News Column

STELLUS CAPITAL INVESTMENT CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements

August 11, 2014

Some of the statements in this quarterly report on Form 10-Q constitute forward-looking statements, which relate to future events or our future performance or financial condition. The forward-looking statements contained in this quarterly report on Form 10-Q involve risks and uncertainties, including statements as to:



our future operating results;

our business prospects and the prospects of our portfolio companies;

the effect of investments that we expect to make;

our contractual arrangements and relationships with third parties;

actual and potential conflicts of interest with Stellus Capital Management;

the dependence of our future success on the general economy and its effect

on the industries in which we invest;

the ability of our portfolio companies to achieve their objectives;

the use of borrowed money to finance a portion of our investments;

the adequacy of our financing sources and working capital;

the timing of cash flows, if any, from the operations of our portfolio

companies;

the ability of Stellus Capital Management to locate suitable investments

for us and to monitor and administer our investments;

the ability of Stellus Capital Management to attract and retain highly

talented professionals;

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

the effect of future changes in laws or regulations (including the

interpretation of these laws and regulations by regulatory authorities) and

conditions in our operating areas, particularly with respect to business

development companies or RICs.

Such forward-looking statements may include statements preceded by, followed by or that otherwise include the words "may," "might," "will," "intend," "should," "could," "can," "would," "expect," "believe," "estimate," "anticipate," "predict," "potential," "plan" or similar words. We have based the forward-looking statements included in this quarterly report on Form 10-Q on information available to us on the date of this quarterly report on Form 10-Q. Actual results could differ materially from those anticipated in our forward-looking statements, and future results could differ materially from historical performance. We undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law or SEC rule or regulation. You are advised to consult any additional disclosures that we may make directly to you or through reports that we in the future may file with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. Overview



We were organized as a Maryland corporation on May 18, 2012 and formally commenced operations on November 7, 2012. Our investment objective is to maximize the total return to our stockholders in the form of current income and capital appreciation through debt and related equity investments in middle-market companies.

We are an externally managed, non-diversified, closed-end investment company that has elected to be regulated as a BDC under the 1940 Act. As a BDC, we are required to comply with certain regulatory requirements. For instance, we generally have to invest at least 70% of our total assets in "qualifying assets," including securities of private or thinly traded public U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt investments that mature in one year or less. 33 --------------------------------------------------------------------------------



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As a BDC, we must not acquire any assets other than "qualifying assets" specified in the 1940 Act unless, at the time the acquisition is made, at least 70% of our total assets are qualifying assets. Qualifying assets include investments in "eligible portfolio companies." Under the relevant SEC rules, the term "eligible portfolio company" includes all private operating companies, operating companies whose securities are not listed on a national securities exchange, and certain public operating companies that have listed their securities on a national securities exchange and have a market capitalization of less than $250 million, in each case organized and with their principal of business in the United States. We have elected to be treated for tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code, or the Code. To maintain our qualification as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements. As of June 30, 2014, we were in compliance with the RIC requirements. As a RIC, we generally will not have to pay corporate-level taxes on any income we distribute to our stockholders. Portfolio Composition and Investment Activity Portfolio Composition We originate and invest primarily in privately-held middle-market companies (typically those with $5.0 million to $50.0 million of EBITDA) through first lien, second lien, unitranche and mezzanine debt financing, often times with a corresponding equity investment. As of June 30, 2014, we had $281.0 million (at fair value) invested in 27 companies. As of June 30, 2014, our portfolio included approximately 18% of first lien debt, 36% of second lien debt, 43% of mezzanine debt and 3% of equity investments at fair value. The composition of our investments at cost and fair value as of June 30, 2014 was as follows: [[Image Removed]] [[Image Removed]] [[Image Removed]] Cost Fair Value



Senior Secured - First Lien $ 51,503,683$ 51,674,288 Senior Secured - Second Lien

98,851,897 100,490,139 Unsecured Debt 124,860,705 121,663,715 Equity 6,110,645 7,150,697 Total Investments $ 281,326,930$ 280,978,839 As of December 31, 2013, we had $277.5 million (at fair value) invested in 26 portfolio companies. As of December 31, 2013, our portfolio included approximately 17% of first lien debt, 43% of second lien debt, 38% of mezzanine debt and 2% of equity investments at fair value. The composition of our investments at cost and fair value as of December 31, 2013 was as follows: [[Image Removed]] [[Image Removed]] [[Image Removed]] Cost Fair Value Senior Secured - First Lien $ 48,341,121$ 48,745,767 Senior Secured - Second Lien 117,166,001 118,171,725 Unsecured Debt 107,318,517 106,219,596 Equity 4,178,827 4,367,422 Total Investments $ 277,004,466$ 277,504,510 The Company's investment portfolio may contain loans that are in the form of lines of credit or revolving credit facilities, which require the Company to provide funding when requested by portfolio companies in accordance with the terms of the underlying loan agreements. As of June 30, 2014 and December 31, 2013, the Company had four and three such investments with aggregate unfunded commitments of $12.6 million and $20.9 million, respectively. 34 --------------------------------------------------------------------------------



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The following is a summary of geographical concentration of our investment portfolio as of June 30, 2014:

[[Image Removed]] [[Image Removed]] [[Image Removed]] [[Image Removed]] % of Total Cost Fair Value Investments New York $ 42,208,984$ 38,471,971 13.69 % Colorado 32,553,026 33,287,806 11.85 % Canada 31,101,590 31,335,162 11.15 % Texas 24,495,762 25,011,920 8.90 % Massachusetts 22,328,007 23,354,498 8.31 % Minnesota 22,058,003 22,368,750 7.96 % Alabama 17,172,755 17,298,344 6.16 % Florida 16,910,423 16,910,423 6.02 % Illinois 14,021,595 14,250,000 5.07 % Indiana 14,168,790 14,210,784 5.06 % Pennsylvania 9,690,923 9,850,000 3.51 % New Jersey 9,972,850 9,653,574 3.44 % Puerto Rico 8,697,439 8,554,666 3.04 % Missouri 4,955,839 5,048,438 1.80 % Kentucky 4,542,428 4,923,986 1.75 % Virginia 3,972,061 3,972,061 1.41 % Tennessee 2,476,455 2,476,455 0.88 % $ 281,326,930$ 280,978,839 100.00 %



The following is a summary of geographical concentration of our investment portfolio as of December 31, 2013:

[[Image Removed]] [[Image Removed]] [[Image Removed]] [[Image Removed]] % of Total Cost Fair Value Investments New York $ 41,093,388$ 39,601,590 14.27 % Colorado 36,412,357 37,108,667 13.37 % Minnesota 34,087,185 34,510,922 12.44 % Massachusetts 32,305,898 32,305,898 11.64 % Canada 27,917,648 28,215,795 10.17 % Texas 17,973,043 18,200,000 6.56 % Florida 16,910,423 16,910,423 6.09 % Illinois 14,008,782 14,115,231 5.09 % Indiana 11,169,118 11,169,118 4.02 % New Jersey 10,176,677 10,176,677 3.67 % Pennsylvania 9,669,695 9,738,000 3.51 % Puerto Rico 8,700,324 8,359,544 3.01 % Missouri 7,925,241 8,120,000 2.93 % Kentucky 4,659,651 4,888,373 1.76 % Virginia 2,514,924 2,584,272 0.93 % Georgia 1,480,112 1,500,000 0.54 % $ 277,004,466$ 277,504,510 100.00 % 35

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The following is a summary of industry concentration of our investment portfolio as of June 30, 2014: [[Image Removed]] [[Image Removed]] [[Image Removed]] [[Image Removed]] % of Total Cost Fair Value Investments Software $ 37,124,865$ 33,354,498 13.65 % Healthcare & Pharmaceuticals 35,732,282 36,146,222 12.86 % High Tech Industries 35,439,534 35,667,939 12.69 % Media: Broadcasting and Subscription 27,578,948 27,887,108 9.92 % Finance 26,354,788 26,872,010 9.56 % Telecommunications 18,753,456 19,104,674 6.80 % Transportation: Cargo 17,891,040 18,082,695 6.44 % Services: Business 16,910,423 16,910,423 6.02 % Beverage, Food, & Tobacco 12,779,328 13,065,000 4.65 % Consumer goods: non-durable 9,690,923 9,850,000 3.51 % Retail 9,972,850 9,653,574 3.44 % Services: Consumer 13,200,354 8,966,881 3.20 % Transportation & Logistics 5,961,401 6,045,313 2.15 % Metals & Mining 4,542,428 4,923,986 1.75 % Services: Government 3,972,061 3,972,061 1.41 % Energy: Oil & Gas 2,945,794 3,000,000 1.07 % Construction & Building 2,476,455 2,476,455 0.88 % $ 281,326,930$ 280,978,839 100.00 %



The following is a summary of industry concentration of our investment portfolio as of December 31, 2013:

[[Image Removed]] [[Image Removed]] [[Image Removed]] [[Image Removed]] % of Total Cost Fair Value Investments Software $ 48,570,692$ 48,805,898 17.59 % Healthcare & Pharmaceuticals 35,707,711 35,874,461 12.93 % High Tech Industries 35,211,794 35,318,243 12.73 % Telecommunications 33,269,455 33,491,491 12.07 % Transportation: Cargo 17,883,754 18,181,901 6.55 % Beverage, Food, & Tobacco 16,689,794 17,000,000 6.13 % Services: Business 16,910,423 16,910,423 6.09 % Media: Broadcasting & Subscription 13,339,965 13,532,500 4.88 % Finance 12,242,889 12,491,250 4.50 % Services: Consumer 13,133,228 11,395,293 4.10 % Retail 10,176,677 10,176,677 3.67 % Consumer Goods: Non-Durable 9,669,695 9,738,000 3.51 % Energy: Oil & Gas 9,538,738 9,700,000 3.49 % Metals & Mining 4,659,651 4,888,373 1.76 % $ 277,004,466$ 277,504,510 100.00 % At June 30, 2014, our average portfolio company investment at amortized cost and fair value was approximately $10.4 million and $10.4 million, respectively, and our largest portfolio company investment by amortized cost and fair value was approximately $22.3 million and $23.4 million, respectively. At December 31, 2013, our average portfolio company investment at amortized cost and fair value was approximately $10.7 million and $10.7 million, respectively, and our largest portfolio company investment by amortized cost and fair value was approximately $22.3 million and $22.3 million, respectively. 36 --------------------------------------------------------------------------------



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At June 30, 2014, 53% of our debt investments bore interest based on floating rates (subject to interest rate floors), such as LIBOR, and 47% bore interest at fixed rates. At December 31, 2013, 58% of our debt investments bore interest based on floating rates (subject to interest rate floors), such as LIBOR, and 42% bore interest at fixed rates. The weighted average yield on all of our debt investments as of June 30, 2014 and December 31, 2013 was approximately 10.9% and 11.4%, respectively. The weighted average yield was computed using the effective interest rates for all of our debt investments, including accretion of original issue discount. As of June 30, 2014 and December 31, 2013, we had cash of $10.2 million and $3.7 million, respectively, and United States Treasury securities of approximately $0 million and $10.0 million, respectively. The United States Treasury securities were purchased and temporarily held in 2013 in connection with complying with RIC diversification requirements under Subchapter M of the Code.



Investment Activity

During the quarter ended June 30, 2014, we made $11.0 million of investments in one new portfolio company and four existing portfolio companies. During the six months ended June 30, 2014, we made $51.5 million of investments in six new portfolio and four existing portfolio companies. During the quarter ended June 30, 2014, we received $25.9 million in proceeds from repayments and sales of our investments, including $0.3 million from amortization of certain other investments. During the six months ended June 30, 2014, we received $48.3 million in proceeds from repayments and sales of our investments, including $0.8 million from amortization of certain other investments. During the year ended December 31, 2013, we made $176.4 million of investments in 16 new portfolio companies and six existing portfolio companies. During the year ended December 31, 2013, we received $97.4 million in proceeds from repayments and sales of our investments, including $3.5 million from amortization of certain other investments. Our level of investment activity can vary substantially from period to period depending on many factors, including the amount of debt and equity capital to middle market companies, the level of merger and acquisition activity, the general economic environment and the competitive environment for the types of investments we make. Asset Quality In addition to various risk management and monitoring tools, Stellus Capital Management uses an investment rating system to characterize and monitor the credit profile and expected level of returns on each investment in our portfolio. This investment rating system uses a five-level numeric scale. The following is a description of the conditions associated with each investment rating:



Investment Rating 1 is used for investments that are performing above

expectations, and whose risks remain favorable compared to the expected

risk at the time of the original investment.

Investment Rating 2 is used for investments that are performing within

expectations and whose risks remain neutral compared to the expected risk

at the time of the original investment. All new loans are initially rated

2.

Investment Rating 3 is used for investments that are performing below

expectations and that require closer monitoring, but where no loss of

return or principal is expected. Portfolio companies with a rating of 3 may

be out of compliance with financial covenants. Investment Rating 4 is used for investments that are performing substantially below expectations and whose risks have increased



substantially since the original investment. These investments are often in

work out. Investments with a rating of 4 are those for which some loss of

return but no loss of principal is expected. Investment Rating 5 is used for investments that are performing substantially below expectations and whose risks have increased



substantially since the original investment. These investments are almost

always in work out. Investments with a rating of 5 are those for which some

loss of return and principal is expected. 37

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[[Image Removed]] [[Image Removed]] [[Image Removed]] [[Image Removed]] [[Image Removed]] [[Image Removed]] [[Image Removed]] As of June 30, 2014 As of December 31, 2013 Number of Number of Investment % of Total Portfolio % of Total Portfolio Rating Fair Value Portfolio Companies Fair Value Portfolio Companies 1 $ - 0 % - $ 21.1 8 % 2 2 253.8 90 % 24 236.6 85 % 22 3 18.2 7 % 2 8.4 3 % 1 4 9.0 3 % 1 11.4 4 % 1 5 - 0 % - - 0 % - Total $ 281.0 100 % 27 $ 277.5 100 % 26



Loans and Debt Securities on Non-Accrual Status

We will not accrue interest on loans and debt securities if we have reason to doubt our ability to collect such interest. As of June 30, 2014, we had one loan on non-accrual status, which represents approximately 4.7% of the loan portfolio at cost and 3.2% at fair value. As of December 31, 2013, we had no loans on non-accrual status.



Results of Operations

An important measure of our financial performance is net increase (decrease) in net assets resulting from operations, which includes net investment income (loss), net realized gain (loss) and net unrealized appreciation (depreciation). Net investment income (loss) is the difference between our income from interest, dividends, fees and other investment income and our operating expenses including interest on borrowed funds. Net realized gain (loss) on investments is the difference between the proceeds received from dispositions of portfolio investments and their amortized cost. Net unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio.



Comparison of the Three Months and Six Months ended June 30, 2014 and 2013 Revenues

We generate revenue in the form of interest income on debt investments and capital gains and distributions, if any, on investment securities that we may acquire in portfolio companies. Our debt investments typically have a term of five to seven years and bear interest at a fixed or floating rate. Interest on our debt securities is generally payable quarterly. Payments of principal on our debt investments may be amortized over the stated term of the investment, deferred for several years or due entirely at maturity. In some cases, our debt investments may pay interest in-kind, or PIK. Any outstanding principal amount of our debt securities and any accrued but unpaid interest will generally become due at the maturity date. The level of interest income we receive is directly related to the balance of interest-bearing investments multiplied by the weighted average yield of our investments. We expect that the total dollar amount of interest and any dividend income that we earn to increase as the size of our investment portfolio increases. In addition, we may generate revenue in the form of prepayment fees, commitment, loan origination, structuring or due diligence fees, fees for providing significant managerial assistance and consulting fees. Investment income for the three months ended June 30, 2014 totaled $8.0 million and was primarily composed of interest income, including $0.1 million of PIK income and $0.3 million of miscellaneous fees. Investment income for the six months ended June 30, 2014 totaled $15.9 million and was primarily composed of interest income, including $0.4 million of PIK income and $0.5 million of miscellaneous fees. Investment income for the three months ended June 30, 2013 totaled $7.3 million and was primarily composed of interest income, including $0.3 million of PIK income and $0.6 million of miscellaneous fees. Investment income for the six months ended June 30, 2013 totaled $13.8 million and was primarily composed of interest income, including $0.5 million of PIK income and $0.8 million of miscellaneous fees.



The increases in investment income from the respective periods were due to the growth in the overall investment portfolio.

Expenses

Our primary operating expenses include the payment of fees to Stellus Capital Management, LLC ("Stellus Capital" or the "Adviser") under the investment advisory agreement, our allocable portion of

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overhead expenses under the administration agreement and other operating costs described below. We bear all other out-of-pocket costs and expenses of our operations and transactions, which may include:

the cost of calculating our net asset value, including the cost of any

third-party valuation services;

the cost of effecting sales and repurchases of shares of our common stock

and other securities;

fees payable to third parties relating to making investments, including

out-of-pocket fees and expenses (such as travel expenses) associated with performing due diligence and reviews of prospective investments;



transfer agent and custodial fees;

out-of-pocket fees and expenses associated with marketing efforts;

federal and state registration fees and any stock exchange listing fees;

U.S. federal, state and local taxes;

independent directors' fees and expenses;

brokerage commissions;

fidelity bond, directors' and officers' liability insurance and other

insurance premiums;

direct costs, such as printing, mailing, long distance telephone and staff; fees and expenses associated with independent audits and outside legal



costs; and

other expenses incurred by Stellus Capital Management or us in connection

with administering our business, including payments under the administration agreement that are based upon our allocable portion of overhead (subject to the review of our board of directors). Operating expenses for the three and six months ended June 30, 2014 totaled $4.3 million and $8.4 million, respectively. Operating expenses, net of fee waiver totaled $3.4 million and $6.1 million for the three and six months ended June 30, 2013. Operating expenses, net of fee waiver consisted of base management fees, incentive fees, administrative services expenses, fees related to the Credit Facility, professional fees, valuation fees, insurance expenses, directors' fees and other general and administrative expenses, partially offset by the waiver of incentive fee. The increase in operating expenses resulted from an increase in interest expense due to increased borrowings under the Credit Facility and the issuance of the Notes.



For the three and six months ended June 30, 2014, the Company incurred base management fees payable to the Advisor of $1.3 million and $2.6 million, respectively, as provided for in the investment advisory agreement. For the three and six months ended June 30, 2013, the Company incurred base management fees payable to the Advisor of $1.0 million and $1.9 million, respectively.

For the three and six months ended June 30, 2014, the Company incurred incentive fees totaling $0.9 million and $1.8 million, respectively. For the three and six months ended June 30, 2013, the Company incurred incentive fees totaling $1.1 million and $2.1 million, respectively. The Company's incentive fee expense includes an accrual relating to the Capital Gains Incentive Fee, as defined in Note 2. For the three and six months ended June 30, 2014, the Company incurred $7 thousand and ($82) thousand, respectively, of incentive fees related to the Capital Gains Incentive Fee. For the three and six months ended June 30, 2013, the Company incurred $101 thousand and $469 thousand, respectively, of incentive fees related to the Capital Gains Incentive Fee. For the three and six months ending June 30, 2013, the Advisor agreed to waive its incentive fee to the extent required to support an annualized dividend yield of 9.0% based on the price per share of our common stock of $15.00, the price to the public in our initial public offering. The Advisor has entered into no such agreement with the Company for periods subsequent to December 31, 2013. While under no obligation to do so, the Advisor may, in its sole discretion determine to waive incentive fees in future periods. For the three and six months ended June 30, 2014, the Advisor waived no incentive fees related to pre-incentive fee net 39

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income. For the three and six months ended June 30, 2013, the Advisor waived $0.2 million and $0.5 million of incentive fees related to pre-incentive fee net investment income, respectively.



Borrowings under the Credit Facility were $91.0 million and $110.0 million as of June 30, 2014 and December 31, 2013, respectively.

For the three months ended June 30, 2014, the Company recorded interest expense and other fees of $1.4 million, of which $0.9 million was interest and commitment fees on the Credit Facility, $253 thousand was interest on the Notes, $151 thousand was administration fees and amortization of the loan fees paid on the Credit Facility, and $28 thousand was administration and amortization of the loan fees and paid on the Notes. The Company paid $1.0 million in interest expense for the three months ended June 30, 2014. For the six months ended June 30, 2014, the Company recorded interest expense and other fees of $2.4 million, of which $1.9 million was interest and commitment fees on the Credit Facility, $253 thousand was interest on the Notes, $296 thousand was administration fees and amortization of the loan fees paid on the Credit Facility, and $28 thousand was amortization of the loan fees paid on the Notes. The Company paid $1.9 million in interest expense for the six months ended June 30, 2014. For the three months ended June 30, 2013, the Company recorded interest and fee expense of $0.7 million for the three months ended June 30, 2014, of which $0.6 million was interest and commitment fees on the Credit Facility and $138 thousand was administration fees and amortization of loan fees paid on the Credit Facility. The Company paid $0.5 million in interest expense for the three months ended June 30, 2014. For the six months ended June 30, 2013, the Company recorded interest and fee expense of $1.3 million for the six months ended June 30, 2014, of which $1.0 million was interest and commitment fees on the Credit Facility and $274 thousand was administration fees and amortization of loan fees paid on the Credit Facility. The Company paid $0.9 million in interest expense for the six months ended June 30, 2014. Administrative expenses for the three months ended June 30, 2014 totaled $275 thousand, $127 thousand of which was related to our third party administrator and $148 thousand of which was allocated to us from Stellus Capital. Administrative expenses for the six months ended June 30, 2014 totaled $544 thousand, $255 thousand of which was related to our third party administrator and $289 thousand of which was allocated to us from Stellus Capital. Administrative expenses for the three months ended June 30, 2013 totaled $228 thousand, $111 thousand of which was related to our third party administrator and $117 million of which was allocated to us from Stellus Capital. Expenses for valuation, professional fees, insurance expenses, and directors' fees and other general and administrative expense for the three and six months ended June 30, 2014 totaled $0.5 million and $1.1 million, respectively. Expenses for valuation, professional fees, insurance expenses, and directors' fees and other general and administrative expense for both the three and six months ended June 30, 2013 totaled $0.1 million.



Net Investment Income

For the three months ended June 30, 2014, net investment income was $3.7 million, or $0.31 per common share (based on 12,132,851 weighted-average common shares outstanding at June 30, 2014). Net investment income includes expense accruals of $7 thousand of incentive fees related to realized and unrealized gains. For the three months ended June 30, 2013, net investment income was $4.0 million, or $0.33 per common share (based on 12,050,618 weighted-average common shares outstanding at June 30, 2013). Net investment income included expense accruals of $101 thousand of incentive fees related to realized and unrealized gains. For the six months ended June 30, 2014, net investment income was $7.5 million, or $0.62 per common share (based on 12,118,498 weighted-average shares outstanding at June 30, 2014). Net investment income includes expense accruals of ($82) thousand of incentive fees related to realized and unrealized gains. For the six months ended June 30, 2013, net investment income was $7.7 million, or $0.64 per common share (based on 12,043,117 weighted-average common shares outstanding at June 30, 2013). Net investment income included accruals of $469 thousand of incentive fees related to realized and unrealized capital gains. 40 --------------------------------------------------------------------------------

TABLE OF CONTENTS Net Realized Gains and Losses We measure realized gains or losses by the difference between the net proceeds from the repayment or sale and the amortized cost basis of the investment, using the specific identification method, without regard to unrealized appreciation or depreciation previously recognized. Repayments of investments and amortization of other certain investments for the three months ended June 30, 2014 totaled $25.9 million and net realized gains totaled $0.3 million. Repayments of investments and amortization of other certain investments for the three months ended June 30, 2013 totaled $23.8 million and net realized gains totaled $0.1 million.



Repayments of investments and amortization of other certain investments for the six months ended June 30, 2014 totaled $48.3 million and net realized gains totaled $0.4 million.

Repayments of investments and amortization of other certain investments for the six months ended June 30, 2013 totaled $49.0 million and net realized gains totaled $1.0 million.

Net Change in Unrealized Appreciation of Investments

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

Net change in unrealized appreciation (depreciation) on investments and cash equivalents for the three months ended June 30, 2014 and 2013 totaled ($1.3) million and $0.4 million, respectively.



Net change in unrealized appreciation (depreciation) on investments and cash equivalents for the six months ended June 30, 2014 and 2013 totaled ($0.8) million and $1.3 million, respectively

The change in unrealized appreciation (depreciation) was due primarily to unrealized depreciation on our one non-accrual investment and was partially offset by net unrealized appreciation on other investments in the portfolio due to a tightening of market interest rate spreads.

Net Increase in Net Assets Resulting from Operations

For the three months ended June 30, 2014, net increase in net assets resulting from operations totaled $2.7 million, or $0.22 per common share (based on 12,132,851 weighted-average common shares outstanding at June 30, 2014.

For the three months ended June 31, 2013, net increase in net assets resulting from operations totaled $4.5 million, or $0.37 per common share (based on 12,050,618 weighted-average common shares outstanding at June 30, 2013.

For the six months ended June 30, 2014, net increase in net assets resulting from operations totaled $7.1 million, or $0.58 per common share (based on 12,118,498 weighted-average common shares outstanding at June 30, 2013.

For the six months ended June 30, 2013, net increase in net assets resulting from operations totaled $10.0 million, or $0.83 per common share (based on 12,043,117 weighted-average common shares resulting from operations at June 30, 2013.



The decline in net increase in net assets resulting from operations was due primarily to unrealized depreciation on our one non-accrual investment which was partially offset by realized gains and unrealized appreciation on other investments in the portfolio due to a tightening of market interest rate spreads.

Financial condition, liquidity and capital resources Cash Flows from Operating and Financing Activities

Our operating activities provided cash of $4.8 million for the six months ended June 30, 2014, primarily in connection with cash interest received and the net repayment of our investments. Our financing activities for the six months ended June 30, 2014 used cash of $8.3 million primarily from net repayments under the Credit Facility. 41

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Our operating activities used cash of $60.3 million for the six months ended June 30, 2013, primarily in connection with purchase of portfolio investments. Our financing activities for the six months ended June 30, 2013 provided cash of $9.1 million primarily from additional borrowings under the Credit Facility. Our liquidity and capital resources are derived from the Credit Facility and Notes and cash flows from operations, including investment sales and repayments, and income earned. Our primary use of funds from operations includes investments in portfolio companies and other operating expenses we incur, as well as the payment of dividends to the holders of our common stock. We used, and expect to continue to use, these capital resources as well as proceeds from turnover within our portfolio and from public and private offerings of securities to finance our investment activities. Although we expect to fund the growth of our investment portfolio through the net proceeds from future public and private equity offerings and issuances of senior securities or future borrowings to the extent permitted by the 1940 Act, our plans to raise capital may not be successful. In this regard, if our common stock trades at a price below our then-current net asset value per share, we may be limited in our ability to raise equity capital given that we cannot sell our common stock at a price below net asset value per share unless our stockholders approve such a sale and our board of directors makes certain determinations in connection therewith. A proposal, approved by our stockholders at our 2014 Annual Meeting of Stockholders, authorizes us to sell shares equal to up to 25% of our outstanding common stock of our common stock below the then current net asset value per share of our common stock in one or more offerings for the period ending on the earlier of (i) June 7, 2015, the one year anniversary of our 2014 Annual Meeting of Stockholders, or (ii) the date of our 2015 Annual Meeting of Stockholders. We would need similar future approval from our stockholders to issue shares below the then current net asset value per share any time after the expiration of the current approval. In addition, we intend to distribute between 90% and 100% of our taxable income to our stockholders in order to satisfy the requirements applicable to RICs under Subchapter M of the Code. Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio companies or to repay borrowings. In addition, the illiquidity of our portfolio investments may make it difficult for us to sell these investments when desired and, if we are required to sell these investments, we may realize significantly less than their recorded value. Also, as a business development company, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, to total senior securities, which include all of our borrowings and any outstanding preferred stock, of at least 200%. This requirement limits the amount that we may borrow. We were in compliance with the asset coverage at all times. As of June 30, 2014 and December 31, 2013 our asset coverage ratio was 253% and 248%, respectively. The amount of leverage that we employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing, such as the maturity, covenant package and rate structure of the proposed borrowings, our ability to raise funds through the issuance of shares of our common stock and the risks of such borrowings within the context of our investment outlook. Ultimately, we only intend to use leverage if the expected returns from borrowing to make investments will exceed the cost of such borrowing. As of June 30, 2014 and December 31, 2013, we had cash of $10.2 million and $13.6 million, respectively, and United States Treasury securities of approximately $0 million and $10.0 million, respectively.



Credit Facility

On November 7, 2012, the Company entered into a revolving credit facility (the "Credit Facility") with various lenders. SunTrust Bank is one of the lenders and serves as administrative agent under the Credit Facility. The Credit Facility originally provided for borrowings in an aggregate amount up to $115,000,000 on a committed basis and an accordion for an additional $35,000,000 for a total facility size of $150,000,000. On July 30, 2013, the Company partially exercised the accordion feature under its Credit Facility and received additional commitments from the existing bank group in the amount of $20,000,000 which increased the total commitment to $135,000,000 under the facility. On May 16, 2014, the Company exercised the remainder of the accordion feature under its Credit Facility and received an additional commitments from a new participant in the bank group in the amount of $15,000,000 which increased the total commitment to $150,000,000 under the facility. 42 --------------------------------------------------------------------------------



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Borrowings under the Credit Facility generally bear interest at LIBOR plus 3.00%. The Credit Facility is a four-year revolving facility secured by substantially all of our investment portfolio assets. The Credit Facility contains affirmative and restrictive covenants, including but not limited to maintenance of a minimum shareholders' equity amount and maintenance of a ratio of total assets (less total liabilities other than indebtedness) to total indebtedness of not less than 2.0:1.0. In addition to the asset coverage ratio described in the preceding sentence, borrowings under the Credit Facility (and the incurrence of certain other permitted debt) are subject to compliance with a borrowing base that applies different advance rates to different types of assets in our portfolio. We have also generally agreed under the terms of the Credit Facility not to incur any additional secured indebtedness. In addition, we have agreed not to incur any additional unsecured indebtedness that has a maturity date prior to the maturity date of the Credit Facility. Furthermore, the Credit Facility contains a covenant requiring us to maintain compliance with RIC provisions at all times, subject to certain remedial provisions. Unless extended, the period during which the Company may make and reinvest borrowings under the Credit Facility will expire on November 13, 2015 and the maturity date of the Credit Facility is November 12, 2016. As of June 30, 2014 and December 31, 2013, $91 million and $110 million was outstanding under the Credit Facility, respectively. The Company incurred costs of $2.0 million in connection with obtaining the Credit Facility, which the Company has recorded as prepaid loan structure fees on its statement of assets and liabilities and is amortizing these fees over the life of the Credit Facility. During the year ended December 31, 2013, the Company incurred costs of $113,384 in connection with the $20,000,000 commitment increase. During the quarter ended June 30, 2014 the Company incurred additional costs of $77,748 in connection with the final $15,000,000 commitment increase. As of June 30, 2014 and December 31, 2013, $1.4 million and $1.6 million of such prepaid loan structure fees had yet to be amortized, respectively. For the three months ended June 30, 2014, the effective interest rate under the Credit Facility was approximately 3.2% (approximately 3.9% including commitment and other loan fees). Interest is paid quarterly in arrears. For the three months ended June 30, 2013, the effective interest rate under the Credit Facility was approximately 3.3% (approximately 4.7% including commitment and other loan fees). Interest is paid quarterly in arrears. For the six months ended June 30, 2014, the effective interest rate under the Credit Facility was approximately 3.2% (approximately 3.9% including commitment and other loan fees). Interest is paid quarterly in arrears. For the six months ended June 30, 2013, the effective interest rate under the Credit Facility was approximately 3.3% (approximately 5.0% including commitment and other loan fees). Interest is paid quarterly in arrears.



Note Offering

On May 5, 2014, the Company closed a public offering of $25.0 million in aggregate principal amount of 6.50% notes (the "Notes"). The Notes mature on April 30, 2019, and may be redeemed in whole or in part at any time or from time to time at the Company's option on or after April 30, 2016. The Notes bear interest at a rate of 6.50% per year payable quarterly on February 15, May 15, August 15 and November 15, of each year, beginning August 15, 2014. The net proceeds to the Company from the sale of the Notes, after underwriting discounts and offering expenses, were approximately $24.1 million. The Company used all of the net proceeds from this offering to repay a portion of the amount outstanding under the Credit Facility. As of June 30, 2014 the carrying amount of the Notes was approximately $25.0 million. As of June 30, 2014, the fair value of the Notes were $26.4 million. The Company has listed the Notes on New York Stock Exchange under the trading symbol "SCQ". In connection with the issuance of the Notes, we incurred $0.9 million of fees which are being amortized over the term of the notes of which $0.9 million remains to be amortized and is included within deferred financing costs on the consolidated statements of assets and liabilities.



Other

On June 20, 2014, the Company's wholly owned subsidiary, Stellus Capital SBIC LP (the "SBIC subsidiary") received a license from the Small Business Administration, or "SBA", to operate as a Small Business Investment Company ("SBIC") under Section 301(c) of the Small Business Investment Company

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Act of 1958. As of June 30, 2014, the SBIC had $31.8 million of regulatory capital, which implies a maximum borrowing of $63.6 million, subject to the criteria discussed above.

The SBIC license allows the SBIC to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and other customary procedures. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and have a ten year maturity. The principal amount of SBA-guaranteed debentures is not required to be paid prior to maturity but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed on a semi-annual basis at a market-driven spread over U.S. Treasury Notes with 10-year maturities. The SBA, as a creditor, will have a superior claim to the SBIC's assets over the Company's stockholders in the event the Company liquidates the SBIC or the SBA exercises its remedies under the SBA-guaranteed debentures issued by the SBIC upon an event of default. As of June 30, 2014, the SBIC has not received a commitment letter from the SBA for any SBA-guaranteed debentures and, therefore, the SBIC has not yet issued any SBA-guaranteed debentures. SBA regulations currently limit the amount that the SBIC may borrow to a maximum of $150 million when it has at least $75 million in regulatory capital, receives a capital commitment from the SBA and has been through an examination by the SBA subsequent to licensing.



Off-Balance Sheet Arrangements

We may be a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our portfolio companies. As of June 30, 2014, our off-balance sheet arrangements consisted of $12.6 million of unfunded commitments, which was comprised of $12.4 million to provide debt financing to three of our portfolio companies and $0.2 million to provide equity financing to one portfolio company. As of December 31, 2013, our off-balance sheet arrangements consisted of $20.9 million of unfunded commitments, which was comprised of $20.9 million to provide debt financing to three of our portfolio companies.



Regulated Investment Company Status and Dividends

We have elected to be treated as a RIC under Subchapter M of the Code. So long as we maintain our status as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders on a timely basis. Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation until realized. Dividends declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital. To qualify for RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company net taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any). If we maintain our qualification as a RIC, we must also satisfy certain distribution requirements each calendar year in order to avoid a federal excise tax on or undistributed earnings of a RIC. We intend to distribute to our stockholders between 90% and 100% of our annual taxable income (which includes our taxable interest and fee income). However, the covenants contained in the Credit Facility may prohibit us from making distributions to our stockholders, and, as a result, could hinder our ability to satisfy the distribution requirement. In addition, we may retain for investment some or all of our net taxable capital gains (i.e., realized net long-term capital gains in excess of realized net short-term capital losses) and treat such amounts as deemed distributions to our stockholders. If we do this, our stockholders will be treated as if they received actual distributions of the capital gains we retained and then reinvested the net after-tax proceeds in our common stock. Our stockholders also may be eligible to claim tax credits (or, in certain circumstances, tax refunds) equal to their allocable share of the tax we paid on the capital gains deemed distributed to them. To the extent our taxable earnings for a fiscal taxable year fall below the total amount of our dividends for that fiscal year, a portion of those dividend distributions may be deemed a return of capital to our stockholders. 44 --------------------------------------------------------------------------------



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We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a business development company under the 1940 Act and due to provisions in Credit Facility. We cannot assure stockholders that they will receive any distributions or distributions at a particular level. In accordance with certain applicable Treasury regulations and private letter rulings issued by the Internal Revenue Service, a RIC may treat a distribution of its own stock as fulfilling its RIC distribution requirements if each stockholder may elect to receive his or her entire distribution in either cash or stock of the RIC, subject to a limitation that the aggregate amount of cash to be distributed to all stockholders must be at least 20% of the aggregate declared distribution. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a pro rata amount of cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive less than 20% of his or her entire distribution in cash. If these and certain other requirements are met, for U.S. federal income tax purposes, the amount of the dividend paid in stock will be equal to the amount of cash that could have been received instead of stock. We have no current intention of paying dividends in shares of our stock in accordance with these Treasury regulations or private letter rulings.



Recent Accounting Pronouncements

See Note 1 to the consolidated financial statements for a description of recent accounting pronouncements, if any, including the expected dates of adoption and the anticipated impact on the financial statements.



Critical Accounting Policies

The preparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Changes in the economic environment, financial markets and any other parameters used in determining such estimates could cause actual results to differ. In addition to the discussion below, our significant accounting policies are further described in the notes to the financial statements.



Valuation of portfolio investments

As a business development company, we generally invest in illiquid loans and securities including debt and equity securities of middle-market companies. Under procedures established by our board of directors, we value investments for which market quotations are readily available at such market quotations. We obtain these market values from an independent pricing service or at the mean between the bid and ask prices obtained from at least two brokers or dealers (if available, otherwise by a principal market maker or a primary market dealer). Debt and equity securities that are not publicly traded or whose market prices are not readily available are valued at fair value as determined in good faith by our board of directors. Such determination of fair values may involve subjective judgments and estimates, although we engage independent valuation providers to review the valuation of each portfolio investment that does not have a readily available market quotation at least twice annually. Investments purchased within 60 days of maturity are valued at cost plus accreted discount, or minus amortized premium, which approximates value. With respect to unquoted securities, our board of directors, together with our independent valuation advisors, values each investment considering, among other measures, discounted cash flow models, comparisons of financial ratios of peer companies that are public and other factors. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, our board of directors uses the pricing indicated by the external event to corroborate and/or assist us in our valuation. Because there is not a readily available market for substantially all of the investments in our portfolio, we value most of our portfolio investments at fair value as determined in good faith by our board of directors using a documented valuation policy and a consistently applied valuation process. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ significantly from the values that would have been used had a readily available market value existed for such investments, and the differences could be material.



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

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



Preliminary valuation conclusions are then documented and discussed with

our senior management and Stellus Capital Management; The audit committee of our board of directors then reviews these preliminary valuations;



At least twice annually, the valuation for each portfolio investment is

reviewed by an independent valuation firm; and

The board of directors then discusses valuations and determines the fair

value of each investment in our portfolio in good faith, based on the input

of Stellus Capital Management, the independent valuation firm and the audit

committee. Revenue recognition We record interest income on an accrual basis to the extent that we expect to collect such amounts. For loans and debt securities with contractual PIK interest, which represents contractual interest accrued and added to the loan balance that generally becomes due at maturity, we do not accrue PIK interest if the portfolio company valuation indicates that such PIK interest is not collectible. We will not accrue interest on loans and debt securities if we have reason to doubt our ability to collect such interest. Loan origination fees, original issue discount and market discount or premium are capitalized, and we then accrete or amortize such amounts using the effective interest method as interest income. Upon the prepayment of a loan or debt security, any unamortized loan origination is recorded as interest income. We record prepayment premiums on loans and debt securities as interest income. Dividend income, if any, will be recognized on the ex-dividend date.



Unrealized Gains Incentive Fee

Under GAAP, the Company calculates the unrealized gains incentive fee payable to the Advisor as if the Company had realized all investments at their fair values as of the reporting date. Accordingly, the Company accrues a provisional unrealized gains incentive fee taking into account any unrealized gains or losses. As the provisional incentive fee is subject to the performance of investments until there is a realization event, the amount of provisional unrealized gains incentive fee accrued at a reporting date may vary from the incentive fee that is ultimately realized and the differences could be material.


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