The information contained in
this section should be read in conjunction with our accompanying
Consolidated Financial Statements
and the notes thereto appearing elsewhere in this Annual Report on Form 10-K.
ITEM 1. BUSINESS
Overview
Organization
We were incorporated under the General Corporation Law of the State of Delaware on February 18, 2005. On June 22, 2005, we completed our initial
public offering and commenced operations. We operate as an externally managed, closed-end, non-diversified management investment company and have elected to be treated as a business development company (BDC) under the Investment Company
Act of 1940, as amended (the 1940 Act). For federal income tax purposes, we have elected to be treated as a regulated investment company (RIC) under Subchapter M of the Internal Revenue Code of 1986, as amended (the
Code). To continue to qualify as a RIC for federal income tax purposes and obtain favorable RIC tax treatment, we must meet certain requirements, including certain minimum distribution requirements. Since our initial public offering in
2005 and through March 31, 2016, we have made 129 consecutive monthly distributions to common stockholders.
Our shares of common stock, 7.125%
Series A Cumulative Term Preferred Stock (Series A Term Preferred Stock), 6.75% Series B Cumulative Term Preferred Stock (Series B Term Preferred Stock) and 6.50% Series C Cumulative Term Preferred Stock
(Series C Term Preferred Stock) are traded on the NASDAQ Global Select Market (NASDAQ) under the trading symbols GAIN, GAINP, GAINO, and GAINN, respectively.
2
Investment Adviser and Administrator
We are externally managed by our affiliated investment adviser, Gladstone Management Corporation (the Adviser), under an investment advisory and
management agreement (the Advisory Agreement) and another of our affiliates, Gladstone Administration, LLC, (the Administrator) provides administrative services to us pursuant to a contractual agreement (the
Administration Agreement). Each of the Adviser and Administrator are privately-held companies that are indirectly owned and controlled by David Gladstone, our chairman and chief executive officer. Mr. Gladstone and Terry Brubaker,
our vice chairman and chief operating officer, also serve on the board of directors of the Adviser, the board of managers of the Administrator, and serve as executive officers of the Adviser and the Administrator. The Administrator employs, among
others, our chief financial officer and treasurer, chief valuation officer, chief compliance officer, general counsel and secretary (who also serves as the president of the Administrator) and their respective staffs. The Adviser and Administrator
have extensive experience in our lines of business and also provide investment advisory and administrative services, respectively, to our affiliates, including, but not limited to: Gladstone Commercial Corporation (Gladstone Commercial),
a publicly-traded real estate investment trust; Gladstone Capital Corporation (Gladstone Capital), a publicly-traded BDC and RIC; and Gladstone Land Corporation (Gladstone Land, with Gladstone Commercial, and
Gladstone Capital, collectively the Affiliated Public Funds), a publicly-traded real estate investment trust. In the future, the Adviser and Administrator may provide investment advisory and administrative services,
respectively, to other funds and companies, both public and private.
The Adviser was organized as a corporation under the laws of the State of Delaware
on July 2, 2002, and is a registered investment adviser under the Investment Advisers Act of 1940, as amended. The Administrator was organized as a limited liability company under the laws of the State of Delaware on March 18, 2005. The
Adviser and Administrator are headquartered in McLean, Virginia, a suburb of Washington, D.C. The Adviser also has offices in several other states.
Investment Objectives and Strategy
We were
established for the purpose of investing in debt and equity securities of established private businesses operating in the United States (U.S.). Our investment objectives are to: (1) achieve and grow current income by investing in
debt securities of established businesses that we believe will provide stable earnings and cash flow to pay expenses, make principal and interest payments on our outstanding indebtedness and make distributions to stockholders that grow over time;
and (2) provide our stockholders with long-term capital appreciation in the value of our assets by investing in equity securities, generally in combination with the aforementioned debt securities, of established businesses that we believe can
grow over time to permit us to sell our equity investments for capital gains. To achieve our objectives, our investment strategy is to invest in several categories of debt and equity securities, with each investment generally ranging from
$5 million to $30 million, although investment size may vary, depending upon our total assets or available capital at the time of investment. We intend that our investment portfolio over time will consist of approximately 75% in debt
securities and 25% in equity securities, at cost. As of March 31, 2016, our investment portfolio was made up of 71.3% in debt securities and 28.7% in equity securities, at cost.
In July 2012, the U.S. Securities and Exchange Commission (SEC) granted us an exemptive order (the Co-Investment Order) that expanded
our ability to co-invest with certain of our affiliates, including Gladstone Capital, under certain circumstances and any future business development company or closed-end management investment company that is advised (or sub-advised if it controls
the fund) by our external investment adviser, or any combination of the foregoing, subject to the conditions in the SECs order.
In general, our
investments in debt securities have a term of no more than seven years, accrue interest at variable rates (based on the one-month London Interbank Offered Rate (LIBOR)) and, to a lesser extent, at fixed rates. We seek debt instruments
that pay interest monthly or, at a minimum, quarterly, and which may include a yield enhancement such as a success fee or deferred interest provision and are primarily interest only, with all principal and any accrued but unpaid interest due at
maturity. Generally, success fees accrue at a set rate and are contractually due upon a change of control of the business. Some debt securities have deferred interest whereby some portion of the interest payment is added to the principal balance so
that the interest is paid, together with the principal, at maturity. This form of deferred interest is often called paid-in-kind (PIK) interest.
Typically, our investments in equity securities take the form of common stock, preferred stock, limited liability company interests, or warrants or options to
purchase the foregoing. Often, these equity investments occur in connection with our original investment, buyouts and recapitalizations of a business, or refinancing existing debt. Since our initial public offering in 2005 and through March 31,
2016, we have made investments in 43 companies, excluding investments in syndicated loans.
We expect that our investment portfolio will primarily include
the following three categories of investments in private companies in the U.S.:
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First Lien Secured Debt Securities:
We seek to invest a portion of our assets in first lien secured debt securities also known as senior loans, senior term loans, lines of credit and senior notes. Using its
assets as collateral, the borrower typically uses first lien secured debt to cover a substantial portion of the funding needs of the business. These debt securities usually take the form of first priority liens on all, or substantially all, of the
assets of the business.
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3
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Second Lien Secured Debt Securities:
We seek to invest a portion of our assets in second lien secured debt securities, which may also be referred to as subordinated loans, subordinated notes and mezzanine loans.
These second lien secured debt securities rank junior to the borrowers first lien secured debt securities and may be secured by second priority liens on all or a portion of the assets of the business. Additionally, we may receive other yield
enhancements, such as warrants to buy common and preferred stock or limited liability interests, in connection with these second lien secured debt securities.
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Preferred and Common Equity/Equivalents:
We seek to invest a portion of our assets in equity securities, which consist of preferred and common equity, limited liability company interests, warrants or options to
acquire such securities, and are generally in combination with our debt investment in a business. Additionally, we may receive equity investments derived from restructurings on some of our existing debt investments. In many cases, we will own a
significant portion of the equity of the businesses in which we invest.
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Additionally, pursuant to the 1940 Act, we must maintain at least
70% of our total assets in qualifying assets, which generally include each of the investment types listed above. Therefore, the 1940 Act permits us to invest up to 30% of our assets in other non-qualifying assets. See
Regulation as a
BDC Qualifying Assets
for a discussion of the types of qualifying assets in which we are permitted to invest pursuant to Section 55(a) of the 1940 Act.
Because the majority of the loans in our portfolio consist of term debt in private companies that typically cannot or will not expend the resources to have
their debt securities rated by a credit rating agency, we expect that most, if not all, of the debt securities we acquire will be unrated. Investors should assume that these loans would be rated below what is today considered investment
grade quality. Investments rated below investment grade are often referred to as high yield securities or junk bonds and may be considered higher risk, as compared to investment-grade debt instruments.
Investment Policies
We seek to achieve a high
level of current income and capital gains through investments in debt securities and preferred and common stock that we generally acquire in connection with buyout and other recapitalizations. The following investment policies, along with these
investment objectives, may not be changed without the approval of our Board of Directors:
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We will at all times conduct our business so as to retain our status as a BDC. In order to retain that status, we must be operated for the purpose of investing in certain categories of qualifying assets. In addition, we
may not acquire any assets (other than non-investment assets necessary and appropriate to our operations as a BDC or qualifying assets) if, after giving effect to such acquisition, the value of our qualifying assets is less than 70% of
the value of our total assets. We anticipate that the securities we seek to acquire will generally be qualifying assets.
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We will at all times endeavor to conduct our business so as to retain our status as a RIC under the Code. To do so, we must meet income source, asset diversification and annual distribution requirements. We may issue
senior securities, such as debt or preferred stock, to the extent permitted by the 1940 Act for the purpose of making investments, to fund share repurchases, or for temporary emergency or other purposes.
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With the exception of our policy to conduct our business as a BDC, these policies are not fundamental and may be changed without stockholder approval.
4
Investment Concentrations
As of March 31, 2016, our investment portfolio consisted of investments in 36 portfolio companies located in 19 states across 17 different industries with
an aggregate fair value of $487.7 million. Our investments in Acme Cryogenics, Inc. (Acme), Counsel Press, Inc. (Counsel Press), Cambridge Sound Management, Inc. (Cambridge), SOG Specialty Knives &
Tools, LLC (SOG), and Nth Degree, Inc. (Nth Degree) represented our five largest portfolio investments at fair value and collectively comprised $148.8 million, or 30.5%, of our total investment portfolio at fair value.
The following table summarizes our investments by security type as of March 31, 2016 and 2015:
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March 31, 2016
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March 31, 2015
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Cost
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Fair Value
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Cost
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Fair Value
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Secured first lien debt
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$
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296,247
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57.2
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%
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$
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280,037
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57.4
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%
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$
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298,448
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59.1
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%
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$
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267,545
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57.4
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%
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Secured second lien debt
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72,978
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14.1
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64,484
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13.2
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71,998
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14.2
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65,974
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14.2
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|
|
|
|
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|
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Total debt
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369,225
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71.3
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344,521
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70.6
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370,446
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73.3
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333,519
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71.6
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Preferred equity
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141,702
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27.3
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113,550
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23.3
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127,762
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25.3
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111,090
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23.8
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Common equity/equivalents
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7,198
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1.4
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29,585
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6.1
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7,050
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1.4
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21,444
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4.6
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|
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|
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|
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|
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Total equity/equivalents
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148,900
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28.7
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143,135
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29.4
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|
|
|
134,812
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26.7
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132,534
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28.4
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|
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Total Investments
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$
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518,125
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100.0
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%
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$
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487,656
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100.0
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%
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$
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505,258
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100.0
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%
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$
|
466,053
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100.0
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%
|
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|
|
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Our investments at fair value consisted of the following industry classifications as of March 31, 2016 and 2015:
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March 31, 2016
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March 31, 2015
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Fair Value
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Percentage
of Total
Investments
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Fair Value
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Percentage
of Total
Investments
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Chemicals, Plastics, and Rubber
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$
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90,602
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18.6
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%
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$
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49,312
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10.6
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%
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Home and Office Furnishings, House wares, and Durable Consumer Products
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86,811
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17.8
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70,533
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15.1
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Diversified/Conglomerate Manufacturing
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64,986
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13.3
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62,996
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13.5
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Diversified/Conglomerate Service
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49,901
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10.2
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31,995
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6.9
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Leisure, Amusement, Motion Pictures, Entertainment
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43,330
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8.9
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44,931
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9.6
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Automobile
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24,402
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5.0
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24,530
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5.3
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Farming and Agriculture
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21,005
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4.3
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22,438
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4.8
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Containers, Packaging, and Glass
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20,108
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4.1
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19,447
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4.2
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Machinery (Non-agriculture, Non-construction, Non-electronic)
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20,011
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4.1
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30,397
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6.5
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Cargo Transport
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14,484
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3.0
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13,972
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3.0
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Telecommunications
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14,000
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2.9
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19,241
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4.1
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Textiles and Leather
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11,995
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2.5
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10,750
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2.3
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Aerospace and Defense
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10,000
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2.1
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18,770
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4.0
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Beverage, Food and Tobacco
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9,050
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|
1.8
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12,982
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2.8
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Personal and Non-Durable Consumer Products
(Manufacturing Only)
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315
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0.1
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25,008
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5.4
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Other < 2.0%
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6,656
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1.3
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|
|
|
8,751
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1.9
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|
|
|
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|
|
|
|
|
|
|
|
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Total Investments
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|
$
|
487,656
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|
|
|
100.0
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%
|
|
$
|
466,053
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|
|
|
100.0
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%
|
|
|
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|
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Our investments at fair value were included in the following U.S. geographic regions as of March 31, 2016 and 2015:
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|
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March 31, 2016
|
|
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March 31, 2015
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Fair Value
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Percentage
of Total
Investments
|
|
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Fair Value
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Percentage
of Total
Investments
|
|
Northeast
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|
$
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183,265
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37.6
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%
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$
|
133,814
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28.7
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%
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South
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129,934
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26.6
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133,703
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28.7
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West
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124,713
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25.6
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161,444
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34.6
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Midwest
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49,744
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10.2
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|
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37,092
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8.0
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|
|
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|
|
|
|
|
|
|
|
|
|
|
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Total Investments
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|
$
|
487,656
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|
|
|
100.0
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%
|
|
$
|
466,053
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|
|
|
100.0
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%
|
|
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|
|
|
|
|
|
|
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The geographic region indicates the location of the headquarters for our portfolio companies. A portfolio company may have
additional business locations in other geographic regions.
5
Investment Process
Overview of Investment and Approval Process
To
originate investments, the Advisers investment professionals use an extensive referral network comprised primarily of private equity sponsors, venture capitalists, leveraged buyout funds, investment bankers, attorneys, accountants, commercial
bankers and business brokers. The Advisers investment professionals review information received from these and other sources in search of potential financing opportunities. If a potential opportunity matches our investment objectives, the
investment professionals will seek an initial screening of the opportunity with our president, David Dullum, to authorize the submission of an indication of interest (IOI) to the prospective portfolio company. If the prospective
portfolio company passes this initial screening and the IOI is accepted by the prospective company, the investment professionals will seek approval to issue a letter of intent (LOI) from the Advisers investment committee, which is
composed of Messrs. Gladstone, Brubaker, and Dullum, to the prospective company. If this LOI is issued, then the Adviser and Gladstone Securities (the Due Diligence Team) will conduct a due diligence investigation and create a detailed
profile summarizing the prospective portfolio companys historical financial statements, industry, competitive position and management team and analyzing its conformity to our general investment criteria. The investment professionals then
present this profile to the Advisers investment committee, which must approve each investment. Further, each investment is available for review by the members of our board of directors (our Board of Directors), a majority of whom
are not interested persons as defined in Section 2(a)(19) of the 1940 Act, and our Board of Directors reviews and approves any investments we may make pursuant to the Co-Investment Order.
Prospective Portfolio Company Characteristics
We
have identified certain characteristics that we believe are important in identifying and investing in prospective portfolio companies. The criteria listed below provide general guidelines for our investment decisions, although not all of these
criteria may be met by each portfolio company.
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Experienced Management.
We typically require that the businesses in which we invest have experienced management teams or a hiring plan in place to install an experienced management team. We also require the
businesses to have in place proper incentives to induce management to succeed and act in concert with our interests as investors, including having significant equity or other interests in the financial performance of their companies.
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Value-and-Income Orientation and Positive Cash Flow.
Our investment philosophy places a premium on fundamental analysis from an investors perspective and has a distinct value-and-income orientation. In
seeking value, we focus on established companies in which we can invest at relatively low multiples of earnings before interest, taxes, depreciation and amortization (EBITDA), and that have positive operating cash flow at the time of
investment. In seeking income, we typically invest in companies that generate relatively stable to growing sales, cash flows, and EBITDA to fixed charges coverage, which provides some assurance that the borrowers will be able to service their debt.
We do not expect to invest in start-up companies or companies with what we believe to be speculative business plans.
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Strong Competitive Position in an Industry.
We seek to invest in businesses that have developed strong market positions and significant relative market share within their respective markets and that we believe
are well-positioned to capitalize on growth opportunities. We seek businesses that demonstrate significant competitive advantages versus their competitors, which we believe will help to protect their market positions and profitability.
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Liquidation Value of Assets.
The projected liquidation value of the assets, if any, is an important factor in our investment analysis in collateralizing our debt securities.
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Extensive Due Diligence
The Due Diligence Team
conducts what we believe are extensive due diligence investigations of our prospective portfolio companies and investment opportunities. The due diligence investigation may begin with a review of publicly available information followed by in depth
business analysis, including, but not limited to, some or all of the following:
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a review of the prospective portfolio companys historical and projected financial information, including a quality of earnings analysis;
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visits to the prospective portfolio companys business site(s) and evaluation of potential environmental issues;
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interviews with the prospective portfolio companys management, employees, customers and vendors;
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6
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review of loan documents and material contracts;
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background checks and a management capabilities assessment on the prospective portfolio companys management team; and
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research, including market analyses, on the prospective portfolio companys products, services or particular industry and its competitive position therein.
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Additional due diligence of a potential investment may be conducted on our behalf by attorneys and independent accountants, as well as other outside advisers,
prior to the closing of the investment, as appropriate.
Investment Structure
Once the Adviser has determined that an investment meets our standards and investment criteria, the Adviser works with the management of that company and other
capital providers to structure the transaction in a way that we believe will provide us with the greatest opportunity to maximize our return on the investment, while providing appropriate incentives to management of the company. As discussed above,
the capital classes through which we typically structure a deal include first lien secured debt, second lien secured debt, and preferred and common equity or equivalents. Through its risk management process, the Adviser seeks to limit the downside
risk of our investments by:
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making investments with an expected total return (including interest, yield enhancements and potential equity appreciation) that it believes compensates us for the credit risk of the investment;
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seeking collateral or superior positions in the portfolio companys capital structure where possible;
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incorporating put and call protection rights into the investment structure where possible;
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negotiating covenants in connection with our investments that afford our portfolio companies as much flexibility as possible in managing their businesses, consistent with preserving our capital; and
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holding board seats or securing board observation rights at the portfolio company.
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We expect to hold most of
our debt investments until maturity or repayment. From time to time, we may sell our investments (including our equity investments) earlier if a liquidity event takes place, such as a recapitalization of a portfolio company, an initial public
offering, or a sale to a third party, including strategic buyers, private equity funds, or existing investors in the portfolio company, and which may be privately negotiated transactions.
Competitive Advantages
A large number of entities
compete with us and make the types of investments that we seek to make in small and medium-sized privately-owned businesses. Such competitors include private equity funds, leveraged buyout funds, other BDCs, venture capital funds, investment banks
and other equity and non-equity based investment funds, and other financing sources, including traditional financial services companies such as commercial banks. Many of our competitors are substantially larger than we are and have considerably
greater funding sources or are able to access capital more cost effectively. In addition, certain of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments,
and establish a larger portfolio of investments. Furthermore, many of these competitors are not subject to the regulatory restrictions that the 1940 Act imposes on us as a BDC. However, we believe that we have the following competitive advantages
over many other providers of financing to small and medium-sized businesses.
Management Expertise
Our Adviser has an investment committee for each of the Company and the Affiliated Public Funds. Mr. Gladstone and Mr. Brubaker serve as members of
the Advisers investment committees for each of the Company and each of the Affiliated Public Funds. Mr. Gladstone and Mr. Dullum have extensive experience in investing in middle market companies and with operating in the BDC
marketplace in general. Mr. Brubaker has substantial experience in acquisitions and operations of companies. These three individuals comprising our executive management dedicate a significant portion of their time to managing our investment
portfolio. They have extensive experience providing capital to small and medium-sized companies and have worked together at the Gladstone family of companies for more than ten years. In addition, we have access to the resources and expertise of
the Advisers investment professionals and support staff who possess a broad range of transactional, financial, managerial, and investment skills.
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Increased Access to Investment Opportunities Developed Through Extensive Research Capability and Network of
Contacts
The Adviser seeks to identify potential investments through active origination and due diligence and through its dialogue with numerous
management teams, members of the financial community and potential corporate partners with whom the Advisers investment professionals have long-term relationships. We believe that the Advisers investment professionals have developed a
broad network of contacts within the investment, commercial banking, private equity and investment management communities, and that their reputation, experience, and focus on investing in small and medium-sized companies enables us to source and
identify well-positioned prospective portfolio companies, which provide attractive investment opportunities. Additionally, the Adviser expects to generate information from its professionals network of accountants, consultants, lawyers and
management teams of portfolio companies and other companies to support the Advisers investment activities.
Disciplined, Value and
Income-Oriented Investment Philosophy with a Focus on Preservation of Capital
In making its investment decisions, the Adviser focuses on the risk and
reward profile of each prospective portfolio company, seeking to minimize the risk of capital loss without foregoing the potential for capital appreciation. We expect the Adviser to use the same value and income-oriented investment philosophy that
its professionals use in the management of the other Gladstone Companies and to commit resources to manage downside exposure. The Advisers approach seeks to reduce our risk in investments by using some or all of the following approaches:
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focusing on companies with attractive and sustainable market positions and cash flow;
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investing in businesses with experienced and established management teams;
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engaging in extensive due diligence from the perspective of a long-term investor;
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investing at low price-to-cash flow multiples; and
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adopting flexible transaction structures by drawing on the experience of the investment professionals of the Adviser and its affiliates.
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Longer Investment Horizon
Unlike private equity and
venture capital funds that are typically organized as finite-life partnerships, we are not subject to standard periodic capital return requirements. The partnership agreements of most private equity and venture capital funds typically provide that
these funds may only invest investors capital once and must return all capital and realized gains to investors within a finite time period, often seven to ten years. These provisions often force private equity and venture capital funds to seek
returns on their investments by causing their portfolio companies to pursue mergers, public equity offerings, or other liquidity events more quickly than might otherwise be optimal or desirable, potentially resulting in a lower overall return to
investors and/or an adverse impact on their portfolio companies. In contrast, we are a corporation of perpetual duration and are exchange-traded. We believe that our flexibility to make investments with a long-term view and without the capital
return requirements of traditional private investment vehicles provides us with the opportunity to achieve greater long-term returns on invested capital.
Flexible Transaction Structuring
We believe our
management teams broad expertise and its ability to draw upon many years of combined experience enables the Adviser to identify, assess, and structure investments successfully across all levels of a companys capital structure and manage
potential risk and return at all stages of the economic cycle. We are not subject to many of the regulatory limitations that govern traditional lending institutions, such as banks. As a result, we are flexible in selecting and structuring
investments, adjusting investment criteria and transaction structures and, in some cases, the types of securities in which we invest, thereby affording us a competitive advantage of providing both, equity and debt financing, which may limit
uncertainty related to the close of the transaction. We believe that this approach enables the Adviser to develop a financing structure which best fits the investment and growth profile of the underlying business and yields attractive investment
opportunities that will continue to generate current income and capital gain potential throughout the economic cycle, including during turbulent periods in the capital markets.
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Ongoing Management of Investments and Portfolio Company Relationships
The Advisers investment professionals actively oversee each investment by continuously evaluating the portfolio companys performance and typically
working collaboratively with the portfolio companys management to identify and incorporate best resources and practices that help us achieve our projected investment performance.
Monitoring
The Advisers investment
professionals monitor the financial performance, trends, and changing risks of each portfolio company on an ongoing basis to determine if each company is performing within expectations and to guide the portfolio companys management in taking
the appropriate courses of action. The Adviser employs various methods of evaluating and monitoring the performance of our investments in portfolio companies, which can include the following:
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monthly analysis of financial and operating performance;
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frequent assessment of the portfolio companys performance against its business plan and our investment expectations;
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attendance at and/or participation in the portfolio companys board of directors or management meetings;
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continuous assessment of portfolio company management, governance and strategic direction;
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continuous assessment of the portfolio companys industry and competitive environment; and
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frequent review and assessment of the portfolio companys operating outlook and financial projections.
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Relationship Management
The Advisers
investment professionals interact with various parties involved with a portfolio company, or investment, by actively engaging with internal and external constituents, including:
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advisers and consultants.
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Managerial Assistance and Services
As a BDC, we make available significant managerial assistance, as defined in the 1940 Act, to our portfolio companies and provide other services (other than
such managerial assistance) to such portfolio companies. Neither we, nor the Adviser, currently receive fees in connection with the managerial assistance we make available. At times, the Adviser may also provide other services to our portfolio
companies under certain agreements and may receive fees for services other than managerial assistance. Such services may include, but are not limited to: (i) assistance obtaining, sourcing or structuring credit facilities, long term loans or
additional equity from unaffiliated third parties; (ii) negotiating important contractual financial relationships; (iii) consulting services regarding restructuring of the portfolio company and financial modeling as it relates to raising
additional debt and equity capital from unaffiliated third parties; and (iv) primary role in interviewing, vetting and negotiating employment contracts with candidates in connection with adding and retaining key portfolio company management
team members. The Adviser voluntarily, unconditionally, and irrevocably credits 100% of these fees against the base management fee that we would otherwise be required to pay to the Adviser as discussed below in
Transactions with
Related Parties Investment Advisory and Management Agreement Base Management Fee;
however, pursuant to the terms of the Advisory Agreement, a small percentage of certain of such fees is retained by the Adviser in the form of
reimbursement, at cost, for tasks completed by personnel of the Adviser, primarily for the valuation of portfolio companies.
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In February 2011, Gladstone Securities started providing other services (such as investment banking and due
diligence services) to certain of our portfolio companies, see
Transactions with Related Parties Other Transactions
below.
Valuation Process
The following is a general
description of our investment valuation policy (the Policy) (which has been approved by our Board of Directors) that the professionals of the Adviser and Administrator, with oversight and direction from our chief valuation officer, an
employee of the Administrator that reports directly to our Board of Directors, (collectively, the Valuation Team) use each quarter to determine the fair value of our investment portfolio. In accordance with the 1940 Act, our Board of
Directors has the ultimate responsibility for reviewing and approving, in good faith, the fair value of our investments based on the Policy. The Adviser values our investments in accordance with the requirements of the 1940 Act and accounting
principles generally accepted in the U.S. (GAAP). There is no single standard for determining fair value (especially for privately-held businesses), as fair value depends upon the specific facts and circumstances of each individual
investment. Each quarter, our Board of Directors reviews the Policy to determine if changes thereto are advisable and assesses whether the Valuation Team has applied the Policy consistently. With respect to the valuation of our investment portfolio,
the Valuation Team performs the following steps each quarter:
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Each investment is initially assessed by the Valuation Team using the Policy, which may include:
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obtaining fair value quotes or utilizing valuation inputs from third party valuation firms; and
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using techniques, such as total enterprise value, yield analysis, market quotes and other factors, including but not limited to: the nature and realizable value of the collateral, including external parties
guaranties; any relevant offers or letters of intent to acquire the portfolio company; and the markets in which the portfolio company operates.
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Preliminary valuation conclusions are then discussed amongst the Valuation Team and with our management and documented for review by our Board of Directors. Written valuation recommendations and supporting material are
sent to the Board of Directors in advance of the quarterly meetings.
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Next, the Valuation Committee of the Board of Directors (comprised entirely of independent directors) meets to review this documentation and discusses the information provided by our Valuation Team, and determines
whether the Valuation Team has followed the Policy, determines whether the Valuation Teams recommended fair value is reasonable in light of the Policy and reviews other facts and circumstances. Then, the Valuation Committee and chief valuation
officer present the Valuation Committees findings to the entire Board of Directors, so that the full Board of Directors may review and approve, with a vote, to accept or reject the fair value recommendations in accordance with the Policy.
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Fair value measurements of our investments may involve subjective judgment and estimates. Due to the uncertainty inherent in valuing these
securities, the Valuation Teams determinations of fair value may fluctuate from period to period and may differ materially from the values that could be obtained if a ready market for these securities existed. Our NAV could be materially
affected if the Valuation Teams determinations regarding the fair value of our investments are materially different from the values that we ultimately realize upon our disposal of such securities. Our valuation policies, procedures and
processes are more fully described under Managements Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies Investment Valuation.
Transactions with Related Parties
Investment Advisory and Management Agreement
Pursuant to our Advisory Agreement, we pay the Adviser certain fees as compensation for its services, consisting of a base management fee and an incentive fee,
each as described below. On July 14, 2015, our Board of Directors, including a majority of the directors who are not parties to the Advisory Agreement or interested persons of such party, approved the annual renewal of the Advisory Agreement
through August 31, 2016. Our Board of Directors considered the following factors as the basis for its decision to renew the Advisory Agreement: (1) the nature, extent and quality of services provided by the Adviser to our stockholders;
(2) the investment performance of the Company and the Adviser, (3) the costs of the services to be provided and profits to be realized by the Adviser and its affiliates from the relationship with the Company, (4) the extent to which
economies of scale will be realized as the Company and the Companys affiliates that are managed by the same Adviser (the Affiliated Public Funds) grow and whether the fee level under the Advisory Agreement reflects the economies of scale for
the Companys investors, (5) the fee structure of the advisory and administrative agreements of comparable funds, and (6) indirect profits to the Adviser created through the Company and (7) in light of the foregoing
considerations, the overall fairness of the advisory fee paid under the Advisory Agreement.
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Base Management Fee
The base management fee is payable quarterly to the Adviser pursuant to our Advisory Agreement and is assessed at an annual rate of 2.0%, computed on the basis
of the value of our average gross assets at the end of the two most recently completed quarters (inclusive of the current quarter), which are total assets, including investments made with proceeds of borrowings, less any uninvested cash or cash
equivalents resulting from borrowings, and adjusted appropriately for any share issuances or repurchases during the period.
Additionally, as stated
above, pursuant to the requirements of the 1940 Act, the Adviser makes available significant managerial assistance to our portfolio companies. The Adviser may also provide other services to our portfolio companies under certain agreements and may
receive fees for services other than managerial assistance. The Adviser voluntarily, unconditionally, and irrevocably credits 100% of these fees against the base management fee that we would otherwise be required to pay to the Adviser; however,
pursuant to the terms of the Advisory Agreement, a small percentage of certain of such fees is retained by the Adviser in the form of reimbursement, at cost, for tasks completed by personnel of the Adviser, primarily for the valuation of portfolio
companies. Loan servicing fees that are payable to the Adviser pursuant to our Fifth Amended and Restated Credit Agreement, as amended (our Credit Facility), are also 100% credited against the base management fee as discussed below
Loan Servicing Fee Pursuant to Credit Facility
).
Incentive Fee
The incentive fee payable to the Adviser under our Advisory Agreement consists of two parts: an income-based incentive fee and a capital gains-based incentive
fee.
The income-based incentive fee rewards the Adviser if our quarterly net investment income (before giving effect to any incentive fee) exceeds 1.75%
of our net assets, adjusted appropriately for any share issuances or repurchases during the period (the Hurdle Rate). The income-based incentive fee with respect to our pre-incentive fee net investment income is payable quarterly to the
Adviser and is computed as follows:
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no incentive fee in any calendar quarter in which our pre-incentive fee net investment income does not exceed the Hurdle Rate (7.0% annualized);
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100.0% of our pre-incentive fee net investment income with respect to that portion of such pre-incentive fee net investment income, if any, that exceeds the Hurdle Rate but is less than 2.1875% of our net assets,
adjusted appropriately for any share issuances or repurchases during the period, in any calendar quarter (8.75% annualized); and
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20.0% of the amount of our pre-incentive fee net investment income, if any, that exceeds 2.1875% of our net assets, adjusted appropriately for any share issuances or repurchases during the period, in any calendar
quarter (8.75% annualized).
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Quarterly Incentive Fee Based on Net Investment Income
Pre-incentive fee net investment income
(expressed as a percentage of the value of net assets)
Percentage of pre-incentive fee net investment income
allocated to income-related portion of incentive fee
The second part of the incentive fee is a capital gains-based incentive fee that is determined and payable in arrears as of the end of each fiscal year (or
upon termination of the Advisory Agreement, as of the termination date), and equals 20.0% of our realized capital gains, less any realized capital losses and unrealized depreciation, calculated as of the end of the preceding calendar year. The
capital gains-based incentive fee payable to the Adviser is calculated based on (i) cumulative aggregate realized capital gains since our inception, less (ii) cumulative aggregate realized capital losses since our inception, less
(iii) the entire portfolios aggregate unrealized capital depreciation, if any, as of the date of the calculation. If this number is positive at the applicable calculation date, then the
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capital gains-based incentive fee for such year equals 20.0% of such amount, less the aggregate amount of any capital gains-based incentive fees paid in respect of our portfolio in all prior
years. For calculation purposes, cumulative aggregate realized capital gains, if any, equals the sum of the excess between the net sales price of each investment, when sold, and the original cost of such investment since our inception. Cumulative
aggregate realized capital losses equals the sum of the deficit between the net sales price of each investment, when sold, and the original cost of such investment since our inception. The entire portfolios aggregate unrealized capital
depreciation, if any, equals the sum of deficit between the fair value of each investment security as of the applicable calculation date and the original cost of such investment security. We have not incurred capital gains-based incentive fees from
inception through March 31, 2016, as cumulative net unrealized capital depreciation has exceeded cumulative realized capital gains net of cumulative realized capital losses.
Additionally, in accordance with GAAP, a capital gains-based incentive fee accrual is calculated using the aggregate cumulative realized capital gains and
losses and aggregate cumulative unrealized capital depreciation included in the calculation of the capital gains-based incentive fee plus the aggregate cumulative unrealized capital appreciation. If such amount is positive at the end of a reporting
period, then GAAP requires us to record a capital gains-based incentive fee equal to 20.0% of such amount, less the aggregate amount of actual capital gains-based incentive fees paid in all prior years. If such amount is negative, then there is no
accrual for such period. GAAP requires that the capital gains-based incentive fee accrual consider the cumulative aggregate unrealized capital appreciation in the calculation, as a capital gains-based incentive fee would be payable if such
unrealized capital appreciation were realized. There can be no assurance that any such unrealized capital appreciation will be realized in the future. There has been no GAAP accrual recorded for a capital gains-based incentive fee since our
inception through March 31, 2016.
Our Board of Directors may accept voluntary, unconditional, and irrevocable credits from the Adviser to reduce the
income-based incentive fee to the extent net investment income generated in the current or prior year does not cover 100% of the distributions to common stockholders for a year. For the years ended March 31, 2016, 2015 and 2014, there were no
such incentive fee credits from the Adviser.
Loan Servicing Fee Pursuant to Credit Facility
The Adviser also services the loans held by our wholly-owned subsidiary, Gladstone Business Investment, LLC (Business Investment) (the borrower
under our Credit Facility), in return for which the Adviser receives a 2.0% annual fee based on the monthly aggregate outstanding balance of loans pledged under our Credit Facility. Since Business Investment is a consolidated subsidiary of ours,
coupled with the fact that the total base management fee paid to the Adviser pursuant to the Advisory Agreement cannot exceed 2.0% of total assets (as reduced by cash and cash equivalents pledged to creditors) during any given calendar year, we
treat payment of the loan servicing as a pre-payment of the base management fee under the Advisory Agreement. Accordingly, these loan servicing fees are 100% voluntarily, unconditionally, and irrevocably credited back to us by the Adviser.
Administration Agreement
We pay the Administrator
pursuant to the Administration Agreement for our allocable portion of the Administrators expenses incurred while performing services to us, which are primarily rent and salaries and benefits expenses of the Administrators employees,
including, but not limited to, our chief financial officer and treasurer, chief valuation officer, chief compliance officer and general counsel and secretary (who also serves as the Administrators president) and their respective staffs. Prior
to July 1, 2014, our allocable portion of the expenses was generally derived by multiplying that portion of the Administrators expenses allocable to all funds managed by the Adviser and serviced by the Administrator by the percentage of
our total assets at the beginning of each quarter in comparison to the total assets at the beginning of each quarter of all funds managed by the Adviser and serviced by the Administrator.
Effective July 1, 2014, our allocable portion of the Administrators expenses are generally derived by multiplying the Administrators total
expenses by the approximate percentage of time during the current quarter the Administrators employees performed services for us in relation to their time spent performing services for all companies serviced by the Administrator. These
administrative fees are accrued at the end of the quarter when the services are performed and recorded in our accompanying
Condensed Consolidated Statements of Operations
and generally paid the following quarter. On July 14, 2015, our
Board of Directors approved the annual renewal of the Administration Agreement through August 31, 2016.
Other Transactions
Mr. Gladstone also serves on the board of managers of our affiliate, Gladstone Securities, LLC (Gladstone Securities), a privately-held
broker-dealer registered with the Financial Industry Regulatory Authority (FINRA) and insured by the Securities Investor Protection Corporation. Gladstone Securities is 100% indirectly owned and controlled by Mr. Gladstone and has
provided other services, such as investment banking and due diligence services, to certain of our portfolio companies, for which Gladstone Securities
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receives a fee. Any such fees paid by portfolio companies to Gladstone Securities do not impact the fees we pay to the Adviser or the voluntary, unconditional, and irrevocable credits against the
base management fee. For additional information refer to Note 4 Related
Party Transactions
of the notes to our accompanying
Consolidated Financial Statements
.
Material U.S. Federal Income Tax Considerations
RIC Status
To qualify for treatment as a RIC under
Subchapter M of the Code, we must generally distribute to our stockholders, for each taxable year, at least 90% of our ordinary income plus the excess of our net short-term capital gains over net long-term capital losses (Investment Company
Taxable Income). We refer to this as the annual distribution requirement. We must also meet several additional requirements, including:
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Business Development Company status.
At all times during the taxable year, we must maintain our status as a BDC.
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Income source requirements.
At least 90% of our gross income for each taxable year must be from dividends, interest, payments with respect to securities loans, gains from sales or other dispositions of securities
or other income derived with respect to our business of investing in securities, and net income derived from an interest in a qualified, publicly-traded partnership.
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Asset diversification requirements.
As of the close of each quarter of our taxable year: (1) at least 50% of the value of our assets must consist of cash, cash items, U.S. government securities, the
securities of other regulated investment companies and other securities to the extent that (a) we do not hold more than 10% of the outstanding voting securities of an issuer of such other securities and (b) such other securities of any one
issuer do not represent more than 5% of our total assets (the 50% threshold), and (2) no more than 25% of the value of our total assets may be invested in the securities of one issuer (other than U.S. government securities or the
securities of other regulated investment companies), or of two or more issuers that are controlled by us and are engaged in the same or similar or related trades or businesses or in the securities of one or more qualified, publicly-traded
partnerships.
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Failure to Qualify as a RIC
If we are unable to qualify for treatment as a RIC, we would be subject to tax on all of our taxable income at regular corporate rates. We would not be able to
deduct distributions to stockholders, nor would we be required to make such distributions. Distributions would be taxable to our stockholders as dividend income to the extent of our current and accumulated earnings and profits. Subject to certain
limitations under the Code, corporate distributees would be eligible for the dividends received deduction. Distributions in excess of our current and accumulated earnings and profits would be treated first as a return of capital to the extent of the
stockholders adjusted tax basis, and then as a gain realized from the sale or exchange of property. If we fail to meet the RIC requirements for more than two consecutive years and then seek to requalify as a RIC, we generally would be subject
to corporate-level federal income tax on any unrealized appreciation with respect to our assets to the extent that any such unrealized appreciation is recognized during the five-year period commencing on the first date on which we requalify as a
RIC.
Qualification as a RIC
If we qualify as
a RIC and distribute to stockholders each year in a timely manner at least 90% of our Investment Company Taxable Income, we will not be subject to federal income tax on the portion of our taxable income and gains we distribute to stockholders. We
would, however, be subject to a 4% nondeductible federal excise tax if we do not distribute, actually or on a deemed basis, an amount at least equal to the sum of (1) 98% of our ordinary income for the calendar year, (2) 98.2% of our
capital gains in excess of capital losses for the one-year period ending on October 31 of the calendar year and (3) any ordinary income and capital gains in excess of capital losses for preceding years that were not distributed during such
years. For the years ended December 31, 2015, 2014 and 2013, we incurred $0.3 million, $0.1 million and $0.3 million, respectively, in excise taxes. As of March 31, 2016, our capital loss carryforward totaled
$13.6 million.
We will be subject to regular corporate income tax, currently at rates up to 35%, on any income that is not distributed or deemed to
be distributed, including both ordinary income and capital gains. We may retain some or all of our long-term capital gains, but we generally intend to treat the retained amount as a deemed distribution. In that case, among other consequences, we
will pay federal tax on the retained amount, each stockholder will be required to include its share of the deemed distribution in income as if it had been actually distributed to the stockholder and the stockholder will be entitled to claim a credit
or refund equal to its allocable share of the tax we pay on the retained long-term capital gain. The amount of the deemed distribution, net of such tax, will be added to the stockholders tax basis for its stock. Since we expect to pay federal
tax on any retained long-term capital gains at our regular corporate capital gain tax rate, and since that rate is in excess of the maximum rate currently payable by individuals on long-term capital gains, the amount of tax that individual
stockholders will be treated as having paid will exceed the tax they owe on the capital gain dividend
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and such excess may be claimed as a credit or refund against the stockholders other tax obligations. A stockholder that is not subject to U.S. federal income tax or tax on long-term capital
gains would be required to file a U.S. federal income tax return on the appropriate form in order to claim a refund for the taxes we paid. In order to utilize the deemed distribution approach, we must provide written notice to the stockholders
after the close of the relevant tax year. We will also be subject to alternative minimum tax, but any tax preference items would be apportioned between us and our stockholders in the same proportion that distributions, other than capital gain
dividends, paid to each stockholder bear to our taxable income determined without regard to the dividends paid deduction. As of March 31, 2016, we have never made a deemed distribution.
Taxation of Our U.S. Stockholders
Distributions
For any period during which we
qualify as a RIC for federal income tax purposes, distributions to our stockholders attributable to our Investment Company Taxable Income generally will be taxable as ordinary income to stockholders to the extent of our current or accumulated
earnings and profits. We first allocate our earnings and profits to distributions to our preferred stockholders and then to distributions to our common stockholders based on priority in our capital structure. Any distributions in excess of our
earnings and profits will first be treated as a return of capital to the extent of the stockholders adjusted basis in his or her shares of stock and thereafter as gain from the sale of shares of our stock. Distributions of our long-term
capital gains, reported by us as such, will be taxable to stockholders as long-term capital gains regardless of the stockholders holding period of the stock and whether the distributions are paid in cash or invested in additional stock.
Corporate stockholders are generally eligible for the 70% dividends received deduction with respect to dividends received from us, other than capital gains dividends, but only to the extent such amount is attributable to dividends received by us
from taxable domestic corporations.
Any distribution declared by us in October, November or December of any calendar year, payable to
stockholders of record on a specified date in such a month and actually paid during January of the following year, will be treated as if it were paid by us and received by the stockholders on December 31 of the previous year. In addition,
we may elect (in accordance with Section 855(a) of the Code) to relate a distribution back to the prior taxable year if we (1) declare such distribution prior to the later of the due date for filing our return for that taxable year or the
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th
day of the ninth month following the close of the taxable year, (2) make the election in that return, and (3) distribute the amount in the 12-month period following the close of the
taxable year but not later than the first regular distribution payment of the same type following the declaration. Any such election will not alter the general rule that a stockholder will be treated as receiving a distribution in the taxable year
in which the distribution is made, subject to the October, November, December rule described above. As of March 31, 2016, our Section 855(a) distributions were $6.9 million.
If a common stockholder participates in our opt in dividend reinvestment plan, any distributions reinvested under the plan will be taxable to the
common stockholder to the same extent, and with the same character, as if the common stockholder had received the distribution in cash. The common stockholder will have an adjusted basis in the additional common shares purchased through the plan
equal to the amount of the reinvested distribution. The additional common shares will have a new holding period commencing on the day following the day on which the shares are credited to the common stockholders account. The plan agent
purchases shares in the open market in connection with the obligations under the plan. We do not have a dividend reinvestment plan for our preferred stockholders.
Sale of Our Shares
A U.S. stockholder
generally will recognize taxable gain or loss if the U.S. stockholder sells or otherwise disposes of the shares of our common or preferred stock. Any gain arising from such sale or disposition generally will be treated as long-term capital gain
or loss if the U.S. stockholder has held the shares for more than one year. Otherwise, it will be classified as short-term capital gain or loss. However, any capital loss arising from the sale or disposition of shares of our stock held for six
months or less will be treated as long-term capital loss to the extent of the amount of capital gain dividends received, or undistributed capital gain deemed received, with respect to such shares. Under the tax laws in effect as of the date of this
filing, individual U.S. stockholders are subject to a maximum federal income tax rate of 20% on their net capital gain (i.e. the excess of realized net long-term capital gain over realized net short-term capital loss for a taxable year)
including any long-term capital gain derived from an investment in our shares. Such rate is lower than the maximum rate on ordinary income currently payable by individuals. Corporate U.S. stockholders currently are subject to federal income tax
on net capital gain at the same rates applied to their ordinary income (currently up to a maximum of 35%). Capital losses are subject to limitations on use for both corporate and non-corporate stockholders. Certain U.S. stockholders who are
individuals, estates or trusts generally are subject to a 3.8% Medicare tax on, among other things, dividends on, and capital gain from the sale or other disposition of, shares of our stock.
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Backup Withholding and Other Required Withholding
We may be required to withhold federal income tax, or backup withholding, currently at a rate of 28%, from all taxable distributions to any non-corporate
U.S. stockholder (1) who fails to furnish us with a correct taxpayer identification number or a certificate that such stockholder is exempt from backup withholding, or (2) with respect to whom the Internal Revenue Service
(IRS) notifies us that such stockholder has failed to properly report certain interest and dividend income to the IRS and to respond to notices to that effect. An individuals taxpayer identification number is generally his or her
social security number. Any amount withheld under backup withholding is allowed as a credit against the U.S. stockholders federal income tax liability, provided that proper information is provided to the IRS.
The Foreign Account Tax Compliance Act (FATCA) imposes a federal withholding tax on certain types of payments made to foreign financial
institutions and certain other non-U.S. entities unless certain due diligence, reporting, withholding, and certification obligation requirements are satisfied. Under delayed effective dates provided for in the Treasury Regulations and other
IRS guidance, such required withholding will not begin until January 1, 2019 with respect to gross proceeds from a sale or other disposition of our stock.
Regulation as a BDC
We are a closed-end,
non-diversified management investment company that has elected to be regulated as a BDC under Section 54 of the 1940 Act. As such, we are subject to regulation under the 1940 Act. The 1940 Act contains prohibitions and restrictions relating to
transactions between BDCs and their affiliates, principal underwriters and affiliates of those affiliates or underwriters and requires that a majority of the directors be persons other than interested persons, as defined in the 1940 Act.
In addition, the 1940 Act provides that we may not change the nature of our business so as to cease to be, or to withdraw our election as, a BDC unless approved by a majority of our outstanding voting securities, as defined in the 1940
Act.
We intend to conduct our business so as to retain our status as a BDC. A BDC may use capital provided by public stockholders and from other sources
to make long-term private investments in businesses. A BDC provides stockholders the ability to retain the liquidity of a publicly-traded stock while sharing in the possible benefits, if any, of investing in primarily privately owned companies. In
general, a BDC must have been organized and have its principal place of business in the U.S. and must be operated for the purpose of making investments in qualifying assets, as described in Sections 55(a)(1) through (a)(3) of the 1940 Act.
Qualifying Assets
Under the 1940 Act, a BDC
may not acquire any asset other than assets of the type listed in Section 55(a) of the 1940 Act, which are referred to as qualifying assets, unless, at the time the acquisition is made, qualifying assets, other than certain interests in
furniture, equipment, real estate, or leasehold improvements (Operating Assets) represent at least 70% of total assets, exclusive of Operating Assets. The types of qualifying assets in which we may invest under the 1940 Act include, but
are not limited to, the following:
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(1)
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Securities purchased in transactions not involving any public offering from the issuer of such securities, which issuer is an eligible portfolio company. An eligible portfolio company is generally defined in the 1940
Act as any issuer which:
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(a)
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is organized under the laws of, and has its principal place of business in, any State or States in the U.S.;
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(b)
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is not an investment company (other than a small business investment company wholly owned by the BDC or otherwise excluded from the definition of investment company); and
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(c)
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satisfies one of the following:
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(i)
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it does not have any class of securities with respect to which a broker or dealer may extend margin credit;
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(ii)
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it is controlled by the BDC and for which an affiliate of the BDC serves as a director;
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(iii)
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it has total assets of not more than $4 million and capital and surplus of not less than $2 million;
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(iv)
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it does not have any class of securities listed on a national securities exchange; or
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(v)
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it has a class of securities listed on a national securities exchange, with an aggregate market value of outstanding voting and non-voting equity of less than $250 million.
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(2)
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Securities received in exchange for or distributed on or with respect to securities described in (1) above, or pursuant to the exercise of options, warrants or rights relating to such securities.
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(3)
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Cash, cash items, government securities or high quality debt securities maturing in one year or less from the time of investment.
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As of March 31, 2016, 99.1% of our assets were qualifying assets.
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Asset Coverage
Pursuant to Section 61(a)(2) of the 1940 Act, we are permitted, under specified conditions, to issue multiple classes of senior securities representing
indebtedness. However, pursuant to Section 18(c) of the 1940 Act, we are permitted to issue only one class of senior securities that is stock. In either case, we may only issue such senior securities if such class of senior securities, after
such issuance, has an asset coverage, as defined in Section 18(h) of the 1940 Act, of at least 200%.
In addition, our ability to pay dividends or
distributions (other than dividends payable in our stock) to holders of any class of our capital stock would be restricted if our senior securities representing indebtedness fail to have an asset coverage of at least 200% (measured at the time of
declaration of such distribution and accounting for such distribution). The 1940 Act does not apply this limitation to privately arranged debt that is not intended to be publicly distributed, unless this limitation is specifically negotiated by the
lender. In addition, our ability to pay dividends or distributions (other than dividends payable in our common stock) to our common stockholders would be restricted if our senior securities that are stock fail to have an asset coverage of at least
200% (measured at the time of declaration of such distribution and accounting for such distribution). If the value of our assets declines, we might be unable to satisfy these asset coverage requirements. To satisfy the 200% asset coverage
requirement in the event that we are seeking to pay a distribution, we might either have to (i) liquidate a portion of our loan portfolio to repay a portion of our indebtedness or (ii) issue common stock. This may occur at a time when a
sale of a portfolio asset may be disadvantageous, or when we have limited access to capital markets on agreeable terms. In addition, any amounts that we use to service our indebtedness or for offering costs will not be available for distributions to
our stockholders. If we are unable to regain asset coverage through these methods, we may be forced to suspend the payment of such dividends or distributions.
Significant Managerial Assistance
A BDC generally
must make available significant managerial assistance to issuers of certain of its portfolio securities that the BDC counts as a qualifying asset for the 70% test described above. Making available significant managerial assistance means, among other
things, any arrangement whereby the BDC, through its directors, officers or employees, offers to provide, and, if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies
of a portfolio company. Significant managerial assistance also includes the exercise of a controlling influence over the management and policies of the portfolio company. However, with respect to certain, but not all such securities, where the BDC
purchases such securities in conjunction with one or more other persons acting together, one of the other persons in the group may make available such managerial assistance, or the BDC may exercise such control jointly.
Code of Ethics
We and all of the Gladstone family
of companies, have adopted a code of ethics and business conduct applicable to all of the officers, directors and personnel of such companies that complies with the guidelines set forth in Item 406 of
Regulation S-K
of the Securities Act of 1933 (the Securities Act) and Rule 17j-1 of the 1940 Act. As required by the 1940 Act, this code establishes procedures for personal investments,
restricts certain transactions by such personnel and requires the reporting of certain transactions and holdings by such personnel. This code of ethics and business conduct is publicly available on our website under Corporate Governance
at www.GladstoneInvestment.com. We intend to provide any required disclosure of any amendments to or waivers of the provisions of this code by posting information regarding any such amendment or waiver to our website or in a Current Report on
Form 8-K.
Compliance Policies and Procedures
We and the Adviser have adopted and implemented written policies and procedures reasonably designed to prevent violation of the federal securities laws, and
our Board of Directors is required to review these compliance policies and procedures annually to assess their adequacy and the effectiveness of their implementation. We have designated a chief compliance officer, John Dellafiora, Jr., who also
serves as chief compliance officer for all of our Gladstone affiliates.
Staffing
We do not currently have any employees and do not expect to have any employees in the foreseeable future. Currently, services necessary for our business are
provided by individuals who are employees of the Adviser and the Administrator pursuant to the terms of the Advisory Agreement and the Administration Agreement, respectively. No employee of the Adviser or the Administrator will dedicate all of his
or her time to us. However, we expect that 25 to 30 full time employees of the Adviser and the Administrator will spend substantial time on our matters during the remainder of calendar year 2016 and all of calendar year 2017. To the extent we
acquire more investments, we anticipate that the number of employees of the Adviser and the Administrator who devote time to our matters will increase.
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As of May 9, 2016, the Adviser and Administrator collectively had 66 full-time employees. A breakdown of
these employees is summarized by functional area in the table below:
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Number of
Individuals
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Functional Area
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12
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Executive management
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17
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Accounting, administration, compliance, human resources, legal and treasury
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37
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Investment management, portfolio management and due diligence
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Available Information
Copies of our annual report on Form 10-K, quarterly reports on
Form 10-Q,
current reports on
Form 8-K,
and amendments, if any, to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the Exchange Act) are
available free of charge through our website at www.GladstoneInvestment.com as soon as reasonably practicable after such materials are electronically filed with or furnished to the SEC. A request for any of these reports may also be submitted to us
by sending a written request addressed to Investor Relations, Gladstone Investment Corporation, 1521 Westbranch Drive, Suite 100, McLean, VA 22102, or by calling our toll-free investor relations line at 1-866-366-5745. The public may read
and copy materials that we file with the SEC at the SECs Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at
1-800-SEC-0330. The SEC also maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.
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ITEM 1A. RISK FACTORS
You should carefully consider these risk factors, together with all of the other information included in this Annual Report on
Form 10-K
and the other reports and documents filed by us with the SEC. The risks set out below are not the only risks we face. Additional risks and uncertainties not presently known to us, or not presently
deemed material by us, may also impair our operations and performance. If any of the following events occur, our business, financial condition, results of operations and cash flows could be materially and adversely affected. In such case, our net
asset value (NAV) and the trading price of our securities could decline, and you may lose all or part of your investment. The risk factors described below are the principal risk factors associated with an investment in our securities as
well as those factors generally associated with an investment company with investment objectives, investment policies, capital structure or trading markets similar to ours.
Risks Related to Our Investments
We operate in
a highly competitive market for investment opportunities.
There has been increased competitive pressure in the BDC and investment company marketplace
for secured first and second lien debt, resulting in lower yields for increasingly riskier investments. A large number of entities compete with us and make the types of investments that we seek to make in small and medium-sized companies. We compete
with public and private buyout funds, commercial and investment banks, commercial financing companies, and, to the extent that they provide an alternative form of financing, hedge funds, mutual funds, and private equity. Many of our competitors are
substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, some competitors may have a lower cost of funds and access to funding sources that are not available to us. In addition, some of
our competitors may have higher risk tolerances or different risk assessments, which would allow them to consider a wider variety of investments and establish more relationships than us. Furthermore, many of our competitors are not subject to the
regulatory restrictions that the 1940 Act imposes on us as a BDC. The competitive pressures we face could have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this competition, we may
not be able to take advantage of attractive investment opportunities from time to time and we can offer no assurance that we will be able to identify and make investments that are consistent with our investment objective. We do not seek to compete
based on the interest rates we offer, and we believe that some of our competitors may make loans with interest rates that will be comparable to or lower than the rates we offer. We may lose investment opportunities if we do not match our
competitors pricing, terms, and structure. However, if we match our competitors pricing, terms, and structure, we may experience decreased net interest income and increased risk of credit loss.
Our investments in small and medium-sized portfolio companies are extremely risky and could cause you to lose all or a part of your investment.
Investments in small and medium-sized portfolio companies are subject to a number of significant risks including the following:
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Small and medium-sized businesses are likely to have greater exposure to economic downturns than larger businesses
. Our portfolio companies may have fewer resources than larger businesses, and any economic
downturns or recessions, are more likely to have a material adverse effect on them. If one of our portfolio companies is adversely impacted by a recession, its ability to repay our loan or engage in a liquidity event, such as a sale,
recapitalization or initial public offering would be diminished.
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Small and medium-sized businesses may have limited financial resources and may not be able to repay the loans we make to them.
Our strategy includes providing financing to portfolio companies that typically do
not have readily available access to financing. While we believe that this provides an attractive opportunity for us to generate profits, this may make it difficult for the portfolio companies to repay their loans to us upon maturity. A
borrowers ability to repay its loan may be adversely affected by numerous factors, including the failure to meet its business plan, a downturn in its industry or negative economic conditions. Deterioration in a borrowers financial
condition and prospects usually will be accompanied by deterioration in the value of any collateral and a reduction in the likelihood of realizing on any guaranties we may have obtained from the borrowers management. As of March 31, 2016
one portfolio company was on non-accrual status with an aggregate debt cost basis of $1.4 million, or 0.4%, of the cost basis of all debt investments in our portfolio. While we are working with the portfolio company to improve its
profitability and cash flows, there can be no assurance that our efforts will prove successful. Although we will generally seek to be the secured first lien lender to a borrower, in some of our loans we expect to be subordinated to a senior lender,
and our security interest in any collateral would, accordingly, likely be second lien and subordinate to another lenders security interest.
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Small and medium-sized businesses typically have narrower product lines and smaller market shares than large
businesses.
Because our target portfolio companies are smaller businesses, they will tend to be more vulnerable to
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competitors actions and market conditions, as well as general economic downturns. In addition, our portfolio companies may face intense competition, including competition from companies
with greater financial resources, more extensive development, manufacturing, marketing and other capabilities and a larger number of qualified managerial and technical personnel.
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There is generally little or no publicly available information about these businesses.
Because we seek to invest in privately owned businesses, there is generally little or no publicly available operating
and financial information about our potential portfolio companies. As a result, we rely on our officers, the Adviser and its employees, Gladstone Securities and consultants to perform due diligence investigations of these portfolio companies, their
operations, and their prospects. We may not learn all of the material information we need to know regarding these businesses through our investigations.
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Small and medium-sized businesses generally have less predictable operating results.
We expect that our portfolio companies may have significant variations in their operating results, may from time to time
be exposed to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, may require substantial additional capital to support their operations, to finance expansion or to maintain their
competitive position, may otherwise have a weak financial position or may be adversely affected by changes in the business cycle. Our portfolio companies may not meet net income, cash flow and other coverage tests typically imposed by their senior
lenders. A borrowers failure to satisfy financial or operating covenants imposed by senior lenders could lead to defaults and, potentially, foreclosure on its senior credit facility, which could additionally trigger cross-defaults in other
agreements. If this were to occur, it is possible that the borrowers ability to repay our loan would be jeopardized.
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Small and medium-sized businesses are more likely to be dependent on one or two persons.
Typically, the success of a small or medium-sized business also depends on the management talents and efforts of one
or two persons or a small group of persons. The death, disability or resignation of one or more of these persons could have a material adverse impact on our borrower and, in turn, on us.
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Small and medium-sized businesses may have limited operating histories.
While we intend to target stable companies with proven track records, we may make loans to new companies that meet our other investment
criteria. Portfolio companies with limited operating histories will be exposed to all of the operating risks that new businesses face and may be particularly susceptible to, among other risks, market downturns, competitive pressures and the
departure of key executive officers.
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Debt securities of small and medium-sized private companies typically are not rated by a credit rating agency
. Typically a small or medium-sized private business cannot or will not expend the resources to have
their debt securities rated by a credit rating agency. We expect that most, if not all, of the debt securities we acquire will be unrated. Investors should assume that these loans would be at rates below what is today considered investment
grade quality. Investments rated below investment grade are often referred to as high yield securities or junk bonds and may be considered high risk as compared to investment-grade debt instruments.
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Because the loans we make and equity securities we receive when we make loans are not publicly traded, there is uncertainty regarding the value of our
privately held securities that could adversely affect our determination of our NAV.
Our portfolio investments are, and we expect will continue
to be, in the form of securities that are not publicly traded. The fair value of securities and other investments that are not publicly traded may not be readily determinable. Our Board of Directors has ultimate responsibility for reviewing and
approving, in good faith, the fair value of our investments, based on the Policy. Our Board of Directors reviews valuation recommendations that are provided by the Valuation Team. In valuing our investment portfolio, several techniques are used,
including, a total enterprise value approach, a yield analysis, market quotes, and independent third party assessments. Currently, Standard & Poors Securities Evaluation, Inc. provides estimates of fair value on generally all of our
debt investments and we use another independent valuation firm to provide valuation inputs for our significant equity investments, including earnings multiple ranges, as well as other information. In addition to these techniques, inputs and
information, other factors are considered when determining fair value of our investments, including but not limited to: the nature and realizable value of the collateral, including external parties guaranties; any relevant offers or letters of
intent to acquire the portfolio company; and the markets in which the portfolio company operates. All new and follow-on debt and equity investments made during the current three month reporting period are generally valued at original cost basis. For
additional information on our valuation policies, procedures and processes, see
Managements Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policy Investment Valuation.
Fair value measurements of our investments may involve subjective judgments and estimates and due to the inherent uncertainty of determining these
fair values, the fair value of our investments may fluctuate from period to period. Additionally, changes in the market environment and other events that may occur over the life of the investment may cause the gains or losses ultimately realized on
these investments to be different than the valuations currently assigned.
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The valuation process for certain of our portfolio holdings creates a conflict of interest.
A substantial portion of our portfolio investments are made in the form of securities that are not publicly traded. As a result, our Board of Directors
determines the fair value of these securities in good faith pursuant the Policy. In connection with that determination, our Valuation Team prepares portfolio company valuations based upon the most recent portfolio company financial statements
available and projected financial results of each portfolio company. The participation of our Advisers investment professionals in our valuation process and Mr. Gladstones pecuniary interest in our Adviser, may result in a conflict
of interest as the management fees that we pay our Adviser are based on our gross assets less uninvested cash or cash equivalents from borrowings.
The
lack of liquidity of our privately held investments may adversely affect our business.
We will generally make investments in private companies whose
securities are not traded in any public market. Substantially all of the investments we presently hold and the investments we expect to acquire in the future are, and will be, subject to legal and other restrictions on resale and will otherwise be
less liquid than publicly-traded securities. The illiquidity of our investments may make it difficult for us to quickly obtain cash equal to the value at which we record our investments if the need arises. This could cause us to miss important
investment opportunities. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may record substantial realized losses upon liquidation. We may also face other restrictions on our ability to liquidate an
investment in a portfolio company to the extent that we, the Adviser, the Administrator, or our respective officers, or affiliates have material non-public information regarding such portfolio company.
Due to the uncertainty inherent in valuing these securities, the Advisers determinations of fair value may differ materially from the values that could
be obtained if a ready market for these securities existed. Our NAV could be materially affected if the Advisers determinations regarding the fair value of our investments are materially different from the values that we ultimately realize
upon our disposal of such securities.
Our financial results could be negatively affected if a significant portfolio investment fails to perform as
expected.
Our total investment in one or more companies may be significant individually or in the aggregate. As a result, if a significant investment
in one or more companies fails to perform as expected, our financial results could be more negatively affected and the magnitude of the loss could be more significant than if we had made smaller investments in more companies. Our five largest
investments represented 30.5% of the fair value of our total portfolio as of March 31, 2016, compared to 28.8% as of March 31, 2015. Any disposition of a significant investment in one or more companies may negatively impact our net
investment income and limit our ability to pay distributions.
The tightening of the U.S. monetary policy through the increase in Federal Reserve
System, or Fed, interest rate, which has been anticipated for several months, finally began in December 2015. The increase in the Fed rate can have a negative effect on our investments by making it harder and more expensive to refinance capital
structures or even obtain financing.
In December 2015, the Fed raised the fed funds rate for the first time in nine years, and projected two to three
rate hikes throughout the year. Per the Feds original statement, interest rates will rise at a slow (.25%) but steady pace. However, due to the drop in both equities and fixed income at the beginning of 2016, the Fed has recently indicated
they might hold off raising rates any further in the near term due to the recent volatility in the markets and continued depressed oil prices. Default rates in the U.S. high yield market currently stand around 4 %, according
to Moodys. The ratings company forecasts that the measure will rise to 5.05 % by the end of the year 2016 in the best-case scenario, and could jump as high as 14.9 % under the most pessimistic projection. The
Fed is looking to tighten U.S. policy as central banks abroad maintain or increase stimulus. The Fed policy meeting to be held mid-June could result in the next increase to the Fed funds rate, among other policy changes. Recently the Fed announced
they were going to suspend rate hikes until stronger economic data and oil stabilization hits the markets. There can be no guaranty the Fed will raise rates at the pace they proposed, nor can there be any assurance that the Fed will make sound
decisions as to when to raise rates. The increase in interest rates could have a negative effect on our investments.
We generally will not control our
portfolio companies.
We do not, and do not expect to, control most of our portfolio companies, even though we may have board representation or board
observation rights, and our debt agreements may contain certain restrictive covenants. As a result, we are subject to the risk that a portfolio company in which we invest may make business decisions with which we disagree and the management of such
company, as representatives of the holders of their common stock, may take risks or otherwise act in ways that do not serve our interests as debt
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investors. Due to the lack of liquidity for our investments in non-traded companies, we may not be able to dispose of our interests in our portfolio companies as readily as we would like or at an
appropriate valuation. As a result, a portfolio company may make decisions that could decrease the value of our portfolio holdings.
We typically
invest in transactions involving acquisitions, buyouts and recapitalizations of companies, which will subject us to the risks associated with change in control transactions.
Our strategy, in part, includes making debt and equity investments in companies in connection with acquisitions, buyouts and recapitalizations, which subjects
us to the risks associated with change in control transactions. Change in control transactions often present a number of uncertainties. Companies undergoing change in control transactions often face challenges retaining key employees and maintaining
relationships with customers and suppliers. While we hope to avoid many of these difficulties by participating in transactions where the management team is retained and by conducting thorough due diligence in advance of our decision to invest, if
our portfolio companies experience one or more of these problems, we may not realize the value that we expect in connection with our investments, which would likely harm our operating results and financial condition.
Our portfolio companies may incur debt that ranks equally with, or senior to, our investments in such companies.
We primarily invest in secured first and second lien debt securities issued by our portfolio companies. In some cases, portfolio companies will be permitted to
have other debt that ranks equally with, or senior to, the debt securities in which we invest. By their terms, such debt securities may provide that the holders thereof are entitled to receive payment of interest and principal on or before the dates
on which we are entitled to receive payments in respect of the debt securities in which we invest. Also, in the event of insolvency, liquidation, dissolution, reorganization, or bankruptcy of a portfolio company, holders of debt instruments ranking
senior to our investment in that portfolio company would typically be entitled to receive payment in full before we receive any distribution in respect of our investment. After repaying such senior creditors, such portfolio company may not have any
remaining assets to use for repaying its obligation to us. In the case of debt ranking equally with debt securities in which we invest, we would have to share on an equal basis any distributions with other creditors holding such debt in the event of
an insolvency, liquidation, dissolution, reorganization, or bankruptcy of a portfolio company.
Prepayments of our investments by our portfolio
companies could adversely impact our results of operations and reduce our return on equity.
In addition to risks associated with delays in investing
our capital, we are also subject to the risk that investments we make in our portfolio companies may be repaid prior to maturity. During the fiscal year 2016, we experienced prepayments of term debt investments of $13.7 million. We will first
use any proceeds from prepayments to repay any borrowings outstanding on our Credit Facility. In the event that funds remain after repayment of our outstanding borrowings, then we will generally reinvest these proceeds in government securities,
pending their future investment in new debt and/or equity securities. These government securities will typically have substantially lower yields than the debt securities being prepaid and we could experience significant delays in reinvesting these
amounts. As a result, our results of operations could be materially adversely affected if one or more of our portfolio companies elect to prepay amounts owed to us. Additionally, prepayments could negatively impact our return on equity, which could
result in a decline in the market price of our common stock.
Higher taxation of our portfolio companies may impact our quarterly and annual operating
results.
The recessions adverse effect on federal, state and municipality revenues may induce these government entities to raise various taxes
to make up for lost revenues. Additional taxation may have an adverse effect on our portfolio companies earnings and reduce their ability to repay our loans to them, thus affecting our quarterly and annual operating results.
Our portfolio is concentrated in a limited number of companies and industries, which subjects us to an increased risk of significant loss if any one of
these companies does not repay us or if the industries experience downturns.
As of March 31, 2016, we had investments in 36 portfolio companies,
the five largest of which included Acme, Counsel Press, Cambridge, SOG, and Nth Degree, and comprised $148.8 million, or 30.5%, of our total investment portfolio, at fair value. A consequence of a limited number of investments is that the
aggregate returns we realize may be substantially adversely affected by the unfavorable performance of a small number of such loans or a substantial write-down of any one investment. Beyond our regulatory and income tax diversification requirements,
as well as our Credit Facility requirements, we do not have fixed guidelines for industry concentration and our investments could potentially be concentrated in relatively few industries. In addition, while we do not intend to invest 25% or more of
our total assets in a particular industry or group of industries at the time of investment, it is possible that as the values of our portfolio companies change, one industry or a group of industries may comprise in excess of 25% of the value of our
total assets. A downturn in a particular industry in which we have invested a significant portion of our total assets could have a materially adverse effect on us. As of March 31, 2016, our largest industry concentration was in Chemicals,
Plastics, and Rubber, representing 18.6% of our total investments, at fair value.
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Our investments are typically long term and will require several years to realize liquidation events.
Since we generally make five to seven year term loans and hold our loans and related equity positions until the loans mature, you should not expect realization
events, if any, to occur over the near term. In addition, we expect that any equity investments may require several years to appreciate in value and we cannot give any assurance that such appreciation will occur.
The disposition of our investments may result in contingent liabilities.
Currently, all of our investments involve private securities. In connection with the disposition of an investment in private securities, we may be required to
make representations about the business and financial affairs of the underlying portfolio company typical of those made in connection with the sale of a business. We may also be required to indemnify the purchasers of such investment to the extent
that any such representations turn out to be inaccurate or with respect to certain potential liabilities. These arrangements may result in contingent liabilities that ultimately yield funding obligations that must be satisfied through our return of
certain distributions previously made to us.
There may be circumstances where our debt investments could be subordinated to claims of other creditors
or we could be subject to lender liability claims.
Even though we have structured most of our investments as secured first and second lien loans, if
one of our portfolio companies were to go bankrupt, depending on the facts and circumstances, including the extent to which we actually provided managerial assistance to that portfolio company, a bankruptcy court might re-characterize our debt
investments and subordinate all, or a portion, of our claims to that of other creditors. Holders of debt instruments ranking senior to our investments typically would be entitled to receive payment in full before we receive any distributions. After
repaying such senior creditors, such portfolio company may not have any remaining assets to use to repay its obligation to us. We may also be subject to lender liability claims for actions taken by us with respect to a borrowers business or in
instances in which we exercised control over the borrower. It is possible that we could become subject to a lenders liability claim, including as a result of actions taken in rendering significant managerial assistance.
Portfolio company-related litigation could result in costs, including defense costs or damages, and the diversion of management time and resources.
In the course of investing in and often providing significant managerial assistance to certain of our portfolio companies, certain persons employed by
the Adviser sometimes serve as directors on the boards of such companies. To the extent that litigation arises out of our investments in these companies, even if meritless, we or such employees may be named as defendants in such litigation, which
could result in additional costs, including defense costs, and the diversion of management time and resources. We may be unable to accurately estimate our exposure to litigation risk if we record balance sheet reserves for probable loss
contingencies. As a result, any reserves we establish to cover any settlements or judgments may not be sufficient to cover our actual financial exposure, which may have a material impact on our results of operations, financial condition, or cash
flows.
In view of the inherent difficulty of predicting the outcome of legal actions and regulatory matters, we cannot provide assurance as to the
outcome of any threatened or pending matter or, if resolved adversely, the costs associated with any such matter, particularly where the claimant seeks very large or indeterminate damages or where the matter presents novel legal theories, involves a
large number of parties or is at a preliminary stage. The resolution of any such matters may be time consuming, expensive, and may distract management from the conduct of our business. The resolution of certain threatened or pending legal actions or
regulatory matters, if unfavorable, whether in settlement or a judgment, could have a material adverse effect on our financial condition, results of operations, or cash flows for the quarter in which such actions or matters are resolved or a reserve
is established.
For example, a former portfolio company, Noble Logistics, Inc. (Noble) is a defendant in employment law wage and hour and
independent contractor misclassification claims in a purported class action seeking monetary damages, Maximo v. Aspen Contracting California LLC d/b/a/ Noble Logistics, et al., or Maximo. Noble is a debtor in a bankruptcy case under Chapter 11 of
the federal bankruptcy code, pending in federal bankruptcy court in Delaware. The claims against Noble asserted in the Maximo case have been stayed by the filing of Nobles bankruptcy case. A lawsuit brought by plaintiffs Clarence and Sheila
Walder against a customer of Noble is also pending in California based on similar facts relating to Noble and claims under California law. The Maximo and Walder plaintiffs have attempted to bring claims against the Company and other former investors
in Noble based primarily on allegations that the Company and other investors controlled Noble and were responsible for the misclassification of Nobles workforce. To date,
22
claims against the Company have been struck by a court or voluntarily dismissed by the plaintiffs in connection with the automatic stay arising in connection with the Noble bankruptcy. While
neither the Company nor any of its portfolio companies (other than Noble) are currently defendants in these cases, they may in the future be subject to claims by these plaintiffs or other persons alleging similar claims, or may expend funds on
behalf of Noble to defend claims.
While the Company believes it would have valid defenses to potential claims, based on the current claims and facts
alleged, and intends to defend any claims vigorously, it may nevertheless expend significant amounts of money in defense costs and expenses. Further, if the Company enters into settlements or suffers an adverse outcome in any litigation, the Company
could be required to pay significant amounts. In addition, if any of the Companys portfolio companies become subject to direct or indirect claims or other obligations, such as defense costs or damages in litigation or settlement, the
Companys investment in such companies could diminish in value and the Company could suffer indirect losses. Further, these matters could cause the Company to expend significant management time and effort in connection with assessment and
defense of any claims. No range of potential expenses, costs or damages in connection with these matters can be estimated at this time.
We may not
realize gains from our equity investments and other yield enhancements.
When we make a loan, we may receive warrants or other equity interests to
purchase stock issued by the borrower or other yield enhancements, such as success fees. Our goal is to ultimately collect the yield enhancements and dispose of these equity interests and realize gains upon our disposition of such interests. We
expect that, over time, the yield enhancements we collect and the gains we realize on these equity interests will offset any losses we may experience on loan defaults. However, any warrants we receive may not appreciate in value and, in fact, may
decline in value and any other yield enhancements, such as success fees, may not be collected. Accordingly, we may not be able to realize gains from our equity interests or other yield enhancements and any gains we do recognize may not be sufficient
to offset losses we experience on our loan portfolio.
During the fiscal years ended March 31, 2016 and 2015, we recorded net realized losses of
$4.6 million and $0.1 million, respectively. During the fiscal year ended March 31, 2014, we recorded a net realized gain of $8.2 million. There can be no guaranties that such realized gains can be achieved in future periods and
the impact of such sales on our results of operations in prior periods should not be relied upon as being indicative of performance in future periods. For the years ended March 31, 2016, 2015 and 2014, success fee income totaled
$1.6 million, $1.4 million and $4.2 million, respectively.
Any cumulative unrealized depreciation we experience on our investment
portfolio may be an indication of future realized losses, which could reduce our income available for distribution.
As a BDC we are required to carry
our investments at market value or, if no market value is ascertainable, at fair value as determined in good faith by or under the direction of our Board of Directors. We will record decreases in the market values or fair values of our investments
as unrealized depreciation. Since our inception, we have, at times, incurred a cumulative net unrealized depreciation of our portfolio. Any unrealized depreciation in our investment portfolio could result in realized losses in the future and
ultimately in reductions of our income available for distribution to stockholders in future periods.
The recent volatility of oil and natural gas
prices could impair certain of our portfolio companies operations and ability to satisfy obligations to their respective lenders and investors, including us, which could negatively impact our financial condition.
Many of our portfolio companies businesses are heavily dependent upon the prices of, and demand for, oil and natural gas, which have recently declined
significantly and such volatility could continue or increase in the future. A substantial or extended decline in oil and natural gas demand or prices may adversely affect the business, financial condition, cash flow, liquidity or results of
operations of these portfolio companies and might impair their ability to meet capital expenditure obligations and financial commitments. A prolonged or continued decline in oil prices could therefore have a material adverse effect on our business,
financial condition and results of operations.
Risks Related to Our External Financing
In addition to regulatory limitations on our ability to raise capital, our Credit Facility contains various covenants which, if not complied with, could
accelerate our repayment obligations under the facility, thereby materially and adversely affecting our liquidity, financial condition, results of operations and ability to pay distributions.
We will have a continuing need for capital to finance our investments. As of March 31, 2016, we, through our wholly-owned subsidiary, Business
Investment, had $95.0 million in borrowings, at cost, outstanding under our Credit Facility, which provides for maximum borrowings of $185.0 million, with a revolving period end date of June 26, 2017 (the Revolving Period End
Date). Our Credit Facility permits us to fund additional loans and investments as long as we are within the conditions and covenants set forth in
23
the credit agreement. Among other things, our Credit Facility contains covenants that require Business Investment to maintain its status as a separate legal entity, prohibit certain significant
corporate transactions (such as mergers, consolidations, liquidations or dissolutions) and restrict material changes to our credit and collection policies without lenders consent. The Credit Facility generally also limits distributions to be
no greater than the sum of certain amounts, including, but not limited to, our net investment income, plus net capital gains, plus amounts elected by the Company to be considered as having been paid during the prior fiscal year in accordance with
Section 855(a) of the Code. Business Investment is also subject to certain limitations on the type of loan investments it can make, including restrictions on geographic concentrations, sector concentrations, loan size, payment frequency and
status, average life and lien property. Our Credit Facility also requires Business Investment to comply with other financial and operational covenants, which obligate us to, among other things, maintain certain financial ratios, including asset and
interest coverage and a minimum number of obligors required in the borrowing base of the credit agreement. Additionally, we are subject to a performance guaranty that requires us to maintain (i) a minimum net worth of $170 million plus 50%
of all equity and subordinated debt raised minus any equity or subordinated debt redeemed or retired after June 26, 2014, which equates to $224.9 million as of March 31, 2016, (ii) asset coverage with respect to senior securities
representing indebtedness of at least 200%, in accordance with Section 18 of the 1940 Act, and (iii) our status as a BDC under the 1940 Act and as a RIC under the Code. As of March 31, 2016, we were in compliance with the covenants
under our Credit Facility; however, our continued compliance depends on many factors, some of which are beyond our control.
Given the continued
uncertainty in the capital markets, the cumulative net unrealized depreciation in our portfolio may increase in future periods and threaten our ability to comply with the minimum net worth covenant and other covenants under our Credit Facility. Our
failure to satisfy these covenants could result in foreclosure by our lenders, which would accelerate our repayment obligations under the facility and thereby have a material adverse effect on our business, liquidity, financial condition, results of
operations and ability to pay distributions to our stockholders.
Any inability to renew, extend or replace our Credit Facility on terms favorable to
us, or at all, could adversely impact our liquidity and ability to fund new investments or maintain distributions to our stockholders.
If our Credit
Facility is not renewed or extended by the Revolving Period End Date, all principal and interest will be due and payable on or before June 26, 2019. Subject to certain terms and conditions, our Credit Facility may be expanded to a total of $250
million through the addition of other lenders to the facility. However, if additional lenders are unwilling to join the facility on its terms, we will be unable to expand the facility and thus will continue to have limited availability to finance
new investments under our Credit Facility. There can be no guaranty that we will be able to renew, extend or replace our Credit Facility upon its Revolving Period End Date on terms that are favorable to us, if at all. Our ability to expand our
Credit Facility, and to obtain replacement financing at or before the time of its Revolving Period End Date, will be constrained by then-current economic conditions affecting the credit markets. In the event that we are not able to expand our
Credit Facility, or to renew, extend or refinance our Credit Facility by the Revolving Period End Date, this could have a material adverse effect on our liquidity and ability to fund new investments, our ability to make distributions to our
stockholders and our ability to qualify as a RIC under the Code.
If we are unable to secure replacement financing, we may be forced to sell certain
assets on disadvantageous terms, which may result in realized losses, and such realized losses could materially exceed the amount of any unrealized depreciation on these assets as of our most recent balance sheet date, which would have a material
adverse effect on our results of operations. Such circumstances would also increase the likelihood that we would be required to redeem some or all of our outstanding mandatorily redeemable preferred stock, which could potentially require us to sell
more assets. In addition to selling assets, or as an alternative, we may issue common equity in order to repay amounts outstanding under our Credit Facility. Based on the recent trading prices of our common stock, such an equity offering may have a
substantial dilutive impact on our existing stockholders interest in our earnings, assets and voting interest in us. If we are able to renew, extend or refinance our Credit Facility prior to maturity, renewal, extension or refinancing, it
could potentially result in significantly higher interest rates and related charges and may impose significant restrictions on the use of borrowed funds to fund investments or maintain distributions to common and preferred stockholders.
Because we expect to distribute substantially all of our Investment Company Taxable Income, at least 90%, on an annual basis, our business plan is
dependent upon external financing, which is constrained by the limitations of the 1940 Act.
We completed recent equity offerings of our Series C and
Series B Term Preferred Stock in May 2015 and November 2014, respectively; our Series A Term Preferred Stock in March 2012; and our common stock offerings in March 2015 and in October 2012, and there can be no assurance that we will be able to raise
capital through issuing equity in the near future. Our business requires a substantial amount of cash to operate and grow. We may acquire such additional capital from the following sources:
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Senior Securities
. We may issue senior securities representing indebtedness (including borrowings under
our Credit Facility) and senior securities that are stock (including our Series A Term Preferred Stock, Series B Term Preferred Stock, and C Term Preferred Stock), up to the maximum amount permitted by the 1940 Act. The 1940 Act currently
permits us, as
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a BDC, to issue senior securities representing indebtedness and senior securities which are stock, in amounts such that our asset coverage, as defined in Section 18(h) of the 1940 Act, is at
least 200% on each such senior security immediately after each issuance of each such senior security. As a result of incurring indebtedness (in whatever form), we will be exposed to the risks associated with leverage. Although borrowing money for
investments increases the potential for gain, it also increases the risk of a loss. A decrease in the value of our investments will have a greater impact on the value of our common stock to the extent that we have borrowed money to make investments.
There is a possibility that the costs of borrowing could exceed the income we receive on the investments we make with such borrowed funds. In addition, our ability to pay distributions, issue senior securities or repurchase shares of our common
stock would be restricted if the asset coverage on each of our senior securities is not at least 200%. If the aggregate fair value of our assets declines, we might be unable to satisfy that 200% requirement. To satisfy the 200% asset coverage
requirement in the event that we are seeking to pay a distribution, we might either have to (i) liquidate a portion of our loan portfolio to repay a portion of our indebtedness or (ii) issue common stock. This may occur at a time when a
sale of a portfolio asset may be disadvantageous, or when we have limited access to capital markets on agreeable terms. In addition, any amounts that we use to service our indebtedness or for offering costs will not be available for distributions to
stockholders. Furthermore, if we have to issue common stock below NAV per common share, any non-participating stockholders will be subject to dilution, as described below. Pursuant to Section 61(a)(2) of the 1940 Act, we are permitted, under
specified conditions, to issue multiple classes of senior securities representing indebtedness. However, pursuant to Section 18(c) of the 1940 Act, we are permitted to issue only one class of senior securities that are stock.
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Common and Convertible Preferred Stock
. Because we are constrained in our ability to issue debt or senior securities for the reasons given above, we are dependent on the issuance of equity as a financing source.
If we raise additional funds by issuing more common stock, the percentage ownership of our common stockholders at the time of the issuance would decrease and our existing common stockholders may experience dilution. In addition, under the 1940 Act,
we will generally not be able to issue additional shares of our common stock at a price below NAV per common share to purchasers, other than to our existing common stockholders through a rights offering, without first obtaining the approval of our
stockholders and our independent directors. If we were to sell shares of our common stock below our then current NAV per common share, as we did in March 2015 and October 2012, such sales would result in an immediate dilution to the NAV per common
share. This dilution would occur as a result of the sale of common shares at a price below the then current NAV per share of our common stock and a proportionately greater decrease in a common stockholders interest in our earnings and assets
and voting percentage than the increase in our assets resulting from such issuance. For example, if we issue and sell an additional 10% of our common stock at a 5% discount from NAV, a common stockholder who does not participate in that offering for
its proportionate interest will suffer NAV dilution of up to 0.5% or $5 per $1,000 of NAV. This imposes constraints on our ability to raise capital when our common stock is trading below NAV per common share, as it generally has for the last several
years. As noted above, the 1940 Act prohibits the issuance of multiple classes of senior securities that are stock. As a result, we would be prohibited from issuing convertible preferred stock to the extent that such a security was deemed to be a
separate class of stock from our outstanding mandatorily redeemable preferred stock.
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We financed certain of our investments with
borrowed money and capital from the issuance of senior securities, which will magnify the potential for gain or loss on amounts invested and may increase the risk of investing in us.
The following table illustrates the effect of leverage on returns from an investment in our common stock assuming various annual returns on our portfolio, net
of expenses. The calculations in the table below are hypothetical and actual returns may be higher or lower than those appearing in the table below.
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Assumed Return on Our Portfolio
(Net of Expenses)
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(10
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)%
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(5
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)%
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0
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%
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5
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%
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10
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%
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Corresponding return to common
stockholder
(A)
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(22.5
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)%
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(13.4
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)%
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(4.3
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)%
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4.7
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%
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13.8
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%
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(A)
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The hypothetical return to common stockholders is calculated by multiplying our total assets as of March 31, 2016, by the assumed rates of return and subtracting
all interest on our debt and dividends on our mandatorily redeemable preferred stock expected to be paid or declared during the twelve months following March 31, 2016; and then dividing the resulting difference by our total net assets
attributable to common stock as of March 31, 2016. Based on $506.3 million in total assets, $95.0 million in borrowings outstanding on our Credit Facility, $5.1 million in a secured borrowing, $40.0 million in aggregate
liquidation preference of Series A Term Preferred Stock, $41.4 million in aggregate liquidation preference of Series B Term Preferred Stock, $40.3 million in aggregate liquidation preference of Series C Term Preferred Stock and
$279.0 million in net assets as of March 31, 2016.
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Based on an aggregate outstanding indebtedness of $100.1 million at principal as of March 31, 2016, the
effective annual interest rate of 3.9% as of that date, and aggregate liquidation preference of our mandatorily redeemable preferred stock of $121.7 million, our investment portfolio at fair value would have to produce an annual return of at
least 2.5% to cover annual interest payments on the outstanding debt and dividends on our mandatorily redeemable preferred stock.
A change in interest
rates may adversely affect our profitability and our hedging strategy may expose us to additional risks.
We anticipate using a combination of equity
and long-term and short-term borrowings to finance our investment activities. As a result, a portion of our income will depend upon the spread between the rate at which we borrow funds and the rate at which we loan these funds. An increase or
decrease in interest rates could reduce the spread between the rate at which we invest and the rate at which we borrow, and thus, adversely affect our profitability, if we have not appropriately hedged against such event. Alternatively, our interest
rate hedging activities may limit our ability to participate in the benefits of lower interest rates with respect to the hedged portfolio.
Ultimately, we
expect approximately 90.0% of the loans in our portfolio to be at variable rates determined on the basis of the LIBOR and approximately 10.0% to be at fixed rates. As of March 31, 2016, based on the total principal balance of debt investments
outstanding, our portfolio consisted of 85.9% of loans at variable rates with floors and 14.1% at fixed rates.
As of March 31, 2016, we had one
interest rate cap agreement for a notional amount of $45.0 million, which expired in April 2016. While hedging activities may insulate us against adverse fluctuations in interest rates, they may also limit our ability to participate in the benefits
of lower interest rates with respect to the hedged portfolio. Adverse developments resulting from changes in interest rates or any future hedging transactions could have a material adverse effect on our business, financial condition and results of
operations. Our ability to receive payments pursuant to an interest rate cap agreement is linked to the ability of the counter-party to that agreement to make the required payments. To the extent that the counter-party to the agreement is unable to
pay pursuant to the terms of the agreement, we may lose the hedging protection of the interest rate cap agreement.
Also, the fair value of certain of our
debt investments is based in part on the current market yields or interest rates of similar securities. A change in interest rates could have a significant impact on our determination of the fair value of these debt investments. In addition, a
change in interest rates could also have an impact on the fair value of any interest rate cap agreements then in effect that could result in the recording of unrealized appreciation or depreciation in future periods. Therefore, adverse developments
resulting from changes in interest rates could have a material adverse effect on our business, financial condition and results of operations. For additional information on interest rate fluctuations, see
Managements Discussion and Analysis
of Financial Condition and Results of Operations Quantitative and Qualitative Disclosures About Market Risk
for additional information on interest rate cap agreements
.
Risks Related to Our Regulation and Structure
We will be subject to corporate-level tax if we are unable to satisfy Code requirements for RIC qualification.
To maintain our qualification as a RIC, we must meet income source, annual distribution and asset diversification requirements. The annual distribution
requirement is satisfied if we distribute at least 90% of our Investment Company Taxable Income to our stockholders on an annual basis. Because we use leverage, we are subject to certain asset coverage ratio requirements under the 1940 Act and
could, under certain circumstances, be restricted from making distributions necessary to qualify as a RIC. Warrants we receive with respect to debt investments will create original issue discount (OID), which we must recognize as
ordinary income over the term of the debt investment. Similarly, PIK interest which is accrued generally over the term of the debt investment but not paid in cash, is recognized as ordinary income. Both OID and PIK interest will increase the amounts
we are required to distribute to maintain our RIC status. Because such OIDs and PIK interest will not produce distributable cash for us at the same time as we are required to make distributions, we will need to use cash from other sources to satisfy
such distribution requirements. Additionally, we must meet asset diversification and income source requirements at the end of each calendar quarter. If we fail to meet these tests, we may need to quickly dispose of certain investments to prevent the
loss of RIC status. Since most of our investments will be illiquid, such dispositions, if even possible, may not be made at prices advantageous to us and, in fact, may result in substantial losses. If we fail to qualify as a RIC as of a calendar
quarter or annually for any reason and become fully subject to corporate income tax, the resulting corporate taxes could substantially reduce our net assets, the amount of income available for distribution, and the actual amount distributed. Such a
failure would have a material adverse effect on us and our common stock. For additional information regarding asset coverage ratio and RIC requirements, see
Business Material U.S. Federal Income Tax Considerations RIC
Status
.
From time to time, some of our debt investments may include success fees that would generate payments to us if the business is
ultimately sold. Because the satisfaction of these success fees, and the ultimate payment of these fees, is uncertain and highly contingent, we generally only recognize them as income when the payment is received. Success fee amounts are
characterized as ordinary income for tax purposes and, as a result, we are required to distribute such amounts to our stockholders in order to maintain our RIC status.
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If we do not invest a sufficient portion of our assets in qualifying assets, we could fail to
qualify as a BDC under the 1940 Act or be precluded from investing according to our current business strategy.
As a BDC, we may not acquire any assets
other than qualifying assets unless, at the time of and after giving effect to such acquisition, at least 70% of our total assets are qualifying assets, as defined in Section 55(a) of the 1940 Act.
We believe that most of the investments that we may acquire in the future will constitute qualifying assets. However, we may be precluded from investing in
what we believe to be attractive investments if such investments are not qualifying assets for purposes of the 1940 Act. If we do not invest a sufficient portion of our assets in qualifying assets, we could violate the 1940 Act provisions applicable
to BDCs. As a result of such violation, specific rules under the 1940 Act could prevent us, for example, from making follow-on investments in existing portfolio companies (which could result in the dilution of our position) or could require us to
dispose of investments at inappropriate times in order to come into compliance with the 1940 Act. If we need to dispose of such investments quickly, it could be difficult to dispose of such investments on favorable terms. We may not be able to find
a buyer for such investments and, even if we do find a buyer, we may have to sell the investments at a substantial loss. Any such outcomes would have a material adverse effect on our business, financial condition, results of operations and cash
flows.
If we do not maintain our status as a BDC, we would be subject to regulation as a registered closed-end investment company under the 1940
Act. As a registered closed-end investment company, we would be subject to substantially more regulatory restrictions under the 1940 Act, which would significantly decrease our operating flexibility. For additional information regarding qualifying
assets, see
Business Regulation as a BDC Qualifying Assets.
Changes in laws or regulations governing our operations,
or changes in the interpretation thereof, and any failure by us to comply with laws or regulations governing our operations may adversely affect our business.
We, and our portfolio companies, are subject to regulation by laws at the local, state and federal levels. These laws and regulations, as well as their
interpretation, may be changed from time to time. Accordingly, any change in these laws or regulations, or their interpretation, or any failure by us or our portfolio companies to comply with these laws or regulations may adversely affect our
business. For additional information regarding the regulations to which we are subject, see
Business Material U.S. Federal Income Tax Considerations RIC Status
and
Business Regulation as a
BDC.
Provisions of the Delaware General Corporation Law and of our certificate of incorporation and bylaws could restrict a change in
control and have an adverse impact on the price of our common stock.
We are subject to provisions of the Delaware General Corporation Law that, in
general, prohibit any business combination with a beneficial owner of 15% or more of our common stock for three years unless the holders acquisition of our stock was either approved in advance by our Board of Directors or ratified by our Board
of Directors and stockholders owning two-thirds of our outstanding stock not owned by the acquiring holder. Although we believe these provisions collectively provide for an opportunity to receive higher bids by requiring potential acquirers to
negotiate with our Board of Directors, they would apply even if the offer may be considered beneficial by some stockholders.
We have also adopted other
measures that may make it difficult for a third party to obtain control of us, including provisions of our certificate of incorporation classifying our Board of Directors in three classes serving staggered three-year terms, and provisions of our
certificate of incorporation authorizing our Board of Directors to induce the issuance of additional shares of our stock. These provisions, as well as other provisions of our certificate of incorporation and bylaws, may delay, defer, or prevent a
transaction or a change in control that might otherwise be in the best interests of our stockholders.
We may not be permitted to declare a dividend or
make any distribution to stockholders or repurchase shares until such time as we satisfy the asset coverage tests under the provisions of the 1940 Act that apply to BDCs. As a BDC, we have the ability to issue senior securities only in amounts such
that our asset coverage, as defined in the 1940 Act, equals at least 200% after each issuance of senior securities. If the value of our assets declines, we may be unable to satisfy this test. If that happens, we may be required to sell a portion of
our investments and, depending on the nature of our leverage, repay a portion of our debt at a time when such sales and/or repayments may be disadvantageous.
Regulations governing our operation as a BDC and RIC will affect our ability to raise, and the way in which we raise, additional capital or borrow for
investment purposes, which may have a negative effect on our growth. As a result of the annual distribution requirement to qualify as a RIC, we may need to periodically access the capital markets to raise cash to fund new investments. We
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may issue senior securities representing indebtedness, including borrowing money from banks or other financial institutions, or senior securities that are stock, such as our Series A Term
Preferred Stock, our Series B Term Preferred Stock, and our Series C Term Preferred Stock, only in amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after each such incurrence or issuance. Further, we may not be
permitted to declare a dividend or make any distribution to our outstanding stockholders or repurchase shares until such time as we satisfy this test. Our ability to issue different types of securities is also limited. Compliance with these
requirements may unfavorably limit our investment opportunities and reduce our ability in comparison to other companies to profit from favorable spreads between the rates at which we can borrow and the rates at which we can lend. As a BDC,
therefore, we intend to continuously issue equity at a rate more frequent than our privately owned competitors, which may lead to greater stockholder dilution. We have incurred leverage to generate capital to make additional investments. If the
value of our assets declines, we may be unable to satisfy the asset coverage test under the 1940 Act, which could prohibit us from paying distributions and could prevent us from qualifying as a RIC. If we cannot satisfy the asset coverage test, we
may be required to sell a portion of our investments and, depending on the nature of our debt financing, repay a portion of our indebtedness at a time when such sales and repayments may be disadvantageous.
Risks Related to Our External Management
We
are dependent upon our key management personnel and the key management personnel of the Adviser, particularly David Gladstone, Terry Lee Brubaker and David Dullum, and on the continued operations of the Adviser, for our future success.
We have no employees. Our chief executive officer, chief operating officer, chief financial officer and treasurer, chief valuation officer, and the employees
of the Adviser, do not spend all of their time managing our activities and our investment portfolio. We are particularly dependent upon David Gladstone, Terry Lee Brubaker and David Dullum for their experience, skills, and networks. Our executive
officers and the employees of the Adviser allocate some, and in some cases a material portion, of their time to businesses and activities that are not related to our business. We have no separate facilities and are completely reliant on the Adviser,
which has significant discretion as to the implementation and execution of our business strategies and risk management practices. We are subject to the risk of discontinuation of the Advisers operations or termination of the Advisory Agreement
and the risk that, upon such event, no suitable replacement will be found. We believe that our success depends to a significant extent upon the Adviser and that discontinuation of its operations or the loss of its key management personnel could have
a material adverse effect on our ability to achieve our investment objectives.
Our success depends on the Advisers ability to attract and retain
qualified personnel in a competitive environment.
The Adviser experiences competition in attracting and retaining qualified personnel, particularly
investment professionals and senior executives, and we may be unable to maintain or grow our business if we cannot attract and retain such personnel. The Advisers ability to attract and retain personnel with the requisite credentials,
experience and skills depends on several factors including, but not limited to, its ability to offer competitive wages, benefits and professional growth opportunities. The Adviser competes with investment funds (such as private equity funds and
mezzanine funds) and traditional financial services companies for qualified personnel, many of which have greater resources than us. Searches for qualified personnel may divert managements time from the operation of our business. Strain
on the existing personnel resources of the Adviser, in the event that it is unable to attract experienced investment professionals and senior executives, could have a material adverse effect on our business.
We are dependent upon the contacts and relationships of the Adviser to provide us with potential investment opportunities.
We depend upon the Adviser to maintain its relationships with private equity sponsors, placement agents, investment banks, management groups and other
financial institutions, and we expect to rely to a significant extent upon these relationships to provide us with potential investment opportunities. If the Adviser or members of our investment team fail to maintain such relationships, or to develop
new relationships with other sources of investment opportunities, we will not be able to grow our investment portfolio. In addition, individuals with whom the Adviser has relationships are not obligated to provide us with investment opportunities,
and we can offer no assurance that these relationships will generate investment opportunities for us in the future. Failure of the Adviser to maintain such relationships or enter into new relationships that would generate additional investment
opportunities, could have a material adverse effect on our business.
The Adviser can resign on 60 days notice, and we may not be able to find a
suitable replacement within that time, resulting in a disruption in our operations that could adversely affect our financial condition, business and results of operations.
The Adviser has the right to resign under the Advisory Agreement at any time upon not less than 60 days written notice, whether we have found a
replacement or not. If the Adviser resigns, we may not be able to find a new investment adviser or hire internal management with similar expertise and ability to provide the same or equivalent services on acceptable terms within 60 days, or at
all. If we are unable to do so quickly, our operations are likely to experience a disruption, our financial condition, business and results of operations as well as our ability to pay distributions are likely to be adversely affected and the market
price of our common stock may decline. In addition, the
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coordination of our internal management and investment activities is likely to suffer if we are unable to identify and reach an agreement with a single institution or group of executives having
the expertise possessed by the Adviser and its affiliates. Even if we are able to retain comparable management, whether internal or external, the integration of such management and their lack of familiarity with our investment objective may result
in additional costs and time delays that may adversely affect our business, financial condition, results of operations and cash flows.
Our incentive
fee may induce the Adviser to make certain investments, including speculative investments.
The management compensation structure that has been
implemented under the Advisory Agreement may cause the Adviser to invest in high-risk investments or take other investment risks. In addition to its management fee, the Adviser is entitled under the Advisory Agreement to receive incentive
compensation based in part upon our achievement of specified levels of income. In evaluating investments and other management strategies, the opportunity to earn incentive compensation based on net investment income may lead the Adviser to place
undue emphasis on the maximization of net investment income at the expense of other criteria, such as preservation of capital, maintaining sufficient liquidity, or management of credit risk or market risk, in order to achieve higher incentive
compensation. Investments with higher yield potential are generally riskier or more speculative. This could result in increased risk to the value of our investment portfolio.
We may be obligated to pay the Adviser incentive compensation even if we incur a loss.
The Advisory Agreement entitles the Adviser to incentive compensation for each fiscal quarter in an amount equal to a percentage of the excess of our net
investment income for that quarter (before deducting incentive fee, net operating losses and certain other items) above a threshold return of 1.75% for that quarter. When calculating our incentive fee, our pre-incentive fee net investment income
excludes realized losses and unrealized depreciation that we may incur in the fiscal quarter, even if such losses or depreciation result in a net decrease in net assets on our statement of operations for that quarter. Thus, we may be required to pay
the Adviser incentive compensation for a fiscal quarter even if there is a decline in the value of our portfolio or we incur a net realized or unrealized loss for that quarter. For additional information on incentive compensation under the Advisory
Agreement with the Adviser, see
Business Investment Advisory and Management Agreement
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We may be required to pay the Adviser
incentive compensation on income accrued, but not yet received in cash.
That part of the incentive fee payable by us that relates to our net
investment income is computed and paid on income that may include interest that has been accrued but not yet received in cash, such as debt instruments with PIK interest. If a portfolio company defaults on a loan, it is possible that such accrued
interest previously used in the calculation of the incentive fee will become uncollectible. Consequently, we may make incentive fee payments on income accruals that we may not collect in the future and with respect to which we do not have a clawback
right against the Adviser. During the years ended March 31, 2016, 2015 and 2014, PIK income and any other non-cash income represented less than 1% of total income for the year.
The Advisers failure to identify and invest in securities that meet our investment criteria or perform its responsibilities under the Advisory
Agreement would likely adversely affect our ability for future growth.
Our ability to achieve our investment objectives will depend on our ability to
grow, which in turn will depend on the Advisers ability to identify and invest in securities that meet our investment criteria. Accomplishing this result on a cost-effective basis will be largely a function of the Advisers structuring of
the investment process, its ability to provide competent and efficient services to us, and our access to financing on acceptable terms. The senior management team of the Adviser has substantial responsibilities under the Advisory Agreement. In order
to grow, the Adviser will need to hire, train, supervise, and manage new employees successfully. Any failure to manage our future growth effectively would likely have a material adverse effect on our business, financial condition, and results of
operations and cash flows.
There are significant potential conflicts of interest, including with the Adviser, which could impact our investment
returns.
Our executive officers and directors, and the officers and directors of the Adviser, serve or may serve as officers, directors, or principals
of entities that operate in the same or a related line of business as we do or of investment funds managed by our affiliates. Accordingly, they may have obligations to investors in those entities, the fulfillment of which might not be in the best
interests of us or our stockholders. For example, Mr. Gladstone, our chairman and chief executive officer, is the chairman of the board and chief executive officer of the Adviser and Administrator, and the Affiliated Public Funds. In addition,
Mr. Brubaker, our vice chairman and chief operating officer, is the vice chairman and chief operating officer of the Adviser and Administrator, and the Affiliated Public Funds. Mr. Dullum, our president, is an executive managing director
of the Adviser. Moreover, the Adviser may establish or sponsor other investment vehicles which from time to time may have potentially overlapping investment objectives with ours and accordingly
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may invest in, whether principally or secondarily, asset classes we target. While the Adviser generally has broad authority to make investments on behalf of the investment vehicles that it
advises, the Adviser has adopted investment allocation procedures to address these potential conflicts and intends to direct investment opportunities to the Company or the Affiliated Public Fund with the investment strategy that most closely fits
the investment opportunity. Nevertheless, the management of the Adviser may face conflicts in the allocation of investment opportunities to other entities managed by the Adviser. As a result, it is possible that we may not be given the opportunity
to participate in certain investments made by other funds managed by the Adviser. Our Board of Directors approved a revision of our investment objectives and strategies that became effective on January 1, 2013, which may enhance the potential
for conflicts in the allocation of investment opportunities to us and other entities managed by the Adviser.
In certain circumstances, we may make
investments in a portfolio company in which one of our affiliates has or will have an investment, subject to satisfaction of any regulatory restrictions and, where required, the prior approval of our Board of Directors. As of March 31, 2016,
our Board of Directors has approved the following types of transactions:
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Our affiliate, Gladstone Commercial, may, under certain circumstances, lease property to portfolio companies that we do not control. We may pursue such transactions only if (i) the portfolio company is not
controlled by us or any of our affiliates, (ii) the portfolio company satisfies the tenant underwriting criteria of Gladstone Commercial, and (iii) the transaction is approved by a majority of our independent directors and a majority of
the independent directors of Gladstone Commercial. We expect that any such negotiations between Gladstone Commercial and our portfolio companies would result in lease terms consistent with the terms that the portfolio companies would be likely to
receive were they not portfolio companies of ours.
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We may invest simultaneously with our affiliate Gladstone Capital in senior loans in the broadly syndicated market whereby neither we nor any affiliate has the ability to dictate the terms of the loans.
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Pursuant to the Co-Investment Order, under certain circumstances, we may co-invest with Gladstone Capital and any future BDC or closed-end management investment company that is advised by the Adviser (or sub-advised by
the Adviser if it controls the fund) or any combination of the foregoing subject to the conditions included therein.
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Certain of our
officers, who are also officers of the Adviser, may from time to time serve as directors of certain of our portfolio companies. If an officer serves in such capacity with one of our portfolio companies, such officer will owe fiduciary duties to
stockholders of the portfolio company, which duties may from time to time conflict with the interests of our stockholders.
In the course of our investing
activities, we will pay management and incentive fees to the Adviser and will reimburse the Administrator for certain expenses it incurs. As a result, investors in our common stock will invest on a gross basis and receive distributions
on a net basis after expenses, resulting in, among other things, a lower rate of return than one might achieve through our investors themselves making direct investments. As a result of this arrangement, there may be times when the
management team of the Adviser has interests that differ from those of our stockholders, giving rise to a conflict. In addition, as a BDC, we make available significant managerial assistance to our portfolio companies and provide other services to
such portfolio companies. While neither we nor the Adviser currently receive fees in connection with managerial assistance, the Adviser and Gladstone Securities have, at various times, provided other services to certain of our portfolio companies
and received fees for services other than managerial assistance as discussed in
Business Ongoing Management of Investment Portfolio Company Relationships Managerial Assistance and Services.
Our business model is dependent upon developing and sustaining strong referral relationships with investment bankers, business brokers and other
intermediaries and any change in our referral relationships may impact our business plan.
We are dependent upon informal relationships with investment
bankers, business brokers and traditional lending institutions to provide us with deal flow. If we fail to maintain our relationship with such funds or institutions, or if we fail to establish strong referral relationships with other funds, we will
not be able to grow our portfolio of investments and fully execute our business plan.
The Adviser is not obligated to provide credits of the base
management fee or incentive fees, which could negatively impact our earnings and our ability to maintain our current level of distributions to our stockholders.
The Advisory Agreement provides for a base management fee, based on our gross assets, and an incentive fee, that is based on our income and capital gains. Our
Board of Directors has accepted in the past and may accept in the future voluntary, unconditional and irrevocable credits to reduce the annual 2.0% base management fee or the incentive fee, on a quarterly or annual basis. Any fees credited may not
be recouped by the Adviser in the future. However, the Adviser is not required to issue these or other credits of fees under the Advisory Agreement. If the Adviser does not issue these credits in the future, it could negatively impact our earnings
and may compromise our ability to maintain our current level of distributions to our stockholders, which could have a material adverse impact on our common stock price.
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Our base management fee may induce the Adviser to incur leverage.
The fact that our base management fee is payable based upon our gross assets, which would include any investments made with proceeds of borrowings, may
encourage the Adviser to use leverage to make additional investments. Under certain circumstances, the use of increased leverage may increase the likelihood of default, which would disfavor holders of our securities. Given the subjective nature of
the investment decisions made by the Adviser on our behalf, we will not be able to monitor this potential conflict of interest.
Risks Related to an
Investment in Our Securities
We may experience fluctuations in our quarterly and annual operating results.
We may experience fluctuations in our quarterly and annual operating results due to a number of factors, including, among others, variations in our investment
income, the interest rates payable on the debt securities we acquire, the default rates on such securities, the level of our expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, placing and removing
investments on non-accrual status, the degree to which we encounter competition in our markets, the ability to sell investments at attractive terms, the ability to fund and close suitable investments, the level of our expenses, the degree to which
we encounter competition in our markets, and general economic conditions, including the impacts of inflation. The majority of our portfolio companies are in industries that are directly impacted by inflation, such as manufacturing and consumer goods
and services. Our portfolio companies may not be able to pass on to customers increases in their costs of production which could greatly affect their operating results, impacting their ability to repay our loans. In addition, any projected future
decreases in our portfolio companies operating results due to inflation could adversely impact the fair value of those investments. Any decreases in the fair value of our investments could result in future realized and unrealized losses and
therefore reduce our net assets resulting from operations. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods.
There is a risk that you may not receive distributions or that distributions may not grow over time.
Our current intention is to distribute at least 90% of our Investment Company Taxable Income to our common stockholders on a quarterly basis by paying monthly
common distributions. We expect to retain some or all net realized long-term capital gains by first offsetting them with realized capital losses, and, secondly, through a deemed distribution to supplement our equity capital and support
the growth of our portfolio, although our Board of Directors may determine in certain cases to distribute these gains to our common stockholders in cash. In addition, our Credit Facility restricts the amount of distributions we are permitted to make
annually. We cannot assure you that we will achieve investment results or maintain a tax status that will allow or require any specified level of cash distributions.
Investing in our securities may involve an above average degree of risk.
The investments we make in accordance with our investment objective may result in a higher amount of risk than alternative investment options and a higher risk
of volatility or loss of principal. Our investments in portfolio companies may be highly speculative, and therefore, an investment in our common stock may not be suitable for someone with lower risk tolerance.
Distributions to our common stockholders have included and may in the future include a return of capital.
Our Board of Directors declares monthly common distributions each quarter based on the respective quarters estimates of Investment Company Taxable Income
for each fiscal year, which may differ, and in the past have differed, from actual results. Because our common distributions are based on estimates of Investment Company Taxable Income that may differ from actual results, future common distributions
payable to our common stockholders may also include a return of capital. Moreover, to the extent that we distribute amounts that exceed our accumulated earnings and profits, these distributions constitute a return of capital. A return of capital
represents a return of a common stockholders original investment in common shares of our stock and should not be confused with a distribution from earnings and profits. Although return of capital distributions may not be taxable, such
distributions may increase an investors tax liability for capital gains upon the sale of our common stock by reducing the investors tax basis for such common stock. Such returns of capital reduce our asset base and also adversely impact
our ability to raise debt capital as a result of the leverage restrictions under the 1940 Act, which could have a material adverse impact on our ability to make new investments.
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The market price of our shares may fluctuate significantly.
The trading price of our common stock and our preferred stock may fluctuate substantially. Due to the volatility and disruptions that have affected the capital
and credit markets over the past few years, our stock has experienced greater than usual price volatility.
The market price and marketability of our
shares may from time to time be significantly affected by numerous factors, including many over which we have no control and that may not be directly related to us. These factors include, but are not limited to, the following:
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general economic trends and other external factors, such as inflation, oil and gas prices, GDP growth;
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price and volume fluctuations in the stock market from time to time, which are often unrelated to the operating performance of particular companies;
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significant volatility in the market price and trading volume of shares of RICs, BDCs or other companies in our sector, which is not necessarily related to the operating performance of these companies;
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changes in stock index definitions or policies, which may impact an investors desire to hold shares of BDCs;
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changes in regulatory policies or tax guidelines, particularly with respect to RICs or BDCs;
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changes in our earnings or variations in our operating results;
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changes and perceived projected changes in prevailing interest rates;
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changes in the value of our portfolio of investments;
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any shortfall in our revenue or net income or any increase in losses from levels expected by securities analysts;
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departure of key personnel;
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operating performance of companies comparable to us;
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short-selling pressure with respect to our shares or BDCs generally;
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the announcement of proposed, or completed, offerings of our securities, including a rights offering; and
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loss of a major funding source.
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Fluctuations in the trading prices of our shares may adversely affect the
liquidity of the trading market for our shares and, if we seek to raise capital through future equity financings, our ability to raise such equity capital.
Common shares of closed-end investment companies frequently trade at a discount from NAV.
Shares of closed-end investment companies frequently trade at a discount from NAV per common share. Since our inception, our common stock has at times traded
above NAV, and at times below NAV. During the past year, our common stock has at times traded significantly below NAV. Subsequent to March 31, 2016, and through May 16, 2016, our common stock has traded at discounts of up to 27.9% of our
NAV per share, which was $9.22 as of March 31, 2016. This characteristic of shares of closed-end investment companies is separate and distinct from the risk that our NAV per share will decline. As with any stock, the price of our common shares
will fluctuate with market conditions and other factors. If common shares are sold, the price received may be more or less than the original investment. Whether investors will realize gains or losses upon the sale of our shares will not depend
directly upon our NAV, but will depend upon the market price of the shares at the time of sale. Since the market price of our common shares will be affected by such factors as the relative demand for and supply of the shares in the market, general
market and economic conditions and other factors beyond our control, we cannot predict whether the common shares will trade at, below or above our NAV. Under the 1940 Act, we are generally not able to issue additional shares of our common stock at a
price below NAV per share to purchasers
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other than our existing common stockholders through a rights offering without first obtaining the approval of our stockholders and our independent directors. Additionally, at times when our
common stock is trading below its NAV per share, our dividend yield may exceed the weighted average returns that we would expect to realize on new investments that would be made with the proceeds from the sale of such stock, making it unlikely that
we would determine to issue additional common shares in such circumstances. Thus, for as long as our common stock may trade below NAV we will be subject to significant constraints on our ability to raise capital through the issuance of common stock.
Additionally, an extended period of time in which we are unable to raise capital may restrict our ability to grow and adversely impact our ability to increase or maintain our distributions.
Common stockholders may incur dilution if we sell shares of our common stock in one or more offerings at prices below the then current NAV per share.
At our most recent annual meeting of stockholders on August 6, 2015, our stockholders approved a proposal designed to allow us to sell shares of
our common stock below the then current NAV per share in one or more offerings for a period of one year from the date of such approval, subject to certain conditions (including, but not limited to, that the number of common shares issued and sold
pursuant to such authority does not exceed 25% of our then outstanding common stock immediately prior to each such sale).
Subject to a previous approval
from our stockholders, we exercised this right with Board of Director approval in March 2015, when we completed a public offering of 3.3 million shares of our common stock at a public offering price of $7.40 per share, which was below our then
current NAV of $8.55 per share. Gross proceeds totaled $24.4 million and net proceeds, after deducting underwriting discounts and offering costs borne by us, were $23.0 million. In April 2015, the underwriters exercised their option to
purchase an additional 495,000 shares at the public offering price of $7.40 per share to cover over-allotments, which resulted in gross proceeds of $3.7 million and net proceeds, after deducting underwriting discounts and offering costs borne
by us, of $3.4 million. The net dilutive effect of the issuance of common stock, net of expenses, below NAV was $0.25 per share of common stock.
Additionally and subject to a previous approval from our stockholders, we also exercised this right with our Board of Directors approval in October
2012, when we completed a public offering of 4.4 million shares of our common stock at a public offering price of $7.50 per share, which was below our then current NAV of $8.65 per share. Gross proceeds totaled $33.0 million and net
proceeds, after deducting underwriting discounts and offering costs borne by us, were $31.0 million. The net dilutive effect of the issuance of common stock, net of expenses, below NAV was $0.31 per share of common stock.
At the upcoming annual stockholders meeting scheduled for August 4, 2016, we expect that our stockholders will again be asked to vote in favor of
renewing this proposal for another year. During the past year, our common stock has traded consistently, and at times significantly, below NAV. Any decision to sell shares of our common stock below the then current NAV per share of our common stock
would be subject to the determination by our Board of Directors that such issuance is in our and our stockholders best interests.
If we were to
sell shares of our common stock below NAV per share, such sales would result in an immediate dilution to the NAV per share. This dilution would occur as a result of the sale of shares at a price below the then current NAV per share of our common
stock and a proportionately greater decrease in a common stockholders interest in our earnings and assets and voting interest in us than the increase in our assets resulting from such issuance. The greater the difference between the sale price
and the NAV per share at the time of the offering, the more significant the dilutive impact would be. Because the number of shares of common stock that could be so issued and the timing of any issuance is not currently known, the actual dilutive
effect, if any, cannot be currently predicted. However, if, for example, we sold an additional 10% of our common stock at a 5% discount from NAV, an existing common stockholder who did not participate in that offering for its proportionate interest
would suffer NAV dilution of up to 0.5% or $5 per $1,000 of NAV.
If we fail to pay dividends on our mandatorily redeemable preferred stock for two
years, the holders of our preferred stock will be entitled to elect a majority of our directors.
The terms of our three series of mandatorily
redeemable preferred stock provide for annual dividends of $1.78125, $1.68750, and $1.62500 per outstanding share of our Series A Term Preferred Stock, Series B Term Preferred Stock and Series C Term Preferred Stock, respectively. In accordance
with the terms of each of our three series of mandatorily redeemable term preferred stock, if dividends thereon are unpaid in an amount equal to at least two years of dividends, the holders of such series of stock will be entitled to elect a
majority of our Board of Directors.
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Other Risks
Market volatility and the condition of the debt and equity capital markets could negatively impact our financial condition and stock price.
Beginning in the third quarter of 2007, global credit and other financial markets began to suffer substantial stress, volatility, illiquidity and disruption.
These forces reached extraordinary levels in late 2008, resulting in the bankruptcy of, the acquisition of, or government intervention in the affairs of several major domestic and international financial institutions. In particular, the financial
services sector was negatively impacted by significant write-offs as the value of the assets held by financial firms declined, impairing their capital positions and abilities to lend and invest. We believe that such value declines were exacerbated
by widespread forced liquidations as leveraged holders of financial assets, faced with declining prices, were compelled to sell to meet margin requirements and maintain compliance with applicable capital standards. Such forced liquidations also
impaired or eliminated many investors and investment vehicles, leading to a decline in the supply of capital for investment and depressed pricing levels for many assets. These events significantly diminished overall confidence in the debt and equity
markets, engendered unprecedented declines in the values of certain assets, and caused extreme economic uncertainty. If market conditions similar to these were to recur, our assets could experience a similar decline in value, among other negative
impacts we could suffer.
Since March 2009, the global credit and other financial market conditions have improved as stability has increased throughout
the international financial system and, specifically, in the U.S. economy in which we operate, and many public market indices have experienced positive total returns. However, the macroeconomic environment and recovery from the downturn has been
challenging and inconsistent. Instability in the credit markets, the impact of periodic uncertainty regarding the U.S. federal budget, tapering of bond purchases by the U.S. Federal Reserve and debt ceiling, the instability in the geopolitical
environment in many parts of the world, sovereign debt conditions in Europe and other disruptions may continue to put pressure on economic conditions in the U.S. and abroad, all of which can have an adverse effect on our business.
Economic recessions or downturns could impair our portfolio companies and harm our operating results.
Many of our portfolio companies may be susceptible to economic downturns or recessions and may be unable to repay our loans during these periods. Therefore,
during these periods our non-performing assets may increase and the value of these assets may decrease. Adverse economic conditions may also decrease the value of collateral securing some of our loans and the value of our equity investments.
Economic slowdowns or recessions could lead to financial losses in our portfolio and a decrease in investment income, net investment income and assets. Unfavorable economic conditions also could increase our funding costs, limit our access to the
capital markets or result in a decision by lenders not to extend credit to us. These events could prevent us from increasing investments and harm our operating results. We experienced to some extent such effects as a result of the economic downturn
that occurred from 2008 through 2009 and may experience such effects again in any future downturn or recession.
We could face losses and potential
liability if intrusion, viruses or similar disruptions to our technology jeopardize our confidential information, whether through breach of our network security or otherwise.
Maintaining our network security is of critical importance because our systems store highly confidential financial models and portfolio company information.
Although we have implemented, and will continue to implement and upgrade, security measures, our technology platform is and will continue to be vulnerable to intrusion, computer viruses or similar disruptive problems caused by transmission from
unauthorized users. The misappropriation of proprietary information could expose us to a risk of loss or litigation.
Terrorist attacks, acts of war,
or national disasters may affect any market for our stock, impact the businesses in which we invest, and harm our business, operating results, and financial conditions.
Terrorist acts, acts of war, or national disasters have created, and continue to create, economic and political uncertainties and have contributed to global
economic instability. Future terrorist activities, military or security operations, or national disasters could further weaken the domestic/global economies and create additional uncertainties, which may negatively impact the businesses in which we
invest directly or indirectly and, in turn, could have a material adverse impact on our business, operating results, and financial condition. Losses from terrorist attacks and national disasters are generally uninsurable.
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