 or 3.
The following table presents our investments carried at fair value as of September 30 and March 31, 2014, by caption on our accompanyingCondensed Consolidated Statements of Assets and Liabilities and by security type and input level on the ASC 820 fair value hierarchy:
Non-Control/Non-Affiliate Investments
Senior debt
Senior subordinated debt
Preferred equity
Common equity/equivalents
Total Non-Control/Non-Affiliate Investments
Affiliate Investments
Total Affiliate Investments
Control Investments
Total Control Investments
Total Investments at fair value usingLevel 3 inputs
In accordance with the FASB’s ASU No. 2011-04, “Fair Value Measurement (Topic820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (“IFRS”), (“ASU 2011-04”), the following table provides quantitative information about our Level 3 fair value measurements of our investments as of September 30 and March 31, 2014. The below table is not intended to be all-inclusive, but rather provides information on the significant Level 3 inputs as they relate to our fair value measurements. The weighted average calculations in the table below are based on the principal balances for all debt-related calculations and on the cost basis for all equity-related calculations for the particular input.
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Range /WeightedAverage as of
Range /WeightedAverage as of March 31,2014
Total
Fair value measurements can be sensitive to changes in one or more of the valuation inputs. Changes in market yields, discounts rates, leverage, EBITDA or EBITDA multiples (or revenue or revenue multiples), each in isolation, may change the fair value of certain of our investments. Generally, an increase in market yields, discount rates or leverage or a decrease in EBITDA or EBITDA multiples (or revenue or revenue multiples) may result in a decrease in the fair value of certain of our investments.
The following tables provide the changes in fair value, broken out by security type, during the three and six months ended September 30, 2014 and 2013 for all of our investments.
Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
Three months ended September 30, 2014:
Fair value as of June 30, 2014
Total (losses) gains:
Net realized losses(A)(D)
Net unrealized (depreciation) appreciation(B)
New investments, repayments and settlements(C):
Issuances / Originations
Settlements / Repayments
Sales(D)
Fair value as of September 30, 2014
Six months ended September 30, 2014:
Fair value as of March 31, 2014
Net unrealized appreciation (depreciation)(B)
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Three months ended September 30, 2013:
Fair value as of June 30, 2013
Total gains (losses):
Net realized gains(A)(D)
Reversal of previously-recorded appreciation upon realization(B)
Fair value as of September 30, 2013
Six months ended September 30, 2013:
Fair value as of March 31, 2013
Reversal of previously-recorded depreciation (appreciation) upon realization(B)
Investment Activity
During the six months ended September 30, 2014, the following significant transactions occurred:
Refer to Note 13—Subsequent Events for significant portfolio activity that occurred after September 30, 2014.
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Investment Concentrations
As of September 30, 2014, our investment portfolio consisted of investments in 30 portfolio companies located in 14 states across 15 different industries with an aggregate fair value of $346.9 million, of which our investments in Acme Cryogenics, Inc. (“Acme”), SOG Specialty K&T, LLC (“SOG”), and CSM, our three largest portfolio investments at fair value, collectively comprised $71.3 million, or 20.6%, of our total investment portfolio at fair value. The following table summarizes our investments by security type as of September 30 and March 31, 2014:
Total debt
Total equity/equivalents
Total Investments
Investments at fair value consisted of the following industry classifications as of September 30 and March 31, 2014:
Machinery (Non-agriculture, Non-construction, Non-electronic)
Beverage Food and Tobacco
Investments at fair value were included in the following geographic regions of the U.S. as of September 30 and March 31, 2014:
West
South
Northeast
Midwest
The geographic region indicates the location of the headquarters for our portfolio companies. A portfolio company may have additional business locations in other geographic regions.
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Investment Principal Repayments
The following table summarizes the contractual principal repayment and maturity of our investment portfolio by fiscal year, assuming no voluntary prepayments, as of September 30, 2014:
For the remaining six months ending March 31:
For the fiscal year ending March 31:
Total contractual repayments
Total cost basis of investments held at September 30, 2014:
Receivables from Portfolio Companies
Receivables from portfolio companies represent non-recurring costs that we incurred on behalf of portfolio companies and are included in other assets on our accompanying Condensed Consolidated Statements of Assets and Liabilities. We maintain an allowance for uncollectible receivables from portfolio companies, which is determined based on historical experience and management’s expectations of future losses. We charge the accounts receivable to the established provision when collection efforts have been exhausted and the receivables are deemed uncollectible. As of September 30 and March 31, 2014, we had gross receivables from portfolio companies of $1.0 million and $0.9 million, respectively. The allowance for uncollectible receivables was $0.2 million as of September 30 and March 31, 2014.
NOTE 4. RELATED PARTY TRANSACTIONS
Investment Advisory and Management Agreement
We entered into an investment advisory and management agreement with the Adviser (the “Advisory Agreement”). The Adviser is controlled by our chairman and chief executive officer. In accordance with the Advisory Agreement, we pay the Adviser certain fees as compensation for its services, such fees consisting of a base management fee and an incentive fee, each as described below. On July 15, 2014, our Board of Directors approved the renewal of the Advisory Agreement through August 31, 2015.
The following table summarizes the management fees, loan servicing fees which are paid in accordance with our line of credit, incentive fees and associated credits reflected in our accompanying Condensed Consolidated Statements of Operations:
Average total assets subject to base management fee(A)
Multiplied by prorated annual base management fee of 2%
Base management fee(B)
Other credits to Adviser fees(B)
Net base management fee
Loan servicing fee(B)
Credit of loan servicing fee(B)
Net loan servicing fee
Incentive fee(B)
Base Management Fee
The base management fee is computed and payable quarterly and is assessed at an annual rate of 2%. It is computed on the basis of the value of our average gross assets at the end of the two most recently completed quarters, which are total assets, including investments made with proceeds of borrowings, less any uninvested cash or cash equivalents resulting from borrowings. As a BDC, we make available significant managerial assistance to our portfolio companies and provide other services to such portfolio companies. Although neither we nor the Adviser receive fees in connection with managerial assistance, the Adviser provides other services to our portfolio companies and receives fees for these other services. 50% of certain of these fees and
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100% of others historically have been credited against the base management fee that we would otherwise be required to pay to the Adviser. Effective October 1, 2013, 100% of all these fees are credited against the base management fee that we would otherwise be required to pay to the Adviser; however, pursuant to the terms of the Advisory Agreement, a small percentage of certain of such fees are retained by the Adviser in the form of reimbursement for certain tasks completed by personnel of the Adviser.
Loan Servicing Fee
In addition, the Adviser services, administers and collects on the loans held by Business Investment, in return for which our
Adviser receives a 2% annual fee payable monthly by Business Investment based on the monthly aggregate balance of loans held by Business Investment in accordance with our line of credit. All loan servicing fees are credited back to us by the Adviser. Overall, the base management fee due to the Adviser cannot exceed 2% of total assets (as reduced by cash and cash equivalents pledged to creditors) during any given fiscal year.
Incentive Fee
The incentive fee consists of two parts: an income-based incentive fee and a capital gains-based incentive fee. The income-based incentive fee rewards the Adviser if our quarterly net investment income (before giving effect to any incentive fee) exceeds 1.75% of our net assets (the “hurdle rate”). We will pay the Adviser an income-based incentive fee with respect to our pre-incentive fee net investment income in each calendar quarter as follows:
The second part of the incentive fee is a capital gains-based incentive fee that will be determined and payable in arrears as of the end of each fiscal year (or upon termination of the Advisory Agreement, as of the termination date) and equals 20% of our realized capital gains as of the end of the fiscal year. In determining the capital gains-based incentive fee payable to the Adviser, we will calculate the cumulative aggregate realized capital gains and cumulative aggregate realized capital losses since our inception, and the aggregate net unrealized capital depreciation as of the date of the calculation, as applicable, with respect to each of the investments in our portfolio. For this purpose, cumulative aggregate realized capital gains, if any, equals the sum of the differences between the net sales price of each investment, when sold, and the original cost of such investment since our inception. Cumulative aggregate realized capital losses equals the sum of the amounts by which the net sales price of each investment, when sold, is less than the original cost of such investment since our inception. Aggregate net unrealized capital depreciation equals the sum of the difference, if negative, between the valuation of each investment as of the applicable calculation date and the original cost of such investment. At the end of the applicable year, the amount of capital gains that serves as the basis for our calculation of the capital gains-based incentive fee equals the cumulative aggregate realized capital gains less cumulative aggregate realized capital losses, less aggregate net unrealized capital depreciation, with respect to our portfolio of investments. If this number is positive at the end of such year, then the capital gains-based incentive fee for such year equals 20% of such amount, less the aggregate amount of any capital gains-based incentive fees paid in respect of our portfolio in all prior years. No capital gains-based incentive fee has been recorded since our inception through September 30, 2014, as cumulative net unrealized capital depreciation has exceeded cumulative realized capital gains net of cumulative realized capital losses.
Additionally, in accordance with GAAP, a capital gains-based incentive fee accrual is calculated using the aggregate cumulative realized capital gains and losses and aggregate cumulative unrealized capital depreciation included in the calculation of the capital gains-based incentive fee plus the aggregate cumulative unrealized capital appreciation. If such amount is positive at the end of a period, then GAAP requires us to record a capital gains-based incentive fee equal to 20% of such amount, less the aggregate amount of actual capital gains-based incentive fees paid in all prior years. If such amount is negative, then there is no accrual for such year. GAAP requires that the capital gains-based incentive fee accrual consider the cumulative aggregate unrealized capital appreciation in the calculation, as a capital gains-based incentive fee would be payable if such unrealized capital appreciation were realized. There can be no assurance that such unrealized capital appreciation will be realized in the future. No GAAP accrual for a capital gains-based incentive fee has been recorded since our inception through September 30, 2014.
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Administration Agreement
We have entered into an administration agreement (the “Administration Agreement”) with the Administrator, whereby we pay for our allocable portion of the Administrator’s expenses incurred while performing services to us, including, but not limited to, rent and the salaries and benefits expenses of the Administrator’s employees, including our chief financial officer and treasurer, chief compliance officer, and general counsel and secretary (who also serves as the Administrator’s president). Prior to July 1, 2014, our allocable portion was derived by multiplying that portion of the Administrator’s expenses allocable to all funds managed by the Adviser by the percentage of our total assets at the beginning of each quarter in comparison to the total assets of all funds managed by the Adviser. As approved by our Board of Directors, effective July 1, 2014, our allocable portion of the Administrator’s expenses will be derived by multiplying the Administrator’s total expenses by the approximate percentage of time the Administrator’s employees perform services for us in relation to their time spent performing services for all companies serviced by the Administrator under contractual agreements. On July 15, 2014, our Board of Directors approved the annual renewal of the Administration Agreement through August 31, 2015.
Related Party Fees Due
Amounts due to related parties on our accompanying Condensed Consolidated Statements of Assets and Liabilities were as follows:
Base management fee due to Adviser
Incentive fee due to Adviser
Other (from) due to Adviser
Total fees due to Adviser
Fee due to Administrator
Total related party fees due
NOTE 5. BORROWINGS
Line of Credit
On June 26, 2014, we, through our wholly-owned subsidiary, Business Investment, entered into Amendment No. 1 to the Fifth Amended and Restated Credit Agreement originally entered into on April 30, 2013, with Key Equipment Finance Inc., as administrative agent, lead arranger and a lender (the “Administrative Agent”), Branch Banking and Trust Company (“BB&T”) as a lender and managing agent, and the Adviser, as servicer, to extend the revolving period and reduce the interest rate of the line of credit (the “Credit Facility”). The revolving period was extended 14 months to June 26, 2017, and if not renewed or extended by June 26, 2017, all principal and interest will be due and payable on or before June 26, 2019 (two years after the revolving period end date). In addition, we have retained the two one-year extension options, to be agreed upon by all parties, which may be exercised on or before June 26, 2015 and 2016, respectively, and upon exercise, the options would extend the revolving period to June 26, 2018 and 2019 and the maturity date to June 26, 2020 and 2021, respectively. Subject to certain terms and conditions, the Credit Facility can be expanded by up to $145 million, to a total facility amount of $250 million, through additional commitments of existing or new committed lenders. Advances under the Credit Facility generally bear interest at 30-day LIBOR, plus 3.25% per annum, down from 3.75% prior to the amendment, and the Credit Facility includes a fee of 0.50% on undrawn amounts. Once the revolving period ends, the interest rate margin increases to 3.75% for the period from June 26, 2017 to June 26, 2018, and further increases to 4.25% through maturity. We incurred fees of $0.4 million in connection with this Amendment No 1.
On September 19, 2014, we further increased our borrowing capacity under the Credit Facility from $105 million to $185 million by entering into Joinder Agreements pursuant to the Credit Facility, by and among Business Investment, the Administrative Agent, the Adviser and each of East West Bank, Manufacturers and Traders Trust, Customers Bank and Talmer Bank and Trust. We incurred fees of $0.8 million in connection with this expansion.
The following tables summarize noteworthy information related to our Credit Facility:
Commitment amount
Borrowings outstanding at cost
Commitment availability
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Weighted average borrowings outstanding
Effective interest rate(A)
Commitment (unused) fees incurred
Interest is payable monthly during the term of the Credit Facility. Available borrowings are subject to various constraints imposed under the Credit Facility, based on the aggregate loan balance pledged by Business Investment, which varies as loans are added and repaid, regardless of whether such repayments are prepayments or made as contractually required. Based on these constraints and pledged collateral, as of September 30, 2014, we had $27.1 million in available borrowings.
The Administrative Agent also requires that any interest or principal payments on pledged loans be remitted directly by the borrower into a lockbox account with The Bank of New York Mellon Trust Company, N.A as custodian. The Administrative Agent is also the trustee of the account and remits the collected funds to us once a month.
Among other things, our Credit Facility contains covenants that require Business Investment to maintain its status as a separate legal entity, prohibit certain significant corporate transactions (such as mergers, consolidations, liquidations or dissolutions) and restrict certain material changes to our credit and collection policies without the lenders’ consent. Our Credit Facility generally also limits payments on distributions to the aggregate net investment income for each of the twelve month periods ending March 31, 2015, 2016 and 2017. Business Investment is also subject to certain limitations on the type of loan investments it can apply toward available credit in the borrowing base, including restrictions on geographic concentrations, sector concentrations, loan size, payment frequency and status, average life and lien property. Our Credit Facility further requires Business Investment to comply with other financial and operational covenants, which obligate Business Investment to, among other things, maintain certain financial ratios, including asset and interest coverage and a minimum number of obligors required in the borrowing base of the credit agreement. Additionally, we are subject to a performance guaranty that requires us to maintain (i) a minimum net worth (defined in our Credit Facility to include our mandatory redeemable term preferred stock) of $170 million plus 50% of all equity and subordinated debt raised after April 30, 2013, which equates to $170 million as of September 30, 2014, (ii) “asset coverage” with respect to “senior securities representing indebtedness” of at least 200%, in accordance with Section 18 of the 1940 Act and (iii) its status as a BDC under the 1940 Act and as a RIC under the Code. As of September 30, 2014, and as defined in the performance guaranty of our Credit Facility, we had a minimum net worth of $264.8 million, an asset coverage of 264% and an active status as a BDC and RIC. Our Credit Facility requires a minimum of 12 obligors in the borrowing base and, as of September 30, 2014, Business Investment had 22 obligors. As of September 30, 2014, we continued to be in compliance with all covenants.
We have entered into an interest rate cap agreement with Keybank National Association that effectively limits the interest rate on a portion of our borrowings under the line of credit pursuant to the terms of our Credit Facility. The agreement, which expires April 2016, provides that the interest rate on $45 million of our borrowings is capped at 6%, plus 3.25% per annum, when 30-day LIBOR is in excess of 6%.
Secured Borrowing
In August 2012, we entered into a participation agreement with a third-party related to $5.0 million of our senior subordinated term debt investment in Ginsey Home Solutions, Inc. (“Ginsey”). In May 2014, we amended the agreement with the third-party to include an additional $0.1 million. ASC 860 requires us to treat the participation as a financing-type transaction. Specifically, the third-party has a senior claim to our remaining investment in the event of default by Ginsey which, in part, resulted in the loan participation bearing a rate of interest lower than the contractual rate established at origination. Therefore, our accompanying Condensed Consolidated Statements of Assets and Liabilities reflects the entire senior subordinated term debt investment in Ginsey and a corresponding $5.1 million secured borrowing liability. The secured borrowing has a stated interest rate of 7.0% and a maturity date of January 3, 2018.
We elected to apply ASC 825, “Financial Instruments,” specifically for our Credit Facility, which was consistent with the application of ASC 820 to our investments. Generally, the Valuation Team estimates the fair value of our Credit Facility using a yield analysis, which includes a DCF calculation, and its own assumptions in the absence of observable market data, including estimated remaining life, counterparty credit risk, current market yield and interest rate spreads of similar securities as of the measurement date. During the three months ended September 30, 2014, due to the addition of four new lenders, amongst other things, cost was deemed to approximate fair value. At each of September 30 and March 31, 2014, all of our borrowings were valued using Level 3 inputs. The following tables present the short-term loan, where applicable, and Credit Facility carried at fair value as of September 30 and March 31, 2014, by caption on our accompanying Condensed Consolidated Statements of Assets and Liabilities for Level 3 of the hierarchy established by ASC 820 and a roll-forward of the changes in fair value during the three and six months ended September 30, 2014 and 2013:
Credit Facility
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Fair Value Measurements of Borrowings Using Significant
Unobservable Inputs (Level 3)
Fair value at June 30, 2014
Borrowings
Repayments
Net unrealized appreciation(A)
Fair value at September 30, 2014
Fair value at March 31, 2014
Net unrealized depreciation(A)
Fair value at June 30, 2013
Fair value at September 30, 2013
Fair value at March 31, 2013
The fair value of the collateral under our Credit Facility was $315.7 million and $288.6 million as of September 30 and March 31, 2014, respectively.
NOTE 6. MANDATORILY REDEEMABLE PREFERRED STOCK
In March 2012, we completed a public offering of 1,600,000 shares of 7.125% Series A Cumulative Term Preferred Stock (our “Term Preferred Stock”) at a public offering price of $25.00 per share. Gross proceeds totaled $40 million and net proceeds, after deducting underwriting discounts and offering expenses borne by us, were $38 million. We incurred $2 million in total offering costs related to these transactions, which have been recorded as deferred financing costs on our accompanying Condensed Consolidated Statements of Assets and Liabilities and will be amortized over the redemption period ending February 28, 2017.
The shares have a redemption date of February 28, 2017, and are traded under the ticker symbol GAINP on the NASDAQ Global Select Market. The Term Preferred Stock is not convertible into our common stock or any other security. The Term Preferred Stock provides for a fixed dividend equal to 7.125% per year, payable monthly. We are required to redeem all of the outstanding Term Preferred Stock on February 28, 2017, for cash at a redemption price equal to $25.00 per share, plus an amount equal to accumulated but unpaid dividends, if any, to, but excluding, the date of redemption. In addition, three other potential redemption triggers are as follows: (1) upon the occurrence of certain events that would constitute a change in control of us, we would be required to redeem all
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of the outstanding Term Preferred Stock, (2) if we fail to maintain an asset coverage ratio of at least 200%, we are required to redeem a portion of the outstanding Term Preferred Stock or otherwise cure the ratio redemption trigger and (3) at our sole option, at any time on or after February 28, 2016, we may redeem some or all of the Term Preferred Stock.
For six months ended September 30, 2014 and 2013, our Board of Directors declared and paid a monthly distribution of $0.1484375 per share, or $0.8906250 per share in aggregate, to preferred stockholders. The tax character of distributions paid by us to preferred stockholders is from ordinary income.
In accordance with ASC 480, “Distinguishing Liabilities from Equity,” mandatorily redeemable financial instruments should be classified as liabilities on the balance sheet and, therefore, the related dividend payments are treated as dividend expense on our accompanying Condensed Consolidated Statements of Operations at the ex-dividend date. The fair value of the Term Preferred Stock, which we consider to be a level 1 liability within the fair value hierarchy, based on the last reported closing sale price as of September 30 and March 31, 2014, was $42.1 million and $42.4 million, respectively.
NOTE 7. COMMON STOCK
Registration Statement
We filed a registration statement on Form N-2 (File No. 333-181879) with the SEC on June 4, 2012, and subsequently filed a Pre-Effective Amendment No. 1 to the registration statement on July 17, 2012, which the SEC declared effective on July 26, 2012. On June 7, 2013, we filed Post-Effective Amendment No. 2 to the registration statement, which the SEC declared effective on July 26, 2013. On June 3, 2014, we filed Post-Effective Amendment No. 3 to the registration statement, and subsequently filed a Post-Effective Amendment No. 4 to the registration statement on September 2, 2014, which the SEC declared effective on September 4, 2014. The registration statement permits us to issue, through one or more transactions, up to an aggregate of $300 million in securities, consisting of common stock, preferred stock, subscription rights, debt securities and warrants to purchase common stock, including through a combined offering of two or more of such securities.
NOTE 8. NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS PER COMMON SHARE
The following table sets forth the computation of basic and diluted net increase in net assets resulting from operations per weighted average common share for the three and six months ended September 30, 2014 and 2013:
Numerator for basic and diluted net increase in net assets resulting from operations per common share
Denominator for basic and diluted weighted average common shares
Basic and diluted net increase in net assets resulting from operations per average common share
NOTE 9. DISTRIBUTIONS TO COMMON STOCKHOLDERS
To qualify to be taxed as a RIC under Subtitle A, Chapter 1 of Subchapter M of the Code, we are required to distribute to our stockholders 90% of our “investment company taxable income,” which is generally our net ordinary income plus the excess of our net short-term capital gains over net long-term capital losses. The amount to be paid out as a distribution is determined by our Board of Directors each quarter and is based on management’s estimate of our estimated taxable income. Based on that estimate, our Board of Directors declares three monthly distributions each quarter.
Our Board of Directors declared the following monthly distributions to common stockholders for the six months ended September 30, 2014 and 2013:
Fiscal Year
2015
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2014
Aggregate common distributions declared quarterly and paid for the six months ended September 30, 2014 and 2013 were approximately $9.5 million and $7.9 million, respectively. We determine the tax characterization of our common distributions as of the end of our fiscal year based upon our taxable income for the full year and distributions paid during the full year. Therefore, a determination of tax attributes made on a quarterly basis may not be representative of the actual tax attributes of distributions for a full year. If we determined the tax attributes of our distributions as of September 30, 2014, 100% would be from ordinary income and 0% would be a return of capital. For the six months ended September 30, 2014, we recorded a $0.2 million adjustment for estimated book-tax differences which decreased Capital in excess of par value and increased Net investment income in excess of distributions. For the fiscal year ended March 31, 2014, taxable income available for common distributions exceeded distributions declared and paid, and, in accordance with Section 855(a) of the Code, we elected to treat $3.9 million of the first common distributions paid in fiscal year 2015, as having been paid in the prior year.
NOTE 10. COMMITMENTS AND CONTINGENCIES
Legal Proceedings
We are party to certain legal proceedings incidental to the normal course of our business, including the enforcement of our rights under contracts with our portfolio companies. We are required to establish reserves for litigation matters where those matters present loss contingencies that are both probable and estimable. When loss contingencies are not both probable and estimable, we do not establish reserves. Based on current knowledge, we do not believe that loss contingencies, if any, arising from pending investigations, litigation or regulatory matters will have a material adverse effect on our financial condition, results of operation or cash flows. Additionally, based on current knowledge, we do not believe such loss contingencies are probable and estimable and therefore, as of September 30, 2014, we have not established reserves for such loss contingencies.
Financial Commitments and Obligations
As of September 30, 2014, we have lines of credit commitments to certain of our portfolio companies that have not been fully drawn. Since these lines of credit have expiration dates and we expect many will never be fully drawn, the total line of credit commitment amounts do not necessarily represent future cash requirements.
In addition to the lines of credit to certain portfolio companies, we have also extended certain guarantees on behalf of some of our portfolio companies. As of September 30, 2014, we have not been required to make any payments on the guarantees discussed below, and we consider the credit risk to be remote and the fair values of the guarantees to be minimal.
The following table summarizes the dollar balance of unused line of credit commitments and guarantees as of September 30 and March 31, 2014:
Unused line of credit commitments
Guarantees
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Escrow Holdbacks
From time to time, we will enter into arrangements relating to exits of certain investments whereby specific amounts of the proceeds are held in escrow to be used to satisfy potential obligations, as stipulated in the sales agreements. We record escrow amounts in restricted cash on our accompanying Condensed Consolidated Statements of Assets and Liabilities. In August 2013, the sale of Venyu resulted in $4.9 million in escrow amounts, of which $0.6 million is held on behalf of the other sellers, which we record in other liabilities on our accompanying Condensed Consolidated Statements of Assets and Liabilities. In September 2014, $1.9 million of the escrow funds related to were released. As of September 30, 2014, there remains $2.9 million in escrow amounts, of which $0.6 million is held on behalf of the sellers, related to the sale of Venyu. We establish a contingent liability against the escrow amounts if we determine that it is probable and estimable that a portion of the escrow amounts will not be ultimately received at the end of the escrow period. The aggregate contingent liability recorded against the escrow amounts was $35 for both September 30 and March 31, 2014.
NOTE 11. FINANCIAL HIGHLIGHTS
Per Common Share Data
NAV at beginning of period(A)
Net investment income(B)
Realized gain on sale of investments and other(B)
Net unrealized (depreciation) appreciation of investments and other(B)
Total from investment operations(B)
Cash distributions from net investment income(B)(C)
NAV at end of period(A)
Per common share market value at beginning of period
Per common share market value at end of period
Total return(D)
Common stock outstanding at end of period
Statement of Assets and Liabilities Data:
Average net assets(E)
Senior Securities Data(F):
Total borrowings, at cost
Mandatorily redeemable preferred stock
Asset coverage ratio(G)
Average coverage per unit(H)
Ratios/Supplemental Data:
Ratio of expenses to average net assets(I)(J)(L)
Ratio of net expenses to average net assets(I)(K)
Ratio of net investment income to average net assets(I)
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NOTE 12. UNCONSOLIDATED SIGNIFICANT SUBSIDIARIES
In accordance with the SEC’s Regulation S-X, we have one unconsolidated subsidiary, Galaxy Tool Holdings, Inc. (“Galaxy”), that met at least one of the significance conditions of the SEC’s Regulation S-X as of September 30, 2014 and 2013 and for the six months ended September 30, 2014 and 2013. Additionally, we have one unconsolidated subsidiary, SOG Specialty K&T, LLC (“SOG”), and one former unconsolidated subsidiary, Venyu Solutions Inc. (“Venyu”), which met at least one of the significance conditions of the SEC’s Regulation S-X for the six months ended September 30, 2013. Accordingly, summarized, comparative financial information, in aggregate, is presented below for our significant unconsolidated subsidiaries.
Income Statement(A)
Net Sales
Gross Profit
Net loss
NOTE 13. SUBSEQUENT EVENTS
New Investment
In October 2014, we invested $24.4 million in Old World Christmas, Inc. (“OWC”) through a combination of debt and equity. OWC, headquartered in Spokane, Washington, is a designer and distributor of an extensive collection of blown glass Christmas ornaments, table top figurines, vintage-style light covers and nostalgic greeting cards into the independent gift channel.
On October 7, 2014, our Board of Directors declared the following monthly cash distributions to common and preferred stockholders:
Declaration Date
Record Date
Payment Date
October 7, 2014
Total for the Quarter:
Additionally, on October 7, 2014, our Board of Directors declared the following one-time special cash distribution to common stockholders:
This represents the third calendar year in a row that a one-time special cash distribution to common stockholders has been declared by our Board of Directors.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
All statements contained herein, other than historical facts, may constitute “forward-looking statements.” These statements may relate to, among other things, our future operating results, our business prospects and the prospects of our portfolio companies, actual and potential conflicts of interest with Gladstone Management Corporation and its affiliates, the use of borrowed money to finance our investments, the adequacy of our financing sources and working capital, and our ability to co-invest, among other factors. In some cases, you can identify forward-looking statements by terminology such as “estimate,” “may,” “might,” “believe,” “will,” “provided,” “anticipate,” “future,” “could,” “growth,” “plan,” “intend,” “expect,” “should,” “would,” “if,” “seek,” “possible,” “potential,” “likely” or the negative of such terms or comparable terminology. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others: (1) further adverse changes in the economy and the capital markets; (2) risks associated with negotiation and consummation of pending and future transactions; (3) the loss of one or more of our executive officers, in particular David Gladstone, Terry Lee Brubaker or David A.R. Dullum; (4) changes in our investment objectives and strategy; (5) availability, terms and deployment of capital; (6) changes in our industry, interest rates, exchange rates or the general economy; (7) the degree and nature of our competition; (8) our ability to maintain our qualification as a RIC and as business development company; and (9) those factors described in the “Risk Factors” section of our Annual Report on Form 10-K filed with the SEC on May 13, 2014. We caution readers not to place undue reliance on any such forward-looking statements. Actual results could differ materially from those anticipated in our forward-looking statements and future results could differ materially from historical performance. We have based forward-looking statements on information available to us on the date of this report. Except as required by the federal securities laws, we undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, after the date of this Quarterly Report on Form 10-Q. Although we undertake no obligation to revise or update any forward-looking statements, 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 have filed or in the future may file with the Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.
The following analysis of our financial condition and results of operations should be read in conjunction with our accompanyingCondensed Consolidated Financial Statements and the notes thereto contained elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the fiscal year ended March 31, 2014, filed with the SEC on May 13, 2014. Historical financial condition and results of operations and percentage relationships among any amounts in the financial statements are not necessarily indicative of financial condition or results of operations for any future periods.
OVERVIEW
General
We are an externally-managed, closed-end, non-diversified management investment company that has elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). In addition, for United States (“U.S.”) federal income tax purposes, we have elected to be treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). As a BDC and a RIC, we are also subject to certain constraints, including limitations imposed by the 1940 Act and the Code.
We were incorporated under the General Corporation Law of the State of Delaware on February 18, 2005. We were established for the purpose of investing in debt and equity securities of established private businesses in the U.S. Debt investments primarily come in the form of three types of loans: senior term loans, senior subordinated loans and junior subordinated debt. Equity investments primarily take the form of preferred or common equity (or warrants or options to acquire the foregoing), often in connection with buyouts and other recapitalizations. To a much lesser extent, we also invest in senior and subordinated syndicated loans. Our investment objectives are (a) to achieve and grow current income by investing in debt securities of established businesses that we believe will provide stable earnings and cash flow to pay expenses, make principal and interest payments on our outstanding indebtedness and make distributions to stockholders that we anticipate will grow over time and (b) to provide our stockholders with long-term capital appreciation in the value of our assets by investing in equity securities of established businesses that we hope will appreciate over time so that we can sell them for capital gains. We expect that our investment allocation over time will consist of approximately 80% in debt securities and 20% in equity securities. As of September 30, 2014, our investment allocation was 72% in debt securities and 28% in equity securities, at cost.
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We focus on investing in small and medium-sized private U.S. businesses that meet certain of the following criteria which we believe will give us the best potential to sell our equity positions at a later date for capital gains: the potential for growth in cash flow, adequate assets for loan collateral, experienced management teams with a significant ownership interest in the borrower, profitable operations based on the borrower’s cash flow and reasonable capitalization of the borrower (usually by leveraged buyout funds or venture capital funds). We anticipate that liquidity in our equity position will be achieved through a merger or acquisition of the borrower, a public offering of the borrower’s stock or by exercising our right to require the borrower to repurchase our warrants, though there can be no assurance that we will always have these rights. We lend to borrowers that need funds to finance growth, restructure their balance sheets or effect a change of control. We invest by ourselves or jointly with other funds and/or management of the portfolio company, depending on the opportunity. If we are participating in an investment with one or more co-investors, our investment is likely to be smaller than if we were investing alone.
Our common stock and 7.125% Series A Cumulative Term Preferred Stock (our “Term Preferred Stock”) are traded on the NASDAQ Global Select Market (“NASDAQ”) under the symbols “GAIN” and “GAINP,” respectively.
We are externally managed by our investment advisor, Gladstone Management Corporation (the “Adviser”), an SEC registered investment adviser and an affiliate of ours, pursuant to an investment advisory and management agreement (the “Advisory Agreement”). The Adviser manages our investment activities. Our Board of Directors, which is composed of a majority of independent directors, supervises such investment activities. We have also entered into an administration agreement (the “Administration Agreement”) with Gladstone Administration, LLC (our “Administrator”), an affiliate of ours and the Adviser, whereby we pay separately for administrative services.
Business Environment
The strength of the global economy, and the U.S. economy in particular, continues to be uncertain and volatile, and we remain cautious about a long-term economic recovery. The effects of the previous recession and the disruptions in the capital markets have impacted our liquidity options and increased our cost of debt and equity capital. In addition, the federal government shutdown in October 2013 combined with the uncertainty surrounding the ability of the federal government to address its fiscal condition in both the short and long term have increased domestic and global economic instability. Many of our portfolio companies, as well as those that we evaluate for possible investments, are adversely impacted by these political and economic conditions. If these conditions persist, it may adversely affect their ability to repay our loans or engage in a liquidity event, such as a sale, recapitalization or initial public offering.
Portfolio Activity
While conditions remain challenging, we are seeing an increase in the number of new investment opportunities consistent with our investing strategy of providing a combination of debt and equity in support of management and sponsor-led buyouts of small and medium-sized companies in the U.S. During the three months ended September 30, 2014, we invested a total of $21.9 million in two new deals, and subsequent to September 30, 2014, we invested $24.4 million in another new deal. These new investments, along with the capital raising efforts discussed below, have allowed us to invest $356.4 million in 22 new proprietary debt and equity deals since October 2010.
These new investments, as well as the majority of our debt securities in our portfolio, have a success fee component, which enhances the yield on our debt investments. Unlike paid-in-kind (“PIK”) income, we generally do not recognize success fees as income until they are received in cash. Due to their contingent nature, there are no guarantees that we will be able to collect any or all of these success fees or know the timing of such collections. As a result, as of September 30, 2014, we had unrecognized success fees of $21.0 million, or $0.79 per common share, which do not meet the recognition criteria under the relevant accounting guidance.
The improved investing environment presented us with an opportunity to realize gains and other income from our investment in Venyu Solutions, Inc. (“Venyu”) as a result of its sale in August 2013. As a result of the sale, we received net cash proceeds of $32.2 million, resulting in a realized gain of $24.8 million and dividend income of $1.4 million. In addition, we received full repayment of our debt investments of $19 million and $1.8 million in success fee income. This represents our fourth management-supported buyout liquidity event since June 2010, and in the aggregate, these four liquidity events have generated $54.5 million in realized gains and $13.1 million in other income, for a total increase to our net assets of $67.6 million. We believe each of these transactions was an equity-oriented investment success and exemplify our investment strategy of striving to achieve returns through current income on the debt portion of our investments and capital gains from the equity portion. These successes, in part, enabled us to increase the monthly distribution 50% since March 2011, allowed us to declare and pay a $0.03 per common share one-time special distribution in fiscal year 2012, a $0.05 per common share one-time special distribution in November 2013, and a $0.05 per common share one-time special distribution payable in December 2014.
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With the four liquidity events that have generated $54.5 million in realized gains since June 2010, we have nearly overcome our cumulative realized losses since inception that were primarily incurred during the recession and in connection with the sale of performing loans at a realized loss to pay off a former lender. We took the opportunity during the fiscal year ended March 31, 2014, to strategically sell our investments in two of our portfolio companies, ASH Holding Corp. (“ASH”) and Packerland Whey Products, Inc. (“Packerland”) to existing members of their management teams and other existing owners, respectively, which resulted in realized losses of $11.4 million and $1.8 million, respectively, as well as the write off our equity investments in Noble Logistics, Inc. (“Noble”), which resulted in a realized loss of $3.4 million. These sales and write off, while at a realized loss, were accretive to our net asset value in aggregate by $5.7 million, reduced our distribution requirements related to our realized gains and reduced our non-accruals outstanding.
Capital Raising Efforts
Despite the challenges that have existed in the economy for the past several years, we have been able to meet our capital needs through increases to our revolving line of credit (our “Credit Facility”) and by accessing the capital markets in the form of public offerings of stock. For example, in October 2012, we issued 4.4 million shares of common stock for gross proceeds of $33 million. Regarding our Credit Facility over the last two years, we have successfully extended the revolving period multiple times, most recently to June 2017, increased the commitment from $60 million to $185 million and reduced the interest rate margin from 3.75% to 3.25%.
Although we were able to access the capital markets during 2012, we believe market conditions continue to affect the trading price of our common stock and thus our ability to finance new investments through the issuance of equity. On October 27, 2014, the closing market price of our common stock was $7.27, which represented a 14.4% discount to our September 30, 2014 net asset value (“NAV”) per share of $8.49. When our stock trades below NAV, our ability to issue equity is constrained by provisions of the1940 Act, which generally prohibit the issuance and sale of our common stock at an issuance price below the then current NAV per share without stockholder approval, other than through sales to our then-existing stockholders pursuant to a rights offering.
At our 2014 Annual Meeting of Stockholders held on August 7, 2014, our stockholders approved a proposal authorizing us to issue and sell shares of our common stock at a price below our then current NAV per share, subject to certain limitations, including that the number of shares issued and sold pursuant to such authority does not exceed 25% of our then outstanding common stock immediately prior to each such sale, provided that our Board of Directors makes certain determinations prior to any such sale. This August 2014 stockholder authorization is in effect for one year from the date of stockholder approval. Prior to the August 2014 stockholder authorization, we sought and obtained stockholder approval concerning a similar proposal at the Annual Meeting of Stockholders held in August 2012, and with our Board of Directors’ subsequent approval, we issued shares of our common stock in October and November 2012 at a price per share below the then current NAV per share. The resulting proceeds, in part, have allowed us to grow the portfolio by making new investments, generate additional income through these new investments, provide us additional equity capital to help ensure continued compliance with regulatory tests and increase our debt capital while still complying with our applicable debt-to-equity ratios.
Regulatory Compliance
Our ability to seek external debt financing, to the extent that it is available under current market conditions, is further subject to the asset coverage limitations of the 1940 Act, which require us to have an asset coverage ratio (as defined in Section 18(h) of the 1940 Act), of at least 200% on our senior securities representing indebtedness and our senior securities that are stock, which we refer to collectively as “Senior Securities.” As of September 30, 2014, our asset coverage ratio was 264%. Our status as a RIC under Subchapter M of the Code, in addition to other requirements, also requires us, at the close of each quarter of the taxable year, to meet an asset diversification test, which requires that at least 50% of the value of our assets consists of cash, cash items, U.S. government securities or certain other qualified securities (the “50% threshold”). In the past, we have obtained this ratio by entering into a short-term loan at quarter end to purchase qualifying assets; however, a short term loan was not necessary at the end of the quarter ended September 30, 2014. Until the composition of our assets is above the required 50% threshold on a consistent basis by a significant margin, we may have to continue to obtain short-term loans on a quarterly basis. When deployed, this strategy, while allowing us to satisfy the 50% threshold for our RIC status, limits our ability to use increased debt capital to make new investments, due to our asset coverage ratio limitations under the 1940 Act.
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Investment Highlights
During the six months ended September 30, 2014, we disbursed $21.9 million in new debt and equity investments and extended $7.4 million of investments to existing portfolio companies through revolver draws or additions to term notes. From our initial public offering in June 2005 through September 30, 2014, we have made 221 investments in 109 companies for a total of approximately $956.9 million, before giving effect to principal repayments on investments and divestitures.
Subsequent to September 30, 2014, the following significant transaction occurred:
Recent Developments
Credit Facility Extension and Expansion
On June 26, 2014, we, through our wholly-owned subsidiary, Business Investment, entered into Amendment No. 1 to the Fifth Amended and Restated Credit Agreement originally entered into on April 30, 2013, with Key Equipment Finance Inc., as administrative agent, lead arranger and a lender (the “Administrative Agent”), Branch Banking and Trust Company (“BB&T”) as a lender and managing agent, and the Adviser, as servicer, to extend the revolving period and reduce the interest rate of the line of credit. The revolving period was extended 14 months to June 26, 2017, and if not renewed or extended by June 26, 2017, all principal and interest will be due and payable on or before June 26, 2019 (two years after the revolving period end date). In addition, we have retained the two one-year extension options, to be agreed upon by all parties, which may be exercised on or before June 26, 2015 and 2016, respectively, and upon exercise, the options would extend the revolving period to June 26, 2018 and 2019 and the maturity date to June 26, 2020 and 2021, respectively. Subject to certain terms and conditions, the Credit Facility can be expanded by up to $145 million, to a total facility amount of $250 million, through additional commitments of existing or new committed lenders. Advances under the Credit Facility generally bear interest at 30-day LIBOR, plus 3.25% per annum, down from 3.75% prior to the amendment, and the Credit Facility includes an unused fee of 0.50% on undrawn amounts. Once the revolving period ends, the interest rate margin increases to 3.75% for the period from June 26, 2017 to June 26, 2018, and further increases to 4.25% through maturity. We incurred fees of $0.4 million in connection with this amendment.
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RESULTS OF OPERATIONS
Comparison of the Three Months Ended September 30, 2014, to the Three Months Ended September 30, 2013
Base management fee
Incentive fee
Administration fee
Interest and dividend expense
UNREALIZED (LOSS) GAIN:
Net realized (loss) gain on investments
Net unrealized depreciation of investments
Net unrealized depreciation of other
Net realized and unrealized (loss) gain on investments and other
NM = Not Meaningful
Investment Income
Total investment income decreased by 20.1% for the three months ended September 30, 2014, as compared to the prior year period. This decrease was due to a decrease in other income, which primarily consisted of success fee and dividend income resulting from our exit of Venyu during the three months ended September 30, 2013. The decrease in other income was partially offset by an increase in interest income resulting from an increase in the size of our portfolio during the three months ended September 30, 2014.
Interest income from our investments in debt securities increased 11.2% for the three months ended September 30, 2014, as compared to the prior year period. The level of interest income from investments is directly related to the principal balance of our interest-bearing investment portfolio outstanding during the period multiplied by the weighted average yield. The weighted average principal balance of our interest-bearing investment portfolio during the three months ended September 30, 2014, was approximately $270.9 million, compared to approximately $242.8 million for the prior year period. This increase was primarily due to approximately $92.9 million in new investments originated after September 30, 2013, including Alloy Die Casting Corp. (“ADC”), Behrens Manufacturing, LLC (“Behrens”), Meridian Rack & Pinion, Inc. (“Meridian”), Head Country Inc. (“Head Country”), Edge Adhesives Holdings, Inc. (“Edge”), TREC, and CSM. At September 30, 2014, loans of one portfolio company, Tread Corp. (Tread”), were on non-accrual, with an aggregate weighted average principal balance of $12.0 million. At September 30, 2013, loans to two portfolio companies, ASH and Tread, were on non-accrual, with an aggregate weighted average principal balance of $26.1 million during the three months ended September 30, 2013. The weighted average yield on our interest-bearing investments was 12.6% for the three months ended September 30, 2014 and 2013, excluding cash and cash equivalents and receipts recorded as other income. The weighted average yield varies from period to period, based on the current stated interest rate on interest-bearing investments.
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The following table lists the investment income for our five largest portfolio company investments based on fair value during the respective periods:
Portfolio Company
SOG Specialty Knives and Tools, LLC
Cambridge Sound Management, LLC(A)
Subtotal—five largest investments
Other portfolio companies
Total investment portfolio
Schylling Investments, LLC (A)
Subtotal—five largest investments(B)
Other income decreased 86.3% from the prior year period. During the three months ended September 30, 2014, other income primarily consisted of $0.2, $0.2, and $0.1 million resulting from prepayments of success fees received from ASH, Frontier Packaging, Inc. (“Frontier”), and Mathey Investments, Inc. (“Mathey”), respectively. During the three months ended September 30, 2013, other income primarily consisted of $3.3 million in success fee and dividend income received in connection with the exit of Venyu and $0.3 million in success fee income resulting from prepayments received from Cavert II Holding Corp. (“Cavert”).
Total expenses, excluding any voluntary and irrevocable credits to the base management and incentive fees, increased 0.1% for the three months ended September 30, 2014, as compared to the prior year period, primarily due to an increase in the base management fee, interest expense, and other expenses as compared to the prior year period. This was partially offset by a decrease in the incentive fee for the three months ended September 30, 2014, as compared to the prior year period.
The base management fee increased for the three months ended September 30, 2014, as compared to the prior year period, as a result of the increased size of our portfolio over the respective periods. An incentive fee of $1.1 million was earned by the Adviser during the three months ended September 30, 2014, compared to an incentive fee of $1.6 million for the prior year period. The base
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management and incentive fees are computed quarterly, as described under “Investment Advisory and Management Agreement” in Note 4 of the notes to our accompanying Condensed Consolidated Financial Statements and are summarized in the following table:
Average gross assets subject to base management fee(A)
Interest and dividend expense increased 9.4% for the three months ended September 30, 2014, as compared to the prior year period, primarily due to increased average borrowings under the Credit Facility. The average balance outstanding on our Credit Facility during the three months ended September 30, 2014, was $64.9 million, as compared to $41.4 million in the prior year period. The increase in average borrowings under the Credit Facility was partially offset by the decrease in interest rate due to an amendment of the Credit facility that occurred June 26, 2014.
Other expenses increased 20.6% for the three months ended September 30, 2014, as compared to the prior year period, primarily due to an increase in legal expenses, as compared to the prior year period.
Realized and Unrealized (Loss) Gain on Investments
Realized (Loss) Gain
During the three months ended September 30, 2014, we recorded a realized loss of $12 relating to post-closing adjustments on previous investment exits. During the three months ended September 30, 2013, we recorded a realized gain of $24.8 million related to the Venyu exit.
Unrealized (Depreciation) Appreciation
During the three months ended September 30, 2014, we recorded net unrealized depreciation on investments in the aggregate amount of $1.5 million. The unrealized appreciation (depreciation) across our investments for the three months ended September 30, 2014, were as follows:
Head Country Inc.
Other, net (<$250 Net)
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The primary change in our net unrealized depreciation of $1.5 million for the three months ended September 30, 2014, was a decrease in the equity valuation of one of our portfolio companies, Galaxy Tool Holding Corp. (“Galaxy”), due to a decrease in company performance. This was partially offset by increased performance in several of our portfolio companies and, to a lesser extent, an increase in certain comparable multiples used to estimate the fair value of our investments.
During the three months ended September 30, 2013, we recorded net unrealized depreciation on investments in the aggregate amount of $15.7 million, which included the reversal of $17.4 million in aggregate unrealized appreciation, related to the Venyu exit. Excluding reversals, we had $1.7 million in net unrealized appreciation for the three months ended September 30, 2013.
The realized gains and unrealized appreciation (depreciation) across our investments for the three months ended September 30, 2013, were as follows:
Venyu Solutions, Inc.(A)
Excluding reversals, the primary changes in our net unrealized appreciation of $1.7 million for the three months ended September 30, 2013, were due to increased equity valuations in several of our portfolio companies, primarily due to increased portfolio company performance and, to a lesser extent, an increase in certain comparable multiples used to estimate the fair value of our investments.
Over our entire investment portfolio, we recorded approximately $2.0 million of net unrealized depreciation on our debt positions and $0.5 million of net unrealized appreciation on our equity holdings for the three months ended September 30, 2014. At September 30, 2014, the fair value of our investment portfolio was less than our cost basis by approximately $65.2 million, as compared to $63.7 million at June 30, 2014, representing net unrealized depreciation of $1.5 million for the three months ended September 30, 2014. We believe that our aggregate investment portfolio is valued at a depreciated value due to the lingering effects of the recent recession on the performance of certain of our portfolio companies. Our entire portfolio was fair valued at 84.2% of cost as of September 30, 2014. The unrealized depreciation of our investments does not have an impact on our current ability to pay distributions to stockholders; however, it may be an indication of future realized losses, which could ultimately reduce our income available for distribution.
Unrealized Appreciation on Other
There was no unrealized appreciation on our Credit Facility recognized for the three months ended September 30, 2014. During the three months ended September 30, 2013, there was net unrealized appreciation of $0.4 million on our Credit Facility. The Credit Facility was fair valued at $87.8 million and $61.7 million as of September 30 and March 31, 2014, respectively.
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Comparison of the Six Months Ended September 30, 2014, to the Six Months Ended September 30, 2013
Total expenses net of credits to fee
REALIZED AND UNREALIZED (LOSS) GAIN ON:
Net realized (loss) gain on sale of investments
Net unrealized appreciation (depreciation) on investments
Net unrealized depreciation on other
Net gain (loss) on investments and other
Total investment income increased by 0.8% for the six months ended September 30, 2014, as compared to the prior year period. This increase was primarily due an overall increase in interest income in the six months ended September 30, 2014, as a result of an increase in the size of our loan portfolio during the six months ended September 30, 2014. This was partially offset by a decrease in other income during the six months ended September 30, 2014 as compared to the prior year period, due to success fee and dividend income resulting from our exit from Venyu during the six months ended September 30, 2013.
Interest income from our investments in debt securities increased 14.0% for the six months ended September 30, 2014, as compared to the prior year period. The level of interest income from investments is directly related to the principal balance of our interest-bearing investment portfolio outstanding during the period multiplied by the weighted average yield. The weighted average principal balance of our interest-bearing investment portfolio during the six months ended September 30, 2014, was approximately $269.2 million, compared to approximately $236.4 million for the prior year period. This increase was primarily due to approximately $92.9 million in new investments originated after September 30, 2013, including ADC, Behrens, Meridian, Head Country, Edge, TREC, and CSM. At September 30, 2014, loans to one portfolio company, Tread, were on non-accrual, with an aggregate weighted average principal balance of $12.0 million. As of September 30, 2013, loans to two portfolio companies, ASH and Tread, were on non-accrual, with an aggregate weighted average principal balance of $25.8 million during the six months ended September 30, 2013. The weighted average yield on our interest-bearing investments was 12.6% for the six months ended September 30, 2014 and 2013, excluding cash and cash equivalents and receipts recorded as other income. The weighted average yield varies from period to period, based on the current stated interest rate on interest-bearing investments.
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The following table lists the investment income from investments for our five largest portfolio company investments based on fair value during the respective periods:
Other income decreased 50.0% from the prior year period. During the six months ended September 30, 2014, other income primarily consisted of $1.3 million of dividend income received from Mathey. During the six months ended September 30, 2013, other income primarily consisted of $3.3 million in success fee and dividend income received in connection with the exit of Venyu.
Total expenses, excluding any voluntary and irrevocable credits to the base management and incentive fees, increased 16.0% for the six months ended September 30, 2014, as compared to the prior year period, primarily due to an increase in the base management fee, incentive fee and interest expense, as compared to the prior year period.
The base management fee increased for the six months ended September 30, 2014, as compared to the prior year period, as a result of the increased size of our portfolio over the respective periods. Additionally, an incentive fee of $2.3 million was earned by the Adviser during the six months ended September 30, 2014, compared to $1.7 million for the prior year period. The base management and incentive fees are computed quarterly, as described under “Investment Advisory and Management Agreement” in Note 4 of the notes to our accompanying Condensed Consolidated Financial Statements and are summarized in the following table:
Other credits to Advisor fees(B)
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Interest and dividend expense increased 15.4% for the six months ended September 30, 2014, as compared to the prior year period, primarily due to increased average borrowings under the Credit Facility. The average balance outstanding on our Credit Facility during the six months ended September 30, 2014, was $62.7 million, as compared to $37.1 million in the prior year period. The increase in average borrowings under the Credit Facility was partially offset by the decrease in interest rate due to an amendment of the Credit facility that occurred June 26, 2014.
During the six months ended September 30, 2014, we recorded a realized loss of $12 relating to post-closing adjustments on the previous investment exits. During the six months ended September 30, 2013, we recorded a realized gain of $24.8 million related to the Venyu sale.
Unrealized Appreciation (Depreciation)
During the six months ended September 30, 2014, we recorded net unrealized appreciation on investments in the aggregate amount of $4.0 million. The unrealized appreciation (depreciation) across our investments for the six months ended September 30, 2014, were as follows:
The primary changes in our net unrealized appreciation for the six months ended September 30, 2014, were due to an increase in equity valuations in several of our portfolio companies, primarily due to an increase portfolio company performance and increases in certain comparable multiples used to estimate the fair value of our investments.
During the six months ended September 30, 2013, we recorded net unrealized depreciation on investments in the aggregate amount of $27.1 million, which included the reversal of $17.4 million in aggregate unrealized appreciation, related to the Venyu sale. Excluding reversals, we had $9.7 million in net unrealized depreciation for the six months ended September 30, 2013.
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The realized gains and unrealized appreciation (depreciation) across our investments for the six months ended September 30, 2013, were as follows:
The primary changes in our net unrealized depreciation for the six months ended September 30, 2013, were due to decreased equity valuations in several of our portfolio companies, primarily due to decreased portfolio company performance and decreases in certain comparable multiples used to estimate the fair value of our investments.
Over our entire investment portfolio, we recorded, in the aggregate, approximately $3.5 million and $0.5 million of net unrealized appreciation on our debt and equity investments, respectively, for the six months ended September 30, 2014. As of September 30, 2014, the fair value of our investment portfolio was less than our cost basis by approximately $65.2 million, as compared to $69.2 million at March 31, 2014, representing net unrealized appreciation of $4.0 million for the six months ended September 30, 2014. We believe that our aggregate investment portfolio is valued at a depreciated value due to the lingering effects of the recent recession on the performance of certain of our portfolio companies. Our entire portfolio was fair valued at 84.2% of cost as of September 30, 2014. The unrealized depreciation of our investments does not have an impact on our current ability to pay distributions to stockholders; however, it may be an indication of future realized losses, which could ultimately reduce our income available for distribution.
Net Unrealized Depreciation on Other
For the six months ended September 30, 2014 and 2013, we recorded $0.5 million and $0.4 million, respectively, of net unrealized depreciation on our Credit Facility.
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LIQUIDITY AND CAPITAL RESOURCES
Operating Activities
Net cash (used in) provided by operating activities for the six months ended September 30, 2014, was approximately $(16.8) million, as compared to $3.4 million during the six months ended September 30, 2013. Even though we disbursed $56.0 million in the prior year period to purchase investments compared to $29.3 million in the current period, the prior year period had significant cash inflows from the sale of Venyu to offset the purchase of investments. The sale of Venyu resulted in proceeds of $30.8 million and principal repayments of $19.0 million. Our cash flows from operations generally come from cash collections of interest and dividend income from our portfolio companies, as well as cash proceeds received through repayments of loan investments and sales of equity investments. These cash collections are primarily used to pay distributions to our stockholders, interest payments on our Credit Facility, dividend payments on our Term Preferred Stock, management fees to the Adviser, and other entity-level expenses.
As of September 30, 2014, we had equity investments in or loans to 30 private companies with an aggregate cost basis of approximately $412.1 million. As of September 30, 2013, we had equity investments in or loans to 24 private companies with an aggregate cost basis of approximately $354.2 million. The following table summarizes our total portfolio investment activity during the six months ended September 30, 2014 and 2013:
Beginning investment portfolio, at fair value
New investments
Disbursements to existing portfolio companies
Increase in investment balance due to PIK
Scheduled principal repayments
Unscheduled principal repayments
Proceeds from sales
Net realized (loss) gain
Net unrealized appreciation (depreciation)
Reversal of net unrealized appreciation
Ending investment portfolio, at fair value
The following table summarizes the contractual principal repayment and maturity of our investment portfolio by fiscal year, assuming no voluntary prepayments, as of September 30, 2013:
Financing Activities
Net cash provided by financing activities for the six months ended September 30, 2014, was approximately $15.3 million, which consisted primarily of $26.5 million of net borrowings on our Credit Facility, partially offset by $9.5 million in distributions to common stockholders. Net cash used in financing activities for the six months ended September 30, 2013, was approximately $42.1 million and consisted primarily of net repayments of our short-term borrowings of $36.0 million and distributions to common stockholders of $7.9 million, partially offset by $3.0 million in net borrowings from our Credit Facility.
To qualify to be taxed as a RIC and thus avoid corporate level tax on the income we distribute to our stockholders, we are required under Subchapter M of the Code, to distribute at least 90% of our ordinary income and short-term capital gains to our stockholders on an annual basis. In accordance with these requirements, we declared and paid monthly cash distributions of $0.06 per common share for each of the six months from April 2014 through September 2014. In October 2014, our Board of Directors also declared a monthly distribution of $0.06 per common share for each of October, November and December 2014 as well as a one-time special distribution of $0.05 in December 2014. Our Board of Directors declared these distributions based on estimates of net taxable income for the fiscal year ending March 31, 2015.
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For the fiscal year ended March 31, 2014, our distributions to common stockholders totaled $18.8 million, and were less than our taxable income over the same year. At March 31, 2014, we elected to treat $3.9 million, of the first distribution paid after year-end as having been paid in the prior year, in accordance with Section 855(a) of the Code. Additionally, the covenants in our Credit Facility generally restrict the amount of distributions that we can pay out to be no greater than our net investment income.
We also declared and paid monthly cash distributions of $0.1484375 per share of Term Preferred Stock for each of the six months from April 2014 through September 2014. In October 2014, our Board of Directors also declared a monthly distribution of $0.1484375 per preferred share for each of October, November and December 2014. In accordance with accounting principles generally accepted in the U.S. (“GAAP”), we treat these monthly distributions as an operating expense. For tax purposes, these preferred distributions are deemed to be paid entirely out of ordinary income to preferred stockholders.
Equity
Common Stock
Pursuant to our registration statement on Form N-2 (Registration No. 333-181879), on October 5, 2012, we completed a public offering of 4 million shares of our common stock at a public offering price of $7.50 per share, which was below then current NAV of $8.65 per share. Gross proceeds totaled $30 million and net proceeds, after deducting underwriting discounts and offering expenses borne by us, were $28.3 million, which was used to repay borrowings under our Credit Facility. In connection with the offering, the underwriters exercised their option to purchase an additional 395,825 shares at the public offering price to cover over-allotments, which resulted in gross proceeds of $3.0 million and net proceeds, after deducting underwriting discounts, of $2.8 million.
We anticipate issuing equity securities to obtain additional capital in the future. However, we cannot determine the terms of any future equity issuances or whether we will be able to issue equity on terms favorable to us, or at all. When our common stock is trading below NAV per share, as it has consistently since September 30, 2008, the 1940 Act places regulatory constraints on our ability to obtain additional capital by issuing common stock. Generally, the 1940 Act provides that we may not issue and sell our common stock at a price below our NAV per common share, other than to our then existing common stockholders pursuant to a rights offering, without first obtaining approval from our stockholders and our independent directors. On October 27, 2014, the closing market price of our common stock was $7.27 per share, representing a 14.4% discount to our NAV of $8.49 as of September 30, 2014. To the extent that our common stock continues to trade at a market price below our NAV per common share, we will generally be precluded from raising equity capital through public offerings of our common stock, other than pursuant to stockholder approval or through a rights offering to existing common stockholders. At our 2014 Annual Meeting of Stockholders held on August 7, 2014, our stockholders approved a proposal authorizing us to issue and sell shares of our common stock at a price below our then current NAV per common share for a period of one year from the date of such approval, provided that our Board of Directors makes certain determinations prior to any such sale.
Term Preferred Stock
Pursuant to our prior registration statement on Form N-2 (File No. 333-160720), in March 2012, we completed an offering of 1.6 million shares of Term Preferred Stock at a public offering price of $25.00 per share. Gross proceeds totaled $40 million, and net proceeds, after deducting underwriting discounts and offering expenses borne by us were $38 million, a portion of which was used to repay borrowings under our Credit Facility, with the remaining proceeds being held to make additional investments and for general corporate purposes. We incurred $2 million in total offering costs related to the offering, which have been recorded as an asset in accordance with GAAP and are being amortized over the redemption period ending February 28, 2017.
The Term Preferred Stock provides for a fixed dividend equal to 7.125% per year, payable monthly (which equates to $2.9 million per year). We are required to redeem all of the outstanding Term Preferred Stock on February 28, 2017, for cash at a redemption price equal to $25.00 per share plus an amount equal to accumulated but unpaid dividends, if any, to the date of redemption. The Term
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Preferred Stock has a preference over our common stock with respect to dividends, whereby no distributions are payable on our common stock unless the stated dividends, including any accrued and unpaid dividends, on the Term Preferred Stock have been paid in full. The Term Preferred Stock is not convertible into our common stock or any other security. In addition, three other potential redemption triggers are as follows: (1) upon the occurrence of certain events that would constitute a change in control of us, we would be required to redeem all of the outstanding Term Preferred Stock; (2) if we fail to maintain an asset coverage ratio of at least 200%, we are required to redeem a portion of the outstanding Term Preferred Stock or otherwise cure the ratio redemption trigger and (3) at our sole option, at any time on or after February 28, 2016, we may redeem some or all of the Term Preferred Stock.
The Term Preferred Stock has been recorded as a liability in accordance with GAAP and, as such, affects our asset coverage, exposing us to additional leverage risks.
Revolving Credit Facility
On June 26, 2014, we, through our wholly-owned subsidiary, Business Investment, entered into Amendment No. 1 to the Fifth Amended and Restated Credit Agreement originally entered into on April 30, 2013, with Key Equipment Finance Inc., as administrative agent, lead arranger and a lender (the “Administrative Agent”), Branch Banking and Trust Company (“BB&T”) as a lender and managing agent, and the Adviser, as servicer, to extend the revolving period and reduce the interest rate of the line of credit (the “Credit Facility”). The revolving period was extended 14 months to June 26, 2017, and if not renewed or extended by June 26, 2017, all principal and interest will be due and payable on or before June 26, 2019 (two years after the revolving period end date). In addition, we have retained the two one-year extension options, to be agreed upon by all parties, which may be exercised on or before June 26, 2015 and 2016, respectively, and upon exercise, the options would extend the revolving period to June 26, 2018 and 2019 and the maturity date to June 26, 2020 and 2021, respectively. Subject to certain terms and conditions, the Credit Facility can be expanded by up to $145 million, to a total facility amount of $250 million, through additional commitments of existing or new committed lenders. Advances under the Credit Facility generally bear interest at 30-day LIBOR, plus 3.25% per annum, down from 3.75% prior to the amendment, and the Credit Facility includes an unused fee of 0.50% on undrawn amounts. Once the revolving period ends, the interest rate margin increases to 3.75% for the period from June 26, 2017 to June 26, 2018, and further increases to 4.25% through maturity. We incurred fees of $0.4 million in connection with this amendment.
The Credit Facility contains covenants that require Business Investment to maintain its status as a separate legal entity; prohibit certain significant corporate transactions (such as mergers, consolidations, liquidations or dissolutions) and restrict material changes to our credit and collection policies without lenders’ consent. The facility generally also limits payments as distributions to the aggregate net investment income for each of the twelve month periods ending March 31, 2015, 2016 and 2017. We are also subject to certain limitations on the type of loan investments we can make, including restrictions on geographic concentrations, sector concentrations, loan size, dividend payout, payment frequency and status, average life and lien property. The Credit Facility also requires us to comply with other financial and operational covenants, which obligate us to, among other things, maintain certain financial ratios, including asset and interest coverage, a minimum net worth and a minimum number of obligors required in the borrowing base of the credit agreement. Additionally, we are subject to a performance guaranty that requires us to maintain (i) a minimum net worth of $170 million plus 50% of all equity and subordinated debt raised after April 30, 2013, which equates to $170 million as of September 30, 2014, (ii) “asset coverage” with respect to “senior securities representing indebtedness” of at least 200%, in accordance with Section 18 of the 1940 Act and (iii) our status as a BDC under the 1940 Act and as a RIC under the Code. As of September 30, 2014, and as defined in the performance guaranty of our Credit Facility, we had a minimum net worth of $264.8 million, an asset coverage of 264% and an active status as a BDC and RIC. As of October 28, 2014, we were in compliance with all covenants.
In July 2013, we entered into a forward interest rate cap agreement, effective October 2013 and expiring April 2016, for a notional amount of $45 million. We incurred a premium fee of $75 in conjunction with this agreement. The interest rate cap agreement effectively limits the interest rate on a portion of the borrowings pursuant to the terms of the Credit Facility.
The Administrative Agent also requires that any interest or principal payments on pledged loans be remitted directly by the borrower into a lockbox account, with The Bank of New York Mellon Trust Company, N.A. as custodian. The Administrative Agent is also the trustee of the account and generally remits the collected funds to us once a month.
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Contractual Obligations and Off-Balance Sheet Arrangements
We have lines of credit to certain of our portfolio companies that have not been fully drawn. Since these lines of credit have expiration dates and we expect many will never be fully drawn, the total line of credit commitment amounts do not necessarily represent future cash requirements. We estimate the fair value of the unused line of credit commitments as of September 30 and March 31, 2014 to be minimal.
In addition to the lines of credit to our portfolio companies, we have also extended certain guaranties on behalf of some our portfolio companies, whereby we have guaranteed an aggregate of $2.7 million of obligations of Country Club Enterprises, LLC (“CCE”). As of September 30, 2014, we have not been required to make any payments on any of the guaranties, and we consider the credit risks to be remote and the fair value of the guaranties to be minimal.
The following table shows our contractual obligations as of September 30, 2014, at cost:
Contractual Obligations(A)
Interest payments on obligations(B)
The majority of our debt securities in our portfolio have a success fee component, which can enhance the yield on our debt investments. Unlike PIK income, we generally do not recognize success fees as income until they are received in cash. Due to their contingent nature, there are no guarantees that we will be able to collect any or all of these success fees or know the timing of such collections. As a result, as of September 30, 2014, we had unrecognized success fees of $21.0 million, or $0.79 per common share, which do not meet the recognition criteria under the relevant accounting guidance.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported consolidated amounts of assets and liabilities, including disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the period reported. Actual results could differ materially from those estimates. We have identified our investment valuation process as our most critical accounting policy.
Investment Valuation
The most significant estimate inherent in the preparation of our consolidated financial statements is the valuation of our investments and the related amounts of unrealized appreciation and depreciation of investments recorded in our Condensed Consolidated Financial Statements.
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When a determination is made to classify our investments within Level 3 of the valuation hierarchy, such determination is based upon the significance of the unobservable factors to the overall fair value measurement. However, Level 3 financial instruments typically include, in addition to the unobservable, or Level 3, inputs, observable inputs (or, components that are actively quoted and can be validated to external sources). The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. As of September 30 and March 31, 2014, all of our investments were valued using Level 3 inputs and during the six months ended September 30, 2014 and 2013, there were no investments transferred in to or out of Level 1, 2 or 3.
In accordance with the 1940 Act, our Board of Director has the ultimate responsibility for reviewing and approving, in good faith, the fair value of our investments based on our established investment valuation policy (the “Policy”). Our Board of Directors reviews valuation recommendations that are provided by professionals of the Adviser and Administrator with oversight and direction from the Valuation Team. There is no single standard for determining fair value (especially for privately-held businesses), as fair value depends upon the specific facts and circumstances of each individual investment. In determining the fair value of our investments, the Valuation Team, led by the Valuation Officer, uses the Policy, which has been approved by our Board of Directors, and each quarter our Board of Directors reviews the Policy to determine if changes thereto are advisable and also reviews whether the Valuation Team has applied the Policy consistently.
The Valuation Team engages third party valuation firms to provide independent assessments of fair value of certain of our investments. Currently, the third-party service provider Standard & Poor’s Securities Evaluation, Inc. (“SPSE”) provides estimates of fair value on the majority of our debt investments.
The Valuation Team generally assigns SPSE’s estimates of fair value to our debt investments where we do not have the ability to effectuate a sale of the applicable portfolio company. The Valuation Team corroborates SPSE’s estimates of fair value using one or more of the valuation techniques discussed below. The Valuation Team’s estimates of value on a specific debt investment may significantly differ from SPSE’s. When this occurs, our Board of Directors reviews whether the Valuation Team has followed the Policy and whether the Valuation Team’s recommended value is reasonable in light of the Policy and other facts and circumstances and then votes to accept or reject the Valuation Team’s recommended valuation.
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Credit Monitoring and Risk Rating
The Adviser monitors a wide variety of key credit statistics that provide information regarding our portfolio companies to help us assess credit quality and portfolio performance and, in some instances, that is used as inputs in our valuation techniques. We, through the Adviser, participate in periodic board meetings of our portfolio companies in which we hold board seats and also generally require them to provide annual audited and monthly unaudited financial statements. Using these statements or comparable information and board discussions, the Adviser calculates and evaluates certain credit statistics.
We risk rate all of our investments in debt securities. We use a proprietary risk rating system. Our risk rating system uses a scale of 0 to >10, with >10 being the lowest probability of default. This system is used to estimate the probability of default on debt securities and the expected loss if there is a default. These types of systems are referred to as risk rating systems and are used by banks and rating agencies. The risk rating system covers both qualitative and quantitative aspects of the business and the securities we hold. During the three months ended June 30, 2014, we modified our risk rating model to incorporate additional factors in our qualitative and quantitative analysis. While the overall process did not change, we believe the additional factors enhance the quality of the risk ratings of our investments. No adjustments were made to prior periods as a result of this modification due to the immaterial effect on the overall portfolio ratings.
We seek to have our risk rating system mirror the risk rating systems of major risk rating organizations, such as those provided by a Nationally Recognized Statistical Rating Organization (“NRSRO”). While we seek to mirror the NRSRO systems, we cannot provide any assurance that our risk rating system will provide the same risk rating as an NRSRO for these securities. The following chart is an estimate of the relationship of our risk rating system to the designations used by two NRSROs as they risk rate debt securities of major companies. Because our system rates debt securities of companies that are unrated by any NRSRO, there can be no assurance that the correlation to the NRSRO set out below is accurate. We believe our risk rating would be significantly higher than a typical NRSRO risk rating because the risk rating of the typical NRSRO is designed for larger businesses. However, our risk rating has been designed to risk rate the securities of smaller businesses that are not rated by a typical NRSRO. Therefore, when we use our risk rating on larger business securities, the risk rating is higher than a typical NRSRO rating. We believe the primary difference between our risk rating and the rating of a typical NRSRO is that our risk rating uses more quantitative determinants and includes qualitative determinants that we believe are not used in the NRSRO rating. It is our understanding that most debt securities of medium-sized companies do not exceed the grade of BBB on a NRSRO scale, so there would be no debt securities in the middle market that would meet the definition of AAA, AA or A. Therefore, the scale begins with the designation >10 as the best risk rating which may be equivalent to a BBB or Baa2 from an NRSRO, however, no assurance can be given that a >10 on the scale is equal to a BBB or Baa2 on an NRSRO scale.
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Adviser’s System
First NRSRO
Second NRSRO
Description(A)
The above scale gives an indication of the probability of default and the magnitude of the expected loss if there is a default. Generally, our policy is to stop accruing interest on an investment if we determine that interest is no longer collectable. As of September 30 and March 31, 2014, Tread was the only portfolio investment on non-accrual with an aggregate fair value of $0. Additionally, we do not risk rate our equity securities.
The following table lists the risk ratings for all proprietary loans in our portfolio as of September 30 and March 31, 2014, representing 100%, of the principal balance of all loans in our portfolio at the end of each period:
Rating
Highest
Average
Weighted Average
Lowest
Tax Status
Federal Income Taxes
We intend to continue to qualify for treatment as a RIC under Subtitle A, Chapter 1 of Subchapter M of the Code. As a RIC, we are not subject to federal income tax on the portion of our taxable income and gains distributed to stockholders. To qualify as a RIC, we must meet certain source-of-income, asset diversification and annual distribution requirements. For more information regarding the requirements we must meet as a RIC, see “—Business Environment.” Under the annual distribution requirements, we are required to distribute to stockholders at least 90% of our investment company taxable income, as defined by the Code. Our practice has been to pay out as distributions up to 100% of that amount.
In an effort to limit certain excise taxes imposed on RICs, we generally distribute during each calendar year, an amount at least equal to the sum of (1) 98% of our ordinary income for the calendar year, (2) 98.2% of our capital gains in excess of capital losses for the one-year period ending on October 31 of the calendar year and (3) any ordinary income and capital gains in excess of capital losses for preceding years that were not distributed during such years. However, we did incur an excise tax of $0.3 million and $31 for the calendar years ended December 31, 2013 and 2012, respectively. Under the RIC Modernization Act (the “RIC Act”), we are permitted to carry forward capital losses incurred in taxable years beginning after March 31, 2011, for an unlimited period. However, any losses incurred during those future taxable years must be used prior to the losses incurred in pre-enactment taxable years, which carry an expiration date. Additionally, post-enactment capital loss carryforwards will retain their character as either short-term or long-term capital losses rather than only being considered short-term as permitted under previous regulation. Our total capital loss carryforward balance was $0.2 million as of March 31, 2014.
Revenue Recognition
Interest income, adjusted for amortization of premiums, amendment fees and acquisition costs and the accretion of discounts, is recorded on the accrual basis to the extent that such amounts are expected to be collected. Generally, when a loan becomes 90 days or more past due, or if our qualitative assessment indicates that the debtor is unable to service its debt or other obligations, we will place the loan on non-accrual status and cease recognizing interest income on that loan until the borrower has demonstrated the ability and intent to pay contractual amounts due. However, we remain contractually entitled to this interest. Interest payments received on non-accrual loans may be recognized as income or applied to the cost basis, depending upon management’s judgment. Generally, non-accrual
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loans are restored to accrual status when past-due principal and interest are paid, and, in management’s judgment, are likely to remain current, or due to a restructuring, the interest income is deemed to be collectible. As of September 30, 2014, our loans to Tread were on non-accrual, with an aggregate debt cost basis of $12.0 million, or 4.0% of the cost basis of all debt investments in our portfolio, and an aggregate fair value of $0. As of March 31, 2014, our loans to Tread were on non-accrual, with an aggregate debt cost basis of $11.7 million, or 4.2% of the cost basis of all debt investments in our portfolio, and an aggregate fair value of $0.
We generally record success fees upon receipt of cash. Success fees are contractually due upon a change of control in a portfolio company. We recorded $0.5 million of success fees for the three and six months ended September 30, 2014, respectively. During the three months ended September 30, 2014, we received success fees of $0.2 million from each of ASH and Frontier and $0.1 million from Mathey. We recorded $2.1 million and $2.3 million of success fees during the three and six months ended September 30, 2013, respectively. During the three months ended September 30, 2013, we received $0.3 million Cavert in success fee prepayments and we received $1.8 million related to the exit of Venyu.
Both dividend and success fee income are recorded in Other income in our accompanyingCondensed Consolidated Statements of Operations.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk includes risks that arise from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market sensitive instruments. The prices of securities held by us may decline in response to certain events, including those directly involving the companies whose securities are owned by us; conditions affecting the general economy; overall market changes; local, regional or global political, social or economic instability; and interest rate fluctuations.
The primary risk we believe we are exposed to is interest rate risk. Because we borrow money to make investments, our net investment is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest those funds. As a result, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income. We use a combination of debt and equity capital to finance our investing activities. We do use interest rate risk management techniques to limit our exposure to interest rate fluctuations. Such techniques may include various interest rate hedging activities to the extent permitted by the 1940 Act.
Our target is to have approximately 20% of the loans in our portfolio at fixed rates and approximately 80% at variable rates or variables rates with a floor mechanism. Currently, all of our variable-rate loans have rates associated with either the current LIBOR or prime rate. As of September 30, 2014, our portfolio consisted of the following breakdown based on total principal balance of all outstanding debt investments:
There have been no material changes in the quantitative and qualitative market risk disclosures for the three and six months ended September 30, 2014 from that disclosed in our Annual Report on Form 10-K for the fiscal year ended March 31, 2014, as filed with the SEC on May 13, 2014.
ITEM 4. CONTROLS AND PROCEDURES.
a) Evaluation of Disclosure Controls and Procedures
As of September 30, 2014 (the end of the period covered by this report), we, including our chief executive officer and chief financial officer, evaluated the effectiveness and design and operation of our disclosure controls and procedures. Based on that evaluation, our management, including the chief executive officer and chief financial officer, concluded that our disclosure controls and procedures were effective at a reasonable assurance level in timely alerting management, including the chief executive officer and chief financial officer, of material information about us required to be included in periodic SEC filings. However, in evaluation of the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
b) Changes in Internal Control over Financial Reporting
There were no changes in internal controls for the three months ended September 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II—OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
From time to time, we may become involved in various investigations, claims and legal proceedings that arise in the ordinary course of our business. Furthermore, third parties may try to seek to impose liability on us in connection with the activities of our portfolio companies. While we do not expect that the resolution of these matters if they arise would materially affect our business, financial condition or results of operations, resolution will be subject to various uncertainties and could result in the expenditure of significant financial and managerial resources.
ITEM 1A. RISK FACTORS.
Our business is subject to certain risks and events that, if they occur, could adversely affect our financial condition and results of operations and the trading price of our securities. For a discussion of these risks, please refer to the “Risk Factors” section in our Annual Report on Form 10-K for the year ended March 31, 2014, as filed with the SEC on May 13, 2014
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
ITEM 4. MINE SAFETY DISCLOSURES.
ITEM 5. OTHER INFORMATION.
ITEM 6. EXHIBITS
See the exhibit index.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ David Watson
Dated: October 28, 2014
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EXHIBIT INDEX
Description
All other exhibits for which provision is made in the applicable regulations of the Securities and Exchange Commission are not required under the related instruction or are inapplicable and therefore have been omitted.
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