Except as otherwise indicated, the terms we, us, our, CM Finance and the Company
refer to CM Finance Inc and CM Investment Partners and the Adviser refer to our investment adviser and administrator, CM Investment Partners LLC.
We were formed in February 2012 and commenced operations in March 2012 as CM Finance LLC, a Maryland limited liability company. Immediately
prior to the pricing of our initial public offering, CM Finance LLC was merged with and into CM Finance Inc, a Maryland corporation (the Merger). We are an externally managed, non-diversified closed-end management investment company that
has elected to be regulated as a business development company (BDC) under the Investment Company Act of 1940, as amended (the 1940 Act).
We are a specialty finance company that invests primarily in the debt of U.S. middle-market companies, which we generally define as those
companies that have an enterprise value, which represents the aggregate of debt value and equity value of the entity, of less than $750 million. We are externally managed by CM Investment Partners. The Adviser is led by Michael C. Mauer and
Christopher E. Jansen, who together have over 40 years of experience in the leveraged debt markets. Our primary investment objective is to maximize total return to stockholders in the form of current income and capital appreciation by investing in
debt and related equity of privately held middle-market companies.
We seek to invest primarily in middle-market companies that have annual
revenues of at least $50 million and EBITDA of at least $15 million. We focus on companies with leading market positions, significant asset or franchise values, strong free cash flow and experienced senior management teams, with emphasis on
companies with high-quality sponsors. Our investments typically range in size from $5 million to $25 million. We expect that our portfolio companies will use our capital for organic growth, acquisitions, market or product expansion, refinancings,
and/or recapitalizations. We invest, and intend to continue to invest, in unitranche loans and standalone second and first lien loans, with an emphasis on floating rate debt. Unitranche loans are loans structured as first lien loans with certain
characteristics of mezzanine loan risk in one security. We also selectively invest in unsecured debt, bonds and in the equity of portfolio companies through warrants and other instruments, in most cases taking such upside participation interests as
part of a broader investment relationship.
We strive to maintain a strong focus on credit quality, investment discipline and investment
selectivity. We believe that investing in the debt of private middle-market companies generally provides a more attractive relative value proposition than investing in broadly syndicated debt due to the conservative capital structures and superior
default and loss characteristics typically associated with middle-market companies. We believe that, because private middle-market companies have limited access to capital providers, debt investments in these companies typically carry above-market
interest rates and include more favorable protections, resulting in attractive risk-adjusted returns across credit cycles while better preserving capital. The companies in which we invest typically are highly leveraged, and, in most cases, our
investments in such companies are not rated by national rating agencies. If such investments were rated, we believe that they would likely receive a rating that is often referred to as junk.
We have, through CM Finance SPV Ltd. (CM SPV), our wholly owned subsidiary, entered into a $102.0 million term secured financing
facility (the Term Financing), due December 5, 2020 with UBS AG, London Branch (together with its affiliates UBS). The Term Financing is collateralized by a portion of the debt investments in our portfolio. Borrowings
under the Term Financing bear interest (i) at a rate per annum equal to one-month LIBOR plus 2.75% through December 4, 2018, and (ii) at a rate per annum equal to one-month LIBOR plus 2.55% from December 5, 2018 through
December 5, 2020 (the Term Financing Rate). We also incur an annual fee of approximately 1% of the outstanding borrowings under the Term Financing. As of June 30, 2018 and June 30, 2017, there were $102.0 million and
$102.0 million borrowings outstanding under the Term Financing, respectively.
1
On November 20, 2017, we entered into a $50 million revolving financing facility (the
2017 UBS Revolving Financing) with UBS. Borrowings under the 2017 UBS Revolving Financing will generally bear interest at a rate per annum equal to one-month LIBOR plus 3.55% (the Revolver Financing Rate). We pay a fee on any
undrawn amounts of 2.50% per annum; provided that if 50% or less of the 2017 UBS Revolving Financing is drawn, the fee will be 2.75% per annum. Any amounts borrowed under the 2017 UBS Revolving Financing will mature, and all accrued and
unpaid interest will be due and payable, on December 5, 2019. As of June 30, 2018, there were $17.8 million borrowings outstanding under the 2017 UBS Revolving Financing. We refer to the Term Financing, the 2017 UBS Revolving Financing and
our prior revolving credit facility with Citibank, N.A., discussed in Managements Discussion and Analysis of Financial Condition and Results of OperationsFinancing Facilities, together as the Financing Facilities.
On July 2, 2018, we closed the public offering of $30 million in aggregate principal amount of 6.125% notes due 2023 (the
Notes). On July 12, 2018, the underwriters exercised their over-allotment option to purchase an additional $4.5 million in aggregate principal amount of the Notes. The total net proceeds to us from the Notes, including the
exercise of the underwriters over-allotment option, after deducting underwriting discounts and commissions of approximately $1.0 million and estimated offering expenses of approximately $230,000, were approximately $33.2 million.
The Notes will mature on July 1, 2023 and bear interest at a rate of 6.125%. The Notes are direct unsecured obligations and rank pari
passu, which means equal in right of payment, with all outstanding and future unsecured indebtedness issued by us. Because the Notes are not secured by any of our assets, they are effectively subordinated to all of our existing and future secured
unsubordinated indebtedness (or any indebtedness that is initially unsecured as to which we subsequently grant a security interest), to the extent of the value of the assets securing such indebtedness. The Notes are structurally subordinated to all
existing and future indebtedness and other obligations of any of our subsidiaries and financing vehicles, including, without limitation, borrowings under the Term Financing and the 2017 UBS Revolving Financing. The Notes are obligations exclusively
of CM Finance Inc and not of any of our subsidiaries. None of our subsidiaries is a guarantor of the Notes and the Notes will not be required to be guaranteed by any subsidiary we may acquire or create in the future.
The Notes may be redeemed in whole or in part at any time or from time to time at our option on or after July 1, 2020. Interest on the
Notes is payable quarterly on January 1, April 1, July 1 and October 1 of each year. The Notes are listed on the NASDAQ Global Select Market under the trading symbol CMFNL. We may from time to time repurchase Notes in
accordance with the 1940 Act and the rules promulgated thereunder. As of September 3, 2018, the outstanding principal balance of the Notes was approximately $34.5 million.
The indenture under which the Notes are issued (the Indenture) contains certain covenants, including covenants (i) requiring
our compliance with the asset coverage requirements set forth in Section 18(a)(1)(A) as modified by Section 61(a) of the 1940 Act, whether or not we continue to be subject to such provisions of the 1940 Act; (ii) requiring our
compliance, under certain circumstances, with the requirements set forth in Section 18(a)(1)(B) as modified by Section 61(a) of the 1940 Act, whether or not we continue to be subject to such provisions of the 1940 Act, prohibiting the
declaration of any cash dividend or distribution upon any class of our capital stock (except to the extent necessary for us to maintain its treatment as a RIC under Subchapter M of the Code), or purchasing any such capital stock, if our asset
coverage, as defined in the 1940 Act, is below 200% (or 150% beginning on May 2, 2019) at the time of the declaration of the dividend or distribution or the purchase and after deducting the amount of such dividend, distribution, or purchase;
and (iii) requiring us to provide financial information to the holders of the Notes and the Trustee if we cease to be subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the Exchange Act). These
covenants are subject to limitations and exceptions that are described in the Indenture.
On May 2, 2018, our board of directors,
including a required majority (as such term is defined in Section 57(o) of the 1940 Act) of the board, approved the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act, as amended by the Small
Business Credit Availability Act. As a result, our asset coverage requirements for senior securities will be changed from 200% to 150%, effective as of May 2, 2019.
2
Portfolio Composition
As of June 30, 2018, our portfolio consisted of debt and equity investments in 25 portfolio companies with a fair value of
$293.6 million. As of June 30, 2018, our portfolio consisted of 52.1% first lien investments, 43.3% second lien investments, 0.2% unsecured debt investments, 4.2% unitranche loans, and 0.2% equity, warrant and other positions. At
June 30, 2018, the weighted average total yield of debt and income producing securities at amortized cost (which includes income and amortization of fees and discounts) was 11.19%. The weighted average total yield was computed using an internal
rate of return calculation of our debt investments based on contractual cash flows, including interest and amortization payments, and, for floating rate investments, the spot London Interbank Offered Rate (LIBOR), as of June 30,
2018 of all of our debt investments. See Managements Discussion and Analysis of Financial Condition and Results of Operations. The weighted average total yield of our debt investments is not the same as a return on investment for
our stockholders but, rather, relates to a portion of our investment portfolio and is calculated before payment of all of our fees and expenses, including any sales load paid in connection with an offering of our securities. There can be no
assurance that the weighted average total yield will remain at its current level.
The industry composition of our portfolio at fair value
at June 30, 2018 was as follows:
|
|
|
|
|
|
|
Percentage of
Total Portfolio
at June 30,
2018
|
|
Professional Services
|
|
|
13.98
|
%
|
Hotels, Restaurants & Leisure
|
|
|
11.36
|
|
Energy Equipment & Services
|
|
|
10.97
|
|
Media
|
|
|
10.88
|
|
Commercial Services & Supplies
|
|
|
10.76
|
|
IT Services
|
|
|
9.54
|
|
Diversified Telecommunication Services
|
|
|
8.49
|
|
Oil, Gas & Consumable Fuels
|
|
|
8.24
|
|
Distributors
|
|
|
4.25
|
|
Health Care Providers & Services
|
|
|
3.85
|
|
Chemicals
|
|
|
2.73
|
|
Health Care Equipment & Supplies
|
|
|
2.55
|
|
Electronic Equipment
|
|
|
2.24
|
|
Wireless Telecommunication Services
|
|
|
0.16
|
|
|
|
|
|
|
|
|
|
100.00
|
%
|
|
|
|
|
|
CM Investment Partners LLC
CM Investment Partners, our external investment adviser, was formed in July 2013 and is a registered investment adviser under the Investment
Advisers Act of 1940 (the Advisers Act). The Adviser is responsible for sourcing investment opportunities, conducting industry research, performing diligence on potential investments, structuring our investments and monitoring our
portfolio companies on an ongoing basis. The Adviser is led by its Co-Chief Investment Officers, Michael C. Mauer and Christopher E. Jansen. Mr. Mauer also serves as the Chairman of our board of directors and our Chief Executive
Officer, and Mr. Jansen also serves as our President and Secretary and as a member of our board of directors. Mr. Mauer was formerly Global Co-Head of Leveraged Finance and Global Co-Head of Fixed Income Currency and
Commodity Distribution at Citigroup Inc. and a senior member of its credit committee responsible for all underwriting and principal commitments of leveraged finance capital worldwide. Mr. Jansen was a founding Managing Partner and Senior
Portfolio Manager for Stanfield Capital Partners and had a leading role in planning its strategic direction. At Stanfield, Mr. Jansen was responsible for the management of 15 different portfolios aggregating in excess of $7 billion in
assets consisting of large corporate loans, middle-market loans, second lien loans, high yield bonds and structured finance securities.
3
The Advisers investment team, led by Messrs. Mauer and Jansen, is supported by four
additional investment professionals, who, together with Messrs. Mauer and Jansen, we refer to as the Investment Team. The members of the Investment Team have over 100 combined years of structuring customized debt solutions for
middle-market companies, which we believe will enable us to generate favorable returns across credit cycles with an emphasis on preserving capital. Messrs. Mauer and Jansen have developed an investment process for reviewing lending opportunities,
structuring transactions and monitoring investments throughout multiple credit cycles. The members of the Investment Team have extensive networks for sourcing investment opportunities through direct corporate relationships and relationships with
private equity firms, investment banks, restructuring advisors, law firms, boutique advisory firms and distressed/specialty lenders. The members of the Investment Team also have extensive experience across various industries, including aviation,
cable, defense, healthcare, media, mining, oil and gas, power, retail, telecommunications, trucking and asset-backed special situations. As a result, we believe we will be able to achieve appropriate risk-adjusted returns by investing in companies
that have restructured but do not have sufficient track records to receive traditional lending terms from a commercial bank or the broadly syndicated leveraged finance market. We believe the members of the Investment Team share a common investment
philosophy built on a framework of rigorous business assessment, extensive due diligence and disciplined risk valuation methodology.
Every
initial investment by us requires the approval by a majority of the Advisers investment committee and such majority must include both Messrs. Mauer and Jansen. Every follow-on investment decision in an existing portfolio company and
every investment disposition require approval by a majority of the Advisers investment committee. The Advisers investment committee currently consists of Messrs. Mauer and Jansen, the Co-Chief Investment Officers of the
Adviser, Andrew Muns, a managing director of the Adviser, and Michael Nitka, Stifel Venture Corp.s (Stifel) designee to the Advisers investment committee. We have entered into an investment advisory agreement (the
Investment Advisory Agreement) with the Adviser, pursuant to which we pay the Adviser a management fee equal to 1.75% of our gross assets, payable in arrears on a quarterly basis. In addition, pursuant to the Investment Advisory
Agreement, we pay the Adviser an Incentive Fee equal to 20.0% of pre-incentive fee net investment income, subject to an annualized hurdle rate of 8.0% with a catch up fee for returns between the 8.0% hurdle and 10.0%, as well
as 20.0% of net capital gains.
Under an administration agreement with the Adviser (the Administration Agreement), the Adviser
provides us with our chief financial officer, accounting and back-office professionals, equipment and clerical, bookkeeping, recordkeeping and other administrative services.
Market Opportunity
We believe that the
current investment environment presents a compelling case for investing in secured debt (including unitranche debt and standalone second and first lien loans) and unsecured debt (including mezzanine/structured equity) of middle-market companies. The
following factors represent the key drivers of our focus on this attractive market segment:
|
|
|
Reduced Availability of Capital for Middle-Market Companies.
We believe there are fewer providers of
financing and less capital available for middle-market companies compared to prior to the economic downturn that began in mid-2007. We believe that, as a result of that downturn:
|
|
|
|
many financing providers have chosen to focus on large, liquid corporate loans and syndicated capital markets
transactions rather than lending to middle-market businesses;
|
|
|
|
regulatory changes, including the introduction of international capital and liquidity requirements for banks
under the 2012 Basel III Accords, or Basel III, have decreased their capacity to hold non-investment grade leveraged loans, causing banks to curtail lending to middle-market companies;
|
|
|
|
hedge funds and collateralized loan obligation managers are less likely to pursue investment opportunities in our
target market as a result of reduced availability of funding for new investments; and
|
|
|
|
consolidation of regional banks into money center banks has reduced their focus on middle-market lending.
|
4
As a result, we believe that less competition facilitates higher quality deal flow and allows for
greater selectivity throughout the investment process.
|
|
|
Robust Demand for Debt Capital.
According to Pitchbook, a market research firm, private equity firms
had approximately $874 billion of uncalled capital as of December 31, 2017. They have expanded their focus to include middle-market opportunities due to the lack of opportunities in large capital buyout transactions. We expect the large
amount of uninvested capital and the expanded focus on middle-market opportunities to drive buyout activity over the next several years, which should, in turn, continue to create lending opportunities for us.
|
|
|
|
Attractive Deal Pricing and Structures.
We believe that, in general, middle-market debt investments
are priced more attractively to lenders than larger, more liquid, public debt financings, due to the more limited universe of lenders as well as the highly negotiated nature of these financings. Middle-market transactions tend to offer stronger
covenant packages, higher interest rates, lower leverage levels and better call protection compared to larger financings. In addition, middle-market loans typically offer other investor protections such as default penalties, lien protection, change
of control provisions and information rights for lenders.
|
|
|
|
Specialized Lending Requirements.
We believe that several factors render many U.S. financial
institutions ill-suited to lend to U.S. middle-market companies. For example, based on the Investment Teams experience, lending to private U.S. middle-market companies is generally more labor-intensive than lending to larger
companies due to the smaller size of each investment and the fragmented nature of information for such companies. Lending to smaller capitalization companies requires due diligence and underwriting practices consistent with the demands and economic
limitations of the middle-market and may also require more extensive ongoing monitoring by the lender. As a result, middle-market companies historically have been served by a limited segment of the lending community.
|
Competitive Strengths
We believe that
the Advisers disciplined approach to origination, portfolio construction and risk management should allow us to achieve favorable risk-adjusted returns while preserving our capital. We believe that the following competitive strengths provide
positive returns for our investors:
|
|
|
Large and Experienced Team with Substantial Resources.
The Adviser and its Investment Team is led by
Messrs. Mauer and Jansen, each with over 20 years of experience investing in, providing corporate finance services to, restructuring and consulting with middle-market companies. Messrs. Mauer and Jansen are supported by four additional
investment professionals, who collectively have over 100 combined years of structuring strategic capital for business expansion, refinancings, capital restructuring, post-reorganization financing and servicing the general corporate needs of
middle-market companies. We believe that the Investment Team and its resources provide a significant advantage and contribute to the strength of our business and enhance the quantity and quality of investment opportunities available to us.
|
|
|
|
Capitalize on the Investment Teams Extensive Relationships with Middle-Market Companies, Private Equity
Sponsors and Intermediaries.
The members of the Investment Team have extensive networks for sourcing investment opportunities through corporate relationships and relationships with private equity firms, investment banks, restructuring
advisors, law firms, boutique advisory firms and distressed/specialty lenders. We believe that the strength of these relationships in conjunction with the Investment Teams ability to structure financing solutions for companies that incorporate
credit protections at attractive returns for us provide us with a competitive advantage in identifying investment opportunities in our target market. In addition, pursuant to the terms of our relationship with Stifel and subject to certain
restrictions, Stifel must use its commercially reasonable efforts to present to the Adviser to review and bid on, Stifel Nicolaus & Company, Incorporated-originated leveraged finance and high yield corporate debt opportunities consistent
with our investment strategy.
|
5
|
|
|
Disciplined Underwriting Policies and Rigorous Portfolio Management.
Messrs. Mauer and Jansen have an
established credit analysis and investment process to analyze investment opportunities thoroughly. This process, followed by the Investment Team, includes structuring loans with appropriate covenants and pricing loans based on our knowledge of the
middle-market and our rigorous underwriting standards. We focus on capital preservation by extending loans to portfolio companies with assets that we believe will retain sufficient value to repay us even in depressed markets or under liquidation
scenarios. Each investment is analyzed from its initial stages by either Mr. Mauer or Mr. Jansen, as the Advisers Co-Chief Investment Officers, and a senior investment professional of the Investment Team. Every initial
investment requires approval by a majority of the Advisers investment committee and such majority must include both Messrs. Mauer and Jansen. The Advisers investment committee consists of Messrs. Mauer, Jansen, Muns and Nitka.
Every follow-on investment decision in an existing portfolio company and every investment disposition require approval by at least a majority of the Advisers investment committee. Under the supervision of Messrs. Mauer and Jansen,
the Investment Teams senior investment professionals also monitor the portfolio for developments on a daily basis, perform credit updates on each investment, review financial performance on at least a quarterly basis, and have regular
discussions with the management of portfolio companies. We believe the Advisers investment and monitoring process and the depth and experience of the Investment Team gives us a competitive advantage in identifying investments and evaluating
risks and opportunities throughout the life cycle of an investment.
|
|
|
|
Ability to Structure Investments Creatively.
Our Investment Team has the expertise and ability to
structure investments across all levels of a companys capital structure. These individuals have extensive experience in cash flow, asset-based lending, workout situations and investing in distressed debt, which should enable us to take
advantage of attractive investments in recently restructured companies. Furthermore, with the capital raised in our initial public offering, we believe we are in a better position to leverage the existing knowledge and relationships that the
Investment Team has developed to lead investments that meet our investment criteria. We believe that current market conditions allow us to structure attractively priced debt investments and may allow us to incorporate other return-enhancing
mechanisms such as commitment fees, original issue discounts, early redemption premiums, payment-in-kind (PIK) interest and certain forms of equity securities.
|
Investment Strategy
We invest in
unitranche loans, standalone second and first lien loans, and selectively in unsecured debt, bonds and in the equity of portfolio companies through warrants and other instruments, in most cases taking advantage of a potential benefit from an
increase in the value of such portfolio company as part of an overall relationship. We seek to invest primarily in middle-market companies that have annual revenues of at least $50 million and EBITDA of at least $15 million. Our
investments typically range in size from $5 million to $25 million. We may invest in smaller or larger companies if there is an attractive opportunity, especially when there are dislocations in the capital markets, including the high yield
and large syndicated loan markets. During such dislocations, we expect to see more deep value investment opportunities offering prospective returns that are disproportionate to the associated risk profile. We focus on companies with leading market
positions, significant asset or franchise values, strong free cash flow and experienced senior management teams, with an emphasis on companies with high-quality sponsors.
Our primary investment objective is to maximize current income and capital appreciation by investing directly in privately held middle-market
companies. The Adviser pursues investments for us with favorable risk-adjusted returns, including debt investments that offer cash origination fees and lower leverage levels. The Adviser seeks to structure our debt investments with strong
protections, including default penalties, information rights, and affirmative and negative financial covenants, such as lien protection and restrictions concerning change of control. We believe these protections, coupled with the other features of
our investments, allow us to reduce our risk of capital loss and achieve attractive risk-adjusted returns, although there can be no assurance that we are always able to structure our investments to minimize risk of loss and achieve attractive
risk-adjusted returns.
6
Investment Criteria
The Investment Team uses the following investment criteria and guidelines to evaluate prospective portfolio companies. However, not all of
these criteria and guidelines are used or met in connection with each of our investments.
|
|
|
Established companies with a history of positive operating cash flow.
We seek to invest in
established companies with sound historical financial performance. The Adviser typically focuses on companies with a history of profitability on an operating cash flow basis. We do not intend to invest in start-up companies or companies
with speculative business plans.
|
|
|
|
Defensible and sustainable business.
We seek to invest in companies with proven products and/or
services that provide a competitive advantage versus its competitors or new entrants. The Adviser places an emphasis on the strength of historical operations and profitability and the generation of free cash flow to reinvest in the business or to
utilize for debt service. The Adviser also focuses on the relative strength of the valuation and liquidity of collateral used to provide security for our investments, when applicable.
|
|
|
|
Seasoned management team with meaningful equity ownership
.
The Adviser generally requires
that our portfolio companies have a seasoned management team, with strong corporate governance. The Adviser also seeks to invest in companies with management teams that have meaningful equity ownership. The Adviser believes that companies that have
proper incentives in place, including having significant equity interests, motivate management teams to enhance enterprise value, which will act in accordance with our interests.
|
|
|
|
Significant Invested Capital.
The Adviser seeks investments in portfolio companies where it
believes that the aggregate enterprise value significantly exceeds aggregate indebtedness, after consideration of our investment. The Adviser believes that the existence of significant underlying equity value (i.e., the amount by which the aggregate
enterprise value exceeds the aggregate indebtedness) provides important support to our debt investments.
|
|
|
|
Investment Partnerships
.
We seek to invest where private equity sponsors have demonstrated
capabilities in building enterprise value. In addition, we seek to partner with specialty lenders and other financial institutions. The Adviser believes that private equity sponsors and specialty lenders can serve as committed partners and advisors
that will actively work with the Adviser, the company and its management team to meet company goals and create value.
|
|
|
|
Ability to exert meaningful influence.
We target investment opportunities in which we will be a
significant investor in the tranche and in which we can add value through active participation in the direction of the company, sometimes through advisory positions.
|
|
|
|
Exit strategy.
We generally seek to invest in companies that the Adviser believes possess attributes that
will provide us with the ability to exit our investments. We typically expect to exit our investments through one of three scenarios: (i) the sale of the company resulting in repayment of all outstanding debt, (ii) the recapitalization of
the company through which our loan is replaced with debt or equity from a third party or parties or (iii) the repayment of the initial or remaining principal amount of our loan then outstanding at maturity. In some investments, there may be
scheduled amortization of some portion of our loan, which would result in a partial exit of our investment prior to the maturity of the loan.
|
Deal Origination
The
Advisers deal-originating efforts are focused on its direct corporate relationships and relationships with private equity firms, investment banks, restructuring advisers, law firms, and boutique advisory firms and distressed/specialty lenders.
The Advisers investment team continues to enhance and expand these relationships. In addition, pursuant to the Stifel arrangement and subject to certain restrictions, Stifel uses its commercially reasonable efforts to present to us to review
and bid on Stifel Nicolaus & Company, Incorporated-originated leveraged finance and high yield corporate debt opportunities consistent with our investment strategy, subject to the approval of our board of directors as necessary, under the
1940 Act and certain other limitations.
7
The origination process is designed to thoroughly evaluate potential financings and to identify
the most attractive of these opportunities on the basis of risk-adjusted returns. Each investment is analyzed from its initial stages through our investment by one of the Co-Chief Investment Officers of the Adviser and a senior investment
professional. If an opportunity fits our criteria for investment and merits further review and consideration, the investment is presented to the investment committee. This first stage of analysis involves a preliminary, but detailed, description of
the potential financing. An investment summary is then generated after preliminary due diligence. The opportunity may be discussed several times by members of the Investment Team. Prior to funding, every initial investment requires the unanimous
approval of the Advisers investment committee consisting Messrs. Mauer, Jansen and Nitka. Follow-on investment decisions in existing portfolio companies and investment dispositions require the approval of a majority of the
Advisers investment committee.
If the Adviser decides to pursue an opportunity, a preliminary term sheet will be produced for the
target portfolio company. This term sheet serves as a basis for the discussion and negotiation of the critical terms of the proposed financing. At this stage, the Adviser begins its formal underwriting and investment approval process as described
below. After the negotiation of a transaction, the financing is presented to the investment committee of the Adviser for approval. Upon approval of a financing transaction, the parties will prepare the relevant loan documentation. An investment is
funded only after all due diligence is satisfactorily completed and all closing conditions have been satisfied. Each of the investments in our portfolio is monitored on a daily basis by a member of the Advisers investment committee aided by
the senior investment professionals of the Investment Team, who also perform credit updates on each investment quarterly.
Underwriting
Underwriting Process and Investment Approval
The Adviser makes investment decisions only after considering a number of factors regarding the potential investment including, but not limited
to:
|
|
|
historical and projected financial performance;
|
|
|
|
company and industry specific characteristics, such as strengths, weaknesses, opportunities and threats;
|
|
|
|
composition and experience of the management team; and
|
|
|
|
track record of the private equity sponsor leading the transaction, if applicable.
|
This methodology is employed to screen a high volume of potential investment opportunities on a consistent basis.
If an investment is deemed appropriate to pursue, a more detailed and rigorous evaluation is made after considering relevant investment
parameters. The following outlines the general parameters and areas of evaluation and due diligence for investment decisions, although not all are necessarily considered or given equal weighting in the evaluation process.
Business model and financial assessment
The Adviser undertakes a review and analysis of the financial and strategic plans for the potential investment. There is significant evaluation
of and reliance upon the due diligence performed by the private equity sponsor, if applicable, and third party experts, including accountants and consultants. Areas of evaluation include:
|
|
|
historical and projected financial performance;
|
|
|
|
quality of earnings, including source and predictability of cash flows;
|
|
|
|
customer and vendor interviews and assessments;
|
8
|
|
|
potential exit scenarios, including probability of a liquidity event;
|
|
|
|
internal controls and accounting systems; and
|
|
|
|
assets, liabilities and contingent liabilities.
|
Industry dynamics
The
Adviser evaluates the portfolio companys industry, and may, if considered appropriate, consult or retain industry experts. The following factors are among those the Adviser analyzes:
|
|
|
sensitivity to economic cycles;
|
|
|
|
competitive environment, including number of competitors, threat of new entrants or substitutes;
|
|
|
|
fragmentation and relative market share of industry leaders;
|
|
|
|
regulatory and legal environment.
|
Management assessment
The Adviser makes an in-depth assessment of the management team, including evaluation along several key metrics:
|
|
|
the number of years in their current positions;
|
|
|
|
management incentive, including the level of direct investment in the enterprise; and
|
|
|
|
completeness of the management team (positions that need to be filled or added).
|
Sponsor Assessment
Among
critical due diligence investigations is the evaluation of a private equity sponsor or specialty lender that has, or is also making, an investment in the portfolio company. A private equity sponsor is typically a controlling stockholder upon
completion of an investment and as such is considered critical to the success of the investment. In addition, a management team with meaningful equity ownership can serve as a committed partner to us and any private equity sponsor or specialty
lender. The Adviser evaluates a private equity sponsor or specialty lender along several key criteria, including:
|
|
|
investment track record;
|
|
|
|
capacity and willingness to provide additional financial support to the company through additional capital
contributions, if necessary; and
|
Investments
The following
describes the types of loans we generally make:
Unitranche loans
. Unitranche loans are loans structured as first lien loans with
certain characteristics of mezzanine loan risk in one security. Unitranche loans typically provide for moderate loan amortization in the
9
initial years of the loan with the majority of the principal repayment deferred until loan maturity. Unitranche loans usually provide us with greater control over a portfolio companys
capital structure, as they provide a one-stop financing solution and limit frictional costs (e.g., negotiations with, and concessions to, other lien holders) in the event of a workout process. Consistent with our focus on capital
preservation, unitranche loans typically have less volatile returns than standalone second lien or mezzanine loans.
Standalone second
lien loans
. Standalone second lien loans are loans that are typically senior on a lien basis to other liabilities in the issuers capital structure and have the benefit of a security interest over the assets of the borrower, although
ranking junior to first lien loans. Standalone second lien loans may provide for moderate loan amortization in the early years of the loan, with the majority of the amortization deferred until loan maturity. Standalone second lien loans can incur
greater frictional costs (e.g., increased professional costs relating to resolving conflicts among the lenders) in the event of a workout and, partly because of this possible impact on recovery rates, we expect to demand a significantly
higher risk premium in the form of higher spreads, call protection and/or warrants for extending standalone second lien loans, compared to first lien loans of similar credit quality.
Standalone first lien loans
. Standalone first lien loans are loans that are typically senior on a lien basis to other liabilities in the
issuers capital structure and have the benefit of a security interest on the assets of the portfolio company. Standalone first lien loans may provide for moderate loan amortization in the early years of the loan, with the majority of the
amortization deferred until loan maturity.
Mezzanine loans/structured equity
. Mezzanine loans are subordinated to senior secured
loans on a payment basis, are typically unsecured and rank pari passu with other unsecured creditors of the issuer. As with standalone second lien loans, we expect to demand a significantly higher risk premium in the form of higher spreads, call
protection and/or warrants for mezzanine loans, given the lower recovery rates for such securities due in part to the greater frictional costs (e.g., increased professional costs relating to resolving conflicts among the lenders) in a
protracted workout. We may take mezzanine type risk in the form of structured equity investments. In cases where portfolio companies may be constrained in their ability to raise additional capital in the form of debt, we may have the
opportunity to structure preferred equity or other equity-like instruments. These equity instruments typically have redemption rights and will either be convertible into common equity at our option, or will have detachable warrants compensating us
for the additional risk inherent in such investments. In most cases, these equity instruments will have debt-like characteristics, which provide more downside protection than a typical equity instrument.
Equity components
. In connection with some of our debt investments, we will also invest in preferred or common stock or receive
nominally priced warrants or options to buy an equity interest in the portfolio company. As a result, as a portfolio company appreciates in value, we may achieve additional investment return from this equity interest. The Adviser may structure such
equity investments and warrants to include provisions protecting our rights as a minority-interest holder, as well as a put, or right to sell such securities back to the issuer, upon the occurrence of specified events. In many cases, we
may also seek to obtain registration rights in connection with these equity interests, which may include demand and piggyback registration rights.
Portfolio Management Strategy
Each of
the investments in our portfolio is monitored on a daily basis by a member of the Advisers investment committee aided by the senior investment professionals of the Investment Team, who also perform credit updates on each investment quarterly.
10
Risk Ratings
In addition to various risk management and monitoring tools, we use the Advisers investment rating system to characterize and monitor the
credit profile and expected level of returns on each investment in our portfolio. This investment rating system uses a five-level numeric rating scale. The following is a description of the conditions associated with each investment rating:
|
|
|
Investment Rating 1
|
|
Investments that are performing above expectations, and whose risks remain favorable compared to the expected risk at the time of the original investment.
|
|
|
Investment Rating 2
|
|
Investments that are performing within expectations and whose risks remain neutral compared to the expected risk at the time of the original investment. All new loans are initially rated 2.
|
|
|
Investment Rating 3
|
|
Investments that are performing below expectations and that require closer monitoring, but where no loss of return or principal is expected. Portfolio companies with a rating of 3 may be out of compliance with their financial
covenants.
|
|
|
Investment Rating 4
|
|
Investments that are performing substantially below expectations and whose risks have increased substantially since the original investment. These investments are often in workout. Investments with a rating of 4 are those for which
some loss of return but no loss of principal is expected.
|
|
|
Investment Rating 5
|
|
Investments that are performing substantially below expectations and whose risks have increased substantially since the original investment. These investments are almost always in workout. Investments with a rating of 5 are those
for which some loss of return and principal is expected.
|
If the Adviser determines that an investment is underperforming, or circumstances suggest that the risk
associated with a particular investment has significantly increased, the Adviser will increase its monitoring intensity and prepare regular updates for the investment committee, summarizing current operating results and material impending events and
suggesting recommended actions. While the investment rating system identifies the relative risk for each investment, the rating alone does not dictate the scope and/or frequency of any monitoring that will be performed. The frequency of the
Advisers monitoring of an investment is determined by a number of factors, including, but not limited to, the trends in the financial performance of the portfolio company, the investment structure and the type of collateral securing the
investment.
The following table shows the investment rankings of the debt investments in our portfolio:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of June 30, 2018
|
|
|
As of June 30, 2017
|
|
Investment Rating
|
|
Fair Value
|
|
|
% of
Portfolio
|
|
|
Number of
Investments
|
|
|
Fair Value
|
|
|
% of
Portfolio
|
|
|
Number of
Investments
|
|
1
|
|
$
|
6,458,750
|
|
|
|
2.2
|
%
|
|
|
1
|
|
|
$
|
|
|
|
|
|
%
|
|
|
|
|
2
|
|
|
267,055,281
|
|
|
|
91.0
|
|
|
|
29
|
|
|
|
212,729,243
|
|
|
|
83.5
|
|
|
|
18
|
|
3
|
|
|
8,765,286
|
|
|
|
3.0
|
|
|
|
1
|
|
|
|
27,899,860
|
|
|
|
10.9
|
|
|
|
3
|
|
4
|
|
|
10,580,954
|
|
|
|
3.6
|
|
|
|
2
|
|
|
|
6,759,238
|
|
|
|
2.7
|
|
|
|
1
|
|
5
|
|
|
731,742
|
|
|
|
0.2
|
|
|
|
2
|
|
|
|
7,518,830
|
|
|
|
2.9
|
|
|
|
2
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
293,592,013
|
|
|
|
100.00
|
%
|
|
|
35
|
|
|
$
|
254,907,171
|
|
|
|
100.0
|
%
|
|
|
24
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Determination of Net Asset Value and Portfolio Valuation Process
The net asset value per share of our outstanding shares of common stock is determined quarterly by dividing the value of total assets minus
liabilities by the total number of shares outstanding.
11
In calculating the value of our total assets, investment transactions will be recorded on the
trade date. Realized gains or losses will be computed using the specific identification method. Investments for which market quotations are readily available are valued at such market quotations. Debt and equity securities that are not publicly
traded or whose market price is not readily available are valued at fair value as determined in good faith by our board of directors based on the input of our management and audit committee. In addition, our board of directors retains one or more
independent valuation firms to review each quarter, the valuation of each portfolio investment for which a market quotation is not available. We also have adopted Accounting Standards Board Accounting Standards Codification 820,
Fair Value
Measurements and Disclosures
, or ASC 820. This accounting statement requires us to assume that the portfolio investment is assumed to be sold in the principal market to market participants, or in the absence of a principal market,
the most advantageous market, which may be a hypothetical market. Market participants are defined as buyers and sellers in the principal or most advantageous market that are independent, knowledgeable, and willing and able to transact. In accordance
with ASC 820, the market in which we can exit portfolio investments with the greatest volume and level activity is considered our principal market.
Investments for which market quotations are readily available are valued at such market quotations unless the quotations are deemed not to
represent fair value. We generally obtain market quotations from recognized exchanges, market quotation systems, independent pricing services or one or more broker dealers or market makers.
Debt and equity securities for which market quotations are not readily available or for which market quotations are deemed not to represent
fair value are valued at fair value as determined in good faith by our board of directors. Because a readily available market value for many of the investments in our portfolio is often not available, we value many of our portfolio investments at
fair value as determined in good faith by our board of directors using a consistently applied valuation process in accordance with a documented valuation policy that has been reviewed and approved by our board of directors. Due to the inherent
uncertainty and subjectivity of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ significantly from the values that would have been used had a readily available
market value existed for such investments and may differ materially from the values that we may ultimately realize. In addition, changes in the market environment and other events may have differing impacts on the market quotations used to value
some of our investments than on the fair values of our investments for which market quotations are not readily available. Market quotations may also be deemed not to represent fair value in certain circumstances where we believe that facts and
circumstances applicable to an issuer, a seller or purchaser, or the market for a particular security causes current market quotations not to reflect the fair value of the security. Examples of these events could include cases where a security
trades infrequently, causing a quoted purchase or sale price to become stale, where there is a forced sale by a distressed seller, where market quotations vary substantially among market makers, or where there is a wide bid-ask spread or
significant increase in the bid ask spread.
Those investments for which market quotations are not readily available or for which market
quotations are deemed not to represent fair value are valued utilizing a market approach, an income approach, or both approaches, as appropriate. The market approach uses prices and other relevant information generated by market transactions
involving identical or comparable assets or liabilities (including a business). The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The measurement is
based on the value indicated by current market expectations about those future amounts. In following these approaches, the types of factors that we may take into account in determining the fair value of our investments include, as relevant and among
other factors: available current market data, including relevant and applicable market trading and transaction comparables, applicable market yields and multiples, security covenants, call protection provisions, information rights, the nature and
realizable value of any collateral, the portfolio companys ability to make payments, its earnings and discounted cash flows, the markets in which the portfolio company does business, comparisons of financial ratios of peer companies that are
public, merger and acquisition comparables, our principal market (as the reporting entity) and enterprise values.
12
With respect to investments for which market quotations are not readily available, our board of
directors undertakes a multi-step valuation process each quarter, as described below:
|
|
|
our quarterly valuation process begins with each portfolio company or investment being initially valued by the
investment professionals of the Investment Adviser responsible for the portfolio investment;
|
|
|
|
preliminary valuation conclusions are then documented and discussed our senior management and the Investment
Adviser;
|
|
|
|
on a periodic basis, at least once annually, the valuation for each portfolio investment is reviewed by an
independent valuation firm engaged by our board of directors;
|
|
|
|
the valuation committee of our board of directors then reviews these preliminary valuations; and
|
|
|
|
the board of directors then discusses these preliminary valuations and determines the fair value of each
investment in our portfolio in good faith, based on the input of the Investment Adviser, the independent valuation firm and the valuation committee.
|
Realization of Investments
The
potential exit scenarios of a portfolio company will play an important role in evaluating investment decisions. The Adviser will formulate specific exit strategies at the time of each investment. Our debt orientation will provide for increased
potential exit opportunities, including the sale of investments in the private markets, the refinancing of investments held, often due to maturity or recapitalizations, and other liquidity events including the sale or merger of the portfolio
company. Since we seek to maintain a debt orientation in our investments, we generally expect to receive interest income over the course of the investment period, receiving a significant return on invested capital well in advance of final exit.
Derivatives
We may utilize
hedging techniques such as interest rate swaps to mitigate potential interest rate risk on our indebtedness. Such interest rate swaps would principally be used to protect us against higher costs on our indebtedness resulting from increases in both
short-term and long-term interest rates. We also may use various hedging and other risk management strategies to seek to manage various risks, including changes in currency exchange rates and market interest rates. Such hedging strategies would be
utilized to seek to protect the value of our portfolio investments, for example, against possible adverse changes in the market value of securities held in our portfolio.
Managerial Assistance
As a BDC, we
offer, and must provide upon request, managerial assistance to our portfolio companies. This assistance could involve monitoring the operations of our portfolio companies, participating in board and management meetings, consulting with and advising
officers of portfolio companies and providing other organizational and financial guidance. The Adviser will provide such managerial assistance on our behalf to portfolio companies that request this assistance. We may receive fees for these services
and will reimburse the Adviser for its allocated costs in providing such assistance, subject to the review by our board of directors, including our independent directors.
Competition
Our primary competitors in
providing financing to middle-market companies include public and private funds, other BDCs, commercial and investment banks, commercial finance companies and, to the extent they provide an alternative form of financing, private equity funds and
hedge funds. Many of our competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, we believe some competitors may have access to funding sources that are not available
to us. In
13
addition, some 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 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 or to the distribution and other requirements we must satisfy to maintain our qualification as a RIC.
We use the expertise of the investment professionals of the Adviser (including those provided to the Adviser under the Services Agreement) to
assess investment risks and determine appropriate pricing for our investments in portfolio companies. In addition, we believe the relationships of these investment professionals will enable us to learn about, and compete effectively for, financing
opportunities with attractive middle-market companies in the industries in which we seek to invest.
Staffing
We do not have any direct employees, and our day-to-day investment operations are managed by the Adviser. We have a Chief Executive Officer,
President, Chief Financial Officer and Chief Compliance Officer. To the extent necessary, our board of directors may hire additional personnel in the future. Our officers are all employees of the Adviser and our allocable portion of the cost of
Rocco DelGuercio, as our Chief Financial Officer and Chief Compliance Officer, and his staff, is paid by us pursuant to the Administration Agreement with the Adviser. The Adviser also has a strategic relationship with Cyrus Capital Partners, L.P.
(Cyrus Capital) in which the Adviser can utilize the expertise of Cyrus Capitals investment, accounting and back office professionals on an as needed basis pursuant to a personnel sharing arrangement.
Management Agreements
Investment Advisory
Agreement
Subject to the overall supervision of our board of directors and in accordance with the 1940 Act, the Adviser manages
our day-to-day operations and provides investment advisory services to us. Under the terms of the Investment Advisory Agreement, the Adviser:
|
|
|
determines the composition of our portfolio, the nature and timing of the changes to our portfolio and the manner
of implementing such changes;
|
|
|
|
identifies, evaluates and negotiates the structure of the investments we make;
|
|
|
|
executes, closes, services and monitors the investments we make;
|
|
|
|
determines the securities and other assets that we will purchase, retain or sell;
|
|
|
|
performs due diligence on prospective portfolio companies; and
|
|
|
|
provides us with such other investment advisory, research and related services as we may, from time to time,
reasonably require for the investment of our funds.
|
Pursuant to the Investment Advisory Agreement, we have agreed to pay
the Adviser a fee for investment advisory and management services consisting of two components a base management fee and an incentive fee. The cost of both the base management fee and the incentive fee will ultimately be borne by our
stockholders.
Management Fee
The
base management fee is calculated at an annual rate of 1.75% of our gross assets, including assets purchased with borrowed funds or other forms of leverage and excluding cash and cash equivalents. For services rendered under the Investment Advisory
Agreement, the base management fee is payable quarterly in arrears. The base management fee is calculated based on the average value of our gross assets, excluding cash and cash equivalents, at the end of the two most recently completed calendar
quarters. Base management fees for any partial month or quarter will be appropriately pro-rated.
14
Incentive Fee
We pay the Adviser an incentive fee. Incentive fees are calculated as below and payable quarterly in arrears (or, upon termination of the
Investment Advisory Agreement, as of the termination date). The incentive fee, which provides the Adviser with a share of the income that it generates for us, has two components, ordinary income and capital gains, calculated as follows:
The ordinary income component is calculated and payable quarterly in arrears based on our pre-incentive fee net investment income for the
immediately preceding calendar quarter, subject to a total return requirement and deferral of non-cash amounts, and is 20.0% of the amount, if any, by which our pre-incentive fee net investment income, expressed as a rate of return on the value of
our net assets attributable to our common stock, for the immediately preceding calendar quarter, exceeds a 2.0% (which is 8.0% annualized) hurdle rate and a catch-up provision measured as of the end of each calendar quarter. Under this
provision, in any calendar quarter, the Adviser receives no incentive fee until our pre-incentive fee net investment income equals the hurdle rate of 2.0%, but then receives, as a catch-up, 100% 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 2.5% (which is 10.0% annualized). The effect of the catch-up provision is that, subject to the
total return and deferral provisions discussed below, if pre-incentive fee net investment income exceeds 2.5% in any calendar quarter, the Adviser receives 20.0% of our pre-incentive fee net investment income as if a hurdle rate did not apply. For
this purpose, pre-incentive fee net investment income means interest income, dividend income and any other income (including any other fees, such as commitment, origination, structuring, diligence, managerial assistance and consulting fees or other
fees that we receive from portfolio companies) accrued during the calendar quarter, minus our operating expenses for the quarter (including the base management fee, expenses payable under the Administration Agreement and any interest expense and any
distributions paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-incentive fee net investment income includes, in the case of investments with a deferred interest feature (such as original issue discount
(OID), debt instruments with PIK interest and zero coupon securities), accrued income that we have not yet received in cash. The foregoing incentive fee is subject to a total return requirement, which provides that no incentive fee in
respect of our pre-incentive fee net investment income is payable except to the extent 20.0% of the cumulative net increase in net assets resulting from operations over the then current and 11 preceding quarters exceeds the cumulative incentive fees
accrued and/or paid for the 11 preceding quarters. In other words, any ordinary income incentive fee that is payable in a calendar quarter is limited to the lesser of (i) 20.0% of the amount by which the Companys pre-incentive fee net
investment income for such calendar quarter exceeds the 2.0% hurdle, subject to the catch-up provision, and (ii) (x) 20.0% of the cumulative net increase in net assets resulting from operations for the then current and 11
preceding calendar quarters
minus
(y) the cumulative incentive fees accrued and/or paid for the 11 preceding calendar quarters. For the foregoing purpose, the cumulative net increase in net assets resulting from operations is
the amount, if positive, of the sum of pre-incentive fee net investment income, realized gains and losses and unrealized appreciation and depreciation of the Company for the then current and 11 preceding calendar quarters. In addition, the portion
of such incentive fee that is attributable to deferred interest (such as PIK interest or OID) will be paid to the Adviser only if and to the extent we actually receive such interest in cash, and any accrual thereof will be reversed if and to the
extent such interest is reversed in connection with any write-off or similar treatment of the investment giving rise to any deferred interest accrual. Any reversal of such accounts would reduce net income for the quarter by the net amount of the
reversal (after taking into account the reversal of incentive fees payable) and would result in a reduction and possible elimination of the incentive fees for such quarter. Notwithstanding any such incentive fee reduction or elimination, there is no
accumulation of amounts on the hurdle rate from quarter to quarter, and accordingly there is no clawback of amounts previously paid if subsequent quarters are below the quarterly hurdle, and there is no delay of payment if prior quarters are below
the quarterly hurdle.
Pre-incentive fee net investment income does not include any realized capital gains, realized capital losses or
unrealized capital appreciation or depreciation. Because of the structure of the incentive fee, it is possible that we may pay an incentive fee in a quarter where we incur a loss, subject to the total return requirement and deferral of non-cash
amounts. For example, if we receive pre-incentive fee net investment income in excess of
15
the quarterly minimum hurdle rate, we would pay the applicable incentive fee even if we have incurred a loss in that quarter due to realized and unrealized capital losses. Our net investment
income used to calculate this component of the incentive fee is also included in the amount of our gross assets used to calculate the 1.75% base management fee. These calculations are appropriately prorated for any period of less than three months
and adjusted for any share issuances or repurchases during the current quarter.
The following is a graphic representation of the
calculation of the income-related portion of the incentive fee:
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 capital gains component of the incentive fee is determined and payable in arrears as of the end of each calendar year (or upon termination
of the Investment Advisory Agreement, as of the termination date), commencing on December 31, 2014, and is equal to 20.0% of our cumulative aggregate realized capital gains from inception through the end of that calendar year, computed net of
our aggregate cumulative realized capital losses and our aggregate cumulative unrealized capital depreciation through the end of such year, less the aggregate amount of any previously paid capital gains incentive fees, provided that the incentive
fee determined as of December 31, 2014 will be calculated for a period of shorter than twelve calendar months to take into account any realized capital gains computed net of all realized capital losses and unrealized capital depreciation for
the period ending December 31, 2014. If such amount is negative, then no capital gains incentive fee will be payable for such year. Additionally, if the Investment Advisory Agreement is terminated as of a date that is not a calendar year end,
the termination date will be treated as though it were a calendar year end for purposes of calculating and paying the capital gains incentive fee.
Under GAAP, we calculate the capital gains component of the incentive fee as if we had realized all assets at their fair values as of the
reporting date. Accordingly, we accrue a provisional capital gains incentive fee taking into account any unrealized gains or losses. As the provisional capital gains incentive fee is subject to the performance of investments until there is a
realization event, the amount of the provisional capital gains incentive fee accrued at a reporting date may vary from the capital gains incentive that is ultimately realized and the differences could be material.
Examples of Quarterly Incentive Fee Calculation
Example 1: Income Related Portion of Incentive Fee before Total Return Requirement Calculation:
Alternative 1
Assumptions
Investment
income (including interest, dividends, fees, etc.) = 1.25%
Hurdle rate
(1)
= 2.0%
Management fee
(2)
= 0.4375%
16
Other expenses (legal, accounting, custodian, transfer agent, etc.)
(3)
= 0.2%
Pre-incentive fee net investment income
(investment income (management fee + other expenses) = 0.6125%
Pre-incentive fee net investment income does not exceed hurdle rate, therefore there is no income-related incentive fee.
Alternative 2
Assumptions
Investment
income (including interest, dividends, fees, etc.) = 2.9%
Hurdle rate
(1)
= 2.0%
Management fee
(2)
= 0.4375%
Other expenses (legal, accounting, custodian, transfer agent, etc.)
(3)
= 0.2%
Pre-incentive fee net investment income
(investment income (management fee + other expenses) = 2.2625%
Incentive fee = 100% × Pre-incentive fee net investment income (subject to catch-up)
(4)
= 100% × (2.2625% 2.0%)
= 0.2625%
Pre-incentive fee net
investment income exceeds the hurdle rate, but does not fully satisfy the catch-up provision; therefore the income related portion of the incentive fee is 0.2625%.
Alternative 3
Assumptions
Investment
income (including interest, dividends, fees, etc.) = 3.5%
Hurdle rate
(1)
= 2.0%
Management fee
(2)
= 0.4375%
Other expenses (legal, accounting, custodian, transfer agent, etc.)
(3)
= 0.2%
Pre-incentive fee net investment income
(investment income (management fee + other expenses) = 2.8625%
|
|
|
Incentive fee =
|
|
100% × Pre-incentive fee net investment income (subject to catch-up)
(4)
|
|
|
Incentive fee =
|
|
100% × catch-up + (20.0% × (Pre-Incentive Fee Net Investment Income 2.5%))
|
|
Catch-up = 2.5% 2.0%
|
= 0.5%
|
|
|
Incentive fee =
|
|
(100% × 0.5%) + (20.0% × (2.8625% 2.5%))
|
= 0.5% + (20.0% × 0.3625%)
|
= 0.5% + 0.725%
|
= 0.5725%
|
Pre-incentive fee net investment income exceeds the hurdle rate, and fully satisfies the catch-up
provision; therefore the income related portion of the incentive fee is 0.5725%.
(1)
|
Represents 8.0% annualized hurdle rate.
|
(2)
|
Represents 1.75% annualized base management fee.
|
(3)
|
Excludes organizational and offering expenses.
|
(4)
|
The catch-up provision is intended to provide the Adviser with an incentive fee of 20.0% on all
pre-incentive fee net investment income as if a hurdle rate did not apply when our net investment income exceeds 2.5% in any fiscal quarter.
|
17
Example 2: Income Portion of Incentive Fee with Total Return Requirement Calculation:
Alternative 1
:
Assumptions
Investment
income (including interest, dividends, fees, etc.) = 3.5%
Hurdle rate
(1)
= 2.0%
Management fee
(2)
= 0.4375%
Other expenses (legal, accounting, custodian, transfer agent, etc.)
(3)
= 0.2%
Pre-incentive fee net investment income
(investment income (management fee + other expenses) = 2.8625%
Cumulative incentive compensation accrued and/or paid for preceding 11 calendar quarters = $9,000,000 20.0% of cumulative net increase in net
assets resulting from operations over current and preceding 11 calendar quarters = $8,000,000
Although our pre-incentive fee net
investment income exceeds the hurdle rate of 2.0% (as shown in Alternative 3 of Example 1 above), no incentive fee is payable because 20.0% of the cumulative net increase in net assets resulting from operations over the then current and 11 preceding
calendar quarters did not exceed the cumulative income and capital gains incentive fees accrued and/or paid for the preceding 11 calendar quarters.
Alternative 2
:
Assumptions
Investment
income (including interest, dividends, fees, etc.) = 3.5%
Hurdle rate
(1)
= 2.0%
Management fee
(2)
= 0.4375%
Other expenses (legal, accounting, custodian, transfer agent, etc.)
(3)
= 0.2%
Pre-incentive fee net investment income
(investment income (management fee + other expenses) = 2.8625%
Cumulative incentive compensation accrued and/or paid for preceding 11 calendar quarters = $9,000,000 20.0% of cumulative net increase in net
assets resulting from operations over current and preceding 11 calendar quarters = $10,000,000
Because our pre-incentive fee net
investment income exceeds the hurdle rate of 2.0% and because 20.0% of the cumulative net increase in net assets resulting from operations over the then current and 11 preceding calendar quarters exceeds the cumulative income and capital gains
incentive fees accrued and/or paid for the preceding 11 calendar quarters, an incentive fee would be payable, as shown in Alternative 3 of Example 1 above.
(1)
|
Represents 8.0% annualized hurdle rate.
|
(2)
|
Represents 1.75% annualized base management fee.
|
(3)
|
Excludes organizational and offering expenses.
|
(4)
|
The catch-up provision is intended to provide the Adviser with an incentive fee of 20.0% on all
pre-incentive fee net investment income as if a hurdle rate did not apply when our net investment income exceeds 2.5% in any fiscal quarter.
|
18
Example 3: Capital Gains Portion of Incentive Fee(*):
Alternative 1:
Assumptions
|
|
|
Year 1:
|
|
$2.0 million investment made in Company A (Investment A), and $3.0 million investment made in Company B (Investment B)
|
Year 2:
|
|
Investment A sold for $5.0 million and fair market value (FMV) of Investment B determined to be $3.5 million
|
Year 3:
|
|
FMV of Investment B determined to be $2.0 million
|
Year 4:
|
|
Investment B sold for $3.25 million
|
The capital gains portion of the incentive fee would be:
|
|
|
Year 1:
|
|
None
|
|
|
Year 2:
|
|
Capital gains incentive fee of $0.6 million ($3.0 million realized capital gains on sale of Investment A multiplied by 20.0%)
|
|
|
Year 3:
|
|
None $0.4 million (20.0% multiplied by ($3.0 million cumulative capital gains less $1.0 million cumulative capital depreciation)) less $0.6 million (previous capital gains fee paid in Year 2)
|
|
|
Year 4:
|
|
Capital gains incentive fee of $50,000 $0.65 million ($3.25 million cumulative realized capital gains multiplied by 20%) less $0.6 million (capital gains incentive fee taken in Year 2)
|
Alternative 2
Assumptions
|
|
|
Year 1:
|
|
$2.0 million investment made in Company A (Investment A), $5.25 million investment made in Company B (Investment B) and $4.5 million investment made in Company C (Investment C)
|
|
|
Year 2:
|
|
Investment A sold for $4.5 million, FMV of Investment B determined to be $4.75 million and FMV of Investment C determined to be $4.5 million
|
|
|
Year 3:
|
|
FMV of Investment B determined to be $5.0 million and Investment C sold for $5.5 million
|
|
|
Year 4:
|
|
FMV of Investment B determined to be $6.0 million
|
|
|
Year 5:
|
|
Investment B sold for $4.0 million
|
The capital gains incentive fee, if any, would be:
|
|
|
Year 1:
|
|
None
|
|
|
Year 2:
|
|
Capital gains incentive fee of $0.4 million 20.0% multiplied by $2.0 million ($2.5 million realized capital gains on Investment A less $0.5 million unrealized capital depreciation on Investment B)
|
|
|
Year 3:
|
|
$0.25 million capital gains incentive fee
(1)
$0.65 million (20.0% multiplied by $3.25 million ($3.5 million cumulative realized capital gains less $0.25 million
unrealized capital depreciation)) less $0.4 million capital gains incentive fee received in Year 2
|
|
|
Year 4:
|
|
$0.05 million capital gains incentive fee $0.7 million ($3.50 million cumulative realized capital gains multiplied by 20.0%) less $0.65 million cumulative capital gains incentive fee paid in Year 2 and Year 3
|
|
|
Year 5:
|
|
None $0.45 million (20.0% multiplied by $2.25 million (cumulative realized capital gains of $3.5 million less realized capital losses of $1.25 million)) less $0.7 million cumulative capital gains incentive fee paid in Year
2, Year 3 and
Year 4
(2)
|
19
*
|
The hypothetical amounts of returns shown are based on a percentage of our total net assets and assume no
leverage. There is no guarantee that positive returns will be realized and actual returns may vary from those shown in this example.
|
(1)
|
As illustrated in Year 3 of Alternative 1 above, if a portfolio company were to be wound up on a date other
than its fiscal year end of any year, it may have paid aggregate capital gains incentive fees that are more than the amount of such fees that would be payable if such portfolio company had been wound up on its fiscal year end of such year.
|
(2)
|
As noted above, it is possible that the cumulative aggregate capital gains fee received by the Adviser ($0.70
million) is effectively greater than $0.45 million (20% of cumulative aggregate realized capital gains less net realized capital losses or net unrealized depreciation ($2.25 million)).
|
Payment of Our Expenses
The base
management fee and incentive compensation remunerates the Adviser for work in identifying, evaluating, negotiating, closing and monitoring our investments. We bear all other out-of-pocket costs and expenses of our operations and transactions,
including, without limitation, those relating to:
|
|
|
our organization, the formation transactions and offerings;
|
|
|
|
calculating our net asset value (including the cost and expenses of any independent valuation firm);
|
|
|
|
fees and expenses payable to third parties, including agents, consultants or other advisors, in monitoring
financial and legal affairs for us and in monitoring our investments and performing due diligence on our prospective portfolio companies or otherwise relating to, or associated with, evaluating and making investments;
|
|
|
|
interest payable on debt, if any, incurred to finance our investments and expenses related to unsuccessful
portfolio acquisition efforts;
|
|
|
|
other offerings of our common stock and other securities;
|
|
|
|
administration fees and expenses, if any, payable under the Administration Agreement (including our allocable
portion of the Advisers overhead in performing its obligations under the Administration Agreement, including rent and the allocable portion of the cost of our chief compliance officer, chief financial officer and their respective staffs);
|
|
|
|
transfer agent, dividend agent and custodial fees and expenses;
|
|
|
|
costs associated with our reporting and compliance obligations under the 1940 Act, as amended, and other
applicable federal and state securities laws, and stock exchange listing fees;
|
|
|
|
fees and expenses associated with independent audits and outside legal costs;
|
|
|
|
federal, state and local taxes;
|
|
|
|
independent directors fees and expenses;
|
|
|
|
costs of any reports, proxy statements or other notices to or communications and meetings with stockholders;
|
|
|
|
costs associated with investor relations;
|
|
|
|
costs and fees associated with any fidelity bond, directors and officers/errors and omissions liability
insurance, and any other insurance premiums;
|
|
|
|
direct costs and expenses of administration, including printing, mailing, long distance telephone, copying,
secretarial and other staff; and
|
|
|
|
all other expenses incurred by us or the Adviser in connection with administering our business.
|
20
Duration and Termination
Unless terminated earlier as described below, the Investment Advisory Agreement will remain in effect from year to year if approved annually by
our board of directors or by the affirmative vote of the holders of a majority of our outstanding voting securities, and, in either case, if also approved by a majority of our directors who are not interested persons. The Investment
Advisory Agreement automatically terminates in the event of its assignment, as defined in the 1940 Act, by the Adviser and may be terminated by either party without penalty upon not less than 60 days written notice to the other. The holders of
a majority of our outstanding voting securities may also terminate the Investment Advisory Agreement without penalty upon 60 days written notice.
Indemnification
The Investment Advisory
Agreement provides that, absent willful misfeasance, bad faith or gross negligence in the performance of its duties or by reason of the reckless disregard of its duties and obligations under the Investment Advisory Agreement, the Adviser and its
officers, managers, partners, agents, employees, controlling persons and members, and any other person or entity affiliated with it, are entitled to indemnification from us for any damages, liabilities, costs and expenses (including reasonable
attorneys fees and amounts reasonably paid in settlement) arising from the rendering of the Advisers services under the Investment Advisory Agreement or otherwise as the Adviser.
Board Approval of the Investment Advisory Agreement
Our board of directors approved the Investment Advisory Agreement at its first meeting, held on October 8, 2013, which became effective in
February 2014. At a meeting of our board of directors held in November 2017, our board of directors, including a majority of the independent directors, approved the annual continuation of the Investment Advisory Agreement. In its consideration of
the Investment Advisory Agreement, the board of directors reviewed a significant amount of information and considered, among other things: (a) the nature, quality and extent of the advisory and other services to be provided to us by our
Adviser; (b) comparative data with respect to advisory fees or similar expenses paid by other BDCs with similar investment objectives; (c) any existing and potential sources of indirect income to our Adviser from its relationships with us
and the profitability of those relationships; (d) information about the services to be performed and the personnel performing such services under the Investment Advisory Agreement; (e) the organizational capability and financial condition
of our Adviser; and (f) various other factors.
In voting to approve the Investment Advisory Agreement, our board of directors,
including all of the directors who are not interested persons, of the Company, made the following conclusions:
|
|
|
Nature, Extent and Quality of Services.
Our board of directors considered the nature, extent and quality
of the advisory and other services to be provided by the Adviser, including the investment performance of the Investment Team. Our board of directors also considered the investment selection process expected to be employed by the Adviser, including
the flow of transaction opportunities resulting from the Investment Teams significant experience in structuring strategic capital for business expansion, refinancings, capital restructuring, post-reorganization financing and servicing the
general corporate needs of middle-market companies; the employment of the Advisers investment philosophy, diligence procedures, credit recommendation process, investment structuring, and ongoing relationships with and monitoring of portfolio
companies, in light of the investment objective of the Company. Our board of directors also considered the Advisers personnel and their prior experience in connection with the types of investments made by us, including such personnels
corporate relationships and relationships with private equity firms, investment banks, restructuring advisors, law firms, boutique advisory firms and distressed/specialty lenders. In addition, our board of directors considered the other terms and
conditions of the Investment Advisory Agreement. Our board of directors determined that the substantive terms of the Investment Advisory Agreement (other than the fees payable thereunder, which our board of directors reviewed separately), including
the services to be provided, are similar to those of comparable BDCs described in the available market data and in the best interests of our stockholders.
|
21
|
|
|
Projected Costs of the Services Provided to the Company.
Our board of directors considered
(i) comparative data based on publicly available information with respect to services rendered and the advisory fees (including the base management fee and incentive fees) of other externally managed BDCs that invest in similar securities, our
total expenses, and expense ratios compared to other BDCs of similar size and with similar investment objectives, (ii) the administrative services that the Adviser will provide to us at cost pursuant to the Administration Agreement, and
(iii) potential fee waivers by the Adviser. Based upon its review, our board of directors determined that the fees to be paid under the Investment Advisory Agreement are reasonable in relation to the services expected to be provided by the
Adviser.
|
|
|
|
Projected Profitability of the Adviser.
Our board of directors considered information about the
Adviser, including the anticipated costs of the services to be provided by the Adviser and the anticipated profits to be realized by the Adviser, which would generally be equal or similar to the profitability of investment advisers managing
comparable BDCs. Our board of directors reviewed our investment performance, as well as comparative data with respect to the investment performance of other externally-managed BDCs, as it relates to the management and incentive fees we pay the
Adviser. As a result of this review, our board of directors determined that our investment performance supported the renewal of the Investment Advisory Agreement.
|
|
|
|
Economies of Scale.
Our board of directors considered the extent to which economies of scale would be
realized as the Company grows, and whether the fees payable under the Investment Advisory Agreement reflect these economies of scale for the benefit of the our stockholders. Taking into account such information, our board of directors determined
that the advisory fee structure under the Investment Advisory Agreement was reasonable with respect to any economies of scale that may be realized as the Company grows.
|
|
|
|
Limited Potential for Additional Benefits Derived by the Adviser.
Our board of directors considered
existing and potential sources of indirect income the Adviser receive as a result of the relationship with us, and whether there would be potential for additional benefits to be derived by the Adviser as a result of our relationship with the
Adviser, and was advised any such potential would be limited.
|
Conclusions:
In view of the wide variety of
factors that our board of directors considered in connection with its evaluation of the Investment Advisory Agreement, it is not practical to quantify, rank or otherwise assign relative weights to the specific factors it considered in reaching its
decision. Our board of directors did not undertake to make any specific determination as to whether any particular factor, or any aspect of any particular factor, was favorable or unfavorable to the ultimate determination of our board of directors.
Rather, our board of directors based its approval on the totality of information presented to, and the investigation conducted by, it. In considering the factors discussed above, individual directors may have given different weights to different
factors.
Based on the information reviewed and the discussions, the board of directors, including a majority of the non-interested
directors, concluded that the investment management fee rates and terms are reasonable in relation to the services to be provided and approved the Investment Advisory Agreement as being in the best interests of our stockholders. Our board of
directors will next consider the Investment Advisory Agreement at a meeting in November 2018.
Administration Agreement
Under the Administration Agreement, the Adviser furnishes us with office facilities and equipment and provides us with clerical, bookkeeping,
recordkeeping and other administrative services at such facilities. Under the Administration Agreement, the Adviser performs, or oversees the performance of, our required administrative services, which includes, among other things, being responsible
for the financial and other records that we are required to maintain and preparing reports to our stockholders and reports and other materials filed with the SEC.
22
In addition, the Adviser assists us in determining and publishing our net asset value, oversees the preparation and filing of our tax returns and the printing and dissemination of reports and
other materials to our stockholders, and generally oversees the payment of our expenses and the performance of administrative and professional services rendered to us by others. Under the Administration Agreement, the Adviser also provides
managerial assistance on our behalf to those portfolio companies that have accepted our offer to provide such assistance. The Adviser may satisfy certain of its obligations under the Administration Agreement to us through the Services Agreement with
Cyrus Capital, including supplying us with accounting and back-office professionals upon the request of the Adviser.
Payments under the
Administration Agreement equal an amount based upon our allocable portion (subject to the review of our board of directors) of the Advisers overhead in performing its obligations under the Administration Agreement, including rent, the fees and
expenses associated with performing compliance functions and our allocable portion of the cost of our Chief Financial Officer and Chief Compliance Officer and their respective staffs. In addition, if requested to provide significant managerial
assistance to our portfolio companies, the Adviser will be paid an additional amount based on the services provided, which shall not exceed the amount we receive from such portfolio companies for providing this assistance. The Administration
Agreement has an initial term of two years and may be renewed with the approval of our board of directors. The Administration Agreement may be terminated by either party without penalty upon 60 days written notice to the other party. To the
extent that the Adviser outsources any of its functions, we pay the fees associated with such functions on a direct basis without any incremental profit to the Adviser.
Indemnification
The Administration
Agreement provides that, absent criminal conduct, willful misfeasance, bad faith or gross negligence in the performance of its duties or by reason of the reckless disregard of its duties and obligations, the Adviser and its officers, managers,
partners, agents, employees, controlling persons and members, and any other person or entity affiliated with it, are entitled to indemnification from us for any damages, liabilities, costs and expenses (including reasonable attorneys fees and
amounts reasonably paid in settlement) arising from the rendering of the Advisers services under the Administration Agreement or otherwise as our administrator.
License Agreement
We have entered into a
license agreement with the Adviser under which the Adviser has agreed to grant us a non-exclusive, royalty-free license to use the name CM Finance. Under this agreement, we have a right to use the CM Finance name for so long
as the Adviser or one of its affiliates remains the Adviser. Other than with respect to this limited license, we have no legal right to the CM Finance name. This license agreement will remain in effect for so long as the Investment
Advisory Agreement with the Adviser is in effect.
Exchange Act Reports
We maintain a website at
www.cmfn-inc.com.
The information on our website is not incorporated by reference in this annual report on Form
10-K.
We make available on or through our website certain reports and amendments to those reports that we file with or furnish to the SEC
in accordance with the Exchange Act. These include our annual reports on Form 10-K, our quarterly reports on Form 10-Q and our current reports on Form 8-K. We make this information available on our website free of charge as soon as reasonably
practicable after we electronically file the information with, or furnish it to, the SEC.
23
Regulation as a BDC
We are a BDC under the 1940 Act. The 1940 Act contains prohibitions and restrictions relating to transactions between BDCs and their affiliates
(including any investment advisers), principal underwriters and affiliates of those affiliates or underwriters and requires that a majority of the directors be persons other than interested persons, as that term is 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.
We may invest up to 100% of our assets in securities acquired directly from issuers in privately negotiated transactions. With respect to such
securities, we may, for the purpose of public resale, be deemed an underwriter as that term is defined in the Securities Act. Our intention is to not write (sell) or buy put or call options to manage risks associated with the publicly
traded securities of our portfolio companies, except that we may enter into hedging transactions to manage the risks associated with interest rate fluctuations. However, we may purchase or otherwise receive warrants to purchase the common stock of
our portfolio companies in connection with acquisition financing or other investments. Similarly, in connection with an acquisition, we may acquire rights to require the issuers of acquired securities or their affiliates to repurchase them under
certain circumstances. We also do not intend to acquire securities issued by any investment company that exceed the limits imposed by the 1940 Act. Under these limits, we generally cannot acquire more than 3% of the voting stock of any registered
investment company, invest more than 5% of the value of our total assets in the securities of one investment company or invest more than 10% of the value of our total assets in the securities of more than one investment company. With regard to that
portion of our portfolio invested in securities issued by investment companies, it should be noted that such investments might subject our stockholders to additional expenses. None of these policies is fundamental and may be changed without
stockholder approval upon 60 days prior written notice to stockholders.
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 represent at least 70% of the companys total assets. The principal categories of qualifying assets relevant to our business are the following:
|
(1)
|
Securities purchased in transactions not involving any public offering from the issuer of such securities,
which issuer (subject to certain limited exceptions) is an eligible portfolio company, or from any person who is, or has been during the preceding 13 months, an affiliated person of an eligible portfolio company, or from any other person, subject to
such rules as may be prescribed by the SEC. Under the 1940 Act and the rules thereunder, eligible portfolio companies include (1) private domestic operating companies, (2) public domestic operating companies whose securities
are not listed on a national securities exchange (e.g., NASDAQ), and (3) public domestic operating companies having a market capitalization of less than $250 million. Public domestic operating companies whose securities are quoted on the
over-the-counter bulletin board or through Pink Sheets LLC are not listed on a national securities exchange and therefore are eligible portfolio companies.
|
|
(2)
|
Securities of any eligible portfolio company which we control.
|
|
(3)
|
Securities purchased in a private transaction from a U.S. issuer that is not an investment company or from an
affiliated person of the issuer, or in transactions incident to such a private transaction, if the issuer is in bankruptcy and subject to reorganization or if the issuer, immediately prior to the purchase of its securities, was unable to meet its
obligations as they came due without material assistance other than conventional lending or financing arrangements.
|
|
(4)
|
Securities of an eligible portfolio company purchased from any person in a private transaction if there is no
ready market for such securities and we already own 60% of the outstanding equity of the eligible portfolio company.
|
24
|
(5)
|
Securities received in exchange for or distributed on or with respect to securities described above, or
pursuant to the exercise of warrants or rights relating to such securities.
|
|
(6)
|
Cash, cash equivalents, U.S. government securities or high-quality debt securities that mature in one year or
less from the date of investment.
|
The regulations defining qualifying assets may change over time. We may adjust our
investment focus as needed to comply with and/or take advantage of any regulatory, legislative, administrative or judicial actions in this area.
Managerial Assistance to Portfolio Companies
Business development companies generally must offer to make available to the issuer of the securities significant managerial assistance, except
in circumstances where either (i) the business development company controls such issuer of securities or (ii) the business development company purchases such securities in conjunction with one or more other persons acting together and one
of the other persons in the group makes available such managerial assistance. Making available managerial assistance means any arrangement whereby the business development company, through its directors, officers, employees or agents, 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. The Adviser will provide such managerial assistance on our behalf to
portfolio companies that request this assistance.
Temporary Investments
Pending investment in other types of qualifying assets, as described above, our investments may consist of cash, cash equivalents, U.S.
government securities, repurchase agreements and high-quality debt investments that mature in one year or less from the date of investment, which we refer to, collectively, as temporary investments, so that 70% of our assets are qualifying assets or
temporary investments. Typically, we will invest in U.S. Treasury bills or in repurchase agreements, so long as the agreements are fully collateralized by cash or securities issued by the U.S. government or its agencies. A repurchase agreement
involves the purchase by an investor, such as us, of a specified security and the simultaneous agreement by the seller to repurchase it at an agreed-upon future date and at a price that is greater than the purchase price by an amount that reflects
an agreed-upon interest rate. There is no percentage restriction on the proportion of our assets that may be invested in such repurchase agreements. However, if more than 25% of our total assets constitute repurchase agreements from a single
counterparty, we would not meet the diversification tests in order to qualify as a RIC for U.S. federal income tax purposes. Accordingly, we do not intend to enter into repurchase agreements with a single counterparty in excess of this limit. The
Adviser will monitor the creditworthiness of the counterparties with which we enter into repurchase agreement transactions.
Senior Securities
We are generally permitted, under specified conditions, to issue multiple classes of indebtedness and one class of stock senior to
our common stock if our asset coverage, as defined in the 1940 Act, is at least equal to 200% immediately after each such issuance. In addition, while any senior securities remain outstanding, we must make provisions to prohibit any distribution to
our stockholders or the repurchase of such securities or shares unless we meet the applicable asset coverage ratios at the time of the distribution or repurchase. However, recent legislation has modified the 1940 Act by allowing a BDC to increase
the maximum amount of leverage it may incur from an asset coverage ratio of 200% to an asset coverage ratio of 150%, if certain requirements are met. We are permitted to increase our leverage capacity if stockholders representing at least a majority
of the votes cast, when quorum is met, approve a proposal to do so. If we receive such stockholder approval, we would be permitted to increase our leverage capacity on the first day after such approval. Alternatively, the legislation allows the
required majority of our independent directors, as defined in Section 57(o) of the 1940 Act, to approve such an increase in our leverage capacity, with such approval becoming effective after one year. In either
25
case, we would be required to make certain disclosures on our website and in SEC filings regarding, among other things, the receipt of approval to increase our leverage, our leverage capacity and
usage, and risks related to leverage.
In accordance with recent legislation, on May 2, 2018, our board of directors, including a
required majority, approved the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. As a result, our asset coverage requirements for senior securities will change from 200% to 150%, effective
May 2, 2019. For a discussion of this recent legislation, see Risk Factors Risks Related to Our Business and Structure Our board of directors has approved our ability to incur additional leverage as permitted by recent
legislation. We may also borrow amounts up to 5% of the value of our total assets for temporary or emergency purposes without regard to asset coverage. For a discussion of the risks associated with leverage, see Risk Factors Risks
Relating to our Business and Structure Regulations governing our operation as a business development company will affect our ability to, and the way in which we, raise additional capital. As a business development company, the necessity of
raising additional capital may expose us to risks, including the typical risks associated with leverage.
Common Stock
We are not generally able to issue and sell our common stock at a price below net asset value per share. We may, however, sell our common stock
at a price below the current net asset value of the common stock if our board of directors determines that such sale is in our best interests and that of our stockholders, and our stockholders approve such sale. In any such case, the price at which
our securities are to be issued and sold may not be less than a price which, in the determination of our board of directors, closely approximates the market value of such securities (less any distributing commission or discount).
Codes of Ethics
We and the
Adviser have each adopted a code of ethics pursuant to Rule 17j-1 under the 1940 Act that establishes procedures for personal investments and restricts certain personal securities transactions. Personnel subject to each such code may invest in
securities for their personal investment accounts, including securities that may be purchased or held by us, so long as such investments are made in accordance with such codes requirements. You may read and copy our code of ethics at the
SECs Public Reference Room in Washington, D.C. You may obtain information on the operation of the Public Reference Room by calling the SEC at (202) 551-8090. In addition, each code of ethics is available on the EDGAR Database on the
SECs website at
www.sec.gov.
You may also obtain copies of each code of ethics, after paying a duplicating fee, by electronic request at the following e-mail address:
publicinfo@sec.gov
, or by writing the SECs Public
Reference Section, 100 F Street, N.E., Washington, D.C. 20549.
Proxy Voting Policies and Procedures
We have delegated our proxy voting responsibility to the Adviser. The Proxy Voting Policies and Procedures of the Adviser are set out below.
The guidelines will be reviewed periodically by the Adviser and our directors who are not interested persons, and, accordingly, are subject to change.
Introduction
As an investment adviser
registered under the Advisers Act, the Adviser has a fiduciary duty to act solely in our best interests. As part of this duty, the Adviser recognizes that it must vote our securities in a timely manner free of conflicts of interest and in our best
interests.
The Advisers policies and procedures for voting proxies for its investment advisory clients are intended to comply with
Section 206 of, and Rule 206(4)-6 under, the Advisers Act.
26
Proxy Policies
The Adviser votes proxies relating to our portfolio securities in what it perceives to be the best interest of our stockholders. The Adviser
reviews on a case-by-case basis each proposal submitted to a stockholder vote to determine its effect on the portfolio securities we hold. In most cases, the Adviser will vote in favor of proposals that the Adviser believes are likely to increase
the value of the portfolio securities we hold. Although the Adviser will generally vote against proposals that may have a negative effect on our portfolio securities, the Adviser may vote for such a proposal if there exist compelling long-term
reasons to do so.
The Adviser has established a proxy voting committee and adopted proxy voting guidelines and related procedures. The
proxy voting committee establishes proxy voting guidelines and procedures, oversees the internal proxy voting process, and reviews proxy voting issues. To ensure that the Advisers vote is not the product of a conflict of interest, the Adviser
requires that (1) anyone involved in the decision-making process disclose to our Chief Compliance Officer any potential conflict that he or she is aware of and any contact that he or she has had with any interested party regarding a proxy vote;
and (2) employees involved in the decision- making process or vote administration are prohibited from revealing how the Adviser intends to vote on a proposal in order to reduce any attempted influence from interested parties. Where conflicts of
interest may be present, the Adviser will disclose such conflicts to us, including our independent directors and may request guidance from us on how to vote such proxies.
Proxy Voting Records
You may obtain
information about how the Adviser voted proxies by making a written request for proxy voting information to: CM Finance Inc, Attention: Investor Relations, 601 Lexington Avenue, 26
th
Floor, New
York, New York 10022, or by calling us collect at (212) 257-5199. The SEC also maintains a website at
www.sec.gov
that contains this information.
Privacy Principles
We are
committed to maintaining the privacy of our stockholders and to safeguarding their nonpublic personal information. The following information is provided to help you understand what personal information we collect, how we protect that information and
why, in certain cases, we may share information with select other parties.
Generally, we do not receive any nonpublic personal information
relating to our stockholders, although certain nonpublic personal information of our stockholders may become available to us. We do not disclose any nonpublic personal information about our stockholders or former stockholders to anyone, except as
permitted by law or as is necessary in order to service stockholder accounts (for example, to a transfer agent or third-party administrator).
We restrict access to nonpublic personal information about our stockholders to employees of the Adviser and its affiliates with a legitimate
business need for the information. We intend to maintain physical, electronic and procedural safeguards designed to protect the nonpublic personal information of our stockholders.
Other
We are required to provide and
maintain a bond issued by a reputable fidelity insurance company to protect us against larceny and embezzlement. Furthermore, as a BDC, we are prohibited from protecting any director or officer against any liability to us or our stockholders arising
from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such persons office.
We and the Adviser are each required to adopt and implement written policies and procedures reasonably designed to prevent violation of
relevant federal securities laws, review these policies and procedures annually for their adequacy and the effectiveness of their implementation, and designate a chief compliance officer to be responsible for administering the policies and
procedures.
27
We may be prohibited under the 1940 Act from knowingly participating in certain transactions with
our affiliates without the prior approval of our board of directors who are not interested persons and, in some cases, prior approval by the SEC. Thus, based on current SEC interpretations, co-investment transactions involving a BDC like us and an
entity that is advised by the Adviser or an affiliated adviser generally could not be effected without SEC relief. The staff of the SEC has, however, granted no-action relief permitting purchases of a single class of privately placed securities,
provided that the adviser negotiates no term other than price and certain other conditions are met. As a result, we only expect to co-invest on a concurrent basis with investment funds, accounts or investment vehicles managed by the Adviser when
each of us and such investment fund, account or investment vehicle will own the same securities of the issuer and when no term is negotiated other than price. Any such investment would be made, subject to compliance with existing regulatory
guidance, applicable regulations and our allocation procedures. If opportunities arise that would otherwise be appropriate for us and for an investment fund, account or investment vehicle managed by the Adviser to invest in different securities of
the same issuer, the Adviser will need to decide which fund will proceed with the investment. Moreover, except in certain circumstances, we will be unable to invest in any issuer in which an investment fund, account or investment vehicle managed by
the Adviser has previously invested.
Under the Stifel arrangement and subject to certain restrictions, Stifel uses its commercially
reasonable efforts to present to the Adviser the opportunity to review and bid on all Stifel Nicolaus & Company, Incorporated-originated leveraged finance and high yield corporate debt opportunities consistent with our investment strategy.
Subject to the approval of our board of directors, as necessary under the 1940 Act, and certain other limitations, Stifel may invest in the same portfolio companies that we invest in (regardless of whether our investment arose from a
Stifel-originated opportunity) and Stifel may, through such investments, have interests that conflict with ours, including receiving fees from the portfolio company directly as well as through its interest in the Adviser. We believe that we may
co-invest with Stifel and its affiliates upon approval of the required majority of our directors as defined in Section 57(o) of the 1940 Act.
As a result of the relationship with Cyrus Capital and certain funds (the Cyrus Funds) managed by Cyrus Capital, we could be
presumed to be an affiliate of the Cyrus Funds under the 1940 Act. We believe we may co-invest with the Cyrus Funds upon approval of the required majority of our directors as defined in Section 57(o) of the 1940 Act. In addition,
the Cyrus Funds may, through such co-investments, have interests that conflict with ours, including receiving fees from the portfolio company directly as well as through its economic interest in the Adviser. Cyrus Capital may also provide us with
investment opportunities.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 imposes a wide variety of regulatory requirements on publicly held companies and their insiders. Many of these
requirements affect us. For example:
|
|
|
pursuant to Rule 13a-14 under the Exchange Act, our principal executive officer and principal financial officer
must certify the accuracy of the financial statements contained in our periodic reports;
|
|
|
|
pursuant to Item 307 under Regulation S-K, our periodic reports must disclose our conclusions about the
effectiveness of our disclosure controls and procedures;
|
|
|
|
pursuant to Rule 13a-15 under the Exchange Act, our management must prepare an annual report regarding its
assessment of our internal control over financial reporting; and
|
|
|
|
pursuant to Item 308 of Regulation S-K and Rule 13a-15 under the Exchange Act, our periodic reports must
disclose whether there were significant changes in our internal controls over financial reporting or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
|
28
Taxation as a Regulated Investment Company
As a BDC, we intend to elect to be treated as a RIC under Subchapter M of the Code. As a RIC, we generally do not have to pay corporate-level
U.S. federal income taxes on any income that we distribute to our stockholders as dividends. To qualify as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements (as described below). In addition, to
qualify for RIC tax treatment we must distribute to our stockholders, for each taxable year, at least 90% of our investment company taxable income, which is generally our ordinary income plus the excess of our realized net short-term
capital gains over our realized net long-term capital losses (the Annual Distribution Requirement).
If we qualify as a RIC and
satisfy the Annual Distribution Requirement, then we generally will not be subject to U.S. federal income tax on the portion of our income we distribute (or are deemed to distribute) to stockholders. We will be subject to U.S. federal income tax at
the regular corporate rates on any income or capital gains not distributed (or deemed distributed) to our stockholders.
We will be subject
to a 4% nondeductible U.S. federal excise tax on certain undistributed income unless we distribute in a timely manner an amount at least equal to the sum of (1) 98% of our net ordinary income for each calendar year, (2) 98.2% of our
capital gain net income for the one-year period ending October 31 in that calendar year and (3) any income recognized, but not distributed, in preceding years (the Excise Tax Avoidance Requirement).
In order to qualify as a RIC for U.S. federal income tax purposes, we must, among other things:
|
|
|
continue to qualify as a BDC under the 1940 Act at all times during each taxable year;
|
|
|
|
derive in each taxable year at least 90% of our gross income from dividends, interest, payments with respect to
loans of certain securities, gains from the sale of stock or other securities, net income from certain qualified publicly traded partnerships, or other income derived with respect to our business of investing in such stock or securities
(the 90% Income Test); and
|
|
|
|
diversify our holdings so that at the end of each quarter of the taxable year:
|
|
|
|
at least 50% of the value of our assets consists of cash, cash equivalents, U.S. Government securities,
securities of other RICs, and other securities if such other securities of any one issuer do not represent more than 5% of the value of our assets or more than 10% of the outstanding voting securities of the issuer; and
|
|
|
|
no more than 25% of the value of our assets is invested in the securities, other than U.S. government securities
or securities of other RICs, of one issuer, of two or more issuers that are controlled, as determined under applicable Code rules, by us and that are engaged in the same or similar or related trades or businesses or of certain qualified
publicly traded partnerships (the Diversification Tests).
|
We may be required to recognize taxable
income in circumstances in which we do not receive cash. For example, if we hold debt obligations that are treated under applicable tax rules as having original issue discount (such as debt instruments with PIK interest or, in certain cases,
increasing interest rates or issued with warrants), we must include in income each year a portion of the original issue discount that accrues over the life of the obligation, regardless of whether cash representing such income is received by us in
the same taxable year. We may also have to include in income other amounts that we have not yet received in cash, such as PIK interest and deferred loan origination fees that are paid after origination of the loan or are paid in non-cash
compensation such as warrants or stock. Because any original issue discount or other amounts accrued will be included in our investment company taxable income for the year of accrual, we may be required to make a distribution to our stockholders in
order to satisfy the Annual Distribution Requirement, even though we will not have received any corresponding cash amount.
29
Although we do not presently expect to do so, we are authorized to borrow funds and to sell
assets in order to satisfy the distribution requirements. However, under the 1940 Act, we are not permitted in certain circumstances to make distributions to our stockholders while our debt obligations and other senior securities are outstanding
unless certain asset coverage tests are met. Moreover, our ability to dispose of assets to meet our distribution requirements may be limited by (1) the illiquid nature of our portfolio and/or (2) other requirements relating to
our status as a RIC, including the Diversification Tests. If we dispose of assets in order to meet the Annual Distribution Requirement or the Excise Tax Avoidance Requirement, we may make such dispositions at times that, from an investment
standpoint, are not advantageous.
In accordance with certain applicable Treasury regulations and private letter rulings issued by the
Internal Revenue Service, a RIC may treat a distribution of its own stock as fulfilling its RIC distribution requirements if each stockholder may elect to receive his or her entire distribution in either cash or stock of the RIC, subject to a
limitation that the aggregate amount of cash to be distributed to all stockholders must be at least 20% of the aggregate declared distribution. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a
pro rata amount of cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive less than 20% of his or her entire distribution in cash. If these and certain other requirements are
met, for U.S. federal income tax purposes, the amount of the dividend paid in stock will be equal to the amount of cash that could have been received instead of stock. We have no current intention of paying dividends in shares of our stock in
accordance with these Treasury regulations or private letter rulings.
Failure to Maintain our Qualification as a RIC
If we fail to satisfy the 90% Income Test or the Diversification Tests for any taxable year, we may nevertheless continue to qualify as a RIC
for such year if certain relief provisions are applicable (which may, among other things, require us to pay certain corporate-level U.S. federal income taxes or to dispose of certain assets).
If we were unable to qualify for treatment as a RIC and the foregoing relief provisions are not applicable, we would be subject to tax on all
of our taxable income at regular corporate rates, regardless of whether we make any distributions to our stockholders. Distributions would not be required, and any distributions would be taxable to our stockholders as ordinary dividend income that,
subject to certain limitations, may be eligible for the 20% maximum rate to the extent of our current and accumulated earnings and profits provided certain holding period and other requirements were met. 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
tax basis, and any remaining distributions would be treated as a capital gain. To requalify as a RIC in a subsequent taxable year, we would be required to satisfy the RIC qualification requirements for that year and dispose of any earnings and
profits from any year in which we failed to qualify as a RIC. Subject to a limited exception applicable to RICs that qualified as such under Subchapter M of the Code for at least one year prior to disqualification and that requalify as a RIC no
later than the second year following the nonqualifying year, we could be subject to tax on any unrealized net built-in gains in the assets held by us during the period in which we failed to qualify as a RIC that are recognized within the subsequent
five years, unless we made a special election to pay corporate-level U.S. federal income tax on such built-in gain at the time of our requalification as a RIC.
Our Status as an Emerging Growth Company
We are an emerging growth company, as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. As an emerging
growth company, we may take advantage of specified reduced disclosure and other requirements that are otherwise applicable generally to public companies. These eased requirements include an exemption from certain financial disclosure and governance
requirements and relaxed restrictions on the sale of securities. The JOBS Act provides scaled disclosure provisions for emerging growth companies,
30
including, among other things, removing the requirement that emerging growth companies comply with Sarbanes-Oxley Act Section 404(b) auditor attestation of internal control over financial
reporting. Section 107(b) of the JOBS Act also permits an emerging growth companies to elect an extended transition period for complying with new or revised accounting standards that have different effective dates for public and private
companies until such time as these new or revised standards are made applicable to all private companies. We have elected to take advantage of the extended transition period for complying with new or revised accounting standards, which may make it
more difficult for investors and securities analysts to evaluate us since our financial statements may not be comparable to companies that comply with public company effective dates. We will remain an emerging growth company until the earlier of
(a) the last day of the fiscal year (i) following the fifth anniversary of the completion of our initial public offering in February 2014, (ii) in which we have total annual gross revenue of at least $1.07 billion, or (iii) in
which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (b) the date on which we have issued more than $1.0
billion in non-convertible debt during the prior three-year period.
The NASDAQ Stock Market Corporate Governance Regulations
Our common stock is listed on the NASDAQ Global Select Market under the symbol CMFN. The Notes are listed on the NASDAQ Global
Select Market under the symbol CMFNL. The NASDAQ Stock Market has adopted corporate governance regulations with which listed companies must comply. We are in compliance with such corporate governance listing standards applicable to BDCs.
31
Investing in our securities involves a number of significant risks. Before you invest in our securities, you should be aware of various
risks, including those described below. You should carefully consider these risk factors, together with all of the other information included in this annual report on Form 10-K, before you decide whether to make an investment in our securities. The
risks set out below are the principal risks with respect to an investment in our securities generally and with respect to a BDC with investment objectives, investment policies, capital structures or trading markets similar to ours. However, they may
not be 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, the net asset value of our common stock and the trading price of our securities could decline, and you may lose all or part of your investment.
Risks Relating to Our Business and Structure
Capital markets may experience periods of disruption and instability and we cannot predict when these conditions will occur. Such market conditions could
materially and adversely affect debt and equity capital markets in the United States and abroad, which could have a negative impact on our business, financial condition and results of operations.
The U.S. and global capital markets experienced extreme volatility and disruption during the economic downturn that began in mid-2007, and the
U.S. economy was in a recession for several consecutive calendar quarters during the same period. In 2010, a financial crisis emerged in Europe, triggered by high budget deficits and rising direct and contingent sovereign debt, which created
concerns about the ability of certain nations to continue to service their sovereign debt obligations. Risks resulting from such debt crisis and any future debt crisis in Europe or any similar crisis elsewhere could have a detrimental impact on the
global economic recovery, sovereign and non-sovereign debt in certain countries and the financial condition of financial institutions generally. In July and August 2015, Greece reached agreements with its creditors for bailouts that provide aid in
exchange for certain austerity measures. These and similar austerity measures may adversely affect world economic conditions and have an adverse impact on our business and that of our portfolio companies. In the second quarter of 2015, stock prices
in China experienced a significant drop, resulting primarily from continued sell-off of shares trading in Chinese markets. In August 2015, Chinese authorities sharply devalued Chinas currency. These market and economic disruptions adversely
affected, and these and other similar market and economic disruptions may in the future affect, the U.S. capital markets, which could adversely affect our business and that of our portfolio companies. These market disruptions materially and
adversely affected, and may in the future affect, the broader financial and credit markets and has reduced the availability of debt and equity capital for the market as a whole and to financial firms, in particular. Additionally, since December
2015, the Federal Reserve has continually raised its federal funds target rate. However, if key economic indicators, such as the unemployment rate or inflation, do not progress at a rate consistent with the Federal Reserves objectives, the
target range for the federal funds rate may further increase and cause interest rates and borrowing costs to rise, which may negatively impact our ability to access the debt markets on favorable terms and may also increase the costs of our
borrowers, hampering their ability to repay us.
At various times, these disruptions resulted in, and may in the future result, a lack of
liquidity in parts of the debt capital markets, significant write-offs in the financial services sector and the repricing of credit risk. These conditions may reoccur for a prolonged period of time again or materially worsen in the future, including
as a result of further downgrades to the U.S. governments sovereign credit rating or the perceived credit worthiness of the United States or other large global economies. Unfavorable economic conditions, including future recessions, 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. We may in the future have difficulty accessing debt and equity capital on attractive terms, or at all, and a severe
disruption and instability in the global financial markets or deteriorations in credit and financing conditions may cause us to reduce the volume of loans we originate and/or fund,
32
adversely affect the value of our portfolio investments or otherwise have a material adverse effect on our business, financial condition, results of operations and cash flows.
Legislative or other actions relating to taxes could have a negative effect on us.
Legislative or other actions relating to taxes could have a negative effect on the Company. The rules dealing with U.S. federal income taxation
are constantly under review by persons involved in the legislative process and by the IRS and the U.S. Treasury Department. On December 20, 2017, the U.S. House of Representatives and the U.S. Senate each voted to approve H.R. 1 (the Tax
Cuts and Jobs Act) and, on December 22, 2017, President Trump signed the Tax Cuts and Jobs Act into law. The Tax Cuts and Jobs Act makes many changes to the Code, including, among other things, significant changes to the taxation of
business entities, the deductibility of interest expense, and the tax treatment of capital investment. We cannot predict with certainty how any changes in the tax laws might affect the Fund, investors, or the Funds portfolio investments.
The United Kingdom referendum decision to leave the European Union may create significant risks and uncertainty for global markets and our investments.
The 2016 decision made in the United Kingdom referendum to leave the European Union has led to volatility in global financial
markets, and in particular in the markets of the United Kingdom and across Europe, and may also lead to weakening in consumer, corporate and financial confidence in the United Kingdom and Europe. The extent and process by which the United Kingdom
will exit the European Union, and the longer term economic, legal, political and social framework to be put in place between the United Kingdom and the European Union are unclear at this stage and are likely to lead to ongoing political and economic
uncertainty and periods of exacerbated volatility in both the United Kingdom and in wider European markets for some time. In particular, the decision made in the United Kingdom referendum may lead to a call for similar referenda in other European
jurisdictions which may cause increased economic volatility and uncertainty in the European and global markets. This volatility and uncertainty may have an adverse effect on the economy generally and on our ability of and the ability of our
portfolio companies to execute our respective strategies and to receive attractive returns.
In particular, currency volatility may mean
that our returns and the returns of our portfolio companies are adversely affected by market movements and may make it more difficult, or more expensive, for us to implement appropriate currency hedging. Potential decline in the value of the British
Pound and/or the euro against other currencies, along with the potential downgrading of the United Kingdoms sovereign credit rating, may also have an impact on the performance of any of our portfolio companies located in the United Kingdom or
Europe.
We depend upon key personnel of the Adviser for our future success. If the Adviser were to lose any of its key personnel, our ability to
achieve our investment objective could be significantly harmed.
We depend on the diligence, skill, experience and network of
business contacts of the Investment Team of the Adviser, in particular Messrs. Mauer and Jansen, who are also members of the Advisers investment committee, our executive officers and members of our board of directors. We can offer no assurance
that Messrs. Mauer and Jansen will continue to provide investment advice to us. The loss of either Mr. Mauer or Mr. Jansen could limit our ability to achieve our investment objective and operate as we anticipate.
In addition, we are dependent on the other members of the Investment Team. If any of the members of the Investment Team were to resign, we may
not be able to hire investment professionals with similar expertise and ability to provide the same or equivalent services on acceptable terms. If we are unable to do so quickly, our operations are likely to experience a disruption, and our
financial condition, business and results of operations may be adversely affected. Even if we are able to retain comparable professionals the integration of such investment professionals 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.
33
Our business model depends to a significant extent upon our Advisers network of relationships. Any
inability of the Adviser to maintain or develop these relationships, or the failure of these relationships to generate investment opportunities, could adversely affect our business.
We depend upon the Adviser to maintain its relationships with private equity sponsors, placement agents, investment banks, management groups
and other financial institutions, including Stifel and Cyrus Capital, 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 the Investment Team fail
to maintain such relationships, or to develop new relationships with other sources of investment opportunities, we may 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.
Our relationship with Cyrus Capital may create conflicts of interest.
The Cyrus Funds, managed by Cyrus Capital, own approximately 28% of our outstanding common stock. The Cyrus Funds also have a 38% indirect
economic interest in the Adviser. Pursuant to the services arrangement with Cyrus Capital, employees of Cyrus Capital, including administrative professionals and investment professionals (the Cyrus Professionals), will be made available
to the Adviser upon request of the Adviser on an as needed basis. These Cyrus Professionals also engage in investment advisory activities for the private investment funds managed by Cyrus Capital, including the Cyrus Funds, which could result in
conflicts of interest with respect to, among other things, the allocation of investment opportunities, and may distract them from their responsibilities to us. Upon request of the Adviser, Cyrus Capital also may provide certain financial, accounting
and administrative services to the Adviser pursuant to the Services Agreement upon which the Adviser may rely to satisfy its obligations under the Administration Agreement.
In addition, as a result of the relationship with Cyrus Capital and the Cyrus Funds, we could be presumed to be an affiliate of the Cyrus Funds
under the 1940 Act. We believe we may co-invest with the Cyrus Funds upon approval of the required majority of our directors as defined in Section 57(o) of the 1940 Act. However, we can provide no assurance that the SEC or its staff
will not take a contrary position. If the SEC or its staff takes a contrary position, we would be required to obtain an exemptive order from the SEC in order to co-invest with affiliates of Cyrus Capital, including the Cyrus Funds. We can offer no
assurance that we will successfully obtain such an order. If we cannot co-invest with affiliates of Cyrus Capital, our business, financial condition, results of operations and cash flows could be materially adversely affected. In addition, the Cyrus
Funds may, through such co-investments, have interests that conflict with ours, including receiving fees from the portfolio company directly as well as through its economic interest in the Adviser.
Our relationship with Stifel may create conflicts of interest.
Stifel owns approximately 16% of our outstanding common stock. Stifel also has a 20% interest in the Adviser. Four members of the Investment
Team are dual employees of the Adviser and Stifel Nicolaus & Company, Incorporated or its affiliates pursuant to a personnel sharing arrangement with Stifel Nicolaus & Company, Incorporated. Although the members of the Investment
Team that are dual employees dedicate substantially all of their time to the business and activities of the Adviser, they may continue to engage in investment advisory activities for Stifel Nicolaus & Company, Incorporated and its
affiliates from time to time. This arrangement could result in a conflict of interest and may distract these investment professionals from their responsibilities to us. Stifel has a right to nominate an individual for election on our board of
directors. Stifel has not exercised its right to nominate for election a member of our board of directors. We expect that if Stifel exercises its right to nominate an individual for election to our board of directors, such person would also be an
employee of Stifel, and would continue to engage in investment advisory activities for Stifel, which could result in a conflict of interest and may distract such director appointee from his or her responsibilities to us. In addition, Mr. Nitka,
Stifels designee to the Advisers investment committee, is a managing director and head of the Credit Investments Group at Stifel Nicolaus & Company, Incorporated. Should any conflicts arise as a result of
34
Mr. Nitkas membership on the Advisers investment committee and his role at Stifel Nicolaus & Company, Incorporated, Mr. Nitka will recuse himself from consideration
of any potential conflict related to Stifel Nicolaus & Company, Incorporated and its affiliates.
Under the Stifel arrangement and
subject to certain restrictions, Stifel will use its commercially reasonable efforts to present to the Adviser to review and bid on, Stifel Nicolaus & Company, Incorporated-originated leveraged finance and high yield corporate debt
opportunities consistent with our investment strategy, subject to the approval of our board of directors, as necessary under the 1940 Act, and certain other limitations. Stifel may invest in the same portfolio companies that we invest in (regardless
of whether our investment arose from a Stifel-originated opportunity), and Stifel may, through such investments, have interests that conflict with ours, including receiving fees from the portfolio company directly as well as through its interest in
the Adviser. We believe that we may co-invest with Stifel and its affiliates upon approval of the required majority of our directors as defined in Section 57(o) of the 1940 Act. However, we can provide no assurance that the SEC or
its staff will not take a contrary position. If the SEC or its staff takes a contrary position, we would be required to obtain an exemptive order from the SEC in order to co-invest with Stifel and its affiliates. We can offer no assurance that we
will successfully obtain such an order. If we cannot co-invest with Stifel and its affiliates, our business, financial condition, results of operations and cash flows could be materially adversely affected.
There are significant potential conflicts of interest that could negatively affect our investment returns.
There may be times when the Adviser or the members of the Investment Team have interests that differ from those of our stockholders, giving
rise to conflicts of interest. The members of the Advisers investment committee and the Investment Team serve, or may serve, as officers, directors, members, or principals of entities that operate in the same or a related line of business as
we do, such as Stifel, or of investment funds, accounts, or investment vehicles managed by the Adviser or Stifel. Similarly, the Adviser or the members of the Investment Team may have other clients with similar, different or competing investment
objectives. In serving in these multiple capacities, they may have obligations to other clients or investors in those entities, the fulfillment of which may not be in the best interests of us or our stockholders. In addition, the Adviser and some of
its affiliates, including our officers and our non-independent directors, are not prohibited from raising money for, or managing, another investment entity that makes the same types of investments as those we target. Four members of the Investment
Team are dual employees of the Adviser and Stifel Nicolaus & Company, Incorporated or its affiliates pursuant to a personnel sharing arrangement with Stifel Nicolaus & Company, Incorporated. Although the members of the Investment
Team that are dual employees dedicate substantially all of their time to the business and activities of the Adviser, they may continue to engage in investment advisory activities for Stifel Nicolaus & Company, Incorporated and its
affiliates from time to time. This arrangement could result in a conflict of interest and may distract these investment professionals from their responsibilities to us. As a result, and although the Adviser and its Investment Team are subject to a
written conflicts of interest policy, the time and resources the Investment Team could devote to us may be diverted. In addition, we may compete with any such Stifel-advised investment entity for the same investors and investment opportunities.
The members of the Investment Team may, from time to time, possess material non-public information, limiting our investment discretion.
Members of the Investment Team may serve as directors of, or in a similar capacity with, portfolio companies in which we invest. In the event
that material nonpublic information is obtained with respect to such companies, or we become subject to trading restrictions under the internal trading policies of those companies or as a result of applicable law or regulations, we could be
prohibited for a period of time from purchasing or selling the securities of such companies, and this prohibition may have an adverse effect on us.
There are conflicts related to other arrangements with the Adviser.
We have entered into a License Agreement with the Adviser under which the Adviser has agreed to grant us a non-exclusive, royalty-free license
to use the name CM Finance. See Business Management Agreements
35
License Agreement. In addition, we have entered into an Administration Agreement with the Adviser pursuant to which we are required to pay to the Adviser our allocable portion of
overhead and other expenses incurred by the Adviser in performing its obligations under such Administration Agreement, such as rent, equipment and our allocable portion of the cost of our Chief Financial Officer and our Chief Compliance Officer and
his respective staffs compensation and compensation-related expenses. This will create conflicts of interest that our board of directors will monitor. For example, under the terms of the license agreement, we will be unable to preclude the
Adviser from licensing or transferring the ownership of the CM Finance name to third parties, some of whom may compete against us. Consequently, we will be unable to prevent any damage to goodwill that may occur as a result of the
activities of the Adviser or others. Furthermore, in the event the license agreement is terminated, we will be required to change our name and cease using CM Finance as part of our name. Any of these events could disrupt our recognition
in the market place, damage any goodwill we may have generated and otherwise harm our business.
Our financial condition, results of operations and
cash flows will depend on our ability to manage our business effectively.
Our ability to achieve our investment objective will
depend on our ability to manage our business and to grow our investments and earnings. This will depend, in turn, on the Advisers ability to identify, invest in and monitor portfolio companies that meet our investment criteria. The achievement
of our investment objective on a cost-effective basis will depend upon the Advisers execution of our investment process, its ability to provide competent, attentive and efficient services to us and, to a lesser extent, our access to financing
on acceptable terms. The Advisers investment professionals may have substantial responsibilities in connection with the management of other investment funds, accounts and investment vehicles. The personnel of the Adviser may also be called
upon to provide managerial assistance to our portfolio companies. These activities may distract them from identifying new investment opportunities for us or slow our rate of investment. Any failure to manage our business and our future growth
effectively could have a material adverse effect on our business, financial condition, results of operations and cash flows.
The Advisers
incentive fee structure may create incentives to it that are not fully aligned with the interests of our stockholders.
In the
course of our investing activities, we pay management and incentive fees to the Adviser. We have entered into an Investment Advisory Agreement with the Adviser that provides that these fees will be based on the value of our gross assets. 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 a lower rate of return than one might achieve through direct investments. Because these
fees are based on the value of our gross assets, the Adviser will benefit when we incur debt or use leverage. This fee structure may encourage the Adviser to cause us to borrow money to finance additional investments. Under certain circumstances,
the use of borrowed money may increase the likelihood of default, which would disfavor our stockholders.
Our board of directors is charged
with protecting our interests by monitoring how the Adviser addresses these and other conflicts of interests associated with its management services and compensation. While our board of directors is not expected to review or approve each investment
decision, borrowing or incurrence of leverage, our independent directors will periodically review the Advisers services and fees as well as its portfolio management decisions and portfolio performance. In connection with these reviews, our
independent directors will consider whether our fees and expenses (including those related to leverage) remain appropriate. As a result of this arrangement, the Adviser may from time to time have interests that differ from those of our stockholders,
giving rise to a conflict.
Our incentive fee may induce the Adviser to make speculative investments.
The Adviser receives an incentive fee based, in part, upon net capital gains realized on our investments. Unlike that portion of the incentive
fee based on income, there is no hurdle rate applicable to the portion of the
36
incentive fee based on net capital gains. Additionally, under the incentive fee structure, the Adviser may benefit when we recognize capital gains and, because the Adviser will determine when to
sell a holding, the Adviser will control the timing of the recognition of such capital gains. As a result, the Adviser may have a tendency to invest more capital in investments likely to result in capital gains, compared to income-producing
securities. Such a practice could result in our investing in more speculative securities than would otherwise be the case, which could result in higher investment losses, particularly during economic downturns.
We may be obligated to pay the Adviser incentive compensation even if we incur a loss and may pay more than 20.0% of our net capital gains because we
cannot recover payments made in previous years.
The Adviser is entitled to incentive compensation for each fiscal quarter in an
amount equal to a percentage of the excess of our investment income for that quarter (before deducting incentive compensation) above a threshold return 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 loss for that quarter. If we pay an incentive fee of 20% of our realized capital gains (net of all realized capital losses and unrealized capital depreciation on a
cumulative basis) and thereafter experience additional realized capital losses or unrealized capital depreciation, we will not be able to recover any portion of the incentive fee previously paid.
PIK interest payments we receive will increase our assets under management and, as a result, will increase the amount of base management fees and
incentive fees payable by us to the Adviser.
Certain of our debt investments contain provisions providing for the payment of PIK
interest. Because PIK interest results in an increase in the size of the loan balance of the underlying loan, the receipt by us of PIK interest will have the effect of increasing our assets under management. As a result, because the base management
fee that we pay to the Adviser is based on the value of our gross assets, receipt of PIK interest will result in an increase in the amount of the base management fee payable by us. In addition, any such increase in a loan balance due to the receipt
of PIK interest will cause such loan to accrue interest on the higher loan balance, which will result in an increase in our pre-incentive fee net investment income and, as a result, an increase in incentive fees that are payable to the Adviser.
The involvement of our interested directors in the valuation process may create conflicts of interest.
We expect to make most of our portfolio investments in the form of loans and securities that are not publicly traded and for which there are
limited or no market based price quotations available. As a result, our board of directors will determine the fair value of these loans and securities in good faith as described below in Most of our portfolio investments will be
recorded at fair value as determined in good faith by our board of directors and, as a result, there may be uncertainty as to the value of our portfolio investments. In connection with that determination, investment professionals from the
Adviser may provide our board of directors with valuations based upon the most recent portfolio company financial statements available and projected financial results of each portfolio company. While the valuation for each portfolio investment will
be reviewed by an independent valuation firm quarterly, the ultimate determination of fair value will be made by our board of directors and not by such third-party valuation firm. In addition, Messrs. Mauer and Jansen, each an interested member of
our board of directors, has a direct or indirect pecuniary interest in the Adviser. The participation of the Advisers investment professionals in our valuation process, and the pecuniary interest in the Adviser by certain members of our board
of directors, could result in a conflict of interest as the Advisers management fee is based, in part, on the value of our gross assets, and our incentive fees will be based, in part, on realized gains and realized and unrealized losses.
37
The Investment Advisory Agreement and the Administration Agreement with the Adviser were not negotiated on
an arms length basis and may not be as favorable to us as if they had been negotiated with an unaffiliated third party.
The
Investment Advisory Agreement and the Administration Agreement were negotiated between related parties. Consequently, their terms, including fees payable to the Adviser, may not be as favorable to us as if they had been negotiated with an
unaffiliated third party. In addition, we may choose not to enforce, or to enforce less vigorously, our rights and remedies under these agreements because of our desire to maintain our ongoing relationship with the Adviser and its affiliates. Any
such decision, however, would breach our fiduciary obligations to our stockholders.
Our incentive fee arrangements with the Adviser may vary from
those of other investment funds, account or investment vehicles that the Adviser may manage in the future, which may create an incentive for the Adviser to devote time and resources to a higher fee-paying fund.
If the Adviser is paid a higher performance-based fee from any other fund that it may manage in the future, it may have an incentive to devote
more research and development or other activities, and/or recommend the allocation of investment opportunities, to such higher fee-paying fund. For example, to the extent the Advisers incentive compensation is not subject to a hurdle or total
return requirement with respect to another fund, it may have an incentive to devote time and resources to such other fund. As a result, the investment professionals of the Adviser may devote time and resources to a higher fee-paying fund.
The Advisers liability is limited under the Investment Advisory Agreement and we have agreed to indemnify the Adviser against certain liabilities,
which may lead the Adviser to act in a riskier manner on our behalf than it would when acting for its own account.
Under the
Investment Advisory Agreement, the Adviser has not assumed any responsibility to us other than to render the services called for under that agreement. It will not be responsible for any action of our board of directors in following or declining to
follow the Advisers advice or recommendations. Under the Investment Advisory Agreement, the Adviser, its officers, members and personnel, and any person controlling or controlled by the Adviser will not be liable to us, any subsidiary of ours,
our directors, our stockholders or any subsidiarys stockholders or partners for acts or omissions performed in accordance with and pursuant to the Investment Advisory Agreement, except those resulting from acts constituting gross negligence,
willful misconduct, bad faith or reckless disregard of the duties that the Adviser owes to us under the Investment Advisory Agreement. In addition, as part of the Investment Advisory Agreement, we have agreed to indemnify the Adviser and each of its
officers, directors, members, managers and employees from and against any claims or liabilities, including reasonable legal fees and other expenses reasonably incurred, arising out of or in connection with our business and operations or any action
taken or omitted on our behalf pursuant to authority granted by the Investment Advisory Agreement, except where attributable to gross negligence, willful misconduct, bad faith or reckless disregard of such persons duties under the Investment
Advisory Agreement. These protections may lead the Adviser to act in a riskier manner when acting on our behalf than it would when acting for its own account.
We operate in a highly competitive market for investment opportunities, which could reduce returns and result in losses.
A number of entities compete with us to make the types of investments that we make. We compete with public and private funds, other BDCs,
commercial and investment banks, commercial financing companies and, to the extent they provide an alternative form of financing, private equity and hedge funds. Many of our competitors are substantially larger and have considerably greater
financial, technical and marketing resources than we do. For example, we believe some of our competitors may have 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 could 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
38
imposes on us as a BDC or the source-of-income, asset diversification and distribution requirements we must satisfy to maintain our RIC qualification. The competitive pressures we face may have a
material adverse effect on our business, financial condition, results of operations and cash flows. As a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time, and we may not be
able to identify and make investments that are consistent with our investment objective.
With respect to the investments we make, we do
not seek to compete based primarily on the interest rates we offer, and we believe that some of our competitors may make loans with interest rates that will be lower than the rates we offer. With respect to all investments, we may lose some
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, lower yields and increased risk
of credit loss.
We will be subject to corporate-level U.S. federal income tax if we are unable to maintain our qualification as a RIC under
Subchapter M of the Code.
To maintain our qualification as a RIC under Subchapter M of the Code, we must meet certain
source-of-income, asset diversification and distribution requirements. The source-of-income requirement will be satisfied if we obtain at least 90% of our income for each year from dividends, interest, gains from the sale of stock or securities or
similar sources. The distribution requirement for a RIC is satisfied if we distribute at least 90% of our net ordinary income and net short-term capital gains in excess of net long-term capital losses, if any, to our stockholders on an annual basis.
Because we incur debt, we will be subject to certain asset coverage ratio requirements under the 1940 Act and financial covenants under loan and credit agreements that could, under certain circumstances, restrict us from making distributions
necessary to maintain our qualification as a RIC. If we are unable to obtain cash from other sources, we may fail to maintain our qualification as a RIC and, thus, may be subject to corporate-level U.S. federal income tax. To maintain our
qualification as a RIC, we must also meet certain asset diversification requirements at the end of each calendar quarter. Failure to meet these tests may result in our having to dispose of certain investments quickly in order to prevent the loss of
our qualification as a RIC. Because most of our investments are in private or thinly-traded public companies, any such dispositions may be made at disadvantageous prices and may result in substantial losses. No certainty can be provided that we will
satisfy the asset diversification requirements of the other requirements necessary to maintain our qualification as a RIC. If we fail to maintain our qualification as a RIC for any reason and become subject to corporate income tax, the resulting
corporate income taxes could substantially reduce our net assets, the amount of income available for distributions to our stockholders and the amount of funds available for new investments. Such a failure would have a material adverse effect on us
and our stockholders. See Business Taxation as a Regulated Investment Company.
We may need to raise additional capital to grow
because we must distribute most of our income.
We may need additional capital to fund new investments and grow our portfolio of
investments. We intend to access the capital markets periodically to issue debt or equity securities or borrow from financial institutions in order to obtain such additional capital. Unfavorable economic conditions 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. A reduction in the availability of new capital could limit our ability to grow. In addition, we are required to distribute at least 90% of our net
ordinary income and net short-term capital gains in excess of net long-term capital losses, if any, to our stockholders to maintain our qualification as a RIC. As a result, these earnings will not be available to fund new investments. An inability
on our part to access the capital markets successfully could limit our ability to grow our business and execute our business strategy fully and could decrease our earnings, if any, which would have an adverse effect on the value of our securities.
Our distributions to stockholders may be funded, in part, from waivers of investment advisory fees by the Adviser.
To the extent, any distributions by us are funded through waivers of the incentive fee portion of our investment advisory fees such
distributions will not be based on our investment performance, and can only be sustained if we achieve positive investment performance in future periods and/or the Adviser continues to waive
39
such fees. Any such waivers in no way imply that the Adviser will waive incentive fees in any future period. There can be no assurance that we will achieve the performance necessary or that the
Adviser will waive all or any portion of the incentive fee necessary to be able to pay distributions at a specific rate or at all.
You may not
receive distributions, or our distributions may not grow over time.
We intend to make distributions on a quarterly basis to our
stockholders out of assets legally available for distribution. We cannot assure you that we will achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions. Our
ability to pay distributions might be adversely affected by the impact of one or more of the risk factors described in this annual report on Form 10-K. Due to the asset coverage test applicable to us under the 1940 Act as a BDC, we may be limited in
our ability to make distributions. All distributions will be made at the discretion of our board of directors and will depend on our earnings, financial condition, maintenance of RIC status, compliance with applicable BDC, SBA regulations (if
applicable) and such other factors as our board of directors may deem relative from time to time. We cannot assure you that we will make distributions to our stockholders in the future.
We may have difficulty paying our required distributions if we recognize income before, or without, receiving cash representing such income.
For U.S. federal income tax purposes, we will include in income certain amounts that we have not yet received in cash, such as the
accrual of OID. This may arise if we receive warrants in connection with the making of a loan and in other circumstances, or through contracted PIK interest, which represents contractual interest added to the loan balance and due at the end of the
loan term. Such OID, which could be significant relative to our overall investment activities, and increases in loan balances as a result of contracted PIK arrangements will be included in income before we receive any corresponding cash payments. We
also may be required to include in income certain other amounts that we will not receive in cash.
Since in certain cases we may recognize
income before or without receiving cash representing such income, we may have difficulty meeting the requirement to distribute at least 90% of our net ordinary income and net short-term capital gains in excess of net long-term capital losses, if
any, to maintain our qualification as a RIC. In such a case, we may have to sell some of our investments at times we would not consider advantageous or raise additional debt or equity capital or reduce new investment originations to meet these
distribution requirements. If we are not able to obtain such cash from other sources, we may fail to maintain our qualification as a RIC and thus be subject to corporate-level U.S. federal income tax. See Business Taxation as a
Regulated Investment Company.
We may in the future choose to pay dividends in our own stock, in which case you may be required to pay tax in
excess of the cash you receive.
We may distribute taxable dividends that are payable in part in our stock. Under certain
applicable provisions of the Code and the Treasury regulations, distributions payable in cash or in shares of stock at the election of stockholders are treated as taxable dividends. The Internal Revenue Service has issued a revenue procedure
indicating that this rule will apply if the total amount of cash to be distributed is not less than 20% of the total distribution. Under these rulings, if too many stockholders elect to receive their distributions in cash, each such stockholder
would receive a pro rata share of the total cash to be distributed and would receive the remainder of their distribution in shares of stock. If we decide to make any distributions consistent with this revenue procedure that are payable in part in
our stock, taxable stockholders receiving such dividends will be required to include the full amount of the dividend (whether received in cash, our stock, or combination thereof) as ordinary income (or as long-term capital gain to the extent such
distribution is properly designated as a capital gain dividend) to the extent of our current and accumulated earnings and profits for U.S. federal income tax purposes. As a result, a U.S. stockholder may be required to pay tax with respect to such
dividends in excess of any cash received. If a U.S. stockholder sells the stock it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the
market
40
price of our stock at the time of the sale. Furthermore, with respect to non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such dividends, including in respect of all
or a portion of such dividend that is payable in stock. If a significant number of our stockholders determine to sell shares of our stock in order to pay taxes owed on dividends, it may put downward pressure on the trading price of our stock.
Regulations governing our operation as a BDC affect our ability to, and the way in which we raise additional capital. As a BDC, the necessity of raising
additional capital may expose us to risks, including the typical risks associated with leverage.
We may issue debt securities or
preferred stock and/or borrow money from banks or other financial institutions, which we refer to collectively as senior securities, up to the maximum amount permitted by the 1940 Act. Under the provisions of the 1940 Act, we are
permitted as a BDC to issue senior securities in amounts such that our asset coverage ratio, as defined in the 1940 Act, equals at least 200% of our gross assets less all liabilities and indebtedness not represented by senior securities, 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 would not be able to borrow additional funds until we were able to comply with the 200% asset coverage ratio under the
1940 Act. Also, any amounts that we use to service our indebtedness would not be available for distributions to our common stockholders. If we issue senior securities, we will be exposed to typical risks associated with leverage, including an
increased risk of loss.
We are not generally able to issue and sell our common stock at a price below net asset value per share. We may,
however, sell our common stock, or warrants, options or rights to acquire our common stock, at a price below then-current net asset value per share of our common stock if our board of directors determines that such sale is in our best interests. At
a meeting initially convened on November 7, 2017 and reconvened on November 30, 2017 and December 21, 2017, our stockholders voted to allow us to issue common stock at a price below net asset value per share for the period ending on
the earlier of the one year anniversary of the date of the Companys 2017 Annual Meeting of Stockholders and the date of the Companys 2018 Annual Meeting of Stockholders, which we expect to be held in November 2018. Our stockholders did
not specify a maximum discount below net asset value at which we are able to issue our common stock, although the number of shares sold in each offering may not exceed 25% of our outstanding common stock immediately prior to such sale. In addition,
we cannot issue shares of our common stock below net asset value unless our board of directors determines that it would be in our and our stockholders best interests to do so. Sales of common stock at prices below net asset value per share
dilute the interests of existing stockholders, have the effect of reducing our net asset value per share and may reduce our market price per share. In addition, continuous sales of common stock below net asset value may have a negative impact on
total returns and could have a negative impact on the market price of our shares of common stock. If we raise additional funds by issuing common stock or senior securities convertible into, or exchangeable for, our common stock, then the percentage
ownership of our stockholders at that time will decrease, and you may experience dilution. In addition, neither Stifel nor the Cyrus Funds are subject to these restrictions and may sell their respective shares of our common stock at a per share
price that is below net asset value per share, which may negatively affect the prevailing market prices for our common stock and our ability to raise additional capital.
Our board of directors has approved our ability to incur additional leverage as permitted by recent legislation.
The 1940 Act generally prohibits us from incurring indebtedness unless immediately after such borrowing we have an asset coverage for total
borrowings of at least 200% (i.e., the amount of debt may not exceed 50% of the value of our assets). However, recent legislation has modified the 1940 Act by allowing a BDC to increase the maximum amount of leverage it may incur from an asset
coverage ratio of 200% to an asset coverage ratio of 150%, if certain requirements are met. In other words, prior to the enactment of the legislation, a BDC could borrow $1 for investment purposes for every $1 of investor equity. Now, for those BDCs
that satisfy the legislations approval and disclosure requirements, the BDC can borrow $2 for investment purposes for every $1 of investor equity. Under the legislation, we are allowed to increase our leverage capacity if stockholders
41
representing at least a majority of the votes cast, when quorum is met, approve a proposal to do so. If we receive stockholder approval, we would be allowed to increase our leverage capacity on
the first day after such approval. Alternatively, the legislation allows the required majority of our independent directors, as defined in Section 57(o) of the 1940 Act, to approve an increase in our leverage capacity, and such
approval would become effective after one year. In either case, we would be required to make certain disclosures on our website and in SEC filings regarding, among other things, the receipt of approval to increase our leverage, our leverage capacity
and usage, and risks related to leverage.
In accordance with the legislation, on May 2, 2018, our board of directors, including a
required majority approved the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. As a result, our asset coverage requirements for senior securities will change from 200% to 150%, effective
May 2, 2019.
Leverage magnifies the potential for loss on investments and on invested equity capital. As we use leverage to partially
finance our investments, you will experience increased risks of investing in our securities. If the value of our assets increases, then leveraging would cause the net asset value attributable to our common stock to increase more sharply than it
would have had we not leveraged. Conversely, if the value of our assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged our business. Similarly, any increase in our income
in excess of interest payable on the borrowed funds would cause our net investment income to increase more than it would without the leverage, while any decrease in our income would cause net investment income to decline more sharply than it would
have had we not borrowed. Such a decline could negatively affect our ability to pay common stock dividends, scheduled debt payments or other payments related to our securities. Increased leverage may also cause a downgrade of our credit rating. See
the risk factor below. Leverage is generally considered a speculative investment technique. See Because we finance our investments with borrowed money, the potential for gain or loss on amounts invested in us is magnified and may
increase the risk of investing in us.
Because we finance our investments with borrowed money, the potential for gain or loss on amounts
invested in us is magnified and may increase the risk of investing in us.
The use of leverage magnifies the potential for gain or
loss on amounts invested. The use of leverage is generally considered a speculative investment technique and increases the risks associated with investing in our securities. If we continue to use leverage to partially finance our investments through
banks, insurance companies and other lenders, you will experience increased risks of investment in our common stock. Lenders of these funds have fixed dollar claims on our assets that are superior to the claims of our common stockholders, and we
would expect such lenders to seek recovery against our assets in the event of a default. As of June 30, 2018, substantially all of our assets were pledged as collateral under the Financing Facilities. In addition, under the terms of the
Financing Facilities and any borrowing facility or other debt instrument we may enter into, we are likely to be required to use the net proceeds of any investments that we sell to repay a portion of the amount borrowed under such facility or
instrument before applying such net proceeds to any other uses. If the value of our assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged, thereby magnifying losses or
eliminating our stake in a leveraged investment. Similarly, any decrease in our revenue or income will cause our net income to decline more sharply than it would have had we not borrowed. Such a decline would also negatively affect our ability to
make distributions with respect to our common stock or preferred stock. Our ability to service any debt will depend largely on our financial performance and will be subject to prevailing economic conditions and competitive pressures. Moreover, as
the base management fee payable to the Adviser will be payable based on the value of our gross assets, including those assets acquired through the use of leverage, the Adviser will have a financial incentive to incur leverage, which may not be
consistent with our stockholders interests. In addition, our common stockholders will bear the burden of any increase in our expenses as a result of our use of leverage, including interest expenses and any increase in the base management fee
payable to the Adviser.
As a BDC, we generally are required to meet a coverage ratio of total assets to total borrowings and other senior
securities, which include all of our borrowings and any preferred stock that we may issue in the future, of
42
at least 200% (or 150% beginning on May 2, 2019). If this ratio declines below 200% (or 150% beginning on May 2, 2019), we will not be able to incur additional debt and could be
required to sell a portion of our investments to repay some debt when it is otherwise disadvantageous for us to do so. This could have a material adverse effect on our operations, and we may not be able to make distributions. The amount of leverage
that we employ will depend on the Advisers and our board of directors assessment of market and other factors at the time of any proposed borrowing. We cannot assure you that we will be able to obtain credit at all or on terms acceptable
to us.
In addition, our debt facilities may impose financial and operating covenants that restrict our business activities, including
limitations that hinder our ability to finance additional loans and investments or to make the distributions required to maintain our qualification as a RIC under the Code.
We may default under the Financing Facilities or any future borrowing facility we enter into or be unable to amend, repay or refinance any such facility
on commercially reasonable terms, or at all, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.
In the event we default under the Financing Facilities or any other future borrowing facility, our business could be adversely affected as we
may be forced to sell a portion of our investments quickly and prematurely at prices that may be disadvantageous to us in order to meet our outstanding payment obligations and/or support working capital requirements under the Financing Facilities or
such future borrowing facility, any of which would have a material adverse effect on our business, financial condition, results of operations and cash flows. In addition, following any such default, the agent for the lenders under the Financing
Facilities or such future borrowing facility could assume control of the disposition of any or all of our assets, including the selection of such assets to be disposed and the timing of such disposition, which would have a material adverse effect on
our business, financial condition, results of operations and cash flows.
Provisions in the Financing Facilities or any other future borrowing
facility may limit our discretion in operating our business.
The Financing Facilities are, and any future borrowing facility may
be, backed by all or a portion of our loans and securities on which the lenders will or, in the case of a future facility, may have a security interest. We may pledge up to 100% of our assets and may grant a security interest in all of our assets
under the terms of any debt instrument we enter into with lenders. We expect that any security interests we grant will be set forth in a pledge and security agreement and evidenced by the filing of financing statements by the agent for the lenders.
In addition, we expect that the custodian for our securities serving as collateral for such loan would include in its electronic systems notices indicating the existence of such security interests and, following notice of occurrence of an event of
default, if any, and during its continuance, will only accept transfer instructions with respect to any such securities from the lender or its designee. If we were to default under the terms of any debt instrument, the agent for the applicable
lenders would be able to assume control of the timing of disposition of any or all of our assets securing such debt, which would have a material adverse effect on our business, financial condition, results of operations and cash flows.
In addition, any security interests as well as negative covenants under the Financing Facilities or any other borrowing facility may limit our
ability to create liens on assets to secure additional debt and may make it difficult for us to restructure or refinance indebtedness at or prior to maturity or obtain additional debt or equity financing. In addition, if our borrowing base under the
Financing Facilities or any other borrowing facility were to decrease, we would be required to secure additional assets in an amount equal to any borrowing base deficiency. In the event that all of our assets are secured at the time of such a
borrowing base deficiency, we could be required to repay advances under the Financing Facilities or any other borrowing facility or make deposits to a collection account, either of which could have a material adverse impact on our ability to fund
future investments and to make stockholder distributions.
In addition, under the Financing Facilities or any future borrowing facility we
will be subject to limitations as to how borrowed funds may be used, which may include restrictions on geographic and industry concentrations,
43
loan size, payment frequency and status, average life, collateral interests and investment ratings, as well as regulatory restrictions on leverage, which may affect the amount of funding that may
be obtained. There may also be certain requirements relating to portfolio performance, including required minimum portfolio yield and limitations on delinquencies and charge-offs, a violation of which could limit further advances and, in some cases,
result in an event of default. An event of default under the Financing Facilities or any other borrowing facility could result in an accelerated maturity date for all amounts outstanding thereunder, which could have a material adverse effect on our
business and financial condition. This could reduce our revenues and, by delaying any cash payment allowed to us under the Financing Facilities or any other borrowing facility until the lenders have been paid in full, reduce our liquidity and cash
flow and impair our ability to grow our business and maintain our qualification as a RIC.
Because we borrow money to make our investments, if
market interest rates were to increase, our cost of capital could increase, which could reduce our net investment income.
Because
we borrow money to make investments, our net investment income will depend, in part, upon the difference between the rate at which we borrow funds and the rate at which we invest those funds. As a result, we can offer no assurance that a significant
change in market interest rates would not have a material adverse effect on our net investment income in the event we use debt to finance our investments. In periods of rising interest rates, our cost of funds would increase, which could reduce our
net investment income. We may use interest rate risk management techniques in an effort to limit our exposure to interest rate fluctuations. Such techniques may include various interest rate hedging activities to the extent permitted by the 1940
Act. There is no limit on our ability to enter derivative transactions.
In addition, a rise in the general level of interest rates
typically leads to higher interest rates applicable to our debt investments. Accordingly, an increase in interest rates may result in an increase of the amount of our pre-incentive fee net investment income and, as a result, an increase in incentive
fees payable to the Adviser.
We are exposed to risks associated with changes in interest rates including potential effects on our cost of capital
and net investment income.
General interest rate fluctuations and changes in credit spreads on floating rate loans may have a
substantial negative impact on our investments and investment opportunities and, accordingly, may have a material adverse effect on our rate of return on invested capital. In addition, an increase in interest rates would make it more expensive to
use debt to finance our investments. Decreases in credit spreads on debt that pays a floating rate of return would have an impact on the income generation of our floating rate assets. Trading prices for debt that pays a fixed rate of return tend to
fall as interest rates rise. Trading prices tend to fluctuate more for fixed rate securities that have longer maturities. Although we have no policy governing the maturities of our investments, under current market conditions we expect that we will
invest in a portfolio of debt generally having maturities of up to 6 years. This means that we will be subject to greater risk (other things being equal) than an entity investing solely in shorter-term securities.
Adverse developments in the credit markets may impair our ability to secure debt financing.
During the economic downturn in the United States that began in mid-2007, many commercial banks and other financial institutions stopped
lending or significantly curtailed their lending activity. In addition, in an effort to stem losses and reduce their exposure to segments of the economy deemed to be high risk, some financial institutions limited routine refinancing and loan
modification transactions and even reviewed the terms of existing facilities to identify bases for accelerating the maturity of existing lending facilities. As a result, it may be difficult for us to obtain desired financing to finance the growth of
our investments on acceptable economic terms, or at all.
If we are unable to consummate credit facilities on commercially reasonable
terms, our liquidity may be reduced significantly. If we are unable to repay amounts outstanding under any facility we may enter into and are
44
declared in default or are unable to renew or refinance any such facility, it would limit our ability to initiate significant originations or to operate our business in the normal course. These
situations may arise due to circumstances that we may be unable to control, such as inaccessibility of the credit markets, a severe decline in the value of the U.S. dollar, a further economic downturn or an operational problem that affects third
parties or us, and could materially damage our business. Moreover, we are unable to predict when economic and market conditions may become more favorable. Even if such conditions improve broadly and significantly over the long term, adverse
conditions in particular sectors of the financial markets could adversely impact our business.
Our ability to enter into transactions involving
derivatives and financial commitment transactions may be limited.
The SEC has proposed a new rule under the 1940 Act that would
govern the use of derivatives (defined to include any swap, security-based swap, futures contract, forward contract, option or any similar instrument) as well as financial commitment transactions (defined to include reverse repurchase agreements,
short sale borrowings and any firm or standby commitment agreement or similar agreement) by BDCs. Under the proposed rule, a BDC would be required to comply with one of two alternative portfolio limitations and manage the risks associated with
derivatives transactions and financial commitment transactions by segregating certain assets. Furthermore, a BDC that engages in more than a limited amount of derivatives transactions or that uses complex derivatives would be required to establish a
formalized derivatives risk management program. If the SEC adopts this rule in the form proposed, our ability to enter into transactions involving such instruments may be hindered, which could have an adverse effect on our business, financial
condition and results of operations.
Terrorist attacks, acts of war or natural disasters may affect any market for our common stock, impact the
businesses in which we invest and harm our business, operating results and financial condition.
Terrorist acts, acts of war or
natural disasters may disrupt our operations, as well as the operations of the businesses in which we invest. Such acts 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 natural 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 natural disasters are generally uninsurable.
The failure in cyber security systems, as well as the occurrence of events unanticipated in our disaster recovery systems and management continuity
planning could impair our ability to conduct business effectively.
The occurrence of a disaster such as a cyber-attack, a natural
catastrophe, an industrial accident, events unanticipated in our disaster recovery systems, or a support failure from external providers, could have an adverse effect on our ability to conduct business and on our results of operations and financial
condition, particularly if those events affect our computer-based data processing, transmission, storage, and retrieval systems or destroy data. If a significant number of our managers were unavailable in the event of a disaster, our ability to
effectively conduct our business could be severely compromised.
We depend heavily upon computer systems to perform necessary business
functions. Despite our implementation of a variety of security measures, our computer systems could be subject to cyber-attacks and unauthorized access, such as physical and electronic break-ins or unauthorized tampering. Like other companies, we
may experience threats to our data and systems, including malware and computer virus attacks, unauthorized access, system failures and disruptions. If one or more of these events occurs, it could potentially jeopardize the confidential, proprietary
and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our operations, which could result in damage to our reputation, financial losses,
litigation, increased costs, regulatory penalties and/or customer dissatisfaction or loss.
45
Third parties with which we do business may also be sources of cybersecurity or other
technological risks. We outsource certain functions and these relationships allow for the storage and processing of our information, as well as customer, counterparty, employee and borrower information. While we engage in actions to reduce our
exposure resulting from outsourcing, ongoing threats may result in unauthorized access, loss, exposure or destruction of data, or other cybersecurity incidents, with increased costs and other consequences, including those described above.
The effect of global climate change may impact the operations of our portfolio companies.
There may be evidence of global climate change. Climate change creates physical and financial risk and some of our portfolio companies may be
adversely affected by climate change. For example, the needs of customers of energy companies vary with weather conditions, primarily temperature and humidity. To the extent weather conditions are affected by climate change, energy use could
increase or decrease depending on the duration and magnitude of any changes. Increases in the cost of energy could adversely affect the cost of operations of our portfolio companies if the use of energy products or services is material to their
business. A decrease in energy use due to weather changes may affect some of our portfolio companies financial condition, through decreased revenues. Extreme weather conditions in general require more system backup, adding to costs, and can
contribute to increased system stresses, including service interruptions.
If we do not invest a sufficient portion of our assets in qualifying
assets, we could fail to maintain our qualification as a BDC 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.
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.
Most of our portfolio investments are recorded at fair value as determined in good faith by our
board of directors and, as a result, there may be uncertainty as to the value of our portfolio investments.
Most of our portfolio
investments will take the form of securities that are not publicly traded. The fair value of loans, securities and other investments that are not publicly traded may not be readily determinable, and we will value these investments at fair value as
determined in good faith by our board of directors, including to reflect significant events affecting the value of our investments. Most, if not all, of our investments (other than cash and cash equivalents) will be classified as Level 3 under the
Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 820: Fair Value Measurements and Disclosures (ASC 820). This means that our portfolio valuations will be based on unobservable inputs and our
own assumptions about how market participants would price the asset or liability in question. Inputs into the determination of fair
46
value of our portfolio investments require significant management judgment or estimation. Even if observable market data are available, such information may be the result of consensus pricing
information or broker quotes, which include a disclaimer that the broker would not be held to such a price in an actual transaction. The non-binding nature of consensus pricing and/or quotes accompanied by disclaimers materially reduces the
reliability of such information. We have retained the services of independent service providers to review the valuation of these loans and securities. The types of factors that the board of directors may take into account in determining the fair
value of our investments generally include, as appropriate, comparison to publicly traded securities including such factors as yield, maturity and measures of credit quality, the enterprise value of a portfolio company, the nature and realizable
value of any collateral, the portfolio companys ability to make payments and its earnings and discounted cash flow, the markets in which the portfolio company does business and other relevant factors. Because such valuations, and particularly
valuations of private securities and private companies, are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that would have been
used if a ready market for these loans and securities existed. Our net asset value could be adversely affected if our determinations regarding the fair value of our investments were materially higher than the values that we ultimately realize upon
the disposal of such loans and securities.
We adjust quarterly the valuation of our portfolio to reflect our board of directors
determination of the fair value of each investment in our portfolio. Any changes in fair value are recorded in our statement of operations as net change in unrealized appreciation or depreciation.
We may experience fluctuations in our quarterly operating results.
We could experience fluctuations in our quarterly operating results due to a number of factors, including the interest rate payable on the
loans and debt securities we acquire, the default rate on such loans and securities, the level of our expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition
in our markets and general economic conditions. In light of these factors, results for any period should not be relied upon as being indicative of performance in future periods.
We are an emerging growth company under the JOBS Act, and we cannot be certain if the reduced disclosure requirements applicable to emerging
growth companies will make our common stock less attractive to investors.
We are and we will remain an emerging growth
company as defined in the JOBS Act until the earlier of (a) the last day of the fiscal year (i) following the fifth anniversary of the completion of our initial public offering, which was in February 2014, (ii) in which we have
total annual gross revenue of at least $1.07 billion, or (iii) in which we are deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the prior
June 30th, and (b) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior three-year period. For so long as we remain an emerging growth company we may take advantage of certain
exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of
Section 404 of the Sarbanes-Oxley Act. We cannot predict if investors will find our common stock less attractive because we will rely on some or all of these exemptions. If some investors find our common stock less attractive as a result, there
may be a less active trading market for our common stock and our stock price may be more volatile.
In addition, Section 107 of the
JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended (the Securities Act) for complying with
new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We will take advantage of the
extended transition period for complying with new or revised accounting standards, which may make it more difficult for investors and securities analysts
47
to evaluate us since our financial statements may not be comparable to companies that comply with public company effective dates and may result in less investor confidence.
If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results
or prevent fraud. As a result, stockholders could lose confidence in our financial and other public reporting, which would harm our business and the trading price of our common stock.
Effective internal controls over financial reporting are necessary for us to provide reliable financial reports and, together with adequate
disclosure controls and procedures, are designed to prevent fraud. Any failure to implement required new or improved controls, or difficulties encountered in their implementation could cause us to fail to meet our reporting obligations. In addition,
any testing by us conducted in connection with Section 404 of the Sarbanes-Oxley Act, or the subsequent testing by our independent registered public accounting firm (when undertaken, as noted below), may reveal deficiencies in our internal
controls over financial reporting that are deemed to be material weaknesses or that may require prospective or retroactive changes to our consolidated financial statements or identify other areas for further attention or improvement. Inferior
internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.
We are required to disclose changes made in our internal control and procedures on a quarterly basis and our management is required to assess
the effectiveness of these controls annually. However, for as long as we are an emerging growth company under the recently enacted JOBS Act, our independent registered public accounting firm will not be required to attest to the
effectiveness of our internal control over financial reporting pursuant to Section 404. We could be an emerging growth company for up to five years. An independent assessment of the effectiveness of our internal controls could detect problems
that our managements assessment might not. Undetected material weaknesses in our internal controls could lead to financial statement restatements and require us to incur the expense of remediation.
Our status as an emerging growth company under the JOBS Act may make it more difficult to raise capital as and when we need it.
Because of the exemptions from various reporting requirements provided to us as an emerging growth company and because we will have
an extended transition period for complying with new or revised financial accounting standards, we may be less attractive to investors and it may be difficult for us to raise additional capital as and when we need it. Investors may be unable to
compare our business with other companies in our industry if they believe that our financial accounting is not as transparent as other companies in our industry. If we are unable to raise additional capital as and when we need it, our financial
condition and results of operations may be materially and adversely affected.
New or amended laws or regulations governing our operations may
adversely affect our business.
We and our portfolio companies will be subject to regulation by laws at the U.S. federal, state and
local levels. These laws and regulations, as well as their interpretation, may change from time to time, and new laws, regulations and interpretations may also come into effect. Any such new or changed laws or regulations could have a material
adverse effect on our business.
Additionally, changes to the laws and regulations governing our operations related to permitted
investments may cause us to alter our investment strategy in order to avail ourselves of new or different opportunities. Such changes could result in material differences to the strategies and plans set forth in this annual report on
Form 10-K
and our filings with the SEC, and may shift our investment focus from the areas of expertise of the Adviser to other types of investments in which the Adviser may have little or no expertise or
experience. Any such changes, if they occur, could have a material adverse effect on our results of operations and the value of your investment.
48
Our board of directors may change our investment objective, operating policies and strategies without prior
notice or stockholder approval.
Our board of directors has the authority, except as otherwise provided in the 1940 Act, to modify
or waive our investment objective or certain of our operating policies and strategies without prior notice and without stockholder approval. However, absent stockholder approval, we may not change the nature of our business so as to cease to be, or
withdraw our election as, a BDC. We cannot predict the effect any changes to our current operating policies and strategies would have on our business, operating results and the market price of our common stock. Nevertheless, any such changes could
adversely affect our business and impair our ability to make distributions to our stockholders.
The Adviser can resign as the Adviser or
administrator upon 60 days notice and we may not be able to find a suitable replacement within that time, or at all, resulting in a disruption in our operations that could adversely affect our financial condition, business and results of
operations.
The Adviser has the right under the Investment Advisory Agreement to resign as the Adviser at any time upon not less
than 60 days written notice, whether we have found a replacement or not. Similarly, the Adviser has the right under the Administration Agreement to resign at any time upon not less than 60 days written notice, whether we have found a
replacement or not. If the Adviser were to resign, we may not be able to find a new investment adviser or administrator 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 to our stockholders are
likely to be adversely affected and the market price of our shares may decline. In addition, the coordination of our internal management and investment or administrative activities, as applicable, 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. 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.
We are highly dependent on information systems, and systems failures could significantly disrupt our business, which may, in turn, negatively affect the
market price of our common stock and our ability to make distributions to our stockholders.
Our business is highly dependent on
the communications and information systems of the Adviser, which are provided to us on behalf of the Adviser by Cyrus Capital pursuant to the Services Agreement directly or through third party service providers. Any failure or interruption of such
systems, including as a result of the termination of the Services Agreement or an agreement with any such third party service provider, could cause delays or other problems in our activities. This, in turn, could have a material adverse effect on
our operating results and negatively affect the market price of our common stock and our ability to make distributions to our stockholders.
The
current state of the economy and financial markets of the United States, China and other several countries in the European Union increases the likelihood of adverse effects on our financial position and results of operations.
Due to federal budget deficit concerns, S&P downgraded the federal governments credit rating from AAA to AA+ for the first time in
history on August 5, 2011. Further, Moodys and Fitch had warned that they may downgrade the federal governments credit rating. Further downgrades or warnings by S&P or other rating agencies, and the United States
governments credit and deficit concerns in general, could cause interest rates and borrowing costs to rise, which may negatively impact both the perception of credit risk associated with our debt portfolio and our ability to access the debt
markets on favorable terms. In addition, a decreased U.S. government credit rating could create broader financial turmoil and uncertainty, which may weigh heavily on our financial performance and the value of our common stock.
49
In 2010, a financial crisis emerged in Europe, triggered by high budget deficits and rising
direct and contingent sovereign debt in Greece, Ireland, Italy, Portugal and Spain, which created concerns about the ability of these nations to continue to service their sovereign debt obligations. While the financial stability of many of such
countries has improved significantly, risks resulting from any future debt crisis in Europe or any similar crisis could have a detrimental impact on the global economic recovery, sovereign and non-sovereign debt in these countries and the financial
condition of European financial institutions. In July and August 2015, Greece reached agreements with its international creditors for bailouts that provide aid in exchange for austerity terms that had previously been rejected by Greek voters. Market
and economic disruptions have affected, and may in the future affect, consumer confidence levels and spending, personal bankruptcy rates, levels of incurrence and default on consumer debt and home prices, among other factors. We cannot assure you
that market disruptions in Europe, including the increased cost of funding for certain governments and financial institutions, will not impact the global economy, and we cannot assure you that assistance packages will be available, or if available,
be sufficient to stabilize countries and markets in Europe or elsewhere affected by a financial crisis. To the extent uncertainty regarding any economic recovery in Europe negatively impacts consumer confidence and consumer credit factors, our
business, financial condition and results of operations could be significantly and adversely affected.
In the second quarter of 2015,
stock prices in China experienced a significant drop, resulting primarily from continued selloff of shares trading in Chinese markets. In addition, in August 2015, Chinese authorities sharply devalued Chinas currency. Since then, the Chinese
capital markets have continued to experience periods of instability. In June 2016, British voters passed a referendum to exit the European Union leading to heightened volatility in global markets and foreign currencies. These market and economic
disruptions have affected, and may in the future affect, the U.S. capital markets, which could adversely affect our business, financial condition or results of operations.
In October 2014, the Federal Reserve announced that it was concluding its bond-buying program, or quantitative easing, which was designed to
stimulate the economy and expand the Federal Reserves holdings of long-term securities, suggesting that key economic indicators, such as the unemployment rate, had showed signs of improvement since the inception of the program. It is unclear
what effect, if any, the conclusion of the Federal Reserves bond-buying program will have on the value of our investments. Additionally, the Federal Reserve has gradually raised the federal funds rate since December 2015, and has announced its
intention to continue to raise the federal funds rate over time. These developments, along with the United States governments credit and deficit concerns, the European sovereign debt crisis and the economic slowdown in China, could cause
interest rates and borrowing costs to rise, which may negatively impact our ability to access the debt markets on favorable terms.
Our board of
directors is authorized to reclassify any unissued shares of common stock into one or more classes of preferred stock, which could convey special rights and privileges to its owners.
Under Maryland General Corporation Law and our charter, our board of directors is authorized to classify and reclassify any authorized but
unissued shares of stock into one or more classes of stock, including preferred stock. Prior to issuance of shares of each class or series, the board of directors will be required by Maryland law and our charter to set the terms, preferences,
conversion or other rights, voting powers, restrictions, limitations as to stockholder distributions, qualifications and terms or conditions of redemption for each class or series. Thus, the board of directors could authorize the issuance of shares
of preferred stock with terms and conditions that could have the effect of delaying, deferring or preventing a transaction or a change in control that might involve a premium price for holders of our common stock or that otherwise might be in their
best interest. The cost of any such reclassification would be borne by our common stockholders. The issuance of preferred shares convertible into shares of common stock may also reduce the net income and net asset value per share of our common stock
upon conversion, provided, that we will only be permitted to issue such convertible preferred stock to the extent we comply with the requirements of Section 61 of the 1940 Act, including obtaining common stockholder approval. These effects,
among others, could have an adverse effect on your investment in our common stock.
50
Certain matters under the 1940 Act require the separate vote of the holders of any issued and outstanding preferred stock. For example, the 1940 Act provides that holders of preferred stock are
entitled to vote separately from holders of common stock to elect two preferred stock directors. We currently have no plans to issue preferred stock.
Provisions of the Maryland General Corporation Law and of our charter and bylaws could deter takeover attempts and have an adverse impact on the price
of our common stock.
Our board of directors is divided into three classes of directors serving staggered terms. A classified board
may render a change in control of us or removal of our incumbent management more difficult. The Maryland General Corporation Law and our charter and bylaws contain additional provisions that may discourage, delay or make more difficult a change in
control of CM Finance Inc or the removal of our directors. We are subject to the Maryland Business Combination Act, subject to any applicable requirements of the 1940 Act. Our board of directors has adopted a resolution exempting from the Business
Combination Act any business combination between us and any other person, subject to prior approval of such business combination by our board of directors, including approval by a majority of our independent directors. If the resolution exempting
business combinations is repealed or our board of directors does not approve a business combination, the Business Combination Act may discourage third parties from trying to acquire control of us and increase the difficulty of consummating such an
offer. Our bylaws exempt from the Maryland Control Share Acquisition Act acquisitions of our stock by any person. If we amend our bylaws to repeal the exemption from the Control Share Acquisition Act, the Control Share Acquisition Act also may make
it more difficult for a third party to obtain control of us and increase the difficulty of consummating such a transaction.
We have also
adopted measures that may make it difficult for a third party to obtain control of us, including provisions of our charter classifying our board of directors in three classes serving staggered three-year terms, and authorizing our board of directors
to classify or reclassify shares of our stock in one or more classes or series, to cause the issuance of additional shares of our stock, to amend our charter without stockholder approval and to increase or decrease the number of shares of stock that
we have authority to issue. These provisions, as well as other provisions of our charter 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.
Risks Relating to our Investments
Economic
recessions or downturns could adversely affect our portfolio companies, leading to defaults on our investments, which would harm our operating results.
Many of the portfolio companies in which we expect to make investments, including those currently included in our portfolio, are likely to be
susceptible to economic slowdowns or recessions and may be unable to repay our loans during such periods. In such event, the number of our non-performing assets is likely to increase and the value of our portfolio is likely to decrease during such
periods. Adverse economic conditions may decrease the value of collateral securing some of our loans and debt securities and the value of our equity investments. Economic slowdowns or recessions could lead to financial losses in our portfolio and a
decrease in revenues, net 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 our investments and harm our operating results.
A portfolio companys failure to satisfy financial or operating
covenants imposed by us or other lenders could lead to defaults and, potentially, termination of its loans and foreclosure on its assets, which could trigger cross-defaults under other agreements and jeopardize our portfolio companys ability
to meet its obligations under the loans and debt securities that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting portfolio company.
51
We may hold the loans and debt securities of leveraged companies that may, due to the significant operating
volatility typical of such companies, enter into bankruptcy proceedings, and we could lose all or part of our investment, which would harm our operating results.
Investment in leveraged companies involves a number of significant risks. Leveraged companies in which we invest may have limited financial
resources and may be unable to meet their obligations under their loans and debt securities that we hold. Such developments may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of our realizing any
guarantees that we may have obtained in connection with our investment. Smaller leveraged companies also may have less predictable operating results and may require substantial additional capital to support their operations, finance their expansion
or maintain their competitive position.
Leveraged companies may also experience bankruptcy or similar financial distress. The bankruptcy
process has a number of significant inherent risks. Many events in a bankruptcy proceeding are the product of contested matters and adversarial proceedings and are beyond the control of the creditors. A bankruptcy filing by a portfolio company may
adversely and permanently affect that company. If the proceeding is converted to a liquidation, the value of the portfolio company may not equal the liquidation value that was believed to exist at the time of the investment. The duration of a
bankruptcy proceeding is also difficult to predict, and a creditors return on investment can be adversely affected by delays until the plan of reorganization or liquidation ultimately becomes effective. The administrative costs in connection
with a bankruptcy proceeding are frequently high and would be paid out of the debtors estate prior to any return to creditors. Because the standards for classification of claims under bankruptcy law are vague, our influence with respect to the
class of securities or other obligations we own may be lost by increases in the number and amount of claims in the same class or by different classification and treatment. In the early stages of the bankruptcy process, it is often difficult to
estimate the extent of, or even to identify, any contingent claims that might be made. In addition, certain claims that have priority by law (for example, claims for taxes) may be substantial.
A portfolio companys failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and,
potentially, termination of its loans and foreclosure on its assets. This could trigger cross-defaults under other agreements and jeopardize such portfolio companys ability to meet its obligations under the loans or debt or equity securities
that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms, which may include the waiver of certain financial covenants, with a defaulting portfolio company.
Credit risk is the potential loss we may incur from a failure of a company to make payments according to the terms of a contract. We are
subject to credit risk because of our strategy of investing in the debt of leveraged companies and our involvement in derivative instruments. Our exposure to credit risk on our investments is limited to the fair value of the investments. Our
derivative contracts are executed pursuant to an International Swaps and Derivatives Association master agreement that we currently have in place with UBS with respect to the Term Financing. Any material exposure due to counter-party risk under the
Term Financing or the Financing Facilities, generally, could have a material adverse effect on our operating results.
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.
If one of our portfolio companies were to go bankrupt, even though we may have structured our interest as senior debt, depending on the facts
and circumstances, including the extent to which we may have actually provided managerial assistance to that portfolio company, a bankruptcy court might re-characterize our debt holding and subordinate all or a portion of our claim to that of other
creditors. In addition, lenders can be subject to lender liability claims for actions taken by them where they become too involved in the borrowers business or exercise control over the borrower. It is possible that we could become subject to
a lenders liability claim, including as a result of actions taken if we actually render significant managerial assistance.
52
Our investments in private and middle-market portfolio companies are risky, and we could lose all or part
of our investment.
Investment in private and middle-market companies involves a number of significant risks. Generally, little
public information exists about these companies, and we will rely on the ability of the Advisers investment professionals to obtain adequate information to evaluate the potential returns and risks from investing in these companies. If we are
unable to uncover all material information about these companies, we may not make a fully informed investment decision, and we may lose money on our investments. Middle-market companies may have limited financial resources and may be unable to meet
their obligations under their loans and debt securities that we hold, which may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of our realizing any guarantees we may have obtained in connection
with our investment. In addition, such companies typically have shorter operating histories, narrower product lines and smaller market shares than larger businesses, which tend to render them more vulnerable to competitors actions and market
conditions, as well as general economic downturns. Additionally, middle-market companies are more likely to depend on the management talents and efforts of a small group of persons. Therefore, the death, disability, resignation or termination of one
or more of these persons could have a material adverse impact on one or more of the portfolio companies we invest in and, in turn, on us. Middle-market companies also may be parties to litigation and may be engaged in rapidly changing businesses
with products subject to a substantial risk of obsolescence. In addition, our executive officers, directors and investment adviser may, in the ordinary course of business, be named as defendants in litigation arising from our investments in
portfolio companies.
Our investments may include PIK interest.
To the extent that we invest in loans with a PIK interest component and the accretion of PIK interest constitutes a portion of our income, we
will be exposed to risks associated with the requirement to include such non-cash income in taxable and accounting income prior to receipt of cash, including the following:
|
|
|
loans with a PIK interest component may have higher interest rates that reflect the payment deferral and
increased credit risk associated with these instruments, and PIK instruments generally represent a significantly higher credit risk than coupon loans;
|
|
|
|
loans with a PIK interest component may have unreliable valuations because their continuing accruals require
continuing judgments about the collectability of the deferred payments and the value of any associated collateral;
|
|
|
|
the deferral of PIK interest increases the loan-to-value ratio, which is a fundamental measure of loan risk; and
|
|
|
|
even if the accounting conditions for PIK interest accrual are met, the borrower could still default when the
borrowers actual payment is due at the maturity of the loan.
|
We may expose ourselves to risks if we engage in hedging
transactions.
If we engage in hedging transactions, we may expose ourselves to risks associated with such transactions. We may
utilize instruments such as forward contracts, currency options and interest rate swaps, caps, collars and floors to seek to hedge against fluctuations in the relative values of our portfolio positions from changes in currency exchange rates and
market interest rates. Hedging against a decline in the values of our portfolio positions does not eliminate the possibility of fluctuations in the values of such positions or prevent losses if the values of such positions decline. However, such
hedging can establish other positions designed to gain from those same developments, thereby offsetting the decline in the value of such portfolio positions. Such hedging transactions may also limit the opportunity for gain if the values of the
underlying portfolio positions should increase. Moreover, it may not be possible to hedge against an exchange rate or interest rate fluctuation that is so generally anticipated that we are not able to enter into a hedging transaction at an
acceptable price.
The success of our hedging transactions will depend on our ability to correctly predict movements in currencies and
interest rates. Therefore, while we may enter into such transactions to seek to reduce currency exchange rate and interest rate risks, unanticipated changes in currency exchange rates or interest rates may result
53
in poorer overall investment performance than if we had not engaged in any such hedging transactions. In addition, the degree of correlation between price movements of the instruments used in a
hedging strategy and price movements in the portfolio positions being hedged may vary. Moreover, for a variety of reasons, we may not seek to establish a perfect correlation between such hedging instruments and the portfolio holdings being hedged.
Any such imperfect correlation may prevent us from achieving the intended hedge and expose us to risk of loss. In addition, it may not be possible to hedge fully or perfectly against currency fluctuations affecting the value of securities
denominated in non-U.S. currencies because the value of those securities is likely to fluctuate as a result of factors not related to currency fluctuations.
The lack of liquidity in our investments may adversely affect our business.
All of our assets may be invested in illiquid loans and securities, and a substantial portion of our investments in leveraged companies will be
subject to legal and other restrictions on resale or will otherwise be less liquid than more broadly traded public securities. The illiquidity of these investments may make it difficult for us to sell such investments if the need arises. In
addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded our investments. Also, as noted above, we may be limited or prohibited in our
ability to sell or otherwise exit certain positions in our initial portfolio as such a transaction could be considered a joint transaction prohibited by the 1940 Act.
Price declines and illiquidity in the corporate debt markets may adversely affect the fair value of our portfolio investments, reducing our net asset
value through increased net unrealized depreciation.
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 our board of directors. As part of the valuation process, we may take into account the following types of factors, if relevant, in determining the fair value of our
investments:
|
|
|
available current market data, including relevant and applicable market trading and transaction comparables;
|
|
|
|
applicable market yields and multiples;
|
|
|
|
call protection provisions;
|
|
|
|
the nature and realizable value of any collateral;
|
|
|
|
the portfolio companys ability to make payments, its earnings and discounted cash flows and the markets in
which it does business;
|
|
|
|
comparisons of financial ratios of peer companies that are public;
|
|
|
|
comparable merger and acquisition transactions; and
|
|
|
|
principal market and enterprise values.
|
When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, we use the pricing indicated by the
external event to corroborate our valuation. We record decreases in the market values or fair values of our investments as unrealized depreciation. Declines in prices and liquidity in the corporate debt markets may result in significant net
unrealized depreciation in our portfolio. The effect of all of these factors on our portfolio may reduce our net asset value by increasing net unrealized depreciation in our portfolio. Depending on market conditions, we could incur substantial
realized losses and may suffer additional unrealized losses in future periods, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.
54
We are a non-diversified investment company within the meaning of the 1940 Act, and therefore we are not
limited with respect to the proportion of our assets that may be invested in securities of a single issuer.
We are classified as a
non-diversified investment company within the meaning of the 1940 Act, which means that we are not limited by the 1940 Act with respect to the proportion of our assets that we may invest in securities of a single issuer. Beyond the asset
diversification requirements associated with our qualification as a RIC under the Code, we do not have fixed guidelines for diversification. To the extent that we assume large positions in the securities of a small number of issuers or our
investments are concentrated in relatively few industries, our net asset value may fluctuate to a greater extent than that of a diversified investment company as a result of changes in the financial condition or the markets assessment of the
issuer. We may also be more susceptible to any single economic or regulatory occurrence than a diversified investment company.
Our portfolio may be
concentrated in a limited number of industries, which may subject us to a risk of significant loss if there is a downturn in a particular industry in which a number of our investments are concentrated.
Our portfolio may be concentrated in a limited number of industries. A downturn in any particular industry in which we are invested could
significantly impact the aggregate returns we realize.
As of June 30, 2018, our investments in the energy equipment and services
industry together with oil, gas and consumable fuels represented approximately 19.2% of the fair value of our portfolio; in the professional services industry represented approximately 14.0% of the fair value of our portfolio; in the hotels,
restaurants and leisure industry represented approximately 11.4% of the fair value of our portfolio; in the media industry represented approximately 10.9% of the fair value of our portfolio; and in the commercial services and supplies industry
represented approximately 10.8% of the fair value of our portfolio. If an industry in which we have significant investments suffers from adverse business or economic conditions, as these industries have to varying degrees, a material portion of our
investment portfolio could be affected adversely, which, in turn, could adversely affect our financial position and results of operations.
Our
investments in the energy equipment and services and oil, gas and consumable fuels industries face considerable uncertainties including substantial regulatory challenges.
Our investments in portfolio companies that operate in the energy equipment and services industry together with oil, gas and consumable fuels
represented approximately 19.2%, in the aggregate, of our total portfolio as of June 30, 2018. The revenues, income (or losses) and valuations of companies in these industries are highly dependent upon the valuations of oil and gas companies,
which can fluctuate suddenly and dramatically due to any one or more of the following factors:
Commodity Pricing Risk.
In
general, commodity prices directly affect oil and gas companies, especially for those who own the underlying commodity. In addition, the volatility of commodity prices can affect other oil and gas companies due to the impact of prices on the volume
of commodities produced, transported, processed, stored or distributed and on the cost of fuel for power generation companies. The volatility of commodity prices can also affect oil and gas companies ability to access the capital markets in
light of market perception that their performance may be directly tied to commodity prices. Historically, energy commodity prices have been cyclical and exhibited significant volatility as evident in the recent and sudden decline in oil prices
during the second half of 2014.
Regulatory Risk.
Changes in the regulatory environment could adversely affect the
profitability of oil and gas companies. Federal, state and local governments heavily regulate the businesses of oil and gas companies in diverse matters, such as the way in which assets are constructed, maintained and operated and the prices oil and
gas companies may charge for their products and services. Such regulation can change over time in scope and intensity.
55
Production Risk.
The volume of crude oil, natural gas or other energy commodities
available for producing, transporting, processing, storing, distributing or generating power may materially impact the profitability of energy companies. A significant decrease in the production of natural gas, crude oil, coal or other energy
commodities, due to the decline of production from existing facilities, import supply disruption, depressed commodity prices, political events, OPEC actions or otherwise, could reduce revenue and operating income or increase operating costs of
energy companies and, therefore, their ability to pay debt or dividends.
Demand Risk.
A sustained decline in demand for crude
oil, natural gas and refined petroleum products could materially affect revenues and cash flows of energy companies. Factors that could lead to a decrease in market demand include a recession or other adverse economic conditions, increases in the
market price of the underlying commodity, higher taxes or other regulatory actions that increase costs, or shifts in consumer demand for such products.
Depletion and Exploration Risk.
Oil and gas companies commodities naturally deplete over time. Depletion could have a
material adverse impact on such companys ability to maintain its revenue. Further, estimates of reserves may not be accurate and, even if accurate, reserves may not be produced profitably. In addition, exploration of energy resources,
especially of oil and natural gas, is inherently risky and requires large amounts of capital.
Weather Risk.
Unseasonable
extreme weather patterns could result in significant volatility in demand for energy and power or may directly affect the operations of individual companies. This weather-related risk may create fluctuations in earnings of energy companies.
Operational Risk.
Oil and gas companies are subject to various operational risks, such as failed drilling or well development,
unscheduled outages, underestimated cost projections, unanticipated operation and maintenance expenses, failure to obtain the necessary permits to operate and failure of third-party contractors to perform their contractual obligations.
Competition Risk.
The oil and gas companies in which we may invest will face substantial competition in acquiring properties,
enhancing and developing their assets, marketing their commodities, securing trained personnel and operating their properties. Many of their competitors may have financial and other resources that substantially exceed their resources.
Valuation Risk.
The valuation of our holdings in oil and gas portfolio companies is subject to uncertainties inherent in estimating
quantities of reserves of oil, natural gas and coal and in projecting future rates of production and the timing of development expenditures, which are dependent upon many factors beyond our control. The estimates rely on various assumptions,
including, but not limited to, commodity prices, operating expenses, capital expenditures and the availability of funds, and are therefore inherently imprecise indications of future net cash flows. Actual future production, cash flows, taxes,
operating expenses, development expenditures and quantities of recoverable reserves may vary substantially from those assumed in the estimates. Any significant variance in these assumptions could materially affect the value of our investments in oil
and gas companies.
Climate Change.
There may be evidence of global climate change. Climate change creates physical and
financial risk and some of our portfolio companies may be adversely affected by climate change. For example, the needs of customers of oil and gas companies vary with weather conditions, primarily temperature and humidity. To the extent climate
changes affect weather conditions, energy use could increase or decrease depending on the duration and magnitude of any changes. Increased oil and gas use due to weather changes may require additional investments by our portfolio companies in more
pipelines and other infrastructure to serve increased demand. A decrease in oil and gas use due to weather changes may affect our portfolio companies financial condition through decreased revenues. Extreme weather conditions in general require
more system backup, adding to costs, and can contribute to increased system stresses, including service interruptions. Potential lawsuits against or taxes or other regulatory costs imposed on greenhouse gas emitters could also affect oil and gas
companies, based on links drawn between greenhouse gas emissions and climate change.
56
Our investments in the professional services industry face considerable uncertainties including significant
regulatory challenges.
Our investments in portfolio companies that operate in the professional services industry represent
approximately 14.0% of our total portfolio as of June 30, 2018. Our investments in portfolio companies in the professional services sector include those that provide services related to data and information, building, cleaning and maintenance
services, and energy efficiency services. Portfolio companies in the professional services sector are subject to many risks, including the negative impact of regulation, changing technology, a competitive marketplace and difficulty in obtaining
financing. Portfolio companies in the professional services industry must respond quickly to technological changes and understand the impact of these changes on customers preferences. Adverse economic, business, or regulatory developments
affecting the professional services sector could have a negative impact on the value of our investments in portfolio companies operating in this industry, and therefore could negatively impact our business and results of operations.
Our investments in the hotels, restaurants and leisure industry face considerable uncertainties including significant technological developments.
Our investments in portfolio companies that operate in the hotels, restaurants and leisure industry represent approximately 11.4%
of our total portfolio as of June 30, 2018. Portfolio companies in the hotels, restaurants and leisure sector are subject to many risks, including the negative impact of regulation, changing technology, a competitive marketplace, difficulty in
obtaining financing, rapid obsolescence, and agreements linking future rate increases to inflation or other factors not directly related to the active operating profits of the portfolio company. Portfolio companies in the hotels, restaurants and
leisure industry must respond quickly to technological changes and understand the impact of these changes on customers preferences. If a portfolio company is unable to participate in new product or distribution technologies, its results of
operations may suffer. Adverse economic, business, or regulatory developments affecting the entertainment sector could have a negative impact on the value of our investments in portfolio companies operating in this industry, and therefore could
negatively impact our business and results of operations.
An investment in media companies may be risky relative to an investment in companies
operating in other industries.
Our investments in portfolio companies that operate in the media industry represent approximately
10.9%
of our total portfolio as of June 30, 2018. There are unique risks in investing in companies in the media industry and a downturn in the industry
could significantly impact the aggregate returns we realize.
Media companies typically have limited operating histories, narrower product
lines and smaller market shares than larger businesses, which tend to render them more vulnerable to competitors actions and market conditions, as well as general economic downturns. In addition, media companies generally have less predictable
operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, and may require substantial additional capital to support their operations,
finance expansion or maintain their competitive position.
In recent years, a number of internet companies have filed for bankruptcy or
liquidated, and many large companies whose purchases affect the demand for products and services in the media industry have experienced financial difficulties, which may result in decreased demand for such products and services in the future. Our
investments in the media industry may be risky and we could lose all or part of our investments.
We invest in the commercial services and supplies
industry, which is subject to specific risks. Any concentration of our portfolio in this industry could subject us to a risk of significant loss if there is a downturn in the industry.
Our investments in portfolio companies that operate in the commercial services and supply industry represent approximately 10.8% of our total
portfolio as of June 30, 2018. There are unique risks in investing in
57
companies in the commercial services and supply industry and a downturn in the industry could significantly impact the aggregate returns we realize.
For example, the operating results and financial condition of our portfolio companies in the commercial services and supplies industry could be
adversely affected due to a number of factors, including but not limited to a decrease in demand for their services or supplies relating to seasonality or market forces, termination of contracts with, or other disruptions in or decay of
relationships with, their customers or other third parties, such as third-party suppliers or manufacturers, and various other factors. Some market forces that could adversely affect the operating results and financial condition of our portfolio
companies in the commercial services and supplies industry may be particular to our specific portfolio companies as a result of direct competition or other factors. In addition, there are risks involved with sales, marketing, managerial and related
capabilities of our portfolio companies in the commercial services and supplies industry. For example, recruiting and training a workforce is expensive and time-consuming and could delay the provision of commercial services, result in diminished
services, or delay the delivery of supplies.
We likely will have little control over the risks that face our portfolio companies in the
commercial services and supplies sector, and any of these companies may fail to devote the necessary resources and attention to sell and market their services or products effectively, which could render them unable to generate revenues and reach or
sustain profitability. Any such occurrence could significantly and adversely impact the aggregate returns we realize.
Our failure to make follow-on
investments in our portfolio companies could impair the value of our portfolio.
Following an initial investment in a portfolio
company, we may make additional investments in that portfolio company as follow-on investments, including exercising warrants, options or convertible securities that were acquired in the original or subsequent financing; in seeking to:
|
|
|
increase or maintain in whole or in part our position as a creditor or our equity ownership percentage in a
portfolio company;
|
|
|
|
preserve or enhance the value of our investment.
|
We have discretion to make follow-on investments, subject to the availability of capital resources. Failure on our part to make follow-on investments may, in
some circumstances, jeopardize the continued viability of a portfolio company and our initial investment, or may result in a missed opportunity for us to increase our participation in a successful operation. Even if we have sufficient capital to
make a desired follow-on investment, we may elect not to make a follow-on investment because we may not want to increase our level of risk, because we prefer other opportunities or because we are inhibited by compliance with BDC requirements of the
1940 Act or the desire to maintain our qualification as a RIC.
Because we generally do not hold controlling equity interests in our portfolio
companies, we may not be able to exercise control over our portfolio companies or to prevent decisions by management of our portfolio companies that could decrease the value of our investments.
We do not hold controlling equity positions in any of the portfolio companies included in our portfolio and, although we may do so in the
future, we do not currently intend to hold controlling equity positions in our portfolio companies. As a result, we will be subject to the risk that a portfolio company may make business decisions with which we disagree, and that the management
and/or stockholders of a portfolio company may take risks or otherwise act in ways that are adverse to our interests. Due to the lack of liquidity of the debt and equity investments that we expect to hold in our portfolio companies, we may not be
able to dispose of our investments in the event we disagree with the actions of a portfolio company and may therefore suffer a decrease in the value of our investments.
58
Prepayments of our debt investments by our portfolio companies could adversely impact our results of
operations and ability to make stockholder distributions and result in a decline in the market price of our shares.
We are subject
to the risk that the debt investments we make in portfolio companies may be repaid prior to maturity. We expect that our investments will generally allow for repayment at any time subject to certain penalties. When this occurs, we intend to
generally reinvest these proceeds in temporary investments, pending their future investment in accordance with our investment strategy. These temporary investments will typically have substantially lower yields than the debt being prepaid, and we
could experience significant delays in reinvesting these amounts. Any future investment may also be at lower yields than the debt that was repaid. As a result, our results of operations could be materially adversely affected if one or more of our
portfolio companies elects to prepay amounts owed to us. Additionally, prepayments could negatively impact our ability to make, or the amount of, stockholder distributions with respect to our common stock, which could result in a decline in the
market price of our shares.
Our portfolio companies may incur debt that ranks equally with, or senior to, our investments in such companies.
We intend to invest a portion of our capital in second lien and subordinated loans issued by our portfolio companies. The
portfolio companies usually have, or may be permitted to incur, other debt that ranks equally with, or senior to, the loans in which we invest. By their terms, such debt instruments may provide that the holders are entitled to receive payment of
interest or principal on or before the dates on which we are entitled to receive payments in respect of the loans 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 senior creditors, a
portfolio company may not have any remaining assets to use for repaying its obligation to us. In the case of debt ranking equally with loans in which we invest, we would have to share any distributions on an equal and ratable basis with other
creditors holding such debt in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy of the relevant portfolio company.
Additionally, certain loans that we may make to portfolio companies may be secured on a second priority basis by the same collateral securing
senior secured debt of such companies. The first priority liens on the collateral will secure the portfolio companys obligations under any outstanding senior debt and may secure certain other future debt that may be permitted to be incurred by
the portfolio company under the agreements governing the loans. The holders of obligations secured by first priority liens on the collateral will generally control the liquidation of, and be entitled to receive proceeds from, any realization of the
collateral to repay their obligations in full before us. In addition, the value of the collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. There can be no assurance that
the proceeds, if any, from sales of all of the collateral would be sufficient to satisfy the loan obligations secured by the second priority liens after payment in full of all obligations secured by the first priority liens on the collateral. If
such proceeds were not sufficient to repay amounts outstanding under the loan obligations secured by the second priority liens, then we, to the extent not repaid from the proceeds of the sale of the collateral, will only have an unsecured claim
against the portfolio companys remaining assets, if any.
We may also make unsecured loans to portfolio companies, meaning that such
loans will not benefit from any interest in collateral of such companies. Liens on such portfolio companies collateral, if any, will secure the portfolio companys obligations under its outstanding secured debt and may secure certain
future debt that is permitted to be incurred by the portfolio company under its secured loan agreements. The holders of obligations secured by such liens will generally control the liquidation of, and be entitled to receive proceeds from, any
realization of such collateral to repay their obligations in full before us. In addition, the value of such collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. There can
be no assurance that the proceeds, if any, from sales of such collateral would be sufficient to satisfy our unsecured loan obligations after payment in full of all secured loan obligations. If such proceeds were
59
not sufficient to repay the outstanding secured loan obligations, then our unsecured claims would rank equally with the unpaid portion of such secured creditors claims against the portfolio
companys remaining assets, if any.
The rights we may have with respect to the collateral securing the loans we make to our portfolio
companies with senior debt outstanding may also be limited pursuant to the terms of one or more intercreditor agreements that we enter into with the holders of such senior debt. Under a typical intercreditor agreement, at any time that obligations
that have the benefit of the first priority liens are outstanding, any of the following actions that may be taken in respect of the collateral will be at the direction of the holders of the obligations secured by the first priority liens:
|
|
|
the ability to cause the commencement of enforcement proceedings against the collateral;
|
|
|
|
the ability to control the conduct of such proceedings;
|
|
|
|
the approval of amendments to collateral documents;
|
|
|
|
releases of liens on the collateral; and
|
|
|
|
waivers of past defaults under collateral documents.
|
We may not have the ability to control or direct such actions, even if our rights are adversely affected.
The disposition of our investments may result in contingent liabilities.
We currently expect that substantially all of our investments will involve loans and private securities. In connection with the disposition of
such an investment, we may be required to make representations about the business and financial affairs of the 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 potential liabilities. These arrangements may result in contingent liabilities that ultimately result in funding obligations that we must
satisfy through our return of distributions previously made to us.
The interest rates of our term loans to our portfolio companies that extend
beyond 2021 might be subject to change based on recent regulatory changes.
LIBOR, the London interbank offered rate, is the basic
rate of interest used in lending between banks on the London interbank market and is widely used as a reference for setting the interest rate on loans globally. We typically use LIBOR as a reference rate in term loans we extend to portfolio
companies such that the interest due to us pursuant to a term loan extended to a partner company is calculated using LIBOR. Some of our term loan agreements with partner companies contain a stated minimum value for LIBOR.
On July 27, 2017, the United Kingdoms Financial Conduct Authority, which regulates LIBOR, announced that it intends to phase out
LIBOR by the end of 2021. It is unclear if at that time whether or not LIBOR will cease to exist or if new methods of calculating LIBOR will be established such that it continues to exist after 2021. The U.S. Federal Reserve, in conjunction with the
Alternative Reference Rates Committee, a steering committee comprised of large US financial institutions, is considering replacing U.S. dollar LIBOR with a new index calculated by short term repurchase agreements, backed by Treasury securities. The
future of LIBOR at this time is uncertain. Uncertainty as to a LIBOR replacement, or the treatment of securities currently benchmarked to LIBOR, may adversely affect the market for LIBOR-based securities, including our portfolio of LIBOR-indexed,
floating-rate debt securities.
We may not realize gains from our equity investments.
When we invest in loans and debt securities, we may acquire warrants or other equity securities of portfolio companies as well. We may also
invest in equity securities directly. To the extent we hold equity investments, we will attempt to dispose of them and realize gains upon our disposition of them. However, the equity interests we receive may not appreciate in value and, may decline
in value. As a result, we may not be able to realize gains
60
from our equity interests, and any gains that we do realize on the disposition of any equity interests may not be sufficient to offset any other losses we experience.
Risks Relating to Our Common Stock
Shares of
closed-end investment companies, including BDCs, may trade at a discount to their net asset value.
Shares of closed-end investment
companies, including BDCs, may trade at a discount from net asset value. This characteristic of closed-end investment companies and BDCs is separate and distinct from the risk that our net asset value per share may decline. We cannot predict whether
our common stock will trade at, above or below net asset value. At a meeting initially convened on November 7, 2017 and reconvened on November 30, 2017 and December 21, 2017, our stockholders voted to allow us to issue common stock at
a price below net asset value per share for the period ending on the earlier of the one year anniversary of the date of the Companys 2017 Annual Meeting of Stockholders and the date of the Companys 2018 Annual Meeting of Stockholders,
which we expect to be held in November 2018. Our stockholders did not specify a maximum discount below net asset value at which we are able to issue our common stock, although the number of shares sold in each offering may not exceed 25% of our
outstanding common stock immediately prior to such sale. In addition, we cannot issue shares of our common stock below net asset value unless our board of directors determines that it would be in our and our stockholders best interests to do
so. Sales of common stock at prices below net asset value per share dilute the interests of existing stockholders, have the effect of reducing our net asset value per share and may reduce our market price per share. In addition, continuous sales of
common stock below net asset value may have a negative impact on total returns and could have a negative impact on the market price of our shares of common stock. See Existing stockholders may incur dilution if, in the future, we sell
shares of our common stock in one or more offerings at prices below the then current net asset value per share of our common stock for a discussion of a proposal approved by our stockholders that permits us to issue shares of our common stock
below net asset value.
There is a risk that you may not receive distributions or that our distributions may not grow over time and a portion of our
distributions may be a return of capital.
We intend to make distributions on a quarterly basis to our stockholders out of assets
legally available for distribution. We cannot assure you that we will achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions. Our ability to pay distributions
might be adversely affected by the impact of one or more of the risk factors described in this annual report on Form 10-K. Due to the asset coverage test applicable to us under the 1940 Act as a BDC, we may be limited in our ability to make
distributions.
When we make distributions, we will be required to determine the extent to which such distributions are paid out of current
or accumulated earnings and profits. Distributions in excess of current and accumulated earnings and profits will be treated as a non-taxable return of capital to the extent of an investors basis in our stock and, assuming that an investor
holds our stock as a capital asset, thereafter as a capital gain.
To the extent, any distributions by us are funded through waivers of the
incentive fee portion of our investment advisory fees such distributions will not be based on our investment performance, and can only be sustained if we achieve positive investment performance in future periods and/or the Adviser continues to waive
such fees. Any such waivers in no way imply that the Adviser will waive incentive fees in any future period. There can be no assurance that we will achieve the performance necessary or that the Adviser will waive all or any portion of the incentive
fee necessary to be able to pay distributions at a specific rate or at all.
Stockholders may experience dilution in their ownership percentage if
they do not participate in our dividend reinvestment plan.
All distributions declared in cash payable to stockholders that are
participants in our dividend reinvestment plan are generally automatically reinvested in shares of our common stock. As a result, stockholders that do not
61
participate in the dividend reinvestment plan may experience dilution over time. Stockholders who receive distributions in shares of common stock may experience accretion to the net asset value
of their shares if our shares are trading at a premium and dilution if our shares are trading at a discount. The level of accretion or discount would depend on various factors, including the proportion of our stockholders who participate in the
plan, the level of premium or discount at which our shares are trading and the amount of the distribution payable to a stockholder.
Existing
stockholders may incur dilution if, in the future, we sell shares of our common stock in one or more offerings at prices below the then current net asset value per share of our common stock.
The 1940 Act prohibits us from selling shares of our common stock at a price below the current net asset value per share of such stock, with
certain exceptions. One such exception is prior stockholder approval of issuances below net asset value provided that our board of directors makes certain determinations. In this regard, at a meeting initially convened on November 7, 2017 and
reconvened on November 30, 2017 and December 21, 2017, our common stockholders voted to allow us to issue common stock at a price below net asset value per share for the period ending on the earlier of the one year anniversary of the date
of the Companys 2017 Annual Meeting of Stockholders and the date of the Companys 2018 Annual Meeting of Stockholders, which we expect to be held in November 2018. Our stockholders did not specify a maximum discount below net asset value
at which we are able to issue our common stock, although the number of shares sold in each offering may not exceed 25% of our outstanding common stock immediately prior to such sale. In addition, we cannot issue shares of our common stock below net
asset value unless our board of directors determines that it would be in our and our stockholders best interests to do so. Continued access to this exception will require approval of similar proposals at future stockholder meetings. Any
decision to sell shares of our common stock below the then current net asset value 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 net asset value per share, such sales would result in an immediate dilution to the net
asset value per share. This dilution would occur as a result of the sale of shares at a price below the then current net asset value per share of our common stock and a proportionately greater decrease in a stockholders interest in our
earnings and assets and voting interest in us than the increase in our assets resulting from such issuance.
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 cannot be predicted; however, the example below illustrates the effect of dilution to existing stockholders resulting from the
sale of common stock at prices below the net asset value of such shares.
Illustration: Example of Dilutive Effect of the Issuance of
Shares Below Net Asset Value.
The example assumes that Company XYZ has 13,500,000 common shares outstanding, $300,000,000 in total assets and $100,000,000 in total liabilities. The current net asset value and net asset value per share are thus
$200,000,000 and $14.81. The table illustrates the dilutive effect on nonparticipating Stockholder A of (1) an offering of 1,350,000 shares (10% of the outstanding shares) at $13.33 per share after offering expenses and commissions (a 10%
discount from net asset value).
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Prior to Sale
Below NAV
|
|
|
Following Sale
Below NAV
|
|
|
Percentage
Change
|
|
Reduction to NAV
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Shares Outstanding . . . . . . . . . . . . . . . . . . . . . . . . .
|
|
|
13,500,000
|
|
|
|
14,850,000
|
|
|
|
10.00
|
%
|
NAV per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
|
$
|
14.81
|
|
|
$
|
14.68
|
|
|
|
(0.91
|
)%
|
|
|
|
|
Dilution to Existing Stockholder
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares Held by Stockholder A . . . . . . . . . . . . . . . . . . . . .
|
|
|
135,000
|
|
|
|
135,000
|
(1)
|
|
|
0.0
|
%
|
Percentage Held by Stockholder A . . . . . . . . . . . . . . . . . .
|
|
|
1.00
|
%
|
|
|
0.91
|
%
|
|
|
(9.09
|
)%
|
Total Interest of Stockholder A in NAV . . . . . . . . . . . . . .
|
|
$
|
2,000,000
|
|
|
$
|
1,981,818
|
|
|
|
(0.91
|
)%
|
(1)
|
Assumes that Stockholder A does not purchase additional shares in the sale of shares below NAV.
|
62
Our shares might trade at premiums that are unsustainable or at discounts from net asset value.
Shares of BDCs like us may, during some periods, trade at prices higher than their net asset value per share and, during other
periods, as frequently occurs with closed-end investment companies, trade at prices lower than their net asset value per share. The perceived value of our investment portfolio may be affected by a number of factors including perceived prospects for
individual companies we invest in, market conditions for common stock generally, for initial public offerings and other exit events for venture capital backed companies, and the mix of companies in our investment portfolio over time. Negative or
unforeseen developments affecting the perceived value of companies in our investment portfolio could result in a decline in the trading price of our common stock relative to our net asset value per share.
The possibility that our shares will trade at a discount from net asset value or at premiums that are unsustainable are risks separate and
distinct from the risk that our net asset value per share will decrease. The risk of purchasing shares of a BDC that might trade at a discount or unsustainable premium is more pronounced for investors who wish to sell their shares in a relatively
short period of time because, for those investors, realization of a gain or loss on their investments is likely to be more dependent upon changes in premium or discount levels than upon increases or decreases in net asset value per share.
Investing in our common stock 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, and higher volatility or loss of
principal, than alternative investment options. Our investments in portfolio companies may be speculative and, therefore, an investment in our common stock may not be suitable for someone with lower risk tolerance.
The market price of our common stock may fluctuate significantly.
The market price and liquidity of the market for our securities may be significantly affected by numerous factors, some of which are beyond our
control and may not be directly related to our operating performance. These factors include:
|
|
|
price and volume fluctuations in the overall stock market from time to time;
|
|
|
|
investor demand for our shares;
|
|
|
|
significant volatility in the market price and trading volume of securities of BDCs or other companies in our
sector, which is not necessarily related to the operating performance of these companies;
|
|
|
|
changes in regulatory policies or tax guidelines, particularly with respect to RICs or BDCs;
|
|
|
|
loss of our qualification as a RIC or BDC;
|
|
|
|
changes in earnings or variations in operating results;
|
|
|
|
changes in the value of our portfolio of investments;
|
|
|
|
increases in the interest rates we pay;
|
|
|
|
changes in accounting guidelines governing valuation of our investments;
|
|
|
|
any shortfall in revenue or net income or any increase in losses from levels expected by investors or securities
analysts;
|
|
|
|
departure of the Advisers key personnel;
|
|
|
|
change in the Advisers relationship with Cyrus Capital under the Services Agreement;
|
|
|
|
change in the Advisers relationship with Stifel under the Stifel arrangement;
|
|
|
|
sales of our shares by the Cyrus Funds;
|
63
|
|
|
sales of our shares by Stifel;
|
|
|
|
operating performance of companies comparable to us; and
|
|
|
|
general economic trends and other external factors.
|
In the past, following periods of volatility in the market price of a companys securities, securities class action litigation has often
been brought against that company. Due to the potential volatility of our stock price, we may become the target of securities litigation in the future. Securities litigation could result in substantial costs and divert managements attention
and resources from our business.
Sales of substantial amounts of our common stock in the public market may have an adverse effect on the market
price of our common stock.
Stifel owns approximately 16% of our total outstanding common stock, and the Cyrus Funds own, in the
aggregate, approximately 28% of our total outstanding common stock. The shares held by Stifel and the Cyrus Funds are generally freely tradable in the public market, subject to the volume limitations, applicable holding periods and other provisions
of Rule 144 under the Securities Act. Sales of substantial amounts of our common stock, the availability of such common stock for sale or the registration of such common stock for sale and the ability of our stockholders, including Stifel and the
Cyrus Funds to sell their respective shares at a price per share that is below our then current net asset value per share could adversely affect the prevailing market prices for our common stock. If this occurs and continues it could impair our
ability to raise additional capital through the sale of securities should we desire to do so and negatively impact the market of our common stock.
Risks Relating to Our Notes
The Notes are
unsecured and therefore are effectively subordinated to any secured indebtedness we have currently incurred or may incur in the future and rank pari passu with, or equal to, all outstanding and future unsecured indebtedness issued by us and our
general liabilities.
The Notes are not be secured by any of our assets or any of the assets of any of our subsidiaries. As a
result, the Notes are effectively subordinated to any secured indebtedness we or our subsidiaries have outstanding (including the Financing Facilities) or that we or our subsidiaries may incur in the future (or any indebtedness that is initially
unsecured as to which we subsequently grant a security interest) to the extent of the value of the assets securing such indebtedness. In any liquidation, dissolution, bankruptcy or other similar proceeding, the holders of any of our secured
indebtedness or secured indebtedness of our subsidiaries may assert rights against the assets pledged to secure that indebtedness in order to receive full payment of their indebtedness before the assets may be used to pay other creditors, including
the holders of the Notes. As of June 30, 2018, we had, through CM SPV, $102.0 million and $17.8 million in outstanding indebtedness under the Term Financing and the 2017 UBS Revolving Financing, respectively, which are secured by the
assets held at CM SPV. The indebtedness under the Financing Facilities is effectively senior to the Notes to the extent of the value of the assets securing such indebtedness. The Notes also rank pari passu with, or equal to, our general liabilities,
which consist of trade and other payables, including any outstanding dividend payable, base and incentive management fees payable, interest and debt fees payable, vendor payables and accrued expenses such as auditor fees, legal fees, director fees,
etc. In total, these general liabilities were $23.1 million as of June 30, 2018.
The Notes are structurally subordinated to the
indebtedness and other liabilities of our subsidiaries.
The Notes are obligations exclusively of CM Finance Inc, and not of any of
our subsidiaries. None of our subsidiaries is a guarantor of the Notes, and the Notes will not be required to be guaranteed by any subsidiary we may acquire or create in the future. Any assets of our subsidiaries will not be directly available to
satisfy the claims of our creditors, including holders of the Notes. Except to the extent we are a creditor with recognized claims against our subsidiaries, all claims of creditors of our subsidiaries will have priority over our equity interests in
such entities (and therefore the claims of our creditors, including holders of the Notes) with respect to
64
the assets of such entities. Even if we are recognized as a creditor of one or more of these entities, our claims would still be effectively subordinated to any security interests in the assets
of any such current or future subsidiary and to any indebtedness or other liabilities of any such current or future subsidiary senior to our claims, including under the Financing Facilities. Consequently, the Notes are structurally subordinated to
all indebtedness and other liabilities, including trade payables, of any of our existing or future subsidiaries.
The indenture under which the
Notes are issued contains limited protection for holders of the Notes.
The Indenture offers limited protection to holders of the
Notes. The terms of the Indenture and the Notes do not restrict our or any of our subsidiaries ability to engage in, or otherwise be a party to, a variety of corporate transactions, circumstances or events that could have a material adverse
impact on your investment in the Notes. In particular, the terms of the Indenture and the Notes do not place any restrictions on our or our subsidiaries ability to:
|
|
|
issue securities or otherwise incur additional indebtedness or other obligations, including (1) any
indebtedness or other obligations that would be equal in right of payment to the Notes, (2) any indebtedness or other obligations that would be secured and therefore rank effectively senior in right of payment to the Notes to the extent of the
values of the assets securing such debt, (3) indebtedness of ours that is guaranteed by one or more of our subsidiaries and which therefore is structurally senior to the Notes and (4) securities, indebtedness or obligations issued or
incurred by our subsidiaries that would be senior to our equity interests in those entities and therefore rank structurally senior to the Notes with respect to the assets of our subsidiaries, in each case other than an incurrence of indebtedness or
other obligation that would cause a violation of Section 18(a)(1)(A) as modified by such provisions of Section 61(a) of the 1940 Act as may be applicable to us from time to time or any successor provisions, whether or not we continue to be
subject to such provisions of the 1940 Act, but giving effect, in each case, to any exemptive relief granted to us by the SEC. Currently, these provisions generally prohibit us from making additional borrowings, including through the issuance of
additional debt or the sale of additional debt securities, unless our asset coverage, as defined in the 1940 Act, equals at least 200% (or 150% beginning on May 2, 2019, as discussed below) after such borrowings. In accordance with recent
legislation, on May 2, 2018, our board of directors, including a required majority approved the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. As a result, our asset coverage requirements
for senior securities will change from 200% to 150%, effective May 2, 2019. See Our board of directors has approved our ability to incur additional leverage as permitted by recent legislation.
|
|
|
|
pay dividends on, or purchase or redeem or make any payments in respect of, capital stock or other securities
ranking junior in right of payment to the Notes, including subordinated indebtedness, in each case other than dividends, purchases, redemptions or payments that would cause our asset coverage to fall below the threshold specified in
Section 18(a)(1)(B) as modified by such provisions of Section 61(a) of the 1940 Act as may be applicable to us from time to time or any successor provisions, giving effect to (i) any exemptive relief granted to us by the SEC and
(ii) no-action relief granted by the SEC to another BDC (or to us if we determine to seek such similar no-action or other relief) permitting the BDC to declare any cash dividend or distribution notwithstanding the prohibition contained in
Section 18(a)(1)(B) as modified by such provisions of Section 61(a) of the 1940 Act as may be applicable to us from time to time in order to maintain the BDCs status as a RIC under Subchapter M of the Code. These provisions generally
prohibit us from declaring any cash dividend or distribution upon any class of our capital stock, or purchasing any such capital stock if our asset coverage, as defined in the 1940 Act, is below 200% (or 150% beginning on May 2, 2019) at
the time of the declaration of the dividend or distribution or the purchase and after deducting the amount of such dividend, distribution or purchase;
|
|
|
|
sell assets (other than certain limited restrictions on our ability to consolidate, merge or sell all or
substantially all of our assets);
|
65
|
|
|
create liens (including liens on the shares of our subsidiaries) or enter into sale and leaseback transactions;
|
|
|
|
create restrictions on the payment of dividends or other amounts to us from our subsidiaries.
|
In addition, the Indenture does not require us to make an offer to purchase the Notes in connection with a change of
control or any other event.
Furthermore, the terms of the Indenture and the Notes do not protect holders of the Notes in the event that we
experience changes (including significant adverse changes) in our financial condition, results of operations or credit ratings, if any, as they do not require that we or our subsidiaries adhere to any financial tests or ratios or specified levels of
net worth, revenues, income, cash flow or liquidity.
Our ability to recapitalize, incur additional debt (including additional debt that
matures prior to the maturity of the Notes) and take a number of other actions that are not limited by the terms of the Notes may have important consequences for you as a holder of the Notes, including making it more difficult for us to satisfy our
obligations with respect to the Notes or negatively affecting the trading value of the Notes.
Other debt we issue or incur in the future
could contain more protections for its holders than the Indenture and the Notes, including additional covenants and events of default. The issuance or incurrence of any such debt with incremental protections could affect the market for trading
levels and prices of the Notes.
Even though the Notes are listed on the NASDAQ Global Select Market, an active trading market for the Notes may not
develop, which could limit your ability to sell the Notes or affect the market price of the Notes.
We cannot provide any
assurances that an active trading market will develop for the Notes, or that, if it does develop, it will be sustained or that you will be able to sell your Notes. The Notes may trade at a discount from the price paid for the notes depending on
prevailing interest rates, the market for similar securities, our credit ratings, if any, general economic conditions, our financial condition, performance and prospects and other factors.
Accordingly, we cannot assure you that a liquid trading market will develop for the Notes or that, if an active trading market for the Notes
does develop, it will be sustained, that you will be able to sell your Notes at a particular time or that the price you receive when you sell will be favorable. To the extent an active trading market does not develop, the liquidity and trading price
for the Notes may be harmed. Accordingly, you may be required to bear the financial risk of an investment in the Notes for an indefinite period of time.
If we default on our obligations to pay our other indebtedness, we may not be able to make payments on the Notes.
Any default under the agreements governing our indebtedness, including a default under the Term Financing or the 2017 UBS Revolving Financing
or other indebtedness to which we may be a party that is not waived by the required lenders, and the remedies sought by lenders or the holders of such indebtedness could make us unable to pay principal, premium, if any, and interest on the Notes and
substantially decrease the market value of the Notes. If we are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or
if we otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our indebtedness (including the Financing Facilities), we could be in default under the terms of the agreements
governing such indebtedness, including the Notes. In the event of such default, the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest, the lenders
under the Financing Facilities or other debt we may incur in the future could elect to terminate their commitment, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or
liquidation.
66
Our ability to generate sufficient cash flow in the future is, to some extent, subject to general
economic, financial, competitive, legislative and regulatory factors as well as other factors that are beyond our control. We cannot assure you that our business will generate cash flow from investment activities, or that future borrowings will be
available to us under the Financing Facilities or otherwise, in an amount sufficient to enable us to meet our payment obligations under the Notes, our other debt, and to fund other liquidity needs.
If our operating performance declines and we are not able to generate sufficient cash flow to service our debt obligations, we may in the
future need to refinance or restructure our debt, including any Notes sold, sell assets, reduce or delay capital investments, seek to raise additional capital or seek to obtain waivers from the lenders under the Financing Facilities or other debt
that we may incur in the future to avoid being in default. If we are unable to implement one or more of these alternatives, we may not be able to meet our payment obligations under the Notes and our other debt. If we breach our covenants under the
Financing Facilities or any of our other debt and seek a waiver, we may not be able to obtain a waiver from the required lenders or holders thereof. If this occurs, we would be in default under the Financing Facilities or other debt, the lenders or
holders could exercise rights as described above, and we could be forced into bankruptcy or liquidation. If we are unable to repay debt, lenders having secured obligations could proceed against the collateral securing the debt, including the
Financing Facilities. Because the Financing Facilities have, and any future credit facilities will likely have, customary cross-default provisions, if we have a default under the terms of the Notes, the obligations under the Financing Facilities or
any future credit facility may be accelerated and we may be unable to repay or finance the amounts due.