Stellus Capital Investment
Annual Report 2019

Plain-text annual report

TABLE OF CONTENTS UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ☒ For the fiscal year ended December 31, 2019 OR ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 1-35730 STELLUS CAPITAL INVESTMENT CORPORATION (Exact name of registrant as specified in its charter) Maryland (State or other jurisdiction of incorporation or organization) 4400 Post Oak Parkway, Suite 2200 Houston, TX (Address of principal executive offices) 46-0937320 (I.R.S. Employer Identification Number) 77027 (Zip Code) Registrant’s telephone number, including area code: (713) 292-5400 Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered Common Stock, par value $0.001 per share 5.75% Notes Due 2022 New York Stock Exchange New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☒ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☐ No ☐ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☒ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer Non-accelerated filer ☐ ☐ Accelerated filer Smaller reporting company Emerging growth company ☒ ☐ ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ The aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant as of June 30, 2019 was: $247,477,542. The number of shares of the issuer’s Common Stock, $0.001 par value per share, outstanding as of February 28, 2020 was 19,474,247. Documents Incorporated by Reference Portions of the registrant’s definitive Proxy Statement relating to the registrant’s 2020 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company’s fiscal year, are incorporated by reference in Part III of this Annual Report on Form 10-K as indicated herein. TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2019 TABLE OF CONTENTS PART I. ITEM 1. BUSINESS ITEM 1A. RISK FACTORS ITEM 1B. UNRESOLVED STAFF COMMENTS ITEM 2. ITEM 3. ITEM 4. PART II. ITEM 5. ITEM 6. ITEM 7. PROPERTIES LEGAL PROCEEDINGS MINE SAFETY DISCLOSURES MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES SELECTED FINANCIAL DATA MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 7A. QUANTITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK ITEM 8. ITEM 9. AUDITED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON ACCOUNTING AND FINANCIAL DISCLOSURE ITEM 9A. CONTROLS AND PROCEDURES ITEM 9B. OTHER INFORMATION PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE ITEM 11. EXECUTIVE COMPENSATION ITEM 12. ITEM 13. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES SIGNATURES 1 31 59 59 60 60 61 64 65 84 85 144 144 145 145 145 145 145 145 146 149 TABLE OF CONTENTS Item 1. Business PART I Except as otherwise indicated, the terms “we,” “us,” “our,” and the “Company” refer to Stellus Capital Investment Corporation; and “Stellus Capital Management” refers to our investment adviser and administrator, Stellus Capital Management, LLC. General We are an externally managed, closed-end, non-diversified management investment company that has elected to be regulated as a business development company, or “BDC”, under the Investment Company Act of 1940, or the “1940 Act.” We were organized as a Maryland corporation on May 8, 2012, and formally commenced operations on November 7, 2012. We originate and invest primarily in private middle-market companies (typically those with $5 million to $50 million of EBITDA (earnings before interest, taxes, depreciation and amortization)) through first lien (including unitranche), second lien, and unsecured debt financing, often with corresponding equity co-investments. Unitranche structures may combine characteristics of first lien senior secured as well as second lien and/or subordinated loans and our unitranche loans will expose us to the risks associated with second lien and subordinated loans to the extent we invest in the “last-out” tranche. Unsecured debt includes senior unsecured and subordinated loans. Our investment activities are managed by our investment adviser, Stellus Capital Management, an investment advisory firm led by Robert T. Ladd and its other senior investment professionals. We source investments primarily through the extensive network of relationships that the senior investment professionals of Stellus Capital Management have developed with financial sponsor firms, financial institutions, middle-market companies, management teams and other professional intermediaries. The companies in which we invest are typically highly leveraged, and, in most cases, our investments in such companies will not be 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.” Our investment objective is to maximize the total return to our stockholders in the form of current income and capital appreciation. We seek to achieve our investment objective by: • • • • • • accessing the extensive origination channels that have been developed and established by the Stellus Capital Management senior investment professionals that include long-standing relationships with private equity firms, commercial banks, investment banks and other financial services firms; investing in what we believe to be companies with strong business fundamentals, generally within our core middle-market company focus; focusing on a variety of industry sectors, including business services, energy, general industrial, government services, healthcare, software and specialty finance; focusing primarily on directly originated transactions; applying the disciplined underwriting standards that the Stellus Capital Management senior investment professionals have developed over their extensive investing careers; and capitalizing upon the experience and resources of the Stellus Capital Management investment team to monitor our investments. We previously received an exemptive order (the “Prior Order”) from the SEC to co-invest with private funds managed by Stellus Capital Management where doing so is consistent with our investment strategy as well as applicable law (including the terms and conditions of the exemptive order issued by the SEC). On December 18, 2018, we received a new exemptive order (the “Order”) that supersedes the Prior Order and permits us greater flexibility to enter into co-investment transactions. The Order expands on the Prior Order and allows us to co- invest with additional types of private funds, other BDCs, and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management, subject to the conditions included therein. Pursuant to the Order, a “required majority” (as defined in Section 57(o) of the 1940 Act) of our independent directors must make certain conclusions in connection with a co-investment transaction, including (1) the terms of 1 TABLE OF CONTENTS the proposed transaction, including the consideration to be paid, are reasonable and fair to the Company and its stockholders and do not involve overreaching of the Company or its stockholders on the part of any person concerned and (2) the transaction is consistent with the interests of the Company’s stockholders and is consistent with its investment objectives and strategies. We co-invest, subject to the conditions in the Order, with private credit funds managed by Stellus Capital Management that have an investment strategy that is similar or identical to our investment strategy, and the we may co-invest with other BDCs and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management in the future. We believe that such co-investments may afford it additional investment opportunities and an ability to achieve greater diversification. As a BDC, we are required to comply with certain regulatory requirements. Prior to June 28, 2018, we were only allowed to employ leverage to the extent that our asset coverage, as defined in the 1940 Act, was equal to at least 200% after giving effect to such leverage. On March 23, 2018, the Small Business Credit Availability Act (the “SBCAA”) was signed into law, which included various changes to regulations under the federal securities laws that impact BDCs. The SBCAA included changes to the 1940 Act to allow BDCs to decrease their asset coverage requirement to 150% from 200% under certain circumstances. On April 4, 2018, our board of directors, or the “Board”, including a “required majority” (as such term is defined in Section 57(o) of the Investment Company Act of 1940, as amended (the “1940 Act”)) of the Board, approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. The Board also approved the submission of a proposal to approve the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act, which was approved by stockholders at the Company’s 2018 annual meeting of stockholders. As a result, the asset coverage ratio test applicable to the Company was decreased from 200% to 150%, effective June 28, 2018. In other words, prior to the enactment of the SBCAA, a BDC could borrow $1.00 for investment purposes for every $1.00 of investor equity. Now, for those BDCs that satisfy the Act’s approval and disclosure requirements, the BDC can borrow $2.00 for investment purposes for every $1.00 of investor equity. The amount of leverage that we employ at any time depends on our assessment of the market and other factors at the time of any proposed borrowing. We have elected and intend to qualify annually to be treated for federal income tax purposes as a regulated investment company, or “RIC,” under Subchapter M of the Internal Revenue Code, or the Code. So long as we maintain our qualification as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders as dividends on a timely basis. Our principal executive office is currently located at 4400 Post Oak Parkway, Suite 2200, Houston, TX 77027, and our telephone number is (713) 292-5400. We maintain a website on the Internet at www.stelluscapital.com (under the “Public Investors” section). Information contained on our website is not incorporated by reference into this annual report on Form 10-K and you should not consider information contained on our website to be part of this annual report on Form 10-K. SBIC Licenses Two of our wholly owned subsidiaries (the “SBIC subsidiaries”) hold a license to operate as small business investment companies, or SBICs. Current SBA regulations allow an SBIC to obtain leverage by issuing debentures guaranteed by the SBA up to a maximum of $175 million under current SBIC regulations, subject to required capitalization of the SBIC subsidiary, SBA approval, and other requirements. SBA-guaranteed debentures have fixed interest rates that equal prevailing 10-year Treasury Note rates plus a market spread and have a maturity of ten years with interest payable semi-annually. The principal amount of the debentures is not required to be paid before maturity but may be pre-paid at any time with no prepayment penalty. We believe that the SBA-guaranteed debentures are an attractive source of debt capital. We have obtained exemptive relief from the SEC to permit us to exclude the debt of the SBIC subsidiaries guaranteed by the SBA from our asset coverage test under the 1940 Act. The exemptive relief provides us 2 TABLE OF CONTENTS with increased flexibility under the asset coverage test by permitting us to borrow up to $325,000,000 more than we would otherwise be able to absent the receipt of this exemptive relief. Portfolio Composition Our investments generally range in size from $5 million to $30 million, and we may also selectively invest in larger positions. We generally expect that the size of our positions will increase in proportion to the size of our capital base. Pending such investments, we may reduce our outstanding indebtedness or invest in cash, cash equivalents, U.S. government securities and other high-quality debt investments with a maturity of one year or less. In the future, we may adjust opportunistically the percentage of our assets held in various types of loans, our principal loan sources and the industries to which we have greatest exposure, based on market conditions, the credit cycle, available financing and our desired risk/return profile. The following table provides a summary of our portfolio investments as of December 31, 2019: Number of investments in portfolio companies Fair value (a) Cost % of portfolio at fair value – first lien debt (b) % of portfolio at fair value – second lien debt % of portfolio at fair value – unsecured debt % of portfolio at fair value – equity Weighted-average annual yield (c) As of December 31, 2019 ($ in millions) 63 $628.9 $642.7 72.4 17.8 3.5 % % % 6.3 % 9.2 % (a) (b) (c) As of December 31, 2019, $ 548.7 million of our debt investments at fair value were at floating interest rates, which represented approximately 93% of our total portfolio of debt investments at fair value. As of December 31, 2019, $ 40.5 million of our debt investments at fair value were at fixed interest rates, which represented approximately 7% of our total portfolio of debt investments at fair value. Includes unitranche investments, which account for 14.4% of our portfolio at fair value. The weighted average yield on all of our debt investments as of December 31, 2019, was approximately 9.2%, of which approximately 8.7% was current cash interest. The weighted average 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 the payment of all of our and our subsidiaries’ fees and expenses. The weighted average yield was computed using the effective interest rates for all of our debt investments, which represents the interest rate on our debt investments restated as an interest rate payable annually in arrears and is computed including cash and payment in kind, or PIK interest, as well as accretion of original issue discount. There can be no assurance that the weighted average yield will remain at its current level. Stellus Capital Management Stellus Capital Management manages our investment activities and is responsible for analyzing investment opportunities, conducting research and performing due diligence on potential investments, negotiating and structuring our investments, originating prospective investments and monitoring our investments and portfolio companies on an ongoing basis. The senior investment professionals of Stellus Capital Management have an average of over 30 years of investing, corporate finance, restructuring, consulting and accounting experience and have worked together at several companies. The Stellus Capital Management senior investment professionals have a wide range of experience in middle-market investing, including originating, structuring and managing loans and debt securities through market cycles. The Stellus Capital Management senior investment professionals continue to provide investment sub-advisory services to the D. E. Shaw & Co., L.P. and its associated investment funds 3 TABLE OF CONTENTS (the “D.E. Shaw group”) with respect to an approximately $10.0 million investment portfolio at fair value (as of December 31, 2019) in middle-market companies pursuant to sub-advisory arrangements. In addition to serving as our investment adviser and the sub-advisor to the D. E. Shaw group as noted above, Stellus Capital Management currently manages private credit funds, some of which have an investment strategy that is similar or identical to our investment strategy, and energy private equity funds. We received the Order from the SEC, which permits us to co-invest with investment funds managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management, where doing so is consistent with our investment strategy as well as applicable law (including the terms and conditions of the exemptive order issued by the SEC). We believe that such co-investments may afford us additional investment opportunities and an ability to achieve greater diversification. We will not co-invest with the energy private equity funds, as the energy private equity funds focus on equity-related investments only in the energy industry, and we focus on predominantly credit-related investments across many industries. In addition, we will not co-invest with D.E. Shaw group funds. Stellus Capital Management is headquartered in Houston, Texas, and also maintains offices in the Washington, D.C. area and Charlotte, North Carolina. Market Opportunity We originate and invest primarily in private middle-market companies through first lien (including unitranche), second lien and unsecured debt financing, often with corresponding equity co-investments. We believe the environment for investing in middle-market companies is attractive for several reasons, including: Robust Demand for Debt Capital. We believe that private equity firms have significant committed but uncalled capital, a large portion of which is still available for investment in the United States. We expect the large amount of uninvested capital commitments will drive buyout activity over the next several years, which should, in turn, create lending opportunities for us. Attractive Environment to Lend To Middle-Market Companies. The current strength of the U.S. economy provides an attractive environment to lend to middle-market companies. The U.S. services, healthcare, technology and consumer products sectors continue to show strong growth and profitability, allowing middle market companies to continue to service their debt and prudently borrow to support growth initiatives and mergers and acquisitions activity. This dynamism, coupled with ample capital from private equity firms to support middle market companies, is creating a large population of credit worthy companies looking for debt capital. Attractive Deal Pricing and Structures. We believe that the pricing of middle-market debt investments is higher, and the terms of such investments are more conservative, compared to larger liquid, public debt financings, due to the more limited universe of lenders as well as the highly negotiated nature of these financings. These 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. Lending to middle-market companies requires in-depth diligence, credit expertise, restructuring experience and active portfolio management. We believe that several factors render many U.S. financial institutions ill-suited to lend to middle-market companies. For example, based on the experience of Stellus Capital Management’s senior investment professionals, lending to middle-market companies in the United States (a) is generally more labor intensive than lending to larger companies due to the smaller size of each investment and the fragmented nature of the information available with respect to such companies, 4 TABLE OF CONTENTS (b) requires specialized due diligence and underwriting capabilities, and (c) may also require more extensive ongoing monitoring by the lender. We believe that, through Stellus Capital Management, we have the experience and expertise to meet these specialized lending requirements. Competitive Strengths We believe that the following competitive strengths will allow us to achieve positive returns for our investors: Experienced Investment Team. Through our investment adviser, Stellus Capital Management, we have access to the experience and expertise of the Stellus Capital Management senior investment professionals, including its senior investment professionals who have an average of over 30 years of investing, corporate finance, restructuring, consulting and accounting experience and have worked together at several companies. The Stellus Capital Management investment professionals have a wide range of experience in middle-market investing, including originating, structuring and managing debt and equity securities through market cycles. We believe the members of Stellus Capital Management’s senior investment team are proven and experienced, with extensive capabilities in credit investing, having participated in these markets for the predominant portion of their careers. We believe that these characteristics enhance the quantity and quality of investment opportunities available to us. Established, Rigorous Investment and Monitoring Process. The Stellus Capital Management investment professionals have developed an extensive review and credit analysis process. Each investment that is reviewed by Stellus Capital Management is brought through a structured, multi-stage approval process. In addition, Stellus Capital Management takes an active approach in monitoring all investments, including reviews of financial performance on at least a quarterly basis and regular discussions with management. Stellus Capital Management’s investment and monitoring process and the depth and experience of its investment professionals should allow it to conduct the type of due diligence and monitoring that enables it to identify and evaluate risks and opportunities. Demonstrated Ability to Structure Investments Creatively. Stellus Capital Management has the expertise and ability to structure investments across all levels of a company’s capital structure. Furthermore, we believe that current market conditions will 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, or “PIK,” interest and various forms of equity securities. Resources of Stellus Capital Management Platform. We have access to the resources and capabilities of Stellus Capital Management, which has 15 investment professionals, including Robert T. Ladd, Dean D’Angelo, Joshua T. Davis and Todd A. Overbergen, who are supported by six managing directors, two vice presidents and three analysts. These individuals have developed long-term relationships with middle-market companies, management teams, financial sponsors, lending institutions and deal intermediaries by providing flexible financing throughout the capital structure. We believe that these relationships provide us with a competitive advantage in identifying investment opportunities in our target market. We also expect to benefit from Stellus Capital Management’s due diligence, credit analysis, origination and transaction execution experience and capabilities, including the support provided with respect to those functions by Mr. Huskinson, who serves as our chief financial officer and chief compliance officer, and his staff of ten finance and operations professionals. Investment Strategy The Stellus Capital Management senior investment professionals employ an opportunistic and flexible investing approach, combined with strong risk management processes, which we believe yields a highly diversified portfolio across companies, geographies, industries, and investment types. We seek direct origination opportunities of first lien (including unitranche), second lien, and unsecured debt financing, 5 TABLE OF CONTENTS often with corresponding equity co-investments, in middle-market companies. We believe that businesses in this size range often have limited access to public financial markets and will benefit from Stellus Capital Management’s reliable lending approach. Many financing providers have chosen to focus on large corporate clients and managing capital markets transactions rather than lending to middle-market businesses. Further, many financial institutions and traditional lenders are faced with constrained balance sheets and are requiring existing borrowers to reduce leverage. With an average of over 30 years of investing, corporate finance, restructuring, consulting and accounting experience, the senior investment professionals of Stellus Capital Management have demonstrated investment expertise throughout the balance sheet and in a variety of situations, including financial sponsor buyouts, growth capital, debt refinancings, balance sheet recapitalizations, rescue financings, distressed opportunities, and acquisition financings. Our investment philosophy emphasizes capital preservation through superior credit selection and risk mitigation. We expect our portfolio to provide downside protection through conservative cash flow and asset coverage requirements, priority in the capital structure and information requirements. We also anticipate benefiting from equity participation through equity co-investments. This flexible approach enables Stellus Capital Management to respond to market conditions and offer customized lending solutions. Stellus Capital Management invests across a wide range of industries with deep expertise in select verticals including, but not limited to, business services, retail, general industrial, government services, healthcare, software and specialty finance. Our typical transactions include providing financing for leveraged buyouts, acquisitions, recapitalizations and growth opportunities. We seek to maintain a diversified portfolio of investments as a method to manage risk and capitalize on specific sector trends. In addition, we co-invest with private credit funds managed by Stellus Capital Management that have a similar, overlapping or identical investment strategy as us and where doing so is consistent with conditions of the Order, and we may co-invest with other BDCs and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management in the future. Our objective is to act as the lead or largest investor in transactions, generally investing between $5 million and $30 million per transaction. We expect the average investment holding period to be between two and four years, depending upon portfolio company objectives and conditions in the capital markets. We focus on middle-market companies with between $5 million and $50 million of EBITDA in a variety of industry sectors with positive long-term dynamics and dependable cash flows. We seek businesses with management teams with demonstrated track records and economic incentives in strong franchises and sustainable competitive advantages with dependable and predictable cash flows. We employ leverage prudently and within the limitations of the applicable laws and regulations for BDCs. Any decision on our part to use leverage will depend upon our assessment of the attractiveness of available investment opportunities in relation to the costs and perceived risks of such leverage. Transaction Sourcing As access to investment opportunities is highly relationship-driven, the senior investment team and other investment professionals of Stellus Capital Management spend considerable time developing and maintaining contacts with key deal sources, including private equity firms, investment banks and senior lenders. The senior investment team and other investment professionals of Stellus Capital Management have been actively investing in the middle-market for more than a decade and have focused on extensive calling and marketing efforts via speaking engagements, sponsorships, industry events and referrals to broaden their relationship network. Existing relationships are constantly cultivated through transactional work and other personal contacts. In addition to financial sponsors, Stellus Capital Management has developed a network of other deal sources, including: • • management teams and entrepreneurs; portfolio companies of private equity firms; 6 TABLE OF CONTENTS • • • • other investment firms that have similar strategies to Stellus Capital Management and are seeking co- investors; placement agents and investment banks representing financial sponsors and issuers; corporate operating advisers and other financial advisers; and consultants, attorneys and other service providers to middle-market companies and financial sponsors. We believe that Stellus Capital Management’s broad network of deal origination contacts will afford us with a continuous source of investment opportunities. These origination relationships provide access not only to potential investment opportunities but also to market intelligence on trends across the credit markets. Since inception, Stellus Capital Management has completed financing transactions with more than 150 equity sponsors and completed multiple financing transactions with 33 of those equity sponsors. We believe that, over the past decade, the senior investment team and other investment professionals of Stellus Capital Management have built a reputation as a thoughtful and disciplined provider of capital to middle- market companies and a preferred financing source for private equity sponsors and management teams. We believe these factors give Stellus Capital Management a competitive advantage in sourcing investment opportunities, which are used for our benefit. Investment Structuring Stellus Capital Management believes that each investment has unique characteristics that must be considered, understood and analyzed. Stellus Capital Management structures investment terms based on the business, the credit profile, the outlook for the industry in which a potential portfolio company operates, the competitive landscape, the products or services which the company sells and the management team and ownership of the company, among other factors. Stellus Capital Management relies upon the analysis conducted and information gathered through the investment process to evaluate the appropriate structure for our investments. We invest primarily in the debt securities of middle-market companies. Our investments typically carry a high level of cash pay interest and may incorporate other return-enhancing mechanisms such as commitment fees, original issue discounts, early redemption premiums, PIK interest and some form of equity participation, including preferred stock, common stock, warrants and other forms of equity participation. We expect that a typical debt investment in which we invest will have a term at origination of between five and seven years. We expect to hold most of our investments to maturity or repayment, but we may sell some of our investments earlier if a liquidity event occurs, such as a sale, recapitalization or worsening of the credit quality of the portfolio company. Stellus Capital Management negotiates covenants in connection with debt investments that provide protection for us but allow appropriate flexibility for the portfolio company. Such covenants may include affirmative and negative covenants, default penalties, lien protection and change of control provisions. Stellus Capital Management requires comprehensive information rights including access to management, financial statements and budgets and, in some cases, membership on the portfolio company’s board of directors or board observation rights. Additionally, Stellus Capital Management generally requires financial covenants and terms that restrict an issuer’s use of leverage and limitations on asset sales and capital expenditures. Secured Debt Secured debt, including first lien (including unitranche) and second lien financing, has liens on the assets of the borrower that serve as collateral in support of the repayment of such loans. First Lien Debt First lien debt is structured with first-priority liens on the assets of the borrower that serve as collateral in support of the repayment of such loans. First lien loans may provide for moderate loan amortization in the early years of the loan, with most of the amortization deferred until loan maturity. 7 TABLE OF CONTENTS Unitranche Debt Unitranche debt typically is structured as first lien loans that combine both senior and junior debt with lenders agreeing separately to an order of priority among them. To the extent that we invest in the “last out” tranche of a unitranche facility, our unitranche investments will have certain risk characteristics of second lien debt. Unitranche debt typically provides for moderate loan amortization in the initial years of the debt, with the majority of the principal payment deferred until loan maturity. Since unitranche debt generally allows the borrower to make a large lump sum payment of principal at the end of the loan term, there is a risk of loss if the borrower is unable to pay the lump sum or refinance the amount owed at maturity. In some cases, we will be the sole lender, or we together with our affiliates will be the sole lender, of unitranche debt, which can provide us with more influence interacting with a borrower in terms of monitoring and, if necessary, remediation in the event of underperformance. Second Lien Debt Second lien debt is structured as junior, secured loans, with second priority liens on an issuer’s assets. These loans typically provide for moderate loan amortization in the initial years of the loan, with the majority of the amortization deferred until loan maturity. Unsecured Debt Unsecured debt, including senior unsecured and subordinated loans, is not be secured by any collateral and is effectively subordinated to the borrower’s secured indebtedness (to the extent of the collateral securing such indebtedness), including pursuant to one or more intercreditor agreements that we enter into with holders of a borrower’s senior debt. Senior Unsecured Loans. Senior unsecured loans are structured as loans that rank senior in right of payment to any of the borrower’s unsecured indebtedness that is contractually subordinated to such loans. These loans generally provide for fixed interest rates and amortize evenly over the term of the loan. Senior unsecured loans are generally less volatile than subordinated loans due to their priority over subordinated loans. Subordinated Loans. Subordinated loans are structured as unsecured, subordinated loans that provide for relatively high, fixed interest rates that provide us with significant current interest income. These loans typically have interest-only payments (often representing a combination of cash pay and PIK interest) in the early years, with amortization of principal deferred to maturity. Subordinated loans generally allow the borrower to make a large lump sum payment of principal at the end of the loan term, and there is a risk of loss if the borrower is unable to pay the lump sum or refinance the amount owed at maturity. Subordinated loans are generally more volatile than secured loans and senior unsecured loans and may involve a greater risk of loss of principal as compared to other types of loans. Subordinated loans often include a PIK feature, which effectively operates as negative amortization of loan principal, thereby increasing credit risk exposure over the life of the loan. Equity Securities In connection with some of our debt investments, we may 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. We 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. Investment Process Through the resources of Stellus Capital Management, we have access to significant research resources, experienced investment professionals, internal information systems and a credit analysis framework and investment process. Stellus Capital Management has designed a highly involved and interactive investment management process, which is the core of its culture and the basis for what we believe is a strong track record of investment returns. The investment process seeks to select only those investments that it believes have the most attractive risk/reward characteristics. The process involves several levels of review and is coordinated in an effort to identify risks in potential investments. Stellus Capital Management applies its expertise to 8 TABLE OF CONTENTS screen our investment opportunities as described below. This rigorous process, combined with our broad origination capabilities, has allowed the Stellus Capital Management team to be prudent in selecting opportunities in which to make an investment. All potential investment opportunities undergo an initial informal review by Stellus Capital Management’s investment professionals. Each potential investment opportunity that an investment professional determines merits consideration is presented and evaluated at a weekly meeting in which Stellus Capital Management’s senior investment professionals discuss the merits and risks of a potential investment opportunity as well as the due diligence process and the pricing and structure. If Stellus Capital Management’s senior investment professionals believe an investment opportunity merits further review, the investment opportunity is assigned a deal team and the deal team prepares and presents to the investment committee for initial review a prescreen memorandum that generally describes the potential transaction and includes a description of the risks, due diligence process and proposed structure and pricing for the proposed investment opportunity. Prior to making an investment, Stellus Capital Management conducts rigorous diligence on each investment opportunity. In connection with its due diligence on a potential investment opportunity, Stellus Capital Management utilizes its internal diligence resources, which include its internally developed credit analytical framework, subscriptions to third party research resources, discussions with industry experts, internal information sharing systems and the analytical expertise of its investment professionals. Stellus Capital Management typically reviews the company’s historical financials; industry drivers and outlook, competitive threats, customer concentration, asset coverage, projected financials and credit metrics; management background checks; and, if applicable, the track record and funding capabilities of the private equity sponsor. Upon review of the prescreen memorandum, if the investment committee determines to proceed with the review of an investment opportunity, the deal team continues its diligence and deal structuring plans and prepares a credit approval memorandum for review by the investment committee. The credit approval memorandum, updates the prescreen memorandum with more deal specific detail, including an update to the diligence process and any changes in the structure and pricing of the proposed investment. Upon unanimous approval by the investment committee of the proposed investment as presented in the credit approval memorandum, Stellus Capital Management’s Chief Investment Officer reviews any amendments before finalizing and closing negotiations with the prospective portfolio company. Investment Committee Each new investment opportunity must be unanimously approved by Stellus Capital Management’s investment committee. Follow-on investments in existing portfolio companies also require the investment committee’s unanimous approval. The purpose of Stellus Capital Management’s investment committee is to evaluate and approve all of our investments, subject at all times to the oversight of our Board. The investment committee process is intended to bring the diverse experience and perspectives of the committee’s members to the analysis and consideration of each investment. The investment committee consists of Messrs. Ladd, D’Angelo, Davis, Overbergen and Huskinson. The investment committee serves to provide investment consistency and adherence to our core investment philosophy and policies. The investment committee also determines appropriate investment sizing and suggests ongoing monitoring requirements. In addition to reviewing investments, investment committee meetings serve as a forum to discuss credit views and outlooks. Potential transactions and deal flow are reviewed on a regular basis. Members of the investment team are encouraged to share information and views on credits with the investment committee early in their analysis. We believe this process improves the quality of the analysis and assists the deal team members to work more efficiently. Each member of the investment committee performs a similar role for other accounts managed by Stellus Capital Management. In certain instances, including in connection with co-investments under our exemptive order, approval by our Board may also be required prior to the making of an investment. Monitoring Investments In most cases, we do not have board influence over portfolio companies. In some instances, Stellus Capital Management’s senior investment professionals may obtain board representation or observation 9 TABLE OF CONTENTS rights in conjunction with our investments. Stellus Capital Management takes an active approach in monitoring all investments, including reviews of financial performance on at least a quarterly basis and regular discussions with management. The monitoring process begins with structuring terms and conditions, which require the timely delivery and access to critical financial and business information on portfolio companies. Specifically, Stellus Capital Management’s monitoring system consists of the following activities: Regular Investment Committee Updates. Key portfolio company developments are discussed each week as part of the standard investment committee meeting agenda. Written Reports. The deal teams provide periodic written updates as appropriate for key events that impact portfolio company performance or valuation. In addition, deal teams provide written updates following each portfolio company board meeting. Quarterly Full Portfolio Review. Stellus Capital Management’s Chief Investment Officer and our Chief Compliance Officer perform a quarterly comprehensive review of every portfolio company with the deal teams. This process includes a written performance and valuation update, and credit-specific discussion on each of our portfolio companies. In addition, pursuant to our valuation policy, the valuation of each portfolio investment for which a market quotation is not readily available is reviewed by our independent third-party valuation firm at least twice annually. In addition, portfolio investments 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 based on the input of our management and audit committee. As part of the monitoring process, Stellus Capital Management also tracks developments in the broader marketplace. Stellus Capital Management’s investment professionals have a wealth of information on the competitive landscape, industry trends, relative valuation metrics, and analyses that assist in the execution of our investment strategy. In addition, Stellus Capital Management’s extensive communications with brokers and dealers allows its investment professionals to monitor market and industry trends that could affect portfolio investments. Stellus Capital Management may provide ongoing strategic, financial and operational guidance to some portfolio companies either directly or by recommending its investment professionals or other experienced representatives to participate on the board of directors. Stellus Capital Management maintains an extensive network of strategic and operational advisers to call upon for industry expertise or to supplement existing management teams. Asset Quality In addition to various risk management and monitoring tools, Stellus Capital Management uses an investment ranking system to characterize and monitor the credit profile and expected level of returns on each investment in our portfolio. This investment ranking system uses a five-level numeric scale. The following is a description of the conditions associated with each investment category: Investment Category 1 is used for investments that are performing above expectations, and whose risks remain favorable compared to the expected risk at the time of the original investment. Investment Category 2 is used for investments that are performing within expectations and whose risks remain neutral compared to the expected risk at the time of the original investment. All new loans are initially rated 2. Investment Category 3 is used for investments that are performing below expectations and that require closer monitoring, but where no loss of return or principal is expected. Portfolio companies with a rating of 3 may be out of compliance with financial covenants. Investment Category 4 is used for investments that are performing substantially below expectations and whose risks have increased substantially since the original investment. These investments are often in work out. Investments with a rating of 4 are those for which some loss of contractual return but no loss of principal is expected. Investment Category 5 is used for investments that are performing substantially below expectations and whose risks have increased substantially since the original investment. These investments are almost always in work out. Investments with a rating of 5 are those for which some loss of return and principal is expected. 10 TABLE OF CONTENTS In the event that Stellus Capital Management determines that an investment is underperforming, or circumstances suggest that the risk associated with a particular investment has significantly increased, Stellus Capital Management 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 ranking system identifies the relative risk for each investment, the ranking alone does not dictate the scope and/or frequency of any monitoring that is performed. The frequency of Stellus Capital Management’s 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. 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. 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 may be 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 based on the input of our management and audit committee. In addition, our Board retains one or more independent valuation firms to review at least twice annually, the valuation of each portfolio investment for which a market quotation is not readily 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. A readily available market value is not expected to exist for most of the investments in our portfolio, and we value these portfolio investments at fair value as determined in good faith by our Board under our valuation policy and process. The types of factors that our Board may take into account in determining the fair value of our investments generally include, as appropriate, comparisons of financial ratios portfolio company to peer companies that are public, the nature and realizable value of any collateral, the portfolio company’s ability to make payments and its earnings and discounted cash flow, the markets in which the portfolio company does business, and other relevant factors. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, we consider the pricing indicated by the external event to corroborate our valuation. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of the investments may differ materially from the values that would have been used had a readily available market value existed for such investments. In addition, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different from the valuations currently assigned. With respect to investments for which market quotations are not readily available, our Board 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 Stellus Capital Management responsible for the portfolio investment; preliminary valuation conclusions are then documented and discussed with our senior investment professionals and Stellus Capital Management; at least twice annually, the valuation for each portfolio investment is reviewed by an independent valuation firm; • the audit committee of our board of directors then reviews these preliminary valuations; 11 TABLE OF CONTENTS • the Board then discusses the valuations and determines the fair value of each investment in our portfolio in good faith, based on the input of Stellus Capital Management, the independent valuation firm and the audit committee. In following these approaches, the types of factors that are taken into account in fair value pricing our investments include, as relevant, but are not limited to: • • • • • • • • • • 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 company’s 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 the principal market and enterprise values. Realization of Investments The potential exit scenarios of a portfolio company play an important role in evaluating investment decisions. Our debt-orientation provides for increased potential exit opportunities, including (a) the sale of investments in the private markets, (b) the refinancing of investments held, often due to maturity or recapitalizations, and (c) other liquidity events including the sale or merger of the portfolio company. Since we seek to maintain a debt orientation in our investments, we expect to receive interest income over the course of the investment period, resulting in a 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. Stellus Capital Management or an affiliate of Stellus Capital Management provides such managerial assistance on our behalf to portfolio companies that request this assistance. We may receive fees for these services and will reimburse Stellus Capital Management or an affiliate of Stellus Capital Management for its allocated costs in providing such assistance, subject to the review by our Board, 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 financing companies and, to the 12 TABLE OF CONTENTS 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 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 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 Stellus Capital Management to which we have access to assess investment risks and determine appropriate pricing for our investments in portfolio companies. In addition, we believe that the relationships of the investment professionals of Stellus Capital Management enable us to learn about, and compete effectively for, financing opportunities with attractive middle-market companies in the industries in which we invest. Employees We do not have any direct employees, and our day-to-day investment operations are managed by Stellus Capital Management. We have a chief executive officer and president and a chief financial officer, chief compliance officer, treasurer and secretary. To the extent necessary, we may hire additional personnel going forward. Our officers are employees of Stellus Capital Management and our allocable portion of the cost of our chief financial officer and chief compliance officer and his staff is paid by us pursuant to the administration agreement that we have entered into with Stellus Capital Management. Management Agreements Stellus Capital Management serves as our investment adviser and is registered as an investment adviser under the Investment Advisers Act of 1940, as amended, or the “Advisers Act.” In addition, Stellus Capital Management serves as our administrator. Investment Advisory Agreement Subject to the overall supervision of our Board and in accordance with the 1940 Act, Stellus Capital Management manages our day-to-day operations and provides investment advisory services to us. Under the terms of the investment advisory agreement, Stellus Capital Management: • • • • • • 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 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 Stellus Capital Management 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 are 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 (including preferred stock, public and private debt issuances, derivative instruments, repurchase agreements and other similar instruments or arrangements) and excluding cash and cash equivalents. For services rendered under the investment advisory agreement, 13 TABLE OF CONTENTS 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 are appropriately pro-rated. Incentive Fee We pay Stellus Capital Management an incentive fee. Incentive fees are calculated as below. The incentive fee, which provides Stellus Capital Management 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, for the benefit off Stellus Capital Management, measured as of the end of each calendar quarter. Under this provision, in any calendar quarter, Stellus Capital Management 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%. The effect of the “catch-up” provision is that, subject to the total return provision discussed below, if pre- incentive fee net investment income exceeds 2.5% in any calendar quarter, Stellus Capital Management 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 (as described below), 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, 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 the Company’s pre-incentive fee net investment income will be payable except to the extent 20.0% of the cumulative net increase in net assets resulting from operations over the 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 will be limited to the lesser of (i) 20.0% of the amount by which our 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 Stellus Capital Management, without any interest thereon, 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 amounts 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. 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 14 TABLE OF CONTENTS prior quarters are below the quarterly hurdle. Stellus Capital Management has agreed to permanently waive any interest accrued on the portion of the incentive fee attributable to deferred interest (such as PIK interest or OID). 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. For example, if we receive pre-incentive fee net investment income in excess of the quarterly minimum hurdle rate, we will 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 graphical 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), 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. 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. Examples of Quarterly Incentive Fee Calculation Example 1: Income Related Portion of Incentive Fee before Total Return Requirement Calculation: Alternative 1 Assumptions (1) Investment income (including interest, dividends, fees, etc.) = 1.25% Hurdle rate = 2.0% Management fee = 0.4375% Other expenses (legal, accounting, custodian, transfer agent, etc.) = 0.2% Pre-incentive fee net investment income (investment income - (management fee + other expenses)) = 0.6125% (2) 15 TABLE OF CONTENTS 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 = 2.0% Management fee = 0.4375% (1) (2) Other expenses (legal, accounting, custodian, transfer agent, etc.) = 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”) = 100% × (2.2625% - 2.0%) = 0.2625% (3) 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 (1) (2) Investment income (including interest, dividends, fees, etc.) = 3.5% Hurdle rate = 2.0% Management fee = 0.4375% Other expenses (legal, accounting, custodian, transfer agent, etc.) = 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”) Incentive fee = 100% × “catch-up” + (20.0% × (Pre-Incentive Fee Net Investment Income - 2.5%)) (3) “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% + 0.0725% = 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) The “catch-up” provision is intended to provide Stellus Capital Management 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. 16 TABLE OF CONTENTS Example 2: Income Portion of Incentive Fee with Total Return Requirement Calculation: Alternative 1: Assumptions (1) (2) Investment income (including interest, dividends, fees, etc.) = 3.5% Hurdle rate = 2.0% Management fee = 0.4375% Other expenses (legal, accounting, custodian, transfer agent, etc.) = 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 (2) (1) Investment income (including interest, dividends, fees, etc.) = 3.5% Hurdle rate = 2.0% Management fee = 0.4375% Other expenses (legal, accounting, custodian, transfer agent, etc.) = 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. 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 17 TABLE OF CONTENTS 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 20.0%) 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: $0.4 million capital gains incentive fee - 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 - $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 (1) 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) * (1) 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. 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 Stellus Capital 18 TABLE OF CONTENTS Management ($0.70 million) is effectively greater than $0.45 million (20.0% of cumulative aggregate realized capital gains less net realized capital losses or net unrealized depreciation ($2.25 million)). Payment of Our Expenses All investment professionals of Stellus Capital Management, when and to the extent engaged in providing investment advisory and management services to us, and the compensation and routine overhead expenses of personnel allocable to these services to us, are provided and paid for by Stellus Capital Management and not by us. We bear all other out-of-pocket costs and expenses of our operations and transactions, including, without limitation, those relating to: • • • • • • • • • • • • • • • • • • organization and offering; 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; offerings of our common stock and other securities; base management and incentive fees; administration fees and expenses, if any, payable under the administration agreement (including our allocable portion of Stellus Capital Management’s overhead in performing its obligations under the administration agreement, including rent and the allocable portion of the cost of our chief compliance officer and chief financial officer and his staff); transfer agent, dividend agent and custodial fees and expenses; U.S. federal and state registration fees; all costs of registration and listing our shares on any securities exchange; U.S. federal, state and local taxes; independent directors’ fees and expenses; costs of preparing and filing reports or other documents required by the SEC or other regulators; costs of any reports, proxy statements or other notices to stockholders, including printing costs; 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, independent auditors and outside legal costs; proxy voting expenses; and all other expenses incurred by us or Stellus Capital Management in connection with administering our business. Duration and Termination Unless terminated earlier as described below, the investment advisory agreement will continue in effect from year to year if approved annually by our Board 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 Stellus Capital Management and may be terminated by either party without penalty upon 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 19 TABLE OF CONTENTS 60 days’ written notice. See Item 1A. “Risk Factors — Risks Relating to our Business and Structure.” We are dependent upon key personnel of Stellus Capital Management for our future success. If Stellus Capital Management were to lose any of its key personnel, our ability to achieve our investment objective could be significantly harmed. Indemnification The investment advisory agreement provides that Stellus Capital Management 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 Stellus Capital Management’s services under the investment advisory agreement or otherwise as our investment adviser. Our obligation to provide indemnification under the investment advisory agreement, however, is limited by the 1940 Act and Investment Company Act Release No. 11330, which, among other things, prohibit us from indemnifying any director, officer or other individual from any liability resulting directly from the willful misconduct, bad faith, gross negligence in the performance of duties or reckless disregard of applicable obligations and duties of the directors, officers or other individuals and require us to set forth reasonable and fair means for determining whether indemnification shall be made. Board Approval of the Investment Advisory Agreement Our Board, including a majority of our independent directors, approved the investment advisory agreement at its first meeting, held on September 24, 2012, and approved the annual continuation of the investment advisory agreement on January 23, 2020. In its consideration of the investment advisory agreement, the Board focused on information it had received relating to, among other things: (a) the nature, quality and extent of the advisory and other services to be provided to us by our investment adviser; (b) comparative data with respect to advisory fees or similar expenses paid by other BDCs with similar investment objectives; (c) our projected operating expenses and expense ratio compared to BDCs with similar investment objectives; (d) any existing and potential sources of indirect income to our investment adviser from its relationships with us and the profitability of those relationships; (e) information about the services to be performed and the personnel performing such services under the investment advisory agreement; (f) the organizational capability and financial condition of our investment adviser; and (g) various other factors. In voting to approve the investment advisory agreement, our Board, 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 considered the nature, extent and quality of the advisory and other services to be provided by Stellus Capital Management, including the investment performance of Stellus Capital Management’s investment team. Our Board also considered the investment selection process expected to be employed by Stellus Capital Management, including the flow of transaction opportunities resulting from its investment team’s significant experience in originating, structuring and managing loans and debt securities through market cycles; the employment of Stellus Capital Management’s investment strategy, rigorous due diligence process, investment structuring, and ongoing relationships with and monitoring of portfolio companies, in light of the investment objective of the Company. Our Board also considered Stellus Capital Management’s personnel and their prior experience in connection with the types of investments made by us, including such personnel’s 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 considered the other terms and conditions of the investment advisory agreement, including the fact that we could terminate the investment advisory agreement without penalty upon 60 days’ notice to Stellus Capital Management. As a result, our Board determined that the substantive terms of the investment advisory agreement (other than the fees payable thereunder, which our Board 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. Moreover, our Board concluded that although the substantive terms of the Investment Advisory Agreement, including the services to be provided, are generally the same as those of comparable BDCs described in the market data then available, it would be difficult to obtain similar services from other third-party 20 TABLE OF CONTENTS • • • • • service providers in light of the nature, quality and extent of the advisory and other services provided to us by Stellus Capital Management. Projected Costs of the Services Provided to the Company. Our Board 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 and (ii) the administrative services that Stellus Capital Management will provide to us at cost pursuant to the administration agreement. Based upon its review, our Board concluded that the fees to be paid under the investment advisory agreement are generally comparable to or more favorable than those payable under agreements of comparable BDCs and reasonable in relation to the services expected to be provided by Stellus Capital Management. Projected Profitability of Stellus Capital Management. Our Board considered information about Stellus Capital Management, including the anticipated costs of the services to be provided by Stellus Capital Management and the anticipated profits to be realized by it, including as a result of our investment performance, which would generally be equal or similar to the profitability of investment advisers managing comparable BDCs. Our Board 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 Stellus Capital Management. As a result of this review, our Board determined that our investment performance supported the renewal of the investment advisory agreement. Economies of Scale. Our Board 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 our stockholders. Considering such information, our Board 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 Stellus Capital Management. Our Board considered existing and potential sources of indirect income Stellus Capital Management would receive as a result of the relationship with us, and whether there would be potential for additional benefits to be derived by Stellus Capital Management as a result of our relationship, and was advised any such potential would be limited. Conclusions. In view of the wide variety of factors that our Board 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. The Board did not rank or otherwise assign relative weights to the specific factors it considered in connection with its evaluation of the Investment Advisory Agreement, nor did it 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 decision made by our Board. Rather, the Board based its approval of the Investment Advisory Agreement on the totality of information presented to 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, 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. Administration Agreement Under the administration agreement, Stellus Capital Management furnishes us with office facilities and equipment and will provide us with clerical, bookkeeping, recordkeeping and other administrative services at such facilities. Stellus Capital Management also performs, or oversees the performance of, our required administrative services, which include 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. In addition, Stellus Capital Management 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 21 TABLE OF CONTENTS 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, Stellus Capital Management also provides managerial assistance on our behalf to those portfolio companies that have accepted our offer to provide such assistance. Payments under the administration agreement are equal to an amount based upon our allocable portion (subject to the review of our Board) of Stellus Capital Management’s 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 his staff. In addition, if requested to provide significant managerial assistance to our portfolio companies, Stellus Capital Management 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. The administration agreement may be terminated by either party without penalty upon 60 days’ written notice to the other party. To the extent that Stellus Capital Management outsources any of its functions, we will pay the fees associated with such functions on a direct basis without any incremental profit to Stellus Capital Management. Stockholder approval is not required to amend the administration agreement. Indemnification The administration agreement provides that Stellus Capital Management, its affiliates and their respective, 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 Stellus Capital Management’s services under the administration agreement or otherwise as our administrator. Our obligation to provide indemnification under the administration agreement, however, is limited by the 1940 Act and Investment Company Act Release No. 11330, which, among other things, prohibit us from indemnifying any director, officer or other individual from any liability resulting directly from the willful misconduct, bad faith, gross negligence in the performance of duties or reckless disregard of applicable obligations and duties of the directors, officers or other individuals and require us to set forth reasonable and fair means for determining whether indemnification shall be made. License Agreement We have entered into a license agreement with Stellus Capital Management under which Stellus Capital Management has agreed to grant us a non-exclusive, royalty-free license to use the name “Stellus Capital.” Under this agreement, we have a right to use the “Stellus Capital” name for so long as Stellus Capital Management or one of its affiliates remains our investment adviser. Other than with respect to this limited license, we have no legal right to the “Stellus Capital” name. This license agreement will remain in effect for so long as the investment advisory agreement with Stellus Capital Management is in effect. Exchange Act Reports We maintain a website at www.stelluscapital.com (under the public investors section). 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 Securities Exchange Act of 1934, or 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. Regulation as a Business Development Company We are a BDC under the 1940 Act that has elected to be treated as a RIC under the Code. 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 22 TABLE OF CONTENTS 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 company’s 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., the New York Stock Exchange), 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) (4) (5) (6) 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. 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. 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. Cash, cash equivalents, U.S. government securities or high-quality debt securities that mature in one year or less from the date of investment. 23 TABLE OF CONTENTS 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 To count portfolio securities as qualifying assets for the purpose of the 70% test, a BDC must either control the issuer of the securities or must offer to make available to the issuer of the securities significant managerial assistance. However, when the BDC purchases securities in conjunction with one or more other persons acting together and one of the other persons in the group may make available such managerial assistance. Making available managerial assistance means any arrangement whereby the BDC, 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. With respect to an SBIC, making available managerial assistance means the making of loans to a portfolio company. Stellus Capital Management 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 maintain our qualification 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. Stellus Capital Management will monitor the creditworthiness of the counterparties with which we enter into repurchase agreement transactions. Warrants and Options Under the 1940 Act, a BDC is subject to restrictions on the amount of warrants, options, restricted stock or rights to purchase shares of capital stock that it may have outstanding at any time. Under the 1940 Act, we may generally only offer warrants provided that (i) the warrants expire by their terms within ten years, (ii) the exercise or conversion price is not less than the current market value at the date of issuance, (iii) our stockholders authorize the proposal to issue such warrants, and our Board approves such issuance on the basis that the issuance is in the best interests of us and our stockholders and (iv) if the warrants are accompanied by other securities, the warrants are not separately transferable unless no class of such warrants and the securities accompanying them has been publicly distributed. The 1940 Act also provides that the amount of our voting securities that would result from the exercise of all outstanding warrants, as well as options and rights, at the time of issuance may not exceed 25% of our outstanding voting securities. In particular, the amount of capital stock that would result from the conversion or exercise of all outstanding warrants, options or rights to purchase capital stock cannot exceed 25% of the BDC’s total outstanding shares of capital stock. Senior Securities We are 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 150% immediately after each such issuance. 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 24 TABLE OF CONTENTS associated with leverage, see Item 1A. “Risk Factors — Risks Relating to our Business and Structure — 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.” 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 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, closely approximates the market value of such securities (less any distributing commission or discount). We would need approval from our stockholders to issue shares below the then current net asset value per share any time after the expiration of the current approval. We may also make rights offerings to our stockholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act. Codes of Ethics We and Stellus Capital Management 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 code’s requirements. In addition, each code of ethics is available on the EDGAR Database on the SEC’s 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. Proxy Voting Policies and Procedures We have delegated our proxy voting responsibility to Stellus Capital Management. The proxy voting policies and procedures of Stellus Capital Management are set out below. The guidelines will be reviewed periodically by Stellus Capital Management and our directors who are not “interested persons,” and, accordingly, are subject to change. Introduction. As an investment adviser registered under the Advisers Act, Stellus Capital Management has a fiduciary duty to act solely in our best interests. As part of this duty, Stellus Capital Management recognizes that it must vote our securities in a timely manner free of conflicts of interest and in our best interests. Stellus Capital Management’s 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. Proxy Policies. Stellus Capital Management votes proxies relating to our portfolio securities in what it perceives to be the best interest of our stockholders. Stellus Capital Management 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 Stellus Capital Management will vote in favor of proposals that Stellus Capital Management believes are likely to increase the value of the portfolio securities we hold. Although Stellus Capital Management will generally vote against proposals that may have a negative effect on our portfolio securities, Stellus Capital Management may vote for such a proposal if there exist compelling long-term reasons to do so. Stellus Capital Management 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 Stellus Capital Management’s vote is not the product of a conflict of interest, Stellus Capital Management requires that 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 25 TABLE OF CONTENTS regarding a proxy vote. Where conflicts of interest may be present, Stellus Capital Management 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 Stellus Capital Management voted proxies by making a written request for proxy voting information to: Stellus Capital Investment Corporation, Attention: Investor Relations, 4400 Post Oak Parkway, Suite 2200, Houston, TX 77027, or by calling us collect at (713) 292-5414. 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 Stellus Capital Management 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 person’s office. We and Stellus Capital Management 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. In general, BDCs are prohibited under the 1940 Act from knowingly participating in certain transactions with our affiliates without the prior approval of our Board who are not interested persons and, in some cases, prior approval by the SEC. The SEC has interpreted the BDC prohibition on transactions with affiliates to prohibit all “joint transactions” between entities that share a common investment adviser. The staff of the SEC has 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. In addition, we previously received the Prior Order from the SEC to co-invest with private funds managed by Stellus Capital Management where doing so is consistent with our investment strategy as well as applicable law (including the terms and conditions of the exemptive order issued by the SEC). On December 18, 2018, we received the Order, which supersedes the Prior Order and permits us greater flexibility to enter into co-investment transactions. The Order expands on the Prior Order and allows us to co-invest with additional types of private funds, other BDCs, and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management, subject to the conditions included therein. Pursuant to the Order, a “required majority” (as defined in Section 57(o) of the 1940 Act) of our independent directors must make certain conclusions in connection with a co-investment transaction, including that (1) the terms of the proposed transaction, including the consideration to be paid, are reasonable and fair to us and our stockholders and do not involve overreaching of us or our stockholders on the part of any person concerned and (2) the transaction is consistent with the interests of our stockholders and is consistent with our investment objectives and 26 TABLE OF CONTENTS strategies. We co-invest, subject to the conditions included in the Order, with private credit funds managed by Stellus Capital Management that have an investment strategy that is similar to or identical to our investment strategy, and we may co-invest with other BDCs and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management in the future. We believe that such co-investments may afford us additional investment opportunities and an ability to achieve greater diversification. 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. Taxation as a Regulated Investment Company As a BDC, we have elected and intend to qualify annually 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 net ordinary income or capital gains that we distribute to our stockholders as dividends. To continue to maintain our qualification as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements (as described below). In addition, to maintain our RIC 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”). For any taxable year in which we: • • qualify as a RIC; and satisfy the Annual Distribution Requirement; We will not be subject to U.S. federal income tax on the portion of our income we 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 our undistributed income unless we distribute in a timely manner an amount at least equal to the sum of (a) 98% of our net ordinary income for each calendar year, (b) 98.2% of our capital gain net income for the one-year period ending December 31 (c) any income realized, but not distributed, in the preceding year and on which we paid no U.S. federal income tax, or the Excise Tax Avoidance Requirement. For this purpose, however, any net ordinary income or capital gain net income retained by us that is subject to corporate income tax for the tax year ending in that calendar year will be considered to have been distributed by year end (or earlier if estimated taxes are paid). 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 year; derive in each taxable year at least 90% of our gross income from dividends, interest, payments with respect to certain securities loans, gains from the sale of stock or other securities, or other income derived with respect to our business of investing in such stock or securities, and net income derived 27 TABLE OF CONTENTS from interests in “qualified publicly traded partnerships” (which generally are partnerships that are traded on an established securities market or tradable on a secondary market, other than partnerships that derive 90% of their income from interest, dividends and other permitted RIC income), or 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 or of two or more issuers that are controlled, as determined under applicable tax rules, by us and that are engaged in the same or similar or related trades or businesses or in the securities of one or more qualified publicly traded partnerships, or the Diversification Tests. We may invest in partnerships, including qualified publicly traded partnerships, which may result in our being subject to state, local or foreign income, franchise or withholding tax liabilities. 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, with 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. Because any original issue discount 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. If we are not able to obtain sufficient cash from other sources to satisfy the Annual Distribution Requirement, we may fail to maintain our tax treatment as a RIC and become subject to corporate-level U.S. federal income taxes on all of our taxable income without the benefit of the dividends-paid deduction. Although we do not presently expect to do so, we are authorized to borrow funds and to sell assets in order to satisfy (i) the Annual Distribution Requirement and to otherwise eliminate our liability for U.S. federal income and excise taxes and/or (ii) the Diversification Tests. 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. See Item 1A. “Regulation as a Business Development Company — Senior Securities.” Moreover, our ability to dispose of assets to meet the Annual Distribution Requirement, the Excise Tax Avoidance Requirement or the Diversification Tests may be limited by (a) the illiquid nature of our portfolio and/or (b) other requirements relating to our qualifications as a RIC, including the Diversification Tests. If we dispose of assets in order to meet the Annual Distribution Requirement, the Excise Tax Avoidance Requirement or the Diversification Tests, we may make such dispositions at times that, from an investment standpoint, are not advantageous. In addition, we have formed and operate two SBIC subsidiaries, and are partially dependent on the SBIC subsidiaries for cash distributions to enable us to meet the RIC distribution requirement. The SBIC subsidiaries may be limited by the Small Business Investment Act of 1958, and SBA regulations governing SBICs, from making certain distributions to us that may be necessary to maintain our tax treatment as a RIC. We may have to request a waiver of the SBA’s restrictions for the SBIC subsidiaries to make certain distributions to maintain our RIC tax treatment. We cannot assure you that the SBA will grant such waiver. If the SBIC subsidiaries are unable to obtain a waiver, compliance with the SBA regulations may cause us to fail to maintain our tax treatment as a RIC, which would result in us becoming subject to corporate-level federal income tax. Certain of our investment practices may be subject to special and complex U.S. federal income tax provisions that may, among other things, (a) treat dividends that would otherwise constitute qualified dividend income as non-qualified dividend income, (b) treat dividends that would otherwise be eligible for 28 TABLE OF CONTENTS the corporate dividends received deduction as ineligible for such treatment, (c) disallow, suspend or otherwise limit the allowance of certain losses or deductions, (d) convert lower-taxed long term capital gain into higher- taxed short-term capital gain or ordinary income, (e) convert an ordinary loss or a deduction into a capital loss (the deductibility of which is more limited), (f) cause us to recognize income or gain without a corresponding receipt of cash, (g) adversely affect the time as to when a purchase or sale of stock or securities is deemed to occur, (h) adversely alter the characterization of certain complex financial transactions and (i) produce income that will not be qualifying income for purposes of the 90% Income Test. We intend to monitor our transactions and may make certain tax elections to mitigate the effect of these provisions and prevent our disqualification as a RIC. Gain or loss realized by us from warrants acquired by us as well as any loss attributable to the lapse of such warrants generally will be treated as capital gain or loss. Such capital gain or loss generally will be long term or short term, depending on how long we held a particular warrant. Some of the income and fees that we may recognize will not satisfy the 90% Income Test. In order to ensure that such income and fees do not disqualify us as a RIC for a failure to satisfy the 90% Income Test, we may hold assets that generate such income and provide services that generate such fees indirectly through one or more entities treated as corporations for U.S. federal income tax purposes. Such corporations will be required to pay U.S. federal corporate income tax on their earnings, which ultimately will reduce our return on such income and fees. If we are unable to qualify for tax treatment as a RIC, and if certain remedial provisions are not available, we would be subject to tax on all of our taxable income at regular corporate rates. We would not be able to deduct distributions to stockholders, nor would they be required to be made. Subject to certain limitations under the Code, corporate stockholders would be eligible to claim a dividends received deduction with respect to such distributions, non-corporate stockholders would be able to treat such dividend income as “qualified dividend income,” which is subject to reduced rates of U.S. federal income tax. 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 stockholder’s tax basis, and any remaining distributions would be treated as a capital gain. If we fail to qualify as a RIC for a period greater than two taxable years, to requalify as a RIC in a subsequent year we may be subject to regular corporate tax on any net built-in gains with respect to certain of our assets ( i.e. , the excess of the aggregate gains, including items of income, over aggregate losses that would have been realized with respect to such assets if we had been liquidated) that we elect to recognize on requalification or when recognized over the next five years. Our Status as an Emerging Growth Company We ceased to qualify as an “emerging growth company” beginning January 1, 2017. The New York Stock Exchange Corporate Governance Regulations The New York Stock Exchange has adopted corporate governance regulations that listed companies must comply with. We are in compliance with such corporate governance listing standards applicable to BDCs. Regulation as a Small Business Investment Company Our wholly owned subsidiaries’ SBIC licenses allow them to obtain leverage by issuing SBA-guaranteed debentures, subject to customary procedures. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and have a ten-year maturity. The principal amount of SBA- guaranteed debentures is not required to be paid prior to maturity but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed at the time of issuance at a market-driven spread over U.S. Treasury Notes with ten-year maturities. SBICs are designed to stimulate the flow of private equity capital to eligible small businesses. Under SBA regulations, SBICs may make loans to eligible small businesses and invest in the equity securities of small businesses. Under present SBA regulations, eligible small businesses include businesses that have a tangible net worth not exceeding $19.5 million and have average annual fully taxed net income not exceeding $6.5 million for the two most recent fiscal years. In addition, an SBIC must devote 25% of its investment activity to “smaller” enterprises as defined by the SBA. A smaller enterprise is one that has a net worth not 29 TABLE OF CONTENTS exceeding $6 million and has average annual fully taxed net income not exceeding $2 million for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services. SBA regulations currently limit the amount that an SBIC subsidiary may borrow to a maximum of $175.0 million, subject to SBA approval, with sufficient regulatory capital (as such term is defined in SBA regulations). The amount of SBA-guaranteed debentures that affiliated SBIC funds can have outstanding is $350.0 million. As of December 31, 2019, our SBIC I subsidiary had $75.0 million in regulatory capital and $150.0 million in SBA-guaranteed debentures outstanding, which approximated their fair value. As of December 31, 2019, our SBIC II subsidiary had $20.0 million in regulatory capital and $11.0 million in SBA- guaranteed debentures outstanding, which approximated their fair value. We have received exemptive relief from the SEC to permit us to exclude the debt of our SBIC subsidiaries guaranteed by the SBA from the definition of senior securities in the 150% asset coverage test under the 1940 Act. This allows us increased flexibility under the 150% asset coverage test by permitting us to borrow up to $325.0 million more (subject to SBA approval) than we would otherwise be able to absent the receipt of this exemptive relief. The SBA restricts the ability of SBICs to repurchase their capital stock. SBA regulations also include restrictions on a “change of control” or transfer of an SBIC and require that SBICs invest idle funds in accordance with SBA regulations. In addition, our SBIC subsidiaries may also be limited in their ability to make distributions to us if they do not have sufficient capital, in accordance with SBA regulations. Our SBIC subsidiaries are subject to regulation and oversight by the SBA, including requirements with respect to maintaining certain minimum financial ratios and other covenants. Receipt of an SBIC license does not assure that our SBIC subsidiaries will receive SBA guaranteed debenture funding, which is dependent upon our SBIC subsidiaries continuing to be in compliance with SBA regulations and policies. The SBA, as a creditor, will have a superior claim to our SBIC subsidiaries’ assets over our stockholders in the event we liquidate one or both of our SBIC subsidiaries or the SBA exercises its remedies under the SBA-guaranteed debentures issued by our SBIC subsidiaries upon an event of default. 30 TABLE OF CONTENTS Item 1A. Risk Factors RISK FACTORS 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, our net asset value 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 We are dependent upon key personnel of Stellus Capital Management for our future success. If Stellus Capital Management 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 and network of business contacts of the senior investment professionals of Stellus Capital Management to achieve our investment objective. Stellus Capital Management’s team of investment professionals evaluates, negotiates, structures, closes and monitors our investments in accordance with the terms of our investment advisory agreement. We can offer no assurance, however, that Stellus Capital Management’s investment professionals will continue to provide investment advice to us. Stellus Capital Management’s investment committee, which provides oversight over our investment activities, is provided to us by Stellus Capital Management under the investment advisory agreement. Stellus Capital Management’s investment committee consists of five members, including Messrs. Ladd, D’Angelo and Davis, each a member of our Board, Mr. Huskinson, chief financial officer and chief compliance officer for us and Stellus Capital Management and Mr. Overbergen, a senior investment professional of Stellus Capital Management. The loss of any of Messrs. Ladd, D’Angelo, Davis or Huskinson may limit our ability to achieve our investment objective and operate our business. This could have a material adverse effect on our financial condition, results of operations and cash flows. Our business model depends to a significant extent upon strong referral relationships. Any inability of Stellus Capital Management 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 investment professionals Stellus Capital Management to maintain their relationships with private equity sponsors, placement agents, investment banks, management groups and other financial institutions, and we rely to a significant extent upon these relationships to provide us with potential investment opportunities. If the investment professionals of Stellus Capital Management fail to maintain such relationships, or to develop new relationships with other sources of investment opportunities, we will not be able to grow our investment portfolio. In addition, individuals with whom the investment professionals of Stellus Capital Management have 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 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 Stellus Capital Management’s 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 Stellus Capital Management’s execution 31 TABLE OF CONTENTS 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. Stellus Capital Management’s senior investment professionals will have substantial responsibilities in connection with the management of other investment funds, accounts and investment vehicles. The personnel of Stellus Capital Management may be called upon to provide managerial assistance to our portfolio companies. These activities may distract them from sourcing 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. There are significant potential conflicts of interest that could negatively affect our investment returns. The members of Stellus Capital Management’s investment committee 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, or of investment funds, accounts, or investment vehicles managed by Stellus Capital Management. Similarly, Stellus Capital Management 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. For example, Stellus Capital Management currently manages private credit funds that have an investment strategy that is similar to, overlapping with or identical to our investment strategy, and with which we co-invest. Stellus Capital Management also provides sub-advisory services to the D. E. Shaw group with respect to a private investment fund and a strategy of a private multi-strategy investment fund to which the D. E. Shaw group serves as investment adviser that have an investment strategy similar to our investment strategy. In addition, there may be times when Stellus Capital Management, members of its investment committee or its other investment professionals have interests that differ from those of our stockholders, giving rise to a conflict of interest. In particular, a private investment fund for which Stellus Capital Management provides investment advisory services hold minority equity interests in certain of the portfolio companies in which we hold debt investments. As a result, Stellus Capital Management, members of its investment committee or its other investment professionals may face conflicts of interest in connection with making business decisions for these portfolio companies to the extent that such decisions affect the debt and equity holders in these portfolio companies differently. In addition, Stellus Capital Management may face conflicts of interests in connection with making investment or other decisions, including granting loan waivers or concessions, on our behalf with respect to these portfolio companies given that they also provide investment advisory services to a private investment fund that holds the equity interests in these portfolio companies. Although our investment adviser will endeavor to handle these investment and other decisions in a fair and equitable manner, we and the holders of the shares of our common stock could be adversely affected by these decisions. Moreover, given the subjective nature of the investment and other decisions made by our investment adviser on our behalf, we are unable to monitor these potential conflicts of interest between us and our investment adviser; however, our Board, including the independent directors, reviews conflicts of interest in connection with its review of the performance of our investment adviser. The senior investment professionals and other investment team members of Stellus Capital Management may, from time to time, possess material non-public information, limiting our investment discretion. The senior investment professionals and other investment team members of Stellus Capital Management, including members of Stellus Capital Management’s investment committee, may serve as directors of, or in a similar capacity with, portfolio companies in which we invest, the securities of which are purchased or sold on our behalf. 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. Our management and incentive fees may induce Stellus Capital Management to incur additional leverage. Generally, the management and incentive fees payable by us to Stellus Capital Management may create an incentive for Stellus Capital Management to use the additional available leverage if this proposal is 32 TABLE OF CONTENTS approved. For example, the fact that the base management fee that we pay to Stellus Capital Management is payable based upon our gross assets (which includes any borrowings for investment purposes) may encourage Stellus Capital Management to use leverage to make additional investments. 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 cyclical economic downturns. Under certain circumstances, the use of additional leverage may increase the likelihood of our default on our borrowings, which would disfavor holders of our common stock. In addition, because the incentive fee on net investment income is calculated as a percentage of our net assets subject to a hurdle, having additional leverage available may encourage Stellus Capital Management to use leverage to increase the leveraged return on our investment portfolio. To the extent additional leverage is available at favorable rates, Stellus Capital Management could use leverage to increase the size of our investment portfolio to generate additional income, which may make it easier to meet the incentive fee hurdle. Our adoption of the reduced minimum asset coverage will allow us to incur additional leverage above the previous 1940 Act limitations. As a result, the incentives for Stellus Capital Management to cause us to use additional leverage may be greater. Our Board is charged with protecting our interests by monitoring how Stellus Capital Management addresses these and other conflicts of interests associated with its management services and compensation. While our Board is not expected to review or approve each investment decision, borrowing or incurrence of leverage, our independent directors will periodically review Stellus Capital Management’s 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. Our incentive fee may induce Stellus Capital Management to make speculative investments. We pay Stellus Capital Management 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 incentive fee based on net capital gains. Additionally, under the incentive fee structure, Stellus Capital Management may benefit when capital gains are recognized and, because Stellus Capital Management will determine when to sell a holding, Stellus Capital Management will control the timing of the recognition of such capital gains. As a result, Stellus Capital Management may have a tendency to invest more capital in investments that are likely to result in capital gains as 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 Stellus Capital Management 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. Stellus Capital Management 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 and subject to a total return requirement. The general effect of this total return requirement is to prevent payment of the foregoing incentive compensation except to the extent 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 incentive fees accrued and/or paid for the 11 preceding calendar quarters. Consequently, we may pay an incentive fee if we incurred losses more than three years prior to the current calendar quarter even if such losses have not yet been recovered in full. Thus, we may be required to pay Stellus Capital Management 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 20.0% 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. 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, commercial and investment banks, commercial financing companies and, to the 33 TABLE OF CONTENTS 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 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 are 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 may also compete for investment opportunities with investment funds, accounts and investment vehicles managed by Stellus Capital Management. Although Stellus Capital Management will allocate opportunities in accordance with its policies and procedures, allocations to such investment funds, accounts and investment vehicles will reduce the amount and frequency of opportunities available to us and may not be in the best interests of us and our stockholders. We will be subject to corporate-level income tax and may default under our revolving credit facility if we are unable to maintain our tax treatment as a RIC under Subchapter M of the Code. To maintain our tax treatment as a RIC under Subchapter M of the Code, we must meet certain source-of- income, asset diversification and distribution requirements. 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 are 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 tax treatment as a RIC. If we are unable to obtain cash from other sources, we may fail to maintain our tax treatment as a RIC and, thus, may be subject to corporate-level income tax. To maintain our tax treatment 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 tax treatment 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 or the other requirements necessary to maintain our tax treatment as a RIC. If we fail to maintain our tax treatment 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. Furthermore, if we fail to maintain our tax treatment as a RIC, we may be in default under the terms of our $220.0 million senior secured revolving credit facility with various lenders (the “Credit Facility”). Such a failure could have a material adverse effect on us and our stockholders. 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 include in income certain amounts that we have not yet received in cash, such as the accrual of original issue discount. 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 original issue discount, which could be significant relative to our overall investment activities and increases 34 TABLE OF CONTENTS in loan balances as a result of contracted PIK arrangements are 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 tax treatment 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 tax treatment as a RIC and thus be subject to corporate-level income tax. 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 Stellus Capital Management. Certain of our debt investments may 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 Stellus Capital Management is based on the value of our gross assets, the receipt by us 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 by us to Stellus Capital Management. 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 that has satisfied certain requirements to issue senior securities in amounts such that our asset coverage ratio, as defined in the 1940 Act, equals at least 150% 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 150% asset coverage ratio applicable to us 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 determines that such sale is in our best interests, and if our stockholders approve such sale. A proposal, approved by our stockholders at our 2019 annual stockholders meeting, authorizes us to sell shares equal to up to 25% of our outstanding common stock of our common stock below the then current net asset value per share of our common stock in one or more offerings. This approval will expire on the earlier of our 2020 annual stockholder meeting or July 22, 2020, the one-year anniversary of our 2019 annual stockholders meeting. The proposal approved by 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. We would need similar future approval from our stockholders to issue shares below the then current net asset value per share any time after the expiration of the current approval. In addition, we intend to distribute between 90% and 100% of our taxable income to our stockholders in order to satisfy the requirements applicable to RICs under Subchapter M of the Code. Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio companies or to 35 TABLE OF CONTENTS repay borrowings. In addition, the illiquidity of our portfolio investments may make it difficult for us to sell these investments when desired and, if we are required to sell these investments, we may realize significantly less than their recorded value. In addition, we cannot issue shares of our common stock below net asset value unless our Board 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, then the percentage ownership of our stockholders at that time will decrease, and you may experience dilution. 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 investing 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. We, through our SBIC subsidiaries, intend to issue debt securities guaranteed by the SBA and sold in the capital markets. Upon any such issuance of debt securities and as a result of its guarantee of the debt securities, if any, the SBA would also have fixed dollar claims on the assets of our SBIC subsidiaries that are superior to the claims of our common stockholders. Upon the issuance of any debt securities guaranteed by the SBA, if we are unable to meet the financial obligations under our 5.75% notes due 2022 or (the “2022 Notes”) or the Credit Facility, the SBA, as a creditor, would have a superior claim to the assets of our SBIC subsidiaries over our stockholders in the event we liquidate or the SBA exercises its remedies under such debentures as the result of a default by us. In addition, under the terms of the Credit Facility 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. Our ability to service any debt depends largely on our financial performance and is subject to prevailing economic conditions and competitive pressures. Moreover, as the base management fee payable to Stellus Capital Management is payable based on the value of our gross assets, including those assets acquired through the use of leverage, Stellus Capital Management will have a financial incentive to incur leverage, which may not be consistent with our stockholders’ interests. In addition, our common stockholders 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 Stellus Capital Management. As a BDC that has satisfied certain requirements under the 1940 Act, 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 at least 150%. If this ratio declines below 150%, we will not be able to incur additional debt until we are able to comply with the 150% asset coverage ratio applicable to us under the 1940 Act. 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 Stellus Capital Management’s and our Boards’ 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. We have received exemptive relief from the SEC to permit us to exclude the debt of our SBIC subsidiaries guaranteed by the SBA from the definition of senior securities in the 150% asset coverage ratio we are 36 TABLE OF CONTENTS required to maintain under the 1940 Act. This relief allows us increased flexibility under the 150% asset coverage test by allowing us to borrow up to $325 million more through our SBIC subsidiaries than we would otherwise be able to borrow absent the receipt of this exemptive relief. 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. Substantially all of our assets are subject to security interests under the Credit Facility or claims of the SBA with respect to SBA-guaranteed debentures we may issue and, if we default on our obligations thereunder, we may suffer adverse consequences, including foreclosure on our assets. As of December 31, 2019, substantially all of our assets were pledged as collateral under the Credit Facility or are subject to a superior claim over the holders of our common stock by the SBA pursuant to the SBA- guaranteed debentures. If we default on our obligations under the Credit Facility or the SBA-guaranteed debentures the lenders and/or the SBA may have the right to foreclose upon and sell, or otherwise transfer, the collateral subject to their security interests or their superior claim. In such event, we may be forced to sell our investments to raise funds to repay our outstanding borrowings in order to avoid foreclosure and these forced sales may be at times and at prices we would not consider advantageous. Moreover, such deleveraging of our company could significantly impair our ability to effectively operate our business in the manner in which we have historically operated. As a result, we could be forced to curtail or cease new investment activities and lower or eliminate the dividends that we have historically paid to our stockholders. In addition, if the lenders exercise their right to sell the assets pledged under the Credit Facility, such sales may be completed at distressed sale prices, thereby diminishing or potentially eliminating the amount of cash available to us after repayment of the amounts outstanding under the Credit Facility. Because we use debt to finance our investments and may in the future issue senior securities including preferred stock and debt securities, 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 and may in the future issue additional senior securities including preferred stock and debt securities, 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 to limit our exposure to interest rate fluctuations. 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 to the extent permitted by the 1940 Act. For example, to the extent any such instruments were to constitute senior securities under the 1940 Act, we would have to and will comply with the asset coverage requirements thereunder or, as permitted in lieu thereof, place certain assets in a segregated account to cover such instruments in accordance with SEC guidance, including, for example, Investment Company Act Release No. IC- 10666, as applicable. There is otherwise no limit as to our ability to enter into such 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 Stellus Capital Management. Adverse developments resulting from changes in interest rates or hedging transactions could have a material adverse effect on our business, financial condition and results of operations. Provisions in the Credit Facility or any other future borrowing facility may limit our discretion in operating our business. The Credit Facility is, 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 37 TABLE OF CONTENTS 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 guarantee 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 Credit Facility or any other borrowing facility may limit our ability to incur additional liens or 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. For example, under the terms of the Credit Facility, we have generally agreed to not incur any additional secured indebtedness, other than certain indebtedness that we may incur, in accordance with the Credit Facility, to allow us to purchase investments in U.S. Treasury Bills. In addition, we have agreed not to incur any additional indebtedness that has a maturity date prior to the maturity date of the Credit Facility. Further, if our borrowing base under the Credit Facility 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 Credit Facility 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 Credit Facility or any other borrowing facility, we may be subject to limitations as to how borrowed funds may be used, which may include restrictions on geographic and industry concentrations, 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. Furthermore, we expect that the terms of the Credit Facility will contain a covenant requiring us to maintain compliance with RIC provisions at all times, subject to certain remedial provisions. Thus, a failure to maintain compliance with RIC provisions could result in an event of default under the Credit Facility. An event of default under the Credit Facility 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 Credit Facility 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. We may in the future determine to fund a portion of our investments with preferred stock, which would magnify the potential for gain or loss and the risks of investing in us in the same way as our borrowings. Preferred stock, which is another form of leverage, has the same risks to our common stockholders as borrowings because the dividends on any preferred stock we issue must be cumulative. Payment of such dividends and repayment of the liquidation preference of such preferred stock must take preference over any dividends or other payments to our common stockholders, and preferred stockholders are not subject to any of our expenses or losses and are not entitled to participate in any income or appreciation in excess of their stated preference. Adverse developments in the credit markets may impair our ability to enter into any other future borrowing facility. 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 38 TABLE OF CONTENTS financial institutions limited refinancing and loan modification transactions and reviewed the terms of existing facilities to identify bases for accelerating the maturity of existing lending facilities. If these conditions recur (for example, as a result of a broadening of the current Euro zone credit crisis), it may be difficult for us to enter into a new borrowing facility, obtain other financing to finance the growth of our investments, or refinance any outstanding indebtedness on acceptable economic terms, or at all. Most of our portfolio investments are recorded at fair value as determined in good faith by our Board 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 value these investments at fair value as determined in good faith by our Board, including to reflect significant events affecting the value of our investments. Most, if not all, of our investments (other than cash and cash equivalents) are classified as Level 3 under ASC Topic 820. This means that our portfolio valuations are 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 value of our portfolio investments require significant management judgment or estimation. Even if observable market data is 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 Board 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 company’s 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 Boards’ 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 expose ourselves to risks if we engage in hedging 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. Use of these hedging instruments may expose us to counter- party credit risk. 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 portfolio positions should increase. Moreover, it may not be possible to hedge against an exchange rate or interest rate fluctuation that is generally anticipated at an acceptable price. 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 39 TABLE OF CONTENTS 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 incur significant costs as a result of being a publicly traded company. As a publicly traded company, we incur legal, accounting, investor relations and other expenses, including costs associated with corporate governance requirements, such as those under the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, other rules implemented by the SEC and the listing standards of the NYSE. Our independent registered public accounting firm is required to attest to the effectiveness of our internal controls over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, which increases the costs associated with our periodic reporting requirements. We are obligated to maintain proper and effective internal control over financial reporting. We may not complete our analysis of our internal control over financial reporting in a timely manner, or our internal controls may not be determined to be effective, which may adversely affect investor confidence in our company and, as a result, the value of our securities. We are required to comply with the independent auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act. Complying with Section 404 requires a rigorous compliance program as well as adequate time and resources. We may not be able to complete our internal control evaluation, testing and any required remediation in a timely fashion. Additionally, if we identify one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal controls are effective. If we are unable to assert that our internal control over financial reporting is effective, or if our auditors are unable to attest to management’s report on the effectiveness of our internal controls, we could lose investor confidence in the accuracy and completeness of our financial reports, which would have a material adverse effect on the price of our securities. 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. An independent assessment of the effectiveness of our internal controls could detect problems that our management’s 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. New or modified laws or regulations governing our operations may adversely affect our business. We and our portfolio companies are 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 may shift our investment focus from the areas of expertise of Stellus Capital Management to other types of investments in which Stellus Capital Management 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. Legislative or other actions relating to taxes could have a negative effect on us. 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. In 2017, the U.S. House of Representatives and U.S. Senate passed tax reform legislation, which the President signed into law. Such 40 TABLE OF CONTENTS legislation makes many changes to the Internal Revenue 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 us, investors or our portfolio investments. New legislation and any U.S. Treasury regulations, administrative interpretations or court decisions interpreting such legislation could significantly and negatively affect our ability to qualify for tax treatment as a RIC or the U.S. federal income tax consequences to us and our investors of such qualification or could have other adverse consequences. Investors are urged to consult with their tax advisor regarding tax legislative, regulatory or administrative developments and proposals and their potential effect on an investment in our securities. Any failure to comply with SBA regulations could have an adverse effect on our SBIC subsidiaries’ operations. On June 20, 2014 and August 14, 2019, our wholly owned subsidiaries, Stellus Capital SBIC LP, and Stellus Capital SBIC II LP, respectively, received licenses from the SBA to operate as SBICs. The SBA places certain limitations on the financing terms of investments by SBICs in portfolio companies and prohibits SBICs from providing funds for certain purposes or to businesses in a few prohibited industries. Compliance with SBIC requirements may cause our SBIC subsidiaries to forgo attractive investment opportunities that are not permitted under SBA regulations. Further, SBA regulations require that an SBIC be examined by the SBA to determine its compliance with the relevant SBA regulations at least every two years. The SBA prohibits, without prior SBA approval, a “change of control” of an SBIC or transfers that would result in any person (or a group of persons acting in concert) owning 10% or more of a class of capital stock of an SBIC. If either of our SBIC subsidiaries fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit its use of debentures, declare outstanding debentures immediately due and payable, and/or limit it from making new investments. In addition, the SBA can revoke or suspend a license for willful or repeated violation of, or willful or repeated failure to observe, any provision of the Small Business Investment Act of 1958 or any rule or regulation promulgated thereunder. These actions by the SBA would, in turn, negatively affect us because our SBIC subsidiaries are our wholly owned subsidiaries. Changes to United States tariff and import/export regulations may have a negative effect on our portfolio companies and, in turn, may have a negative impact on our business. There has been on-going discussion and commentary regarding potential significant changes to United States trade policies, treaties and tariffs. The current administration, along with Congress, has created significant uncertainty about the future relationship between the United States and other countries with respect to the trade policies, treaties and tariffs. These developments, or the perception that any of them could occur, may have a material adverse effect on global economic conditions and the stability of global financial markets, and may significantly reduce global trade and, in particular, trade between the impacted nations and the United States. Any of these factors could depress economic activity and restrict our portfolio companies’ access to suppliers or customers and have a material adverse effect on their business, financial condition and results of operations, which in turn would negatively impact our business. Risks Related to Our Operations Because we intend to distribute substantially all of our income to our stockholders to obtain and maintain our status as a RIC, we will continue to need additional capital to finance our growth. If additional funds are unavailable or not available on favorable terms, our ability to grow may be impaired. We will 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 41 TABLE OF CONTENTS 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 shares of common stock. As a BDC that has satisfied certain conditions under the 1940 Act, we are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities and excluding SBA- guaranteed debentures as permitted by exemptive relief obtained from the SEC, to total senior securities, which includes all of our borrowings with the exception of SBA-guaranteed debentures, of at least 150%. This requirement limits the amount that we may borrow. Since we continue to need capital to grow our investment portfolio, these limitations may prevent us from incurring debt and require us to raise additional equity at a time when it may be disadvantageous to do so. While we expect that we will be able to borrow and to issue additional debt securities and expect that we will be able to issue additional equity securities, which would in turn increase the equity capital available to us, we cannot assure you that debt and equity financing will be available to us on favorable terms, or at all. In addition, as a BDC, we generally are not permitted to issue equity securities priced below net asset value without stockholder approval. If additional funds are not available us, we may be forced to curtail or cease new investment activities, and our net asset value could decline. Our wholly owned SBIC subsidiaries may be unable to make distributions to us that will enable us to maintain RIC tax treatment, which could result in the imposition of an entity-level tax. In order for us to continue to qualify for RIC tax treatment and to minimize corporate-level taxes, we are required to distribute substantially all of our net ordinary income and net capital gain income, including income from certain of our subsidiaries, which includes the income from our SBIC subsidiaries. We are partially dependent on our SBIC subsidiaries for cash distributions to enable us to meet the RIC distribution requirements. Our SBIC subsidiaries may be limited by the Small Business Investment Act of 1958, and SBA regulations governing SBICs, from making certain distributions to us that may be necessary to maintain our tax treatment as a RIC. We may have to request a waiver of the SBA’s restrictions for our SBIC subsidiaries to make certain distributions to maintain our RIC tax treatment. We cannot assure you that the SBA will grant such waiver and if our SBIC subsidiaries are unable to obtain a waiver, compliance with the SBA regulations may result in loss of RIC tax treatment and a consequent imposition of an entity-level tax on us. Our ability to enter into certain transactions with our affiliates is restricted, which may limit the scope of investments available to us. We are prohibited under the 1940 Act from participating in certain transactions with our affiliates without the prior approval of our independent directors and, in some cases, the SEC. Any person that owns, directly or indirectly, 5% or more of our outstanding voting securities will be our affiliate for purposes of the 1940 Act, and we are generally prohibited from buying or selling any security from or to such affiliate without the prior approval of our independent directors. The 1940 Act also prohibits certain “joint” transactions with certain of our affiliates, which could include concurrent investments in the same portfolio company, without prior approval of our independent directors and, in some cases, of the SEC. We are prohibited from buying or selling any security from or to any person that controls us or who owns more than 25% of our voting securities or certain of that person’s affiliates, or entering into prohibited joint transactions with such persons, absent the prior approval of the SEC. As a result of these restrictions, we may be prohibited from buying or selling any security (other than any security of which we are the issuer) from or to any portfolio company of a private fund managed by Stellus Capital Management or its affiliates without the prior approval of the SEC, which may limit the scope of investment opportunities that would otherwise be available to us. We have received exemptive relief from the SEC to co-invest with investment funds managed by Stellus Capital Management (other than the D. E. Shaw group funds, as defined below) where doing so is consistent with our investment strategy as well as applicable law (including the terms and conditions of the exemptive order issued by the SEC). Under the terms of the relief permitting us to co-invest with other funds managed by Stellus Capital Management, a “required majority” (as defined in Section 57(o) of the 1940 Act) of our independent directors must make certain conclusions in connection with a co-investment transaction, including that (1) the terms of the proposed transaction, including the consideration to be paid, are 42 TABLE OF CONTENTS reasonable and fair to us and our stockholders and do not involve overreaching of us or our stockholders on the part of any person concerned and (2) the transaction is consistent with the interests of our stockholders and is consistent with our investment objectives and strategies. The involvement of our interested directors in the valuation process may create conflicts of interest. We make many of our portfolio investments in the form of loans and securities that are not publicly traded and for which no market-based price quotation is available. As a result, our Board determines the fair value of these loans and securities in good faith as described elsewhere in this annual report on Form 10-K. In connection with that determination, investment professionals from Stellus Capital Management provide our Board 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 is reviewed by an independent valuation firm at least twice annually, the ultimate determination of fair value is made by our Board, including our interested directors, and not by such third-party valuation firm. In addition, Messrs. Ladd, D’Angelo and Davis, each an interested member of our Board, has a direct pecuniary interest in Stellus Capital Management. The participation of Stellus Capital Management’s investment professionals in our valuation process, and the pecuniary interest in Stellus Capital Management by certain members of our Board, could result in a conflict of interest as Stellus Capital Management’s management fee is based, in part, on the value of our gross assets, and incentive fees are based, in part, on realized gains and realized and unrealized losses. There are conflicts related to other arrangements with Stellus Capital Management. We have entered into a license agreement with Stellus Capital Management under which Stellus Capital Management has agreed to grant us a non-exclusive, royalty-free license to use the name “Stellus Capital.” In addition, we have entered into an administration agreement with Stellus Capital Management pursuant to which we are required to pay to Stellus Capital Management our allocable portion of overhead and other expenses incurred by Stellus Capital Management in performing its obligations under such administration agreement, such as rent and our allocable portion of the cost of our chief financial officer and chief compliance officer and his staff. This will create conflicts of interest that our Board will monitor. For example, under the terms of the license agreement, we will be unable to preclude Stellus Capital Management from licensing or transferring the ownership of the “Stellus Capital” 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 Stellus Capital Management or others. Furthermore, in the event the license agreement is terminated, we will be required to change our name and cease using “Stellus Capital” as part of our name. Any of these events could disrupt our recognition in the marketplace, damage any goodwill we may have generated and otherwise harm our business. The investment advisory agreement and the administration agreement with Stellus Capital Management were not negotiated on an arm’s 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 Stellus Capital Management, 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 Stellus Capital Management and its affiliates. Any such decision, however, would breach our fiduciary obligations to our stockholders. The time and resources that Stellus Capital Management devote to us may be diverted, and we may face additional competition due to the fact that Stellus Capital Management and its affiliates are not prohibited from raising money for, or managing, another entity that makes the same types of investments that we target. Stellus Capital Management 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. For example, Stellus Capital Management currently manages private credit funds that have investment strategies that are similar, overlapping or identical to our investment 43 TABLE OF CONTENTS strategy and with which we co-invest. In addition, pursuant to sub-advisory arrangements, Stellus Capital Management provides non-discretionary advisory services to the D. E. Shaw group related to a private investment fund and a strategy of a private multi-strategy investment fund to which the D. E. Shaw group serves as investment adviser. As a result, the time and resources they could devote to us may be diverted. In addition, we may compete with any such investment entity for the same investors and investment opportunities. Our incentive fee arrangements with Stellus Capital Management may vary from those of other investment funds, account or investment vehicles managed by Stellus Capital Management, which may create an incentive for Stellus Capital Management to devote time and resources to a higher fee-paying fund. If Stellus Capital Management is paid a higher performance-based fee from any of its other funds, 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 Stellus Capital Management’s 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. Stellus Capital Management’s liability is limited under the investment advisory agreement and we have agreed to indemnify Stellus Capital Management against certain liabilities, which may lead Stellus Capital Management to act in a riskier manner on our behalf than it would when acting for its own account. Under the investment advisory agreement, Stellus Capital Management 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 in following or declining to follow Stellus Capital Management’s advice or recommendations. Under the investment advisory agreement, Stellus Capital Management, its officers, members and personnel, and any person controlling or controlled by Stellus Capital Management will not be liable to us, any subsidiary of ours, our directors, our stockholders or any subsidiary’s 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 misfeasance, bad faith or reckless disregard of the duties that Stellus Capital Management owes to us under the investment advisory agreement. In addition, as part of the investment advisory agreement, we have agreed to indemnify Stellus Capital Management 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 misfeasance, bad faith or reckless disregard of such person’s duties under the investment advisory agreement. These protections may lead Stellus Capital Management to act in a riskier manner when acting on our behalf than it would when acting for its own account. Stellus Capital Management can resign as our investment 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. Stellus Capital Management has the right under the investment advisory agreement to resign as our investment adviser at any time upon 60 days’ written notice, whether we have found a replacement or not. Similarly, Stellus Capital Management has the right under the administration agreement to resign at any time upon 60 days’ written notice, whether we have found a replacement or not. If Stellus Capital Management was 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 Stellus Capital Management. Even if we are able to retain comparable management, whether internal or external, the integration of such management and 44 TABLE OF CONTENTS 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. If we fail to maintain our status as a BDC, our business and operating flexibility could be significantly reduced. We have elected to be regulated as a BDC under the 1940 Act. The 1940 Act imposes numerous constraints on the operations of BDCs. For example, BDCs are required to invest at least 70.0% of their total assets in specified types of securities, primarily in private companies or thinly traded U.S. public companies, cash, cash equivalents, U.S. government securities and other high quality debt investments that mature in one year or less. Failure to comply with the requirements imposed on BDCs by the 1940 Act could cause the SEC to bring an enforcement action against us and/or expose us to claims of private litigants. In addition, upon approval of a majority of our stockholders, we may elect to withdraw their respective election as a BDC. If we decide to withdraw our election, we may be required to register as an investment company under the 1940 Act and be subject to the substantially greater regulation under the 1940 Act as a closed-end investment company. Compliance with these regulations would significantly decrease our operating flexibility and could significantly increase our cost of doing business. If we do not invest a sufficient portion of our assets in qualifying assets, we could violate the 1940 Act provisions applicable to BDCs 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). If we do not maintain our election to be regulated 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. We may experience fluctuations in our annual and quarterly operating results. We could experience fluctuations in our annual and 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. Our Board may change our investment objective, operating policies and strategies without prior notice or stockholder approval. Our Board has the authority, except as otherwise provided in the 1940 Act, to modify or waive 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. 45 TABLE OF CONTENTS Our Board 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 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 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 could authorize the issuance of shares of preferred stock with terms and conditions which 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. 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. 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. 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. The Maryland General Corporation Law and our charter and bylaws contain provisions that may discourage, delay or make more difficult a change in control of Stellus Capital Investment Corporation 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 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, including approval by a majority of our independent directors. If the resolution exempting business combinations is repealed or our Board 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 in three classes serving staggered three-year terms, and authorizing our Board 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. 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 Stellus Capital Management. In addition, certain of these systems are provided to Stellus Capital Management by third party service providers. Any failure or interruption of such systems, including as a result of the termination of 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. 46 TABLE OF CONTENTS 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, a terrorist attack or war, public health crises (including the recent coronavirus outbreak), 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. Risks Related to Economic Conditions Global economic, political and market conditions may adversely affect our business, results of operations and financial condition, including our revenue growth and profitability. The current worldwide financial market situation, as well as various social and political tensions in the United States and around the world, may contribute to increased market volatility, may have long-term effects on the United States and worldwide financial markets and may cause economic uncertainties or deterioration in the U.S. and worldwide. The impact of downgrades by rating agencies to the U.S. government’s sovereign credit rating or its perceived creditworthiness as well as potential government shutdowns could adversely affect the U.S. and global financial markets and economic conditions. Since 2010, several European Union, or EU, countries have faced budget issues, some of which may have negative long-term effects for the economies of those countries and other EU countries. There is continued concern about national-level support for the Euro and the accompanying coordination of fiscal and wage policy among European Economic and Monetary Union member countries. In addition, the fiscal policy of foreign nations, such as Russia and China, may have a severe impact on the worldwide and U.S. financial markets. The decision made in the United Kingdom referendum to leave the EU (“Brexit”) has led to volatility in global financial markets and may lead to weakening in consumer, corporate and financial confidence in the United Kingdom and Europe. While the United Kingdom exited the EU on January 31, 2020, uncertainty remains as to the effects of the transition period and the United Kingdom’s ability to negotiate a free trade deal, which may lead to continued volatility. Additionally, volatility in the Chinese stock markets and global markets for commodities may affect other financial markets worldwide. We cannot predict the effects of these or similar events in the future on the U.S. and global economies and securities markets or on our investments. We monitor developments in economic, political and market conditions and seek to manage our investments in a manner consistent with achieving our investment objective, but there can be no assurance that we will be successful in doing so. The Chinese capital markets have experienced periods of instability over the past several years. The current political climate has also intensified concerns about a potential trade war between the U.S. and China in connection with each country’s recent or proposed tariffs on the other country’s products. These market and economic disruptions, the potential trade war with China and the impact of public health epidemics like the coronavirus currently affecting China and the wider global community may have a material adverse impact on the ability of our portfolio companies to fulfill their end customers’ orders due to supply chain delays, limited access to key commodities or technologies or other events that impact their manufacturers or their suppliers. Such events have affected, and may in the future affect, the global and U.S. capital markets, and our business, financial condition or results of operations. 47 TABLE OF CONTENTS Risks Related to our Investments Economic recessions or downturns could impair our portfolio companies, which would harm our operating results. Many of the portfolio companies in which we make, and 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. Therefore, 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 company’s 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 company’s 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. In addition, lenders in certain cases can be subject to lender liability claims for actions taken by them when they become too involved in the borrower’s business or exercise control over a borrower. It is possible that we could become subject to a lender’s liability claim, including as a result of actions taken if we render significant managerial assistance to the borrower. Furthermore, if one of our portfolio companies were to file for bankruptcy protection, a bankruptcy court might re-characterize our debt holding and subordinate all or a portion of our claim to claims of other creditors, even though we may have structured our investment as senior secured debt. The likelihood of such a re- characterization would depend on the facts and circumstances, including the extent to which we provided managerial assistance to that portfolio company. Our investments in leveraged portfolio companies may be risky, and we could lose all or part of our investment. 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. 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. Leveraged companies may 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 adversary 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 creditor’s 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 debtor’s 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. 48 TABLE OF CONTENTS 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 rely on the ability of Stellus Capital Management’s investment professionals to obtain adequate information to evaluate the potential returns 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. The lack of liquidity in our investments may adversely affect our business. Most of our assets are invested in illiquid loans and securities, and a substantial portion of our investments in leveraged companies are subject to legal and other restrictions on resale or are otherwise 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 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. 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; security covenants; call protection provisions; information rights; the nature and realizable value of any collateral; the portfolio company’s 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 the principal market and enterprise values. 49 TABLE OF CONTENTS 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. 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 market’s assessment of the issuer. We may also be more susceptible to any single economic or regulatory occurrence than a diversified investment company. 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, in seeking to: • • increase or maintain in whole or in part our position as a creditor or equity ownership percentage in a portfolio company; exercise warrants, options or convertible securities that were acquired in the original or subsequent financing; or • 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. Our ability to make follow-on investments may also be limited by our compliance with the conditions under the exemptive relief order we received from the SEC related to co-investments with investment funds managed by Stellus Capital Management or Stellus Capital Management’s allocation policy. 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 (including those included in our portfolio). As a result, we are 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 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. 50 TABLE OF CONTENTS Defaults by our portfolio companies will harm our operating results. A portfolio company’s 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 company’s 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. 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 our 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. The interest rates of our floating-rate 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 transactions 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 floating-rate loans we extend to portfolio companies such that the interest due to us pursuant to a term loan extended to a portfolio company is calculated using LIBOR. The terms of our debt investments generally include minimum interest rate floors which are calculated based on LIBOR. On July 27, 2017, the U.K. Financial Conduct Authority announced that it intends to stop persuading or compelling banks to submit the London Interbank Offered Rate (“LIBOR”) after 2021. It is unclear if at that time whether 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 U.S. financial institutions, is considering replacing U.S. dollar LIBOR with a new index calculated by short term repurchase agreements, backed by Treasury securities called the Secured Overnight Financing Rate (“SOFR”). The first publication of SOFR was released in April 2018. Whether or not SOFR attains market traction as a LIBOR replacement remains a question and the future of LIBOR at this time is uncertain. Additionally, on June 12, 2019 the Staff of the SEC’s Division of Corporate Finance, Division of Investment Management, Division of Trading and Markets, and Office of the Chief Accountant issued a statement about the potentially significant effects on financial markets and market participants when LIBOR is discontinued in 2021 and no longer available as a reference benchmark rate. The Staff encouraged all market participants to identify contracts that reference LIBOR and begin transitions to alternative rates. On December 30, 2019, the SEC’s Chairman, Division of Corporate Finance and Office of the Chief Accountant issued a statement to encourage audit committees in particular to understand management’s plans to identify and address the risks associated with the elimination of LIBOR, and, specifically, the impact on accounting and financial reporting and any related issues associated with financial products and contracts that reference LIBOR, as the risks associated with the discontinuation of LIBOR and transition to an alternative reference rate will be exacerbated if the work is not completed in a timely manner. The elimination of LIBOR or any other changes or reforms to the determination or supervision of LIBOR could have an adverse impact on the market for or value of any LIBOR-linked securities, loans, and 51 TABLE OF CONTENTS other financial obligations or extensions or credit held by or due to us or on our overall financial condition or results of operations. If LIBOR ceases to exist, we may need to renegotiate the credit agreements extending beyond 2021 with our portfolio companies that utilize LIBOR as a factor in determining the interest rate to replace LIBOR with the new standard that is established. In addition, the cessation of LIBOR could: • • • • • Adversely impact the pricing, liquidity, value of, return on and trading for a broad array of financial products, including any LIBOR-linked securities, loans and derivatives that are included in our assets and liabilities; Require extensive changes to documentation that governs or references LIBOR or LIBOR-based products, including, for example, pursuant to time-consuming renegotiations of existing documentation to modify the terms of outstanding investments; Result in inquiries or other actions from regulators in respect of our preparation and readiness for the replacement of LIBOR with one or more alternative reference rates; Result in disputes, litigation or other actions with portfolio companies, or other counterparties, regarding the interpretation and enforceability of provisions in our LIBOR-based investments, such as fallback language or other related provisions, including, in the case of fallbacks to the alternative reference rates, any economic, legal, operational or other impact resulting from the fundamental differences between LIBOR and the various alternative reference rates; Require the transition and/or development of appropriate systems and analytics to effectively transition our risk management processes from LIBOR-based products to those based on one or more alternative reference rates, which may prove challenging given the limited history of the proposed alternative reference rates; and • Cause us to incur additional costs in relation to any of the above factors. There is no guarantee that a transition from LIBOR to an alternative will not result in financial market disruptions, significant increases in benchmark rates, or borrowing costs to borrowers, any of which could have a material adverse effect on our business, result of operations, financial condition, and unit price. 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. In December 2015 the United Nations, of which the U.S. is a member, adopted a climate accord (the “Paris Agreement”) with the long-term goal of limiting global warming and the short-term goal of significantly reducing greenhouse gas emissions. Although the U.S. ratified the Paris Agreement on November 4, 2016, the current administration announced the U.S. would cease participation. As a result, some of our portfolio companies may become subject to new or strengthened regulations or legislation, at least through November 4, 2020 (the earliest date the U.S. may withdraw from the Paris Agreement), which could increase their operating costs and/or decrease their revenues. Our portfolio companies may incur debt that ranks equally with, or senior to, our investments in such companies. We 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 52 TABLE OF CONTENTS 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 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 company’s 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 company’s 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 company’s 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 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 company’s 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. We may be exposed to special risks associated with bankruptcy cases. One or more of our portfolio companies may be involved in bankruptcy or other reorganization or liquidation proceedings. Many of the events within a bankruptcy case are adversarial and often beyond the control of the creditors. While creditors generally are afforded an opportunity to object to significant actions, we cannot assure you that a bankruptcy court would not approve actions that may be contrary to our 53 TABLE OF CONTENTS interests. There also are instances where creditors can lose their ranking and priority if they are considered to have taken over management of a borrower. To the extent that portfolio companies in which we have invested through a unitranche facility are involved in bankruptcy proceedings, the outcome of such proceedings may be uncertain. For example, it is unclear whether a bankruptcy court would enforce an agreement among lenders which sets the priority of payments among unitranche lenders. In such a case, the “first out” lenders in the unitranche facility may not receive the same degree of protection as they would if the agreement among lenders was enforced. The reorganization of a company can involve substantial legal, professional and administrative costs to a lender and the borrower. It is subject to unpredictable and lengthy delays and during the process a company’s competitive position may erode, key management may depart and a company may not be able to invest adequately. In some cases, the debtor company may not be able to reorganize and may be required to liquidate assets. The debt of companies in financial reorganization will, in most cases, not pay current interest, may not accrue interest during reorganization and may be adversely affected by an erosion of the issuer’s fundamental value. In addition, lenders can be subject to lender liability claims for actions taken by them where they become too involved in the borrower’s business or exercise control over the borrower. For example, we could become subject to a lender liability claim (alleging that we misused our influence on the borrower for the benefit of its lenders), if, among other things, the borrower requests significant managerial assistance from us and we provide that assistance. To the extent we and an affiliate both hold investments in the same portfolio company that are of a different character, we may also face restrictions on our ability to become actively involved in the event that portfolio company becomes distressed as a result of the restrictions imposed on transactions involving affiliates under the 1940 Act. In such cases, we may be unable to exercise rights we may otherwise have to protect our interests as security holders in such portfolio company. If we make subordinated investments, the obligors or the portfolio companies may not generate sufficient cash flow to service their debt obligations to us. We may make subordinated investments that rank below other obligations of the obligor in right of payment. Subordinated investments are subject to greater risk of default than senior obligations as a result of adverse changes in the financial condition of the obligor or economic conditions in general. If we make a subordinated investment in a portfolio company, the portfolio company may be highly leveraged, and its relatively high debt- to-equity ratio may create increased risks that its operations might not generate sufficient cash flow to service all of its debt obligations. The disposition of our investments may result in contingent liabilities. Substantially all of our investments involve loans and private securities. In connection with the disposition of an investment in loans and private securities, 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. 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 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. Changes in healthcare laws and other regulations applicable to some of our portfolio companies’ businesses may constrain their ability to offer their products and services. As of December 31, 2019, our investments in Healthcare & Pharmaceuticals companies represented 14.9% of our total portfolio, at fair value. Changes in healthcare or other laws and regulations applicable to 54 TABLE OF CONTENTS the businesses of some of our portfolio companies may occur that could increase their compliance and other costs of doing business, require significant systems enhancements, or render their products or services less profitable or obsolete, any of which could have a material adverse effect on their results of operations. There has also been an increased political and regulatory focus on healthcare laws in recent years, and new legislation could have a material effect on the business and operations of some of our portfolio companies. Our ability to enter into transactions involving derivatives and financial commitment transactions may be limited. In November 2019, the SEC proposed a rule regarding the ability of a BDC (or a registered investment company) to use derivatives and other transactions that create future payment or delivery obligations (except reverse repurchase agreements and similar financing transactions). If adopted as proposed, BDCs that use derivatives would be subject to a value-at-risk (“VaR”) leverage limit, certain other derivatives risk management program and testing requirements and requirements related to board reporting. These new requirements would apply unless the BDC qualified as a “limited derivatives user,” as defined in the SEC’s proposal. A BDC that enters into reverse repurchase agreements or similar financing transactions would need to aggregate the amount of indebtedness associated with the reverse repurchase agreements or similar financing transactions with the aggregate amount of any other senior securities representing indebtedness when calculating the BDC’s asset coverage ratio. Under the proposed rule, a BDC may enter into an unfunded commitment agreement that is not a derivatives transaction, such as an agreement to provide financing to a portfolio company, if the BDC has a reasonable belief, at the time it enters into such an agreement, that it will have sufficient cash and cash equivalents to meet its obligations with respect to all of its unfunded commitment agreements, in each case as it becomes due. If the BDC cannot meet this test, it is required to treat unfunded commitments as a derivatives transaction subject to the requirements of the rule. Collectively, these proposed requirements, if adopted, may limit our ability to use derivatives and/or enter into certain other financial contracts. Risks Relating to Our Common Stock 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 monthly basis to our stockholders out of assets legally available for distribution (i.e., not subject to any legal restrictions under Maryland law on the distribution thereof). 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. All distributions will be made at the discretion of our Board and will depend on our earnings, financial condition, maintenance of RIC status, compliance with applicable BDC, SBA regulations and such other factors as our Board may deem relative from time to time. We cannot assure you that we will make distributions to our stockholders in the future. 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. In addition, restrictions and provisions in our Credit Facility, the 2022 Notes and any future credit facilities, as well as in the terms of any debt securities we issue, may limit our ability to make distributions in certain circumstances. 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 investor’s basis in our stock and, assuming that an investor holds our stock as a capital asset, thereafter as a capital gain. 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 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 55 TABLE OF CONTENTS 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. 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 securities may involve an above average degree of risk. The investments we make in accordance with our investment objective may result in a higher amount of risk, 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 securities may not be suitable for someone with lower risk tolerance. The market price of our securities 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: • • • • • • • • • • 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, BDCs and SBICs; loss of our qualification as a RIC or BDC or the status of either of our SBIC subsidiaries as a SBIC; changes in earnings or variations in operating results; changes in the value of our portfolio of investments; 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 Stellus Capital Management’s key personnel; operating performance of companies comparable to us; and general economic trends and other external factors. Risks Relating to Our Debt Securities The 2022 Notes are unsecured and therefore are effectively subordinated to any secured indebtedness we have incurred or may incur in the future. The 2022 Notes are not and will not be secured by any of our assets or any of the assets of any future subsidiaries and rank equally in right of payment of our future unsubordinated, unsecured senior 56 TABLE OF CONTENTS indebtedness. As a result, the 2022 Notes are effectively subordinated to any secured indebtedness we or our subsidiaries have incurred and may incur in the future (or any indebtedness that is initially unsecured to which we subsequently grant security) 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 existing or future secured indebtedness and the secured indebtedness of any future 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 2022 Notes. As of December 31, 2019, we had $161.6 million outstanding under the Credit Facility. The indebtedness under the Credit Facility is effectively senior to the 2022 Notes to the extent of the value of the assets securing such indebtedness. The 2022 Notes are structurally subordinated to the indebtedness and other liabilities of any future subsidiaries. The 2022 Notes are obligations exclusively of Stellus Capital Investment Corporation and not of our subsidiaries. None of our subsidiaries are or will be a guarantor of the 2022 Notes and the 2022 Notes are not required to be guaranteed by any subsidiaries we may acquire or create in the future. 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 subsidiaries (and therefore the claims of our creditors, including holders of the 2022 Notes) with respect to the assets of such subsidiaries. Even if we are recognized as a creditor of one or more of our subsidiaries, our claims would still be effectively subordinated to any security interests in the assets of any such subsidiary and to any indebtedness or other liabilities of any such subsidiary senior to our claims. Consequently, the 2022 Notes are structurally subordinated to all indebtedness, including any future SBA- guaranteed debentures, and other liabilities of any of our subsidiaries and any subsidiaries that we may in the future acquire or establish. In addition, our subsidiaries may incur substantial additional indebtedness in the future, all of which would be structurally senior to the 2022 Notes. The indenture under which the 2022 Notes is issued contains limited protection for holders of the 2022 Notes. The indenture under which the 2022 Notes is issued offers limited protection to holders of the 2022 Notes. The terms of the indenture and the 2022 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 an adverse impact on an investment in the 2022 Notes. In particular, the terms of the indenture and the 2022 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 2022 Notes, (2) any indebtedness or other obligations that would be secured and therefore rank effectively senior in right of payment to the 2022 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 2022 Notes and (4) securities, indebtedness or obligations issued or incurred by our subsidiaries or that would be senior to our equity interests in those entities and therefore rank structurally senior to the 2022 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 Section 61(a)(1) of the 1940 Act 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 150% after such borrowings; 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 2022 Notes, including subordinated indebtedness, in each case other than dividends, purchases, redemptions or payments that would cause a violation of Section 18(a)(1)(B) as modified by (i) Section 61(a)(1) of the 1940 Act or any successor provisions and (ii) the exception set forth below, despite the fact that we are not currently subject to such provisions of the 1940 Act in connection with the offer and sale of the 2022 Notes, except that we will be permitted to declare a cash dividend or distribution notwithstanding the prohibition contained in Section 18(a)(1)(B) as modified by Section 61(a)(1) of the 1940 Act, but only up to such amount 57 TABLE OF CONTENTS as is necessary in order for us to maintain our status as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986 and, provided that, any such prohibition will not apply until such time as our asset coverage has been below the minimum asset coverage required pursuant to clause (i) above for more than six consecutive months. If Section 18(a)(1)(B) as modified by Section 61(a)(1) of the 1940 Act were currently applicable to us in connection with the offering of the 2022 Notes, these provisions would 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, were below 150% 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); enter into transactions with affiliates; create liens (including liens on the shares of our subsidiaries) or enter into sale and leaseback transactions; make investments; or create restrictions on the payment of dividends or other amounts to us from our subsidiaries. • • • • • In addition, the indenture does not require us to offer to purchase the 2022 Notes in connection with a change of control or any other event. Furthermore, the terms of the indenture and the 2022 Notes do not protect holders of the 2022 Notes in the event that we experience changes (including significant adverse changes) in our financial condition, results of operations or credit ratings, 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 and take a number of other actions that are not limited by the terms of the 2022 Notes may have important consequences for holders of the 2022 Notes, including making it more difficult for us to satisfy our obligations with respect to the 2022 Notes or negatively affecting the trading value of the 2022 Notes. Other debt we issue or incur in the future could contain more protections for its holders than the indenture and the 2022 Notes, including additional covenants and events of default. For example, the indenture under which the 2022 Notes is issued does not contain cross-default provisions that are contained in the Credit Facility. The issuance or incurrence of any such debt with incremental protections could affect the market for and trading levels and prices of the 2022 Notes. An active trading market for the 2022 Notes may not develop, which could limit the market price of the 2022 Notes. Moreover, the 2022 Notes are not expected to be rated, which may subject them to greater volatility than rated 2022 Notes and particularly, greater than similar securities with an investment grade rating. Although we have listed the 2022 Notes on the NYSE under the symbol “SCA,” we cannot provide any assurances that an active trading market will develop or be maintained for the 2022 Notes. The 2022 Notes are not rated which would impact their trading and subject them to greater price volatility. To the extent they are rated and received a non-investment grade rating, their price and trading activity could be negatively impacted. Moreover, if a rating agency assigns the 2022 Notes a non-investment grade rating, the 2022 Notes may be subject to greater price volatility than securities of similar maturity without such a non-investment grade rating. Certain of the underwriters have advised us that they intend to make a market in the 2022 Notes, but they are not obligated to do so. The underwriters may discontinue any market-making in the 2022 Notes at any time at their sole discretion. Accordingly, we cannot assure you that a liquid trading market will develop for the 2022 Notes, that you will be able to sell your 2022 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 2022 Notes may be harmed. Accordingly, you may be required to bear the financial risk of an investment in the 2022 Notes for an indefinite period of time. 58 TABLE OF CONTENTS We may choose to redeem the 2022 Notes when prevailing interest rates are relatively low. Since September 15, 2019, we have had the option to choose to redeem the 2022 Notes from time to time, especially when prevailing interest rates are lower than the rate borne by the 2022 Notes. If prevailing rates are lower at the time of redemption, holders of the 2022 Notes may not be able to reinvest the redemption proceeds in a comparable security at an effective interest rate as high as the interest rate on the 2022 Notes being redeemed. Our redemption right also may adversely impact a Noteholder’s ability to sell the 2022 Notes as the optional redemption date or period approaches. If we default on our obligations to pay our other indebtedness, we may not be able to make payments on the 2022 Notes. As of December 31, 2019, we had approximately $161.6 million of indebtedness outstanding under the Credit Facility. Any default under the agreements governing our indebtedness, including a default under the Credit Facility or other indebtedness to which we may be a party that is not waived by the required lenders, and the remedies sought by the holders of such indebtedness could make us unable to pay principal, premium, if any, and interest on the 2022 Notes and substantially decrease the market value of the 2022 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 Credit Facility), we could be in default under the terms of the agreements governing such indebtedness. 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 Credit Facility or other debt we may incur in the future could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. 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 operations, or that future borrowings will be available to us under the Credit Facility or otherwise, in an amount sufficient to enable us to meet our payment obligations under the 2022 Notes and 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 2022 Notes sold, sell assets, reduce or delay capital investments, seek to raise additional capital or seek to obtain waivers from the required lenders under the Credit Facility 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 2022 Notes and our other debt. If we breach our covenants under the Credit Facility or other debt and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under the Credit Facility or other debt, the lenders could exercise their 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. Because the Credit Facility has, and any future credit facilities will likely have, customary cross-default provisions, if the indebtedness under the 2022 Notes, the Credit Facility or under any future credit facility is accelerated, we may be unable to repay or finance the amounts due. Item 1B. Unresolved Staff Comments Not applicable. Item 2. Properties We do not own any real estate or other physical properties materially important to our operation. Our headquarters are located at 4400 Post Oak Parkway, Suite 2200, Houston, Texas. We also maintain offices in Charlotte, North Carolina and in the Washington, D.C. area. All locations are provided to us by Stellus Capital Management pursuant to the administration agreement. We believe that our office facilities are suitable and adequate for our business as we contemplate conducting it. 59 TABLE OF CONTENTS Item 3. Legal Proceedings We and Stellus Capital Management are not currently subject to any material legal proceedings, nor, to our knowledge, is any material legal proceeding threatened against us. From time to time, we may be a party to certain legal proceedings in the ordinary course of business, including proceedings relating to the enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations. Item 4. Mine Safety Disclosures Not applicable. 60 TABLE OF CONTENTS PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Our common stock is traded on the New York Stock Exchange, or “NYSE”, under the symbol “SCM.” As of January 31, 2020, we had 10 stockholders of record, which did not include stockholders for whom shares are held in nominee or street name. We generally intend to pay monthly distributions to our stockholders out of assets legally available for distribution. Our monthly distributions, if any, will be determined by our board of directors. From Inception to December 2013, we paid dividends equivalent to $.1133 per share on a quarterly basis. Beginning in January 2014, we have paid aggregate monthly dividends of $0.1133 per share on our common shares. Payment of dividends on our common shares is within the discretion of the Board, and depends on, among other factors, net earnings, capital requirements and the financial condition of the Company. However, the Company intends to continue to pay comparable dividends to shareholders in the future. See Note 3 for detail of distributions paid life to date. Recent Sales of Unregistered Securities During the year ended December 31, 2019, no shares of common stock were issued under the distribution reinvestment program (“DRIP”). During the year ended December 31, 2018, we issued a total of 7,931 shares of common stock under the distribution reinvestment program (“DRIP”). This issuance was not subject to the registration requirements of the Securities Act of 1933. The aggregate value of the shares of our common stock issued under the DRIP for the year ended December 31, 2018 was approximately $94,788. No shares were issued under the DRIP program during the year ended December 31, 2017. Use of Proceeds from Recent Sales of Registered Securities In March and April 2019, the Company sold 2,952,149 shares of its common stock for net proceeds of $41,302,707, which was used to repay borrowings under the Credit Facility. For the year ended December 31, 2019, the Company sold 225,787 additional shares of common stock through an at-the-market sales program (the “ATM Program”) for net proceeds of $3,022,689, (including underwriter and other expenses of $240,040) which was used to repay borrowings under the Credit Facility. During April 2017, the Company sold 3,162,500 shares of its common stock for net proceeds of $43,060,618, which was used to repay borrowings under the Credit Facility. Subsequently, the Credit Facility was redrawn to fund additional equity in the SBIC I Subsidiary and fund new transactions. During August and September 2017, the Company issued unsecured notes totaling $48,875,000, the proceeds of which were used to redeem the existing unsecured notes and repay borrowings under the Credit Facility. For the year ended December 31, 2017, the Company sold 303,422 additional shares of common stock through the ATM Program for net proceeds of $4,014,887, which was used to repay borrowings under the Credit Facility. 61 TABLE OF CONTENTS Purchases of Equity Securities Dividend Reinvestment Plan During the year ended December 31, 2019, as a part of our dividend reinvestment plan for our common stockholders, we purchased 117,713 shares of our common stock for an average price per share of $14.03 in the open market in order to satisfy the reinvestment portion of our dividends. The following chart outlines such purchases of our common stock during the year ended December 31, 2019: Period January 1, 2019 through January 31, 2019 February 1, 2019 through February 29, 2019 March 1, 2019 through March 31, 2019 April 1, 2019 through April 30, 2019 May 1, 2019 through May 31, 2019 June 1, 2019 through June 30, 2019 July 1, 2019 through July 31, 2019 August 1, 2019 through August 31, 2019 September 1, 2019 through September 30, 2019 October 1, 2019 through October 31, 2019 November 1, 2019 through November 30, 2019 December 1, 2019 through December 31, 2019 Total Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Maximum (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs 9,681 9,024 11,019 10,154 10,896 10,983 10,348 9,868 9,223 9,279 8,739 8,499 117,713 $ 13.90 $ 14.79 $ 14.06 $ 14.38 $ 14.14 $ 14.14 $ 14.20 $ 12.97 $ 13.66 $ 13.44 $ 14.21 $ 14.54 $ 14.03 $ — $ — $ — $ — $ — $ — $ — $ — $ — $ — $ — $ — $ — $— $— $— $— $— $— $— $— $— $— $— $— $— 62 TABLE OF CONTENTS Stock Performance Graph This graph compares the return on our common stock with that of the Standard & Poor’s 500 Stock Index, the Russell 2000 Financial Services Index, and the Raymond James BDC Index, for the period from inception through March 2, 2020. The graph assumes that, at inception, a person invested $100 in each of our common stock, the S&P 500 Index, the Russell 2000 Financial Services Index, and the Raymond James BDC Index. The graph measures total stockholder return, which takes into account both changes in stock price and dividends. It assumes that dividends paid are invested in like securities. The graph and other information furnished under this Part II Item 5 of this Form 10-K shall not be deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C, or to the liabilities of Section 18 of the 1934 Act. The stock price performance included in the above graph is not necessarily indicative of future stock price performance. 63 TABLE OF CONTENTS Item 6. Selected Financial Data The selected financial data for the years ended December 31, 2019, 2018, 2017, 2016 and 2015 set forth below was derived from our financial statements which have been audited by Grant Thornton LLP, our independent registered public accounting firm. The data should be read in conjunction with our financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report. Statement of Operations Data: Total investment income Total expenses, net of fee waiver Net investment income Net increase in net assets resulting from operations Per Share Data: Net asset value Net investment income Net increase in net assets resulting from operations Distributions declared Balance Sheet Data: Investments at fair value Cash and cash equivalents Total assets Total liabilities Total net assets Other Data: Number of portfolio companies at period end Weighted average yield on debt investments at period end (1) (3) For the year ended December 31, 2019 For the year ended December 31, 2018 For the year ended December 31, 2017 For the year ended December 31, 2016 For the year ended December 31, 2015 $58,911,889 $53,266,338 $30,629,801 $36,473,080 $22,636,537 $22,438,809 $39,648,193 $21,677,433 $17,970,760 $39,490,197 $22,177,996 $17,312,201 $35,158,559 $18,611,431 $16,547,128 $26,438,186 $26,194,578 $22,613,257 $23,199,062 $ 7,670,536 $ $ $ $ 14.14 1.23 1.45 1.36 $ $ $ $ 14.09 1.42 1.64 1.36 $ $ $ $ 13.81 1.21 1.52 1.36 $ $ $ $ 13.69 1.39 1.86 1.36 $ $ $ $ 13.19 1.33 0.61 1.36 As of December 31, 2019 As of December 31, 2018 As of December 31, 2017 As of December 31, 2016 As of December 31, 2015 (2) $628,948,077 $504,483,668 $ 16,133,315 $ 17,467,146 $648,513,227 $526,287,251 $377,942,054 $301,442,244 $270,571,173 $224,845,007 $371,839,772 $ 25,110,718 $ $400,260,855 $180,013,613 $220,247,242 $365,625,891 9,194,129 $379,878,729 $208,996,944 $170,881,785 $349,017,697 $ 10,875,790 $365,368,412 $200,717,308 $164,651,104 63 57 48 45 39 9.2 % 10.9 % 10.8 % 11.0 % 10.6 % (1) (2) (3) Computed using the effective interest rates for all of our debt investments, including accretion of original issue discount. ASU No. 2015-03 — Simplifying the Presentation of Debt Issuance Costs was effective from the quarter ended March 31, 2016. Total assets and total liabilities as of December 31, 2015 have been modified by debt issuance costs of $3,905,673 to conform to this presentation. The weighted average yield of our debt investments is not the same as a return on investment for our stockholders, rather, relates to a portion of our investment portfolio and is calculated before the payment of all of our subsidiaries’ fees and expenses. The weighted average yield was computed using the effective interest rates for all of our debt investment restated as an interest rate payable annually in arrears and is computed including cash and payment in kind, or PIK interest, as well as accretion of original issue discount. 64 TABLE OF CONTENTS Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements Some of the statements in this annual report on Form 10-K constitute forward-looking statements, which relate to future events or our future performance or financial condition. The forward-looking statements contained in this annual report on Form 10-K involve risks and uncertainties, including statements as to: • • • • • • • • • • • • • • our future operating results; our business prospects and the prospects of our portfolio companies; the effect of investments that we expect to make; our contractual arrangements and relationships with third parties; actual and potential conflicts of interest with Stellus Capital Management; the dependence of our future success on the general economy and its effect on the industries in which we invest; the ability of our portfolio companies to achieve their objectives; the use of borrowed money to finance a portion of our investments; the adequacy of our financing sources and working capital; the timing of cash flows, if any, from the operations of our portfolio companies; the ability of Stellus Capital Management to locate suitable investments for us and to monitor and administer our investments; the ability of Stellus Capital Management to attract and retain highly talented professionals; our ability to maintain our qualification as a RIC and as a BDC; and the effect of future changes in laws or regulations (including the interpretation of these laws and regulations by regulatory authorities) and conditions in our operating areas, particularly with respect to business development companies or RICs. Such forward-looking statements may include statements preceded by, followed by or that otherwise include the words “may,” “might,” “will,” “intend,” “should,” “could,” “can,” “would,” “expect,” “believe,” “estimate,” “anticipate,” “predict,” “potential,” “plan” or similar words. We have based the forward-looking statements included in this annual report on Form 10-K on information available to us on the date of this annual report on Form 10-K. Actual results could differ materially from those anticipated in our forward-looking statements, and future results could differ materially from historical performance. We undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law or SEC rule or regulation. You are advised to consult any additional disclosures that we may make directly to you or through reports that we in the future may file with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. Overview We are an externally managed, non-diversified, closed-end investment company that has elected to be regulated as a BDC under the 1940 Act. Our investment activities are managed by our investment adviser, Stellus Capital Management. We were organized as a Maryland corporation on May 18, 2012 and formally commenced operations on November 7, 2012. Our investment objective is to maximize the total return to our stockholders in the form of current income and capital appreciation through debt and related equity investments in middle-market companies. 65 TABLE OF CONTENTS As a BDC, we are required to comply with certain regulatory requirements. For instance, as a BDC, we must not acquire any assets other than “qualifying assets” specified in the 1940 Act unless, at the time the acquisition is made, at least 70% of our total assets are qualifying assets. Qualifying assets include investments in “eligible portfolio companies.” Under the relevant SEC rules, the term “eligible portfolio company” includes all private operating companies, operating companies whose securities are not listed on a national securities exchange, and certain public operating companies that have listed their securities on a national securities exchange and have a market capitalization of less than $250 million, in each case organized and with their principal of business in the United States. We have elected to be treated for tax purposes as a RIC under Subchapter M of the Code. To maintain our qualification as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements. As of December 31, 2019, we were in compliance with the RIC requirements. As a RIC, we generally will not have to pay corporate-level U.S. federal income taxes on any income we distribute to our stockholders. Prior to June 28, 2018, we were only allowed to employ leverage to the extent that our asset coverage, as defined in the 1940 Act, was equal to at least 200% after giving effect to such leverage. On March 23, 2018, the Small Business Credit Availability Act (the “SBCAA”) was signed into law, which included various changes to regulations under the federal securities laws that impact BDCs. The SBCAA included changes to the 1940 Act to allow BDCs to decrease their asset coverage requirement to 150% from 200% under certain circumstances. On April 4, 2018, the Board, including a “required majority” (as such term is defined in Section 57(o) of the Investment Company Act of 1940, as amended (the “1940 Act”)) of the Board, approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. The Board also approved the submission of a proposal to stockholders to approve the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act, which was approved by stockholders at our 2018 annual meeting of stockholders. As a result, the asset coverage ratio applicable to us was decreased from 200% to 150%, effective June 28, 2018, which effectively increased the amount of leverage we may incur. As of December 31, 2019, our asset coverage ratio was 229%. The amount of leverage that we employ at any time depends on our assessment of the market and other factors at the time of any proposed borrowing. Portfolio Composition and Investment Activity Portfolio Composition We originate and invest primarily in privately-held middle-market companies (typically those with $5.0 million to $50.0 million of EBITDA) through first lien (including unitranche), second lien, and unsecured debt financing, often times with a corresponding equity investment. As of December 31, 2019, we had $ 628.9 million (at fair value) invested in 63 companies. As of December 31, 2019, our portfolio included approximately 72% of first lien debt, 18% of second lien debt, 4% of unsecured debt and 6% of equity investments at fair value. The composition of our investments at cost and fair value as of December 31, 2019 was as follows: (1) Senior Secured – First Lien Senior Secured – Second Lien Unsecured Debt Equity Total Investments Cost $461,107,595 130,600,172 22,279,519 28,720,538 $642,707,824 Fair Value $455,169,878 111,961,013 22,137,186 39,680,000 $628,948,077 (1) Includes unitranche investments, which account for 14.4% of our portfolio at fair value. Unitranche structures may combine characteristics of first lien senior secured as well as second lien and/or subordinated loans and our unitranche loans will expose us to the risks associated with the second lien and subordinated loans to the extent we invest in the “last-out” tranche. 66 TABLE OF CONTENTS As of December 31, 2018, we had $504.5 million (at fair value) invested in 57 companies. As of December 31, 2018, our portfolio included approximately 58% of first lien debt, 30% of second lien debt, 5% of unsecured debt and 7% of equity investments at fair value. The composition of our investments at cost and fair value as of December 31, 2018 was as follows: (1) Senior Secured – First Lien Senior Secured – Second Lien Unsecured Debt Equity Total Investments Cost $297,965,589 155,382,612 25,436,237 23,959,211 $502,743,649 Fair Value $292,004,982 149,661,220 23,697,466 39,120,000 $504,483,668 (1) Includes unitranche investments, which account for 20.6% of our portfolio at December 31, 2018 fair value. Unitranche structures may combine characteristics of first lien senior secured as well as second lien and/or subordinated loans and our unitranche loans will expose us to the risks associated with the second lien and subordinated loans to the extent we invest in the “last-out” tranche. Our investment portfolio may contain loans that are in the form of lines of credit or revolving credit facilities, which require us to provide funding when requested by portfolio companies in accordance with the terms and conditions of the underlying loan agreements. As of December 31, 2019 and December 31, 2018, we had unfunded commitments of $37.5 million and $21.2 million, respectively, to provide debt financing for seventeen and eleven portfolio companies, respectively. As of December 31, 2019, the Company had sufficient liquidity to fund such unfunded commitments should the need arise. The following is a summary of geographical concentration of our investment portfolio as of December 31, 2019: Texas California Arizona New Jersey Ohio Illinois Canada New York United Kingdom Wisconsin South Carolina Tennessee Pennsylvania Maryland Indiana Florida Colorado Arkansas Missouri Georgia North Carolina Puerto Rico Utah Massachusetts Cost $134,451,527 79,090,474 52,390,949 52,548,769 48,502,609 41,869,947 21,201,137 19,922,689 20,116,695 19,207,770 19,935,337 19,854,956 17,408,508 17,103,044 14,064,012 13,663,116 10,867,843 14,920,694 10,078,235 575,000 4,961,969 8,613,244 41,894 1,317,406 $642,707,824 Fair Value $120,672,985 78,136,331 53,274,526 51,637,750 50,092,839 44,406,252 21,217,811 20,584,020 20,116,695 19,466,054 19,366,716 19,260,076 17,566,213 17,325,000 13,997,251 13,820,256 12,444,250 11,989,446 10,428,223 5,250,000 4,375,000 3,490,383 30,000 — $628,948,077 % of Total Investments at fair value % 19.19 % 12.42 % 8.47 % 8.21 % 7.96 % 7.06 % 3.37 % 3.27 % 3.20 % 3.10 % 3.08 % 3.06 % 2.79 % 2.75 % 2.23 % 2.20 % 1.98 % 1.91 % 1.66 % 0.83 % 0.70 % 0.55 % 0.00 % — % 100.00 67 TABLE OF CONTENTS The following is a summary of geographical concentration of our investment portfolio as of December 31, 2018: Texas California New Jersey Ohio Illinois Canada Arizona South Carolina New York Tennessee Arkansas Pennsylvania Maryland Wisconsin Colorado Georgia Indiana Puerto Rico North Carolina Massachusetts Missouri Virginia Florida Utah Cost Fair Value % of Total Investments $100,229,354 86,550,134 43,513,698 36,209,514 19,941,053 27,902,537 21,682,522 20,871,587 20,446,690 20,117,218 17,696,537 17,732,831 17,237,500 11,437,711 10,777,822 5,988,728 7,363,628 8,797,954 4,946,554 1,317,406 139,656 50,001 242,304 1,550,710 $ 97,474,226 85,880,918 41,473,072 36,273,224 29,880,018 27,935,931 21,603,741 20,385,325 20,287,086 19,381,134 18,013,941 17,824,372 17,237,500 10,869,000 10,777,822 9,820,000 7,087,500 5,029,913 4,425,000 1,670,000 670,000 280,000 110,000 93,945 19.32 17.03 8.22 7.19 5.92 5.54 4.28 4.04 4.02 3.84 3.57 % % % % % % % % % % % 3.53 % 3.42 % 2.15 % 2.14 % 1.95 % 1.40 % 1.00 % 0.88 % 0.33 % 0.13 % 0.06 % 0.02 % 0.02 % $502,743,649 $504,483,668 100.00 % 68 TABLE OF CONTENTS The following is a summary of industry concentration of our investment portfolio as of December 31, 2019: Healthcare & Pharmaceuticals Services: Business Aerospace & Defense Consumer Goods: Durable Beverage, Food, & Tobacco Media: Broadcasting & Subscription Finance Education Media: Advertising, Printing & Publishing High Tech Industries Capital Equipment Retail Metals & Mining Transportation & Logistics Automotive Software Containers, Packaging, & Glass Environmental Industries Energy: Oil & Gas Services: Consumer Chemicals, Plastics, & Rubber Consumer goods: non-durable Construction & Building Utilities: Oil & Gas Hotel, Gaming, & Leisure Cost Fair Value $ 98,307,360 56,354,433 44,970,957 47,933,468 42,131,354 32,353,301 27,776,880 26,594,771 22,425,972 $ 94,000,860 62,410,845 46,547,324 44,158,660 42,592,966 33,218,991 29,562,500 25,661,125 21,965,124 21,201,137 20,093,379 19,935,337 17,103,044 17,173,599 17,151,902 15,807,191 14,306,286 15,256,675 12,624,269 26,075,606 11,880,825 14,973,711 21,217,811 20,237,066 19,366,716 17,325,000 17,226,294 17,221,213 15,516,250 14,564,570 14,410,327 13,582,102 13,345,105 11,857,228 11,770,000 10,408,323 10,750,000 9,868,044 — 9,900,000 540,000 % of Total Investments at fair value 14.95 9.92 7.40 7.02 6.77 5.28 4.70 4.08 3.49 % % % % % % % % % 3.37 % 3.22 % 3.08 % 2.75 % 2.74 % 2.74 % 2.47 % 2.32 % 2.29 % 2.16 % 2.12 % 1.89 % 1.87 % 1.71 % 1.57 % 0.09 % $642,707,824 $628,948,077 100.00 % 69 TABLE OF CONTENTS The following is a summary of industry concentration of our investment portfolio as of December 31, 2018: Cost Fair Value % of Total Investments Healthcare & Pharmaceuticals Software Finance Media: Broadcasting & Subscription Retail Services: Business Consumer Goods: Durable Education High Tech Industries Beverage, Food, & Tobacco Services: Consumer Automotive Metals & Mining Energy: Oil & Gas Consumer goods: non-durable Environmental Industries Chemicals, Plastics, & Rubber Containers, Packaging, & Glass Aerospace & Defense Construction & Building Utilities: Oil & Gas Capital Equipment Media: Advertising, Printing & Publishing Transportation: Cargo Insurance Hotel, Gaming, & Leisure Services: Government $ 58,682,811 51,432,916 34,208,412 31,079,169 28,764,221 22,942,733 26,981,015 26,562,249 21,094,192 $ 54,785,327 51,458,750 41,910,000 30,857,379 27,525,897 27,094,812 26,811,552 25,325,000 21,094,192 20,709,134 17,952,663 17,457,259 17,237,500 14,312,328 14,994,980 14,004,667 11,835,100 11,437,711 10,777,822 10,374,827 9,853,435 7,535,876 7,058,675 6,808,345 5,425,301 3,170,307 50,001 18,213,945 17,640,255 17,282,187 17,237,500 15,542,102 14,579,375 12,835,509 11,707,835 10,869,000 10,777,822 10,280,000 9,853,435 7,929,775 6,875,625 6,841,739 5,460,000 3,414,655 280,000 10.86 10.20 8.31 6.12 5.46 5.37 5.30 5.02 4.18 % % % % % % % % % 3.61 % 3.50 % 3.43 % 3.42 % 3.08 % 2.89 % 2.54 % 2.32 % 2.15 % 2.14 % 2.04 % 1.95 % 1.57 % 1.36 % 1.36 % 1.08 % 0.68 % 0.06 % $502,743,649 504,483,668 100.00 % Certain portfolio company classifications were updated to more adequately align to the risks of the portfolio investments with other companies in such industries. Industry classification for the prior year financial statements included above were reclassified to the current presentation. The following changes and their December 31, 2018 cost and fair value, respectively, were made: 1) Consumer Goods: Durable to Metals & Mining; $17,237,500 for both cost and fair value, 2) Media: Broadcasting & Subscription to Media: Advertising, Printing & Publishing; $7,058,675 and $6,875,625, 3) Services: Business to Aerospace & Defense; $10,777,822 for both cost and value, 4) Services: Business to Environmental Industries; $13,058,543 and $12,505,509, 5) Services: Business to Software; $14,005,369 and $13,432,500. At December 31, 2019, our average portfolio company investment at amortized cost and fair value was approximately $10.2 million and $10.0 million, respectively, and our largest portfolio company investment at amortized cost and fair value was approximately $ 21.6 million and $ 21.3 million, respectively. At December 31, 2018, our average portfolio company investment at both amortized cost and fair value was approximately $8.9 million, and our largest portfolio company investment at amortized cost and fair value was approximately $21.6 million and $22.3 million, respectively. 70 TABLE OF CONTENTS At December 31, 2019, 93% of our debt investments bore interest based on floating rates (subject to interest rate floors), such as LIBOR, and 7% bore interest at fixed rates. At December 31, 2018, 91% of our debt investments bore interest based on floating rates (subject to interest rate floors), such as LIBOR, and 9% bore interest at fixed rates. The weighted average yield on all of our debt investments as of December 31, 2019 and December 31, 2018 was approximately 9.2% and 10.9%, respectively. The weighted average yield was computed using the effective interest rates for all of our debt investments, including accretion of original issue discount. The weighted average 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 the payment of all of our subsidiaries’ fees and expenses. As of December 31, 2019 and December 31, 2018, we had cash and cash equivalents of $16.1 million and $17.5 million, respectively. Investment Activity During the year ended December 31, 2019, we made $246.5 million of investments in seventeen new portfolio companies and twelve existing portfolio companies. During the year ended December 31, 2019, we received $128.2 million in proceeds principally from prepayments of our investments, including $19.2 million from amortization of certain other investments. During the year ended December 31, 2018, we made $272.9 million of investments in seventeen new portfolio companies and twelve existing portfolio companies. During the year ended December 31, 2018, we received $147.6 million in proceeds principally from prepayments of our investments, including $22.9 million from amortization of certain other investments. Our level of investment activity can vary substantially from period to period depending on many factors, including the amount of debt and equity capital to middle market companies, the level of merger and acquisition activity, the general economic environment and the competitive environment for the types of investments we make. Asset Quality In addition to various risk management and monitoring tools, Stellus Capital Management uses an investment rating system to characterize and monitor the credit profile and expected level of returns on each investment in our portfolio. This investment rating system uses a five-level numeric scale. The following is a description of the conditions associated with each investment category: • • • • • Investment Category 1 is used for investments that are performing above expectations, and whose risks remain favorable compared to the expected risk at the time of the original investment. Investment Category 2 is used for investments that are performing within expectations and whose risks remain neutral compared to the expected risk at the time of the original investment. All new loans are initially rated 2. Investment Category 3 is used for investments that are performing below expectations and that require closer monitoring, but where no loss of return or principal is expected. Portfolio companies with a rating of 3 may be out of compliance with financial covenants. Investment Category 4 is used for investments that are performing substantially below expectations and whose risks have increased substantially since the original investment. These investments are often in work out. Investments with a rating of 4 are those for which some loss of return but no loss of principal is expected. Investment Category 5 is used for investments that are performing substantially below expectations and whose risks have increased substantially since the original investment. These investments are almost always in work out. Investments with a rating of 5 are those for which some loss of return and principal is expected. 71 TABLE OF CONTENTS Investment Category 1 2 3 4 5 Total As of December 31, 2019 As of December 31, 2018 Fair Value % of Total Portfolio Number of Portfolio Companies (1) Fair Value % of Total Portfolio Number of Portfolio Companies (dollars in millions) $ 70.4 492.2 49.3 12.0 5.0 $628.9 11 78 8 2 1 % % % % % 100 % 11 41 7 1 4 64 $ 92.5 372.3 26.8 12.8 0.1 $504.5 18 74 5 3 — % % % % % 100 % 13 37 3 4 1 58 (1) One portfolio company appears in two categories as of December 31, 2019 and December 31, 2018. Loans and Debt Securities on Non-Accrual Status We will not accrue interest on loans and debt securities if we have reason to doubt our ability to collect such interest. As of December 31, 2019, we had loans to 2 portfolio companies that were on non-accrual status, which represented approximately 3.6% of our loan portfolio at cost and 0.9% at fair value. As of December 31, 2018, we had loans to four portfolio companies that were on non-accrual status, which represented approximately 3.9% of our loan portfolio at cost and 2.8% at fair value. Results of Operations An important measure of our financial performance is net increase (decrease) in net assets resulting from operations, which includes net investment income (loss), net realized gain (loss) and net unrealized appreciation (depreciation). Net investment income (loss) is the difference between our income from interest, dividends, fees and other investment income and our operating expenses including interest on borrowed funds. Net realized gain (loss) on investments is the difference between the proceeds received from dispositions of portfolio investments and their amortized cost. Net unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio. Comparison of the Years ended December 31, 2019, 2018, and 2017 Revenues We generate revenue in the form of interest income on debt investments and capital gains and distributions, if any, on investment securities that we may acquire in portfolio companies. Our debt investments typically have a term of five to seven years and bear interest at primarily floating rates. Interest on our debt securities is generally payable quarterly. Payments of principal on our debt investments may be amortized over the stated term of the investment, deferred for several years or due entirely at maturity. In some cases, our debt investments may pay interest in-kind, or PIK interest. Any outstanding principal amount of our debt securities and any accrued but unpaid interest will generally become due at the maturity date. The level of interest income we receive is directly related to the balance of interest-bearing investments multiplied by the weighted average yield of our investments. We expect that the total dollar amount of interest and any dividend income that we earn will increase as the size of our investment portfolio increases. In addition, we may generate revenue in the form of prepayment fees, commitment, loan origination, structuring or due diligence fees, fees for providing significant managerial assistance and consulting fees. 72 TABLE OF CONTENTS The following shows the breakdown of investment income for the years ended December 31, 2019, 2018, and 2017 (in millions). Interest Income (1) PIK Income Miscellaneous fees (1) Total Year ended December 31, 2019 Year ended December 31, 2018 Year ended December 31, 2017 $56.5 0.4 2.0 $58.9 $49.6 1.9 1.8 $53.3 $37.6 0.5 1.6 $39.7 (1) For the years ended December 31, 2019, 2018, and 2017, we recognized $2.8 million, $3.4 million and $2.5 million of non-recurring income, respectively. Non-recurring income was related to early repayments, the recognition of previously reserved income from a prior period, and amendments to specific loan positions. The increase in interest income from the respective periods were due primarily to growth in the overall investment portfolio. Expenses Our primary operating expenses include the payment of fees to Stellus Capital Management under the investment advisory agreement, our allocable portion of overhead expenses under the administration agreement and other operating costs described below. We bear all other out-of-pocket costs and expenses of our operations and transactions, which may include: • • • • • • • • • • • • • • organization and offering; 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; base management and incentive fees; administration fees and expenses, if any, payable under the administration agreement (including our allocable portion of Stellus Capital’s overhead in performing its obligations under the administration agreement, including rent and the allocable portion of the cost of our chief compliance officer and chief financial officer and their respective staff); transfer agent, dividend agent and custodial fees and expenses; U.S. federal and state registration fees; all costs of registration and listing our securities on any securities exchange; U.S. federal, state and local taxes; independent directors’ fees and expenses; costs of preparing and filing reports or other documents required by the SEC or other regulators; costs of distributing any reports, proxy statements or other notices to stockholders, including printing costs; costs and fees associated with any fidelity bond, directors and officers/errors and omissions liability insurance, and any other insurance premiums; 73 TABLE OF CONTENTS • • • direct costs and expenses of administration, including printing, mailing, long distance telephone, copying, secretarial and other staff, independent auditors and outside legal costs; proxy voting expenses; and all other expenses incurred by us or Stellus Capital in connection with administering our business. The following shows the breakdown of operating expenses for the years ended December 31, 2019, 2018 and 2017 (in millions). Operating Expenses Management Fees Valuation Fees Administrative services expenses Income incentive fees Capital gain incentive fees Professional fees Directors’ fees Insurance expense Interest expense and other fees Income tax expense Other general and administrative Total Operating Expenses Loss on extinguishment of debt Total Expenses Year ended December 31, 2019 Year ended December 31, 2018 Year ended December 31, 2017 $ 9.7 0.3 1.7 5.8 0.8 1.0 0.4 0.3 15.0 0.9 0.6 $36.5 — $36.5 $ 8.2 0.3 1.4 5.5 0.1 1.2 0.3 0.3 12.3 0.3 0.7 $30.6 — $30.6 $ 6.3 0.3 1.3 2.9 — 1.3 0.3 0.4 7.9 — 0.6 $21.3 0.4 $21.7 The increase in operating expenses for the respective periods was primarily due to 1) an increase in management fees, directly related to the growth of our portfolio, 2) increased interest expense due to the higher balances on the Credit Facility and SBA-guaranteed debentures outstanding during the period, 3) excise taxes as a result of capital gains on certain equity positions, and 4) higher income incentive fees and capital gains incentive fees due to performance of the portfolio. Net Investment Income Net investment income was $22.4 million, or $1.23 per common share based on 18,275,696 weighted- average common shares outstanding at December 31, 2019. Net investment income was $22.6 million, or $1.42 per common share based on 15,953,571 weighted-average common shares outstanding at December 31, 2018. Net investment income was $18.0 million, or $1.21 per common share based on 14,870,981 weighted-average common shares outstanding at December 31, 2017. Net investment income for the year ended December 31, 2019 decreased compared to the year ended December 31, 2018 as a result of an increase in accrued capital gains incentive fees and excise taxes generated by realized gains on certain equity positions and higher interest expense from larger amounts outstanding under the Credit Facility and SBA-guaranteed debentures; offset by higher investment income due to a larger portfolio. Net Realized Gains and Losses We measure realized gains or losses by the difference between the net proceeds from the repayment, sale or other disposition and the amortized cost basis of the investment, using the specific identification method, without regard to unrealized appreciation or depreciation previously recognized. 74 TABLE OF CONTENTS Proceeds from repayments of investments and amortization of certain other investments for the year ended December 31, 2019 totaled $128.2 million and net realized gains totaled $19.6 million. Proceeds from repayments of investments and amortization of certain other investments for the year ended December 31, 2018 totaled $147.5 million and net realized gain totaled $5.5 million. Proceeds from the sales and repayments of investments and amortization of certain other investments for the year ended December 31, 2017 totaled $172.3 million and net realized gains totaled $4.7 million. Net realized gains in all periods presented resulted from the realization of our equity investments in certain portfolio companies. Net Change in Unrealized Appreciation (Depreciation) of Investments Net change in unrealized appreciation primarily reflects the change in portfolio investment values during the reporting period, including the reversal of previously recorded appreciation or depreciation when gains or losses are realized. Net change in unrealized appreciation (depreciation) on investments and cash equivalents for the year ended December 31, 2019, 2018 and 2017 totaled ($15.5) million, ($1.6) million, and ($0.0) million, respectively. The change in unrealized depreciation in 2019 was primarily due to write downs on specific investments. The change in unrealized depreciation in 2018 was due to a significant widening of spreads during the fourth quarter, offset by the write up of a specific equity investment. There was relatively no change in unrealized appreciation in 2017. Provision for Taxes on Unrealized Appreciation on Investments We have direct wholly owned subsidiaries that have elected to be taxable entities (the “Taxable Subsidiaries”). The Taxable Subsidiaries permit us to hold equity investments in portfolio companies which are “pass through” entities for tax purposes and continue to comply with the “source-of-income” requirements contained in RIC tax provisions of the Code. The Taxable Subsidiaries are not consolidated with us for income tax filing purposes and may generate income tax expense, benefit, and the related tax assets and liabilities, as a result of their ownership of certain portfolio investments. The income tax expense, or benefit, if any, and related tax assets and liabilities are reflected in our consolidated financial statements. For the year ended December 31, 2019, 2018 and 2017, we recognized a deferred tax benefit (provision) related to unrealized appreciation on certain equity investments for income tax at our Taxable Subsidiaries of $(66.8) thousand, $(68.0) thousand and $9.0 thousand, respectively. As of December 31, 2019 and 2018, a deferred tax liabilities of $134.7 thousand and $68.0 thousand, respectively, were included on the Consolidated Statement of Assets and Liabilities. For the year ended December 31, 2018, we recognized tax expense related to the realized gains on certain equity investments at our taxable subsidiaries of $267.0 thousand. There was no such tax expense for the years ended December 31, 2019 and 2017. As of December 31, 2019 and 2018, no tax liability related to the taxes on realized gains were included on the Consolidated Statement of Assets and Liabilities. Net Increase in Net Assets Resulting from Operations Net increase in net assets resulting from operations totaled $26.4 million, or $1.45 per common share based on weighted-average shares of 18,275,696 for the year ended December 31, 2019, as compared to $26.2 million, or $1.64 per common share based on weighted-average shares of 15,953,571 common shares outstanding for the year ended December 31, 2018, as compared to $22.6 million, or $1.52 per common share based on weighted- average shares of 14,870,981 common shares outstanding for the year ended December 31, 2017. The increase in net assets resulting from operations for the year ended December 31, 2019 as compared to the year ended December 31, 2018 was higher due primarily to a larger amount of realized gains, offset by unrealized depreciation. The increase in net assets resulting from operations for the year ended December 31, 2018 as compared to the year ended December 31, 2017 was higher due primarily to a higher net investment income as a result of portfolio growth, as well as a larger amount of realized gains. 75 TABLE OF CONTENTS Financial condition, liquidity and capital resources Cash Flows from Operating and Financing Activities Our operating activities used net cash of ($93.3) million for the year ended December 31, 2019, primarily in connection with the purchase of portfolio investments, offset by sales and repayments of portfolio investments. Our financing activities for the year ended December 31, 2019 provided cash of $92.0 million primarily from proceeds from the issuance of common stock, proceeds from SBA-guaranteed debentures and net borrowings on our credit facility. Our operating activities used net cash of ($102.4) million for the year ended December 31, 2018, primarily in connection with the purchase of portfolio investments, offset by sales and repayments of portfolio investments. Our financing activities for the year ended December 31, 2018 provided cash of $94.8 million primarily from proceeds from SBA-guaranteed debentures and net borrowings on our credit facility Our operating activities provided net cash of $18.9 million for the year ended December 31, 2017, primarily in connection with income earned on our portfolio investments, offset by the purchase and origination of portfolio investments. Our financing activities for the year ended December 31, 2017 used cash of ($2.9) million, primarily from net repayments on our credit facility. Liquidity and Capital Resources Our liquidity and capital resources are derived from the Credit Facility, the 2022 Notes, SBA-guaranteed debentures and cash flows from operations, including investment sales and repayments, and income earned. Our primary use of funds from operations includes investments in portfolio companies and other operating expenses we incur, as well as the payment of dividends to the holders of our common stock. We used, and expect to continue to use, these capital resources as well as proceeds from turnover within our portfolio and from public and private offerings of securities to finance our investment activities. Although we expect to fund the growth of our investment portfolio through the net proceeds from future public and private equity offerings and issuances of senior securities or future borrowings to the extent permitted by the 1940 Act, our plans to raise capital may not be successful. In this regard, if our common stock trades at a price below our then-current net asset value per share, we may be limited in our ability to raise equity capital given that we cannot sell our common stock at a price below net asset value per share unless our stockholders approve such a sale and our board of directors makes certain determinations in connection therewith. A proposal, approved by our stockholders at our 2019 annual stockholders meeting, authorizes us to sell up to 25% of our outstanding common shares at a price equal to or below the then current net asset value per share in one or more offerings. This approval will expire on the earlier of our 2020 annual stockholder meeting or July 22, 2020, the one-year anniversary of our 2019 annual stockholders meeting. We would need similar future approval from our stockholders to issue shares below the then current net asset value per share any time after the expiration of the current approval. In addition, we intend to distribute between 90% and 100% of our taxable income to our stockholders in order to satisfy the requirements applicable to RICs under Subchapter M of the Code. Consequently, we may not have the funds or the ability to fund new investments, to make additional investments in our portfolio companies, to fund our unfunded commitments to portfolio companies or to repay borrowings. In addition, the illiquidity of our portfolio investments may make it difficult for us to sell these investments when desired and, if we are required to sell these investments, we may realize significantly less than their recorded value. Also, as a BDC, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities, to total senior securities, which include all of our borrowings and any outstanding preferred stock, of at least 150% effective June 28, 2018 (at least 200% prior to June 28, 2018). This requirement limits the amount that we may borrow. We have received exemptive relief from the SEC to permit us to exclude the debt of our SBIC subsidiaries guaranteed by the SBA from the definition of senior securities in the asset coverage test under the 1940 Act. We were in compliance with the asset coverage ratios at all times. As of December 31, 2019 and December 31, 2018, our asset coverage ratio was 229% and 251%, respectively. The amount of leverage that we employ will depend on our assessment of market conditions and other factors at the time of any proposed borrowing, such as the maturity, 76 TABLE OF CONTENTS covenant package and rate structure of the proposed borrowings, our ability to raise funds through the issuance of shares of our common stock and the risks of such borrowings within the context of our investment outlook. Ultimately, we only intend to use leverage if the expected returns from borrowing to make investments will exceed the cost of such borrowing. As of December 31, 2019 and December 31, 2018, we had cash and cash equivalents of $16.1 million and $17.5 million, respectively. Credit Facility On November 7, 2012, we entered into a revolving credit facility (the “Original Facility”) with various lenders. SunTrust Bank, one of the lenders, served as administrative agent under the Original Facility. We terminated the Original Facility on October 11, 2017, in conjunction with securing and entering into a new senior secured revolving credit agreement, dated as of October 10, 2017, as amended on March 28, 2018, August 2, 2018, September 13, 2019, and December 27, 2019, with ZB, N.A., dba Amegy Bank and various other lenders (the “Credit Facility”). The Credit Facility, as amended, provides for borrowings up to a maximum of $220.0 million on a committed basis with an accordion feature that allows the Company to increase the aggregate commitments up to $250.0 million, subject to new or existing lenders agreeing to participate in the increase and other customary conditions. Borrowings under the Credit Facility bear interest, subject to our election, on a per annum basis equal to (i) LIBOR plus 2.50% (or 2.75% during certain periods in which the our asset coverage ratio is equal to or below 1.90 to 1.00) with no LIBOR floor, or (ii) 1.50% (or 1.75% during certain periods in which our asset coverage ratio is equal to or below 1.90 to 1.00) plus an alternate base rate based on the highest of the Prime Rate, Federal Funds Rate plus 0.5% or one month LIBOR plus 1.0%. We pay unused commitment fees of 0.50% per annum on the unused lender commitments under the Credit Facility. Interest is payable quarterly in arrears. The commitment to fund the revolver expires on October 10, 2020, after which we may no longer borrow under the Credit Facility. We must begin repaying principal equal to 1/12 of the aggregate amount outstanding under the Credit Facility beginning October 15, 2020. Any amounts borrowed under the Credit Facility will mature, and all accrued and unpaid interest thereunder will be due and payable, on October 10, 2021. Our obligations to the lenders are secured by a first priority security interest in its portfolio of securities and cash not held at the SBIC subsidiaries, but excluding short term investments. The Credit Facility contains certain covenants, including but not limited to: (i) maintaining a minimum liquidity test of at least $10.0 million, including cash, liquid investments and undrawn availability, (ii) maintaining an asset coverage ratio of at least 1.75 to 1.0, and (iii) maintaining a minimum shareholder’s equity. As of December 31, 2019, we were in compliance with these covenants. As of December 31, 2019 and December 31, 2018, the outstanding balance under the Credit Facility was $161.6 million and $99.6 million, respectively. The carrying amount of the amount outstanding under the Credit Facility approximates its fair value. The fair values of the Credit Facility is determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The fair value of the Credit Facility is estimated based upon market interest rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any. We have incurred costs of $1.8 million in connection with the current Credit Facility, which are being amortized over the life of the facility. Additionally, $0.3 million of costs from the Original Facility will continue to be amortized over the remaining life of the Credit Facility. As of December 31, 2019 and 2018, $1.0 million and $1.3 million of such prepaid loan structure fees and administration fees had yet to be amortized, respectively. These prepaid loan fees are presented on our consolidated statement of assets and liabilities as a deduction from the debt liability attributable to the Credit Facility. 77 TABLE OF CONTENTS Interest is paid quarterly in arrears. The following table summarizes the interest expense and amortized loan fees on the Credit Facility for the years ended December 31, 2019, 2018, and 2017 (dollars in millions): Interest expense Loan fee amortization Commitment fees on unused portion Administration fees Total interest expense and other fees Loss on extinguishment of debt Weighted average interest rate Effective interest rate (including fee amortization) Average debt outstanding Cash paid for interest and unused fees SBA-guaranteed debentures For the years ended December 31, 2019 December 31, 2018 December 31, 2017 $ $ 5.1 0.5 0.4 — 6.0 $ — 4.8 % 5.7 % $106.2 $ 5.2 $ 3.7 0.4 0.4 0.1 $ 4.6 $ — 4.7 % 5.7 % $79.8 $ 4.2 $ 2.2 0.4 0.3 0.1 $ 3.0 $ 0.1 3.7 % 5.0 % $60.1 $ 2.5 Due to the SBIC subsidiaries’ status as licensed SBICs, we can issue debentures guaranteed by the SBA at favorable interest rates. Under the regulations applicable to SBIC funds, a single licensee can have outstanding debentures guaranteed by the SBA subject to a regulatory leverage limit, up to two times the amount of regulatory capital. As of both December 31, 2019 and 2018, the SBIC subsidiary had $75.0 million in regulatory capital, as such term is defined by the SBA. As of December 31, 2019, the year ending the first year of operations, the SBIC II subsidiary had $20.0 million in regulatory capital, as such term is defined by the SBA. On August 12, 2014, we obtained exemptive relief from the SEC to permit us to exclude the debt of the SBIC subsidiaries guaranteed by the SBA from our asset coverage test under the 1940 Act. The exemptive relief provides us with increased flexibility under the asset coverage test by permitting us to borrow up to $325.0 million more than we would otherwise be able to absent the receipt of this exemptive relief. On a stand-alone basis, the SBIC subsidiaries held $240.1 million and $225.5 million in assets at December 31, 2019 and 2018, respectively, which accounted for approximately 37.0% and 42.9% of our total consolidated assets at December 31, 2019 and 2018, respectively. Debentures guaranteed by the SBA have fixed interest rates that equal prevailing 10-year Treasury Note rates plus a market spread and have a maturity of ten years with interest payable semi-annually. The principal amount of the debentures is not required to be paid before maturity, but may be pre-paid at any time with no prepayment penalty. As of December 31, 2019 and 2018, the SBIC subsidiaries had $161.0 million and $150.0 million of the SBA-guaranteed debentures outstanding, respectively. SBA-guaranteed debentures drawn before October 1, 2019 incur upfront fees of 3.425%, which consists of a 1.00% commitment fee and a 2.425% issuance discount, which are amortized over the life of the SBA-guaranteed debentures. SBA-guaranteed debentures drawn after October 1, 2019 incur upfront fees of 3.435%, which consists of a 1.00% commitment fee and a 2.435% issuance discount, which are amortized over the life of the SBA-guaranteed debentures. Once pooled, which occurs in March and September each year, the SBA-guaranteed debentures bear interest at a fixed rate that is set to the current 10-year treasury rate plus a spread at each pooling date. As of December 31, 2019 and 2018, the carrying amount of the SBA-guaranteed debentures approximated their fair value. The fair values of the SBA-guaranteed debentures are determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The fair value of the SBA- guaranteed debentures are estimated based upon market interest 78 TABLE OF CONTENTS rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any. At December 31, 2019 and 2018, the SBA-guaranteed debentures would be deemed to be Level 3, as defined in Note 6. As of December 31, 2019, we have incurred $5.6 million in financing costs related to the SBA-guaranteed debentures since the SBIC subsidiaries have received their licenses, which were recorded as prepaid loan fees. As of December 31, 2019 and 2018, $3.5 million and $3.6 million of prepaid financing costs had yet to be amortized, respectively. These prepaid loan fees are presented on the consolidated statement of assets and liabilities as a deduction from the debt liability. The following table summarizes the interest expense and amortized fees on the SBA-guaranteed debentures for the years ended December 31, 2019, 2018 and 2017 (dollars in millions; averages for periods outstanding): Interest expense Debenture fee amortization Total interest expense and other fees Weighted average interest rate Effective interest rate (including fee amortization) Average debt outstanding Cash paid for interest Notes For the years ended December 31, 2019 December 31, 2018 December 31, 2017 $ $ 5.2 0.6 5.8 3.4 3.8 % % $151.9 $ 5.0 $ $ 4.0 0.6 4.6 3.2 3.7 % % $125.4 $ 3.1 $ 2.1 0.3 $ 2.4 3.1 3.6 % % $67.3 $ 2.0 On May 5, 2014, we closed a public offering of $25.0 million aggregate principal amount of 6.50% notes (the “2019 Notes”) due April 30, 2019. We redeemed all $25.0 million in aggregate principal amount of the 2019 Notes on September 20, 2017. As a result of the redemption, we recognized a loss on the extinguishment of debt of $0.3 million for the year ended December 31, 2017, due to the write off of the remaining deferred financing costs on the 2019 Notes. The following table summarizes the interest expense and deferred financing costs on the 2019 Notes for the years ended December 31, 2019, 2018, and 2017 (dollars in millions; averages for period outstanding): Interest expense Deferred financing costs Total interest expense and other fees Loss on extinguishment of debt Weighted average interest rate Effective interest rate (including fee amortization) Average debt outstanding Cash paid for interest For the year ended December 31, 2019 December 31, 2018 December 31, 2017 $ — — $ — — — % — % $ — — $ — — — % — % $ — $ — $ — $ — $ 1.2 0.1 $ 1.3 0.3 6.5 % 7.3 % $25.0 $ 1.4 On August 21, 2017, we issued $42.5 million in aggregate principal amount of 5.75% fixed-rate notes due 2022 (the “2022 Notes”). On September 8, 2017, we issued an additional $6.4 million in aggregate principal amount of the 2022 Notes pursuant to a full exercise of the underwriters’ overallotment option. The 2022 Notes will mature on September 15, 2022, and may be redeemed in whole or in part at any time or 79 TABLE OF CONTENTS from time to time at the Company’s option on or after September 15, 2019 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest. Interest is payable quarterly. We used all of the net proceeds from this offering to fully redeem the 2019 Notes and a portion of the amount outstanding under the Original Facility. As of both December 31, 2019 and 2018, the aggregate carrying amount of all Notes was $48.9 million and the fair value of the Notes was approximately $49.7 million and $47.6 million, respectively. The 2022 Notes are listed on New York Stock Exchange under the trading symbol “SCA”. The fair value of the Notes is based on the closing price of the security, which is a Level 2 input under ASC 820 due to sufficient trading volume. In connection with the issuance and maintenance of the 2022 Notes, we have incurred $1.7 million of fees which are being amortized over the term of the 2022 Notes, of which $0.9 million and $1.2 million remained to be amortized as of December 31, 2019 and 2018, respectively. These financing costs are presented on the consolidated statement of assets and liabilities as a deduction from the debt liability. The following table summarizes the interest expense and deferred financing costs on the 2022 Notes for the years ended December 31, 2019, 2018, 2017 (in millions): For the year ended December 31, 2019 For the year ended December 31, 2018 For the year ended December 31, 2017 (1) $ 2.8 0.3 $ 3.1 5.8 6.4 $ 48.9 $ 2.8 % % $ 2.8 0.3 $ 3.1 5.8 6.4 $ 48.9 $ 2.8 % % $ 1.0 0.1 $ 1.1 5.8 6.5 $ 48.0 $ 0.9 % % Interest expense Deferred financing costs Total interest expense and other fees Weighted average interest rate Effective interest rate (including fee amortization) Average debt outstanding Cash paid for interest (1) for the period outstanding Contractual Obligations As of December 31, 2019, our future fixed commitments for cash payments on contractual obligations for each of the next five years and thereafter are as follows: Total 2020 2021 2022 2023 2024 2025 and thereafter (dollars in thousands) Credit facility payable (1) Notes payable SBA-guaranteed debentures $161,550 $ 48,875 $161,000 $ — — — 161,550 $ — — 48,875 — — — — — $ — — — — — $161,000 Total $371,425 $ — $161,550 $48,875 $ — $ — $161,000 (1) We must begin repaying principal equal to 1/12 of the aggregate amount outstanding under the Credit Facility beginning October 15, 2020. See Note 9 for further discussion. Off-Balance Sheet Arrangements We may be a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our portfolio companies. As of December 31, 2019, our only off-balance sheet arrangements consisted of $37.5 million of unfunded commitments to provide debt financing to seventeen of our portfolio companies. As of December 31, 2018, our only off-balance sheet arrangements consisted of a $21.2 million unfunded commitments to provide debt financing to eleven of our portfolio companies. 80 TABLE OF CONTENTS Regulated Investment Company Status and Dividends We have elected to be treated as a RIC under Subchapter M of the Code. So long as we maintain our status as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders as dividends on a timely basis. Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation until realized. Distributions declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital. To qualify for RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company net taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any). If we maintain our qualification as a RIC, we must also satisfy certain distribution requirements each calendar year in order to avoid a federal excise tax on our undistributed earnings of a RIC. We intend to distribute to our stockholders between 90% and 100% of our annual taxable income (which includes our taxable interest and fee income). However, the covenants contained in the Credit Facility may prohibit us from making distributions to our stockholders, and, as a result, could hinder our ability to satisfy the distribution requirement. In addition, we may retain for investment some or all of our net taxable capital gains (i.e., realized net long-term capital gains in excess of realized net short-term capital losses) and treat such amounts as deemed distributions to our stockholders. If we do this, our stockholders will be treated as if they received actual distributions of the capital gains we retained and then reinvested the net after-tax proceeds in our common stock. Our stockholders also may be eligible to claim tax credits (or, in certain circumstances, tax refunds) equal to their allocable share of the tax we paid on the capital gains deemed distributed to them. To the extent our taxable earnings for a fiscal taxable year fall below the total amount of our dividends for that fiscal year, a portion of those dividend distributions may be deemed a return of capital to our stockholders. We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a business development company under the 1940 Act and due to provisions in Credit Facility. We cannot assure stockholders that they will receive any distributions or distributions at a particular level. In accordance with certain applicable Treasury regulations and private letter rulings issued by the Internal Revenue Service, a RIC may treat a distribution of its own stock as fulfilling its RIC distribution requirements if each stockholder may elect to receive his or her entire distribution in either cash or stock of the RIC, subject to a limitation that the aggregate amount of cash to be distributed to all stockholders must be at least 20% of the aggregate declared distribution. If too many stockholders elect to receive cash, each stockholder electing to receive cash must receive a pro rata amount of cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive less than 20% of his or her entire distribution in cash. If these and certain other requirements are met, for U.S. federal income tax purposes, the amount of the dividend paid in stock will be equal to the amount of cash that could have been received instead of stock. We have no current intention of paying dividends in shares of our stock in accordance with these Treasury regulations or private letter rulings. Recent Accounting Pronouncements See Note 1 to the financial statements for a description of recent accounting pronouncements, if any, including the expected dates of adoption and the anticipated impact on the financial statements. Critical Accounting Policies The preparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Changes in the economic 81 TABLE OF CONTENTS environment, financial markets and any other parameters used in determining such estimates could cause actual results to differ. In addition to the discussion below, our significant accounting policies are further described in the notes to the financial statements. Valuation of portfolio investments As a business development company, we generally invest in illiquid loans and securities including debt and equity securities of middle-market companies. Under procedures established by our Board, we may value investments for which market quotations are readily available at such market quotations. We obtain these market values from an independent pricing service or at the mean between the bid and ask prices obtained from at least two brokers or dealers (if available, otherwise by a principal market maker or a primary market dealer). Debt and equity securities that are not publicly traded or whose market prices are not readily available are valued at fair value as determined in good faith by our Board. Such determination of fair values may involve subjective judgments and estimates, although we engage independent valuation providers to review the valuation of each portfolio investment that does not have a readily available market quotation at least twice each year. Investments purchased within 90 days of maturity are valued at cost plus accreted discount, or minus amortized premium, which approximates value. With respect to unquoted securities, our Board, together with our independent valuation advisors, values each investment considering, among other measures, discounted cash flow models, comparisons of financial ratios of peer companies that are public and other factors. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, our Board uses the pricing indicated by the external event to corroborate and/or assist us in our valuation. Because there is not a readily available market for substantially all of the investments in our portfolio, we value most of our portfolio investments at fair value as determined in good faith by our Board using a documented valuation policy and a consistently applied valuation process. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ significantly from the values that would have been used had a readily available market value existed for such investments, and the differences could be material. With respect to investments for which market quotations are not readily available, our Board 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 Stellus Capital Management responsible for the portfolio investment; Preliminary valuation conclusions are then documented and discussed with our senior management and Stellus Capital Management; At least twice annually, the valuation for each portfolio investment is reviewed by an independent valuation firm; The audit committee of our Board then reviews these preliminary valuations; and The Board then discusses valuations and determines the fair value of each investment in our portfolio in good faith, based on the input of Stellus Capital Management, the independent valuation firm and the audit committee. Revenue recognition We record interest income on an accrual basis to the extent that we expect to collect such amounts. For loans and debt securities with contractual PIK interest, which represents contractual interest accrued and added to the loan balance that generally becomes due at maturity, we do not accrue PIK interest if the portfolio company valuation indicates that such PIK interest is not collectible. We will not accrue interest on loans and debt securities if we have reason to doubt our ability to collect such interest. Loan origination fees, original issue discount and market discount or premium are capitalized, and we then accrete or amortize such amounts using the effective interest method as interest income. Upon the prepayment of a loan or 82 TABLE OF CONTENTS debt security, any unamortized loan origination is recorded as interest income. We record prepayment premiums on loans and debt securities as interest income. Dividend income, if any, will be recognized on the ex-dividend date. We have investments in our portfolio that contain a PIK interest provision. Any PIK interest is added to the principal balance of such investments and is recorded as income, if the portfolio company valuation indicates that such PIK interest is collectible. In order to maintain our status as a RIC, substantially all of this income must be paid out to stockholders in the form of dividends, even if we have not collected any cash. Net realized gains or losses and net change in unrealized appreciation or depreciation We measure realized gains or losses by the difference between the net proceeds from the repayment, sale, or other disposition and the amortized cost basis of the investment, without regard to unrealized appreciation or depreciation previously recognized. Net change in unrealized appreciation or depreciation reflects the change in portfolio investment values during the reporting period, including any reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized. Capital Gains Incentive Fee Under GAAP, the Company calculates the capital gains incentive fee payable to the Advisor as if the Company had realized all investments at their fair values as of the reporting date. Accordingly, the Company accrues a provisional capital gains incentive fee taking into account any unrealized gains or losses. As the provisional incentive fee is subject to the performance of investments until there is a realization event, the amount of provisional capital gains incentive fee accrued at a reporting date may vary from the incentive fee that is ultimately realized and the differences could be material. Recent Developments Investment Portfolio On January 3, we received full repayment on the first lien term loan of APG Intermediate Sub 2 Corp. for total proceeds of $10 million, including a $0.1 million prepayment fee. We also received $2.4 million in full realization on the equity of the company, resulting in a $1.3 million gain. On January 7, 2020, we invested $14.4 million in the first lien term loan of Sales Benchmark Index, LLC, $1.3 million in the unfunded revolver, and $3.3 million in the unfunded delayed draw term loan of Sales Benchmark, LLC, a provider of revenue growth management consulting services for private equity-owned and large enterprise clients. Additionally, we invested $0.7 million in the preferred equity of the company. On January 15, 2020, Apex Environmental Resources Holdings, LLC was merged with a provider of non- hazardous waste management, collection, and recycling services, creating Interstate Waste Services, Inc. Our common and preferred ownership positions in Apex Environmental Resources Holdings, LLC was rolled into the combined entity. On January 31, 2020, we invested $18.9 million in the first lien term loan and $2.7 million in the unfunded revolver of Elliott Aviation, LLC, a provider of maintenance, repair, and overhaul and fixed-base operator services to the business aviation sector. Additionally, we invested $0.9 million in the preferred equity of the company. Credit Facility The outstanding balance under the Credit Facility as of February 28, 2020 was $175.3 million. ATM Program Since December 31, 2019, we issued 332,591 shares under the At-the-Market (“ATM”) Program, for gross proceeds of $4.8 million. The average per share offering price of shares issued in the ATM Program was $14.42. 83 TABLE OF CONTENTS SBA-guaranteed Debentures The outstanding balance under SBA-guaranteed Debentures as of February 28, 2020 was $161.0 million. Dividend Declared On January 10, 2020, the Company’s Board declared a regular monthly dividend for each of January, February and March 2020. Declared 1/10/2020 1/10/2020 1/10/2020 Ex-Dividend Date Record Date Payment Date Amount per Share 1/30/2020 2/27/2020 3/30/2020 1/31/2020 2/28/2020 3/31/2020 2/14/2020 3/13/2020 4/15/2020 $0.1133 $0.1133 $0.1133 Item 7A. Quantitative and Qualitative Disclosures About Market Risk We are subject to financial market risks, including changes in interest rates. For the year ended December 31, 2019 and 2018, 93% and 91% of the loans in our portfolio bore interest at floating rates, respectively. These floating rate loans typically bear interest in reference to LIBOR, which are indexed to 30-day or 90-day LIBOR rates, subject to an interest rate floor. As of December 31, 2019 and 2018, the weighted average interest rate floor on our floating rate loans was 1.13% and 0.94%, respectively. Assuming that the Statement of Assets and Liabilities as of December 31, 2019 were to remain constant and no actions were taken to alter the existing interest rate sensitivity, the following table shows the annual impact on net income of changes in interest rates: Change in Basis Points Up 200 basis points Up 150 basis points Up 100 basis points Up 50 basis points Down 50 basis points Down 100 basis points Down 150 basis points Down 200 basis points Interest Income Interest Expense Net Interest Income (1) ($ in millions) $10.8 8.1 5.4 2.7 (2.5 ) (4.1 ) (4.8 ) (5.3 ) $(3.2 (2.4 (1.6 ) ) ) (0.8 ) 0.8 1.6 2.4 3.2 $ 7.6 5.7 3.8 1.9 (1.7 ) (2.5 ) (2.4 ) (2.1 ) (1) Excludes the impact of incentive fees based on pre-incentive fee net investment income. See Note 2 for more information on the incentive fee. Although we believe that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of the assets on the balance sheet and other business developments that could affect net increase in net assets resulting from operations. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by this estimate. We may hedge against interest rate fluctuations by using standard hedging instruments such as futures, options and forward contacts subject to the requirements of the 1940 Act. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in the benefits of lower interest rates with respect to our portfolio of investments. For the years ended December 31, 2019 and 2018, we did not engage in hedging activities. 84 TABLE OF CONTENTS Item 8. Financial Statements and Supplementary Data Index to Financial Statements Report of Independent Registered Public Accounting Firm Statements of Assets and Liabilities as of December 31, 2019 and December 31, 2018 Statements of Operations for the years ended December 31, 2019, 2018, and 2017 Statements of Changes in Net Assets for the years ended December 31, 2019, 2018, and 2017 Statements of Cash Flows for the years ended December 31, 2019, 2018, and 2017 Schedule of Investments as of December 31, 2019 and December 31, 2018 Notes to Financial Statements Page 86 89 90 91 92 93 108 85 TABLE OF CONTENTS REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders Stellus Capital Investment Corporation Opinion on the financial statements We have audited the accompanying consolidated statements of assets and liabilities of Stellus Capital Investment Corporation (a Maryland corporation) and subsidiaries (the “Company”), including the consolidated schedules of investments as of December 31, 2019 and 2018, the related consolidated statements of operations, changes in net assets, and cash flows for each of the three years in the period ended December 31, 2019, and the related notes, schedules, and financial highlights (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019 and the financial highlights for each of the five years in the period ended December 31, 2019, in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in the 2013 Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), and our report dated March 2, 2020 expressed an unqualified opinion. Basis for opinion These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our procedures included verification by confirmation of securities as of December 31, 2019 and 2018, by correspondence with the portfolio companies and custodians, or by other appropriate auditing procedures where replies were not received. We believe that our audits provide a reasonable basis for our opinion. /s/ GRANT THORNTON LLP We have served as the Company’s auditor since 2012 Dallas, Texas March 2, 2020 86 TABLE OF CONTENTS REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders Stellus Capital Investment Corporation Opinion on internal control over financial reporting We have audited the internal control over financial reporting of Stellus Capital Investment Corporation (a Maryland corporation) and subsidiaries (the “Company”) as of December 31, 2019, based on criteria established in the 2013 Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in the 2013 Internal Control — Integrated Framework issued by COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated financial statements of the Company as of and for the year ended December 31, 2019, and our report dated March 2, 2020 expressed an unqualified opinion on those financial statements. Basis for opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and limitations of internal control over financial reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. 87 TABLE OF CONTENTS Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ GRANT THORNTON LLP Dallas, Texas March 2, 2020 88 TABLE OF CONTENTS PART I — FINANCIAL INFORMATION STELLUS CAPITAL INVESTMENT CORPORATION CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES ASSETS Non-controlled, affiliated investments, at fair value (amortized cost of $0 and $52,185, respectively) $ — $ 50,000 December 31, 2019 December 31, 2018 Non-controlled, non-affiliated investments, at fair value (amortized cost of $642,707,824 and $502,691,464, respectively) Cash and cash equivalents Receivable for sales and repayments of investments Interest receivable Other receivables Deferred offering costs Prepaid expenses Total Assets LIABILITIES Notes payable Credit facility payable SBA-guaranteed debentures Dividends payable Management fees payable Income incentive fees payable Capital gains incentive fees payable Interest payable Unearned revenue Administrative services payable Deferred tax liability (Note 13) Income tax payable Other accrued expenses and liabilities Total Liabilities Commitments and contingencies (Note 7) Net Assets NET ASSETS 628,948,077 504,433,668 16,133,315 17,467,146 123,409 2,914,710 25,495 — 368,221 99,213 3,788,684 85,246 18,673 344,621 $648,513,227 $526,287,251 $ 47,974,202 $ 47,641,797 160,510,633 98,237,227 157,543,853 146,387,802 2,167,630 2,695,780 1,618,509 880,913 2,322,314 559,768 413,278 134,713 917,000 203,461 1,807,570 2,183,975 1,936,538 81,038 1,863,566 410,593 392,191 67,953 316,092 115,902 $377,942,054 $301,442,244 $270,571,173 $224,845,007 Common stock, par value $0.001 per share (100,000,000 shares authorized; 19,131,746 and 15,953,810 issued and outstanding, respectively) $ 19,132 $ 15,954 Paid-in capital Accumulated undistributed deficit Net Assets Total Liabilities and Net Assets Net Asset Value Per Share 272,117,091 228,160,491 (1,565,050 ) (3,331,438 ) $270,571,173 $224,845,007 $648,513,227 $526,287,251 $ 14.14 $ 14.09 See accompanying notes to these consolidated financial statements. 89 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS INVESTMENT INCOME Interest income Other income Total Investment Income OPERATING EXPENSES Management fees Valuation fees Administrative services expenses Income incentive fees Capital gains incentive fees Professional fees Directors’ fees Insurance expense Interest expense and other fees Income tax expense Other general and administrative expenses Total Operating Expenses Loss on extinguishment of debt Net Investment Income Net realized gain on non-controlled, non-affiliated investments Tax provision on realized gain on investments Net change in unrealized appreciation (depreciation) on For the year ended December 31, 2019 For the year ended December 31, 2018 For the year ended December 31, 2017 $ 56,895,990 2,015,899 $51,463,033 1,803,305 38,071,449 1,576,744 $ 58,911,889 $53,266,338 $39,648,193 $ 9,703,706 265,103 1,691,764 5,809,672 799,876 1,040,011 383,000 352,382 $ 8,154,842 307,838 1,390,375 5,529,376 81,038 1,189,071 317,000 348,500 14,976,024 12,338,755 903,905 547,637 275,106 697,900 6,255,911 336,300 1,245,727 2,911,392 — 1,274,066 331,000 429,897 7,855,211 — 621,204 $ 36,473,080 $30,629,801 $21,260,708 — — 416,725 $ 22,438,809 $22,636,537 $17,970,760 $ 19,565,903 $ 5,540,518 4,655,976 — (267,975 ) — non-controlled, non-affiliated investments $(15,501,951 ) $ (1,706,549 ) 40,113 Net change in unrealized appreciation (depreciation) on non-controlled, affiliated investments Benefit (provision) for taxes on net unrealized gain on investments in taxable subsidiaries 2,185 60,000 (62,185 ) (66,760 ) (67,953 ) 8,593 Net Increase in Net Assets Resulting from Operations $ 26,438,186 $26,194,578 $22,613,257 Net Investment Income Per Share Net Increase in Net Assets Resulting from Operations Per Share Weighted Average Shares of Common Stock Outstanding Distributions Per Share $ $ $ 1.23 1.45 $ $ 1.42 1.64 $ $ 1.21 1.52 18,275,696 15,953,571 14,870,981 1.36 $ 1.36 $ 1.36 See accompanying notes to these consolidated financial statements. 90 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS Increase in Net Assets Resulting from Operations Net investment income Net realized gain on non-controlled, non-affiliated investments Tax provision on realized gain on investments Net change in unrealized appreciation (depreciation) on non- For the year ended December 31, 2019 For the year ended December 31, 2018 For the year ended December 31, 2017 $ 22,438,809 $ 22,636,537 17,970,760 19,565,903 5,540,518 4,655,976 — (267,975 ) — controlled, non-affiliated investments (15,501,951 ) (1,706,549 ) 40,113 Net change in unrealized appreciation (depreciation) on non- controlled, affiliated investments 2,185 60,000 (62,185 ) Benefit (provision) for taxes on unrealized appreciation on investments (66,760 ) (67,953 ) 8,593 Net Increase in Net Assets Resulting from Operations $ 26,438,186 $ 26,194,578 $ 22,613,257 Stockholder Distributions From: Net investment income Net realized capital gains Total Distributions Capital Share Transactions Issuance of common stock Sales load Offering costs Partial share transactions Net Increase in Net Assets Resulting From Capital Share Transactions Total Increase in Net Assets $ (10,000,000 (15,038,173 ) ) $ (16,418,007 (5,272,543 ) ) $ (17,970,760 (2,352,545 ) ) $ (25,038,173 ) $ (21,690,550 ) $ (20,323,305 ) $ 45,862,239 (1,015,127 (521,715 755 ) ) $ 44,326,153 $ 45,726,166 $ $ $ 94,788 — — (1,051 ) $ 48,741,549 (1,358,880 (307,022 (142 ) ) ) 93,737 $ 47,075,505 4,597,765 $ 49,365,457 Net Assets at Beginning of Period $224,845,007 $220,247,242 $170,881,785 Net Assets at End of Period $270,571,173 $224,845,007 $220,247,242 See accompanying notes to these consolidated financial statements. 91 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Cash flows from operating activities Net Increase in net assets resulting from operations Adjustments to reconcile net increase in net assets resulting from operations to net cash used in operating activities: Purchases of investments Proceeds from sales and repayments of investments Net change in unrealized depreciation (appreciation) on investments Increase in investments due to PIK Amortization of premium and accretion of discount, net Deferred tax provision Amortization of loan structure fees Amortization of deferred financing costs Amortization of loan fees on SBA-guaranteed debentures Net realized gain on investments Loss on extinguishment of debt Changes in other assets and liabilities Decrease (increase) in interest receivable Decrease (increase) in other receivable Decrease (increase) in prepaid expenses Increase in management fees payable Increase (decrease) in incentive fees payable Increase in capital gains incentive fees payable Increase in administrative services payable Increase in interest payable Increase in unearned revenue Increase in income tax payable Increase (decrease) in other accrued expenses and liabilities Net Cash Provided by (Used in) Operating Activities Cash flows from Financing Activities Proceeds from the issuance of common stock Sales load for common stock issued Offering costs paid for common stock Proceeds from notes issued Financing costs paid for Notes issued Repayments on Notes issued Stockholder distributions paid Proceeds from SBA Debentures Financing costs paid on SBA Debentures Borrowings under Credit Facility Repayments of Credit Facility Financing costs paid on Credit Facility Partial share transactions Net Cash Provided by (Used in) Financing Activities Net Increase (Decrease) in Cash and Cash Equivalents Cash and cash equivalents balance at beginning of period Cash and Cash Equivalents Balance at End of Period Supplemental and Non-Cash Activities Cash paid for interest expense Excise tax paid Shares issued pursuant to Dividend Reinvestment Plan Increase in distribution payable Increase (decrease) in deferred offering costs For the year ended December 31, 2019 For the year ended December 31, 2018 For the year ended December 31, 2017 $ 26,438,186 $ 26,194,578 $ 22,613,257 ) ) ) ) ) ) ) ) ) ) ) ) ) ) (246,438,384 128,206,318 15,499,766 (415,933 (1,774,469 66,760 519,995 332,407 623,900 (19,565,903 — 873,974 59,751 (23,600 511,805 (318,029 799,875 21,087 458,748 149,175 600,908 87,559 $ (93,286,104 $ 45,862,239 (1,015,127 (503,042 — — — (24,678,113 11,000,000 (467,850 245,750,000 (183,750,000 (246,589 755 $ 91,952,273 (1,333,831 $ 17,467,146 $ 16,133,315 (272,927,459 147,528,448 1,646,549 (1,869,905 (1,553,333 67,953 456,151 335,309 623,989 (5,540,518 — (866,480 (85,246 16,649 562,383 1,564,891 81,038 65,158 842,393 271,289 316,092 (152,511 $(102,422,582 ) ) ) ) ) ) ) ) (172,171,246 172,260,541 22,072 (499,595 (1,196,566 (8,593 455,893 251,826 333,027 (4,655,976 416,725 ) ) ) ) ) 1,679,538 748 94,949 13,297 (981,624 — 54,522 47,361 119,349 — 1,022 $ 18,850,527 ) ) $ — $ 48,741,549 (1,358,880 — (307,022 (18,673 48,875,000 — (1,688,961 — (25,000,000 — (19,930,616 (21,594,863 25,000,000 60,000,000 (856,250 (2,055,000 194,250,000 246,300,000 (269,500,000 (187,500,000 (1,158,616 (351,403 (142 (1,051 $ $ 94,779,010 (2,933,938 $ 15,916,589 (7,643,572 $ 9,194,129 25,110,718 $ 25,110,718 $ 17,467,146 ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) $ 13,035,976 280,000 — 360,060 (18,673 ) $ 10,075,913 27,717 94,788 899 18,673 $ 6,762,104 37,648 — 392,689 — See accompanying notes to these consolidated financial statements. 92 TABLE OF CONTENTS Investments Non-controlled, non-affiliated investments Abrasive Products & Equipment, LLC, et al Term Loan (SBIC) APE Holdings, LLC Class A Common Units Total Adams Publishing Group, LLC Term Loan Delayed Draw Term Loan Total Advanced Barrier Extrusions, LLC Term Loan (SBIC) GP ABX Holdings Partnership, L.P. Common Stock Total Apex Environmental Resources Holdings, LLC Common Units Preferred Units Total APG Intermediate Sub 2 Corp. Term Loan APG Holdings, LLC Class A Preferred Units Total Stellus Capital Investment Corporation Consolidated Schedule of Investments December 31, 2019 Footnotes Security Coupon floor Cash PIK LIBOR Investment Date Maturity Headquarters/ Industry Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets (2)(9) (2)(12) Second Lien L+10.50% 1.00 % 12.45 % 9/5/2014 3/5/2021 Rubber $5,325,237 $ 5,320,277 $ 5,112,228 1.89 % 3M Deer Park, TX Chemicals, Plastics, & Equity 9/5/2014 375,000 units 375,000 160,000 $ 5,695,277 $ 5,272,228 0.06 1.95 % % (4) (3) (12) (12) (8) 3M First Lien L+7.50% 1.00 % 9.44 % 8/3/2018 6/30/2023 3M First Lien L+7.50% 1.00 % 9.45 % 8/3/2018 6/30/2023 (2)(12) First Lien L+5.75% 1.00 % 7.70 % 8/8/2018 8/8/2023 3M (4) Equity 8/8/2018 (4) (4) Equity Equity 10/30/2015 10/30/2015 Greenville, TN Media: Advertising, Printing & Publishing Rhinelander, WI Containers, Packaging & Glass Amsterdam, OH Environmental Industries Castle Rock, CO $5,411,955 5,371,128 5,222,536 1.93 % $173,277 173,277 167,213 $ 5,544,405 $ 5,389,749 0.06 1.99 % % $14,286,000 14,056,286 14,214,570 5.25 % 250,000 units 250,000 350,000 $14,306,286 $14,564,570 0.13 5.38 % % 945 shares 945 shares 945 945,179 946,124 $ 0 540,000 540,000 0.00 0.20 0.20 % % % $ 1,127,652 units 1,127,652 2,420,000 $10,867,843 $12,444,250 0.89 4.59 % % Atlanta, GA Services: Business Chicago, IL Healthcare & Pharmaceuticals 254,250 units 0 1,100,000 0.41 % 750,000 units $ 0 3,250,000 0 $ 4,350,000 1.20 1.61 % % $4,537,037 4,511,837 4,514,352 1.67 % (22) First Lien P+5.00% 1.00 % 9.75 % 11/30/2018 11/30/2023 Aerospace & Defense $9,925,000 9,740,191 10,024,250 3.70 % (4) Equity 11/30/2018 Atmosphere Aggregator Holdings II, LP Common Units Stratose Aggregator Holdings, LP Common Units Total ASC Communications, LLC (4) (4) (7) Equity Equity 1/26/2016 6/30/2015 Term Loan (SBIC) (2)(12) First Lien L+6.25% 1.00 % 8.05 % 6/29/2017 6/29/2023 1M 1M (12) First Lien L+6.25% 1.00 % 8.05 % 2/4/2019 6/29/2023 $7,712,963 7,634,025 7,674,398 2.84 % Term Loan ASC Communications Holdings, LLC Class A Preferred Units (SBIC) Total (2)(4) Equity 6/29/2017 BFC Solmetex, LLC (23) 3M Revolver (12)(19) First Lien L+6.50% 1.00 % 8.45 % 4/2/2018 9/26/2023 3M Nashville, TN Environmental Industries 73,529 shares 90,895 580,000 $12,236,757 $12,768,750 0.21 4.72 % % $1,650,367 1,650,367 1,584,352 0.59 % Term Loan (SBIC) Bonded Filter Co. LLC, Term Loan (SBIC) Total BW DME Acquisition, LLC Term Loan (SBIC) BW DME Holdings, LLC, Term Loan BW DME Holdings, LLC Class A-1 Preferred Units BW DME Holdings, LLC Class A-2 Preferred Units Total Café Valley, Inc. Term Loan CF Topco LLC, Common Units Total (2)(12) First Lien L+6.50% 1.00 % 8.45 % 4/2/2018 9/26/2023 $11,592,818 11,468,077 11,129,105 4.11 % (2)(12) First Lien L+6.50% 1.00 % 8.45 % 4/2/2018 9/26/2023 3M (2)(13)(22) First Lien L+6.00% 1.00 % 9.59 % 8/24/2017 8/24/2022 3M Tempe, AZ Healthcare & Pharmaceuticals $1,205,073 1,192,107 1,156,870 $14,310,551 $13,870,327 0.43 5.13 % % $16,695,804 16,392,213 16,445,367 6.08 % (6) (4) (4) Unsecured 17.50% 17.50 % 6/1/2018 6/30/2020 $329,504 329,504 329,504 0.12 % Equity Equity 3M 8/24/2017 1/26/2018 1,000,000 shares 1,000,000 1,110,000 0.41 % 937,261 shares 937,261 1,040,000 $18,658,978 $18,924,871 0.38 6.99 % % Phoenix, AZ Beverage, Food, & (12) First Lien L+6.00% 1.25 % 7.95 % 8/28/2019 8/28/2024 Tobacco $17,575,000 17,242,956 17,399,250 6.43 % (4) Equity 8/28/2019 8,810 shares 880,952 860,000 $18,123,908 $18,259,250 0.32 6.75 % % See accompanying notes to these consolidated financial statements. 93 TABLE OF CONTENTS Stellus Capital Investment Corporation Consolidated Schedule of Investments December 31, 2019 Investments C.A.R.S. Protection Plus, Inc. Footnotes Security Coupon LIBOR floor Cash PIK Investment Date Maturity 1M Headquarters/ Industry Murrysville, PA Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets Term Loan (12) First Lien L+8.50% 0.50 % 10.30 % 12/31/2015 12/31/2020 Automotive $94,003 $ 93,553 $ 94,003 0.03 % Term Loan (SBIC) CPP Holdings LLC Class A Common Units Total Colford Capital Holdings, LLC Preferred Units Condor Borrower, LLC Term Loan Condor Top Holdco Limited Convertible Preferred Shares Condor Holdings Limited Preferred Shares, Class B Total Convergence Technologies, Inc. (2)(12) First Lien L+8.50% 0.50 % 10.30 % 12/31/2015 12/31/2020 $7,332,210 7,297,083 7,332,210 2.71 % 1M (4) Equity (4)(5) Equity 3M 12/31/2015 8/20/2015 149,828 shares 149,828 240,000 $ 7,540,464 $ 7,666,213 0.09 2.83 % % 38,893 units 195,036 20,000 0.01 % New York, NY Finance Clifton, NJ (12) Second Lien L+8.75% 1.00 % 10.68 % 10/27/2017 4/27/2025 Software $13,750,000 13,534,399 13,406,250 4.95 % (4) (4) Equity Equity 10/27/2017 10/27/2017 500,000 shares 442,197 330,000 0.12 % 500,000 shares 57,804 40,000 $14,034,400 $13,776,250 0.01 5.08 % % 3M Indianpolis, IN Term Loan (SBIC) (2)(12) First Lien L+6.75% 1.50 % 8.70 % 8/31/2018 8/30/2024 Services: Business $7,053,571 6,937,850 6,983,036 2.58 % Term Loan Delayed Draw Term Loan Tailwind Core Investor, LLC Class A Preferred Units Total Data Centrum Communications, Inc. (12) (12) (4) 3M First Lien L+6.75% 1.50 % 8.70 % 2/28/2019 8/30/2024 $1,417,857 1,392,977 1,403,679 0.52 % 3M First Lien L+6.75% 1.50 % 8.70 % 8/31/2018 8/30/2024 $5,303,571 5,303,571 5,250,536 1.94 % Equity 8/31/2018 4,275 units 429,614 360,000 $14,064,012 $13,997,251 0.13 5.17 % % (12) First Lien L+5.50% 1.00 % 7.44 % 5/15/2019 5/15/2024 3M Term Loan Health Monitor Holdings, LLC Seires A Preferred Units Total Douglas Products Group, LP (4) Equity Class A Common Units DRS Holdings III, Inc. (4) Equity 1M 5/15/2019 12/27/2018 (12) First Lien L+5.75% 1.00 % 7.55 % 11/1/2019 11/1/2025 1M (10)(12) First Lien L+5.75% 1.00 % 7.55 % 11/1/2019 11/1/2025 Montvale, NJ Media: Advertising, Printing & Publishing Liberty, MO Chemicals, Plastics, & Rubber St. Louis, MO Consumer Goods: Durable Roselle, IL $16,168,750 15,881,567 15,845,375 5.86 % 1,000,000 shares 1,000,000 730,000 $16,881,567 $16,575,375 0.27 6.13 % % 322 shares 139,656 490,000 0.18 % $10,000,000 9,902,215 9,902,215 3.66 % $36,364 36,364 36,008 $ 9,938,579 $ 9,938,223 0.01 3.67 % % Term Loan Revolver Total DTE Enterprises, LLC Term Loan DTE Holding Company, LLC Common Shares, Class A-2 DTE Holding Company, LLC Preferred Shares, Class AA Total Empirix Holdings I, Inc. Common Shares, Class A Common Shares, Class B Total Energy Labs Holding Corp. Common Stock Exacta Land Surveyors, LLC Term Loan (SBIC) SP ELS Holdings LLC, Class A Common Units Total EOS Fitness Holdings, LLC Preferred Units Class B Common Units Total (18) (12) (4) (4) (4) (4) (4) (14)(25) 1M First Lien L+7.50% 1.50 % 9.24 % 4/13/2018 4/13/2023 Energy: Oil & Gas $10,991,941 10,836,199 10,772,102 3.98 % Equity Equity Equity Equity Equity 3M 4/13/2018 4/13/2018 11/1/2013 11/1/2013 9/29/2016 776,316 shares 466,204 1,000,000 0.37 % 723,684 shares 723,684 940,000 $12,026,087 $12,712,102 0.35 4.70 % % 1,304 shares 1,317,406 shares 1,304,232 13,174 $ 1,317,406 $ 0 0 0 0.00 0.00 0.00 % % % 598 shares 598,182 870,000 0.32 % Billerica, MA Software Houston, TX Energy: Oil & Gas Cleveland, OH (2)(12) First Lien L+5.75% 1.50 % 7.70 % 2/8/2019 2/8/2024 Services: Business $16,884,375 16,594,835 16,715,532 6.18 % (4) Equity 2/8/2019 1,069,143 shares 1,069,143 880,000 $17,663,978 $17,595,532 0.33 6.51 % % (4) (4) Equity Equity 12/30/2014 12/30/2014 Phoenix, AZ Hotel, Gaming, & Leisure 118 shares 3,017 shares $ 0 0 0 $ 530,000 10,000 540,000 0.20 0.00 0.20 % % % See accompanying notes to these consolidated financial statements. 94 TABLE OF CONTENTS Stellus Capital Investment Corporation Consolidated Schedule of Investments December 31, 2019 Investments Fast Growing Trees, LLC Footnotes (16) Security Coupon LIBOR floor Cash PIK Investment Date Maturity Headquarters/ Industry Fort Mill, SC Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets Term Loan (SBIC) SP FGT Holdings, LLC, Class A Common Total FB Topco, Inc. Term Loan (2)(12) First Lien (4) Equity (13)(22) First Lien Delayed Draw Term Loan (13)(22) First Lien 3M L+7.75% 3M L+6.35% 3M L+6.35% 1.00 % 9.70 % 2/5/2018 02/05/23 Retail $19,192,490 $18,935,337 $18,616,716 6.88 % 2/5/2018 1,000,000 shares 1,000,000 750,000 $19,935,337 $19,366,716 0.28 7.16 % % Camden, NJ 1.00 % 10.45 % 6/27/2018 4/24/2023 Education $20,803,881 20,492,224 20,179,764 7.46 % 1.00 % 10.48 % 6/27/2018 4/24/2023 $1,140,578 1,140,578 1,106,361 $21,632,802 $21,286,125 0.41 7.87 % % First Lien 7.00% 7.00 % 6/10/2016 6/10/2021 Fort Smith, AR Consumer Goods: Durable $14,801,785 14,678,894 11,989,446 4.43 % (6) Unsecured 11.00% 11.00 % 6/10/2016 2/3/2021 $147,231 147,231 0 0.00 % (4) Equity 6/10/2016 (12) Second Lien L+10.25% 1.00 % 12.19 % 1/30/2015 1/20/2022 3M 1.50 % 10.95 % 5/1/2018 11/1/2023 13,445 shares 94,569 0 $14,920,694 $11,989,446 0.00 4.43 % % $5,000,000 4,961,969 4,375,000 1.62 % $4,500,000 4,432,260 4,230,000 1.56 % Cary, NC Education San Antonio, TX Services: Business Carlsbad, CA Beverage, Food, & Total Furniture Factory Outlet, LLC Term Loan Furniture Factory Holdings, LLC Term Loan Furniture Factory Ultimate Holding, LP Common Units Total GK Holdings, Inc. Term Loan General LED OPCO, LLC Term Loan GS HVAM Intermediate, LLC (12) (21)(34) Second Lien Term Loan HV GS Acquisition, LP Class A Interests Total Grupo HIMA San Pablo, Inc., (12) First Lien (4) Equity et al Term Loan Term Loan Total (12)(27) (15)(27) Second Lien First Lien ICD Intermediate Holdco 2, LLC Term Loan (SBIC) ICD Holdings, LLC, Class A Preferred Total (2)(5)(12) Second Lien (4)(5) Equity Integrated Oncology Network, LLC (29)(30) Term Loan Intuitive Health, LLC (12) First Lien Term Loan (SBIC II) (9)(12) First Lien Term Loan Total Invincible Boat Company, LLC (12) First Lien Term Loan (SBIC II) (9)(12) First Lien Term Loan (12) First Lien Revolver Invincible Parent Holdco, LLC Class A Common Units (12)(28) First Lien (4) Equity Total J.R. Watkins, LLC Revolver (12) First Lien Term Loan (SBIC) J.R. Watkins Holdings, Inc. Class A Preferred Total (2)(12) First Lien (4) Equity 3M L+9.00% 1M L+5.75% 3M L+7.00% 13.75% 3M L+9.00% 3M L+5.50% 3M L+6.00% 3M L+6.00% 3M L+6.50% 3M L+6.50% 3M L+6.50% 1M L+6.50% 1M L+6.50% 1.00 % 7.56 % 10/18/2019 10/2/2024 Tobacco $13,257,576 13,128,716 13,128,716 4.85 % 6/29/2018 1,796 shares 1,618,844 1,620,000 $14,747,560 $14,748,716 0.60 5.45 % % 1.50 % 8.94 0.00 % % 2/1/2013 2/1/2013 1/31/2018 7/31/2018 San Juan, PR Healthcare & Pharmaceuticals San Francisco, CA $4,503,720 $4,109,524 4,503,720 4,109,524 3,490,383 0 $ 8,613,244 $ 3,490,383 1.29 0.00 1.29 % % % 1.00 % 10.95 % 1/1/2018 7/1/2024 Finance $10,000,000 9,847,895 10,000,000 3.70 % 1/1/2018 9,962 shares 496,405 1,030,000 $10,344,300 $11,030,000 0.38 4.08 % % 1.50 % 7.43 % 7/17/2019 6/24/2024 1.50 % 7.95 % 10/18/2019 10/18/2024 1.50 % 7.95 % 10/18/2019 10/18/2024 1.50 % 8.45 % 8/28/2019 8/28/2025 Newport Beach, CA Healthcare & Pharmaceuticals Plano, TX Healthcare & Pharmaceuticals Opa Locka, FL Consumer Goods: Durable $16,637,202 16,332,432 16,387,644 6.06 % $6,000,000 5,883,278 5,883,278 2.17 % $11,500,000 11,276,284 11,276,284 $17,159,562 $17,159,562 4.17 6.34 % % $5,962,500 5,848,418 5,843,250 2.16 % 1.50 % 8.45 % 8/28/2019 8/28/2025 $6,459,375 6,264,417 6,330,188 2.34 % 1.50 % 8.45 % 8/28/2019 8/28/2025 $568,182 568,182 556,818 0.21 % 8/28/2019 1,000,000 shares 982,099 1,090,000 $13,663,116 $13,820,256 0.40 5.11 % % 1.25 % 8.30 % 12/22/2017 12/22/2022 San Francisco, CA Consumer Goods: non-durable $1,750,000 1,750,000 1,470,000 0.54 % 1.25 % 8.30 % 12/22/2017 12/22/2022 $12,250,000 12,091,135 10,290,000 3.80 % 12/22/2017 1,133 shares 1,132,576 10,000 $14,973,711 $11,770,000 0.00 4.34 % % See accompanying notes to these consolidated financial statements. 95 TABLE OF CONTENTS Investments Jurassic Acquisiton Corp. Term Loan Kelleyamerit Holdings, Inc. Term Loan (SBIC) KidKraft, Inc. Term Loan Lynx FBO Operating, LLC Term Loan Lynx FBO Investments, LLC Class A-1 Common Units Total Madison Logic, Inc. Term Loan (SBIC) Madison Logic Holdings, Inc. Common Stock (SBIC) Madison Logic Holdings, Inc. Series A Preferred Stock (SBIC) Total Mobile Acquisition Holdings, LP Class A Common Units Munch’s Supply, LLC Term Loan Cool Supply Holdings, LLC Class A Common Units Total National Trench Safety, LLC, et al Term Loan (SBIC) NTS Investors, LP Class A Common Units Total Naumann/Hobbs Material Handling Corporation II, Inc. (6) (31) (12) (4) (4) (20) (12) (4) (2) (4) (32) Stellus Capital Investment Corporation Consolidated Schedule of Investments December 31, 2019 Footnotes Security Coupon floor Cash PIK LIBOR (12) First Lien L+5.50% 0.00 % 7.30 % 1M Investment Date Maturity Headquarters/ Industry Sparks, MD 12/28/2018 11/15/2024 Metals & Mining Walnut Creek, CA Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets $17,325,000 $17,103,044 $17,325,000 6.40 % (2)(13)(22) First Lien L+7.50% 1.00 % 10.03 % 3/30/2018 3/30/2023 3M Second Lien 12.00% 11.00 % 1.00 % 9/30/2016 3/30/2022 3M First Lien L+5.75% 1.50 % 7.86 % 9/30/2019 9/30/2024 Aerospace & Defense $13,750,000 13,486,379 13,486,379 4.98 % Equity 9/30/2019 3,704 shares 500,040 500,000 $13,986,419 $13,986,379 0.18 5.16 % % Automotive Dallas, TX Consumer Goods: Durable Houston, TX $9,750,000 9,611,438 9,555,000 3.53 % $9,503,655 9,411,079 8,410,735 3.11 % (2)(12) First Lien L+8.00% 0.50 % 9.80 % 11/30/2016 11/30/2021 1M New York, NY Media: Broadcasting & Subscription Santa Clara, CA Software New Lenox, IL $4,581,402 4,561,449 4,581,402 1.69 % 5,000 shares 50,000 60,000 0.02 % 4,500 shares 450,000 520,000 $ 5,061,449 $ 5,161,402 0.19 1.90 % % 750 units 455,385 1,740,000 0.64 % 11/30/2016 11/30/2016 11/1/2016 (2)(4) Equity (2)(4) Equity Equity 3M First Lien L+6.25% 1.00 % 8.35 % 4/11/2019 4/11/2024 Capital Equipment $7,960,000 7,890,332 7,880,400 2.91 % Equity 4/11/2019 500,000 units 498,779 410,000 $ 8,389,111 $ 8,290,400 0.15 3.06 % % Second Lien 11.50% 11.50 % 3/31/2017 3/31/2022 Equity 3/31/2017 Houston, TX Construction & Building Phoenix, AZ $10,000,000 9,908,323 10,000,000 3.70 % 2,335 units 500,000 500,000 $10,408,323 $10,500,000 0.18 3.88 % % Term Loan (SBIC II) (9)(12) First Lien L+6.25% 1.50 % 8.20 % 8/30/2019 8/30/2024 Services: Business $5,978,693 5,865,655 5,859,119 2.17 % 3M Term Loan CGC NH, Inc. Common Units Total NGS US Finco, LLC Term Loan (SBIC) NS412, LLC Term Loan NS Group Holding Company, LLC Class A Common Units Total NuMet Machining Techniques, LLC Term Loan Bromford Industries Limited Term (12) (4) First Lien Equity 3M L+6.25% 1.50 % 8.20 % 8/30/2019 8/30/2019 8/30/2024 $9,480,904 123 shares 9,301,650 440,758 9,291,286 400,000 $15,608,063 $15,550,405 3.43 0.15 5.75 % % % 1M Bradford, PA (2)(12) Second Lien L+8.50% 1.00 % 10.30 % 10/1/2018 4/1/2026 Utilities: Oil & Gas $10,000,000 9,868,044 9,900,000 3.66 % (12) Second Lien L+8.50% 1.00 % 10.45 % 5/6/2019 11/6/2025 Services: Consumer $7,615,000 7,474,214 7,500,775 2.77 % 3M Dallas, TX (4) Equity 5/6/2019 750 shares 750,000 810,000 $ 8,224,214 $ 8,310,775 0.30 3.07 % % 6M Birmingham, UK (5)(35) Second Lien L+9.00% 2.00 % 11.00 % 11/5/2019 5/5/2026 Aerospace & Defense $11,700,000 11,470,017 11,470,017 4.24 % 6M Loan (5)(35) Second Lien L+9.00% 2.00 % 11.00 % 11/5/2019 5/5/2026 $7,800,000 7,646,678 7,646,678 2.83 % Bromford Holdings, L.P. Class A Membership Units Total Nutritional Medicinals, LLC Term Loan Functional Aggregator, LLC Common Units Total PCP MT Aggregator Holdings, L.P. Common LP Units (4)(5) Equity 11/5/2019 (24) (12) (4) 3M First Lien L+6.00% 1.00 % 7.95 % 11/15/2018 11/15/2023 Centerville, OH Healthcare & Pharmaceuticals Equity 11/15/2018 1,000,000 shares 1,000,000 1,000,000 $20,116,695 $20,116,695 0.37 7.44 % % $14,845,000 14,606,657 14,399,650 5.32 % 12,500 shares 1,250,000 1,260,000 $15,856,657 $15,659,650 0.47 5.79 % % (4) Equity 3/29/2019 Oak Brook, IL Finance 750,000 shares 0 1,080,000 0.40 % See accompanying notes to these consolidated financial statements. 96 TABLE OF CONTENTS Stellus Capital Investment Corporation Consolidated Schedule of Investments December 31, 2019 Investments PCS Software, Inc. Footnotes (11)(33) Security Coupon floor Cash PIK LIBOR Investment Date Maturity Term Loan (SBIC) (2)(12) First Lien L+5.75% 1.50 % 7.70 % 7/1/2019 7/1/2024 3M 3M Headquarters/ Industry Shenandoah, Tx Transportation & Logistics Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets $1,990,000 $ 1,953,461 $ 1,960,150 0.72 % First Lien L+5.75% 1.50 % 7.70 % 7/1/2019 7/1/2024 $15,173,750 14,895,138 14,946,144 5.52 % (12) (4) Term Loan PCS Software Holdings, LLC Class A Preferred Units Total Pioneer Transformers, L.P. Term Loan (SBIC II) Premiere Digital Services, Inc. Equity 7/1/2019 (9)(12) First Lien L+6.00% 1.50 % 7.79 % 11/22/2019 1M Franklin, WI 8/16/2024 Capital Equipment Los Angeles, CA Media: Broadcasting 325,000 shares 325,000 320,000 $17,173,599 $17,226,294 0.12 6.36 % % $4,987,500 4,901,484 4,901,484 1.81 % Term Loan (SBIC) (2)(13)(22) First Lien L+5.50% 1.50 % 8.73 % 10/18/2018 10/18/2023 3M 3M & Subscription $9,992,518 9,753,256 9,842,630 3.64 % Class A Common Units (4) Equity SQAD, LLC Term Loan Premiere Digital Holdings, Inc., Common Stock Premiere Digital Holdings, Inc., Preferred Stock Total Price for Profit, LLC Term Loan (SBIC) I2P Holdings, LLC, Series A Preferred Total Protect America, Inc. Term Loan (SBIC) Skopos Financial, LLC Term Loan Skopos Financial Group, LLC Series A Preferred Units Total Specified Air Solutions, LLC Term Loan (SBIC) SQAD Holdco, Inc. Preferred Shares, Series A (SBIC) SQAD Holdco, Inc. Common Shares (SBIC) Total TechInsights, Inc. Term Loan Time Manufacturing Acquisition, LLC Term Loan Time Manufacturing Investments, LLC Class A Common Units Total TFH Reliability, LLC Term Loan (SBIC) TFH Reliability Group, LLC Class A Common Units Total U.S. Auto Sales, Inc. et al USASF Blocker II, LLC Common Units USASF Blocker III, LLC Series C Preferred Units USASF Blocker LLC Common Units Total (13)(22) First Lien L+5.50% 1.50 % 8.73 % 10/18/2018 10/18/2023 $2,428,772 2,372,392 2,392,341 0.88 % Equity Equity (4) (4) (17) 3M 10/18/2018 10/18/2018 5,000 shares 50,000 70,000 0.03 % 4,500 shares 450,000 600,000 $12,625,648 $12,904,971 0.22 4.77 % % Cleveland, OH (2)(12) First Lien L+6.50% 1.00 % 8.45 % 1/31/2018 1/31/2023 Services: Business $3,887,657 3,836,120 3,887,657 1.44 % (4) Equity 1/31/2018 750,000 shares 750,000 2,800,000 $ 4,586,120 $ 6,687,657 1.03 2.47 % % Austin TX (2)(6)(12)(26) Second Lien L+7.75% 1.00 % 0.00 % 8/30/2017 10/30/2020 Services: Consumer $17,979,749 17,851,392 5,034,330 1.86 % 3M (5) Unsecured 12.00% 12.00 % 1/31/2014 1/31/2021 (4)(5) Equity 1/31/2014 6/30/2017 (2)(12) First Lien L+6.50% 1.00 % 8.44 % 12/22/2017 12/22/2022 3M (2)(4) (2)(4) Equity Equity 10/31/2013 10/31/2013 Irving, TX Finance Buffalo, NY Construction & Building Tarrytown, NY Media: Broadcasting & Subscription Ottawa, Ontario $15,500,000 15,500,000 15,422,500 5.70 % 1,120,684 units 1,162,544 1,110,000 $16,662,544 $16,532,500 0.41 6.11 % % 3,846 shares 0 250,000 0.09 % $14,497,594 14,447,718 14,352,618 5.30 % 5,624 shares 156,001 720,000 0.27 % 5,800 shares 62,485 80,000 $14,666,204 $15,152,618 0.03 5.60 % % (5)(13)(22) First Lien L+6.00% 1.00 % 9.33 % 8/16/2017 10/2/2023 High Tech Industries $21,540,925 21,201,137 21,217,811 7.84 % 3M (6) (4) Unsecured 11.50% 10.75 % 0.75 % 2/3/2017 8/3/2023 Capital Equipment $6,385,182 6,302,784 6,385,182 2.36 % Waco, TX Equity 2/3/2017 5,000 units 500,000 660,000 $ 6,802,784 $ 7,045,182 0.24 2.60 % % 3M Houston, TX Chemicals, Plastics, & (2)(12) Second Lien L+10.75% 0.50 % 12.70 % 10/21/2016 4/21/2022 Rubber $5,875,000 5,814,371 5,875,000 2.17 % (4) Equity 10/21/2016 (4)(5) (4)(5) (4)(5) Equity Equity Equity 6/8/2015 2/13/2018 6/8/2015 250,000 shares 231,521 220,000 $ 6,045,892 $ 6,095,000 0.08 2.25 % % Lawrenceville, GA Finance 441 units 441,000 690,000 0.26 % 125 Units 125,000 200,000 0.07 % 9,000 units 9,000 575,000 $ 10,000 900,000 0.00 0.33 % % $ See accompanying notes to these consolidated financial statements. 97 TABLE OF CONTENTS Stellus Capital Investment Corporation Consolidated Schedule of Investments December 31, 2019 Investments VRI Intermediate Holdings, LLC Term Loan (SBIC) VRI Ultimate Holdings, LLC Class A Preferred Units Total Whisps Acquisiton Corp. Term Loan Whisps Holding LP Class A Common Units Total Wise Parent Company, LLC Footnotes Security Coupon floor Cash PIK LIBOR Investment Date Maturity (2)(12) Second Lien L+9.25% 1.00 % 11.20 % 5/31/2017 10/31/2020 3M Headquarters/ Industry Franklin, OH Healthcare & Pharmaceuticals Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets $9,000,000 $ 8,949,730 $ 9,000,000 3.33 % (4) Equity 5/31/2017 326,797 shares (12) First Lien L+6.00% 0.00 % 7.95 % 4/26/2019 4/18/2025 Tobacco $8,875,000 3M Elgin, IL Beverage, Food, & (4) Equity 4/18/2019 500,000 shares 500,000 9,449,730 $ 610,000 9,610,000 0.23 3.56 % % 8,717,992 8,875,000 3.28 % 500,000 9,217,992 $ 680,000 9,555,000 0.25 3.53 % % $ $ Salt Lake City, UT Beverage, Food, & Membership Units (4) Equity 8/27/2018 Tobacco 6 units 41,894 30,000 0.01 % Total Non-controlled, non-affiliated investments Net Investments LIABILITIES IN EXCESS OF OTHER ASSETS NET ASSETS 642,707,824 642,707,824 628,948,077 232.45 628,948,077 232.45 % % (358,376,904 (132.45 $ 270,571,173 100.00 ) )% % (1) (2) (3) (4) (5) (6) (7) (8) (9) See Note 1 of the Notes to the Consolidated Financial Statements for a discussion of the methodologies used to value securities in the portfolio. Investments held by the SBIC subsidiaries (as defined in Note 1), which include $8,445,923 of cash and $222,009,613 of investments (at cost), are excluded from the obligations to the lenders of the Credit Facility as defined in Note 9. The Company’s obligations to the lenders of the Credit Facility are secured by a first priority security interest in all investments and cash and cash equivalents, except for investments held by the SBIC subsidiaries. Excluded from the investment is an undrawn delayed draw term loan commitment in an amount not to exceed $669,231, with an interest rate of LIBOR plus 7.50% and a maturity of June 30, 2023. This investment is accruing an unused commitment fee of 0.375% per annum. Security is non-income producing. The investment is not a qualifying asset under the Investment Company Act of 1940, as amended. The Company may not acquire any non-qualifying assets unless, at the time of the acquisition, qualifying assets represent at least 70% of the Company’s total assets. Qualifying assets represent approximately 89% of the Company’s total assets as of December 31, 2019. Represents a PIK interest security. At the option of the issuer, interest can be paid in cash or cash and PIK interest. The percentage of PIK interest shown is the maximum PIK interest that can be elected by the issuer. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $666,666, with an interest rate of LIBOR plus 6.25% and a maturity of June 29, 2022. This investment is accruing an unused commitment fee of 0.50% per annum. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $2,000,000, with an interest rate of LIBOR plus 5.75% and a maturity of August 8, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. Investments held by the SBIC II subsidiary (as defined in Note 1), which include $477,392 of cash and $22,498,836 of investments (at cost), are excluded from the obligations to the lenders of the Credit Facility as defined in Note 9. The Company’s obligations to the lenders of the Credit Facility are secured by a first priority security interest in all investments and cash and cash equivalents, except for investments held by the SBIC II subsidiary. See accompanying notes to these consolidated financial statements. 98 TABLE OF CONTENTS Stellus Capital Investment Corporation Consolidated Schedule of Investments December 31, 2019 (10) (11) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $872,727, with an interest rate of LIBOR plus 5.75% and a maturity of November 1, 2025. This investment is accruing an unused commitment fee of 0.50% per annum. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $1,500,000, with an interest rate of LIBOR plus 5.75% and a maturity of July 1, 2024. This investment is accruing an unused commitment fee of 0.50% per annum. (12) These loans have LIBOR floors that are lower than the applicable LIBOR rates; therefore, the floors are not in effect. (13) These loans are last-out term loans with contractual rates higher than the applicable LIBOR rates; therefore, the floors are not in effect. (14) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $1,500,000, with an interest rate of LIBOR plus 5.75% and a maturity of February 8, 2024. This investment is accruing an unused commitment fee of 0.50% per annum. (15) Investment has been on non-accrual since October 31, 2017. (16) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $1,000,000, with an interest rate of LIBOR plus 7.75% and a maturity of February 5, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. (17) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $1,500,000, with an interest rate of LIBOR plus 6.50% and a maturity of January 31, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. (18) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $750,000, with an interest rate of LIBOR plus 7.50% and a maturity of April 13, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. (19) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $488,998, with an interest rate of LIBOR plus 6.50% and a maturity of September 26, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. (20) Excluded from the investment is an undrawn delayed draw term loan commitment in an amount not to exceed $2,222,222, with an interest rate of LIBOR plus 6.25% and a maturity of April 11, 2024. This investment is accruing an unused commitment fee of 1.00% per annum (21) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $2,651,515, with an interest rate of LIBOR plus 5.75% and a maturity of October 2, 2024. This investment is accruing an unused commitment fee of 0.50% per annum. (22) This loan is a unitranche investment. (23) Excluded from the investment is an undrawn delayed draw term loan commitment in an amount not to exceed $1,662,592, with an interest rate of LIBOR plus 6.50% and a maturity of September 26, 2023. This investment is not accruing an unused commitment fee. (24) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $2,000,000 with an interest rate of LIBOR plus 6.00% and a maturity of November 15, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. (25) Excluded from the investment is an undrawn delayed draw term commitment in an amount not to exceed $4,000,000, with an interest rate of LIBOR plus 5.75% and a maturity of February 8, 2024. This investment is accruing an unused commitment fee of 0.50% per annum. See accompanying notes to these consolidated financial statements. 99 TABLE OF CONTENTS Stellus Capital Investment Corporation Consolidated Schedule of Investments December 31, 2019 (26) Investment has been on non-accrual since June 28, 2019. (27) Maturity date is under on-going negotiations with portfolio company and other lenders, if applicable. (28) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $852,273, with an interest rate of LIBOR plus 6.50% and a maturity of August 28, 2025. This investment is accruing an unused commitment fee of 0.50% per annum. (29) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $553,517, with an interest rate of LIBOR plus 5.50% and a maturity of June 24, 2024. This investment is accruing an unused commitment fee of 0.50% per annum. (30) Excluded from the investment is an undrawn delated draw term loan commitment in an amount not to exceed $2,767,584, with an interest rate of LIBOR plus 5.50% and a maturity of June 24, 2024. This investment is accruing an unused commitment fee of 1.00% per annum. (31) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $1,875,000, with an interest rate of LIBOR plus 5.75% and a maturity of September 30, 2024. This investment is accruing an unused commitment fee of 0.50% per annum. (32) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $2,644,550, with an interest rate of LIBOR plus 6.25% and a maturity of August 30, 2024. This investment is accruing an unused commitment fee of 0.50% per annum. (33) Excluded from the investment is an undrawn delated draw term loan commitment in an amount not to exceed $3,750,000, with an interest rate of LIBOR plus 5.75% and a maturity of March 31, 2020. This investment is not accruing an unused commitment fee. (34) Excluded from the investment is an undrawn delated draw term loan commitment in an amount not to exceed $1,590,909, with an interest rate of LIBOR plus 5.75% and a maturity of October 2, 2024. This investment is accruing an unused commitment fee of 1.00% per annum. (35) These loans have LIBOR Floors which are higher than the current applicable LIBOR rates; therefore, the floors are in effect. Abbreviation Legend PIK — Payment-In-Kind L — LIBOR Euro — Euro Dollar See accompanying notes to these consolidated financial statements. 100 TABLE OF CONTENTS Investments Non-controlled, affiliated investments Glori Energy Production Inc. Glori Energy Production, LLC Class A Common Units Subtotal Non-controlled, affiliated investments Non-controlled, non-affiliated investments Abrasive Products & Equipment, LLC, et al Term Loan (SBIC) APE Holdings, LLC Class A Common Units Total Adams Publishing Group, LLC Term Loan Advanced Barrier Extrusions, LLC Term Loan (SBIC) GP ABX Holdings Partnership, L.P. Common Stock Total Apex Environmental Resources Holdings, LLC Common Units Preferred Units Total APG Intermediate Sub 2 Corp. Term Loan APG Holdings, LLC Class A Preferred Units Total Atmosphere Aggregator Holdings II, LP Stellus Capital Investment Corporation Consolidated Schedule of Investments December 31, 2018 Footnotes Security Coupon floor Cash PIK LIBOR Investment Date Maturity Headquarters/ Industry Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets (2) (4) (2) Equity 2/1/2017 Energy: Oil & Gas 1,000 shares $ 52,185 $ 50,000 0.02 % Houston, TX 52,185 50,000 0.02 % (2)(12)(20) Second Lien L+10.50% 1.00 % 0.00 % 9/5/2014 3/5/2020 Plastics, & Rubber $5,325,237 5,294,907 4,712,835 2.10 % 3M Deer Park, TX Chemicals, Equity 9/5/2014 375,000 units 375,000 5,669,907 0 4,712,835 0.00 2.10 % % (4) (3) (12) (8) First Lien 3M L+7.50% 1.00 % 9.93 % 8/3/2018 6/30/2023 (2)(12) First Lien 3M L+5.75% 1.00 % 8.56 % 8/8/2018 8/8/2023 (4) Equity 8/8/2018 Greenville, TN Media: Advertising, Printing & Publishing Rhinelander, WI Containers, Packaging & Glass Amsterdam, OH Environmental Industries Castle Rock, CO Aerospace & Atlanta, GA Services: Business Chicago, IL Healthcare & Pharmaceuticals Austin TX FIRE: Insurance Nashville, TN Environmental Industries $7,125,000 7,058,675 6,875,625 3.06 % $11,400,000 11,187,711 10,659,000 4.74 % 250,000 units 250,000 11,437,711 210,000 10,869,000 0.09 4.83 % % 945 shares 945 shares 945 945,179 946,124 0 330,000 330,000 0.00 0.15 0.15 % % % 10,000,000 1,000,000 units 9,777,822 9,777,822 4.35 % 1,000,000 10,777,822 1,000,000 10,777,822 0.44 4.79 % % 254,250 units 750,000 units 254,250 1,190,000 0.53 % 750,000 1,004,250 3,510,000 4,700,000 1.56 2.09 % % $5,083,335 $ 5,045,552 $ 5,057,916 2.25 % 73,529 shares 483,540 5,529,092 800,000 5,857,916 0.36 2.61 % % $5,000,000 4,925,301 4,950,000 2.20 % 500,000 units 500,000 5,425,301 510,000 5,460,000 0.23 2.43 % % $305,623 305,623 288,814 0.13 % (4) (4) Equity Equity (13)(22) First Lien (4) Equity 3M L+6.00% 1.00 % 10.05 % 11/30/2018 11/30/2023 Defense 10/30/2015 10/30/2015 11/30/2018 6/30/2015 6/30/2015 Common Units Atmosphere Aggregator Holdings, LP Common Units Total ASC Communications, LLC (4) (4) (7) Equity Equity Term Loan (SBIC) ASC Communications Holdings, LLC Class A Preferred Units (SBIC) Total Beneplace, LLC Term Loan (SBIC) Beneplace Holdings, LLC Preferred Units Total BFC Solmetex, LLC (2)(12) First Lien 1M L+5.75% 1.00 % 8.27 % 6/29/2017 6/29/2022 (2)(4) Equity 6/29/2017 (2)(12) SecondLien L+10.00% 1.00 % 12.81 % 3/27/2017 9/27/2022 3M Equity 3/27/2017 (4) (23) Revolver (12)(19) First Lien Term Loan (SBIC) Bonded Filter Co. LLC, Term Loan (SBIC) Total (2)(12) First Lien (2)(12) First Lien 3M L+6.25% 3M L+6.25% 3M L+6.25% 1.00 % 9.06 % 4/2/2018 9/26/2023 1.00 % 9.06 % 4/2/2018 9/26/2023 $11,711,033 11,552,684 11,066,926 4.92 % 1.00 % 9.06 % 4/2/2018 9/26/2023 $1,216,687 1,200,236 13,058,543 1,149,769 12,505,509 0.51 5.56 % % See accompanying notes to these consolidated financial statements. 101 Term Loan (13)(22) First Lien Delayed Draw Term Loan (13)(22) First Lien TABLE OF CONTENTS Investments BW DME Acquisition, LLC Term Loan (SBIC) BW DME Holdings, LLC, Term Loan (SBIC) BW DME Holdings, LLC Class A-1 Preferred Units BW DME Holdings, LLC Class A-2 Preferred Units Total C.A.R.S. Protection Plus, Inc. Term Loan Term Loan (SBIC) CPP Holdings LLC Class A Common Units Total Catapult Learning, Inc. Total Colford Capital Holdings, LLC Preferred Units Condor Borrower, LLC Term Loan Condor Top Holdco Limited Convertible Preferred Shares Condor Holdings Limited Preferred Shares, Class B Total Convergence Technologies, Inc. Term Loan (SBIC) Tailwind Core Investor, LLC Class A Preferred Units Total Douglas Products Group, LP Class A Common Units Dream II Holdings, LLC Class A Common Units DTE Enterprises, LLC Term Loan DTE Holding Company, LLC Common Shares, Class A-2 DTE Holding Company, LLC Preferred Shares, Class AA Total Empirix Inc. Empirix Holdings I, Inc. Common Shares, Class A Empirix Holdings I, Inc. Common Shares, Class B Total Energy Labs Inc. Energy Labs Holding Corp. Common Stock Stellus Capital Investment Corporation Consolidated Schedule of Investments (continued) December 31, 2018 Footnotes Security Coupon floor Cash PIK LIBOR Investment Date Maturity (2)(13)(22) First Lien 3M L+6.00% 1.00 % 10.50 % 8/24/2017 8/24/2022 Headquarters/ Industry Tempe, AZ Healthcare & Pharmaceuticals Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets $16,695,804 16,297,319 16,111,451 7.17 % (6) (4) (4) Unsecured 17.50% 17.50 % 6/1/2018 12/31/2019 $277,635 277,635 277,635 0.12 % Equity Equity 8/24/2017 1/26/2018 1,000,000 shares 937,261 shares 1,000,000 930,000 0.41 % 937,261 18,512,215 870,000 18,189,086 0.39 8.09 % % (12) First Lien (2)(12) First Lien (4) Equity Murrysville, PA 3M L+8.50% 3M L+8.50% 3M L+6.35% 3M L+6.35% 0.50 % 11.21 % 12/31/2015 12/31/2020 Automotive $98,746 97,843 98,746 0.04 % 0.50 % 11.21 % 12/31/2015 12/31/2020 12/31/2015 $7,702,191 149,828 shares 7,631,725 7,702,191 3.43 % 149,828 7,879,396 170,000 7,970,937 0.08 3.55 % % Camden, NJ 1.00 % 11.08 % 6/27/2018 4/24/2023 Education $20,856,549 20,472,244 19,813,722 8.81 % 1.00 % 11.22 % 6/27/2018 4/24/2023 $1,143,451 1,143,451 21,615,695 1,086,278 20,900,000 0.48 9.29 % (4)(5) Equity 8/20/2015 New York, NY Finance Clifton, NJ 38,893 units 247,815 60,000 0.03 % (12) Second Lien 3M L+8.75% 1.00 % 11.28 % 10/27/2017 4/27/2025 Software $13,750,000 13,505,368 13,062,500 5.81 % Equity Equity (4) (4) (14) (2)(12) First Lien (4) Equity (4) Equity (4) (18) (12) (4) (4) (4) (4) Equity First Lien 3M L+7.50% Equity Equity Equity Equity (4) Equity 10/27/2017 10/27/2017 3M L+6.75% 1.50 % 9.56 % 8/31/2018 8/30/2024 Indianpolis, IN Services: Business 8/31/2018 12/27/2018 10/20/2014 1.50 % 10.12 % 4/13/2018 4/13/2023 4/13/2018 4/13/2018 Liberty, MO Chemicals, Plastics, & Rubber Boca Raton, FL Services: Consumer Roselle, IL Energy: Oil & Gas Billerica, MA 500,000 shares 500,000 shares $ 442,197 $ 330,000 0.15 % 57,804 14,005,369 40,000 13,432,500 0.02 5.98 % % $7,125,000 6,988,628 6,697,500 2.98 % 3,750 units 375,000 7,363,628 390,000 7,087,500 0.17 3.15 % % 322 shares 139,656 670,000 0.30 % 250,000 units $12,491,941 776,316 shares 723,684 shares 242,304 110,000 0.05 % 12,271,851 12,242,102 5.44 % 776,316 1,410,000 0.63 % 613,794 13,661,961 1,320,000 14,972,102 0.59 6.66 % % 11/1/2013 Software 1,304 shares 1,304,232 1,650,000 0.73 % 11/1/2013 9/29/2016 1,317,406 shares 13,174 1,317,406 20,000 1,670,000 0.01 0.74 % % 598 shares 598,182 520,000 0.23 % Houston, TX Energy: Oil & Gas See accompanying notes to these consolidated financial statements. 102 TABLE OF CONTENTS Investments EOS Fitness OPCO Holdings, LLC Term Loan (SBIC) EOS Fitness Holdings, LLC Class A Preferred Units EOS Fitness Holdings, LLC Class B Common Units Total Fast Growing Tree, LLC Term Loan (SBIC) SP FGT Holdings, LLC, Class A Common Total Furniture Factory Outlet, LLC Term Loan Revolver Furniture Factory Holdings, LLC Term Loan Furniture Factory Ultimate Holdings, LP Common Units Total GK Holdings, Inc. General LED OPCO, LLC Term Loan Good Source Solutions, Inc. Term Loan HV GS Acquisition, LLC Class A Preferred Units HV GS Acquisition, LLC Class B Common Units Total Grupo HIMA San Pablo, Inc., et al Term Loan Term Loan Total ICD Intermediate Holdco 2, LLC Term Loan (SBIC) ICD Holdings, LLC, Class A Preferred Total J.R. Watkins, LLC Stellus Capital Investment Corporation Consolidated Schedule of Investments (continued) December 31, 2018 Footnotes Security Coupon floor Cash PIK LIBOR Investment Date Maturity Headquarters/ Industry Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets (2)(12) First Lien 1M L+8.25% 0.75 % 10.60 % 12/30/2014 12/30/2019 Phoenix, AZ Hotel, Gaming, & Leisure Equity Equity (4) (4) (16) (2)(12) First Lien (4) Equity 12/30/2014 12/30/2014 3M L+7.75% 1.00 % 10.56 % 2/5/2018 02/05/23 Retail Fort Mill, SC 2/5/2018 $3,064,655 3,049,620 3,064,655 1.36 % 118 shares 117,670 340,000 0.15 % 3,017 shares 3,017 3,170,307 10,000 3,414,655 % 0.00 1.51 $20,215,000 1,000,000 shares 19,871,587 19,305,325 8.59 % $ 1,000,000 $ 1,080,000 20,385,325 20,871,587 0.48 9.07 % % First Lien First Lien 3M L+8.00% 3M L+8.00% 0.50 % 10.81 % 6/10/2016 6/10/2021 Fort Smith, AR Consumer Goods: Durable $15,163,885 14,961,912 15,163,885 6.74 % 0.50 % 10.81 % 12/17/2018 6/10/2021 $2,500,000 2,500,000 2,500,000 1.11 % Unsecured 11.00% 11.00 % 6/10/2016 2/3/2021 $140,056 140,056 140,056 0.06 % (12) (12) (6) (4) Equity 6/10/2016 Term Loan (12) Second Lien L+10.25% 1.00 % 13.05 % 1/30/2015 1/20/2022 3M (12) Second Lien 3M L+9.00% 1.50 % 11.81 % 5/1/2018 11/1/2023 (13)(22) First Lien 3M L+6.00% 1.00 % 11.13 % 6/29/2018 6/29/2023 (4) (4) Equity Equity 6/29/2018 6/29/2018 (12) (25) (15) (25) First Lien Second Lien 3M L+7.00% 13.75% 1.50 % 9.54 0.00 % % 2/1/2013 2/1/2013 1/31/2018 7/31/2018 13,445 shares 94,569 17,696,537 210,000 18,013,941 0.09 8.00 % % $5,000,000 4,946,554 4,425,000 1.97 % $4,500,000 4,418,420 4,252,500 1.89 % $18,500,000 18,158,424 17,390,000 7.73 % 1,000 shares 1,000,000 730,000 0.32 % 28,125 shares 0 19,158,424 0 18,120,000 0.00 8.05 % % $4,688,430 $4,109,524 4,688,430 4,109,524 8,797,954 4,125,818 904,095 5,029,913 1.83 0.40 2.23 % % % Cary, NC Education San Antonio, TX Services: Business Carlsbad, CA Beverage, Food, & Tobacco San Juan, PR Healthcare & Pharmaceuticals San Francisco, CA (2)(5)(12) Second Lien 3M L+9.00% 1.00 % 11.81 % 1/2/2018 7/1/2024 Finance $10,000,000 9,822,706 9,900,000 4.40 % (4)(5) Equity 1/2/2018 9,962 shares 496,409 10,319,115 820,000 10,720,000 0.36 4.76 % % Revolver (12) First Lien Term Loan (SBIC) J.R. Watkins Holdings, Inc. Class A Preferred Total Jurassic Intermediate Holdings Corp. Term Loan Kelleyamerit Holdings, Inc. (2)(12) First Lien (4) Equity (12) First Lien Term Loan (SBIC) (2)(13)(22) First Lien 3M L+6.50% 3M L+6.50% 3M L+5.50% 3M L+7.50% 1.25 % 9.31 % 12/22/2017 12/22/2022 San Francisco, CA Consumer Goods: non-durable $1,750,000 1,750,000 1,671,250 0.74 % 1.25 % 9.31 % 12/22/2017 12/22/2022 $12,375,000 12,169,222 11,818,125 5.26 % 12/22/2017 1,076 shares 1,075,758 14,994,980 1,090,000 14,579,375 0.48 6.48 % % 0.00 % 8.14 % 12/28/2018 11/15/2024 Sparks, MD Metals & Mining Walnut Creek, CA $17,500,000 $ 17,237,500 $ 17,237,500 7.67 % 1.50 % 10.98 % 3/30/2018 3/30/2023 Automotive $9,750,000 9,577,863 9,311,250 4.14 % See accompanying notes to these consolidated financial statements. 103 TABLE OF CONTENTS Investments Keais Records Service, LLC Keais Holdings, LLC Class A Units KidKraft, Inc. Term Loan Livingston International, Inc. Term Loan Madison Logic, Inc. Term Loan (SBIC) Madison Logic Holdings, Inc. Common Stock (SBIC) Madison Logic Holdings, Inc. Series A Preferred Stock (SBIC) Total Magdata Intermediate Holdings, LLC Term Loan Mobileum, Inc. Term Loan Mobile Acquisition Holdings, LP Class A-2 Common Units Total MTC Parent, L.P. Class A-2 Common Units National Trench Safety, LLC, et al Term Loan (SBIC) NTS Investors, LP Class A Common Units Total NGS US Finco, LLC Term Loan (SBIC) Nutritional Medicinals, LLC Term Loan Functional Aggregator, LLC Common Units Total OGS Holdings, Inc. Series A Convertible Preferred Stock Premiere Digital Services, Inc. Stellus Capital Investment Corporation Consolidated Schedule of Investments (continued) December 31, 2018 Footnotes Security Coupon floor Cash PIK LIBOR Investment Date Maturity (4) (6) Equity 6/30/2016 Second Lien 12.00% 11.00 1.00 % % 9/30/2016 3/30/2022 (5)(12) Second Lien 3M L+8.25% 1.25 % 11.05 % 4/23/2013 4/18/2020 (2)(12) First Lien (2)(4) Equity (2)(4) Equity (12) Second Lien (12) Second Lien 1M L+8.00% 0.50 % 10.51 % 11/30/2016 11/30/2021 11/30/2016 11/30/2016 1.00 % 12.31 % 10/16/2017 4/16/2024 3M L+9.50% 3M (4) Equity 11/1/2016 (4) Equity 12/1/2015 Finance Oak Brook, IL Second Lien Equity Second Lien First Lien Equity 11.50% 11.50 % 3/31/2017 3/31/2022 3/31/2017 1M L+8.50% 3M L+6.00% 1.00 % 10.88 % 10/4/2018 4/1/2026 1.00 % 8.81 % 11/15/2018 11/15/2023 11/15/2018 Equity 4/22/2014 (2) (4) (2)(12) (24) (12) (4) (4) (10) Principal Amount/ Shares 148,335 units Amortized Cost Fair Value (1) % of Net Assets 736,595 820,000 0.36 % $9,409,210 9,284,478 8,797,611 3.91 % $6,841,739 6,808,345 6,841,739 3.04 % $4,730,117 4,700,059 4,706,466 2.09 % 5,000 shares 50,000 50,000 0.02 % 4,500 shares 450,000 5,200,059 470,000 5,226,466 0.21 2.32 % % $14,750,000 14,490,683 14,086,250 6.26 % Headquarters/ Industry Houston, TX Dallas, TX Consumer Goods: Durable Toronto, Ontario Transportation: Cargo New York, NY Media: Broadcasting & Subscription Austin TX Software Santa Clara, CA 750 units 750,000 shares 455,385 21,619,458 770,000 22,270,000 0.34 9.90 % % 0 7,750,000 3.45 % $10,000,000 9,874,827 9,650,000 4.29 % 2,335 units 500,000 10,374,827 380,000 10,030,000 0.17 4.46 % % $10,000,000 9,853,435 9,853,435 4.38 % $15,500,000 12,500 shares 15,198,412 15,198,412 6.76 % $ 1,250,000 $ 1,250,000 16,448,412 16,448,412 0.56 7.32 % % 11,521 shares 50,001 280,000 0.12 % $8,250,000 8,019,407 8,019,407 3.57 % Houston, TX Construction & Building Bradford, PA Utilities: Oil & Gas Centerville, OH Healthcare & Pharmaceuticals Chantilly, Virginia Services: Government Los Angeles, CA Media: Broadcasting & Subscription L+10.25% 0.75 % 13.06 % 11/1/2016 5/1/2022 Software $21,500,000 21,164,073 21,500,000 9.56 % Term Loan (SBIC) (2)(13)(22) First Lien Term Loan Premiere Digital Holdings, Inc., Common Stock Premiere Digital Holdings, Inc., Preferred Stock Total Price for Profit, LLC (13)(22) First Lien Equity Equity (4) (4) (17) Term Loan (SBIC) I2P Holdings, LLC, Series A Preferred Total (2)(12) First Lien (4) Equity 3M L+5.50% 3M L+5.50% 1.50 % 9.60 % 10/18/2018 10/18/2023 1.50 % 9.60 % 10/18/2018 10/18/2023 $2,428,772 2,360,887 2,360,887 1.05 % 10/18/2018 10/18/2018 3M L+6.50% 1.00 % 9.31 % 1/31/2018 1/31/2023 Cleveland, OH Services: Business 1/31/2018 5,000 shares 50,000 50,000 0.02 % 4,500 shares 450,000 10,880,294 450,000 10,880,294 0.20 4.84 % % $8,818,907 750,000 shares 8,669,840 8,774,812 3.90 % 750,000 9,419,840 1,460,000 10,234,812 0.65 4.55 % % See accompanying notes to these consolidated financial statements. 104 TABLE OF CONTENTS Stellus Capital Investment Corporation Consolidated Schedule of Investments (continued) December 31, 2018 Investments Protect America, Inc. Footnotes Security Coupon floor Cash PIK LIBOR Investment Date Maturity Term Loan (SBIC) Refac Optical Group, et al (2)(6)(12) (11) Second Lien 1.00 % 10.56 2.00 % % 8/30/2017 10/30/2020 Headquarters/ Industry Austin TX Services: Consumer Blackwood, NJ Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets $17,979,749 17,710,359 17,530,255 7.80 % Revolver Term A Loan Term B Loan Total (9)(10)(12)(26) First Lien (9)(12)(26) First Lien 0.00 % 11/7/2012 9/30/2018 Retail $880,000 880,000 880,000 0.39 % 0.00 % 11/7/2012 9/30/2018 $472,968 472,968 472,968 0.21 % (6)(9)(12)(26) First Lien L+10.75% 0.00 0.00 % % 11/7/2012 9/30/2018 $6,539,666 6,539,666 7,892,634 5,787,604 7,140,572 % 2.57 3.17 3M L+9.75% 1M L+8.00% 1M L+8.00% 1M Resolute Industrial, LLC Resolute Industrial Holdings, LLC Class A Preferred Units Total Roberts-Gordon, LLC Specified Air Solutions, LLC Class A Common Units Skopos Financial, LLC Term Loan Skopos Financial Group, LLC (4) (4) (5) Equity Equity 7/26/2017 6/30/2017 Unsecured 12.00% 12.00 % 1/31/2014 1/31/2020 (4)(5) Equity 1/31/2014 (2) First Lien 3M L+6.50 1.00 % 9.30 % 12/22/2017 12/22/2022 (2)(4) Equity (2)(4) Equity 10/31/2013 10/31/2013 (5)(13)(22) First Lien 3M L+6.00% 1.00 % 10.32 % 8/16/2017 10/2/2023 (6) Unsecured 11.50% 10.75 0.75 % % 2/3/2017 8/3/2023 (4) Equity 2/3/2017 3M L+10.75% 0.50 % 13.56 % 10/21/2016 4/21/2022 10/21/2016 (2)(12) Second Lien (4) Equity (5)(12) Second Lien (4)(5) Equity (4)(5) (4)(5) Equity Equity 6/8/2015 2/13/2018 6/8/2015 Class A Units Total SQAD, LLC Term Loan (SBIC) SQAD Holdco, Inc. Preferred Shares, Series A (SBIC) SQAD Holdco, Inc. Common Shares (SBIC) Total TechInsights, Inc. Term Loan Time Manufacturing Acquisition, LLC Term Loan Time Manufacturing Investments, LLC Class A Common Units Total TFH Reliability, LLC Term Loan (SBIC) TFH Reliability Group, LLC Class A Common Units Total U.S. Auto Sales, Inc. et al Term Loan USASF Blocker II, LLC Common Units USASF Blocker III, LLC Series C Preferred Units USASF Blocker LLC Common Units Total VRI Intermediate Holdings, LLC Term Loan (SBIC) VRI Ultimate Holdings, LLC Class A Preferred Units Total (2)(12) Second Lien 3M L+9.25% 1.00 % 12.06 % 5/31/2017 10/31/2020 Franklin, OH Healthcare & Pharmaceuticals (4) Equity 5/31/2017 See accompanying notes to these consolidated financial statements. 105 Wheeling, IL Capital Equipment Buffalo, NY Construction & Building Irving, TX Finance Tarrytown, NY Media: Broadcasting & Subscription Ottawa, Ontario High Tech Industries Waco, TX Capital Equipment Houston, TX Chemicals, Plastics, & Rubber Lawrenceville, GA 601 units 750,000 1,300,000 0.58 % % 3,846 shares $17,500,000 1,120,684 units 0 250,000 0.11 % 17,494,460 17,150,000 7.63 % 1,162,544 18,657,004 1,110,000 18,260,000 0.49 8.12 % % $14,846,000 $ 14,780,330 $ 14,400,620 6.40 % 5,624 shares 156,001 310,000 0.14 % 5,800 shares 62,485 14,998,816 40,000 14,750,620 0.02 6.56 % % $21,540,923 21,094,192 21,094,192 9.38 % $6,385,182 6,285,876 6,129,775 2.73 % 5,000 units 500,000 6,785,876 500,000 6,629,775 0.22 2.95 % % $5,875,000 250,000 shares 5,794,016 5,875,000 2.61 % 231,521 6,025,537 450,000 6,325,000 0.20 2.81 % % 441 units 441,000 550,000 0.24 % 50 units 50,000 60,000 0.03 9,000 units 9,000 4,984,478 10,000 5,120,000 0.00 2.27 % % $9,000,000 326,797 shares 8,895,138 8,820,000 3.92 % 500,000 9,395,138 440,000 9,260,000 0.20 4.12 % % 1M L+10.50% 1.00 % 12.85 % 6/8/2015 6/8/2020 Finance $4,500,000 4,484,478 4,500,000 2.00 % TABLE OF CONTENTS Stellus Capital Investment Corporation Consolidated Schedule of Investments (continued) December 31, 2018 Investments Footnotes Security Coupon floor Cash PIK LIBOR Investment Date Maturity Wise Holding Corporation Term Loan (12)(20) Unsecured L+11.00% 1.00 % 0.00 % 6/30/2016 12/31/2021 3M Headquarters/ Industry Salt Lake City, UT Beverage, Food, & Tobacco Principal Amount/ Shares Amortized Cost Fair Value (1) % of Net Assets $1,250,000 1,238,210 0 0.00 % Delayed Draw Term Loan Wise Parent Company, LLC Membership Units Total Total Non-controlled, non- affiliated investments Net Investments LIABILITIES IN EXCESS OF OTHER ASSETS NET ASSETS (12)(21) First Lien (4) Equity 1M L+6.5% 1.00 % 0.00 % 8/27/2018 6/30/2021 $253,906 253,906 93,945 0.04 % 6/30/2016 1 units 58,594 1,550,710 0 93,945 0.00 0.04 % % $502,691,464 $ 504,433,668 224.35 504,483,668 224.37 502,743,649 % % (279,638,661 (124.37 $ 224,845,007 100.00 ) )% % (1) (2) (3) (4) (5) (6) (7) (8) See Note 1 of the Notes to the Consolidated Financial Statements for a discussion of the methodologies used to value securities in the portfolio. Investments held by the SBIC subsidiary, which include $13,410,706 of cash and $214,114,498 of investments (at cost) are excluded from the obligations to the lenders of the Credit Facility. The Company’s obligations to the lenders of the Credit Facility, as defined in Note 9, are secured by a first priority security interest in all investments and cash and cash equivalents, except for investments held by the SBIC Subsidiary. Excluded from the investment is an undrawn delayed draw term loan commitment in an amount not to exceed $865,385, with an interest rate of LIBOR plus 7.50% and a maturity of June 30, 2023. This investment is accruing an unused commitment fee of 0.375% per annum. Security is non-income producing. The investment is not a qualifying asset under the Investment Company Act of 1940, as amended. The Company may not acquire any non-qualifying assets unless, at the time of the acquisition, qualifying assets represent at least 70% of the Company’s total assets. Qualifying assets represent approximately 87% of the Company’s total assets as of December 31, 2018. Represents a PIK interest security. At the option of the issuer, interest can be paid in cash or cash and PIK interest. The percentage of PIK interest shown is the maximum PIK interest that can be elected by the issuer. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $666,666, with an interest rate of LIBOR plus 5.75% and a maturity of June 29, 2022. This investment is accruing an unused commitment fee of 0.50% per annum. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $2,000,000, with an interest rate of LIBOR plus 5.75% and a maturity of August 8, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. (9) Investment has been on non-accrual since November 30, 2018. (10) (11) Excluded from the investment is an undrawn delayed draw term loan commitment in an amount not to exceed $3,669,681 with an interest rate of LIBOR plus 5.50% and a maturity of October 18, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $520,000, with an interest rate of LIBOR plus 8.00% and a maturity of September 30, 2018. This investment is not accruing an unused commitment fee. (12) These loans have LIBOR floors that are lower than the applicable LIBOR rates; therefore, the floors are not in effect. See accompanying notes to these consolidated financial statements. 106 TABLE OF CONTENTS Stellus Capital Investment Corporation Consolidated Schedule of Investments (continued) December 31, 2018 (13) These loans are last-out term loans with contractual rates higher than the applicable LIBOR rates; therefore, the floors are not in effect. (14) Excluded from the investment is an undrawn delayed draw term loan commitment in an amount not to exceed $5,357,143, with an interest rate of LIBOR plus 6.75% and a maturity of August 30, 2024. This investment is accruing an unused commitment fee of 0.50% per annum. (15) Investment has been on non-accrual since November 1, 2017. (16) (17) (18) (19) Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $1,000,000, with an interest rate of LIBOR plus 7.75% and a maturity of February 5, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $1,500,000, with an interest rate of LIBOR plus 6.50% and a maturity of January 31, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $750,000, with an interest rate of LIBOR plus 7.50% and a maturity of April 13, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $1,222,494, with an interest rate of LIBOR plus 6.25% and a maturity of September 26, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. (20) Investment has been on non-accrual since March 29, 2018. (21) Investment has been on non-accrual since October 31, 2018. (22) This loan is a unitranche investment. (23) (24) Excluded from the investment is an undrawn delayed draw term loan commitment in an amount not to exceed $1,662,592, with an interest rate of LIBOR plus 6.25% and a maturity of September 26, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. Excluded from the investment is an undrawn revolver commitment in an amount not to exceed $2,000,000 with an interest rate of LIBOR plus 6.00% and a maturity of November 15, 2023. This investment is accruing an unused commitment fee of 0.50% per annum. (25) Maturity date is under on-going negotiations with the portfolio company and other lenders, if applicable. (26) Payments on the Company’s investment in Refac Optical Group are currently past due. Abbreviation Legend PIK — Payment-In-Kind L — LIBOR Euro — Euro Dollar See accompanying notes to these consolidated financial statements. 107 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 NOTE 1 — NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES Nature of Operations Stellus Capital Investment Corporation (“we”, “us”, “our” and the “Company”) was formed as a Maryland corporation on May 18, 2012 (“Inception”) and is an externally managed, closed-end, non-diversified investment management company. The Company is applying the guidance of Accounting Standards Codification (“ASC”) Topic 946, Financial Services Investment Companies. The Company has elected to be regulated as a business development company under the Investment Company Act of 1940, as amended (the “1940 Act”) and treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”) for U.S. federal income tax purposes. The Company’s investment activities are managed by our investment adviser Stellus Capital Management, LLC (“Stellus Capital” or the “Advisor”). As of December 31, 2019 the Company has issued a total of 19,131,746 shares and raised $281,605,976 in gross proceeds since inception, incurring $9,103,378 in offering expenses and sales load fees for net proceeds from offerings of $272,502,598. The Company’s shares are currently listed on the New York Stock Exchange under the symbol “SCM”. See Note 4 for further details. The Company has established wholly owned subsidiaries: SCIC — Consolidated Blocker 1, Inc., SCIC — ICD Blocker 1, Inc., SCIC — Invincible Blocker 1, Inc., SCIC — FBO Blocker 1, Inc., SCIC — SKP Blocker 1, Inc., SCIC — APE Blocker 1, Inc., SCIC — CC Blocker 1, Inc., SCIC — ERC Blocker 1, Inc., and SCIC — Hollander Blocker 1, Inc., which are structured as Delaware entities, to hold equity or equity-like investments in portfolio companies organized as limited liability companies, or LLCs (or other forms of pass-through entities) (collectively, the “Taxable Subsidiaries”). The Taxable Subsidiaries are consolidated for U.S. generally accepted accounting principles (“U.S GAAP”) reporting purposes, and the portfolio investments held by them are included in the consolidated financial statements. On June 14, 2013, we formed Stellus Capital SBIC, LP (the “SBIC subsidiary”), a Delaware limited partnership, and its general partner, Stellus Capital SBIC GP, LLC, a Delaware limited liability company, as wholly owned subsidiaries of the Company. On June 20, 2014, the SBIC subsidiary received a license from the U.S. Small Business Administration (“SBA”) to operate as a Small Business Investment Company (“SBIC”) under Section 301(c) of the Small Business Investment Company Act of 1958, as amended. The SBIC subsidiary and its general partner are consolidated for U.S. GAAP reporting purposes, and the portfolio investments held by it are included in the consolidated financial statements. On November 29, 2018, we formed Stellus Capital SBIC II, LP (The “SBIC II subsidiary”), a Delaware limited partnership, and its general partner, Stellus Capital SBIC II GP, LLC, a Delaware limited liability company, as wholly owned subsidiaries of the Company. On August 14, 2019, the SBIC II subsidiary received a license from the SBA to operate as an SBIC under Section 301(c) of the Small Business Investment Company Act of 1958, as amended. The SBIC II subsidiary and its general partner are consolidated for U.S. GAAP reporting purposes, and the portfolio investments held by it are included in the consolidated financial statements. The SBIC licenses allow the SBIC subsidiary and SBIC II subsidiary (together, “the SBIC subsidiaries”) to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and other customary procedures. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and have a ten year maturity. The principal amount of SBA-guaranteed debentures is not required to be paid prior to maturity but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed on a semi-annual basis at a market-driven spread over U.S. Treasury Notes with 10-year maturities. The SBA, as a creditor, will have a superior claim to the SBIC subsidiaries’ assets over the Company’s stockholders in the event the Company liquidates one or both of the SBIC subsidiaries or the SBA exercises its remedies under the SBA-guaranteed 108 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 debentures issued by the SBIC subsidiaries upon an event of default. For the SBIC subsidiary, SBA regulations currently limit the amount that a single licensee may borrow to a maximum of $150,000,000 when it has at least $75,000,000 in regulatory capital, as such term is defined by the SBA, receives a capital commitment from the SBA and has been through an examination by the SBA subsequent to licensing. For the SBIC II subsidiary, SBA regulations limit these amounts to $175,000,000 of borrowings when it has at least $87,500,000 of regulatory capital. As of both December 31, 2019 and 2018, the SBIC subsidiary had $75,000,000 of regulatory capital, as such term is defined by the SBA. As of both December 31, 2019 and 2018, the SBIC subsidiary had $150,000,000 of SBA-guaranteed debentures outstanding. As of December 31, 2019, which was the end of its the first year of operations, the SBIC II subsidiary had $20,000,000 in regulatory capital and $11,000,000 of SBA-guaranteed debentures outstanding. See footnote (2) of the Consolidated Schedule of Investments for additional information regarding the treatment of investments in the SBIC subsidiaries with respect to the Credit Facility. As a BDC, we are required to comply with certain regulatory requirements. Prior to June 28, 2018, we were only allowed to employ leverage to the extent that our asset coverage, as defined in the 1940 Act, was equal to at least 200% after giving effect to such leverage. On March 23, 2018, the Small Business Credit Availability Act (the “SBCAA”) was signed into law, which included various changes to regulations under the federal securities laws that impact BDCs. The SBCAA included changes to the 1940 Act to allow BDCs to decrease their asset coverage requirement to 150% from 200% under certain circumstances. On April 4, 2018, the Company’s board of directors (the “Board”), including a “required majority” (as such term is defined in Section 57(o) of the Investment Company Act of 1940, as amended (the “1940 Act”)) of the Board, approved the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act. The Board also approved the submission of a proposal to approve the application of the modified asset coverage requirements set forth in Section 61(a)(2) of the 1940 Act, which was approved by shareholders at the Company’s 2018 annual meeting of stockholders. As a result, the asset coverage ratio test applicable to the Company was decreased from 200% to 150%, effective June 28, 2018. The amount of leverage that we employ at any time depends on our assessment of the market and other factors at the time of any proposed borrowing. As of December 31, 2019, the Company’s asset coverage ratio was 229%. The Company’s investment objective is to maximize the total return to its stockholders in the form of current income and capital appreciation through debt and related equity investments in middle-market companies. The Company seeks to achieve its investment objective by originating and investing primarily in private U.S. middle- market companies (typically those with $5.0 million to $50.0 million of EBITDA (earnings before interest, taxes, depreciation and amortization)) through first lien, second lien, unitranche and unsecured debt financing, with corresponding equity co-investments. It sources investments primarily through the extensive network of relationships that the principals of Stellus Capital have developed with financial sponsor firms, financial institutions, middle-market companies, management teams and other professional intermediaries. Summary of Significant Accounting Policies Basis of Presentation The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in conformity with generally accepted accounting principles in the United States of America (“GAAP”) and pursuant to the requirements for reporting on Form 10-K and Article 10 of regulation S-X. 109 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 In the opinion of management, the consolidated financial results included herein contain all adjustments, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements for the periods included herein. Certain reclassifications have been made to certain prior period balances to conform with current presentation. In accordance with Regulation S-X under the Securities Act of 1933, as amended, and Securities Exchange Act of 1934, as amended, the Company does not consolidate portfolio company investments. The accounting records of the Company are maintained in U.S. dollars. Portfolio Investment Classification The Company classifies its portfolio investments with the requirements of the 1940 Act, (a) “Control Investments” are defined as investments in which the Company owns more than 25% of the voting securities or has rights to maintain greater than 50% of the board representation, (b) “Affiliate Investments” are defined as investments in which the Company owns between 5% and 25% of the voting securities and does not have rights to maintain greater than 50% of the board representation, and (c) “Non-controlled, non-affiliate investments” are defined as investments that are neither Control Investments or Affiliate Investments. Cash and Cash Equivalents At December 31, 2019, cash balances totaling $151,909 did not exceed FDIC insurance protection levels of $250,000. In addition, at December 31, 2019, the Company held $15,981,406 in cash equivalents which are carried at cost, which approximates the fair value of the cash equivalents. All of the Company’s cash deposits are held at large established high credit quality financial institutions and management believes that risk of loss associated with any uninsured balances is remote. Cash consists of bank demand deposits. We deem certain U.S. Treasury Bills and other high-quality, short- term debt securities as cash equivalents. Fair Value Measurements We account for substantially all of our financial instruments at fair value in accordance with ASC Topic 820 — Fair Value Measurements and Disclosures (“ASC Topic 820”). ASC Topic 820 defines fair value, establishes a framework used to measure fair value, and requires disclosures for fair value measurements, including the categorization of financial instruments into a three-level hierarchy based on the transparency of valuation inputs. ASC Topic 820 requires disclosure of the fair value of financial instruments for which it is practical to estimate such value. We believe that the carrying amounts of our financial instruments such as cash, receivables and payables approximate the fair value of these items due to the short maturity of these instruments. This is considered a Level 1 valuation technique. The carrying values of our Credit Facility and SBA-guaranteed debentures approximate fair value because the interest rates adjusts to the market interest rates (Level 3 input). The carrying value of our 2022 Notes (as defined in Note 11 below) is based on the closing price of the security (level 2 input). See Note 6 to the consolidated financial statements for further discussion regarding the fair value measurements and hierarchy. Consolidation As permitted under Regulation S-X under the Exchange Act and ASC Topic 946, we generally do not consolidate our investment in a portfolio company other than an investment company subsidiary. Accordingly, we consolidated the results of the SBIC subsidiaries and the Taxable Subsidiaries. All intercompany balances have been eliminated upon consolidation. 110 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 Use of Estimates The preparation of the statement of assets and liabilities in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ materially. Deferred Financing Costs Deferred financing costs, prepaid loan fees on SBA-guaranteed debentures and prepaid loan structure fees consist of fees and expenses paid in connection with the closing of the Company’s Credit Facility, 2022 Notes and SBA-guaranteed debentures and are capitalized at the time of payment. These costs are amortized using the straight line method over the term of the respective instrument. Offering Costs Deferred offering costs consist of fees and expenses incurred in connection with the offer and sale of the Company’s common stock, including legal, accounting, printing fees and other related expenses, as well as costs incurred in connection with the filing of a shelf registration statement. These costs are capitalized when incurred and recognized as a reduction of offering proceeds when the offering is consummated and shown on the Consolidated Statement of Changes in Net Assets and Liabilities as a reduction to Paid-in-Capital. During the year ended December 31, 2018, the Company incurred $18,673 of costs related to the preparation of a registration statement, which were capitalized until the related offering consummated during 2019. There were no such costs on the Consolidated Statement of Assets and Liabilities as of December 31, 2019. Investments As a BDC, the Company will generally invest in illiquid loans and securities including debt and equity securities of private middle-market companies. Under procedures established by our board of directors, the Company intends to value investments for which market quotations are readily available at such market quotations. The Company will obtain these market values from an independent pricing service or at the median between the bid and ask prices obtained from at least two brokers or dealers (if available, otherwise by a principal market maker or a primary market dealer). Debt and equity securities that are not publicly traded or whose market prices are not readily available will be valued at fair value as determined in good faith by our board of directors. Such determination of fair values may involve subjective judgments and estimates. The Company also engages independent valuation providers to review the valuation of each portfolio investment that does not have a readily available market quotation at least twice annually. Investments purchased within approximately 90 days of the valuation date will be valued at cost plus accreted discount, or minus amortized premium, which approximates fair value. With respect to unquoted securities, our board of directors, will value each investment considering, among other measures, discounted cash flow models, comparisons of financial ratios of peer companies that are public and other factors. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, the board of directors will use the pricing indicated by the external event to corroborate and/or assist us in our valuation. Because the Company expects that there will not be a readily available market for many of the investments in its portfolio, the Company expects to value most of its portfolio investments at fair value as determined in good faith by the board of directors using a documented valuation policy and a consistently applied valuation process. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ significantly from the values that would have been used had a readily available market value existed for such investments, and the differences could be material. 111 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 In following these approaches, the types of factors that will be taken into account in fair value pricing investments will include, as relevant, but not be limited to: • • • • • • • • • • 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 company’s 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 the principal market and enterprise values. Revenue Recognition We record interest income on an accrual basis to the extent such interest is deemed collectible. Payment-in- kind (“PIK”) interest, represents contractual interest accrued and added to the loan balance that generally becomes due at maturity. We will not accrue any form of interest on loans and debt securities if we have reason to doubt our ability to collect such interest. Loan origination fees, original issue discount and market discount or premium are capitalized, and we then accrete or amortize such amounts using the effective interest method as interest income. Upon the prepayment of a loan or debt security, any unamortized loan origination fee is recorded as interest income. We record prepayment premiums on loans and debt securities as other income. Dividend income, if any, will be recognized on the ex-dividend date. A presentation of the interest income we have received from portfolio companies for the years ended December 31, 2019, 2018 and 2017 is as follows: Loan interest PIK income Fee amortization income (1) Fee income acceleration (2) Total Interest Income For the year ended December 31, 2019 December 31, 2018 December 31, 2017 $53,358,856 415,933 $46,501,235 1,869,905 $34,890,298 499,595 1,982,868 1,138,333 1,636,168 1,455,725 1,235,568 1,445,988 $56,895,990 $51,463,033 $38,071,449 (1) (2) Includes amortization of fees on unfunded commitments. Unamortized loan origination fees recognized upon realization. To maintain our treatment as a RIC, substantially all of this income must be paid to stockholders in the form of distributions, even if we have not collected any cash. 112 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 We will not accrue interest on loans and debt securities if we have reason to doubt our ability to collect such interest. Management considers portfolio specific circumstances as well as other economic factors in determining collectability. As of December 31, 2019, we had two loans on non-accrual status, which represented approximately 3.6% of our loan portfolio at cost and 0.9% at fair value. As of December 31, 2018, we had four loans on non-accrual status, which represented approximately 3.9% of our loan portfolio at cost and 2.8% at fair value. As of December 31, 2019 and 2018, $3,779,593 and $1,856,272 of earned income from investments has not been accrued. If a loan or debt security’s status significantly improves regarding the debtor’s ability to service the debt or other obligations, or if a loan or debt security is sold or written off, we will remove it from non- accrual status. Net Realized Gains or Losses and Net Change in Unrealized Appreciation or Depreciation We measure realized gains or losses by the difference between the net proceeds from the repayment, sale or disposition and the amortized cost basis of the investment, without regard to unrealized appreciation or depreciation previously recognized. Net change in unrealized appreciation or depreciation reflects the change in portfolio investment values during the reporting period, including any reversal of previously recorded unrealized appreciation or depreciation, when gains or losses are realized. Investment Transaction Costs Costs that are material associated with an investment transaction, including legal expenses, are included in the cost basis of purchases and deducted from the proceeds of sales unless such costs are reimbursed by the borrower. Receivables and Payables for Unsettled Securities Transaction The Company records all investments on a trade date basis. U.S. Federal Income Taxes The Company has elected to be treated as a RIC under Subchapter M of the Code, and to operate in a manner so as to qualify for the tax treatment applicable to RICs. To qualify for tax treatment as a RIC, among other things, the Company is required to timely distribute to its stockholders at least 90% of investment company taxable income, as defined by the Code, for each year. So long as the Company maintains its status as a RIC, it generally will not pay corporate-level U.S. federal income taxes on any ordinary income or capital gains that it distributes at least annually to its stockholders as dividends. Rather, any tax liability related to income earned by the Company represents obligations of the Company’s investors and will not be reflected in the consolidated financial statements of the Company. To avoid a 4% U.S federal excise tax on undistributed earnings, the Company is required to distribute each calendar year the sum of (i) 98% of its ordinary income for such calendar year (ii) 98.2% of its net capital gains for the one-year period ending December 31 (iii) any income recognized, but not distributed, in preceding years and on which the Company paid no federal income tax or the Excise Tax Avoidance Requirement. For this purpose, however, any net ordinary income or capital gain net income retained by us that is subject to corporate income tax for the tax year ending in that calendar year will be considered to have been distributed by year end (or earlier if estimated taxes are paid). The Company, at its discretion, may choose not to distribute all of its taxable income for the calendar year and pay a non-deductible 4% excise tax on this income. If the Company chooses to do so, all other things being equal, this would increase expenses and reduce the amount available to be distributed to stockholders. To the extent that the Company determines that its estimated current year annual taxable income will be in excess of estimated current year dividend distributions from such taxable income, the Company accrues excise taxes on estimated excess taxable income as taxable income is earned. As of December 31, 2019, the Company had approximately $24,602,435 of undistributed taxable income that was carried forward toward distributions to be paid in 2020. 113 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 Income tax expense of $903,905 and $275,106 for the years ended December 31, 2019 and 2018 is related to state and excise taxes. Excise taxes for the year ended December 31, 2017 of $42,552 is included in Other general and administrative expense. The Company evaluates tax positions taken or expected to be taken in the course of preparing its tax returns to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authority. Tax positions deemed to meet a “more-likely-than-not” threshold would be recorded as a tax benefit or expense in the applicable period. As of December 31, 2019 and 2018, the Company had not recorded a liability for any unrecognized tax positions. Management’s evaluation of uncertain tax positions may be subject to review and adjustment at a later date based upon factors including, but not limited to, an on-going analysis of tax laws, regulations and interpretations thereof. The Company’s policy is to include interest and penalties related to income taxes, if applicable, in general and administrative expenses. Any expenses for the years ended December 31, 2019, 2018 and 2017, were de minimis. The Taxable Subsidiaries are direct wholly owned subsidiaries of the Company that have elected to be taxable entities. The Taxable Subsidiaries permit the Company to hold equity investments in portfolio companies that are “pass through” entities for tax purposes and continue to comply with the “source-of-income” requirements contained in RIC tax provisions of the Code. The Taxable Subsidiaries are not consolidated with the Company for income tax purposes and may generate income tax expense, benefit, and the related tax assets and liabilities, as a result of their ownership of certain portfolio investments. The income tax expense, or benefit, if any, and related tax assets and liabilities are reflected in the Company’s consolidated financial statements. The Taxable Subsidiaries use the liability method in accounting for income taxes. Deferred tax assets and liabilities are recorded for temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, using statutory tax rates in effect for the year in which the temporary differences are expected to reverse. A valuation allowance is provided against deferred tax assets when it is more likely than not that some portion or all of the deferred tax asset will not be realized. Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses. Taxable income generally excludes net unrealized appreciation or depreciation, as investment gains or losses are not included in taxable income until they are realized. For the years ended December 31, 2019, 2018 and 2017, the Company recorded deferred income tax benefit (provision) of $ (66,760), $ (67,953) and $ 8,593, respectively, related to the Taxable Subsidiaries. As of December 31, 2019 and 2018, the Company had a net deferred tax liability of $134,713 and $67,953, respectively. See Note 13 for a schedule of the deferred tax asset and valuation allowance reducing the deferred tax asset. Earnings per Share Basic per share calculations are computed utilizing the weighted average number of shares of common stock outstanding for the period. The Company has no common stock equivalents. As a result, there is no difference between diluted earnings per share and basic per share amounts. Paid In Capital The Company records the proceeds from the sale of its common stock on a net basis to (i) capital stock and (ii) paid in capital in excess of par value, excluding all commissions and marketing support fees. 114 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 Recently Issued Accounting Standards In August 2018, the FASB issued ASU No. 2018-13 -- Changes to the Disclosure Requirements for Fair Value Measurement. ASU 2018-13 is part of the disclosure framework project, which primarily focuses on improving the effectiveness of disclosures in the notes to financial statements. The amendments in this update remove, modify, and add certain disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement. The update is effective for annual periods beginning after December 31, 2019. Early adoption is allowed and the Company adopted this guidance on January 1, 2019. No material changes were required to the disclosures in the notes to financial statements. Securities Exchange Commission (“SEC”) Disclosure Update and Simplification In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532 (the “Rule”), Disclosure Update and Simplification, amending certain disclosure requirements that were redundant, outdated or superseded. The Rule is intended to facilitate the disclosure of information to investors and simplify compliance. The Company has adopted the Rule. The Rule included amendments to Regulation S-X (the “Amendments”), including revisions to Rule 6-04.17 under Regulation S-X to remove the requirement to separately state the book basis components of net assets on the Consolidated Statement of Assets and Liabilities: undistributed (over distribution of) net investment income, accumulated undistributed net realized gains (losses), and net unrealized appreciation (depreciation). Instead, consistent with GAAP, funds are required to disclose total distributable earnings. The components that make up distributable earnings (accumulated undistributed deficit) on the Statement of Assets and Liabilities as of December 31, 2019 and 2018 are as follows: Accumulated net realized loss from investments, net of cumulative dividends of $24,557,535 and $9,519,362, respectively Net unrealized appreciation (depreciation) on non-controlled non-affiliated investments and cash equivalents, net of provision for taxes of $134,713 and $67,953, respectively Accumulated undistributed net investment income Accumulated undistributed deficit As of December 31, 2019 As of December 31, 2018 ) $ (6,258,510 ) $(10,786,240 ) (13,894,460 18,587,920 1,672,066 5,782,736 ) $ (1,565,050 $ (3,331,438 ) Additionally, the Amendments remove the requirement to separately state the source of distributions paid and the requirement to parenthetically state the book basis amount of undistributed (over distribution of) net investment income on the Consolidated Statement of Changes in Net Assets. The Company’s Consolidated Statement of Assets and Liabilities and Consolidated Statement of Changes in Net Assets for the current and comparative reporting period have been modified to conform to the rule. From time to time, new accounting pronouncements are issued by the FASB or other standards setting bodies that are adopted by the Company as of the specified effective date. We believe the impact of the recently issued standards and any that are not yet effective will not have a material impact on our consolidated financial statements upon adoption. NOTE 2 — RELATED PARTY ARRANGEMENTS Investment Advisory Agreement The Company has entered into an investment advisory agreement with Stellus Capital pursuant to which Stellus Capital serves as its investment adviser. Pursuant to this agreement, the Company has agreed 115 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 to pay to Stellus Capital an annual base management fee of 1.75% of gross assets, including assets purchased with borrowed funds or other forms of leverage and excluding cash and cash equivalents, and an incentive fee. For the years ended December 31, 2019, 2018 and 2017, the Company recorded an expense for base management fees of $9,703,706, $8,154,842, and $6,255,911 respectively. As of December 31, 2019 and December 31, 2018, $2,695,780 and $2,183,975 was payable to Stellus Capital, respectively. The incentive fee has two components, investment income and capital gains, as follows: Investment Income Incentive Fee The income component (“Income Incentive Fee”) is calculated, and payable to the Advisor, quarterly in arrears based on the Company’s pre-incentive fee net investment income for the immediately preceding calendar quarter, subject to a cumulative total return requirement and to deferral of non-cash amounts. The pre-incentive fee net investment income, which is expressed as a rate of return on the value of the Company’s net assets attributable to the Company’s common stock, for the immediately preceding calendar quarter, has a 2.0% hurdle rate (also referred to as the “Hurdle”). Pre-incentive fee net investment income means interest income, dividend income and any other income accrued during the calendar quarter, minus the Company’s operating expenses for the quarter 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, debt instruments with PIK interest and zero-coupon securities), accrued income that the Company has not yet received in cash. The Advisor receives no incentive fee for any calendar quarter in which the Company’s pre-incentive fee net investment income does not exceed the Hurdle. Subject to the cumulative total return requirement described below, the Advisor receives 100% of the Company’s pre-incentive fee net investment income for any calendar quarter with respect to that portion of the pre-incentive net investment income for such quarter, if any, that exceeds the Hurdle but is less than 2.5% of net assets (also referred to as the “Catch-up”) and 20.0% of the Company’s pre-incentive fee net investment income for such calendar quarter, if any, greater than 2.5% of net assets. The foregoing incentive fee is subject to a total return requirement, which provides that no incentive fee in respect of the Company’s 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 calendar quarters exceeds the cumulative incentive fees accrued and/or paid for the 11 preceding quarters. In other words, any Income Incentive Fee that is payable in a calendar quarter is limited to the lesser of (i) 20% of the amount by which the Company’s pre-incentive fee net investment income for such calendar quarter exceeds the 2.0% hurdle, subject to the Catch-up, and (ii) (x) 20% of the cumulative net increase in net assets resulting from operations for the then current and 11 preceding 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 Advisor is not paid the portion of such incentive fee that is attributable to deferred interest until the Company actually receives such interest in cash. For the years ended December 31, 2019, 2018 and 2017, the Company incurred $5,809,672, $5,529,376 and $2,911,392, respectively, of Investment Income Incentive Fees. As of December 31, 2019 and 2018, $1,618,509 and $1,936,538, respectively, of such incentive fees were payable to the Advisor, of which $1,466,033 and $1,675,804, respectively, were currently payable (as explained below). As of December 31, 2019 and December 31, 2018, $152,476 and $260,734, respectively, of incentive fees incurred but not paid by the Company were generated from deferred interest (i.e. PIK, certain discount accretion and deferred interest) and are not payable until such amounts are received in cash. 116 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 Capital Gains Incentive Fee The Company also pays the Advisor an incentive fee based on capital gains (the “Capital Gains Incentive Fee”). The Capital Gains Incentive Fee is determined and payable in arrears as of the end of each calendar year (or upon termination of the investment management agreement, as of the termination date). The Capital Gains Incentive Fee is equal to 20.0% of the Company’s cumulative aggregate realized capital gains from Inception through the end of that calendar year, computed net of the cumulative aggregate realized capital losses and cumulative aggregate unrealized capital depreciation through the end of such year. The aggregate amount of any previously paid Capital Gains Incentive Fees is subtracted from such Capital Gains Incentive Fee calculated. GAAP requires that the incentive fee accrual considers the cumulative aggregate realized gains and losses and unrealized capital appreciation and depreciation of investments or other financial instruments in the calculation, as an incentive fee would be payable if such unrealized capital appreciation or depreciation were realized, even though such unrealized capital appreciation is not permitted to be considered in calculating the fee actually payable under the investment advisory agreement. There can be no assurance that unrealized appreciation or depreciation will be realized in the future. Accordingly, such fees, as calculated and accrued, may not necessarily be payable under the investment advisory agreement, and may never be paid based upon the computation of incentive fees in subsequent periods. For the years ended December 31, 2019, 2018 and 2017, the Company incurred $799,876, $81,038, and $0, respectively. As of December 31, 2019 and December 31, 2018, $880,913 and $81,038, respectively of Capital Gains Incentive Fees were payable to the Advisor. The following tables summarize the components of the incentive fees discussed above: Investment Income Incentive Fee Incurred Capital Gains Incentive Fee Accrued Incentive Fee Expense Investment Income Incentive Fee Currently Payable Investment Income Incentive Fee Deferred Capital Gains Incentive Fee Deferred Incentive Fee Payable Director Fees For the year ended December 31, 2019 $5,809,672 799,876 For the year ended December 31, 2018 $5,529,376 81,038 For the year ended December 31, 2017 $2,911,392 — $ $6,609,548 $5,610,414 $2,911,392 December 31, 2019 December 31, 2018 $1,466,033 152,476 880,913 $1,675,804 260,734 81,038 $2,499,422 $2,017,576 For the years ended December 31, 2019, 2018 and 2017, the Company recorded an expense relating to director fees $383,000, $317,000 and $331,000, respectively. As of December 31, 2019 and 2018, the Company owed its independent directors no unpaid director fees. Co-Investments On October 23, 2013, the Company received an exemptive order (the “Prior Order”) from the SEC to co- invest with private funds managed by Stellus Capital Management where doing so is consistent with the Company’s investment strategy as well as applicable law (including the terms and conditions of the exemptive order issued by the SEC). On December 18, 2018, the Company received a new exemptive order (the 117 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 “Order”) that supersedes the Prior Order and permits the Company greater flexibility to enter into co-investment transactions. The Order expands on the Prior Order and allows the Company to co-invest with additional types of private funds, other BDCs, and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management, subject to the conditions included therein. Pursuant to the Order, a “required majority” (as defined in Section 57(o) of the 1940 Act) of the Company’s independent directors must make certain conclusions in connection with a co-investment transaction, including (1) the terms of the proposed transaction, including the consideration to be paid, are reasonable and fair to the Company and its stockholders and do not involve overreaching of the Company or its stockholders on the part of any person concerned and (2) the transaction is consistent with the interests of the Company’s stockholders and is consistent with its investment objectives and strategies. The Company co-invests, subject to the conditions in the Order, with private credit funds managed by Stellus Capital Management that have an investment strategy that is similar or identical to the Company’s investment strategy, and the Company may co-invest with other BDCs and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management in the future. The Company believes that such co-investments may afford it additional investment opportunities and an ability to achieve greater diversification Administrative Agent The Company serves as the administrative agent on certain investment transactions, including co- investments with its affiliates under the exemptive relief order. As of December 31, 2019 and December 31, 2018, there was no cash due to other investment funds related to interest paid by a borrower to the Company as administrative agent. Any such amount would be included in “Other Accrued Expenses and Liabilities” on the Consolidated Statement of Assets and Liabilities. License Agreement The Company has entered into a license agreement with Stellus Capital under which Stellus Capital has agreed to grant the Company a non-exclusive, royalty-free license to use the name “Stellus Capital.” Under this agreement, the Company has a right to use the “Stellus Capital” name for so long as Stellus Capital or one of its affiliates remains its investment adviser. Other than with respect to this limited license, the Company has no legal right to the “Stellus Capital” name. This license agreement will remain in effect for so long as the investment advisory agreement with Stellus Capital is in effect. Administration Agreement The Company entered into an administration agreement with Stellus Capital pursuant to which Stellus Capital will furnish the Company with office facilities and equipment and will provide the Company with the clerical, bookkeeping, recordkeeping and other administrative services necessary to conduct day-to-day operations. Under this administration agreement, Stellus Capital will perform, or oversee the performance of, its required administrative services, which includes, among other things, being responsible for the financial records which it is required to maintain and preparing reports to its stockholders and reports filed with the SEC. For the years ended December 31, 2019, 2018 and 2017, the Company recorded expenses of $1,469,706, $1,195,174, and $1,117,011, respectively, related to the administration agreement. As of December 31, 2019 and December 31, 2018, $372,524 and $323,188, respectively, remained payable to Stellus Capital relating to the administration agreement. 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 118 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 under the investment advisory agreement, Stellus Capital 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 the Company for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of Stellus Capital’s services under the investment advisory agreement or otherwise as our investment adviser. NOTE 3 — DISTRIBUTIONS Distributions are generally declared by the Company’s board of directors each calendar quarter, paid monthly and recognized as distribution liabilities on the ex-dividend date. The Company intends to distribute net realized gains (i.e., net capital gains in excess of net capital losses), if any, at least annually. The stockholder distributions, if any, will be determined by the board of directors. Any distribution to stockholders will be declared out of assets legally available for distribution. The following table reflects the Company’s distributions declared and paid or to be paid on its common stock since Inception: Date Declared Fiscal 2012 December 7, 2012 Fiscal 2013 March 7, 2013 June 7, 2013 August 21, 2013 November 22, 2013 Fiscal 2014 December 27, 2013 January 20, 2014 January 20, 2014 January 20, 2014 April 17, 2014 April 17, 2014 April 17, 2014 July 7, 2014 July 7, 2014 July 7, 2014 October 15, 2014 October 15, 2014 October 15, 2014 Fiscal 2015 January 22, 2015 January 22, 2015 January 22, 2015 April 15, 2015 April 15, 2015 April 15, 2015 Record Date Payment Date Per Share December 21, 2012 December 27, 2012 $0.1812 March 21, 2013 June 21, 2013 September 5, 2013 December 9, 2013 March 28, 2013 June 28, 2013 September 27, 2013 December 23, 2013 January 15, 2014 January 31, 2014 February 28, 2014 March 31, 2014 April 30, 2014 May 30, 2014 June 30, 2014 July 31, 2014 August 29, 2014 September 30, 2014 October 31, 2014 November 28, 2014 December 31, 2014 January 24, 2014 February 14, 2014 March 14, 2014 April 15, 2014 May 15, 2014 June 16, 2014 July 15, 2014 August 15, 2014 September 15, 2014 October 15, 2014 November 14, 2014 December 15, 2014 January 15, 2015 February 2, 2015 February 27, 2015 March 31, 2015 April 30, 2015 May 29, 2015 June 30, 2015 February 13, 2015 March 13, 2015 April 15, 2015 May 15, 2015 June 15, 2015 July 15, 2015 $0.3400 $0.3400 $0.3400 $0.3400 $0.0650 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 119 TABLE OF CONTENTS Date Declared July 8, 2015 July 8, 2015 July 8, 2015 October 14, 2015 October 14, 2015 October 14, 2015 Fiscal 2016 January 13, 2016 January 13, 2016 January 13, 2016 April 15, 2016 April 15, 2016 April 15, 2016 July 7, 2016 July 7, 2016 July 7, 2016 October 7, 2016 October 7, 2016 October 7, 2016 Fiscal 2017 January 13, 2017 January 13, 2017 January 13, 2017 April 14, 2017 April 14, 2017 April 14, 2017 July 7, 2017 July 7, 2017 July 7, 2017 October 12, 2017 October 12, 2017 October 12, 2017 Fiscal 2018 January 11, 2018 January 11, 2018 January 11, 2018 April 16, 2018 April 16, 2018 April 16, 2018 July 12, 2018 July 12, 2018 STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 Record Date Payment Date Per Share July 31, 2015 August 31, 2015 September 20, 2015 October 30, 2015 November 30, 2015 December 31, 2015 August 14, 2015 September 15, 2015 October 15, 2015 November 13, 2015 December 15, 2015 January 15, 2016 January 29, 2016 February 29, 2016 March 31, 2016 April 29, 2016 May 31, 2016 June 30, 2016 July 29, 2016 August 31, 2016 September 30, 2016 October 31, 2016 November 30, 2016 December 30, 2016 January 31, 2017 February 28, 2017 March 31, 2017 April 28, 2017 May 31, 2017 June 30, 2017 July 31, 2017 August 31, 2017 September 29, 2017 October 31, 2017 November 30, 2017 December 29, 2017 January 31, 2018 February 28, 2018 March 29, 2018 April 30, 2018 May 31, 2018 June 29, 2018 July 31, 2018 August 31, 2018 February 15, 2016 March 15, 2016 April 15, 2016 May 13, 2016 June 15, 2016 July 15, 2016 August 15, 2016 September 15, 2016 October 14, 2016 November 15, 2016 December 15, 2016 January 13, 2017 February 15, 2017 March 15, 2017 April 14, 2017 May 15, 2017 June 15, 2017 July 14, 2017 August 15, 2017 September 15, 2017 October 13, 2017 November 15, 2017 December 15, 2017 January 12, 2018 February 15, 2018 March 15, 2018 April 13, 2018 May 15, 2018 June 15, 2018 July 13, 2018 August 15, 2018 September 14, 2018 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 120 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 Date Declared July 12, 2018 October 16, 2018 October 16, 2018 October 16, 2018 Fiscal 2019 January 11, 2019 January 11, 2019 January 11, 2019 April 11, 2019 April 11, 2019 April 11, 2019 July 3, 2019 July 3, 2019 July 3, 2019 October 15, 2019 October 15, 2019 October 15, 2019 Total Record Date September 28, 2018 October 31, 2018 November 29, 2018 December 31, 2018 Payment Date October 15, 2018 November 15, 2018 December 14, 2018 January 15, 2019 January 31, 2019 February 28, 2019 March 29, 2019 April 30, 2019 May 31, 2019 June 28, 2019 July 31, 2019 August 30, 2019 September 30, 2019 October 31, 2019 November 29, 2019 December, 2019 February 15, 2019 March 15, 2019 April 15, 2019 May 15, 2019 June 14, 2019 July 15, 2019 August 15, 2019 September 13, 2019 October 15, 2019 November 15, 2019 December 13, 2019 January 15, 2020 Per Share $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $0.1133 $9.7638 The Company has adopted an “opt out” dividend reinvestment plan (“DRIP”) pursuant to which a stockholder whose shares are held in his own name will receive distributions in shares of the Company’s common stock under the Company’s DRIP unless it elects to receive distributions in cash. Stockholders whose shares are held in the name of a broker or the nominee of a broker may have distributions reinvested only if such service is provided by the broker or the nominee, or if the broker of the nominee permits participation in our DRIP. Although distributions paid in the form of additional shares of the Company’s common stock will generally be subject to U.S. federal, state and local taxes in the same manner as cash distributions, investors participating in the Company’s DRIP will not receive any corresponding cash distributions with which to pay any such applicable taxes. Any distributions reinvested through the issuance of shares through the Company’s DRIP will increase the Company’s gross assets on which the base management fee and the incentive fee are determined and paid to Stellus Capital. The Company issued 7,931 shares through the DRIP during the year ended December 31, 2018. No new shares were issued in connection with the DRIP during the year ended December 31, 2019. 121 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 NOTE 4 — EQUITY OFFERINGS AND RELATED EXPENSES The table below illustrates the number of common stock shares the Company issued since inception through various equity offerings and pursuant to the Company’s DRIP. Issuance of Common Stock Year ended December 31, 2012 Year ended December 31, 2013 Year ended December 31, 2014 Year ended December 31, 2015 Year ended December 31, 2016 Year ended December 31, 2017 Year ended December 31, 2018 Year ended December 31, 2019 Total Number of Shares Gross Proceeds (1)(2) Underwriting fees Offering Expenses Net Proceeds (3) Offering Price 12,035,023 $180,522,093 $ 4,959,720 $ 835,500 $174,726,873 $14.90 899,964 $14.06 — 63,998 5,380,366 $14.47 75,510 380,936 — — — — — — — — 47,075,505 $14.06 1,358,880 3,465,922 93,737 $11.85 — 7,931 3,177,936 44,326,153 $14.43 1,015,127 19,131,746 $281,605,975 $ 7,409,237 $1,694,140 $272,502,598 899,964 5,485,780 — — 48,741,406 93,737 45,862,995 — 29,904 — — 307,021 — 521,715 (1) (2) (3) Net of partial share redemptions. Such share redemptions impacted gross proceeds by $755, $(1,051), $(142), $(31) and $(29) in 2019, 2018, 2017, 2016 and 2015, respectively. Includes common shares issued under the DRIP of $94,788 during the year ended December 31, 2018, $0 for the years ended 2019, 2017, 2016 and 2015, and $390,505, $930,385, $113,000 for the years ended 2014, 2013, and 2012, respectively. Net Proceeds per this equity table will differ from the Statement of Assets and Liabilities as of December 31, 2019 in the amount of $366,375, which represents a tax reclassification of stockholders’ equity in accordance with generally accepted accounting principles. This reclassification reduces paid-in capital and increases distributable earnings (reducing the accumulated undistributed deficit). The Company issued 2,952,149 shares during the year ended December 31, 2019 in a secondary offering on March 15, 2019 and the underwriters’ exercise of their overallotment option on April 11, 2019. Gross proceeds resulting from the secondary offering totaled $42,599,510 and underwriting and other expenses totaled $1,296,803. The per share offering price for the secondary offering was $14.43. The Company issued 225,787 shares under the At-the-Market (“ATM”) Program in 2019, for gross proceeds of $3,262,729 and underwriting and other expenses of $240,040. The average per share offering price of shares issued in the ATM Program during 2019 was $14.45. The Company issued 7,931 shares through the DRIP during the year ended December 31, 2018. No new shares were issued in connection with the DRIP during the year ended December 31, 2019. NOTE 5 — NET INCREASE IN NET ASSETS PER COMMON SHARE The following information sets forth the computation of net increase in net assets resulting from operations per common share for the years ended December 31, 2019, 2018 and 2017. Net increase in net assets resulting from operations Weighted average common shares $ 26,438,186 18,275,696 $ 26,194,578 15,953,571 $ 22,613,257 14,870,981 Basic and diluted earnings per common share $ 1.45 $ 1.64 $ 1.52 For the year ended December 31, 2019 For the year ended December 31, 2018 For the year ended December 31, 2017 122 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 NOTE 6 — PORTFOLIO INVESTMENTS AND FAIR VALUE In accordance with the authoritative guidance on fair value measurements and disclosures under GAAP, the Company discloses the fair value of its investments in a hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The guidance establishes three levels of the fair value hierarchy as follows: Level 1 — Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; Level 2 — Quoted prices in markets that are not considered to be active or financial instruments for which significant inputs are observable, either directly or indirectly; Level 3 — Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable. The level of an asset or liability within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. However, the determination of what constitutes “observable” requires significant judgment by management. The Company considers whether the volume and level of activity for the asset or liability have significantly decreased and identifies transactions that are not orderly in determining fair value. Accordingly, if the Company determines that either the volume and/or level of activity for an asset or liability has significantly decreased (from normal conditions for that asset or liability) or price quotations or observable inputs are not associated with orderly transactions, increased analysis and management judgment will be required to estimate fair value. Valuation techniques such as an income approach might be appropriate to supplement or replace a market approach in those circumstances. At December 31, 2019, the Company had investments in 63 portfolio companies. The total cost and fair value of the investments were $642,707,824 and $628,948,077, respectively. The composition of our investments as of December 31, 2019 is as follows: Senior Secured – First Lien (1) Senior Secured – Second Lien Unsecured Debt Equity Total Investments Cost Fair Value $461,107,595 130,600,172 22,279,519 28,720,538 $455,169,878 111,961,013 22,137,186 39,680,000 $642,707,824 $628,948,077 (1) Includes unitranche investments, which account for 14.4% of our portfolio at fair value. Unitranche structures may combine characteristics of first lien senior secured as well as second lien and/or subordinated loans and our unitranche loans will expose us to the risks associated with the second lien and subordinated loans to the extent we invest in the “last-out” tranche. 123 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 At December 31, 2018, the Company had investments in 57 portfolio companies. The total cost and fair value of the investments were $502,743,649 and $504,483,668, respectively. The composition of our investments as of December 31, 2018 was as follows: (1) Senior Secured – First Lien Senior Secured – Second Lien Unsecured Debt Equity Total Investments Cost Fair Value $297,965,589 155,382,612 25,436,237 23,959,211 $502,743,649 $292,004,982 149,661,220 23,697,466 39,120,000 $504,483,668 (1) Includes unitranche investments, which account for 20.6% of our portfolio at fair value. Unitranche structures may combine characteristics of first lien senior secured as well as second lien and/or subordinated loans and our unitranche loans will expose us to the risks associated with the second lien and subordinated loans to the extent we invest in the “last-out” tranche. The Company’s investment portfolio may contain loans that are in the form of lines of credit or revolving credit facilities, which require the Company to provide funding when requested by portfolio companies in accordance with the terms of the underlying loan agreements. As of December 31, 2019 and December 31, 2018, the Company had seventeen and eleven such investments with aggregate unfunded commitments of $37,517,784 and $21,213,962, respectively. The Company maintains sufficient liquidity to fund such unfunded loan commitments should the need arise. The fair values of our investments disaggregated into the three levels of the fair value hierarchy based upon the lowest level of significant input used in the valuation as of December 31, 2019 are as follows: Senior Secured – First Lien Senior Secured – Second Lien Unsecured Debt Equity Total Investments Quoted Prices in Active Markets for Identical Securities (Level 1) Significant Other Observable Inputs (Level 2) $ — — — — $ — $ — — — — $ — Significant Unobservable Inputs (Level 3) $455,169,878 111,961,013 22,137,186 39,680,000 $628,948,077 Total $455,169,878 111,961,013 22,137,186 39,680,000 $628,948,077 The fair values of our investments disaggregated into the three levels of the fair value hierarchy based upon the lowest level of significant input used in the valuation as of December 31, 2018 are as follows: Senior Secured – First Lien Senior Secured – Second Lien Unsecured Debt Equity Total Investments Significant Other Observable Inputs (Level 2) $ — — — — $ — Significant Unobservable Inputs (Level 3) $292,004,982 149,661,220 23,697,466 39,120,000 $504,483,668 Total $292,004,982 149,661,220 23,697,466 39,120,000 $504,483,668 Quoted Prices in Active Markets for Identical Securities (Level 1) $ — — — — $ — 124 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The aggregate values of Level 3 portfolio investments changed during the year ended December 31, 2019 are as follows: Senior Secured Loans-First Lien Senior Secured Loans-Second Lien Unsecured Debt Equity Total Fair value at beginning of period Purchases of investments Payment-in-kind interest Sales and Redemptions Realized Gains Change in unrealized appreciation (depreciation) included in earnings Amortization of premium and accretion of discount, net $292,004,982 $149,661,220 $23,697,466 $ 39,120,000 $ 504,483,668 246,480,276 415,933 (128,274,623 19,568,120 — 9,940,714 — (22,594,613 17,415,227 209,966,863 262,444 (48,114,716 (212,012 59,044 (5,605,908 — 2,364,905 26,572,699 94,445 (51,959,386 ) ) ) ) ) ) 22,891 (12,917,767 ) 1,596,438 (4,201,328 ) (15,499,766 ) 1,239,426 509,802 25,241 — 1,774,469 Fair value at end of period $455,169,878 $ 111,961,013 $22,137,186 $ 39,680,000 $ 628,948,077 There were no Level 3 transfers during the twelve months ended December 31, 2019. The aggregate values of Level 3 portfolio investments changed during the year ended December 31, 2018 are as follows: Senior Secured Loans-First Lien Senior Secured Loans-Second Lien Unsecured Debt Equity Total Fair value at beginning of year Purchases of investments Payment-in-kind interest Sales and redemptions Realized gains Change in unrealized appreciation $141,006,923 $178,432,850 $27,430,000 $24,969,999 $ 371,839,772 272,927,459 1,869,905 (147,600,770 5,540,518 9,605,730 — (9,657,263 — 5,540,518 224,555,549 106,314 (68,382,321 — 38,515,000 1,696,547 (66,658,090 — 251,180 67,044 (2,903,096 ) ) ) ) ) (depreciation) (6,052,424 ) (2,989,511 ) (1,265,630 ) 8,661,016 (1,646,549 ) Amortization of premium and accretion of discount, net 770,941 664,424 117,968 — 1,553,333 Fair value at end of year $292,004,982 $149,661,220 $23,697,466 $39,120,000 $ 504,483,668 There were no Level 3 transfers during the twelve months ended December 31, 2018. 125 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The following is a summary of geographical concentration of our investment portfolio as of December 31, 2019: Texas California Arizona New Jersey Ohio Illinois Canada New York United Kingdom Wisconsin South Carolina Tennessee Pennsylvania Maryland Indiana Florida Colorado Arkansas Missouri Georgia North Carolina Puerto Rico Utah Massachusetts Cost Fair Value $134,451,527 79,090,474 52,390,949 52,548,769 48,502,609 41,869,947 21,201,137 19,922,689 20,116,695 19,207,770 19,935,337 $120,672,985 78,136,331 53,274,526 51,637,750 50,092,839 44,406,252 21,217,811 20,584,020 20,116,695 19,466,054 19,366,716 19,854,956 17,408,508 17,103,044 14,064,012 13,663,116 10,867,843 14,920,694 10,078,235 575,000 4,961,969 8,613,244 41,894 1,317,406 19,260,076 17,566,213 17,325,000 13,997,251 13,820,256 12,444,250 11,989,446 10,428,223 5,250,000 4,375,000 3,490,383 30,000 — % of Total Investments at fair value 19.19 12.42 8.47 8.21 7.96 7.06 3.37 3.27 3.20 3.10 3.08 % % % % % % % % % % % 3.06 % 2.79 % 2.75 % 2.23 % 2.20 % 1.98 % 1.91 % 1.66 % 0.83 % 0.70 % 0.55 % 0.00 % — % $642,707,824 $628,948,077 100.00 % 126 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The following is a summary of geographical concentration of our investment portfolio as of December 31, 2018: Texas California New Jersey Ohio Illinois Canada Arizona South Carolina New York Tennessee Arkansas Pennsylvania Maryland Wisconsin Colorado Georgia Indiana Puerto Rico North Carolina Massachusetts Missouri Virginia Florida Utah Cost Fair Value % of Total Investments $100,229,354 86,550,134 43,513,698 36,209,514 19,941,053 27,902,537 21,682,522 20,871,587 20,446,690 20,117,218 17,696,537 17,732,831 17,237,500 11,437,711 10,777,822 5,988,728 7,363,628 8,797,954 4,946,554 1,317,406 139,656 50,001 242,304 1,550,710 $ 97,474,226 85,880,918 41,473,072 36,273,224 29,880,018 27,935,931 21,603,741 20,385,325 20,287,086 19,381,134 18,013,941 17,824,372 17,237,500 10,869,000 10,777,822 9,820,000 7,087,500 5,029,913 4,425,000 1,670,000 670,000 280,000 110,000 93,945 19.32 17.03 8.22 7.19 5.92 5.54 4.28 4.04 4.02 3.84 3.57 % % % % % % % % % % % 3.53 % 3.42 % 2.15 % 2.14 % 1.95 % 1.40 % 1.00 % 0.88 % 0.33 % 0.13 % 0.06 % 0.02 % 0.02 % $502,743,649 $504,483,668 100.00 % 127 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The following is a summary of industry concentration of our investment portfolio as of December 31, 2019: Healthcare & Pharmaceuticals Services: Business Aerospace & Defense Consumer Goods: Durable Beverage, Food, & Tobacco Media: Broadcasting & Subscription Finance Education Media: Advertising, Printing & Publishing High Tech Industries Capital Equipment Retail Metals & Mining Transportation & Logistics Automotive Software Containers, Packaging, & Glass Environmental Industries Energy: Oil & Gas Services: Consumer Chemicals, Plastics, & Rubber Consumer goods: non-durable Construction & Building Utilities: Oil & Gas Hotel, Gaming, & Leisure Cost Fair Value % of Total Investments at fair value $ 98,307,360 56,354,433 44,970,957 47,933,468 42,131,354 32,353,301 27,776,880 26,594,771 22,425,972 21,201,137 20,093,379 19,935,337 17,103,044 17,173,599 17,151,902 15,807,191 14,306,286 15,256,675 12,624,269 26,075,606 11,880,825 14,973,711 $ 94,000,860 62,410,845 46,547,324 44,158,660 42,592,966 33,218,991 29,562,500 25,661,125 21,965,124 21,217,811 20,237,066 19,366,716 17,325,000 17,226,294 17,221,213 15,516,250 14,564,570 14,410,327 13,582,102 13,345,105 11,857,228 11,770,000 10,408,323 10,750,000 9,868,044 — 9,900,000 540,000 14.95 9.92 7.40 7.02 6.77 5.28 4.70 4.08 3.49 3.37 3.22 % % % % % % % % % % % 3.08 % 2.75 % 2.74 % 2.74 % 2.47 % 2.32 % 2.29 % 2.16 % 2.12 % 1.89 % 1.87 % 1.71 % 1.57 % 0.09 % $642,707,824 $628,948,077 100.00 % 128 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The following is a summary of industry concentration of our investment portfolio as of December 31, 2018: Cost Fair Value % of Total Investments Healthcare & Pharmaceuticals Software Finance Media: Broadcasting & Subscription Retail Services: Business Consumer Goods: Durable Education High Tech Industries Beverage, Food, & Tobacco Services: Consumer Automotive Metals & Mining Energy: Oil & Gas Consumer goods: non-durable Environmental Industries Chemicals, Plastics, & Rubber Containers, Packaging, & Glass Aerospace & Defense Construction & Building Utilities: Oil & Gas Capital Equipment Media: Advertising, Printing & Publishing Transportation: Cargo Insurance Hotel, Gaming, & Leisure Services: Government $ 58,682,811 51,432,916 34,208,412 31,079,169 28,764,221 22,942,733 26,981,015 26,562,249 21,094,192 $ 54,785,327 51,458,750 41,910,000 30,857,379 27,525,897 27,094,812 26,811,552 25,325,000 21,094,192 20,709,134 17,952,663 17,457,259 17,237,500 14,312,328 14,994,980 14,004,667 11,835,100 11,437,711 10,777,822 10,374,827 9,853,435 7,535,876 7,058,675 6,808,345 5,425,301 3,170,307 50,001 18,213,945 17,640,255 17,282,187 17,237,500 15,542,102 14,579,375 12,835,509 11,707,835 10,869,000 10,777,822 10,280,000 9,853,435 7,929,775 6,875,625 6,841,739 5,460,000 3,414,655 280,000 10.86 10.20 8.31 6.12 5.46 5.37 5.30 5.02 4.18 % % % % % % % % % 3.61 % 3.50 % 3.43 % 3.42 % 3.08 % 2.89 % 2.54 % 2.32 % 2.15 % 2.14 % 2.04 % 1.95 % 1.57 % 1.36 % 1.36 % 1.08 % 0.68 % 0.06 % $502,743,649 504,483,668 100.00 % Certain portfolio company classifications were updated to more adequately align to the risks of the portfolio investments with other companies in such industries. Industry classification for the prior year financial statements included above were reclassified to the current presentation. The following changes and their December 31, 2018 cost and fair value, respectively, were made: 1) Consumer Goods: Durable to Metals & Mining; $17,237,500 for both cost and fair value, 2) Media: Broadcasting & Subscription to Media: Advertising, Printing & Publishing; $7,058,675 and $6,875,625, 3) Services: Business to Aerospace & Defense; $10,777,822 for both cost and value, 4) Services: Business to Environmental Industries; $13,058,543 and $12,505,509, 5) Services: Business to Software; $14,005,369 and $13,432,500. 129 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The following provides quantitative information about Level 3 fair value measurements as of December 31, 2019: Description: First lien debt Fair Value Valuation Technique Unobservable Inputs Range (Average) (1)(3) $455,169,878 Income/Market approach (2) HY credit spreads, Risk free rates Market multiples -2.19% to 6.98% (0.57%) -1.48% to 0.52% (-0.68%) 6x to 29x (12x) (4) Second lien debt $111,961,013 Unsecured debt $ 22,137,186 Income/Market approach (2) HY credit spreads, Risk free rates Market multiples -0.69% to 5.94% (1.19%) -1.34% to 0.48% (-0.42%) 7x to 34x (14x) (4) Income/Market (2) approach HY credit spreads, Risk free rates Market multiples -0.39% to 0.00% (-0.35%) -0.45% to -0.42% (-0.43%) 1x to 20x (4x) (4) Equity investments $ 39,680,000 Market approach (5) Underwriting EBITDA Multiple 2x to 17x (10x) Total Long Term Level 3 Investments $628,948,077 (1) Weighted average based on fair value as of December 31, 2019. (2) (3) Inclusive of but not limited to (a) the market approach which is used to determine sufficient enterprise value, and (b) the income approach which is based on discounting future cash flows using an appropriate market yield. The Company calculates the price of the loan by discounting future cash flows, which include forecasted future LIBOR rates based on the published forward LIBOR curve at the valuation date, using an appropriate yield calculated as of the valuation date. This yield is calculated based on the loan’s yield at the original investment and is adjusted as of the valuation date based on: changes in comparable credit spreads, changes in risk free interest rates (per swap rates), and changes in credit quality (via an estimated shadow rating). Significant movements in any of these factors would result in a significantly lower or higher fair value measurement. As an example, the “Range (Average)” for a first lien debt instruments in the table above indicates that the change in the HY spreads between the date a loan closed and the valuation date ranged from -2.19% (-219 basis points) to 6.98% (698 basis points). The average of all changes was 0.57%. (4) Median of LTM (last twelve months) EBITDA multiples of comparable companies. (5) The primary significant unobservable input used in the fair value measurement of the Company’s equity investments is the EBITDA multiple (the “Multiple”). Significant increases (decreases) in the Multiple in isolation would result in a significantly higher (lower) fair value measurement. To determine the Multiple for the market approach, the Company considers current market trading and/or transaction multiple, portfolio company performance (financial ratios) relative to public and private peer companies and leverage levels, among other factors. Changes in one or more of these factors can have a similar directional change on other factors in determining the appropriate Multiple to use in the market approach. 130 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The following provides quantitative information about Level 3 fair value measurements as of December 31, 2018: Description: First lien debt Fair Value Valuation Technique Unobservable Inputs Range (Average) (1)(3) $292,004,982 Income/Market (2) approach HY credit spreads, Risk free rates Market multiples -1.03% to 2.59% (0.85%) -5.62% to 6.64% (1.64%) 4x to 22x (10x) (4) Second lien debt $149,661,220 Unsecured debt $ 23,697,466 Income/Market (2) approach Income/Market (2) approach HY credit spreads, Risk free rates Market multiples -0.00% to 2.66% (0.93%) -0.14% to 10.66% (1.70%) 2x to 17x (11x) (4) HY credit spreads, Risk free rates Market multiples -1.03% to 0.57% (-0.01%) -5.62% to 0.32% (-1.27%) 2x to 9x (3x) (4) Equity investments $ 39,120,000 Market approach (5) Underwriting multiple/ EBITDA Multiple 2x to 15x (10x) Total Long Term Level 3 Investments $504,483,668 (1) (2) (3) (4) (5) Weighted average based on fair value as of December 31, 2018. Inclusive of but not limited to (a) the market approach which is used to determine sufficient enterprise value, and (b) the income approach which is based on discounting future cash flows using an appropriate market yield. The Company calculates the price of the loan by discounting future cash flows, which include forecasted future LIBOR rates based on the published forward LIBOR curve at the valuation date, using an appropriate yield calculated as of the valuation date. This yield is calculated based on the loan’s yield at the original investment and is adjusted as of the valuation date based on: changes in comparable credit spreads, changes in risk free interest rates (per swap rates), and changes in credit quality (via an estimated shadow rating). Significant movements in any of these factors would result in a significantly lower or higher fair value measurement. As an example, the “Range (Average)” for a first lien debt instruments in the table above indicates that the change in the HY spreads between the date a loan closed and the valuation date ranged from -1.03% (-103 basis points) to 2.59% (259 basis points). The average of all changes was 0.85%. Median of LTM (last twelve months) EBITDA multiples of comparable companies. The primary significant unobservable input used in the fair value measurement of the Company’s equity investments is the Multiple. Significant increases (decreases) in the Multiple in isolation would result in a significantly higher (lower) fair value measurement. To determine the Multiple for the market approach, the Company considers current market trading and/or transaction multiple, portfolio company performance (financial ratios) relative to public and private peer companies and leverage levels, among other factors. Changes in one or more of these factors can have a similar directional change on other factors in determining the appropriate Multiple to use in the market approach. NOTE 7 — COMMITMENTS AND CONTINGENCIES The Company is currently not subject to any material legal proceedings, nor, to our knowledge, is any material legal proceeding threatened against us. From time to time, we may be a party to certain legal proceedings in the ordinary course of business, including proceedings relating to the enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot be predicted with certainty, we do not expect that these proceedings will have a material effect upon our business, financial condition or results of operations. 131 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 As of December 31, 2019, the Company had $37,517,784 of unfunded commitments to provide debt financing to seventeen existing portfolio companies. As of December 31, 2018 the Company had $21,213,961 of unfunded commitments to provide debt financing to eleven existing portfolio companies. As of December 31, 2019, the Company had sufficient liquidity to fund such unfunded loan commitments should the need arise. NOTE 8 — FINANCIAL HIGHLIGHTS For the year ended December 31, 2019 For the year ended December 31, 2018 For the year ended December 31, 2017 For the year ended December 31, 2016 For the year ended December 31, 2015 Per Share Data: (1) Net asset value at beginning of year/period Net investment income Net change in unrealized appreciation (depreciation) on investments Net realized gain (loss) on investments Tax provision on realized gain on investments Benefit (provision) for taxes on net unrealized gain on investments in taxable subsidiaries Total from investment operations Sales Load Offering Costs Stockholder distributions from: Net investment income Net realized capital gains Other (3) Net asset value at the end of year/period Per share market value at end of year/period Total return based on market value Weighted average shares outstanding at the end of (4) $ $ period Ratio/Supplemental Data: $ $ 14.09 1.23 $ 13.81 1.42 $ 13.69 1.21 $ 13.19 1.39 ) (0.85 1.07 — — 1.45 (0.06 (0.03 ) ) (0.54 (0.82 ) ) 0.05 14.14 14.23 $ $ (0.11 0.35 (0.02 ) ) — 1.64 — — (1.03 (0.33 ) ) — 14.09 12.95 $ $ — 0.31 — — 1.52 (0.09 (0.02 ) ) (1.20 (0.16 ) ) 0.07 13.81 13.14 $ $ 1.49 (1.05 — ) 0.03 1.86 — — ) (1.36 — — 13.69 12.06 $ $ 13.94 1.33 ) (0.74 0.03 — (0.01 ) 0.61 — — (1.33 (0.03 ) ) — 13.19 9.64 21.97 % 8.68 % 20.29 % 42.83 % (7.76 )% 18,275,696 15,953,571 14,870,981 12,479,959 12,479,961 Net assets at the end of year/period $270,571,173 $224,845,007 $220,247,242 $170,881,785 $164,651,104 Weighted average net assets Annualized ratio of gross operating expenses to net assets (7)(8) Annualized ratio of net operating expenses to net assets (7)(8) Annualized ratio of interest expense and other fees to net assets (2 ) Annualized ratio of net investment income before fee waiver to net assets (7)(8) Annualized ratio of net investment income to net assets (7)(8) Portfolio Turnover (5) Notes Payable Credit Facility Payable SBA-guaranteed debentures Asset Coverage Ratio (6) $259,020,507 $223,750,302 $ 195,211,550 $165,189,142 $173,453,813 14.11 % 13.72 % 11.10 % 14.11 % 13.72 % 11.10 % 5.78 % 5.51 % 8.64 % 10.09 % 8.64 % 23 % 10.09 % 32 % 4.02 % 9.21 % 9.21 % 48 % 13.2 % 13.2 % 4.84 % 10.71 % 10.71 % 16 % 11.16 % 10.78 % 3.56 % 9.11 % 9.49 % 29 % $ 48,875,000 $ 48,875,000 $ 48,875,000 $ 25,000,000 $ 25,000,000 $161,550,000 $ 99,550,000 $ 40,750,000 $ 116,000,000 $109,500,000 $161,000,000 $150,000,000 $ 90,000,000 $ 65,000,000 $ 65,000,000 2.29x 2.51x 3.46x 2.21x 2.22x (1) Financial highlights are based on weighted average shares outstanding as of year/period ended. 132 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 (2) (3) (4) (5) (6) (7) Excludes debt extinguishment costs of $416,725 for the year ended December 31, 2017. Including these costs, this ratio would be 4.24%. Includes the impact of different share amounts as a result of calculating certain per share data based on weighted average shares outstanding during the period and certain per share data based on shares outstanding as of the period end. Total return on market value is based on the change in market price per share since the end of the prior quarter and includes dividends paid, which are assumed to be reinvested. The total returns are not annualized. Calculated as the lesser of purchases or paydowns divided by average portfolio balance and is not annualized. Asset coverage ratio is equal to total assets less all liabilities and indebtedness not represented by senior securities over the aggregate amount of the senior securities. SBA-guaranteed debentures are excluded from the numerator and denominator. These ratios include the impact of the benefit (provision) for income taxes related to net unrealized loss (gain) on certain investments of $(66,760), $(67,953), and $8,593 for the years ended December 31, 2019, 2018 and 2017 respectively, which are not reflected in net investment income, gross operating expenses or net operating expenses. The benefit (provision) for income taxes related to net realized loss or unrealized loss (gain) on investments at taxable subsidiaries to net assets for the years ended December 31, 2019, 2018 and 2017 is less than (0.03)%, (0.03)% and (0.01)%, respectively. (8) Deferred offering costs of $261,761 for the year ended December 31, 2016 are not annualized. NOTE 9 — CREDIT FACILITY On November 7, 2012, the Company entered into a revolving credit facility (the “Original Facility”) with various lenders. SunTrust Bank, one of the lenders, served as administrative agent under the Original Facility. The Company terminated the Original Facility on October 11, 2017, in conjunction with securing and entering into a new senior secured revolving credit agreement, dated as of October 10, 2017, as amended on March 28, 2018, August 2, 2018, September 13, 2019, and December 27, 2019 with ZB, N.A., dba Amegy Bank and various other lenders (the “Credit Facility”). The Credit Facility, as amended, provides for borrowings up to a maximum of $220,000,000 on a committed basis with an accordion feature that allows the Company to increase the aggregate commitments up to $250,000,000, subject to new or existing lenders agreeing to participate in the increase and other customary conditions. Borrowings under the Credit Facility bear interest, subject to the Company’s election, on a per annum basis equal to (i) LIBOR plus 2.50% (or 2.75% during certain periods in which the Company’s asset coverage ratio is equal to or below 1.90 to 1.00) with no LIBOR floor, or (ii) 1.50% (or 1.75% during certain periods in which the Company’s asset coverage ratio is equal to or below 1.90 to 1.00) plus an alternate base rate based on the highest of the Prime Rate, Federal Funds Rate plus 0.5% or one month LIBOR plus 1.0%. The Company pays unused commitment fees of 0.50% per annum on the unused lender commitments under the Credit Facility. Interest is payable quarterly in arrears. The commitment to fund the revolver expires on October 10, 2020, after which the Company may no longer borrow under the Credit Facility. The Company must begin repaying principal equal to 1/12 of the aggregate amount outstanding under the Credit Facility beginning October 15, 2020. Any amounts borrowed under the Credit Facility will mature, and all accrued and unpaid interest thereunder will be due and payable, on October 10, 2021. 133 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The Company’s obligations to the lenders are secured by a first priority security interest in its portfolio of securities and cash not held at the SBIC subsidiaries, but excluding short term investments. The Credit Facility contains certain covenants, including but not limited to: (i) maintaining a minimum liquidity test of at least $10,000,000, including cash, liquid investments and undrawn availability, (ii) maintaining an asset coverage ratio of at least 1.75 to 1.0, and (iii) maintaining a minimum shareholder’s equity. As of December 31, 2019, the Company was in compliance with these covenants. As of December 31, 2019 and December 31, 2018, the outstanding balance under the Credit Facility was $161,550,000 and $99,550,000, respectively. The carrying amount of the amount outstanding under the Credit Facility approximates its fair value. The fair values of the Credit Facility is determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The fair value of the Credit Facility is estimated based upon market interest rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any. The Company has incurred costs of $1,756,607 in connection with the current Credit Facility, which are being amortized over the life of the facility. Additionally, $341,979 of costs from the Original Facility will continue to be amortized over the remaining life of the Credit Facility. As of December 31, 2019 and 2018, $1,039,367 and $1,312,773 of such prepaid loan structure fees and administration fees had yet to be amortized, respectively. These prepaid loan fees are presented on our consolidated statement of assets and liabilities as a deduction from the debt liability. The following is a summary of the Credit Facility, net of prepaid loan structure fees: Credit Facility payable Prepaid loan structure fees Credit facility payable, net of prepaid loan structure fees December 31, 2019 December 31, 2018 $161,550,000 1,039,367 $99,550,000 1,312,773 $160,510,633 $98,237,227 Interest is paid quarterly in arrears. The following table summarizes the interest expense and amortized loan fees on the Credit Facility for the years ended December 31, 2019, 2018, and 2017: Interest expense Loan fee amortization Commitment fees on unused portion Administration fees Total interest expense and other fees Loss on extinguishment of debt Weighted average interest rate Effective interest rate (including fee amortization) Average debt outstanding Cash paid for interest and unused fees 134 For the years ended December 31, 2019 December 31, 2018 December 31, 2017 $ $ $ 5,112,499 485,017 405,438 34,978 $ 3,737,735 415,179 387,601 40,972 $ 2,247,048 416,612 311,174 39,282 6,037,932 $ 4,581,487 $ 3,014,116 — $ — $ 113,993 4.8 % 5.7 % 4.7 % 5.7 % 3.7 % 5.0 % $106,244,521 $79,818,493 $60,053,425 $ 5,217,832 $ 4,158,382 $ 2,476,340 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 NOTE 10 — SBA-GUARANTEED DEBENTURES Due to the SBIC subsidiaries’ status as licensed SBICs, the Company has the ability to issue debentures guaranteed by the SBA at favorable interest rates. Under the regulations applicable to SBIC funds, a single licensee can have outstanding debentures guaranteed by the SBA subject to a regulatory leverage limit, up to two times the amount of regulatory capital. As of both December 31, 2019 and 2018, the SBIC subsidiary had $75,000,000 in regulatory capital, as such term is defined by the SBA, and $150,000,000 of SBA-guaranteed debentures outstanding. As of December 31, 2019, which was the end of the first year of operations of the SBIC II subsidiary, it had $20,000,000 in regulatory capital and $11,000,000 of SBA-guaranteed debentures outstanding. On August 12, 2014, the Company obtained exemptive relief from the SEC to permit it to exclude the debt of the SBIC subsidiaries guaranteed by the SBA from its asset coverage test under the 1940 Act. The exemptive relief provides the Company with increased flexibility under the asset coverage test by permitting it to borrow up to $325,000,000 more than it would otherwise be able to absent the receipt of this exemptive relief. On a stand-alone basis, the SBIC subsidiaries held $240,109,144 and $225,525,663 in assets at December 31, 2019 and 2018, respectively, which accounted for approximately 37.0% and 42.9% of our total consolidated assets at December 31, 2019 and 2018, respectively. Debentures guaranteed by the SBA have fixed interest rates that equal prevailing 10-year Treasury Note rates plus a market spread and have a maturity of ten years with interest payable semi-annually. The principal amount of the debentures is not required to be paid before maturity, but may be pre-paid at any time with no prepayment penalty. As of December 31, 2019 and 2018, the SBIC subsidiaries had $161,000,000 and $150,000,000 of the SBA-guaranteed Debentures outstanding, respectively. SBA-guaranteed debentures drawn before October 1, 2019 incur upfront fees of 3.425%, which consists of a 1.00% commitment fee and a 2.425% issuance discount, which are amortized over the life of the SBA-guaranteed debentures. SBA-guaranteed debentures drawn after October 1, 2019 incur upfront fees of 3.435%, which consists of a 1.00% commitment fee and a 2.435% issuance discount, which are amortized over the life of the SBA-guaranteed debentures. Once pooled, which occurs in March and September each year, the SBA-guaranteed debentures bear interest at a fixed rate that is set to the current 10-year treasury rate plus a spread at each pooling date. 135 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The following table summarizes the SBIC subsidiary’s SBA-guaranteed debentures as of December 31, 2019: Issuance Date October 14, 2014 October 17, 2014 December 24, 2014 June 29, 2015 October 22, 2015 October 22, 2015 November 10, 2015 November 18, 2015 November 25, 2015 December 16, 2015 December 29, 2015 November 28, 2017 April 27, 2018 July 30, 2018 September 25, 2018 October 17, 2019 November 15, 2019 Maturity Date Debenture Amount Interest Rate SBA Annual Charge March 1, 2025 March 1, 2025 March 1, 2025 September 1, 2025 March 1, 2026 March 1, 2026 March 1, 2026 March 1, 2026 March 1, 2026 March 1, 2026 March 1, 2026 March 1, 2028 September 1, 2028 September 1, 2028 March 1, 2029 March 1, 2030 March 1, 2030 $ 6,500,000 6,500,000 3,250,000 9,750,000 6,500,000 1,500,000 8,800,000 1,500,000 8,800,000 2,200,000 9,700,000 25,000,000 40,000,000 17,500,000 2,500,000 6,000,000 5,000,000 2.52 2.52 2.52 2.83 2.51 2.51 2.51 2.51 % % % % % % % % 2.51 % 2.51 % 2.51 % 3.19 % 3.55 % 3.55 % 2.88 2.27 2.21 % %(1) %(1) 0.36 0.36 0.36 0.36 0.36 0.74 0.74 0.74 % % % % % % % % 0.74 % 0.74 % 0.74 % 0.22 % 0.22 % 0.22 % 0.22 % 0.09 % 0.09 % Total SBA-guaranteed debentures $ 161,000,000 (1) Debenture interest rate will be set as determined by the SBA when pooled on March 25, 2020 As of December 31, 2019 and 2018, the carrying amount of the SBA-guaranteed debentures approximated their fair value. The fair values of the SBA-guaranteed debentures are determined in accordance with ASC 820, which defines fair value in terms of the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The fair value of the SBA- guaranteed debentures are estimated based upon market interest rates for our own borrowings or entities with similar credit risk, adjusted for nonperformance risk, if any. At December 31, 2019 and 2018, the SBA- guaranteed debentures would be deemed to be Level 3, as defined in Note 6. As of December 31, 2019, the Company has incurred $5,605,350 in financing costs related to the SBA- guaranteed debentures since receiving our licenses, which were recorded as prepaid loan fees. As of December 31, 2019 and 2018, $3,456,147 and $3,612,198 of prepaid financing costs had yet to be amortized, respectively. These prepaid loan fees are presented on the consolidated statement of assets and liabilities as a deduction from the debt liability. The following is a summary of the SBA-guaranteed debentures, net of prepaid loan fees: SBA-guaranteed debentures payable Prepaid loan fees SBA-guaranteed debentures, net of prepaid loan fees 136 December 31, 2019 December 31, 2018 $161,000,000 3,456,147 $150,000,000 3,612,198 $157,543,853 $146,387,802 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The following table summarizes the interest expense and amortized fees on the SBA-guaranteed debentures for the years ended December 31, 2019, 2018 and 2017: Interest expense Debenture fee amortization Total interest expense and other fees Weighted average interest rate Effective interest rate (including fee amortization) Average debt outstanding Cash paid for interest NOTE 11 — NOTES For the years ended December 31, 2019 December 31, 2018 $ $ 5,166,475 623,900 5,790,375 $ $ 3,982,658 623,989 December 31, 2017 $ 2,067,308 333,027 4,606,647 $ 2,400,335 3.4 3.8 % % 3.2 3.7 % % 3.1 3.6 % % $151,893,151 $125,390,411 $67,328,767 $ 5,007,832 $ 3,107,218 $ 2,019,095 On May 5, 2014, the Company closed a public offering of $25,000,000 in aggregate principal amount of 6.50% notes (the “2019 Notes”), due on April 30, 2019. The Company redeemed all $25,000,000 in aggregate principal amount of the 2019 Notes on September 20, 2017 at 100% of their principal amount, plus the accrued and unpaid interest thereon through the redemption date. As a result of the redemption, the Company recognized a loss on the extinguishment of debt of $302,732 for the year ended December 31, 2017, due to the write off of the remaining deferred financing costs on the 2019 Notes. The following table summarizes the interest expense and deferred financing costs on the 2019 Notes for the years ended December 31, 2019, 2018, and 2017: For the year ended December 31, 2019 December 31, 2018 December 31, 2017 Interest expense Deferred financing costs Administration fees Total interest expense and other fees Loss on extinguishment of debt Weighted average interest rate Effective interest rate (including fee amortization) Average debt outstanding Cash paid for interest $ $ $ $ — $ — — — — — $ 1,169,097 131,377 5,000 — $ — $ 1,305,474 — — % — % — $ — $ — — % — % 302,732 6.5 % 7.3 % — $25,000,000 — $ 1,376,736 On August 21, 2017, the Company issued $42,500,000 in aggregate principal amount of 5.75% fixed-rate notes due September 15, 2022 (the “2022 Notes”). On September 8, 2017, the Company issued an additional $6,375,000 in aggregate principal amount of the 2022 Notes pursuant to a full exercise of the underwriters’ overallotment option. The 2022 Notes will mature on September 15, 2022, and may be redeemed in whole or in part at any time or from time to time at the Company’s option on or after September 15, 2019 at a redemption price equal to 100% of the outstanding principal, plus accrued and unpaid interest. Interest is payable quarterly. 137 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 The Company used all of the net proceeds from this offering to fully redeem the 2019 Notes and a portion of the amount outstanding under the Original Facility. As of both December 31, 2019 and 2018, the aggregate carrying amount of all Notes was $48,875,000 and the fair value of the Notes was approximately $49,715,650 and $47,604,250, respectively. The 2022 Notes are listed on New York Stock Exchange under the trading symbol “SCA”. The fair value of the Notes is based on the closing price of the security, which is a Level 2 input under ASC 820 due to sufficient trading volume. In connection with the issuance and maintenance of the 2022 Notes, we have incurred $1,688,961 of fees which are being amortized over the term of the 2022 Notes, of which $900,798 and $1,233,203 remained to be amortized as of December 31, 2019 and 2018, respectively. These financing costs are presented on the consolidated statement of assets and liabilities as a deduction from the debt liability. The following table summarizes the interest expense and deferred financing costs on the 2022 Notes for the years ended December 31, 2019, 2018, 2017. Interest expense Deferred financing costs Administration fees For the year ended December 31, 2019 For the year ended December 31, 2018 For the year ended December 31, 2017 (1) $ 2,810,312 332,403 5,000 $ 2,810,312 332,404 7,905 $ 1,014,835 118,066 2,383 Total interest expense and other fees $ 3,147,715 $ 3,150,621 $ 1,135,284 Weighted average interest rate Effective interest rate (including fee amortization) Average debt outstanding Cash paid for interest 5.8 6.4 $ 48,875,000 % % 5.8 6.4 $ 48,875,000 % % 5.8 6.5 $ 48,012,218 % % $ 2,810,312 $ 2,810,312 $ 889,932 (1) averages for period outstanding in 2017 The following is a summary of the Notes Payable, net of deferred financing costs: Notes payable Deferred financing costs Notes payable, net of deferred financing costs December 31, 2019 December 31, 2018 $48,875,000 900,798 $48,875,000 1,233,203 $47,974,202 $47,641,797 The indenture and supplements thereto relating to the 2022 Notes contain certain covenants, including but not limited to (i) a requirement that the Company comply with the asset coverage requirements of the 1940 Act or any successor provisions, and (ii) a requirement to provide financial information to the holders of the notes and the trustee under the indenture if the Company should no longer be subject to the reporting requirements under the Exchange Act. 138 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 NOTE 12 — SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The following table sets forth the results of operations for the years ended December 31, 2019, 2018, and 2017. Results for any quarter are not necessarily indicative of results for the full year or for any future quarter. Total Investment Income Net Investment Income Net Increase in Net Assets from Operations Total Investment Income per share (1) (1) Net Investment Income per share Net Increase in Net Assets from Operations per (1) share Total Investment Income Net Investment Income Net Increase in Net Assets from Operations Total Investment Income per share (1) Net Investment Income per share Net Increase in Net Assets from Operations per (1) (1) share Total Investment Income Net Investment Income Net Increase in Net Assets from operations Total Investment Income per share (1) Net Investment Income per share Net Increase in Net Assets from Operations per (1) share (1) 2019 Qtr. 1 Qtr. 2 Qtr. 3 Qtr. 4 $13,834,929 $ 4,333,659 $10,142,443 $14,170,255 $ 5,415,400 $ 5,994,683 $15,515,227 $ 5,798,659 $ 8,468,254 $15,391,478 $ 6,891,091 $ 1,832,807 $ $ $ 0.85 0.27 0.62 $ $ $ 0.75 0.29 0.32 $ $ $ 2018 0.82 0.31 0.45 $ $ $ 0.81 0.36 0.10 Qtr. 1 $10,911,781 $ 4,475,379 $ 7,343,929 0.68 $ 0.28 $ Qtr. 2 $12,619,657 $ 4,727,236 $ 7,603,246 0.79 $ 0.30 $ Qtr. 3 $14,487,623 $ 5,609,974 $ 8,884,517 0.91 $ 0.35 $ Qtr. 4 $15,247,277 $ 7,823,948 $ 2,362,886 0.96 $ 0.49 $ $ 0.46 $ 0.48 $ 0.56 $ 0.14 Qtr. 1 $9,863,980 $4,143,627 $6,024,752 0.79 $ 0.33 $ 2017 Qtr. 2 $10,394,365 $ 4,938,459 $ 6,044,766 0.68 $ 0.32 $ Qtr. 3 $9,978,345 $4,475,952 $5,636,598 0.64 $ 0.29 $ Qtr. 4 $9,411,503 $4,412,722 $4,907,141 0.59 $ 0.28 $ $ 0.48 $ 0.39 $ 0.36 $ 0.31 (1) Per share amounts are calculated using weighted average shares outstanding during the period. NOTE 13 — INCOME TAXES As of December 31, 2019 and December 31, 2018, the Company had $22,548,941 and $8,572,366, respectively, of undistributed ordinary income. the periods ended December 31, 2019 and December 31, 2018, respectively. Undistributed qualified Undistributed capital gains were $2,053,494 and $700,000 for (1) (1) The Company’s taxable income for each period is an estimate and will not be finally determined until the Company files its tax return for each year. Therefore, final taxable income earned in each period, and the undistributed ordinary income and capital gains for each period carried forward for distribution in the following period, may be different than this estimate. 139 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 dividends were $0 and $31,504 for the years ended December 31, 2019 and 2018, respectively. All of the undistributed ordinary income as of December 31, 2019 will have been distributed within the required period of time such that the Company will not have to pay corporate-level U.S. federal income tax for the year ended December 31, 2019. We will be subject to a 4% nondeductible U.S. federal excise tax on our undistributed income to the extent we did not distribute an amount equal to at least 98% of our net ordinary income plus 98.2% of our capital gain net income attributable to the period. The Company has accrued $900,000 and $316,092 of U.S. federal excise tax for the tax years ended December 31, 2019 and December 31, 2018, respectively, independent of prior year adjustments. See note 1 for further discussion of tax expense in each year. Ordinary dividend distributions from a RIC do not qualify for the reduced maximum tax rate on qualified dividend income from domestic corporations, except to the extent that the RIC received the income in the form of qualifying dividends from domestic corporations and qualified foreign corporations. The tax character distributions paid in the years ended December 31, 2019 and 2018 was as follows: of (2) Ordinary income Qualified dividends Distributions of long-term capital gains (2) Total distributions accrued or paid to common stockholders December 31, 2019 $10,000,000 103,080 14,935,093 $25,038,173 December 31, 2018 $15,492,724 250,000 5,947,826 $21,690,550 Listed below is a reconciliation of “Net increase in net assets resulting from operations” to taxable income and total distributions declared to common stockholders for the years ended December 31, 2019, 2018 and 2017: Net increase in net assets resulting from operations (includes NII, realized gain/loss, unrealized gain/loss and taxes) $ 26,438,186 $26,194,578 $22,613,257 Net change in unrealized depreciation (appreciation) Income tax provision (benefit) Pre-tax (income) expense, (gain) loss reported at Taxable Subsidiaries, not consolidated for tax purposes 15,499,766 66,760 1,646,549 67,953 22,072 (8,593 ) (5,819,114 ) 416,203 (4,721,039 ) 2019 2018 2017 Book income and tax income differences, including debt origination, interest accrual, income from pass-through investments, dividends, realized gains (losses) and changes in estimates Estimated taxable income Taxable income earned in prior year and carried forward for 3,791,081 1,524,556 1,835,779 $ 39,976,679 $29,849,839 $19,741,476 distribution in current year 7,496,299 (662,990 ) (106,530 ) Taxable income earned prior to period end and carried forward for distribution next period (24,602,435 ) (9,303,869 ) (1,118,312 ) (2) Distributions of long-term capital gains of $14,935,093 as of December 31, 2019 differs from distributions of net capital gains on the Consolidated Statement of Changes in Net Assets because certain long-term capital gains were recognized in Taxable Subsidiaries. The qualified dividend amount in 2019 and 2018 are derived from qualified dividends received by the Company from a portfolio company. Additional differences arise because certain prepayment gains are characterized differently for tax reporting purposes. 140 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 Distribution payable as of period end and paid in following period 2,167,630 1,807,570 1,806,671 Total distributions accrued or paid to common stockholders $25,038,173 $21,690,550 $ 20,323,305 2019 2018 2017 The aggregate gross unrealized appreciation and depreciation, the net unrealized appreciation, and the aggregate cost of the Company’s portfolio company securities for federal income tax purposes as of December 31, 2019 and December 31, 2018 were as follows: Aggregate cost of portfolio securities for federal income tax purposes $643,573,873 $503,079,738 Gross unrealized appreciation of portfolio company securities 17,587,984 18,423,224 Gross unrealized depreciation of portfolio company securities (31,347,731 ) (16,683,205 ) Net unrealized appreciation (depreciation) of portfolio company securities $ (13,759,747 ) $ 1,740,019 2019 2018 As of December 31, 2019, the Taxable Subsidiaries had unrealized losses in investments, net operating loss (“NOL”) carryovers, and capital loss carryovers creating a net deferred tax asset equal to $146,797, as reflected below. As of December 31, 2019, for U.S. federal income tax purposes, the Taxable Subsidiaries had capital loss capital forward of $1,103,401, which, if unused, will expire in the taxable year 2021. As of December 31, 2019, for U.S. federal income tax purposes, the Taxable Subsidiaries had net operating loss carryforwards totaling $2,761,004 of which $1,615,912 will expire during the tax years 2023 through 2037 if unused. Due to the nature of the Taxable Subsidiaries’ holdings, a valuation allowance was established when management determined it is more likely than not that some of the deferred tax assets will not be realized prior to expiration. Although our future projections indicate that we may be able to realize a portion of these deferred tax assets, due to the degree of uncertainty of these projections, management has recorded a deferred tax asset valuation allowance of $281,510. Deferred Tax Asset Deferred Tax Liability Total Deferred Tax Asset before valuation allowance Deferred tax valuation allowance Net Deferred Tax Liability 2019 2018 $ 2,189,818 (2,043,021 ) $ 2,930,694 (1,648,207 ) 146,797 $ $ (281,510 ) $ 1,282,487 $(1,350,440 ) $ (134,713 ) $ (67,953 ) Although the Company files federal and state tax returns, its major tax jurisdiction is federal. The 2016, 2017 and 2018 federal tax years for the Company remain subject to examination by the Internal Revenue Service. NOTE 14 — SUBSEQUENT EVENTS Investment Portfolio On January 3, 2020, the Company received full repayment on the first lien term loan of APG Intermediate Sub 2 Corp. for total proceeds of $10,066,786, including a $141,785 prepayment fee. The Company also received $2,424,445 in full realization on the equity of APG Holdings, resulting in a $1,296,793 gain. 141 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 On January 7, 2020, the Company invested $14,424,157 in the first lien term loan of Sales Benchmark Index, LLC, $1,331,461 in the unfunded revolver, and $3,328,652 in the unfunded delayed draw term loan of Sales Benchmark, LLC, a provider of revenue growth management consulting services for private equity-owned and large enterprise clients. Additionally, the Company invested $665,730 in the preferred equity of the company. On January 15, 2020, Apex Environmental Resources Holdings, LLC was merged with a provider of non- hazardous waste management, collection, and recycling services, creating Interstate Waste Services, Inc. The Company's common and preferred ownership positions in Apex Environmental Resources Holdings, LLC was rolled into the combined entity. On January 31, 2020, the Company invested $18,900,000 in the first lien term loan and $2,700,000 in the unfunded revolver of Elliott Aviation, LLC, a provider of maintenance, repair, and overhaul and fixed-base operator services to the business aviation sector. Additionally, the Company invested $900,000 in the preferred equity of the company. Credit Facility The outstanding balance under the Credit Facility as of February 28, 2020 was $175,250,000. ATM Program Since December 31, 2019, the Company issued 332,591 shares under the At-the-Market (“ATM”) Program, for gross proceeds of $4,794,995 and underwriting expenses of $5,684. The average per share offering price of shares issued in the ATM Program was $14.42. SBA-guaranteed Debentures The outstanding balance of SBA-guaranteed Debentures as of February 28, 2020 was $161,000,000. Dividend Declared On January 10, 2020, the Company’s board of directors declared a regular monthly dividend for each of January, February and March 2020 as follows: Declared 1/10/2020 1/10/2020 1/10/2020 Ex-Dividend Date Record Date Payment Date Amount per Share 1/30/2020 2/27/2020 3/30/2020 1/31/2020 2/28/2020 3/31/2020 2/14/2020 3/13/2020 4/15/2020 $ 0.1133 $ 0.1133 $ 0.1133 142 TABLE OF CONTENTS STELLUS CAPITAL INVESTMENT CORPORATION NOTES TO THE FINANCIAL STATEMENTS December 31, 2019 STELLUS CAPITAL INVESTMENT CORPORATION Consolidated Schedule of Investments in and Advances to Affiliates December 31, 2019 (dollars in thousands) Investment (1) December 31, 2018 Fair Value Amount of Realized Gain/(Loss) Amount of Unrealized Gain/(Loss) Amount of Interest, Fees or Dividends Credit to (2) Income Gross Additions (3) Gross Reductions (4) December 31, 2019 Fair Value Company Non-control Investments Affiliate investments Glori Energy Production Inc. Total Non-Control/Affiliate investments Class A Common Units $50 $50 $ — $ — $ — $ — $ — $ — $ — $ — $(50 ) $(50 ) $ — $ — (1) (2) (3) (4) This schedule should be read in conjunction with Stellus’s consolidated financial statements, including the consolidated schedule of investments and notes to the consolidated financial statements. The principal amount and ownership detail for equity investments is included in the consolidated schedule of investments. Represents the total amount of interest, fees and dividends credited to income for the portion of the period for which an investment was included in Control or Affiliate categories, respectively. For investments transferred between Control and Affiliate categories during the period, any income or investment balances related to the time period it was in the category other than the one shown at period end is included in “Amounts from investments transferred from other 1940 Act classifications during the period.” Gross additions include increases in the cost basis of investments resulting from new portfolio investments, follow-on investments and accrued PIK interest, and the exchange of one or more existing securities for one or more new securities. Gross additions also include the movement of an existing portfolio company into this category and out of a different category. Gross reductions include decreases in the cost basis of investments resulting from principal repayments or sales and the exchange of one or more existing securities for one or more new securities. Gross reductions also include the movement of an existing portfolio company out of this category and into a different category. 143 TABLE OF CONTENTS Item 9. Changes in and Disagreements with Independent Registered Public Accounting Firm on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures. (a) Evaluation of Disclosure Controls and Procedures As of December 31, 2019 (the end of the period covered by this report), we, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the 1934 Act). Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective and provided reasonable assurance that information required to be disclosed in our periodic SEC filings is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. However, in evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. (b) Management’s Report on Internal Control Over Financial Reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rule 13a-15(f), and for performing an assessment of the effectiveness of internal control over financial reporting as of December 31, 2019. Internal control over financial reporting is a process designed by, or under the supervision of, our principal executive and principal financial officers, or persons performing similar functions, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Management performed an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2019 based upon the criteria set forth in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our assessment, management determined that our internal control over financial reporting was effective as of December 31, 2019. (c) Report of the Independent Registered Public Accounting Firm Our independent registered public accounting firm Grant Thornton, LLP, has issued an attestation report on the effectiveness of our internal control over financial reporting, which is set forth above under the heading “Reports of Independent Registered Public Accounting Firm” in Item 8. 144 TABLE OF CONTENTS (d) Changes in Internal Controls Over Financial Reporting There have been no changes in our internal control over financing reporting that occurred during the fourth fiscal quarter of 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Item 9B. Other Information. None. PART III We will file with the SEC a definitive Proxy Statement for our 2020 Annual Meeting of Stockholders, pursuant to Regulation 14A, not later than 120 days after the end of our fiscal year. Accordingly, certain information required by Part III has been omitted under General Instruction G(3) to the annual report on Form 10-K. Only those sections of our definitive Proxy Statement that specifically address the items set forth herein are incorporated by reference. Item 10. Directors, Executive Officers and Corporate Governance The information required by Item 10 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to the Company’s 2020 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company’s fiscal year. We have adopted a code of business conduct and ethics that applies to our directors, officers and employees. This code of ethics is published on our website at www.stelluscapital.com . We intend to disclose any future amendments to, or waivers from, this code of conduct within four business days of the waiver or amendment through a website posting. Item 11. Executive Compensation The information required by Item 11 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to the Company’s 2020 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company’s fiscal year. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by Item 12 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to the Company’s 2020 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company’s fiscal year. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by Item 13 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to the Company’s 2020 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company’s fiscal year. Item 14. Principal Accountant Fees and Services The information required by Item 14 is hereby incorporated by reference from the Company’s definitive Proxy Statement relating to the Company’s 2020 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission within 120 days following the end of the Company’s fiscal year. 145 TABLE OF CONTENTS PART IV Item 15. Exhibits, Financial Statement Schedules a. Documents Filed as Part of this Report The following financial statements are set forth in Item 8: Report of Independent Registered Public Accounting Firm Statements of Assets and Liabilities as of December 31, 2019 and December 31, 2018 Statements of Operations for the years ended December 31, 2019, 2018, and 2017 Statements of Changes in Net Assets for the years ended December 31, 2019, 2018, and 2017 Statements of Cash Flows for the years ended December 31, 2019, 2018, and 2017 Schedule of Investments as of December 31, 2019 and December 31, 2018 Notes to Financial Statements b. Exhibits Page 86 89 90 91 92 93 108 The following exhibits are filed as part of this report or hereby incorporated by reference to exhibits previously filed with the SEC: 3.1 3.3 4.1 4.2 4.4 4.6 Articles of Amendment and Restatement (Incorporated by reference to Exhibit (a)(1) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012). Bylaws (Incorporated by reference to Exhibit (b)(1) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012). Form of Stock Certificate (Incorporated by reference to Exhibit (d) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012). Form of Indenture (Incorporated by reference to Exhibit (d)(2) to the Registrant’s Registration Statement on Form N-2 (File No. 333-189938, filed January 29, 2014). Second Supplemental Indenture between the Registrant and U.S. Bank National Association, date August 21, 2017, (Incorporated by reference on exhibit (d)(6) to the Registrant’s Registration Statement on Form N-2 (File No. 333-216138), filed on August 23, 2017). Form of Global Note with respect to the 5.75% Note due 2022 (Incorporated by reference to Exhibit 4.4). 4.7* Description of Securities 10.1 10.2 10.3 10.4 Form of Investment Advisory Agreement between Registrant and Stellus Capital Management, LLC (Incorporated by reference to Exhibit (g)(1) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012). Custody Agreement between Registrant and ZB, National Association (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No. 814-00971), filed on November 7, 2017). Administration Agreement between Registrant and Stellus Capital Management, LLC (Incorporated by reference to Exhibit (k)(1) to the Registrant’s Registration Statement on Form N-2 (File No. 333- 184195), filed on October 23, 2012). Dividend Reinvestment Plan (Incorporated by reference to Exhibit (e) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012). 146 TABLE OF CONTENTS 10.5 10.6 10.7 10.8 10.9 10.10 10.11 Form of License Agreement between the Registrant and Stellus Capital Management (Incorporated by reference to Exhibit (k)(2) to the Registrant’s Registration Statement on Form N-2 (File No. 333- 184195), filed on October 23, 2012). Form of Indemnification Agreement between the Registrant and the directors (Incorporated by reference to Exhibit (k)(3) to the Registrant’s Registration Statement on Form N-2 (File No. 333- 184195), filed on October 23, 2012). Form of Senior Secured Revolving Credit Agreement, between the Registrant, as a borrower, the lenders party hereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to the Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (File No 814-00971), filed on October 13, 2017). Form of Guarantee and Security Agreement, the Registrant, ZB, N.A., dba Amegy Bank, as administrative agent, and ZB, N.A. dba Amegy Bank, as collateral agent (Incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K (File No. 814-00971), filed on October 13, 2017). Consent and Waiver, dated March 28, 2018, between the Registrant, as a borrower, the lenders party hereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q (File No.814-00971), filed on May 8, 2018). First Amendment to Senior Secured Revolving Credit Agreement and Commitment Increase, dated August 2, 2018, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q (File No.814-00971), filed on August 8, 2018). Second Amendment to Senior Secured Revolving Credit Agreement and Commitment Increase, dated September 13, 2019, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent (Incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K(File No. 814-00971), filed on September 18, 2019). 10.12* Increase Agreement, dated December 27, 2019, between the Registrant, as a borrower, the lenders party thereto and ZB, N.A. dba Amegy Bank, as administrative agent 14.1 21.1 Code of Ethics (Incorporated by reference to Exhibit (r)(1) to the Registrant’s Registration Statement on Form N-2 (File No. 333-184195), filed on October 23, 2012). Subsidiaries of the Registrant and jurisdiction of incorporation/organizations: Stellus Capital SBIC, LP — Delaware Stellus Capital SBIC GP, LLC — Delaware Stellus Capital SBIC II, LP — Delaware Stellus Capital SBIC II GP, LLC — Delaware SCIC-SKP Blocker 1, Inc. — Delaware SCIC-ERC Blocker 1, Inc. — Delaware SCIC-Consolidated Blocker 1, Inc. — Delaware SCIC-CC Blocker 1, Inc. — Delaware SCIC-APE Blocker 1, Inc. — Delaware SCIC-Hollandar Blocker 1, Inc. — Delaware SCIC-Invincible Blocker 1, Inc. — Delaware SCIC-FBO Blocker 1, Inc. — Delaware SCIC-ICD Blocker 1, Inc. — Delaware 31.1* Certification of Chief Executive Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended. 147 TABLE OF CONTENTS 31.2* Certification of Chief Financial Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended. 32.1* Certification of Chief Executive Officer pursuant to Section 906 of The Sarbanes-Oxley Act of 2002. 32.2* Certification of Chief Financial Officer pursuant to Section 906 of The Sarbanes-Oxley Act of 2002. * Filed herewith. c. Financial statement schedules No financial statement schedules are filed herewith because (1) such schedules are not required or (2) the information has been presented in the aforementioned financial statements. 148 TABLE OF CONTENTS Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SIGNATURES Date: March 2, 2020 STELLUS CAPITAL INVESTMENT CORPORATION /s/ Robert T. Ladd Robert T. Ladd Chief Executive Officer and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated. Date: March 2, 2020 /s/ Robert T. Ladd Robert T. Ladd Chief Executive Officer, President and Chairman of the Board of Directors Date: March 2, 2020 /s/ W. Todd Huskinson W. Todd Huskinson Chief Financial Officer, Chief Compliance Officer and Secretary(Principal Accounting and Financial Officer) Date: March 2, 2020 Date: March 2, 2020 Date: March 2, 2020 Date: March 2, 2020 Date: March 2, 2020 Date: March 2, 2020 /s/ Dean D’Angelo Dean D’Angelo Director /s/ Joshua T. Davis Joshua T. Davis Director /s/ J. Tim Arnoult J. Tim Arnoult Director /s/ Bruce R. Bilger Bruce R. Bilger Director /s/ Paul Keglevic Paul Keglevic Director /s/ William C. Repko William C. Repko Director 149 DESCRIPTION OF SECURITIES Exhibit 4.7 The following is a brief description of the securities of Stellus Capital Investment Corporation (the “Company,” “we,” “our” or “us”), registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). This description of our securities does not purport to be complete and is subject to and qualified in its entirety by reference to the applicable provisions of Maryland General Corporation Law (the “MGCL”), and the full text of our charter, bylaws and the relevant indenture and supplemental indenture governing the debt securities described herein. As of December 31, 2019 and the date hereof, our common stock and the debt securities described herein are the only securities that we have registered under Section 12 of the Exchange Act. A. Common Stock As of December 31, 2019, our authorized stock consists of 100,000,000 shares of stock, par value $0.001 per share, all of which are initially designated as common stock. Our common stock is listed on the New York Stock Exchange under the ticker symbol “SCM.” There are no outstanding options or warrants to purchase our stock. No stock has been authorized for issuance under any equity compensation plans. Our fiscal year-end is December 31st. Under Maryland law, our stockholders generally are not personally liable for our debts or obligations. Under our charter, our board of directors is authorized to classify and reclassify any unissued shares of stock into other classes or series of stock without obtaining stockholder approval. As permitted by the MGCL, our charter provides that the board of directors, without any action by our stockholders, may amend the charter from time to time to increase or decrease the aggregate number of shares of stock or the number of shares of stock of any class or series that we have authority to issue. All shares of our common stock have equal rights as to earnings, assets, voting, and distributions and, when they are issued, will be duly authorized, validly issued, fully paid and nonassessable. Distributions may be paid to the holders of our common stock if, as and when authorized by our board of directors and declared by us out of assets legally available therefor. Shares of our common stock have no preemptive, conversion or redemption rights and are freely transferable, except where their transfer is restricted by federal and state securities laws or by contract. In the event of our liquidation, dissolution or winding up, each share of our common stock would be entitled to share ratably in all of our assets that are legally available for distribution after we pay all debts and other liabilities and subject to any preferential rights of holders of our preferred stock, if any preferred stock is outstanding at such time. Each share of our common stock is entitled to one vote on all matters submitted to a vote of stockholders, including the election of directors. Except as provided with respect to any other class or series of stock, the holders of our common stock possess exclusive voting power. There is no cumulative voting in the election of directors, which means that holders of a majority of the outstanding shares of common stock can elect all of our directors, and holders of less than a majority of such shares will be unable to elect any director. Certain Provisions of the MGCL and Our Charter and Bylaws The MGCL and our charter and bylaws contain provisions that could make it more difficult for a potential acquirer to acquire us by means of a tender offer, proxy contest or otherwise. These provisions are expected to discourage certain coercive takeover practices and inadequate takeover bids and to encourage persons seeking to acquire control of us to negotiate first with our board of directors. We believe that the benefits of these provisions outweigh the potential disadvantages of discouraging any such acquisition proposals because, among other things, the negotiation of such proposals may improve their terms. Classified Board of Directors Our board of directors is divided into three classes of directors serving staggered three-year terms. Upon expiration of their terms, directors of each class will be elected to serve for three-year terms and until their successors are duly elected and qualify and each year one class of directors will be elected by the stockholders. A classified board may render a change in control of us or removal of our incumbent management more difficult. We believe, however, that the longer time required to elect a majority of a classified board of directors will help to ensure the continuity and stability of our management and policies. Election of Directors Our charter and bylaws provide that the affirmative vote of the holders of a plurality of the outstanding shares of stock entitled to vote in the election of directors cast at a meeting of stockholders duly called and at which a quorum is present will be required to elect a director. Pursuant to our charter our board of directors may amend the bylaws to alter the vote required to elect directors. Number of Directors; Vacancies; Removal Our charter provides that the number of directors will be set only by the board of directors in accordance with our bylaws. Our bylaws provide that a majority of our entire board of directors may at any time increase or decrease the number of directors. However, unless our bylaws are amended, the number of directors may never be less than one or more than nine. Our charter provides that, at such time as we have at least three independent directors and our common stock is registered under the Exchange Act, we elect to be subject to the provision of Subtitle 8 of Title 3 of the MGCL regarding the filling of vacancies on the board of directors. Accordingly, at such time, except as may be provided by the board of directors in setting the terms of any class or series of preferred stock, any and all vacancies on the board of directors may be filled only by the affirmative vote of a majority of the remaining directors in office, even if the remaining directors do not constitute a quorum, and any director elected to fill a vacancy will serve for the remainder of the full term of the directorship in which the vacancy occurred and until a successor is elected and qualifies, subject to any applicable requirements of the Investment Company Act of 1940, as amended (the “1940 Act”). Our charter provides that a director may be removed only for cause, as defined in our charter, and then only by the affirmative vote of at least two-thirds of the votes entitled to be cast in the election of directors. Action by Stockholders Under the MGCL, stockholder action can be taken only at an annual or special meeting of stockholders or (unless the charter provides for stockholder action by less than unanimous written consent, which our charter does not) by unanimous written consent in lieu of a meeting. These provisions, combined with the requirements of our bylaws regarding the calling of a stockholder-requested special meeting of stockholders discussed below, may have the effect of delaying consideration of a stockholder proposal until the next annual meeting. Advance Notice Provisions for Stockholder Nominations and Stockholder Proposals Our bylaws provide that with respect to an annual meeting of stockholders, nominations of persons for election to the board of directors and the proposal of business to be considered by stockholders may be made only (a) pursuant to our notice of the meeting, (b) by the board of directors or (c) by a stockholder who is entitled to vote at the meeting and who has complied with the advance notice procedures of our bylaws. With respect to special meetings of stockholders, only the business specified in our notice of the meeting may be brought before the meeting. Nominations of persons for election to the board of directors at a special meeting may be made only (1) pursuant to our notice of the meeting, (2) by the board of directors or (3) provided that the board of directors has determined that directors will be elected at the meeting, by a stockholder who is entitled to vote at the meeting and who has complied with the advance notice provisions of the bylaws. The purpose of requiring stockholders to give us advance notice of nominations and other business is to afford our board of directors a meaningful opportunity to consider the qualifications of the proposed nominees and the advisability of any other proposed business and, to the extent deemed necessary or desirable by our board of directors, to inform stockholders and make recommendations about such qualifications or business, as well as to provide a more orderly procedure for conducting meetings of stockholders. Although our bylaws do not give our board of directors any power to disapprove stockholder nominations for the election of directors or proposals recommending certain action, they may have the effect of precluding a contest for the election of directors or the consideration of stockholder proposals if proper procedures are not followed and of discouraging or deterring a third party from conducting a solicitation of proxies to elect its own slate of directors or to approve its own proposal without regard to whether consideration of such nominees or proposals might be harmful or beneficial to us and our stockholders. Calling of Special Meetings of Stockholders Our bylaws provide that special meetings of stockholders may be called by our board of directors and certain of our officers. Additionally, our bylaws provide that, subject to the satisfaction of certain procedural and informational requirements by the stockholders requesting the meeting, a special meeting of stockholders will be called by the secretary of the corporation upon the written request of stockholders entitled to cast not less than a majority of all the votes entitled to be cast at such meeting. Approval of Extraordinary Corporate Action; Amendment of Charter and Bylaws Under Maryland law, a Maryland corporation generally cannot dissolve, amend its charter, merge, sell all or substantially all of its assets, engage in a share exchange or engage in similar transactions outside the ordinary course of business, unless approved by the affirmative vote of stockholders entitled to cast at least two-thirds of the votes entitled to be cast on the matter. However, a Maryland corporation may provide in its charter for approval of these matters by a lesser percentage, but not less than a majority of all of the votes entitled to be cast on the matter. Our charter generally provides for approval of charter amendments and extraordinary transactions by the stockholders entitled to cast at least a majority of the votes entitled to be cast on the matter. Our charter also provides that certain charter amendments, any proposal for our conversion, whether by charter amendment, merger or otherwise, from a closed-end company to an open-end company and any proposal for our liquidation or dissolution requires the approval of the stockholders entitled to cast at least 80% of the votes entitled to be cast on such matter. However, if such amendment or proposal is approved by a majority of our continuing directors (in addition to approval by our board of directors), such amendment or proposal may be approved by a majority of the votes entitled to be cast on such a matter. In either event, in accordance with the requirements of the 1940 Act, any such amendment or proposal that would have the effect of changing the nature of our business so as to cause us to cease to be, or to withdraw our election as, a BDC would be required to be approved by a majority of our outstanding voting securities, as defined under the 1940 Act. The “continuing directors” are defined in our charter as (a) our current directors, (b) those directors whose nomination for election by the stockholders or whose election by the directors to fill vacancies is approved by a majority of our current directors then on the board of directors or (c) any successor directors whose nomination for election by the stockholders or whose election by the directors to fill vacancies is approved by a majority of continuing directors or the successor continuing directors then in office. Our charter and bylaws provide that the board of directors have the exclusive power to make, alter, amend or repeal any provision of our bylaws. No Appraisal Rights Except with respect to appraisal rights arising in connection with the Control Share Act discussed below, as permitted by the MGCL, our charter provides that stockholders will not be entitled to exercise appraisal rights unless a majority of the board of directors shall determine such rights apply. Control Share Acquisitions The MGCL provides that control shares of a Maryland corporation acquired in a control share acquisition have no voting rights except to the extent approved by a vote of two-thirds of the votes entitled to be cast on the matter, or the Control Share Act. Shares owned by the acquirer, by officers or by directors who are employees of the corporation are excluded from shares entitled to vote on the matter. Control shares are voting shares of stock which, if aggregated with all other shares of stock owned by the acquirer or in respect of which the acquirer is able to exercise or direct the exercise of voting power (except solely by virtue of a revocable proxy), would entitle the acquirer to exercise voting power in electing directors within one of the following ranges of voting power: • • • one-tenth or more but less than one-third; one-third or more but less than a majority; or a majority or more of all voting power. The requisite stockholder approval must be obtained each time an acquirer crosses one of the thresholds of voting power set forth above. Control shares do not include shares the acquiring person is then entitled to vote as a result of having previously obtained stockholder approval. A control share acquisition means the acquisition of control shares, subject to certain exceptions. A person who has made or proposes to make a control share acquisition may compel the board of directors of the corporation to call a special meeting of stockholders to be held within 50 days of demand to consider the voting rights of the shares. The right to compel the calling of a special meeting is subject to the satisfaction of certain conditions, including an undertaking to pay the expenses of the meeting. If no request for a meeting is made, the corporation may itself present the question at any stockholders meeting. If voting rights are not approved at the meeting or if the acquiring person does not deliver an acquiring person statement as required by the statute, then the corporation may redeem for fair value any or all of the control shares, except those for which voting rights have previously been approved. The right of the corporation to redeem control shares is subject to certain conditions and limitations, including, as provided in our bylaws, compliance with the 1940 Act. Fair value is determined, without regard to the absence of voting rights for the control shares, as of the date of the last control share acquisition by the acquirer or of any meeting of stockholders at which the voting rights of the shares are considered and not approved. If voting rights for control shares are approved at a stockholders meeting and the acquirer becomes entitled to vote a majority of the shares entitled to vote, all other stockholders may exercise appraisal rights. The fair value of the shares as determined for purposes of appraisal rights may not be less than the highest price per share paid by the acquirer in the control share acquisition. The Control Share Act does not apply (a) to shares acquired in a merger, consolidation or share exchange if the corporation is a party to the transaction or (b) to acquisitions approved or exempted by the charter or bylaws of the corporation. Our bylaws contain a provision exempting from the Control Share Act any and all acquisitions by any person of our shares of stock. There can be no assurance that such provision will not be amended or eliminated at any time in the future. However, we will amend our bylaws to be subject to the Control Share Act only if the board of directors determines that it would be in our best interests and if the Securities and Exchange Commission (the “SEC”) staff does not object to our determination that our being subject to the Control Share Act does not conflict with the 1940 Act. Business Combinations Under Maryland law, “business combinations” between a Maryland corporation and an interested stockholder or an affiliate of an interested stockholder are prohibited for five years after the most recent date on which the interested stockholder becomes an interested stockholder, or the Business Combination Act. These business combinations include a merger, consolidation, share exchange or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities. An interested stockholder is defined as: • • any person who beneficially owns 10% or more of the voting power of the corporation’s outstanding voting stock; or an affiliate or associate of the corporation who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of the voting power of then outstanding voting stock of the corporation. A person is not an interested stockholder under this statute if the board of directors approved in advance the transaction by which the stockholder otherwise would have become an interested stockholder. However, in approving a transaction, the board of directors may provide that its approval is subject to compliance, at or after the time of approval, with any terms and conditions determined by the board. After the five-year prohibition, any business combination between the Maryland corporation and an interested stockholder generally must be recommended by the board of directors of the corporation and approved by the affirmative vote of at least: • • 80% of the votes entitled to be cast by holders of outstanding shares of voting stock of the corporation; and two-thirds of the votes entitled to be cast by holders of voting stock of the corporation other than shares held by the interested stockholder with whom or with whose affiliate the business combination is to be effected or held by an affiliate or associate of the interested stockholder. These super-majority vote requirements do not apply if the corporation’s common stockholders receive a minimum price, as defined under Maryland law, for their shares in the form of cash or other consideration in the same form as previously paid by the interested stockholder for its shares. The statute permits various exemptions from its provisions, including business combinations that are exempted by the board of directors before the time that the interested stockholder becomes an interested stockholder. Our board of directors has adopted a resolution that any business combination between us and any other person is exempted from the provisions of the Business Combination Act, provided that the business combination is first approved by the board of directors, including a majority of the directors who are not interested persons as defined in the 1940 Act. This resolution may be altered or repealed in whole or in part at any time; however, our board of directors will adopt resolutions so as to make us subject to the provisions of the Business Combination Act only if the board of directors determines that it would be in our best interests and if the SEC staff does not object to our determination that our being subject to the Business Combination Act does not conflict with the 1940 Act. If this resolution is repealed, or the board of directors does not otherwise approve a business combination, the statute may discourage others from trying to acquire control of us and increase the difficulty of consummating any offer. Conflict with 1940 Act Our bylaws provide that, if and to the extent that any provision of the MGCL, including the Control Share Act (if we amend our bylaws to be subject to such Act) and the Business Combination Act, or any provision of our charter or bylaws conflicts with any provision of the 1940 Act, the applicable provision of the 1940 Act will control. B. Debt Securities – 5.75% Notes due 2022 On August 21, 2017, we issued $42.5 million in aggregate principal amount of 5.75% fixed-rate notes due 2022 (the “2022 Notes”) under an indenture dated as of May 5, 2014 and the second supplemental indenture thereto, dated August 21, 2017, entered into between us and U.S. Bank National Association, as trustee (together, the “Indenture”). On September 8, 2017, the Company issued an additional $6.4 million in aggregate principal amount of the 2022 Notes pursuant to a full exercise of the underwriters’ overallotment option. The 2022 Notes will mature on September 15, 2022. The principal payable at maturity will be 100% of the aggregate principal amount. The interest rate of the 2022 Notes is 5.75% per year and will be paid every March 15, June 15, September 15 and December 15, which began December 15, 2017, and the regular record dates for interest payments will be every March 1, June 1, September 1 and December 1 of each year, beginning December 1, 2017. If an interest payment date falls on a non-business day, the applicable interest payment will be made on the next business day and no additional interest will accrue as a result of such delayed payment. The initial interest period was the period from and including August 21, 2017, to, but excluding, the initial interest payment date, and the subsequent interest periods are the periods from and including an interest payment date to, but excluding, the next interest payment date or the stated maturity date, as the case may be. The 2022 Notes are issued in denominations of $25 and integral multiples of $25 in excess thereof. The 2022 Notes are not subject to any sinking fund and holders of the 2022 Notes (the “Noteholders”) do not have the option to have the 2022 Notes repaid prior to the stated maturity date. The Indenture does not contain any provisions that give the Noteholders protection in the event we issue a large amount of debt or are acquired by another entity. We have the ability to issue indenture securities with terms different from the 2022 Notes and, without the consent of the holders thereof, to reopen the 2022 Notes and issue additional 2022 Notes. Optional Redemption The 2022 Notes may be redeemed in whole or in part at any time or from time to time at our option on or after September 15, 2019 upon not less than 30 days nor more than 60 days written notice by mail prior to the date fixed for redemption thereof, at a redemption price of 100% of the outstanding principal amount of the 2022 Notes to be redeemed plus accrued and unpaid interest payments otherwise payable thereon for the then-current quarterly interest period accrued to the date fixed for redemption. The Noteholders may be prevented from exchanging or transferring the 2022 Notes when they are subject to redemption. In case any 2022 Notes are to be redeemed in part only, the redemption notice will provide that, upon surrender of such Note, the Noteholders will receive, without a charge, a new 2022 Note or 2022 Notes of authorized denominations representing the principal amount of the Noteholders remaining unredeemed 2022 Notes. Any exercise of our option to redeem the 2022 Notes will be done in compliance with the 1940 Act. If we redeem only some of the 2022 Notes, the trustee will determine the method for selection of the particular 2022 Notes to be redeemed, in accordance with the Indenture and in accordance with the rules of any national securities exchange or quotation system on which the 2022 Notes are listed. Unless we default in payment of the redemption price, interest will cease to accrue on the 2022 Notes called for redemption on and after the date of redemption. Events of Default The Noteholders have rights if an Event of Default occurs in respect of the 2022 Notes, as described later in this subsection. The term “Event of Default” in respect of the 2022 Notes means any of the following: • We do not pay the principal of (or premium, if any, on) any 2022 Note within five days of its due date. • We do not pay interest on any 2022 Note when due, and such default is not cured within 30 days. • We remain in breach of any other covenant with respect to the 2022 Notes for 60 days after we receive a written notice of default stating we are in breach. The notice must be sent by either the Trustee or holders of at least 25% of the principal amount of the 2022 Notes. • We file for bankruptcy or certain other events of bankruptcy, insolvency or reorganization occur and in the case of certain orders or decrees entered against us under any bankruptcy law, such order or decree remains undischarged or unstayed for a period of 60 days. • On the last business day of each of twenty-four consecutive calendar months, the 2022 Notes have an asset coverage of less than 100%, after giving effect to any exemptive relief granted to us by the SEC. No periodic evidence is required to be furnished as to the absence of default or as to compliance with the terms of the Indenture. An Event of Default for the 2022 Notes does not necessarily constitute an Event of Default for any other series of debt securities issued under the same or any other indenture. The trustee may withhold notice to the holders of the 2022 Notes of any default, except in the payment of principal or interest, if it in good faith considers the withholding of notice to be in the best interests of the holders. Remedies if an Event of Default Occurs If an Event of Default has occurred and is continuing, the trustee or the holders of not less than 25% in principal amount of the 2022 Notes may declare the entire principal amount of all the 2022 Notes to be due and immediately payable. This is called a declaration of acceleration of maturity. In certain circumstances, a declaration of acceleration of maturity may be canceled by the holders of a majority in principal amount of the 2022 Notes if (1) we have deposited with the trustee all amounts due and owing with respect to the 2022 Notes (other than principal that has become due solely by reason of such acceleration) and certain other amounts, and (2) any other Events of Default have been cured or waived. The trustee is not required to take any action under the Indenture at the request of any holders unless the holders offer the trustee protection from expenses and liability reasonably satisfactory to it (called an “indemnity”). If indemnity reasonably satisfactory to the trustee is provided, the holders of a majority in principal amount of the 2022 Notes may direct the time, method and place of conducting any lawsuit or other formal legal action seeking any remedy available to the trustee. The trustee may refuse to follow those directions in certain circumstances. No delay or omission in exercising any right or remedy will be treated as a waiver of that right, remedy or Event of Default. Before the Noteholders are allowed to bypass the trustee and bring their own lawsuit or other formal legal action or take other steps to enforce their rights or protect their interests relating to the 2022 Notes, the following must occur: • • The Noteholders must give the trustee written notice that an Event of Default has occurred and remains uncured; the holders of at least 25% in principal amount of all the 2022 Notes must make a written request that the trustee take action because of the default and must offer reasonable indemnity to the trustee against the costs, expenses and other liabilities of taking that action; • • the trustee must not have taken action for 60 days after receipt of the above notice and offer of indemnity; and the holders of a majority in principal amount of the 2022 Notes must not have given the trustee a direction inconsistent with the above notice during that 60-day period. However, the Noteholders are entitled at any time to bring a lawsuit for the payment of money due on their 2022 Notes on or after the due date. Book-entry and other indirect holders should consult their banks or brokers for information on how to give notice or direction to or make a request of the trustee and how to declare or cancel an acceleration of maturity. Each year, we will furnish to the trustee a written statement of certain of our officers certifying that to their knowledge we are in compliance with the Indenture and the 2022 Notes, or else specifying any default. Waiver of Default The holders of a majority in principal amount of the 2022 Notes may waive any past defaults other than a default: • • the payment of principal of (or premium, if any) or interest; or in respect of a covenant that cannot be modified or amended without the consent of each holder. Modification or Waiver There are three types of changes we can make to the Indenture and the 2022 Notes issued thereunder. Changes Requiring the Noteholders’ Approval First, there are changes that we cannot make to the Noteholders’ 2022 Notes without their specific approval. The following is a list of those types of changes: • • change the stated maturity of the principal of or interest on the 2022 Notes; reduce any amounts due on the 2022 Notes; • • • • • • reduce the amount of principal payable upon acceleration of the maturity of a 2022 Note following a default; change the place or currency of payment on a 2022 Note; impair the Noteholders’ right to sue for payment; adversely affect any rights to convert or exchange any note in accordance with its terms; reduce the percentage of the Noteholders whose consent is needed to modify or amend the Indenture; reduce the percentage of the Noteholders whose consent is needed to waive compliance with certain provisions of the Indenture or to waive certain defaults; and • modify any other material aspect of the Indenture dealing with supplemental indentures, modification and waiver of past defaults, reduction of the quorum or voting requirements or the waiver of certain covenants. Changes Not Requiring Approval The second type of change does not require any vote by the Noteholders. This type is limited to clarifications and certain other changes that would not adversely affect the Noteholders in any material respect. Changes Requiring Majority Approval Any other change to the Indenture and the 2022 Notes would require the following approval: • • if the change affects only the 2022 Notes, it must be approved by the holders of a majority in principal amount of the 2022 Notes; and if the change affects more than one series of debt securities issued under the same indenture, it must be approved by the holders of a majority in principal amount of all of the series affected by the change, with all affected series voting together as one class for this purpose. In each case, the required approval must be given by written consent. The holders of a majority in principal amount of all of the series of debt securities issued under an indenture, voting together as one class for this purpose, may waive our compliance with some of our covenants in that indenture. However, we cannot obtain a waiver of a payment default or of any of the matters covered by the bullet points included above under “— Changes Requiring the Noteholders’ Approval.” Further Details Concerning Voting When taking a vote, we use the principal amount that would be due and payable on the voting date if the maturity of the 2022 Notes were accelerated to that date because of a default, to decide how much principal to attribute to the 2022 Notes: The 2022 Notes will not be considered outstanding, and therefore not eligible to vote, if we have deposited or set aside in trust money for their payment or redemption. The 2022 Notes will also not be eligible to vote if they have been fully defeased as described later under “— Defeasance — Full Defeasance.” We are generally entitled to set any day as a record date for the purpose of determining the Noteholders that are entitled to vote or take other action under the Indenture. However, the record date may not be more than 30 days before the date of the first solicitation of holders to vote on or take such action. If we set a record date for a vote or other action to be taken by the Noteholders, that vote or action may be taken only by persons who are the Noteholders on the record date and must be taken within eleven months following the record date. Defeasance The following defeasance provisions are applicable to the 2022 Notes. “Defeasance” means that, by depositing with a trustee an amount of cash and/or government securities sufficient to pay all principal and interest, if any, on the 2022 Notes when due and satisfying any additional conditions noted below, we will be deemed to have been discharged from our obligations under the 2022 Notes. In the event of a “covenant defeasance,” upon depositing such funds and satisfying similar conditions discussed below we would be released from certain covenants under the Indenture relating to the 2022 Notes. The consequences to the Noteholders would be that, while they would no longer benefit from certain covenants under the Indenture, and while the 2022 Notes could not be accelerated for any reason, the Noteholders nonetheless would be guaranteed to receive the principal and interest owed to them. Covenant Defeasance Under current U.S. federal tax law and the Indenture, we can make the deposit described below and be released from some of the restrictive covenants in the Indenture under which the 2022 Notes were issued. This is called “covenant defeasance.” In that event, the Noteholders would lose the protection of those restrictive covenants but would gain the protection of having money and government securities set aside in trust to repay their 2022 Notes. If we achieve covenant defeasance and the Noteholders’ 2022 Notes were subordinated as described under “Indenture Provisions — Ranking” below, such subordination would not prevent the trustee under the Indenture from applying the funds available to it from the deposit described in the first bullet below to the payment of amounts due in respect of such debt securities for the benefit of the subordinated debtholders. In order to achieve covenant defeasance, we must do the following: • Since the 2022 Notes are denominated in U.S. dollars, we must deposit in trust for the benefit of all the Noteholders a combination of cash and U.S. government or U.S. government agency notes or bonds that will generate enough cash to make interest, principal and any other payments on the 2022 Notes on their various due dates; • • • • we must deliver to the trustee a legal opinion of our counsel confirming that, under current U.S. federal income tax law, we may make the above deposit without causing the Noteholders to be taxed on the 2022 Notes any differently than if we did not make the deposit; we must deliver to the trustee a legal opinion of our counsel stating that the above deposit does not require registration by us under the 1940 Act, and a legal opinion and officers’ certificate stating that all conditions precedent to covenant defeasance have been complied with; defeasance must not result in a breach or violation of, or result in a default under, the Indenture or any of our other material agreements or instruments; and no default or event of default with respect to the 2022 Notes shall have occurred and be continuing and no defaults or events of default related to bankruptcy, insolvency or reorganization shall occur during the next 90 days. If we accomplish covenant defeasance, the Noteholders can still look to us for repayment of the 2022 Notes if there were a shortfall in the trust deposit or the trustee is prevented from making payment. In fact, if one of the remaining Events of Default occurred (such as our bankruptcy) and the 2022 Notes became immediately due and payable, there might be a shortfall. Depending on the event causing the default, the Noteholders may not be able to obtain payment of the shortfall. Full Defeasance If there is a change in U.S. federal tax law, as described below, we can legally release ourselves from all payment and other obligations on the 2022 Notes (called “full defeasance”) if we put in place the following other arrangements for the Noteholders to be repaid: • • Since the 2022 Notes are denominated in U.S. dollars, we must deposit in trust for the benefit of all the Noteholders a combination of money and U.S. government or U.S. government agency notes or bonds that will generate enough cash to make interest, principal and any other payments on the 2022 Notes on their various due dates; we must deliver to the trustee a legal opinion confirming that there has been a change in current U.S. federal tax law or an IRS ruling that allows us to make the above deposit without causing the Noteholders to be taxed on the 2022 Notes any differently than if we did not make the deposit; • • • we must deliver to the trustee a legal opinion of our counsel stating that the above deposit does not require registration by us under the 1940 Act, and a legal opinion and officers’ certificate stating that all conditions precedent to defeasance have been complied with; defeasance must not result in a breach or violation of, or constitute a default under, of the Indenture or any of our other material agreements or instruments; and no default or event of default with respect to the 2022 Notes shall have occurred and be continuing and no defaults or events of default related to bankruptcy, insolvency or reorganization shall occur during the next 90 days. If we ever did accomplish full defeasance, as described above, the Noteholders would have to rely solely on the trust deposit for repayment of the 2022 Notes. The Noteholders could not look to us for repayment in the unlikely event of any shortfall. Conversely, the trust deposit would most likely be protected from claims of our lenders and other creditors if we ever became bankrupt or insolvent. If the Noteholders’ 2022 Notes were subordinated as described later under “— Indenture Provisions — Ranking,” such subordination would not prevent the trustee under the Indenture from applying the funds available to it from the deposit referred to in the first bullet of the preceding paragraph to the payment of amounts due in respect of such 2022 Notes for the benefit of the subordinated debtholders. Other Covenants In addition to any other covenants described in this description, as well as standard covenants relating to payment of principal and interest, maintaining an office where payments may be made or securities can be surrendered for payment, payment of taxes by the Company and related matters, the following covenants apply to the 2022 Notes: • We agree that for the period of time during which the 2022 Notes are outstanding, we will not violate Section 18(a)(1)(A) as modified by Section 61(a)(1) of the 1940 Act or any successor provisions, whether or not we continue to be subject to such provisions of the 1940 Act, but giving effect, in either 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 150% after such borrowings. • We agree that for the period of time during which the 2022 Notes are outstanding, we will not violate Section 18(a)(1)(B) as modified by (i) Section 61(a)(1) of the 1940 Act or any successor provisions and (ii) the exception set forth below, despite the fact that we are not currently subject to such provisions of the 1940 Act, except that we are permitted to declare a cash dividend or distribution notwithstanding the prohibition contained in Section 18(a)(1)(B) as modified by Section 61(a)(1) of the 1940 Act, but only up to such amount as is necessary in order for us to maintain our status as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986 and, provided that, any such prohibition will not apply until such time as our asset coverage has been below the minimum asset coverage required pursuant to clause (i) above for more than six consecutive months. If Section 18(a)(1)(B) as modified by Section 61(a)(1) of the 1940 Act were currently applicable to us in connection with this offering, these provisions would 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, were below 150% 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. • If, at any time, we are not subject to the reporting requirements of Sections 13 or 15(d) of the Exchange Act, to file any periodic reports with the SEC, we agree to furnish to the Noteholders and the Trustee, for the period of time during which the 2022 Notes are outstanding, our audited annual consolidated financial statements, within 90 days of our fiscal year end, and unaudited interim consolidated financial statements, within 45 days of our fiscal quarter end (other than our fourth fiscal quarter). All such financial statements are prepared, in all material respects, in accordance with applicable United States generally accepted accounting principles. Indenture Provisions — Ranking The 2022 Notes are designated as Senior Securities and, therefore, Senior Indebtedness under the Indenture. Senior Indebtedness is defined in the Indenture as the principal of (and premium, if any) and unpaid interest on: • our indebtedness (including indebtedness of others guaranteed by us), whenever created, incurred, assumed or guaranteed, for money borrowed, that we have designated as “Senior Indebtedness” for purposes of the Indenture and in accordance with the terms of the Indenture (including any indenture securities designated as Senior Indebtedness), and • renewals, extensions, modifications and refinancings of any of this indebtedness. The 2022 Notes are not secured by any assets of the Company. As unsecured obligations of the Company designated as Senior Indebtedness under the Indenture, the 2022 Notes rank • • • pari passu, or equal, with our future senior unsecured indebtedness; senior to any of our future indebtedness that expressly provides it is subordinated to the 2022 Notes; effectively subordinated to all of our existing and future secured indebtedness (including indebtedness that is initially unsecured to which we subsequently grant security), to the extent of the value of the assets securing such indebtedness, including without limitation, borrowings under our $220.0 million senior secured revolving credit facility, or the Credit Facility, of which $161.6 million was outstanding as of December 31, 2019; and • structurally subordinated to all existing and future indebtedness and other obligations of any of our subsidiaries. In particular, as designated Senior Indebtedness under the Indenture, the 2022 Notes will rank senior to any future securities we issue under the Indenture that are designated as subordinated debt securities. Any such Indenture securities designated as subordinated debt securities will be subordinated in right of payment of the principal of (and premium if any) and interest, if any, on such subordinated debt securities to the prior payment in full of the 2022 Notes, and all other Senior Indebtedness under the Indenture, upon any distribution of our assets upon our dissolution, winding up, liquidation or reorganization. In addition, no payment on account of principal (or premium, if any), sinking fund or interest, if any, may be made on such subordinated debt securities at any time unless full payment of all amounts due in respect of the principal (and premium, if any), sinking fund and interest on the 2022 Notes, and all other Senior Indebtedness, has been made or duly provided for in money or money’s worth. In the event that, notwithstanding the foregoing, any payment by us is received by the trustee in respect of subordinated debt securities or by the holders of any of such subordinated debt securities, upon our dissolution, winding up, liquidation or reorganization before the 2022 Notes, and all other Senior Indebtedness, are paid in full, the payment or distribution must be paid over to the holders of our Senior Indebtedness, including the 2022 Notes, or on their behalf for application to the payment of all Senior Indebtedness, including the 2022 Notes, remaining unpaid until all Senior Indebtedness, including the 2022 Notes, have been paid in full, after giving effect to any concurrent payment or distribution to the holders of our Senior Indebtedness, including the 2022 Notes. Subject to the payment in full of the all Senior Indebtedness, including the 2022 Notes, upon this distribution by us, the holders of such subordinated debt securities will be subrogated to the rights of the holders of our Senior Indebtedness, including the 2022 Notes, to the extent of payments made to the holders of our Senior Indebtedness, including the 2022 Notes, out of the distributive share of such subordinated debt securities. By reason of this subordination, in the event of a distribution of our assets upon our insolvency, our Senior Indebtedness, including the 2022 Notes, and certain of our senior creditors, may recover more, ratably, than holders of any subordinated debt securities or the holders of any indenture securities that are not Senior Indebtedness. The Indenture provides that these subordination provisions will not apply to money and securities held in trust under the defeasance provisions of the Indenture. The Trustee under the Indenture U.S. Bank National Association serves as the trustee under the Indenture. INCREASE AGREEMENT Exhibit 10.12 THIS INCREASE AGREEMENT dated as of December 27, 2019 (this “Agreement”), is among STELLUS CAPITAL INVESTMENT CORPORATION, a Maryland corporation (the “Borrower”), the LENDERS party hereto, and ZIONS BANCORPORATION, N.A. dba AMEGY BANK, as Administrative Agent. Capitalized terms used herein and not otherwise defined shall have the meanings given to such terms in Article I of this Agreement. W I T N E S S E T H: WHEREAS, the Borrower, the Lenders and the Administrative Agent are parties to that certain Senior Secured Revolving Credit Agreement, dated as of October 10, 2017 (as amended by that certain First Amendment to Senior Secured Revolving Credit Agreement and Commitment Increase dated as of August 2, 2018, that certain Second Amendment to Senior Secured Revolving Credit Agreement and Commitment Increase dated as of September 13, 2019, and as the same may be further amended, supplemented, amended and restated or otherwise modified from time to time, the “Credit Agreement”); WHEREAS, the Borrower requests that the total Commitments be increased from $200,000,000 to $220,000,000; and WHEREAS, each Increasing Lender named in Article III hereof is willing on the terms and subject to the conditions hereinafter set forth, to increase their respective Commitment, subject to the terms and conditions of this Agreement. NOW, THEREFORE, the parties hereto hereby covenant and agree as follows: ARTICLE I DEFINITIONS Section 1.1 Certain Definitions. The following terms when used in this Agreement shall have the following meanings (such meanings to be equally applicable to the singular and plural forms thereof): “Agreement” is defined in the preamble. “Borrower” is defined in the preamble. “Credit Agreement” is defined in the first recital. “Effective Date” is defined in Article V. Section 1.2 Other Definitions. Capitalized terms used in this Agreement but not defined herein, shall have the meanings given such terms in the Credit Agreement. ARTICLE II COMMITMENT INCREASE REQUEST On or before December 19, 2019, the Borrower irrevocably requested that the Commitments be increased from $200,000,000 to $220,000,000 in the aggregate (the “Commitment Increase”) pursuant to Section 2.08(e) of the Credit Agreement. ARTICLE III AGREEMENT TO INCREASE COMMITMENTS Subject to the occurrence of the Effective Date (as hereinafter defined), the Commitments are increased on the Effective Date as follows: Section 3.1 Increasing Lenders. Zions Bancorporation, N.A. dba Amegy Bank hereby agrees to increase its Dollar Commitment from $30,000,000 to $35,000,000. Hancock Whitney Bank hereby agrees to increase its Dollar Commitment from $20,000,000 to $30,000,000. Frost Bank hereby agrees to increase its Dollar Commitment from $30,000,000 to $35,000,000. The foregoing Lenders in this Section 4.1 are referred to herein collectively, as “Increasing Lenders.” Section 3.2 Commitment Increase. On the Effective Date, adjustments of Borrowings will be made in accordance with Section 2.08(e)(iv) of the Credit Agreement that will result in, after giving effect to all such deemed prepayments and borrowings, such Loans and participations in Letters of Credit, Swingline Loans and Multicurrency Loans being held by the Lenders ratably in accordance with their Commitments, after giving effect to the Commitment Increase herein, as described on Schedule 1.01(b) attached hereto. ARTICLE IV BORROWER COMMITMENT INCREASE CERTIFICATIONS Pursuant to Section 2.08(e)(i) of the Credit Agreement, the Borrower hereby certifies as of the date hereof that: Section 4.1 No Default. No Default or Event of Default has occurred and is continuing. Section 4.2 Representations and Warranties. The representations and warranties contained in the Credit Agreement are be true and correct in all material respects (or, in the case of any portion of the representations and warranties already subject to a materiality qualifier, true and correct in all respects) on and as of the date hereof as if made on and as of the date hereof (or, if any such representation or warranty is expressly stated to have been made as of a specific date, as of such specific date). Section 5.1 Effective Date. This Agreement shall become effective on the date (the “Effective Date”) when the Administrative Agent shall have received: ARTICLE V CONDITIONS TO EFFECTIVENESS (a) (b) (c) (d) (e) (f) counterparts of this Agreement duly executed and delivered on behalf of the Borrower and each of the Increasing Lenders, together with the Subsidiary Guarantors’ Consent and Agreement executed by each Subsidiary Guarantor; a replacement Revolving Credit Note in the maximum principal amount of $35,000,000 executed by Borrower and made payable to Zions Bancorporation, N.A. dba Amegy Bank; a replacement Revolving Credit Note in the maximum principal amount of $35,000,000 executed by Borrower and made payable to Frost Bank; a replacement Revolving Credit Note in the maximum principal amount of $30,000,000 executed by Borrower and made payable to Hancock Whitney Bank; a certificate of a duly authorized officer of the Borrower stating that each of the applicable conditions set forth in Section 2.8(e)(i) of the Credit Agreement have been satisfied; and payment by the Borrower of all fees payable pursuant to the Increase Agreement Fee Letter dated as of the date hereof between the Borrower and Amegy Bank. 2 ARTICLE VI MISCELLANEOUS Section 6.1 Representations. The Borrower hereby represents and warrants that (i) this Agreement constitutes a legal, valid and binding obligation of it, enforceable against it in accordance with its terms, (ii) upon the effectiveness of this Agreement, no Event of Default shall exist and (iii) its representations and warranties as set forth in the Loan Documents, as applicable, are true and correct in all material respects (except those representations and warranties qualified by materiality or by reference to a material adverse effect, which are true and correct in all respects) on and as of the date hereof as though made on and as of the date hereof (unless such representations and warranties specifically refer to a specific date, in which case, they shall be complete and correct in all material respects (or, with respect to such representations or warranties qualified by materiality or by reference to a material adverse effect, complete and correct in all respects) on and as of such specific date). Section 6.2 Cross-References. References in this Agreement to any Article or Section are, unless otherwise specified, to such Article or Section of this Agreement. Section 6.3 Loan Document Pursuant to Credit Agreement. This Agreement is a Loan Document executed pursuant to the Credit Agreement and shall (unless otherwise expressly indicated therein) be construed, administered and applied in accordance with all of the terms and provisions of the Credit Agreement, as amended hereby, including Article IX thereof. Section 6.4 Successors and Assigns. The provisions of this Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns. Section 6.5 Counterparts. This Agreement may be executed in counterparts (and by different parties hereto on different counterparts), each of which shall constitute an original, but all of which when taken together shall constitute a single contract. Delivery of an executed counterpart of a signature page of this Agreement by telecopy electronically (e.g. pdf) shall be effective as delivery of a manually executed counterpart of this Agreement. Section 6.6 Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of New York. Section 6.7 Full Force and Effect. All of the representations, warranties, terms, covenants, conditions and other provisions of the Credit Agreement and the other Loan Documents shall remain unchanged and shall continue to be, and shall remain, in full force and effect in accordance with their respective terms. Upon and after the execution of this Agreement by each of the parties hereto, each reference in the Credit Agreement to “this Agreement”, “hereunder”, “hereof” or words of like import referring to the Credit Agreement, and each reference in the other Loan Documents to “the Credit Agreement”, “thereunder”, “thereof” or words of like import referring to the Credit Agreement, shall mean and be a reference to the Credit Agreement as modified hereby. [Signatures on Following Pages.] 3 IN WITNESS WHEREOF, the parties hereto have executed and delivered this Agreement as of the date first above written. BORROWER: STELLUS CAPITAL INVESTMENT CORPORATION By: /s/ W. Todd Huskinson W. Todd Huskinson Chief Financial Officer, Chief Compliance Officer, Treasurer, and Secretary SIGNATURE PAGE TO INCREASE AGREEMENT – STELLUS LENDERS: ZIONS BANCORPORATION, N.A. DBA AMEGY BANK as Administrative Agent, Swingline Lender, Issuing Bank and as a Lender By: /s/ Lauren Page Lauren Page Vice President SIGNATURE PAGE TO INCREASE AGREEMENT – STELLUS FROST BANK, as a Lender /s/ Jake Fitzpatrick By: Name: Jake Fitzpatrick Title: Vice President SIGNATURE PAGE TO INCREASE AGREEMENT – STELLUS HANCOCK WHITNEY BANK, as a Lender /s/ Eric Luttrell By: Name: Eric Luttrell Title: Senior Vice President SIGNATURE PAGE TO INCREASE AGREEMENT – STELLUS SUBSIDIARY GUARANTORS’ CONSENT AND AGREEMENT TO INCREASE AGREEMENT As an inducement to Administrative Agent and Lenders party thereto to execute, and in consideration of Administrative Agent’s and such Lenders’ execution of, the Increase Agreement dated as of December 27, 2019 (the “Agreement”) (capitalized terms used herein and not otherwise defined shall have the meanings given to such terms in Article I of the Agreement), among Stellus Capital Investment Corporation, a Maryland corporation, the Lenders party thereto, and Zions Bancorporation, N.A. dba Amegy Bank, as Administrative Agent, each of the undersigned Subsidiary Guarantors hereby consents to the Agreement, and agrees that the Agreement shall in no way release, diminish, impair, reduce or otherwise adversely affect the obligations and liabilities of the undersigned under any Guarantee and Security Agreement executed by the undersigned in connection with the Credit Agreement, or under any Loan Documents, agreements, documents or instruments executed by the undersigned to create liens, security interests or charges to secure any of the Guaranteed Obligations (as defined in the Guarantee and Security Agreement), all of which are in full force and effect. Each of the undersigned further represents and warrants to Administrative Agent and the Lenders that, after giving effect to the Agreement, (a) the representations and warranties in each Loan Document to which the undersigned is a party are true and correct in all material respects (or, in the case of any portion of the representations and warranties already subject to a materiality qualifier, true and correct in all respects) on and as of the date of the Agreement as if made on and as of the date of the Agreement (or, if any such representation or warranty is expressly stated to have been made as of a specific date, as of such specific date), and (b) no Default or Event of Default has occurred and is continuing. Each undersigned Subsidiary Guarantor agrees to be bound by the terms, conditions, covenants and agreements in the Agreement. This Consent and Agreement is executed as of the date of the Agreement and shall be binding upon each of the undersigned, and their respective successors and assigns, and shall inure to the benefit of Administrative Agent, Lenders, and their successors and assigns. [Signatures on Following Pages.] SUBSIDIARY GUARANTORS: SCIC – ERC BLOCKER 1, INC., a Delaware corporation By:/s/ W. Todd Huskinson Name: W. Todd Huskinson Title: Authorized Signatory SCIC – SKP BLOCKER 1, INC., a Delaware corporation By:/s/ W. Todd Huskinson Name: W. Todd Huskinson Title: Authorized Signatory SCIC – APE BLOCKER 1, INC., a Delaware corporation By:/s/ W. Todd Huskinson Name: W. Todd Huskinson Title: Authorized Signatory SCIC – CONSOLIDATED BLOCKER, INC. a Delaware corporation By:/s/ W. Todd Huskinson Name: W. Todd Huskinson Title: Authorized Signatory SCIC – INVINCIBLE BLOCKER 1, INC. a Delaware corporation By:/s/ W. Todd Huskinson Name: W. Todd Huskinson Title: Authorized Signatory SCIC – CC BLOCKER 1, INC., a Delaware corporationt By:/s/ W. Todd Huskinson Name: W. Todd Huskinson Title: Authorized Signatory SCIC – HOLLANDER BLOCKER 1, INC., a Delaware corporation By:/s/ W. Todd Huskinson Name: W. Todd Huskinson Title: Authorized Signatory SCIC – ICD BLOCKER 1, INC. a Delaware corporation By:/s/ W. Todd Huskinson Name: W. Todd Huskinson Title: Authorized Signatory SCIC – FBO BLOCKER 1, INC. a Delaware corporation By:/s/ W. Todd Huskinson Name: W. Todd Huskinson Title: Authorized Signatory SCHEDULE 1.01(b) Commitments Lender Total Commitment Applicable Percentage Zions Bancorporation, N.A. dba Amegy Bank (Administrative Agent) Frost Bank (Documentation Agent) Cadence Bank, N.A. (Co-Syndication Agent) Hancock Whitney Bank (Co-Syndication Agent) City National Bank CommunityBank of Texas, N.A. Woodforest National Bank Stifel Bank and Trust Texas Capital Bank, National Association $35,000,000 $35,000,000 $30,000,000 $30,000,000 $25,000,000 $20,000,000 $20,000,000 $15,000,000 $10,000,000 USD $220,000,000.00 15.9090909091% 15.9090909091% 13.6363636364% 13.6363636364% 11.3636363636% 9.0909090909% 9.0909090909% 6.8181818182% 4.5454545454% 100.0000000000% SCHEDULE 1.01(B) TO INCREASE A GREEMENT – STELLUS Exhibit 31.1 I, Robert T. Ladd, Chief Executive Officer of Stellus Capital Investment Corporation certify that: 1. 2. 3. 4. I have reviewed this annual report on Form 10-K of Stellus Capital Investment Corporation; Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) (b) (c) (d) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Dated this 2 day of March 2020. nd By: /s/ Robert T. Ladd Robert T. Ladd Chief Executive Officer 150 Exhibit 31.2 I, W. Todd Huskinson, Chief Financial Officer of Stellus Capital Investment Corporation certify that: 1. 2. 3. 4. I have reviewed this annual report on Form 10-K of Stellus Capital Investment Corporation; Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) (b) (c) (d) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Dated this 2 day of March 2020. nd By: /s/ W. Todd Huskinson W. Todd Huskinson Chief Financial Officer 151 Exhibit 32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) In connection with this Annual Report on Form 10-K (the “Report”) of Stellus Capital Investment Corporation (the “Registrant”), as filed with the Securities and Exchange Commission on the date hereof, I, Robert T. Ladd, the Chief Executive Officer of the Registrant, hereby certify, to the best of my knowledge, that: (1) (2) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant. /s/ Robert T. Ladd Name: Date: Robert T. Ladd March 2, 2020 152 Exhibit 32.2 Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) In connection with this Annual Report on Form 10-K (the “Report”) of Stellus Capital Investment Corporation (the “Registrant”), as filed with the Securities and Exchange Commission on the date hereof, I, W. Todd Huskinson, the Chief Financial Officer of the Registrant, hereby certify, to the best of my knowledge, that: (1) (2) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended; and The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant. /s/ W. Todd Huskinson Name: Date: W. Todd Huskinson March 2, 2020 153 

Continue reading text version or see original annual report in PDF format above