The following discussion and analysis should be read in conjunction with our
consolidated financial statements and related notes and other financial
information appearing elsewhere in this Quarterly Report on Form 10-Q.
Except as otherwise specified, references to "we," "us," "our" or the "Company", refer to
This Quarterly Report, including Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve substantial risks and uncertainties. These forward-looking statements are not historical facts, but rather are based on current expectations, estimates and projections about the Company, our current and prospective portfolio investments, our industry, our beliefs, and our assumptions. Words such as "anticipates," "expects," "intends," "plans," "will," "may," "continue," "believes," "seeks," "estimates," "would," "could," "should," "targets," "projects," and variations of these words and similar expressions are intended to identify forward-looking statements.
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 impact of investments that we expect to make; • our contractual arrangements and relationships with third parties;
• the dependence of our future success on the general economy and its
impact on the industries in which we invest; • the ability of our portfolio companies to achieve their objectives; • our expected financings and investments; • the adequacy of our cash resources and working capital; and • the timing of cash flows, if any, from the operations of our portfolio companies. These statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements, including without limitation: • an economic downturn could impair our portfolio companies' ability to continue to operate or repay their borrowings, which could lead to the loss of some or all of our investments in such portfolio companies; • a contraction of available credit and/or an inability to access the equity markets could impair our lending and investment activities; • interest rate volatility could adversely affect our results, particularly if we use leverage as part of our investment strategy; and • the risks, uncertainties and other factors we identify in "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q. 35 Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also could be inaccurate. Important assumptions include our ability to originate new loans and investments, certain margins and levels of profitability and the availability of additional capital. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this Quarterly Report on Form 10-Q should not be regarded as a representation by us that our plans and objectives will be achieved. These risks and uncertainties include those described or identified in "Risk Factors" in our Annual Report on Form 10-
K. Youshould not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. 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 U.S. Securities and Exchange Commission("SEC") rule or regulation. OVERVIEW We are a Marylandcorporation that has elected to be regulated as a business development company ("BDC") under the Investment Company Act of 1940 (the "1940 Act"). We are an emerging growth company within the meaning of the Jumpstart Our Business Startups Act of 2012 (the "JOBS Act"), and as such, are subject to reduced public company reporting requirements. Our investment objective is to generate both current income and capital appreciation through debt and equity investments. We are managed by Capitala Investment Advisors, LLC(the "Investment Advisor"), and Capitala Advisors Corp.(the "Administrator") provides the administrative services necessary for us to operate.
We provide capital to smaller and lower middle-market companies in
We invest in mezzanine and senior subordinated debt investments that are secured by subordinated liens on all of our borrowers' assets and, to a lesser extent, in senior, cash flow-based "unitranche" securities. Most of our debt investments are coupled with equity interests, whether in the form of detachable "penny" warrants or equity co-investments made pari passu with our borrowers' financial sponsors. 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. In addition, we are only allowed to borrow money such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such borrowing, with certain limited exceptions. To maintain our regulated investment company ("RIC") status, we must meet specified source-of-income and asset diversification requirements. To maintain our RIC tax treatment under subchapter M for U.S. federal income tax purposes, we must distribute at least 90% of our net ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, for the taxable year. Corporate History We commenced operations on
May 24, 2013and completed our initial public offering ("IPO") on September 30, 2013. The Company was formed for the purpose of (i) acquiring, through a series of transactions, an investment portfolio from the following entities: CapitalSouth Partners Fund I Limited Partnership("Fund I"); CapitalSouth Partners Fund II Limited Partnership("Fund II"); CapitalSouth Partners Fund III, L.P.("Fund III Parent"); CapitalSouth Partners SBIC Fund III, L.P.("Fund III") and CapitalSouth Partners Florida Sidecar Fund I, L.P.("Florida Sidecar" and, collectively with Fund I, Fund II, Fund III and Fund III Parent, the "Legacy Funds"); (ii) raising capital in the IPO and (iii) continuing and expanding the business of the Legacy Funds by making additional debt and equity investments in smaller and lower middle market companies. 36
September 24, 2013, the Company acquired 100% of the limited partnership interests in Fund II, Fund III and Florida Sidecar and each of their respective general partners, as well as certain assets from Fund I and Fund III Parent, in exchange for an aggregate of 8,974,420 shares of the Company's common stock (the "Formation Transactions"). Fund II, Fund III and Florida Sidecar became the Fund's wholly-owned subsidiaries. Fund II and Fund III retained their SBIC licenses and continue to hold their existing investments and continue to make new investments. The IPO consisted of the sale of 4,000,000 shares of the Company's common stock at a price of $20.00per share resulting in net proceeds to the Company of $74.25 million, after deducting underwriting fees and commissions totaling $4.0 millionand offering expenses totaling $1.75 million. The other costs of the IPO were borne by the limited partners of the Legacy Funds. As of June 30, 2014, the Company had 12,974,420 shares of common stock outstanding. At the time of the Formation Transactions, our portfolio consisted of: (i) approximately $326.3 millionin investments; (ii) an aggregate of approximately $67.1 millionin cash, interest receivable and other assets; and (iii) liabilities of approximately $202.2 millionof SBA-guaranteed debt payable. We have two SBIC-licensed subsidiaries that have elected to be regulated as BDCs under the 1940 Act. We may also seek other forms of leverage and borrow funds to make investments, including before we have fully invested the proceeds of this offering. Basis of Presentation The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in conformity with U.S. generally accepted accounting principles ("U.S. GAAP"). The consolidated financial statements of the Company include the accounts of the Company and its wholly-owned subsidiaries as described in the Formation Transactions presented in Note 1 to our Consolidated Financial Statements. The transactions related to Fund II, Fund III, and the Florida Sidecar constitute an exchange of shares between entities under common control and will be accounted for in accordance with the Accounting Standards Codification ("ASC"), Topic 805, Business Combinations("ASC 805"). As such, the results of the Company's operations and cash flows for the six months ended June 30, 2013, have been presented on a combined basis in order to provide comparative information with respect to prior periods. The Formation Transactions also included an asset acquisition of certain assets in Fund I and Fund III Parent. In accordance with ASC 805, the assets acquired were recorded at fair value at the date of acquisition, September 24, 2013. The Company's financial position as of June 30, 2014is presented on a consolidated basis. The effects of all intercompany transactions between the Company and its subsidiaries (Fund II, Fund III, and the Florida Sidecar) have been eliminated in consolidation. All financial data and information included in these financial statements have been presented on the basis described above. In the opinion of management, the financial statements reflect all adjustments that are necessary for the fair presentation of financial results as of and for
the periods presented. Revenues We generate revenue primarily from the periodic cash interest we will collect on our debt investments. In addition, most of our debt investments offer the opportunity to participate in a borrower's equity performance through warrant participation, direct equity ownership or otherwise, which we expect to result in revenue in the form of dividends and/or capital gains. Further, we may generate revenue in the form of commitment, origination, structuring or diligence fees, monitoring fees, fees for providing managerial assistance and possibly consulting fees and performance-based fees. These fees will be recognized as they are earned. Expenses Our primary operating expenses include the payment of investment advisory fees to our Investment Adviser, our allocable portion of overhead and other expenses incurred by our Administrator in performing its obligations under the Administration Agreement and other operating expenses as detailed below. Our investment advisory fee will compensate our Investment Adviser for its work in identifying, evaluating, negotiating, closing, monitoring and servicing our investments. We will bear all other expenses of our operations and transactions, including (without limitation): • the cost of our organization; 37 • 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 our shares and other
securities; • interest payable on debt, if any, to finance our investments; • fees payable to third parties relating to, or associated with, making investments, including fees and expenses associated with performing due diligence reviews of prospective investments and advisory fees; • transfer agent and custodial fees; • fees and expenses associated with marketing efforts; • costs associated with our reporting and compliance obligations under the 1940 Act, the Securities Exchange Act of 1934 (the "Exchange Act"), other applicable federal and state
and ongoing stock exchange listing fees; • federal, state and local taxes; • independent directors' fees and expenses; • brokerage commissions; • costs of proxy statements, stockholders' reports and other communications with stockholders;
• fidelity bond, directors' and officers' liability insurance, errors
and omissions liability insurance and other insurance premiums; • direct costs and expenses of administration, including printing, mailing, telephone and staff; • fees and expenses associated with independent audits and outside legal costs; and • all other expenses incurred by either our Administrator or us in connection with administering our business, including payments under the Administration Agreement that will be based upon our allocable portion of overhead and other expenses incurred by our Administrator in performing its obligations under the Administration Agreement, including rent, the fees and expenses associated with performing compliance functions, and our allocable portion of any costs of compensation and related expenses of our chief compliance officer and our chief financial officer and any administrative support staff.
Critical Accounting Policies and Use of Estimates
In the preparation of our consolidated financial statements and related disclosures, we have adopted various accounting policies that govern the application of U.S. GAAP. Our significant accounting policies are described in Note 2 to our Consolidated Financial Statements. While all of these policies are important to understanding our consolidated financial statements, certain accounting policies and estimates are considered critical due to their impact on the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses for the periods covered by such financial statements. We have identified investment valuation, revenue recognition, and income taxes as our most critical accounting estimates. We continuously evaluate our estimates, including those related to the matters described below. Because of the nature of the judgment and assumptions we make, actual results could materially differ from those estimates under different assumptions or conditions. A discussion of our critical accounting policies follows. 38 Valuation of Investments The Company applies fair value accounting to all of its financial instruments in accordance with the 1940 Act and ASC Topic 820 - Fair Value Measurements and Disclosures ("ASC 820"). ASC 820 defines fair value, establishes a framework used to measure fair value and requires disclosures for fair value measurements. In accordance with ASC 820, the Company has categorized its financial instruments carried at fair value, based on the priority of the valuation technique, into a three-level fair value hierarchy as discussed in Note 4 to our Consolidated Financial Statements. In determining fair value, our board of directors (the "Board") uses various valuation approaches, and engages a third-party independent valuation firm, which provides positive assurance on the investments they review. In accordance with U.S. GAAP, a fair value hierarchy for inputs is used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Board. Unobservable inputs reflect the Boards' assumptions about the inputs market participants would use in pricing the asset or liability developed based upon the best information available in the circumstances. The fair value hierarchy is categorized into three levels based on the inputs as follows: Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not applied to Level 1 securities. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment.
Level 2 - Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
The availability of valuation techniques and observable inputs can vary from security to security and is affected by a wide variety of factors including, the type of security, whether the security is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Those estimated values do not necessarily represent the amounts that may be ultimately realized due to the occurrence of future circumstances that cannot be reasonably determined. Because of the inherent uncertainty of valuation, those estimated values may be materially higher or lower than the values that would have been used had a market for the securities existed. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for securities categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls, is determined based on the lowest level input that is significant to the fair value measurement. Fair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the Company's own assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date. We use prices and inputs that are current as of the measurement date, including periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many securities. This condition could cause a security to be reclassified to a lower level within the fair value hierarchy. 39 Valuation Techniques
Senior and Subordinated Secured Loans
The Company's portfolio primarily consists of private debt instruments ("Level 3 debt"). We consider our Level 3 debt to be performing loans if the borrower is not in default, the borrower is remitting payments in a timely manner, the loan is in covenant compliance or is otherwise not deemed to be impaired. In determining the fair value of the performing Level 3 debt, the Company's Board considers fluctuations in current interest rates, the trends in yields of debt instruments with similar credit ratings (if applicable), the financial condition of the borrower, economic conditions and other relevant factors, both qualitative and quantitative. In the event that a Level 3 debt instrument is not performing, as defined above, the Board will evaluate the value of the collateral utilizing the same framework described above for a performing loan to determine the value of the Level 3 debt instrument. This evaluation will be updated no less than quarterly for Level 3 debt instruments that are not performing, and more frequently for time periods where there are significant changes in the collateral or significant changes in the perceived performance of the underlying portfolio company. The collateral value will be analyzed on an ongoing basis using internal metrics, appraisals, third-party valuation agents and other data as may be acquired and analyzed
by our management and Board.
Equity Investments in Private Companies
Our Board determines the fair value of its investments in private companies by incorporating valuations that consider the evaluation of financing and sale transactions with third-parties, expected cash flows and market-based information, including comparable transactions, and performance multiples, among other factors, and may use third-party valuation agents. Such non-public investments are included in Level 3 of the fair value hierarchy. Warrants
Our Board will ascribe value to warrants based on fair value holdings that can include discounted cash flow analyses, option pricing models, comparable analyses and other techniques as deemed appropriate. Such warrants are included in Level 3 of the fair value hierarchy to the extent issued by non-public companies. Revenue Recognition
The Company's revenue recognition policies are as follows:
Interest Income and Paid-in Kind Interest Income: Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. The company has loans in the portfolio that contain a payment-in-kind ("PIK") provision. The PIK interest, which represents contractually deferred interest added to the loan balance that is generally due at maturity, is recorded on the accrual basis to the extent that such amounts are expected to be collected. PIK interest is not accrued if the Company does not expect the issuer to be able to pay all principal and interest when due. Non-accrual income: Generally, when interest and/or principal payments on a loan become materially past due, or if the Company otherwise does not expect the borrower to be able to service its debt and other obligations, the Company will place the loan on non-accrual status, and will generally cease recognizing interest income and PIK on that loan for financial reporting purposes. Interest payments received on non-accrual loans may be recognized as income or applied to principal depending upon management's judgment. The Company writes off any previously accrued and uncollected interest when it is determined that interest is no longer considered collectible. The company may elect to cease accruing PIK and continue accruing interest income in cases where a loan is currently paying interest income but, in management's judgment, there is a reasonable likelihood of principal loss on the loan. Non-accrual loans are returned to accrual status when the borrower's financial condition improves such that management believes current interest and principal payments are expected to be collected.
Gains and Losses on investment sales and paydowns: Realized gains and losses on investments are recognized using the specific identification method.
40 Dividend Income and Paid-in-kind Dividends: Dividend income is recognized on the date dividends are declared. The Company holds preferred equity investments in the portfolio that contain a payment-in-kind dividend ("PIK dividends") provision. PIK dividends, which represent contractually deferred dividends added to the equity balance, are recorded on the accrual basis to the extent that such amounts are expected to be collected. The Company will typically cease accrual of PIK dividends when the fair value of the equity investment is less than the cost basis of the investment or when it is otherwise determined by management that collection of PIK dividends are unlikely to be collected. If management determines that a decline in fair value is temporary in nature and the PIK dividends are more likely than not to be collected, management may elect to continue accruing PIK dividends. Other Income: Origination, amendment, consent, closing and/or commitment fees associated with investments in portfolio companies are recognized as income when the investment transaction closes. Prepayment penalties received by the Company for debt instruments repaid prior to maturity date are recorded as income upon receipt. Income Taxes Prior to the Formation Transactions, the Legacy Funds were treated as partnerships for U.S. federal, state and local income tax purposes and, therefore, no provision has been made in the accompanying consolidated financial statements for federal, state or local income taxes. In accordance with the partnership tax law requirements, each partner would include their respective components of the Legacy Funds' taxable profits or losses, as shown on their Schedule K-1s in their respective tax or information returns. The Legacy Funds are disregarded entities for tax purposes prior to and post the Formation Transactions. The Company intends to elect to be treated for federal income tax purposes, and intends to qualify annually thereafter, as a RIC under Subchapter M of the Code and, among other things, intends to make the requisite distributions to its stockholders which will relieve the Company from federal income taxes. Therefore, no provision has been recorded for federal income taxes. In order to qualify as a RIC, among other requirements, the Company is required to timely distribute to its stockholders at least 90.0% of its investment company taxable income, as defined by the Code, for each fiscal tax year. The Company will be subject to a nondeductible U.S. federal excise tax of 4.0% on undistributed income if it does not distribute at least 98.0% of its ordinary income in any calendar year and 98.2% of its capital gain net income for each one-year period ending on
October 31. Depending on the level of taxable income earned in a tax year, the Company may choose to carry forward taxable income in excess of current year dividend distributions into the next tax year and pay a 4.0% excise tax on such income, as required. To the extent that the Company determines that its estimated current year annual taxable income will be in excess of estimated current year dividend distributions for excise tax purposes, the Company accrues excise tax, if any, on estimated excess taxable income as taxable income is earned. 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 on the aggregate amount of cash to be distributed to all stockholders, which limitation must be at least 20.0% of the aggregate declared distribution. If too many stockholders elect to receive cash, each stockholder electing to receive cash will 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 20.0% 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. ASC Topic 740, Income Taxes ("ASC 740"), provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the consolidated financial statements. ASC 740 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company's tax returns to determine whether the tax positions are "more-likely-than-not" of being sustained by the applicable tax authority. Tax positions deemed to meet a "more-likely-than-not" threshold would be recorded as a tax benefit or expense in the current period. The Company recognizes interest and penalties, if any, related to unrecognized tax benefits as income tax expense in the consolidated statements of operations. As of June 30, 2014and December 31, 2013, there
were no uncertain tax positions. 41
The Company is required to determine whether a tax position of the Company is more likely-than-not to be sustained upon examination by the applicable taxing authority, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The tax benefit to be recognized is measured as the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. De-recognition of a tax benefit previously recognized could result in the Company recording a tax liability that could have a negative impact the Company's net assets.
U.S. GAAP provides guidance on thresholds, measurement, de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition that is intended to provide better financial statement comparability among different entities.
The Company has concluded that it was not necessary to record a liability for any such tax positions as of
June 30, 2014and December 31, 2013. However, the Company's conclusions regarding this policy may be subject to review and adjustment at a later date based on factors including, but not limited to, ongoing analyses of, and changes to, tax laws, regulations and interpretations thereof.
The Company's activities from commencement of operations remain subject to examination by U.S. federal, state, and local tax authorities. No interest expense or penalties have been assessed for the three and six month periods ended
June 30, 2014and June 30, 2013. If the Company were required to recognize interest and penalties, if any, related to unrecognized tax benefits this would be recognized as income tax expense in the consolidated statement of operations.
Portfolio and Investment Activity
During the three months ended
June 30, 2014, we made approximately $22.6 millionof investments in new or existing portfolio companies and had approximately $9.4 millionin exits and repayments resulting in net investments of approximately $13.2 millionfor the period. During the three months ended June 30, 2013, we made approximately $20.2 millionof investments in new or existing portfolio companies and had approximately $15.7 millionin exits and repayments resulting in net investments of approximately $4.5 millionfor the period. During the six months ended June 30, 2014, we made approximately $63.6 millionof investments in new or existing portfolio companies and had approximately $20.2 millionin exits and repayments resulting in net investments of approximately $43.4 millionfor the period. During the six months ended June 30, 2013, we made approximately $41.4 millionof investments in new or existing portfolio companies and had approximately $28.7 millionin exits and repayments resulting in net investments of approximately $12.7 millionfor the period. As of June 30, 2014, our average portfolio company investment and our largest portfolio company investment at amortized cost and fair value was approximately $7.7 millionand $9.0 million, and $25.5 millionand $25.5 million, respectively. As of June 30, 2014, the Company had approximately $166.5 millionof cash and cash equivalents. As of December 31, 2013, our average portfolio company investment and our largest portfolio company investment at amortized cost and fair value was approximately $7.3 millionand $8.9 million, and $25.3 millionand $25.3 million, respectively. As of December 31, 2013, the Company had $101.6 millionof cash and cash equivalents. 42 The following table summarizes the amortized cost and the fair value of investments and cash and cash equivalents as of June 30, 2014(dollars in thousands): Amortized Cost Fair Value Investments at Percentage of Investments at Percentage of Amortized Cost Total Portfolio Fair Value Total Portfolio Senior Secured Debt $ 127,02624.7 % $ 128,91322.5 % Subordinated Debt 156,534 30.4 % 151,683 26.5 % Equity and Warrants 64,186 12.5 % 124,963 21.8 % Cash and Cash Equivalents 166,503 32.4 % 166,503 29.2 % Total $ 514,249100.0 % $ 572,062100.0 % The following table summarizes the amortized cost and the fair value of investments and cash and cash equivalents as of December 31, 2013(dollars in thousands): Amortized Cost Fair Value Investments at Percentage of Investments at Percentage of Amortized Cost Total Portfolio Fair Value Total Portfolio Senior Secured Debt $ 103,45725.7 % $ 102,07121.9 % Subordinated Debt 136,638 33.9 % 133,710 28.7 % Equity and Warrants 61,204 15.2 % 128,938 27.6 % Cash and Cash Equivalents 101,622 25.2 % 101,622 21.8 % Total $ 402,921100.0 % $ 466,341100.0 % As of June 30, 2014, our income-bearing investment portfolio, which represented nearly 69% of our total portfolio, had a weighted average yield of approximately 13.4%. As of June 30, 2014, 95% of our income-bearing investment portfolio was bearing a fixed rate of interest. As of December 31, 2013, our income-bearing investment portfolio, which represented nearly 65% of our total portfolio, had a weighted average yield of approximately 13.7% all bearing a fixed rate of interest.
The following table shows the portfolio composition by industry grouping at fair value (dollars in thousands):
June 30, 2014 December 31, 2013 Percentage Percentage Investments of Investments of at Total at Total Fair Value Portfolio Fair Value Portfolio
Oil & Gas Services
$ 29,9167.4 % $ 25,3217.0 % Transportation 24,482 6.0 % 6,000 1.6 % QSR Franchisee 24,099 5.9 % 24,787 6.8 %
Sales & Marketing Services 22,865 5.6 % 22,753 6.3 % Professional Employer Organization 21,369 5.3 % 22,677 6.2 % Printing Services 20,543 5.1 % 16,448 4.5 % Personal Product Manufacturer 18,157 4.5 % 14,073 3.9 % Footwear Retail 15,542 3.8 % 14,807 4.1 % Oil & Gas Engineering and Consulting Services 15,491 3.8 % 15,000 4.1 % Industrial Equipment Rental 13,333 3.3 % 22,500 6.2 % Medical Device Distributor 12,432 3.1 % 11,121 3.0 % Specialty Clothing 12,374 3.1 % 12,724 3.5 % Retail Display & Security Services 11,910 2.9 %
10,823 3.0 % QSR Franchisor 11,188 2.8 % 14,622 4.0 % Culinary Products 10,642 2.6 % 10,302 2.8 % Computer Supply Retail 10,606 2.6 % 6,673 1.8 % Restaurant 10,000 2.5 % - - %
Aerospace Parts Manufacturer 9,934 2.4 % 10,064 2.8 % Textile Equipment Manufacturer 9,786 2.4 % 9,031 2.5 % Dental Practice Management 9,004 2.2 %
9,273 2.6 % Financial Services 8,300 2.0 % - - % Energy Services 8,025 2.0 % 8,783 2.4 %
Fuel Transportation Services 7,622 1.9 %
10,274 2.8 % Conglomerate 7,225 1.8 % 7,630 2.1 % Western Wear Retail 7,177 1.8 % 4,774 1.3 % Produce Distribution 6,109 1.5 % 6,631 1.8 %
Environmental Services Products 5,230 1.3 % 5,185 1.4 % Advertising & Marketing Services 5,156 1.3 % 4,911 1.3 % Data Processing & Digital Marketing 5,061 1.2 % 5,061 1.4 % Replacement Window Manufacturer 5,042 1.2 % 6,284 1.7 % Metal Recycler 3,950 1.0 % 3,950 1.1 % Automotive Chemicals & Lubricants 3,817 0.9 % 3,886 1.1 % Petroleum Equipment Supplier 3,680 0.9 %
3,624 1.0 % Industrial Manufacturing 3,469 0.9 % 3,440 0.9 % Building Supplies 2,886 0.7 % 2,509 0.7 %
Specialty Defense Contractor 2,541 0.6 % 2,799 0.8 % Quick Lube Services 2,047 0.5 % 1,604 0.4 % Industrial Boiler Manufacturer 1,915 0.5 % 1,536 0.4 % Online Travel Sales & Marketing 1,610 0.4 % 1,638 0.4 % In-Home Healthcare Services 609 0.2 %
748 0.2 % IT Hosting Services 415 0.1 % 453 0.1 % Total
$ 405,559100.0 % $ 364,719100.0 % 43 With the exception of an $8.3 millioninvestment in an internationally headquartered company, all investments made by the Company as of June 30, 2014and December 31, 2013were made in portfolio companies located in the United States. The geographic composition is determined by the location of the corporate headquarters of the portfolio company, which may not be indicative of the primary source of the portfolio company's business. The following table shows the portfolio composition by geographic region at fair value as of June 30, 2014and December 31, 2013(dollars in thousands): June 30, 2014 December 31, 2013 Percentage Percentage Investments of Investments of at Total at Total Fair Value Portfolio Fair Value Portfolio South $ 265,27765.4 % $ 254,14369.7 % West 87,580 21.6 % 66,637 18.3 % Northeast 24,327 6.0 % 23,436 6.4 % Midwest 20,075 5.0 % 20,503 5.6 % International 8,300 2.0 % - 0.0 % Total $ 405,559100.0 % $ 364,719100.0 %
The Investment Advisor regularly assesses the risk profile of each of our investments and rates each of them based on the following categories, which we refer to as the Investment Advisor's investment credit rating:
Credit Rating Definition 1 Investments that are performing above expectations. 2 Investments that are performing within expectations, with risks that are neutral or favorable compared to risks at the time of origination. All new loans are rated '2'. 3 Investments that are performing below expectations and that require closer monitoring, but where no loss of interest, dividend or principal is expected. Companies rated '3' may be out of compliance with financial covenants, however, loan payments are generally not past due. 4 Investments that are performing below expectations and for which risk has increased materially since origination. Some loss of interest or dividend is expected but no loss of principal. In addition to the borrower being generally out of
debt covenants, loan payments may be past due (but generally not more than 180 days past due). 5 Investments that are performing substantially below
and whose risks have increased substantially since
Most or all of the debt covenants are out of compliance and payments are substantially delinquent. Some loss of principal is expected. 44
The following table shows the distribution of our investments on the 1 to 5 investment performance rating scale at fair value as of
Investments Percentage at Fair of Total Investment Performance Rating Value Investments 1
$ 199,68749.2 % 2 122,857 30.3 % 3 77,455 19.1 % 4 5,560 1.4 % 5 - - Total $ 405,559100.0 %
The following table shows the distribution of our investments on the 1 to 5 investment performance rating scale at fair value as of
Investments Percentage at Fair of Total Investment Performance Rating Value Investments 1
$ 183,19450.2 % 2 129,721 35.5 % 3 44,680 12.3 % 4 7,124 2.0 % 5 - - Total $ 364,719100.0 % As of June 30, 2014, the Company had four portfolio investments on non-accrual status with a total principal amount of $10.3 million, amortized cost of $8.6 millionand a fair value of $5.6 million, which represented 3.2%, 2.5% and 1.4% of the investment portfolio, respectively. As of December 31, 2013the Company had four portfolio investments on non-accrual status with a total principal amount of $12.1 million, amortized cost of $10.3 millionand a fair value of $6.5 millionrepresenting 3.3%, 2.8% and 1.8% of the investment portfolio,
respectively. Results of Operations
Operating results for the three and six months ended
45 For the three months ended For the six months ended June 30, June 30, June 30, June 30, 2014 2013 2014 2013 Total investment income
$ 12,526 $ 8,216 $ 24,901 $ 14,487Total expenses, net 6,892 3,558 13,546 6,539 Net investment income 5,634 4,658 11,355 7,948
Net realized gain from investments 462 365 1,682 365 Net increase (decrease) in unrealized appreciation 116 6,560 (5,607 ) 5,839 Net increase in net assets resulting from operations
$ 6,212 $ 11,583 $ 7,430 $ 14,152Investment income
The composition of our investment income for the three and six months ended
For the three months ended For the six months ended June 30, June 30, June 30, June 30, 2014 2013 2014 2013
Interest and fee income
$ 8,513 $ 6,561 $ 16,528 $ 11,865Dividend income 3,263 443 7,025 517 Payment-in-kind interest and dividend income 744 375 1,334 668 Interest from cash and cash equivalents 6 48 14 76 Other Income - 789 - 1,361 Total Investment Income $ 12,526 $ 8,216 $ 24,901 $ 14,487
For the three months ended
June 30, 2014, total investment income increased $4.3 million, or 52.5% compared to the three months ended June 30, 2013. For the six months ended June 30, 2014, total investment income increased $10.4 million, or 71.9% compared to the six months ended June 30, 2013. The increase from the prior period relates to higher dividend income mostly from recapitalizations of control investments, and higher loan interest and fee income resulting from an increasing investment portfolio. Operating expenses
The composition of our expenses for the three and six months ended
For the three months ended For the six months ended June 30, June 30, June 30, June 30, 2014 2013 2014 2013 Interest expense and amortization of deferred financing fees
$ 2,401 $ 2,226 $ 4,601 $ 4,291Management fees, net of management fee waiver 2,200 1,230 4,094 2,014 Incentive fees 1,408 - 2,838 - General and administrative expenses 883 102
2,013 234 Total expenses
$ 6,892 $ 3,558 $ 13,546 $ 6,539
For the three months ended
June 30, 2014, operating expenses increased $3.3 million, or 93.7% compared to the three months ended June 30, 2013. For the six months ended June 30, 2014, operating expenses increased $7.0 million, or 107.2% compared to the six months ended June 30, 2013. The increase from the prior period is attributable to incentive and management fees under the new advisory agreement along with increased general and administrative expenses due to regulatory and reporting costs subsequent to our IPO on September 30, 2013, and an increase in interest expense as a result of our June 2014 $113.4 millionoffering of 7.125% fixed rate notes due 2021. 46
Net realized gains/losses on sales of investments
During the three and six months ended
June 30, 2014, we recognized $0.5 millionand $1.7 million, respectively, of net realized gains on our portfolio investments. During the three and six months ended June 30, 2013, we recognized $0.4 millionand $0.4 million, respectively, of net realized gains on portfolio investments.
Net unrealized appreciation/depreciation on investments
Net change in unrealized appreciation on investments reflects the net change in the fair value of our investment portfolio. For the three months ended
June 30, 2014, we had a $0.1 millionincrease in unrealized appreciation on portfolio investments. For the six months ended June 30, 2014, we had a $5.6 milliondecrease in unrealized appreciation on portfolio investments. For the three and six months ended June 30, 2013, we had a $6.6 millionand $5.8 million, respectively, increase in unrealized appreciation on portfolio investments.
Changes in net assets resulting from operations
For the three and six months ended
June 30, 2014, we recorded a net increase in net assets resulting from operations of $6.2 millionand $7.4 million, respectively. Based on the weighted average shares of common stock outstanding for the three and six months ended June 30, 2014our per share net increase in net assets resulting from operations was $0.48and $0.57, respectively. For the three and six months ended June 30, 2013, we recorded a net increase in net assets resulting from operations of $11.6 millionand $14.2 million, respectively.
Financial Condition, Liquidity and Capital Resources
In addition to the
$74.25 millionof net proceeds from our IPO, we intend to continue to generate cash from future offerings of securities and cash flows from operations, including earnings on investments in our portfolio and future investments, as well as interest earned from the temporary investment of cash in U.S. government securities and other high-quality debt investments that mature in one year or less. In addition to our existing SBA-guaranteed debentures, we may, if permitted by regulation, seek to issue additional SBA-guaranteed debentures as well as other forms of leverage and borrow funds to make investments. On June 10, 2014, we received an exemptive order from the SECexempting us, Fund II and Fund III from certain provisions of the 1940 Act (including an exemptive order granting relief from the asset coverage requirements for certain indebtedness issued by Fund II and Fund III as SBICs) and from certain reporting requirements mandated by the Securities Exchange Act of 1934, as amended, with respect to Fund II and Fund III. We intend to comply with the conditions of the order.
June 2014, we issued $113.4 millionin aggregate principal amount of 7.125% fixed-rate notes due 2021 (the "Notes"). The Notes will mature on June 16, 2021, 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 June 17, 2017at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest. The notes will bear interest at a rate of 7.125% per year payable quarterly on March 16, June 16, September 16, and December 16of each year, beginning September 16, 2014. The Notes are listed on the NYSEunder the trading symbol "CLA" with a par
$25.00per share. Contractual obligations We have entered into two contracts under which we have material future commitments, the Investment Advisory Agreement, pursuant to which the Investment Advisor serves as our investment adviser, and the Administration Agreement, pursuant to which our Administrator agrees to furnish us with certain administrative services necessary to conduct our day-to-day operations. Payments under the Investment Advisory Agreement in future periods will be equal to: (1) a percentage of the value of our gross assets; and (2) an incentive fee based on our performance. Payments under the Administration Agreement will occur on an ongoing basis as expenses are incurred on our behalf by our Administrator. 47
The Investment Advisory Agreement and the Administration Agreement are each terminable by either party without penalty upon 60 days' written notice to the other. If either of these agreements is terminated, the costs we incur under new agreements may increase. In addition, we will likely incur significant time and expense in locating alternative parties to provide the services we expect to receive under both our Investment Advisory Agreement and our Administration Agreement. Any new Investment Advisory Agreement would also be subject to approval by our stockholders.
A summary of the Company's significant contractual payment obligations as of
Contractual Obligations Payments Due by Period Less Than 1 - 3 3 - 5 More Than 1 Year Years Years 5 Years Total SBA-Guaranteed Debentures $ -
$ 21,500 $ 5,000 $ 165,700 $ 192,200Note Obligations $ - $ - $ - $ 113,438 $ 113,438Total Contractual Obligations $ - $ 21,500 $ 5,000 $ 279,138 $ 305,638Distributions In order to qualify as a RIC and to avoid U.S. federal corporate level income tax on the income we distribute to our stockholders, we are required to distribute at least 90% of our net ordinary income and our net short-term capital gains in excess of net long-term capital losses, if any, to our stockholders on an annual basis. Additionally, we must distribute an amount at least equal to the sum of 98% of our net ordinary income (during the calendar year) plus 98.2% of our net capital gain income (during each 12-month period ending on October 31) plus any net ordinary income and capital gain net income for preceding years that were not distributed during such years and on which we paid no U.S. federal income tax to avoid a U.S. federal excise tax. To the extent that we have income available, we intend to make quarterly distributions to our stockholders for the first four full quarters subsequent to our IPO and then make monthly distributions thereafter. Our monthly stockholder distributions, if any, will be determined by our Board on a quarterly basis. Any distribution to our stockholders will be declared out of assets legally available for distribution. 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 our distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage requirements applicable to us as a BDC under the 1940 Act. If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including the possible loss of our qualification as a RIC. We cannot assure stockholders that they will receive any distributions. To the extent our taxable earnings fall below the total amount of our distributions for that fiscal year, a portion of those distributions may be deemed a return of capital to our stockholders for U.S. federal income tax purposes. Thus, the source of a distribution to our stockholders may be the original capital invested by the stockholder rather than our income or gains. Stockholders should read any written disclosure accompanying any stockholder distribution carefully and should not assume that the source of any distribution is our ordinary income or capital gains. We have adopted an "opt out" dividend reinvestment plan for our common stockholders. As a result, if we declare a distribution, then stockholders' cash distributions will be automatically reinvested in additional shares of our common stock unless a stockholder specifically "opts out" of our dividend reinvestment plan. If a stockholder opts out, that stockholder will receive cash distributions. Although distributions paid in the form of additional shares of our common stock will generally be subject to U.S. federal, state and local taxes in the same manner as cash distributions, stockholders participating in our dividend reinvestment plan will not receive any corresponding cash distributions with which to pay any such applicable taxes. 48 Related Parties
We have entered into the Investment Advisory Agreement with the Investment Advisor.
Mr. Alala, our chief executive officer, president and chairman of our Board, is the managing partner and chief investment officer of our Investment Advisor, and Mr. Broyhill, a member of our Board, has an indirect controlling interest in the Investment Advisor. In addition, the Investment Advisor's investment team also manages Fund IV, a private investment limited partnership providing financing solutions to smaller and lower middle-market companies that had its first closing in March 2013and obtained SBA approval for its SBIC license in April 2013. In addition to Fund IV, affiliates of the Investment Advisor may manage several affiliated funds whereby institutional limited partners in Fund IV, have had the opportunity to co-invest with Fund IV in portfolio investments. The Investment Advisor and its affiliates may also manage other funds in the future that may have investment mandates that are similar, in whole and in part, with ours. The Investment Advisor and its affiliates may determine that an investment is appropriate for us and for one or more of those other funds. In such event, depending on the availability of such investment and other appropriate factors, the Investment Advisor or its affiliates may determine that we should invest side-by-side with one or more other funds. Any such investments will be made only to the extent permitted by applicable law and interpretive positions of the SECand its staff, and consistent with the Investment Advisor's allocation procedures. We do not expect to make co-investments, or otherwise compete for investment opportunities, with Fund IV because its focus and investment strategy differ from our own.
We have entered into a license agreement with the Investment Advisor, pursuant to which the Investment Advisor has agreed to grant us a non-exclusive, royalty-free license to use the name "Capitala."
We have entered into the Administration Agreement with our Administrator. Pursuant to the terms of the Administration Agreement, our Administrator provides us with the office facilities and administrative services necessary to conduct our day-to-day operations.
Mr. Alala, our chief executive officer, president and chairman of our Board, is the chief executive officer, president and a director of our Administrator, and Mr. Broyhill, a member of our Board, is the trustee of a trust that has a controlling interest in our Adminstrator.
Off-balance sheet arrangements
We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Recent Developments On
July 15, 2014, we invested approximately $7.2 millionin the junior subordinated debt (12% cash interest), $5.0 millionin the senior subordinated debt (14% cash interest), and $1.8 millionin the common equity of Burgaflex Holdings, LLC.
August 1, 2014, we invested $5.3 millionin senior revolving debt (current contractual rate of LIBOR plus 6.75% cash interest, .25% floor) and $3.4 millionin senior term debt (current contractual rate of LIBOR plus 7.75% cash interest, .25% floor) of Impresa Aerospace Holdings, LLC, an existing portfolio company.