Forward-Looking Statements
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. Forward-looking statements may include, among other things, statements as to our future operating results, our business prospects and the prospects of our portfolio companies, the impact of the investments that we expect to make, 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. 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," variations of such words, and similar expressions. Readers are cautioned that the forward-looking statements contained in this Quarterly Report on Form 10-Q are only predictions, are not guarantees of future performance, and are subject to risks, events, uncertainties and assumptions that are difficult to predict. Our actual results could differ materially from those implied or expressed in the forward-looking statements, and future results could differ materially from historical performance, for any reason, including any risk factors discussed herein, and in Item 1A entitled "Risk Factors" in Part I of our Annual Report on Form 10-K for the year endedDecember 31, 2020 . Other factors that could cause our actual results and financial condition to differ materially include, but are not limited to:
•our future operating results, including the performance of our existing investments;
•the introduction, withdrawal, success and timing of business initiatives and strategies;
•changes in political, economic or industry conditions, the interest rate environment or conditions affecting the financial and capital markets, including with respect to changes from the impact of the COVID-19 pandemic;
•the length and duration of the COVID-19 outbreak in
•the effect of the disruptions caused by the COVID-19 pandemic on our ability to continue to effectively manage our business and on the availability of equity and debt capital and our use of borrowed money to finance a portion of our investments;
•the relative and absolute investment performance and operations of our investment adviser;
•the impact of increased competition;
•the impact of investments we intend to make and future acquisitions and divestitures;
•our ability to turn potential investment opportunities into transactions and thereafter into completed and successful investments;
•the unfavorable resolution of any existing or future legal proceedings;
•the effect of the COVID-19 pandemic on our business prospects and the prospects of our portfolio companies, including our and their ability to achieve our respective objectives;
•our regulatory structure and tax status;
•the adequacy of our cash resources and working capital;
•the timing of cash flows, if any, from the operations of our portfolio companies;
•the impact of interest rate volatility on our results, particularly because we use leverage as part of our investment strategy;
45 -------------------------------------------------------------------------------- •the impact of legislative and regulatory actions and reforms, including in response to the COVID-19 pandemic; and regulatory, supervisory or enforcement actions of government agencies relating to us or our investment adviser;
•our contractual arrangements and relationships with third parties, including but not limited to lenders and investors, including other investors in our portfolio companies;
•our ability to access capital and any future financings by us;
•the ability of our investment adviser to attract and retain highly talented professionals;
•the impact of changes to tax legislation and, generally, our tax position;
•the ability of the parties to consummate the Mergers on the expected timeline, or at all;
•the ability to realize the anticipated benefits of the proposed Mergers;
•the effects of disruption on our business from the proposed Mergers;
•the combined company's plans, expectations, objectives and intentions, as a result of the Mergers;
•the effect that the pendency of the Mergers or consummation of the Mergers may have on the trading price of our common stock or PTMN Common Stock; and
•any potential termination of the Merger Agreement or action of our stockholders or PTMN's stockholders with respect to any proposed transaction.
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 report, and we assume no obligation to update any such forward-looking statements. 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 orSEC rules or regulations. 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 theSEC , including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.
The following analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes thereto contained elsewhere in this Quarterly Report on Form 10-Q.
Overview
We were formed as aDelaware corporation onNovember 14, 2012 and completed our initial public offering onMay 7, 2013 . Immediately prior to the initial public offering, we acquiredHarvest Capital Credit LLC in a merger whereby the outstanding limited liability company membership interests ofHarvest Capital Credit LLC were converted into shares of our common stock and we assumed and succeeded to all ofHarvest Capital Credit LLC's assets and liabilities, including its entire portfolio of investments. Our investment objective is to generate both current income and capital appreciation primarily by making direct investments in the form of senior debt, subordinated debt and, to a lesser extent, minority equity investments. We seek to accomplish our investment objective by targeting investments in small to mid-sizedU.S. private companies with annual revenues of less than$100 million and annual EBITDA (earnings before interest, taxes, depreciation and amortization) of less than$15 million . We believe that transactions involving companies of this size offer higher yielding investment opportunities, lower leverage levels and other terms more favorable than transactions involving larger companies.
We are an externally managed, closed-end, non-diversified management investment company that has elected to be regulated as a BDC under the 1940 Act.
46 -------------------------------------------------------------------------------- We have also elected to be treated forU.S. federal income tax purposes as a RIC under Subchapter M of the Code, and we intend to continue to qualify annually for tax treatment as a RIC. Our investment adviser,HCAP Advisors , which is registered as an investment adviser under the Advisers Act, manages our day-to-day operations and provides investment advisory and management services to us, subject to the overall supervision of our board of directors and pursuant to an investment advisory and management agreement.HCAP Advisors also serves as our administrator pursuant to an administration agreement, through which it furnishes us with office facilities, equipment and clerical, bookkeeping and recordkeeping services and performs, or oversees the performance of, our required administrative services.
Proposed Merger with Portman Ridge Finance Corporation
OnDecember 23, 2020 , we entered into the Merger Agreement with PTMN, Acquisition Sub andSierra Crest . The Merger Agreement provides that (i) Acquisition Sub will merge with and into the Company in the First Merger, with us continuing as the surviving corporation and as a wholly-owned subsidiary of PTMN, and (ii) immediately after the effectiveness of the First Merger, we will merge with and into PTMN in the Second Merger, with PTMN continuing as the surviving corporation.Sierra Crest is expected to manage the combined company following the Mergers. The consummation of the Mergers is subject to the satisfaction or (to the extent permitted by law) waiver of certain customary closing conditions, including obtaining the requisite approval of our stockholders. For further information, see "Note 1. Organization-The Proposed Merger with Portman Ridge Finance Corporation" to our consolidated financial statements included in this Quarterly Report on Form 10-Q. COVID-19 Update The COVID-19 pandemic, and the related effects on theU.S. and global economies, has had adverse consequences for the business operations of certain of our portfolio companies and has adversely affected, and threatens to continue to adversely affect, our operations and the operations ofHCAP Advisors . We are continuing to monitor the COVID-19 pandemic and its impact on our business and the business of our portfolio companies, and we have continued to fund existing unfunded revolving lines of credit when requests have been made from our portfolio companies and intend to continue to do so. We may also participate in follow-on investments with respect to existing portfolio companies. Due to the adverse effects of the COVID-19 pandemic on our operations and our liquidity, and in light of our contractual obligations, we have decided to temporarily cease to make and originate new investments. We will decide to resume to make and originate new investments when we believe it is prudent in light of our capital needs and contractual obligations, and in the best interests of us and our stockholders. Neither our management nor our board of directors can predict the full impact of the COVID-19 pandemic, including its duration and the magnitude of its economic impact, and we cannot predict the extent and duration of various travel restrictions, business closures and other quarantine measures imposed, or that may in the future be imposed, by various local, state, and federal governmental authorities, as well as non-U.S. governmental authorities. As such, we are unable to accurately predict the extent to which COVID-19 will negatively affect our portfolio companies' operating results or the impact that such disruptions may have on our results of operations and financial condition. Depending on the duration and extent of the disruption to the operations of our portfolio companies, we expect that certain of our portfolio companies will, and will continue to, experience financial distress and possibly default on their financial obligations to us and their other capital providers. This risk is amplified with respect to portfolio companies operating in certain industries, such as aerospace and defense, beverage, food and tobacco, construction and building, consumer goods, retail, business services, energy services and others. Some of our portfolio companies have taken steps to reduce operating expenses, such as significantly curtailing business operations, reducing headcounts and/or deferring capital expenditures, and we expect that additional portfolio companies may take similar steps if subjected to prolonged and severe financial distress, which may impair their business on a permanent basis. These developments would likely result in a decrease in the value of our investment in any such portfolio company, which decrease could be material. 47 -------------------------------------------------------------------------------- The COVID-19 pandemic and its effects on our portfolio companies have already had adverse material effects on our investment income, particularly our interest income, received from our investments, and we expect that such adverse effects will continue for the duration of the pandemic and potentially for some time thereafter. During the year endedDecember 31, 2020 , we added three portfolio companies,ProAir Holdings Corporation ,GK Holdings, Inc. , andGeneral Nutrition Centers, Inc. ("GNC"), to our non-accrual assets. GNC was subsequently removed from our non-accrual assets after it was restructured. We may need to restructure our investments in some of our portfolio companies as a result of the adverse effects of the COVID-19 pandemic, which could result in reduced interest payments, an increase in the amount of "paid-in-kind" or "PIK" interest we receive, and the placement of any such investment on non-accrual status. Certain restructurings of our portfolio investments included in the borrowing base for our Credit Facility or any future credit facility could result in a reduction in any such borrowing base, which may have a material adverse effect on our results of operations, financial condition and available liquidity going forward. As ofMarch 31, 2021 , we had two portfolio companies, with a combined fair value of$6.2 million , on non-accrual status. The effects of the COVID-19 pandemic discussed above increase the risk that we will place additional portfolio investments on non-accrual status in the future. In addition, any decreases in our net investment income would increase the portion of our cash flows dedicated to servicing borrowings, including existing borrowings and required amortization payments under the Credit Facility and existing borrowings under the 2022 Notes, and any distribution payments to stockholders. Our board of directors previously took action to defer the record dates and payments of ourMarch 2020 andApril 2020 monthly dividends and determined to suspend the declaration of any future dividends until further notice. We ultimately paid the previously declared but deferredMarch 2020 andApril 2020 monthly dividends in a single distribution of$0.16 per share onDecember 29, 2020 to shareholders of record at the close of business onDecember 15, 2020 . Depending on contractual restrictions under our borrowing arrangements, the duration of the COVID-19 pandemic and the extent of its effects on our portfolio companies' operations and our net investment income, any future distributions to our stockholders may be for amounts less than our historical distributions, may be made less frequently than historical practices, and may be made in part cash and part stock (as per each stockholder's election), 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. As ofMarch 31, 2021 , we are permitted under the 1940 Act, as a BDC, to borrow amounts such that our asset coverage, as defined in the 1940 Act, equals at least 150% after such borrowing. In addition, the Credit Facility contains events of default and cross-default provisions relating to other indebtedness, as well as affirmative and negative covenants, including, among other things: (i) a limit on our senior debt-to-tangible equity ratio of 1.00 to 1.00 at any time; (ii) a limit on our total debt-to-tangible equity ratio of 1.40 to 1.00 at any time; (iii) a limit on our debt service coverage ratio of 1.25 to 1.00 as of the end of any quarter in the period beginning as ofAugust 1, 2020 (which ratio was 1.40 to 1.00 as of the end of any quarter prior toAugust 1, 2020 ); (iv) a requirement that our tangible net worth not be less than$58.0 million ; (v) minimum liquidity; and (vi) maintenance of RIC and BDC status. The 2022 Notes Indenture also contains certain covenants, including covenants (i) prohibiting our issuance of any senior securities unless, immediately after such issuance, we are in compliance with the 1940 Act asset coverage requirements (after giving effect to any exemptive relief granted to us by theSEC ), and, (ii) if our asset coverage has been below the 1940 Act minimum asset coverage requirements (after giving effect to any exemptive relief granted to us by theSEC ) for more than six consecutive months, prohibiting the declaration of any cash dividend or distribution on our common stock (except to the extent necessary for us to maintain our treatment as a RIC under Subchapter M of the Code), or purchasing any of our common stock, unless, at the time of the declaration of the dividend or distribution or the purchase, and after deducting the amount of such dividend, distribution, or purchase, we are in compliance with the 1940 Act asset coverage requirements (after giving effect to any exemptive relief granted to us by theSEC ). As ofMarch 31, 2021 , we were in compliance with our asset coverage requirements under the 1940 Act and with the covenants under the terms of the Credit Facility and under the 2022 Notes Indenture. However, any increase in net unrealized depreciation on our investment portfolio or significant reductions in our net asset value as a result of the effects of the COVID-19 pandemic or otherwise increases the risk of (i) triggering the 1940 Act asset coverage covenants under the 2022 Notes Indenture, which would limit our ability to raise debt capital, pay distributions to our stockholders, and repurchase shares of our common stock, (ii) reducing our borrowing base under the Credit Facility or any future credit facility going forward, and (iii) breaching certain covenants under the Credit Facility, including but not limited to those relating to tangible net worth and debt service coverage ratio. In the event that unrealized depreciation in the fair value of portfolio investments included in the borrowing base of the Credit Facility or any future credit facility or other factors cause our aggregate outstanding borrowings under the Credit Facility or such other credit facility to exceed the applicable borrowing base, we would be required to immediately prepay the lenders an amount equal to such excess amount. If we are unable to remit such payment or we otherwise breach a covenant under the Credit Facility, or are unable to cure any event of default or obtain a waiver from the lenders, the lenders may choose to foreclose upon and sell, or otherwise transfer, the collateral subject to their security interests, 48 -------------------------------------------------------------------------------- which comprises all of our assets as ofMarch 31, 2021 , and accelerate our repayment obligations under the Credit Facility. Any such event would have a material adverse effect on our business, liquidity, financial condition, results of operations and ability to pay distributions to our stockholders. In addition, if the lenders exercise their right to sell the assets pledged under the Credit Facility, such sales may be completed at distressed sale prices, thereby diminishing or potentially eliminating the amount of cash available to us after repayment of the amounts outstanding under the Credit Facility. See "Risk Factors" included in Part I, Item 1A in our most recent Annual Report on Form 10-K and the other risk factors contained in our subsequent filings with theSEC . We are also subject to financial risks, including changes in market interest rates. As ofMarch 31, 2021 , 47.0% of our debt investments bore interest based on floating rates (some of which were subject to interest rate floors), which generally are LIBOR-based. In addition, the Credit Facility has floating rate interest provisions. In connection with the COVID-19 pandemic, theU.S. Federal Reserve and other central banks have reduced certain interest rates and LIBOR has decreased. A prolonged reduction in interest rates will reduce our gross investment income and could result in a decrease in our net investment income if such decreases in LIBOR are not offset by a corresponding increase in the spread over LIBOR that we earn on any portfolio investments, a decrease in our operating expenses, or a decrease in the interest rate of our floating interest rate liabilities tied to LIBOR. See "Item 3. Quantitative and Qualitative Disclosures About Market Risk" for an analysis of the impact of hypothetical base rate changes in interest rates. We will continue to monitor the evolving situation relating to the COVID-19 pandemic and related guidance fromU.S. and international authorities, including federal, state and local public health authorities. Given the dynamic nature of this situation and the fact that there may be developments outside of our control that require us or our portfolio companies to adjust plans of operation, we cannot reasonably estimate the full impact of COVID-19 on our financial condition, results of operations or cash flows in the future. However, we do expect that it could have a material adverse impact on our future net investment income, the fair value of our portfolio investments, and the results of operations and financial condition of us and our portfolio companies.
Portfolio
Portfolio Composition
As ofMarch 31, 2021 , we had$77.1 million (at fair value) invested in 20 portfolio companies. As ofMarch 31, 2021 , our portfolio, at fair value, was comprised of approximately 76.4% senior secured debt, 13.0% junior secured debt and 10.6% equity and equity-like investments. As ofDecember 31, 2020 , we had$89.6 million (at fair value) invested in 21 portfolio companies. As ofDecember 31, 2020 , our portfolio, at fair value, was comprised of approximately 71.1% senior secured debt, 10.5% junior secured debt and 18.4% equity and equity-like investments.
We originate and invest primarily in privately-held middle-market companies
(typically those with less than
March 31, 2021 December 31, 2020 Cost Fair Value Cost Fair Value Senior Secured Debt$ 59,432,377 $ 58,891,399 $ 66,041,926 $ 64,629,875 Junior Secured Debt 14,359,842 10,052,161 14,329,126 9,417,801 Equity 10,872,048 8,193,990 13,663,289 15,506,897 Total Investments$ 84,664,267 $ 77,137,550 $ 94,034,341 $ 89,554,573 AtMarch 31, 2021 , our average portfolio company debt investment at amortized cost and fair value was approximately$4.3 million and$4.1 million , respectively, and our largest portfolio company debt investment by amortized cost and fair value was approximately$13.9 million and$11.7 million , respectively. AtDecember 31, 2020 , our average portfolio company debt investment at amortized cost and fair value was approximately$4.2 million and$3.9 million , respectively, and our largest portfolio company debt investment by amortized cost and fair value was approximately$13.7 million and$10.8 million , respectively. 49 -------------------------------------------------------------------------------- AtMarch 31, 2021 , 47.0% of our debt investments bore interest based on floating rates (some of which were subject to interest rate floors), such as LIBOR, and 53.0% of our debt investments bore interest at fixed rates. AtDecember 31, 2020 , 48.4% of our debt investments bore interest based on floating rates (some of which were subject to interest rate floors), such as LIBOR, and 51.6% bore interest at fixed rates. The weighted average effective yield of our debt and other income-producing investments, as ofMarch 31, 2021 andDecember 31, 2020 , was 12.3% and 11.9%, respectively. The weighted average effective yield on the entire portfolio, as ofMarch 31, 2021 andDecember 31, 2020 , was 10.0% and 9.1%, respectively. The weighted average annualized effective yield on debt and other income-producing investments is computed using the effective interest rates for our debt and other income-producing investments, including cash and PIK interest as well as the accretion of deferred fees. The individual investment yields are then weighted by the respective fair values of the investments (as of the date presented) in calculating the weighted average effective yield as a percentage of our debt and other income-producing investments.ProAir Holdings Corporation andGK Holdings, Inc were excluded from the calculation as ofMarch 31, 2021 andDecember 31, 2020 because they were on non-accrual status as of those dates. Equity components of the investment portfolio were also excluded from these calculations either because they do not have stated interest rates or are non-income-producing. The weighted average annualized yield on total investments takes the same yields but weights them to determine the weighted average effective yield as a percentage of our total investments. The dollar-weighted average annualized yield on the Company's investments for a given period will generally be higher than what investors in our common stock would realize in a return over the same period because the dollar-weighted average annualized yield does not reflect our expenses or any sales load that may be paid by investors. For investments that have a PIK interest component, PIK interest is accrued each period but generally not collected until the debt investment is sold or paid off. A roll forward of PIK interest for each of the three months endedMarch 31, 2021 andMarch 31, 2020 is summarized in the table below. Three Months Ended March 31, 2021 2020 PIK, beginning of period$ 4,046,725 $
3,855,222 Accrual 367,253 264,962 Payments (85,470) (17,958) Write-off - -
PIK, end of period$ 4,328,508 $
4,102,226 Investment Activity
During the three months ended
During the three months endedMarch 31, 2021 , we exited$5.5 million of debt investment commitments and$2.8 million of equity investments in one portfolio company. During the three months endedMarch 31, 2020 , we exited$2.2 million of debt investment commitments and$0.1 million in equity investments in one portfolio company.
Our level of investment activity can vary substantially from period to period depending on many factors, including the level of merger and acquisition activity in our target market, 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, we use 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: 50 --------------------------------------------------------------------------------
•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 workout. Investments with a rating of 4 are those for which there is an increased possibility of 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 workout. Investments with a rating of 5 are those for which loss of return and principal is expected. The following table shows the investment rankings of our debt investments at fair value (in millions): As of March 31, 2021 As of December 31, 2020 Fair Value (in % of Debt Number of Fair Value (in % of Debt Number of Investment Rating millions) Portfolio Portfolio Companies millions) Portfolio Portfolio Companies 1$ 16.9 24.5 % 3$ 16.0 21.9 % 3 2 13.5 19.6 % 3 20.1 27.5 % 4 3 12.9 18.8 % 3 13.0 17.8 % 3 4 25.6 37.1 % 4 24.0 32.8 % 4 5 - - % - - - % -$ 68.9 100.0 % 13$ 73.1 100.0 % 14
We do not accrue interest income on loans and debt securities if we doubt our ability to collect such interest. Generally, when an interest payment default occurs on a loan in the portfolio, when interest has not been paid for greater than 90 days, or when management otherwise believes that the issuer of the loan will not be able to service the loan and other obligations, we will place the loan on non-accrual status and will cease accruing interest income on that loan until all principal and interest is current through payment or until a restructuring occurs, such that the interest income is deemed collectible. However, collections actually received on non-accrual loans may be recognized as interest income on a cash basis or applied to principal depending on management's judgment regarding collectability. As ofMarch 31, 2021 , we had investments in two portfolio companies on non-accrual status (our junior secured debt investment inProAir Holdings Corporation and our junior secured debt investment inGK Holdings, Inc. ), which totaled$6.2 million at fair value and$10.4 million at cost and comprised an aggregate of 14.1% of our debt investments at cost. As ofDecember 31, 2020 , we had investments in two portfolio companies on non-accrual status (our junior secured debt investment inProAir Holdings Corporation and our junior secured debt investment inGK Holdings, Inc. ), which totaled$5.6 million at fair value and$10.4 million at cost and comprised an aggregate of 12.9% of our debt investments at cost. The failure by a borrower or borrowers to pay interest and repay principal could have a material adverse effect on our financial condition and results of operation.
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Results of Operations
An important measure of our financial performance is the net increase or decrease in net assets resulting from operations, which includes net investment income, net change in realized gain or loss and net change in unrealized appreciation or
51 -------------------------------------------------------------------------------- depreciation. Net investment income is the difference between our income from interest, distributions, fees and other investment income and our operating expenses, including interest on borrowed funds. Net realized gain or loss on investments is generally the difference between the proceeds received from dispositions of portfolio investments and their amortized cost. Net change in unrealized appreciation or depreciation on investments is the net unrealized change in the fair value of our investment portfolio.
Comparison of the Three Months Ended
Revenues
We generate revenue primarily in the form of interest income on debt investments and, to a lesser extent, capital gains on equity investments we make in portfolio companies. Our debt investments typically have terms of five to seven years and bear interest at a fixed or floating rate. Interest on our debt investments is payable at least 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 investments 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 dollar amount of interest and any dividend income that we earn to increase as the size of our investment portfolio increases and to decrease as the size of our portfolio decreases. In addition, we may generate revenue in the form of prepayment, commitment, loan origination, structuring or due diligence fees and consulting fees, which may be non-recurring in nature. Investment income for the three months endedMarch 31, 2021 totaled$2.2 million , compared to investment income of$3.3 million for the three months endedMarch 31, 2020 . Investment income for the three months endedMarch 31, 2021 was comprised primarily of$1.5 million in cash interest,$0.3 million in PIK interest,$0.2 million in fees earned on the investment portfolio, and$0.1 million of other income (which was primarily a prepayment fee earned upon the full payoff ofNational Program Management & Project Controls, LLC ). Investment income for the three months endedMarch 31, 2020 was comprised primarily of$2.9 million in cash interest,$0.3 million in PIK interest, and$0.2 million in fees earned on the investment portfolio.
The decrease in investment income in the three months ended
Expenses
Our primary operating expenses include the payment of fees toHCAP Advisors under the investment advisory and management agreement, our allocable portion of overhead expenses and other administrative expenses under the administration agreement withHCAP Advisors , including the allocated costs incurred byHCAP Advisors in providing managerial assistance to those portfolio companies that request it, and other operating costs described below. We bear all other out-of-pocket costs and expenses of our operations and transactions, which include:
•interest expense and unused line fees;
•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 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;
52 --------------------------------------------------------------------------------
•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
•costs associated with our reporting and compliance obligations under applicable
Operating expenses totaled$2.1 million for the three months endedMarch 31, 2021 , compared to$2.3 million for the three months endedMarch 31, 2020 . Interest expense decreased by$0.3 million to$0.7 million due to a lower average outstanding debt balance, slightly offset by a higher weighted-average interest rate on borrowings under our Credit Facility during the three months endedMarch 31, 2021 , compared to the three months endedMarch 31, 2020 . Professional fees increased for the three months endedMarch 31, 2021 compared to the three months endedMarch 31, 2020 primarily due to professional fees incurred in connection with the pending transaction with PTMN. General and administrative expenses remained relatively flat at$0.2 million for both the three months endedMarch 31, 2021 andMarch 31, 2020 . We incurred$0.3 million , or$0.04 per share, in professional fees in connection with the pending merger with PTMN during the three months endedMarch 31, 2021 and we expect to incur an additional$1.5 million , or$0.24 per share, in professional fees during the second quarter of 2021 in connection with the pending transaction with PTMN. Base management fees for the three months endedMarch 31, 2021 were$0.4 million , compared to$0.6 million for the three months endedMarch 31, 2020 . The decrease in base management fees is attributable to a lower average amount of gross investments, at fair value, outstanding during the 2021 period, as compared to the 2020 period. We did not incur any incentive fees for either of the three months endedMarch 31, 2021 or 2020 because our pre-incentive fee net investment income did not exceed the hurdle rate for the relevant periods. We only incur an income incentive fee if our pre-incentive fee net investment income return exceeds a 2.0% quarterly (8.0% annualized) hurdle rate. Our pre-incentive fee net investment income return failed to meet this hurdle rate with respect to each of the relevant periods in the three months endedMarch 31, 2021 and 2020. In addition, the incentive fees paid or owed toHCAP Advisors are subject to a three-year total return requirement, such that no incentive fee, in respect of pre-incentive fee net investment income, will be payable except to the extent 20.0% of the cumulative net increase in net assets resulting from operations over the calendar quarter for which such fees are being calculated and the 11 preceding quarters exceeds the cumulative incentive fees paid or accrued over the 11 preceding quarters.
Administrative services expense was
Net Investment Income
For the three months ended
For the three months ended
Net Realized Gains and Losses
Realized gains and losses on investments are calculated using the specific identification method. We measure realized gains or losses on equity investments as the difference between the net proceeds from the sale and the amortized cost basis of the investment, without regard to unrealized appreciation or depreciation previously recognized. We measure realized gains or 53 -------------------------------------------------------------------------------- losses on debt investments as the difference between the net proceeds from the repayment or sale and the contractual amount owed to us on the investment, without regard to unrealized appreciation or depreciation previously recognized or unamortized deferred fees. Upon prepayment of debt investments, we recognize the acceleration of unamortized deferred fees as interest income and we recognize the collection of prepayment and other fees as other income. We recognized$6.4 million in realized gains on our investments for the three months endedMarch 31, 2021 , compared to$86,427 of net realized losses on our investments in the three months endedMarch 31, 2020 .
A summary of net realized gains and losses for the three months ended
Three
Months Ended
2021 2020 Flight Lease VII, LLC (Common Equity Interest) $ - $ - Flight Lease XII, LLC (Common Equity Interest) - - Fox Rent A Car, Inc. (Common Equity Warrants) - 15,994
6,445,524 - Regional Engine Leasing, LLC (Residual Value) - (102,421) Net realized gains (losses)$ 6,445,524 $ (86,427)
Net Change in Unrealized Appreciation (Depreciation) of Investments
Net change in unrealized appreciation (depreciation) 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 depreciation on investments totaled$3.0 million and$4.6 million for the three months endedMarch 31, 2021 andMarch 31, 2020 , respectively. The decrease in net unrealized depreciation between periods is primarily due to an improvement in general economic conditions as well as improvement in the operations and liquidity of certain portfolio companies. Excluding the change in unrealized depreciation recorded due to the exit of our investment inNational Program Management & Project Controls, LLC , we recorded$3.6 million in net change in unrealized appreciation on our existing portfolio during the three months endedMarch 31, 2021 .
Net Increase in Net Assets Resulting from Operations
We had a net increase in net assets resulting from operations of
Financial Condition, Liquidity and Capital Resources
Our liquidity and capital resources are derived from our Credit Facility, subject to the restrictions therein, proceeds received from the offerings of our securities, such as the 2022 Notes inAugust 2017 , cash flows from operations, including investment sales and repayments, and cash 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 distributions to the holders of our common stock. We used, and expect to continue to use, these capital resources as well as proceeds from public and private offerings of securities to finance our investment activities. To the extent the proposed Mergers do not close, we may amend or refinance our leverage facilities and borrowings, in order to, among other things, modify covenants or the interest rates payable and extend the reinvestment period or maturity date. We believe that our current cash on hand and our anticipated cash flows from operations will be adequate to meet our cash needs for our daily operations. This "Financial Condition, Liquidity and Capital Resources" section should be read in conjunction with "COVID-19 Update" above. 54 --------------------------------------------------------------------------------
Cash Flows from Operating and Financing Activities
Our operating activities provided cash of$15.0 million for the three months endedMarch 31, 2021 and used cash of$0.1 million for the three months endedMarch 31, 2020 , primarily in connection with investment exits, fundings of new investments, interest income received, and proceeds from principal payments. Our financing activities used cash of$25.6 million for the three months endedMarch 31, 2021 and used cash of$1.0 million for the three months endedMarch 31, 2020 . Our financing activity proceeds and uses for both periods were primarily in connection with net activity under our Credit Facility and, for the 2020 period, with distributions paid to stockholders. Although we have no current plans to raise capital, we may need to raise capital in the future and cannot assure you that we will be successful if we need to do so. In this regard, for so long as our common stock trades at a price below our net asset value per share, we will likely 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. For all of 2021 and 2020, our common stock traded at a discount to our then-current net asset value. If our common stock continues to trade at a discount to net asset value, we will be limited in our ability to raise equity capital unless we obtain the approval described above, which we have not previously requested from stockholders. BDCs are generally required, upon issuing any senior securities, 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 the BDC's borrowings and any outstanding preferred stock, of at least 200%. However, the SBCAA, which was signed into law, inMarch 2018 , among other things, amended Section 61(a) of the 1940 Act to add a new Section 61(a)(2) that reduces the asset coverage requirement applicable to BDCs from 200% to 150% so long as the BDC meets certain disclosure requirements and obtains certain approvals. OnMay 4, 2018 , our board of directors unanimously approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. As a result, effectiveMay 4, 2019 , our applicable asset coverage ratio under the 1940 Act decreased to 150% from 200%. As ofMarch 31, 2021 , our aggregate indebtedness, including outstanding borrowings under our Credit Facility and the aggregate principal amount outstanding on our 2022 Notes, was$38.8 million , and our asset coverage, as defined in the 1940 Act, was 272%. The amount of leverage that we employ as a BDC 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
Credit Facility
OnOctober 29, 2013 , we entered into the Loan and Security Agreement to provide us with our$45.0 million Credit Facility. The Credit Facility is secured by all of our assets, including our equity interest inHCAP Equity Holdings, LLC andHCAP ICC, LLC . As ofMarch 31, 2021 , advances under the Credit Facility bear interest at a rate per annum equal to the lesser of (i) the applicable LIBOR plus 4.50% (with a 1.00% LIBOR floor) and (ii) the maximum rate permitted under applicable law. During the revolving period, availability under the Credit Facility is determined by advance rates against eligible loans in the borrowing base up to a maximum aggregate availability of$44.3 million . Advance rates against individual investments range from 40% to 65% depending on the seniority of the investment in the borrowing base. In addition, as ofMarch 31, 2021 , the Credit Facility included the following terms, among other things: (i) a revolving period scheduled to expire onJune 30, 2021 , until which date we may receive additional advances at the discretion of the lenders; (ii) provides for a senior leverage ratio (the ratio of total borrowed money other than subordinated debt and unsecured longer-term indebtedness to equity) of 1-to-1; (iii) provides for a total leverage ratio (the ratio of total debt to equity) of 1.4-to-1 and a limit on our debt service coverage ratio of 1.25-to-1.00 as of the end of any quarter in the period beginning as ofAugust 1, 2020 (which ratio was 1.40-to-1.00 as of the end of any quarter prior toAugust 1, 2020 ); (iv) additional advances requested 55 -------------------------------------------------------------------------------- under the Credit Facility will be made only at the discretion of the lenders; (v) aggregate commitments under the Loan and Security Agreement are$45.0 million ; (vi) a tangible net worth covenant that reflects a minimum amount equal to$58.0 million ; (vii) an effective limitation on the aggregate value of eligible loans in the borrowing base to maximum of approximately$44.3 million ; (viii) requires us to pay a monthly fee of 0.50% per annum for unused amounts during the revolving period, calculated based on the difference between (a) the maximum loan amount under the Loan and Security Agreement and (b) the average daily principal balance of the obligations outstanding during the prior calendar month; (ix) prohibits us from repurchasing shares of our common stock and declaring and paying any distribution or dividend until the termination of the Loan and Security Agreement, except, in the case of distributions and dividends, to the extent necessary for us to maintain our eligibility to qualify as a RIC under Subchapter M of the Code; (x) includes a minimum liquidity covenant threshold of least$2.2 million through termination of the Loan and Security Agreement; and (xi) permits the use of an Alternative Rate (as defined in the Loan and Security Agreement) in place of LIBOR if certain conditions are satisfied. Beginning as ofAugust 1, 2020 , during the amortization period, we are required to pay down the principal amount outstanding under the Credit Facility on a monthly basis in equal installments during the relevant calendar quarter so that such outstanding amounts will be reduced by an amount equal to or greater than (i)$2.2 million for each of the first two full calendar quarters followingJuly 31, 2020 , (ii)$3.3 million for each of the succeeding two full calendar quarters and (iii)$4.3 million for each succeeding calendar quarter until termination of the Credit Facility, which is scheduled to mature onOctober 30, 2021 . During the amortization period, 90% of all principal collections we receive from our portfolio companies must generally be paid to the lenders to pay down our obligations and other amounts outstanding under the Credit Facility. In addition, any proceeds we receive from the sale or issuance of our equity or debt securities during the amortization period must generally be applied to the prepayment of our obligations under the Credit Facility. The Credit Facility contains additional customary terms and conditions, including, without limitation, affirmative and negative covenants, including, without limitation, information reporting requirements, a minimum debt-service coverage ratio, and maintenance of RIC and BDC status. The Credit Facility also contains customary events of default, including, without limitation, nonpayment, misrepresentation of representations and warranties in a material respect, breach of covenant, cross-default to other indebtedness, bankruptcy, change of control, and the occurrence of a material adverse effect. In addition, the Credit Facility provides that, upon the occurrence and during the continuation of any event of default, our administration agreement could be terminated and a backup administrator could be substituted by the agent. The maturity date under the Credit Facility is the earlier of (x)October 30, 2021 , or (y) the date that is six months prior to the maturity of any of our outstanding unsecured long-term indebtedness. Based on our outstanding 2022 Notes that mature onSeptember 15, 2022 , the maturity date under the Credit Facility isOctober 30, 2021 .HCAP Equity Holdings, LLC became a co-borrower under the Credit Facility inAugust 2016 , andHCAP ICC, LLC , became a borrower under the Credit Facility inNovember 2017 . As ofMarch 31, 2021 andDecember 31, 2020 , the outstanding balance on the Credit Facility was$10.0 million and$35.6 million , respectively.
2022 Notes
OnAugust 24, 2017 , we closed the public offering of$25.0 million in aggregate principal amount of 2022 Notes. OnSeptember 1, 2017 , we closed on an additional$3.75 million in aggregate principal amount of 2022 Notes to cover the over-allotment option exercised by the underwriters. In total, we issued 1,150,000 of the 2022 Notes at a price of$25.00 per Note. The total net proceeds from the issuance of the 2022 Notes, after deducting underwriting discounts of$0.9 million and offering expenses of$0.2 million , were$27.7 million . As ofMarch 31, 2021 , the outstanding principal balance of the 2022 Notes was$28.8 million and the debt issuance costs balance was$0.4 million . As ofDecember 31, 2020 , the outstanding principal balance of the 2022 Notes was$28.8 million and the debt issuance costs balance was$0.4 million . The 2022 Notes mature onSeptember 15, 2022 and bear interest at a rate of 6.125%. They are redeemable in whole or in part at any time at our option at a price equal to 100% of the outstanding principal amount of the 2022 Notes plus accrued and unpaid interest. The 2022 Notes are unsecured obligations and rank pari passu with any existing and future unsecured indebtedness; senior to any of our future indebtedness that expressly provides it is subordinated to the 2022 Notes; effectively subordinated to all of the existing and future secured indebtedness, to the extent of the value of the assets securing such indebtedness, including borrowings under the Credit Facility; and structurally subordinated to all existing and future indebtedness and other obligations of any subsidiaries, financing vehicles, or similar facilities we may form in the future, with respect to claims on the assets of any such subsidiaries, financing vehicles, or similar facilities. Interest on the 2022 Notes is 56 -------------------------------------------------------------------------------- payable quarterly onMarch 15 ,June 15 ,September 15 , andDecember 15 of each year. The 2022 Notes are listed on the Nasdaq Global Market under the trading symbol "HCAPZ." We may from time to time repurchase 2022 Notes in accordance with the 1940 Act and the rules promulgated thereunder. The 2022 Notes Indenture contains certain covenants, including covenants (i) prohibiting our issuance of any senior securities unless, immediately after such issuance, we are in compliance with the 1940 Act asset coverage requirements (after giving effect to any exemptive relief granted to us by theSEC ); (ii) if our asset coverage has been below the 1940 Act minimum asset coverage requirements (after giving effect to any exemptive relief granted to us by theSEC ) for more than six consecutive months, prohibiting the declaration of any cash dividend or distribution on our common stock (except to the extent necessary for us to maintain our treatment as a RIC under Subchapter M of the Code), or purchasing any of our common stock, unless, at the time of the declaration of the dividend or distribution or the purchase, and after deducting the amount of such dividend, distribution, or purchase, we are in compliance with the 1940 Act asset coverage requirements (after giving effect to any exemptive relief granted to us by theSEC ); and (iii) requiring us to provide financial information to the holders of the 2022 Notes and the Trustee if we cease to be subject to the reporting requirements of the Exchange Act. These covenants are subject to limitations and exceptions that are described in the 2022 Notes Indenture.
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 ofMarch 31, 2021 , our only off-balance sheet arrangements consisted of$1.3 million of unfunded revolving lines of credit and delayed draw term loans to two of our portfolio companies. As ofDecember 31, 2020 , our only off-balance sheet arrangements consisted of$1.8 million of unfunded revolving lines of credit and delayed draw term loans to four of our portfolio companies.
Critical Accounting Policies
Our consolidated financial statements are prepared in accordance withU.S. GAAP, which requires the use of estimates that involve the exercise of judgment and the use of assumptions as to future uncertainties. Our most critical accounting policies involve decisions and assessments that could affect our reported assets and liabilities, as well as our reported revenues and expenses. We believe that all of the decisions and assessments upon which our consolidated financial statements are based are reasonable at the time made and based upon information available to use at that time. We rely upon a thorough valuation process, which includes, for certain portfolio investments, the input of an external independent third-party valuation firm to arrive at what we believe to be reasonable estimates of fair value, whenever available. As ofMarch 31, 2021 , our investment portfolio had a fair value of$77.1 million and we recognized$3.0 million of net unrealized depreciation for the three months endedMarch 31, 2021 . For more information on our fair value measurements, see Note 6 of the notes to our Consolidated Financial Statements. For a review of our significant accounting policies and the recent accounting pronouncements that may impact our results of operations, see Note 2 of the notes to our Consolidated Financial Statements.
Regulated Investment Company Status and Distributions
We have elected to be treated as a RIC under Subchapter M of the Code. If we receive RIC tax treatment, 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. Distributions declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital. To receive RIC tax treatment, the Company is required to meet certain income and asset diversification tests in addition to distributing at least 90% of ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, out of the assets legally available for distribution. As a RIC, the Company will be subject to a 4% nondeductibleU.S. federal excise tax on certain undistributed income unless the Company distributes in a timely manner an amount at least equal to the sum of (1) 98% of its ordinary income for each calendar year, (2) 98.2% of its capital gain net income for the 1-year period endingOctober 31 in that calendar year and (3) any ordinary income and net capital gains for preceding years that were not distributed during such years and on which the Company paid noU.S. federal income tax. 57 -------------------------------------------------------------------------------- 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 and in the indenture governing the 2022 Notes, as well as restrictions under the Merger Agreement, 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 distributions for that fiscal year, a portion of those distributions may be deemed a return of capital to our stockholders. 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 BDC under the 1940 Act and due to provisions in the Credit Facility and the indenture governing the 2022 Notes. For example, we are prohibited under the Loan and Security Agreement from declaring and paying any distribution or dividend, except to the extent necessary for us to maintain our eligibility to qualify as a RIC under Subchapter M of the Code. We cannot assure stockholders that they will receive any dividends or distributions at a particular level. In this regard, onMarch 12, 2020 , we announced monthly distributions of$0.08 per share payable on each ofApril 30, 2020 (the "March 2020 Dividend") andMay 28, 2020 (the "April 2020 Dividend") to record holders as ofApril 23, 2020 andMay 21, 2020 , respectively. However, our board of directors resolved to defer the record date and payment of each of theMarch 2020 Dividend and theApril 2020 Dividend and determined to suspend the declaration of any future dividends until such later time as our board of directors determines is prudent in light of our capital needs and contractual obligations, and in our stockholders' best interests. We ultimately paid the previously declared but deferredMarch 2020 Dividend andApril 2020 Dividend in a single distribution of$0.16 per share onDecember 29, 2020 to shareholders of record at the close of business onDecember 15, 2020 , but did not declare or pay any other monthly dividends in 2020 after the declaration and payment of theMarch 2020 Dividend and theApril 2020 Dividend. and have not declared any dividends to date in 2021. In accordance with certain Internal Revenue Service revenue procedures, 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, the cash available for distribution must be allocated among each stockholder electing to receive cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive less than the lesser of (a) the portion of the distribution such stockholder has elected to receive in cash, or (b) an amount equal to his or her entire distribution times the percentage limitation on cash available for distribution. If these and certain other requirements are met, forU.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.
Recent Developments
As of
OnApril 5, 2021 , we sold our membership interests inInfinite Care, LLC and received a final payment to satisfy the amounts outstanding under our senior secured term loan and revolving line of credit provided toInfinite Care, LLC . We received$7.6 million in gross proceeds at the closing of the transaction. An additional$2.2 million of proceeds is scheduled to be released to us at various dates during the two-year period following the closing date of the transaction once certain conditions are met.
On
OnMay 3, 2021 , we received$4.4 million fromSafety Services Acquisition Corp. , representing a full payoff at par of our senior secured term loan. We retained our Series A preferred stock investment inSafety Services Acquisition Corp.
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