ITEM 1.
BUSINESS.
Introduction
Siguler Guff Small Business Credit Opportunities Fund, Inc. (“SBCOF” or the “Fund”) was incorporated in Maryland on July 7, 2014, and is a non-diversified, closed-end management investment company electing status as a BDC under the Investment Company Act of 1940 (the “1940 Act”). The Fund is a wholly-owned subsidiary of Siguler Guff Small Business Credit Opportunities Fund, LP, a Delaware limited partnership (the “Partnership”). The Partnership is the Fund’s sole direct shareholder and makes capital contributions to the Fund as needed for the Fund to make investments or pay its expenses, to the extent that the Partnership has available capital and in accordance with the Partnership’s governing documents.
The Partnership’s investment objective is to achieve attractive risk-adjusted returns by generating current income from debt investments and capital appreciation from equity investments. The Partnership makes its debt investments through the Fund. The Fund primarily invests in carefully selected U.S. companies in the lower middle market. The Investment Manager (as defined below) defines the “lower middle market” as privately-owned companies with between $2 million to $15 million of earnings before income tax, depreciation and amortization (“EBITDA”), and between $10 million to $100 million of revenue. Investments generally take the form of mezzanine debt as well as some “unitranche” loans with a first lien on the company’s assets, as well as second lien loans. The Partnership generally seeks to purchase equity securities alongside the Fund’s investments into those same companies, generally with an aggregate cost of up to 20% of the value of the investment. The Partnership or the Fund, depending on the form of the security, also may extend mezzanine financing in forms other than subordinated loans, such as convertible loans and preferred stock.
Siguler Guff Advisers serves as the Fund’s Investment Manager. Prior to commencing operations on October 13, 2015, the Fund had no operations other than the sale of 100,000 shares of its Common Stock, $.001 par value (“Shares”), to the Partnership for $25,000 on September 19, 2014. The Fund’s principal office is located at 825 Third Avenue, 10th Floor, New York, NY and its telephone number is (212) 332-5100.
Because the Partnership owns 100% of the Shares, the Fund is indirectly owned by the limited partners of the Partnership. References in this Form 10-K to the Fund’s “investors” or “shareholders” refer to the limited partners of the Partnership, as the context so requires. The Partnership is the Fund’s sole direct shareholder.
Investment Program
General.
The Partnership’s investment objective is to achieve attractive risk-adjusted returns by generating current income from debt investments and capital appreciation from equity investments. There can be no assurance that the Fund will attain its investment objective. The Partnership makes its debt investments through the Fund. The Fund primarily invests in carefully selected companies in the lower middle market. The Investment Manager defines the “lower middle market” as privately-owned companies with between $2 to $15 million of EBITDA, and between $10 to $100 million of revenue. Investments generally take the form of mezzanine debt as well as some “unitranche” loans with a first lien on the company’s assets, as well as second lien loans. The Partnership generally seeks to purchase equity securities alongside the Fund’s investments into those same companies, generally with an aggregate cost of up to 20% of the value of the Partnership’s total investment. The Partnership or the Fund, depending on the form of the security, also may extend mezzanine financing in forms other than subordinated loans, such as convertible loans and preferred stock. The Fund makes available significant managerial assistance through its officers to certain companies whose securities are held in the Fund’s portfolio, as described in this Item 1 under the caption “Regulation.”
As a BDC, the Fund must invest at least 70% of its total assets in qualifying assets (“Qualifying Assets”) consisting of (a) interests in “eligible portfolio companies” as defined in the 1940 Act (“Eligible Portfolio Companies”) and (b) certain other assets including cash and cash equivalents. An Eligible Portfolio Company is a United States company that is neither an investment company, as defined in the 1940 Act, nor excluded from the definition of investment company by Section 3(c) of the 1940 Act, and that either: (i) does not have a class of securities listed on a national securities exchange, or does have a class of securities listed on a national securities exchange, but has an aggregate market value of outstanding voting and non-voting common equity of less than $250 million; (ii) is actively controlled by a BDC and has an affiliate of a BDC on the Eligible Portfolio Company’s board of directors; (iii) has total assets of not more than $4 million and capital and surplus of not less than $2 million; or (iv) meets such other criteria as may be established by the SEC. Control under the 1940 Act is presumed to exist where a BDC owns more than 25% of the outstanding voting securities of the Eligible Portfolio Company. Also included in Qualifying Assets are follow-on investments in a company that met the definition of Eligible Portfolio Company at the time of the Fund’s initial investment, but subsequently does not meet such definition because it has a class of securities listed on a national securities exchange, if, at the time of the follow-on investment, the Fund (a) owns at least 50% of (i) the greatest number of equity securities of such company, including securities convertible into or exchangeable for such securities, and (ii) the greatest amount of certain debt securities of such company held by the Fund at any time during the period when such company was an Eligible Portfolio Company, and (b) is one of the twenty largest holders of record of the company’s outstanding voting securities. The Fund may invest up to 30% of its total assets in non-Qualifying Assets, including interests in companies that are not Eligible Portfolio Companies (for example, because the company’s securities are quoted on the NASDAQ Global Market and do not meet the capitalization thresholds described above) and Eligible Portfolio Companies as to which the Fund does not offer to make available significant managerial assistance.
The descriptions of investments below reflect the terms and conditions that the Investment Manager expects to be typical based on current market conditions - the terms of individual securities may vary from those described below, and changes in market practices or conditions could change the typical terms and conditions upon which the Fund’s investments will be made. In addition, the summary of the investment limitations applicable to BDCs described above is qualified by the full text of the 1940 Act and the rules thereunder.
Mezzanine Loans.
Mezzanine loans are individually negotiated with each borrower, with detailed documentation of matters such as affirmative, negative and financial covenants, and events of default. Mezzanine loans are typically unsecured, are subordinate to one or more classes of senior secured debt, have priority over equity investors and, in some cases, over junior subordinated lenders. The Fund’s mezzanine loans will typically have a stated term of 5-7 years, with a “bullet” maturity, meaning that, while the lender pays periodic interest payments over the term of the loan, the entire principal amount is due only at maturity. Mezzanine loans frequently require that the borrower pay a prepayment fee, which could be substantial, to make a full or partial voluntary repayment of the loan prior to maturity. Prepayment fees may also apply to mandatory prepayments, such as prepayments upon a change in control.
Mezzanine loans generally provide for a portion of the interest due to be paid in cash periodically, typically on a monthly basis (the “cash coupon”), with the remainder “paid in kind,” meaning that the accrued interest is added to the outstanding principal (the “PIK coupon”). In addition to interest payments and prepayment fees, mezzanine loans often require borrowers to pay origination, structuring or commitment fees, as well as the lender’s legal and other out-of-pocket fees.
Mezzanine loans are subordinate to more senior indebtedness, and certain senior indebtedness will have security interests in property of the borrower, which could make that property unavailable to satisfy claims by the mezzanine lender. The mezzanine lender generally will enter into an intercreditor agreement with the more senior lenders, which may limit or delay the ability of the mezzanine lender to receive payment following a default under the senior credit facility, limit or delay the mezzanine lender’s ability to exercise its rights upon a default under the mezzanine debt facility, and otherwise limit the mezzanine lender’s rights.
Unitranche Loans.
Unitranche (also called “one-stop”) loans combine senior and subordinated debt in one facility. Unitranche loans are typically issued under a single set of documents and carry a single “blended” interest rate (which may be fixed or floating) derived from both the senior and subordinated tranches. Unitranche loans are backed by a first lien on specific assets of the borrower. Unitranche loans typically have a term of five years with amortization over the term of the loan and prepayment permissible, although with some prepayment fees.
Unitranche loans may involve fees from the borrower that are similar to those of mezzanine debt. Representations and covenants are generally more restrictive than those for mezzanine debt, and include covenants relating to maintenance and preservation of collateral. Because the senior and subordinated indebtedness are owned by the same lender, documentation generally is less complex and detailed.
Second Lien Loans.
Second lien loans are secured loans with security interests subordinate to the borrower’s senior secured debt. Thus, second lien loans generally rank between senior secured and mezzanine debt, and are often used to fill a gap in the available financing for a transaction. In some cases, second lien loans are subordinate to senior secured debt with respect to shared collateral, but hold the primary lien with respect to other collateral. Similar to mezzanine loans, the holders of second lien loans typically enter into an intercreditor agreement with the senior secured and mezzanine debtholders, which may limit the rights of the second lien loan holder vis a vis the senior secured debtholders, particularly with respect to acceleration and foreclosure on collateral. Second lien loans may involve fees from the borrower that are similar to those of other tiers of debt. Representations and covenants are generally more restrictive than those for mezzanine debt, and include covenants relating to maintenance and preservation of collateral.
Equity Securities.
The Partnership may acquire equity securities of a borrower in connection with a mezzanine or unitranche loan by the Fund. These are typically co-investments made alongside the equity sponsor. The Partnership typically acquires convertible or participating preferred stock, although the Partnership may acquire common stock. The Partnership typically acquires the same or similar equity securities as those owned by the equity sponsor of the borrower.
When the Partnership acquires an equity security, it typically becomes a party to a shareholder agreement between the Partnership and the other shareholders of the borrower, and a registration rights agreement granting shareholders the right, under specified circumstances and subject to specified limitations, to cause the company to register the shareholders’ securities for sale under the Securities Act of 1933, as amended (the “1933 Act”).
The Partnership seeks board observer rights with each equity and debt investment that it or the Fund makes. In times of financial distress or other situations involving a conflict of interest between a borrower and the Fund, the Partnership’s representative would recuse itself from the relevant board meetings and information flows. Because the Partnership typically owns a relatively small percentage of the total equity of a borrower, its ability to negotiate the terms of a shareholder agreement generally is limited, and the Partnership typically has limited corporate governance rights, and limited ability to cause the company or other shareholders to engage in exit transactions such as a sale of the company or an initial public offering.
Warrants to Acquire Equity Securities.
In lieu of or in addition to acquiring equity securities of a borrower in connection with a mezzanine or unitranche loan, the Partnership might acquire warrants to acquire equity securities.
The equity securities issuable upon the exercise of warrants generally have the characteristics described under “Equity Securities” above.
Special Situations.
The Fund may invest up to 10% of its aggregate investments determined cumulatively over the life of the Fund in special situation investments, including investments in secondary transactions. Special situation investments may be structured as senior debt, convertible debt, or other debt/equity structures. In addition, special situations could include investments in a “troubled” company undergoing a restructuring or recapitalization of its existing debt or equity, and making investments in subordinated debt, providing bridge financing to a company which is in the process of raising additional private equity, planning an initial public offering or is seeking to enter into a business combination through which it would be acquired.
Convertible Preferred Securities and Convertible Debt.
The Fund may provide mezzanine financing in the form of convertible preferred securities or convertible debt. Convertible preferred securities may contain provisions comparable to those of mezzanine debt, but rank lower in seniority to all debt of the issuer and lack the covenant provisions that benefit debt securities. Income to the Fund from preferred securities is paid in the form of dividends rather than interest. Dividends, unlike interest, are payable only if declared by the borrower’s board of directors, and might not be legally payable if the borrower is unprofitable or if prohibited by the terms of the borrower’s agreements with lenders.
Investment Policies and Restrictions
Diversification Standards.
The Fund is classified as a “non-diversified” closed-end investment company under the 1940 Act. Until the Fund qualifies as a regulated investment company (“RIC”), it will not be subject to the diversification requirements applicable to RICs under the Internal Revenue Code of 1986, as amended (the “Code”). The Investment Manager will seek to increase the diversification of the Fund’s portfolio so as to make it possible (during the first quarter of 2018) to meet the RIC diversification requirements, as described below. There can be no assurance, however, that the Fund will be able to meet those requirements.
To qualify as a RIC, the Fund must meet the issuer diversification standards under the Code that require that, at the close of each quarter of the Fund’s taxable year (a) at least 50% of the value of the Fund’s total assets is represented by (i) cash and cash items, U.S. government securities, and securities of other RICs, and (ii) other securities (counting each investment in such other securities only if the value of such securities does not exceed 5% of the value of the Fund’s total assets and the Fund does not own more than 10% of the outstanding voting securities of the issuer of such securities), and (b) not more than 25% of the value of the Fund’s total assets is invested in (i) the securities (other than U.S. government securities and securities of other RICs) of any one issuer, (ii) the securities (other than securities of other RICs) of two or more issuers that the Fund controls (defined as 20% or more of the voting power) and that are engaged in the same, similar, or related trades or businesses, or (iii) the securities of one or more qualified publicly traded partnerships. For more information about the requirements imposed on RICs under the Code, please see the disclosure in this Item 1 under the caption “Taxation.”
Industry Segment Concentration.
The Fund seeks to invest no more that 30% of its total assets in securities of companies in any single industry segment. The broad industry categories in which the Fund anticipates that most of the investments will fall (and within each of which there may be several “segments” for purposes of the industry diversification policy) include: industrial goods and services, consumer products, oil and gas-related products and services, health care, food and beverage, technology, and media. The industry segment concentration requirements do not require that the Fund divest securities in its portfolio because of a subsequent change in the value of securities the Fund has previously acquired.
Investment Guidelines.
In selecting investments for the Fund’s portfolio, the Investment Manager endeavors to meet the investment guidelines as established by the Fund’s board of directors (the “Fund Board”). However, the Fund may make investments that do not conform to one or more of these guidelines when deemed appropriate by the Investment Manager. Such investments might be made if the Investment Manager believes that a failure to conform in one area is offset by exceptional strength in another or is compensated for by a higher yield, favorable equity or warrant issuance or other attractive transaction terms or features.
In general, the Fund invests in accordance with the following investment guidelines:
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The Fund invests in later stage, profitable companies, typically with EBITDA between $2 and $15 million, and with revenue between $10 and $100 million.
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Companies may use the capital for a range of purposes, including but not limited to change of control transactions, organic growth, acquisition, debt refinancing and dividend recapitalizations.
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The Fund invests in companies that the Investment Manager considers to have stable operating performance and a strong position in their respective markets. Underwriting criteria may include some or all of the following:
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Historical profitability, with predictable cash flow and realistic growth prospects;
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Strong management team, with incentives to perform;
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Good strategic position in the market with high barriers to entry, reasonable customer concentration risk and a differentiated product or service;
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Strong operating performance with good margins;
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Strong balance sheet and liquidity;
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Good reputation among customers and suppliers; and
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Backing by a high-quality financial sponsor.
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Transaction guidelines will include:
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Debt investments ranging from $2 to $30 million;
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Equity investments (by the Partnership) totaling up to 20% of the total investment in a deal;
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Sufficient cash flow to cover debt service expense; and
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Underwriting parameters will be set and regularly reviewed by the Investment Manager and team and may include: maximum leverage multiples, minimum debt service coverage ratios, and minimum capitalization requirements.
International Investments.
With certain exceptions, as a BDC, the Fund may invest no more than 30% of its total assets in companies which are not “Eligible Portfolio Companies.” An “Eligible Portfolio Company” must be organized under the laws of, and have its principal place of business in, the United States. Therefore, the Fund could invest up to, but no more than, 30% of its total assets in companies based outside of the United States. It is anticipated that the majority of non-U.S. investments would be in companies doing business in North America or Western Europe. These requirements generally will not require the Fund to divest an investment if this threshold is exceeded due to market movements.
Leverage.
The Fund intends to borrow money from and issue debt securities to banks, insurance companies and other lenders to obtain additional funds to originate loans, if such borrowings are available on terms that are acceptable to the Investment Manager and the Fund Board. It is possible, in the event of the tightening of the credit markets, that the Fund may not be able to secure such borrowings on acceptable terms. See the discussion at Item lA under the captions “Risk Factors - General Economic, Market and Political Conditions” and “Risk Factors - Regulatory Risks.” The use of leverage increases investment risk. See the discussion at Item lA under the caption “Risk Factors - Leverage.”
Temporary Investments.
Pending investment, and until distributions to the shareholders are made, the Fund and the Partnership invest excess cash in: (i) time deposits, certificates of deposit and similar instruments of highly-rated banks; (ii) securities issued or guaranteed by the U.S. government, its agencies or instrumentalities; (iii) repurchase agreements that are: (a) issued by highly-rated banks or securities dealers; and (b) fully collateralized by U.S. government securities; (iv) short-term high-quality debt instruments of U.S. corporations; and (v) money market funds and other pooled investment funds whose investments are restricted to those described above. The average maturity of such investments, weighted by their par value, is not expected to exceed 90 days.
Other Investment Policies.
The Fund will not sell securities short (except to the extent the Fund has a warrant for, or owns, shares equal to the number of shares which is the subject of the proposed short sale), purchase securities on margin (except to the extent the Fund’s permitted borrowings are deemed to constitute margin purchases), purchase or sell commodities or commodity contracts (except interest rate hedging transactions in connection with the Fund’s permitted borrowings), or purchase or sell real estate. The Fund may, however, write puts and calls, and acquire options, as a hedge for equity investments and to increase return through a covered call. The Fund will not underwrite the securities of other companies, except to the extent it may be deemed an underwriter upon the disposition of restricted securities acquired in the ordinary course of its business. The Fund may, however, use borrowed funds for its lending activities. See the discussion at Item 1A
ITEM 1A.
RISK FACTORS.
Risks Associated with Investing in Smaller and Lower Middle Market Companies. The Fund invests primarily in mezzanine, unitranche and second lien loans in privately-held companies with EBITDA between approximately $2 million and $15 million. Companies of this size typically have weaker financial and human resources than larger companies, have less extensive research and development, manufacturing, marketing and/or service capabilities, and may be susceptible to competition from larger and better capitalized companies. Smaller companies often depend upon the management talents and efforts of a small group of individuals, and the loss of one or more of these individuals could have a significant impact on the investment returns from a particular company. Also, smaller companies frequently have less diverse product lines and smaller market presence than larger companies, and may not have as great an ability to raise additional capital. Smaller companies may have a shorter history of operations as compared to larger companies, which could make it more difficult for the Fund to evaluate their future performance. There is often less publicly available information about smaller companies than larger companies. They are thus generally less liquid and more vulnerable to economic downturns and may experience substantial variations in operating results.
Although the Fund will seek to mitigate these risks through diversification and conservative deal terms (covenants, monitoring, board observation rights, etc.), it must be anticipated that (a) one or more of the Fund’s investments (collectively, “Portfolio Investments”) may be unprofitable over the Fund’s investment life and (c) the Fund will incur losses on some of the Portfolio Investments.
Leverage. Borrowings to finance the acquisition of Portfolio Investments may occur at the Fund level or the portfolio company level, if any or all directly incur leverage in connection with a Portfolio Investment or an investment by a portfolio company, as applicable. The leverage used by the Fund may take the form of indebtedness for borrowed money as well as financial leverage in the form of options and other similar transactions. Any borrowings of the Fund will be subject to the asset coverage requirements under the 1940 Act. See the discussion at Item 1 under the caption “Regulation.”
Leverage may have important adverse consequences to the Fund and its portfolio companies. The amount borrowed in connection with an investment and the interest rates on those borrowings, which may fluctuate from time to time, as well as the fees and other costs of borrowing, may have a marked effect on such investment’s performance. The borrower may be subject to restrictive financial and operating covenants. Leverage also may impair the borrowers’ ability to finance their future operations and capital needs. As a result, their flexibility to respond to changing business and economic conditions and to business opportunities may be limited. A leveraged investment’s income and net assets will tend to fluctuate at a greater rate than if leverage were not used. In addition, if an investment has a leveraged capital structure, it will be subject to increased exposure to adverse economic factors such as a significant rise in interest rates, a severe downturn in the economy or deterioration in the condition of the borrower or its industry. Furthermore, a borrower that has secured its leverage through the pledging of collateral may, if such borrower is unable to generate sufficient cash flow to meet principal and interest payments on its indebtedness, be subject to risk that a lender seizes its assets through margin calls or otherwise.
The Fund will pay a management fee (the “Investment Management Fee”) to the Investment Manager. The Investment Management Fee base will include the cost basis of portfolio investments acquired with borrowed funds. This effectively increases the cost of the Fund’s borrowings by the incremental Investment Management Fee.
If the Fund borrows at variable rates without hedging to mitigate the effect of interest rate fluctuations, and makes the bulk of its loans at fixed rates, an increase in prevailing interest rates would narrow the spread between the Fund’s cost of capital and its investment return, to the detriment of the Fund’s performance. In addition, because the terms of the Fund’s borrowing facilities are set for relatively long periods of time, reductions in the returns available from the Fund’s investments due to changes in prevailing rates could make the use of leverage unattractive unless the terms of the borrowing facility were renegotiated.
Risks Associated with Loans. The Fund invests primarily in senior secured and unsecured loans. The Fund generally makes the loan directly, although occasionally loans may be originated and syndicated by banks or other financial institutions, or acquired in the secondary market. Loans generally are not readily marketable and are subject to restrictions on resale. In some cases, negotiations involved in disposing of indebtedness may require weeks to complete. Consequently, some indebtedness may be difficult or impossible to dispose of readily at what the Investment Manager believes to be a fair price. In addition, loans are often less liquid than other types of debt securities, particularly in times of significant market dislocation.
Lenders depend primarily upon the creditworthiness of the corporate or other borrower for payment of principal and interest. If the Fund does not receive scheduled interest or principal payments on such indebtedness, the value of the Portfolio Investments would be adversely affected. The Fund may invest in secured and unsecured loans. Loans that are fully secured may offer the Fund more protection than an unsecured loan in the event of non-payment of scheduled interest or principal. However, there is no assurance that the liquidation of any collateral from a secured loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. In the event of the bankruptcy of a borrower, the Fund could experience delays or limitations in its ability to realize the benefits of any collateral securing a loan.
Loans may permit or require, in addition to scheduled payments of interest and principal, the prepayment of the loan from free cash flow. The degree to which borrowers prepay loans, whether as a contractual requirement or at their election, may be affected by prevailing interest rates, general business conditions, the financial condition of the borrower and competitive conditions among lenders, among others. As such, prepayments cannot be predicted with accuracy. Upon a prepayment, either in part or in full, the actual outstanding debt on which the Fund derives interest income will be reduced. The effect of prepayments on the Fund’s performance may or may not be mitigated by the receipt of prepayment fees and/or the Fund’s reinvestment of prepayments in other loans that have comparable yields. See “Credit Risk” below.
Credit Risk. The Fund is subject to credit risk, i.e., the risk that an issuer or borrower will default in the payment of principal and/or interest on an instrument. Credit risk also includes the risk that a counterparty to a derivatives instrument (e.g., a swap counterparty) will be unwilling or unable to meet its obligations. Financial strength and solvency of an issuer or borrower are the primary factors influencing credit risk. Degree of subordination, lack or inadequacy of collateral or credit enhancement for a debt instrument may affect the Fund’s credit risk. There are no restrictions on the credit quality of the Portfolio Investments. Securities in which the Fund may invest generally will not have been rated by any rating agency, with the result that the Investment Manager must rely on its own evaluation of the financial strength of the borrower, without the benefit of rating agency research.
Subordination of Investments. Portfolio Investments may be in subordinated loans, structurally subordinated loans, mezzanine loans and other structured investments and preferred equity interests or equity interests of an issuer. These Portfolio Investments will be subordinated to the senior obligations of the property or issuer, either contractually, structurally or inherently due to the nature of the securities. Greater credit risks are usually attached to these subordinated investments than to investments in senior obligations. In addition, these securities may not be protected by financial or other covenants, such as limitations upon additional indebtedness, typically protecting the senior debt, and may have limited liquidity. Adverse changes in the borrower’s financial condition and/or in general economic conditions may impair the ability of the borrower to make payments on the subordinated securities and cause it to default more quickly with respect to such securities than with respect to the borrower’s senior obligations. Holders of subordinated securities are generally not entitled to receive any payments in bankruptcy or liquidation until senior creditors are paid in full. In addition, in many cases, the Fund’s management of its investment and its remedies with respect thereto, including the ability to foreclose on any collateral securing such investment will be limited by restrictions benefiting more senior lenders and contractual intercreditor provisions.
Interest Rate Risk. “Interest rate risk” refers to the risks associated with market changes in interest rates. In general, rising interest rates will negatively impact the price of fixed rate debt instruments and falling interest rates will have a positive effect on the price of fixed rate debt instruments. The prices of long term debt obligations generally fluctuate more than prices of short term debt obligations as interest rates change. To the extent the Fund invests primarily in longer term debt obligations, the Fund will be impacted to a greater degree by changes in market interest rates than if the Fund invested primarily in short term debt securities. Even in the case of debt investments that are guar-anteed or insured in whole or in part, such guarantees and insurance do not protect the Fund from declines in market value caused by changes in interest rates. However, to the extent that the Fund holds a loan to maturity (as will generally be the case), interim changes in the value of the loan due to interest rate fluctuations are not expected to affect the Fund’s ultimate return on the investment, provided interest and principal are paid in a timely fashion.
Increasing interest rates may also increase the amount of interest owed with respect to different types of financing the Fund may enter into in order to finance its investments, and may create or exacerbate financial stress on the Fund’s borrowers.
Declining interest rates also can adversely affect the Fund’s overall performance, because the Fund may be forced to re-deploy principal and interest payments from existing investments into lower-yielding investments. This “reinvestment risk” can be exacerbated to the extent borrowers can prepay their loans without significant penalties, particularly because such prepayments tend to increase as interest rates decline.
Although variable or floating rate investments allow the Fund to participate in increases in interest rates through upward adjustments of the coupon rates on such investments, during periods of increasing interest rates, changes in the coupon rates may lag behind the change in market rates or may have limits on the maximum increase in coupon rates. Alternatively, during periods of declining interest rates, the coupon rates on such investments re-adjust downward, resulting in a lower yield. Further, while increases in interest rates are generally beneficial with respect to instruments owned by the Fund, such increases may also be detrimental to the investment itself and therefore to the Fund, depending on the investments owned, particularly if such investment is subordinated to more senior loans. Interest rate sensitivity is generally more pronounced and less predictable in instruments with uncertain payment or prepayment schedules. Declines in market value, if not offset by any corresponding gains on hedging instruments, if any, may ultimately reduce earnings or result in losses to the Fund.
Bridge Financings. The Fund may provide interim debt or interim equity financing to an existing or prospective portfolio company in anticipation of permanent financing (including an investment by the Fund). These bridge loans will typically be convertible into a term loan or permanent equity investment in the portfolio company; however, for reasons not always in the Investment Manager’s control, the anticipated long term securities issuance or other refinancing or syndication may not occur and the bridge loan may remain outstanding. In such event, the interest rate on such bridge loan may not adequately reflect the risk associated with the unsecured position taken by the Fund.
Payment-In-Kind Securities. Payment-in-kind securities (“PIKs”) are debt obligations that pay “interest” in the form of other debt obligations, instead of in cash. Because PIKs allow an issuer to avoid or delay the need to generate cash to meet current interest payments, such securities may involve greater credit risk than bonds that pay interest currently or in cash.
Warrants and Rights. The Fund may obtain and hold warrants to purchase equity securities. Warrants do not carry with them the right to dividends or voting rights with respect to the securities that they entitle their holder to purchase, and they do not represent any rights in the assets of the issuer. As a result, warrants may be considered more speculative than certain other types of investments. In addition, the market value of a warrant does not necessarily change with the market value of the underlying securities, and a warrant ceases to have market value if it is not exercised prior to its expiration date. Furthermore, the terms of warrants or rights may limit the Fund’s ability to exercise the warrants or rights at such time, or in such quantities, as the Fund would otherwise desire.
Additional Risks Associated With Portfolio Investments. In some cases the Fund will make investments as part of an investment group with one or more other investment funds (or with their sponsors), while in others the Fund may independently invest in a financing opportunity (alongside another investment fund, as part of a joint venture or alone). When the Fund invests as part of an investment group alongside another investment fund or a joint venture partner, the Fund will typically be required to rely on the sponsor of the other investment fund or its joint venture partner to make decisions regarding the investment and, accordingly, the value of the Portfolio Investment could be adversely affected if the interests of the Fund diverge from those of the sponsor, its joint venture partner or the investment group. When the Fund invests independently, it may not have the same level of governance rights and other protections it would enjoy as part of a larger group. Furthermore, with respect to independently-sourced Portfolio Investments, the Investment Manager may have to rely solely on its own research and analysis.
Historical Performance Not a Guarantee of Future Results. The Fund’s investment performance may be better or worse than that of other investment funds managed by the Investment Manager. In particular, the debt and mezzanine financing markets have historically been cyclical, and debt and mezzanine financing market conditions during the Fund’s investment period may differ from those that prevailed during the investment periods for other investment funds managed by the Investment Manager. It is impossible to predict the precise conditions in the debt and mezzanine financing and private equity markets in the future. In addition, even though previous activities and investments of other funds managed by the Investment Manager have been subject to similar risk factors discussed herein, the Fund may not be able to duplicate any previous success in avoiding certain deleterious effects from the risks involved.
Illiquidity of Shares. An investment in the Fund is intended for long-term investors who can accept the risks associated with making speculative, primarily illiquid, investments in privately negotiated transactions. The Shares, and the limited partnership interests in the Partnership, will not be registered under the 1933 Act or the securities laws of the various states or other jurisdictions and are subject to substantial restrictions on transfer. There will be no trading market for these investments, and investors are likely to be required to hold their investments until the final liquidation of the Fund. An investment in the Fund is therefore illiquid and should be considered only by investors financially able to maintain their investment for the long term.
Similarly, most Portfolio Investments are expected to be illiquid when acquired and may be subject to certain transfer restrictions. Some Portfolio Investments will not provide any liquidity rights. See “Illiquidity of the Portfolio Investments” below. Even if the Fund is able to obtain liquidity rights, economic factors (such as the inability to dispose of investments at the price desired) may limit the Fund’s ability to exercise these rights. In addition, applicable law, including the 1940 Act, may limit the amount of dividends and other distributions payable by the Fund, and all such dividends and other distributions must be authorized by the Fund Board. Furthermore, since the amount and timing of the Fund’s cash distributions to investors is dependent upon the cash flow that the Fund receives from the Portfolio Investments and upon the realization of the Portfolio Investments, and because of the Fund’s ability to reinvest proceeds, the Portfolio Investments, even if they prove successful, are unlikely to produce significant cash flow for investors for a period of years. There can be no assurance that the Fund will be able to liquidate a particular Portfolio Investment or distribute securities at the time or upon the terms it desires.
Illiquidity of the Portfolio Investments. The Portfolio Investments are expected in general to range from somewhat to extremely illiquid. It is possible that the liquidity of a security will decline sharply after its purchase, whether because of adverse developments affecting that security or a general withdrawal of capital from the small and lower middle market.
General Economic, Market and Political Conditions. The success of the Fund’s activities will be affected by general economic and market conditions, changes in laws, trade barriers, currency exchange controls, and national and international political circumstances. These factors may affect the level and volatility of prices and the liquidity of Portfolio Investments, which could adversely affect the Fund’s profitability or result in losses. Events such as war, terrorism and related geopolitical risks have led, and may in the future lead, to increased volatility and may have adverse long-term effects on the U.S. and world economies and markets generally.
Global financial markets have occasionally experienced periods of unprecedented turmoil. The debt and equity capital markets in the United States were negatively impacted by significant write-offs in the financial services sector relating to subprime mortgages and the re-pricing of credit risk in the broader market, among other things. These events, along with the deterioration of the housing market, the failure of major financial institutions and the concerns that other financial institutions as well as the global financial system were also experiencing severe economic distress materially and adversely impacted the broader financial and credit markets and reduced the availability of debt and equity capital for the market as a whole and financial firms in particular. These events contributed to severe market volatility and caused severe liquidity strains in the credit markets, which in turn severely affected participants in the private equity industry. Volatile financial markets can expose the Fund to greater market and liquidity risk. Risks to a robust resumption of growth persist (albeit to a lesser extent): a weak consumer weighed down by too much debt and significant joblessness, the growing size of the federal budget deficit and national debt, and the threat of inflation.
The public securities markets have seen significant volatility and the ability of companies to obtain financing for ongoing operations or expansions may be severely constrained by the tightening of the credit markets and deterioration of the U.S. and global financial market conditions. The ability to realize investments depends not only on the underlying portfolio companies and their historical results and prospects, but also on political, market and economic conditions at the time of realization of such investments. The trading market, if any, for the securities of any portfolio company may not be sufficiently liquid to enable the Fund to sell these securities when it believes it is most advantageous to do so, or without adversely affecting the stock price. The instability in the financial markets has led the U.S. government to take a number of unprecedented actions designed to support certain financial institutions and segments of the financial markets that have experienced extreme volatility, and in some cases a lack of liquidity. See “Regulatory Risks” below. Federal, state, and other governments, their regulatory agencies, or self-regulatory organizations may take actions that affect the regulation of the instruments in which the Fund is expected to invest, or the issuers of such instruments, in ways that are unforeseeable.
In addition, on August 5, 2011, Standard & Poor’s lowered its long-term sovereign credit rating on the United States from AAA to AA+. Because of the unprecedented nature of negative credit rating actions with respect to U.S. government obligations, the ultimate impact of the downgrade is unpredictable and may not be immediately apparent. However, if the other major credit rating agencies issue downgrades, or if Standard & Poor’s issues further downgrades, the resulting market response could be extreme and possibly adverse to the Portfolio Investments.
Investment Selection. The success of the Fund depends to a great extent upon the Investment Manager’s ability to identify superior investments. While the Portfolio Investment selection process entails consideration of many subjective factors, investors in the Fund will not have an opportunity to evaluate for themselves the relevant subjective factors and will be dependent on the judgment and ability of the Investment Manager in selecting such investments. There can be no assurance that the Investment Manager will fulfill the Fund’s objective of investing in Portfolio Investments that can produce superior returns over the lifetime of the Fund.
Risks Regarding Dispositions of Portfolio Investments. In connection with the disposition of Portfolio Investments, the Fund may be required to make representations and warranties about the business and financial affairs of the issuer typical of those made in connection with the sale of any busi-ness. The Fund may also be required to indemnify the purchasers of such investment to the extent that such representations and warranties turn out to be inaccurate or misleading. These arrangements may result in liabilities for the Fund. Although the securities in which the Fund is expected to invest generally will not be publicly traded, the ability to successfully exit those investments may be negatively impacted by public market conditions.
Concentration/Diversification Standards. Although the Investment Manager will seek to diversify the Fund’s investment portfolio to the extent possible consistent with the Fund’s investment strategy, various factors, including prevailing market conditions, available investment opportunities, regulatory constraints, constraints imposed by certain portfolio companies, and the timing of investments, may prevent the Investment Manager from diversifying the Fund’s portfolio or may result in the Fund’s portfolio not being as diversified as the Investment Manager may otherwise prefer. The Fund will not be “diversified” for purposes of the 1940 Act.
It is anticipated that, during the first quarter of 2018, the Fund will seek to meet the requirements, including diversification requirements, to qualify as a RIC under the Code. See the discussion at Item l under the caption “Taxation.” There can be no assurance, however, that the Fund will be able to meet those requirements. In addition, prior to the time, if any, that the Fund qualifies as a RIC, it will not be subject to such diversification requirements.
For these and other reasons, the Fund could potentially be concentrated in relatively few Portfolio Investments, or types of Portfolio Investments. One risk of having a limited number of Portfolio Investments is that the aggregate returns realized by the investors may be substantially adversely affected by the unfavorable performance of a small number of such Portfolio Investments. Similarly, should the Portfolio Investments be concentrated in a small number of industries or related industries, the risk to the investors would increase, because companies in the same industry or related industries are often subject to similar business risks and regulatory burdens, and the impact of a single economic, political or regulatory occurrence may have a greater adverse impact on the Portfolio Investments.
Risks Associated With Control Strategies. The Fund may hold a controlling position in a Portfolio Investment and may hold board or observer seats on many of its portfolio companies. Although such positions may be important to the Fund’s investment strategy, they may subject the Fund to claims it would not otherwise be subject to if such controlling position or board or observer seats were not held. The Fund will generally indemnify the Investment Manager and its affiliates from such claims, which may be costly to defend and could result in substantial liability.
The exercise of control over a company may impose, for example, additional risks of liability for environmental damage, product defects, failure to supervise management, pension and other fringe benefits, violation of governmental regulations (including securities laws) or other types of related liability. If these liabilities were to arise, the Fund may suffer a significant loss in such investment.
Lack of Control of Portfolio Investments. In some cases, the Fund will not have the right to participate in the day-to-day management, control or operation of the Portfolio Investments, nor will it have the unilateral right to remove the managers thereof. The Fund also will not necessarily have the opportunity to evaluate the relevant economic, financial and other information which will be utilized by the managers of its portfolio companies with respect to the operation of such portfolio companies. As a result, the Fund’s ability to protect its position in such asset will be limited. In addition, these Portfolio Investments may involve risks in connection with third-party management or strategic partners having financial difficulties, resulting in a negative impact on such investment, and such third parties may have economic or business interests or goals which are inconsistent with those of the Fund or may be in a position to take (or block) action contrary to the Fund’s investment objectives. In addition, the Fund may, in certain circumstances, be liable for the actions of such third-party management or strategic partners.
Abundance of Capital. The Investment Manager believes that the supply of investments in the small and lower middle market today exceeds the amount of capital committed to these markets. This imbalance could be reduced or even reversed, in certain markets or sub-markets, as publicly traded companies (including public BDCs), private equity funds, hedge funds, proprietary trading desks and other investors increase their commitments to these markets. Some of these competing sources of capital might be able to obtain investment capital more readily or on better terms than the Fund, particularly competitors that have access to the public equity or debt markets. Increased demand for the securities of small and lower middle market companies could drive up pricing and make investing in the sector less attractive. Similarly, the Investment Manager may not obtain as favorable terms as it would otherwise in a less competitive environment. Additionally, the Fund’s need to comply with provisions of the 1940 Act pertaining to BDCs and, if the Fund qualifies as a RIC, provisions of the Code pertaining to RICs, may restrict the Fund’s flexibility as compared with its competitors. The Fund and its portfolio companies may incur significant expenses investigating potential investments which are ultimately not consummated, including expenses relating to due diligence, transportation, legal expenses and the fees of other third-party advisers.
Uncertainty of Valuation. Generally, there will be no readily available market for all or a substantial number of the Portfolio Investments and, hence, most of the Portfolio Investments will be difficult to value. This uncertainty of valuations could both limit the ability of the Fund’s investors to gauge the Fund’s ongoing performance, and the ability of the Investment Manager to evaluate the past performance of prospective Portfolio Investments. For these and other reasons, it will be difficult for an investor to value its interest in the Fund.
Regulatory Restrictions. The Fund has elected to be treated as a BDC under the 1940 Act. Although BDCs are exempt from registration under the 1940 Act and are relieved from compliance with some (but not all) of the provisions of the 1940 Act, there are greater restrictions in some respects on permitted types of investments for BDCs than there are for unregulated funds. These requirements may limit the Fund’s investment opportunities. Moreover, the applicable provisions of the 1940 Act continue to impose numerous restrictions on the activities of the Fund, including restrictions on leverage and on the nature of its investments. While the Fund is not aware of any judicial rulings under, and is aware of only a few administrative interpretations of, the Small Business Incentive Act of 1980, there can be no assurance that such act will be interpreted or administratively implemented in a manner consistent with the Fund’s objectives or manner of operation. See the discussion at Item 1 under the caption “Regulation.” If the Fund fails to continuously qualify as a BDC, the Fund might be subject to substantially more onerous regulatory restrictions under the 1940 Act and correspondingly its operating flexibility would be decreased.
Lack of Ability to Participate. Investors will have limited rights and powers to participate in the management or control of the business of the Fund and thus must depend solely upon the ability of the Investment Manager with respect to making, monitoring and disposing of investments.
Regulatory Risks. Legal, tax and regulatory changes could occur during the term of the Fund that may adversely affect the Fund. In particular, changes in the laws or regulations, or the interpretations of the laws and regulations, which govern BDCs, RICs or non-depository commercial lenders could significantly and adversely affect the Fund’s operations and cost of doing business. In addition, the regulatory environment for private funds is evolving, and changes in the regulation of private funds may adversely affect the value of Portfolio Investments and the ability of the Fund and the Portfolio Investments to obtain the leverage they may otherwise obtain. The SEC and other regulators and self-regulatory organizations and exchanges are authorized to take extraordinary actions in the event of market emergencies. The regulation of private investment funds is an evolving area of law and is subject to modification by government and judicial action. The effect of any future regulatory change on the Fund or the Investment Manager could be substantial and adverse.
Additionally, certain Portfolio Investments may be in industries subject to extensive government regulation. Certain regulations may prevent the Fund from making certain investments that it otherwise would make. Other regulations may require the Fund to incur substantial additional costs or lengthy delays in connection with the completion of an investment, or substantially reduce the value of the Portfolio Investments. In addition, governmental regulation may not be predictable and may be subject to political, economic, social and/or market developments. For example, the Fund may be subject to the regulations of the Federal Communications Commission (the “FCC”) if the Fund invests in an entity that has a direct or indirect interest in, owns or controls a “media company,” such as a television or radio station, cable system or daily newspaper, or a company providing wireless communications pursuant to an FCC license (“wireless licensee”). These restrictions may, among other things, prohibit certain communications between an investor (or such investor’s officers, directors, partners or other officials) and the Investment Manager pertaining to the operations of the media company and may limit an investor from serving as an agent or employee of the Fund. These restrictions may also prevent the Fund from investing in certain media companies or wireless licensees, or require the Fund to divest certain media companies or wireless licensees, due to FCC restrictions on concentration of ownership of media companies and wireless licensees. See also “Regulatory Restrictions,” and “Business and Regulatory Risks of Private Investment Funds.”
Key Personnel. The performance of the Fund will depend in significant part upon the skill and expertise of the key personnel of the Investment Manager and the Portfolio Investments, and may be adversely affected by key individuals joining or leaving the Investment Manager or the portfolio companies’ investment or management teams. Although the Investment Manager’s personnel will devote as much time as they believe necessary to assist the Fund in achieving its investment objectives, only some individuals will devote substantially all of his or her working time to the affairs of the Fund. The loss of key personnel could have a material adverse effect on the performance of the Fund or a Portfolio Investment.
Management Fees and Expenses. The Fund incurs management fees and expenses. The investment return on the Portfolio Investments therefore must be sufficient to offset management fees and expenses before the Fund will earn a positive investment return.
In-Kind Distribution of Illiquid Securities. The Fund may make in-kind distributions of Portfolio Investments, all of which may be highly illiquid. There can be no assurance that investors in the Fund will be able to dispose of these Portfolio Investments or will not incur significant costs and expenses in connection with any such disposition, or that the value of these Portfolio Investments as determined by the Investment Manager in connection with the determination of distributions will ultimately be realized.
Tax Status. The Fund must meet a number of requirements, described in Item 1 under the caption “Taxation” to qualify for the pass-through status as a RIC and, if qualified, to continue to so qualify. If the Fund experiences difficulty in meeting the diversification requirement for any fiscal quarter of its taxable year, it may accelerate capital contributions from the Partnership or, if available, borrowings in order to increase the portion of the Fund’s total assets represented by cash, cash items and U.S. government securities as of the close of the following fiscal quarter and thus attempt to meet the diversification requirement. The Fund, however, would incur additional interest and other expenses in connection with any such accelerated borrowings, and increased investments by the Fund in cash, cash items and U.S. government securities (whether the funds to make such investments are derived from called equity capital or from accelerated borrowings) are likely to reduce the Fund’s return. Furthermore, there can be no assurance that the Fund would be able to meet the diversification requirements through such actions. Failure to qualify as a RIC would deny the Fund pass-through status and, in a year in which the Fund has taxable income, would have a significant adverse effect on the returns of the Fund.
When the Fund elects to convert its status from that of an ordinary, or C, corporation to that of a RIC, it must choose either to (i) pay tax whenever an asset is sold during the subsequent “conversion period” (generally, ten years) following the conversion on the amount of gain which would have been realized had the asset been sold on the conversion date, or (ii) treat the entire amount of “built-in gain” as income at the time of conversion.
Accelerated Transactions. For the Fund to take advantage of available investment opportunities, the Investment Manager may need to make investment decisions on an expedited basis. In such cases, the information available to the Investment Manager at the time of an investment decision may be limited. The Investment Manager may not, therefore, have access to the detailed information necessary for a full analysis and evaluation of the investment opportunity.
Follow-On Investments. Following its initial investment in a Portfolio Investment, the Fund may have the opportunity to increase its investment in such Portfolio Investment. There is no assurance that the Fund will make follow-on investments or that the Fund will have sufficient resources to, or be permitted to, make such investments. Any decision not to make follow-on investments or the Fund’s inability to make them may have a substantial negative impact on such Portfolio Investment in need of such an additional investment, may result in missed opportunities for the Fund or may result in dilution of the Fund’s investment. In certain cases, the 1940 Act may impose restrictions on the Fund’s ability to make follow-on investments even when such an investment would be beneficial to the Fund.
Counterparty Risk. The Fund will be subject to credit risk with respect to the counterparties to the derivative contracts and other instruments entered into directly or indirectly by it. The Fund will also be subject to the risk that a counterparty to a trade may become unwilling or unable to meet its obligations prior to settlement. This risk may be more acute with respect to fixed income securities because the settle-ment periods for such securities are often longer than for equity securities. If a counterparty becomes bankrupt or otherwise fails to perform its obligations under a derivative contract due to financial difficulties, the Fund may experience significant delays in obtaining any recovery under the derivative contract in a bankruptcy or other reorganization proceeding. The Fund may obtain only a limited recovery or may obtain no recovery in such circumstances.
In situations where the Fund is required to post margin or other collateral with a counterparty, the counterparty may fail to segregate the collateral or may commingle the collateral with the counterparty’s own assets. As a result, in the event of the counterparty’s bankruptcy or insolvency, the Fund’s collateral may be subject to the conflicting claims of the counterparty’s creditors and the Fund may be exposed to the risk of a court treating it as a general unsecured creditor of the counterparty, rather than as the owner of the collateral.
The Fund may effect certain transactions in “over-the-counter” or “interdealer” markets. The participants in such markets are typically not subject to credit evaluation and regulatory oversight, as are members of “exchange based” markets. The Fund is likely to be treated as an unsecured creditor of any “over-the-counter” derivative counterparty in the event of the counterparty’s insolvency, both with respect to the amounts owed by the counterparty under the derivatives transaction and with respect to any collateral that has been transferred to such counterparty. The credit risk arising from futures and cleared derivatives is generally different from the credit risk arising from “over-the-counter” derivatives, because a party to a futures contract or a cleared derivatives transaction is generally subject to the credit risk of the clearing house and the futures commission merchant or clearing member through which it holds its cleared position, rather than the credit risk of a market “counterparty.” The Fund generally may only close out “over-the-counter” transactions (including swaps and contracts for differences) with the relevant counterparty, and may only transfer a position with the consent of the particular counterparty. Also, if the counterparty defaults, the Fund will have contractual remedies, but there is no assurance that the counterparty will be able to meet its contractual obligations or that, in the event of default, the Fund will succeed in enforcing them.
Securities Markets Risk. The value of Portfolio Investments could be affected by factors affecting the securities markets generally, such as real or perceived adverse economic conditions, supply and demand for particular instruments, changes in the general outlook for the securities market or corporate earnings, interest rates, announcements of political information or adverse investor sentiment generally. The market values of Portfolio Investments may decline for a number of reasons, including increases in defaults resulting from overall economic conditions, increases in prepayments resulting from increased borrower mobility or the availability of “cash-out” refinancing opportunities or widening of credit spreads. Unfavorable securities markets conditions may also increase the Fund’s costs, limit its access to the capital markets or result in a decision by lenders not to extend credit to the Fund or a Portfolio Investment.
Inflation/Deflation Risk. Inflation risk is the risk that the value of assets or income from Portfolio Investments will be worth less in the future as inflation decreases the value of payments at future dates. As inflation increases, the real value of Portfolio Investments could decline and the interest payments on any related borrowings may increase. Deflation risk is the risk that prices throughout the economy decline over time. Deflation may have an adverse effect on the creditworthiness of issuers, increase the real value of debts owed, and may make issuer default more likely, which may result in a decline in the value of the Portfolio Investments.
Risks of Litigation. The Fund’s investment activities may include activities that are hostile in nature and will subject it to the risks of becoming involved in litigation with third parties. This risk may be greater where the Fund exercises control or significant influence over a Portfolio Investment. The Fund may have indemnification obligations in connection with any such litigation. In particular, the Fund may be obligated to indemnify the Investment Manager, its affiliates, members, employees and agents, and each director and officer of the Fund.
Satisfaction of Liabilities of the Fund. It is anticipated that the assets of the Fund, including any Portfolio Investments, will be available to satisfy the liabilities and other obligations of the Fund. If the Fund becomes subject to a liability, parties seeking to have the liability satisfied may have recourse to the Fund’s assets generally and not be limited to any particular assets, such as the asset representing the Portfolio Investment giving rise to the liability. This may result in the Fund disposing of assets it holds in order to satisfy liabilities arising from other assets, which could have a material adverse effect on the Fund.
Cyclical Nature of Debt Markets. From time to time the market for private equity/debt transactions has been adversely affected by a decrease in the availability of senior and subordinated financing for transactions, sometimes in response to regulatory pressures on providers of financing to reduce or eliminate their exposure to such transactions. A general downturn in the debt markets can create a situation in which Portfolio Investments suffer rising default rates. Such rising default rates may further tighten the lending environment, leading to a cycle of default and increasing interest rates. The inability of portfolio companies to secure debt financing at reasonable interest rates may adversely affect their profitability and financial stability, and will subject such portfolio companies to increased exposure to adverse economic factors such as a significant rise in interest rates, a severe downturn in the economy or deterioration in the condition of that portfolio company.
The debt markets have, from time to time, experienced a significant lack of liquidity. This lack of liquidity creates a number of risks. There can be no assurance that the market will, in the future, become more liquid and it may well continue to be volatile for the foreseeable future. It is also possible that illiquidity in the debt markets could cause prices to decline further, which may have the result of forcing portfolio companies or other leveraged investment vehicles to sell assets to satisfy requirements under their borrowing arrangements or to meet margin calls, which could, in turn, create further downward price pressure.
Foreign Investing. Portfolio Investments may be subject to changing political environments, regulatory restrictions, and changes in government institutions and policies, any of which could adversely affect their value. The Fund does not intend to obtain political risk insurance. As a BDC, the Fund may invest up to 30% of its total assets in securities of companies which are not “Eligible Portfolio Companies.” An “Eligible Portfolio Company” must be organized under the laws of, and have its principal place of business in, the United States. (See the discussion at Item 1 under the caption “Regulation.”) Therefore, the Fund may invest up to 30% of its total assets in non-U.S. companies. To the extent that the Fund invests in non-U.S. assets and securities, actions by the governments of foreign countries could have a significant effect on the economies of various countries, which could adversely affect market conditions, as well as prices and, if applicable, yields, and the cost and availability of leverage. Political and economic instability in any of the foreign countries in which the Fund invests could adversely affect the Fund. While the developed economies and many emerging economies have achieved relatively stable political, economic and social structures, it is possible that conditions could change materially during the lifetime of the Fund. Investments in developing economies or emerging markets may be more subject than those in developed markets to the risks of internal and external conflicts, currency devaluations, foreign ownership limitations and tax increases. Also, nationalization, expropriation or confiscatory taxation, currency blockage, market disruption, political changes, security suspensions or diplomatic developments could adversely affect investments in foreign economies, particularly emerging market countries.
Although developed countries generally recognize basic commercial relationships and rights, some still lack the extensive body of law and practice normally encountered in Western business environments. Laws and regulations in developing market countries affecting Western business and investment, particularly those involving taxation, foreign investment and trade, can change quickly and unpredictably in a more volatile manner than in the United States or other developed market economies. Additionally, attempts at judicial enforcement of existing laws, judgments or arbitral awards may encounter significant delay and difficulty, and courts may not be totally impartial in adjudicating disputes between foreigners and local persons or companies. In addition, although substantial revisions have been made to the commercial law of some of the countries in which the Fund may invest, the judicial and civil procedures often have not been modernized to nearly the same extent. As a result, not only do courts lack experience in commercial dispute resolution, but many of the procedural remedies for enforcement and protection of legal rights typically found in Western jurisdictions are less available. In particular, the bankruptcy or receivership process in countries outside the United States may be less transparent, or provide less protection to creditors, than is the case in the United States.
Because non-U.S. entities are not subject to uniform accounting, auditing, and financial reporting standards, practices and requirements comparable to those applicable to U.S. companies, there may be different types of, and lower-quality, information available about companies in foreign markets than is the case for companies in the U.S. This reduced transparency may make it more difficult to select and manage investments, and makes the valuation of the securities of companies less reliable.
Changes in any jurisdiction’s policy with regard to taxation, fiscal and monetary policies, repatriation of profits, and other economic regulations are possible, any of which may have an adverse effect on investments in such jurisdiction. Any such changes may adversely affect the value of Portfolio Investments. The economies of the foreign countries in which the Fund makes investments may differ favorably or unfavorably from the U.S. economy with regard to the rate of growth of gross domestic product, the rate of inflation, capital reinvestment, resource self-sufficiency and balance of payments.
Restrictions on Repatriation of Capital and Profits. Some countries in which the Fund may invest control, in varying degrees, the repatriation of capital and profits that result from foreign investment. Capital markets, often opaque, continue to be highly regulated and will likely be subject to continuing government restrictions. There can be no assurance that the Fund will be permitted to repatriate capital or profits, if any, from these countries.
Euro-Related Risk. The recent global economic crisis brought several small economies in Europe to the brink of bankruptcy and many other economies into recession and weakened the banking and financial sectors of many European countries. For example, the governments of Greece, Spain, Portugal, Italy and the Republic of Ireland have all recently experienced large public budget deficits, the effects of which are still yet unknown and may slow the overall recovery of the European economies from the recent global economic crisis. In addition, due to large public deficits, some European countries may be dependent on assistance from other European governments and institutions or multilateral agencies and offices. Assistance may be dependent on a country’s implementation of reforms or reaching a certain level of performance. Failure to reach those objectives or an insufficient level of assistance could result in a deep economic downturn which could significantly affect the value of European Portfolio Investments.
The Economic and Monetary Union of the European Union (“EMU”) is comprised of the European Union members that have adopted the euro currency. By adopting the euro as its currency, a member state relinquishes control of its own monetary policies. As a result, European countries are significantly affected by fiscal and monetary controls implemented by the EMU. The euro currency may not fully reflect the strengths and weaknesses of the various economies that comprise the EMU and Europe generally.
It is possible that EMU member countries could abandon the euro and return to a national currency and/or that the euro will cease to exist as a single currency in its current form. The effects of such an abandonment or a country’s forced expulsion from the euro on that country, the rest of the EMU, and global markets are impossible to predict, but are likely to be negative. The exit of any country out of the euro would likely have an extremely destabilizing effect on all Eurozone countries and their economies and a negative effect on the global economy as a whole. In addition, under these circumstances, it may be difficult to value investments denominated in euros or in a replacement currency.
Currency Risk. A portion of the Portfolio Investments may be denominated in currencies other than the U.S. dollar. Accordingly, the value of such Portfolio Investments and the cash flow generated therefrom may decline due to fluctuations in the exchange rates between U.S. dollars and such other currencies. Because such Portfolio Investments may require the Fund to transact business in non-U.S. dollar currencies during the completion of its investment program, the Fund may be affected favorably or unfavorably by changes in currency rates and in exchange control regulations and may incur transaction costs in connection with conversions between various currencies.
Lender Liability Considerations and Equitable Subordination. In recent years, a number of judicial decisions in the United States have upheld the right of borrowers to sue lending institutions on the basis of various evolving legal theories (collectively termed “lender liability”). Generally, lender liability is founded upon the premise that an institutional lender has violated a duty (whether implied or contractual) of good faith and fair dealing owed to the borrower or has assumed a degree of control over the borrower or the borrower’s assets resulting in creation of a duty owed to the borrower or its other creditors or interest holders. In addition, courts have in some cases applied the doctrine of equitable subordination to subordinate the claim of a lending institution against a borrower to claims of other creditors of the borrower when the lending institution, or its assignor or predecessor in interest, is found to have engaged in unfair, inequitable or fraudulent conduct. Because of the nature of certain of the Portfolio Investments, the Fund could be subject to allegations of lender liability or to claims that such investments should be equitably subordinated.
Fraudulent Conveyance and Preference Considerations. Various federal and state laws enacted for the protection of creditors may apply to the purchase of Portfolio Investments by virtue of the Fund’s role as a creditor with respect to the borrowers under such investments or as a holder of equity interests in such borrowers. If a court in a lawsuit brought by an unpaid creditor or representative of creditors of a borrower were to find that the borrower did not receive fair consideration or reasonably equivalent value for incurring indebtedness evidenced by an investment and the grant of any security interest or other lien securing such investment, such court could, under certain circumstances, invalidate, in whole or in part, such indebtedness and such security interest or other lien as fraudulent conveyances, could subordinate such indebtedness to existing or future creditors of the borrower or could allow the borrower to recover amounts previously paid by the borrower to the creditor (including to the Fund) in satisfaction of such indebtedness or the proceeds of such security interest or other lien previously applied in satisfaction of such indebtedness. In addition, in the event of the insolvency of an issuer of an investment, payments made with respect to the Portfolio Investment could be subject to avoidance as a “preference” if made within a certain period of time (which may be as long as one year) before insolvency depending on a number of factors, and such payments can be recaptured either from the initial recipient (such as the Fund) or from subsequent transferees of such payments, including limited partners.
The Investment Manager does not intend to cause the Fund to engage in conduct that would form the basis for a successful cause of action based upon fraudulent conveyance, preference or equitable subordination. There can be no assurance, however, as to whether any portfolio company or lending institution or other party from which the Fund may acquire such indebtedness engaged in any such conduct (or any other conduct that would subject such indebtedness and the Fund to insolvency laws) and, if it did, as to whether such creditor claims could be asserted in a U.S. court (or in the courts of any other country) against the Fund.
Indebtedness consisting of obligations of non-U.S. issuers may be subject to various laws enacted in the countries of their issuance for the protection of creditors. These insolvency considerations and the levels of protection provided will differ depending on the country in which each issuer is located or domiciled and may differ depending on whether the issuer is a non-sovereign or a sovereign entity.
Uncertainties Associated With the Bankruptcy Process. Issuers of the Portfolio Investments may file for bankruptcy. Bankruptcy proceedings generally are contested and adversarial, and unanticipated adverse developments can occur that are often beyond the control of the creditors or the debtor. While creditors generally are afforded an opportunity to object to significant actions, there can be no assurance that a bankruptcy court would not approve actions that may be contrary to the interests of the Fund. These include the risks that one or more classes of securities could be deemed to have priority over the Fund’s interest, undue delays or expenses in resolving the bankruptcy, use of the cash flow by the debtor during the bankruptcy process in a way that is adverse to its creditors, and the possibility that, to facilitate emergence from bankruptcy, it may be necessary to provide some level of recovery to one or more classes of securities beyond what these classes are entitled to from a strict economic standpoint. Moreover, the duration of a bankruptcy case can only be roughly estimated. In some cases the pendency of bankruptcy proceedings can adversely affect a company’s business, particularly if customers, suppliers and employees lose confidence in the company’s viability as a going concern. If a company in bankruptcy is forced to dispose of assets (particularly in a Chapter 7 liquidation proceeding), the value realized on the disposition of those assets may be less than if the assets were disposed of outside the bankruptcy context.
During the bankruptcy, an automatic stay will prevent all creditors from taking action against the debtor to collect on amounts owed to such creditors. Unless a creditor’s claim in such case is secured by assets having a value in excess of such claim, no interest will be permitted to accrue and, therefore, the creditor’s return on investment can be adversely affected by the passage of time during which the plan of reorganization of the debtor is being negotiated, approved by the creditors and confirmed by the bankruptcy court.
Notwithstanding special purpose entities created to hold assets and to structure for bankruptcy remoteness, such entities may, in certain cases, be consolidated in bankruptcy proceedings which can affect the outcome of such proceedings and the amounts ultimately received by creditors.
The administrative costs in connection with a bankruptcy proceeding are frequently high and will generally be paid out of the debtor’s estate prior to any return to creditors (other than out of assets or proceeds thereof which are subject to valid and enforceable liens and other security interests) and equity holders. In addition, certain claims that have priority by law over the claims of certain creditors (for example, claims for taxes) may be quite high.
U.S. bankruptcy law permits the classification of “substantially similar” claims in determining the classification of claims in a reorganization for purpose of voting on a plan of reorganization. Because the standard for classification is vague, there exists a significant risk that the Fund’s influence with respect to a class of securities can be lost by the inflation of the number and the amount of claims in, or other gerrymandering of, the class.
Claims in bankruptcy cases are often paid at less than par and depending on the debtor’s assets and liabilities, there may be no recovery at all for some classes of creditors. The claims of secured creditors are often paid out over time. Initially, only the debtor may file and prosecute a plan of reorganization. While the U.S. bankruptcy code permits other parties-in-interest to file and prosecute a plan of reorganization after the debtors’ “exclusive period” to do so ends, bankruptcy courts often extend the debtor’s exclusive period, which effectively permits only the debtor to file or prosecute a reorganization plan. While creditors can vote on the plan of reorganization, the unanimous consent of all creditor classes is not necessarily required for the bankruptcy court to confirm the plan. Therefore, a plan can, subject to the provisions of the bankruptcy code, be “crammed down” on dissenting classes of creditors.
Some of the Portfolio Investments may be subject to bankruptcy and insolvency laws of non-U.S. jurisdictions. These laws may be substantially less favorable to creditors than or otherwise significantly different from U.S. bankruptcy and insolvency laws.
Use of Derivatives. The Fund may, but is not required to, use derivatives to seek to hedge the Fund’s exposure to changes in value of one or more Portfolio Investments, including hedging interest rate and currency risk. To the extent the Fund elects to engage in these transactions, it will incur additional costs, and there can be no assurance that any particular derivatives transaction will achieve its intended purpose or that suitable derivatives transactions will be available. Many derivative instruments are inherently leveraged, and will expose the Fund to the risks of leverage discussed elsewhere.
Unanticipated movements in markets may result in a poorer overall performance for the Fund than if the Fund had not engaged in any derivatives transaction. In addition, the degree of correlation between price movements of the instruments used in a derivatives strategy and price movements in the underlying reference instrument (e.g., securities of the Portfolio Investment being hedged) may vary. Moreover, for a variety of reasons, the Fund may not seek to establish a perfect correlation between such derivatives instruments and the underlying reference instrument. Such imperfect correlation may prevent the Fund from achieving the intended result or expose the Fund to risk of loss. Finally, the Fund may simply not anticipate the occurrence of a particular risk or may deem the probability of such occurrence too low (or the cost of hedging too high) to warrant establishing a hedging position. Engaging in derivative transactions will also expose the Fund to the risk that a counterparty will be unwilling or unable to meet its obligations, and to the risks related to the relatively untested nature of the markets for certain derivative instruments. See “Counterparty Risk” above.
Certain derivatives transactions used by the Fund, including certain interest rate swaps and certain credit default index swaps, will be required to be centrally cleared. In a cleared derivatives transaction, the Fund’s counterparty to the transaction is a central derivatives clearing organization, or clearing house, rather than a bank or broker. Since the Fund is not a member of a clearing house, and only members of a clearing house (“clearing members”) can participate directly in the clearing house, the Fund will hold cleared derivatives transactions through accounts at clearing members, who are futures commission merchants who are members of the clearing houses. The Fund will make and receive payments owed under cleared derivatives transactions (including margin payments) through the Fund’s accounts at clearing members. Such clearing members guarantee the Fund’s performance of its obligations to the clearing house. In contrast to bilateral derivatives transactions, following a period of advance notice to the Fund, clearing members can generally require termination of existing cleared derivatives transactions at any time and increase the amount of margin required to be provided by the Fund to the clearing member for any cleared derivatives transaction above the amount of margin that was required at the beginning of the transaction. Also, the Fund is subject to execution risk if it enters into a derivatives transaction that is required to be cleared (or which the Investment Manager expects to be cleared), and no clearing member is willing to clear the transaction on the Fund’s behalf. In that case, the transaction may have to be terminated, and the Fund could lose some or all of the benefit of any increase in the value of the transaction after the time of the trade and will not be able to maintain the desired transaction.
Derivatives are also subject to a number of other risks described herein such as interest rate risk, liquidity risk, management risk and the risk of mispricing or improper or subjective valuation.
Effect of Borrowings. The Investment Management Fee will be based on a percentage of the net invested capital of the Fund, including assets acquired with borrowed funds. Therefore, decisions by the Investment Manager to cause the Fund to borrow additional funds may increase the quarterly fees payable to the Investment Manager. The Fund’s overall borrowing limits, however, are set by the Fund Board in light of its fiduciary obligations.
Indemnification and Exculpation. The charter of the Fund authorizes it and the bylaws of the Fund (the “Bylaws”) obligate it to indemnify its directors, officers, employees and agents (including the Investment Manager), among others of the Fund to the full extent permitted by Maryland law and the 1940 Act, including the advance of expenses and reasonable counsel fees. The charter of the Fund also contains a provision eliminating personal liability of a Fund director or officer to the Fund or its shareholders for money damages, subject to specified exceptions. A successful claim for such indemnification, including payment of any expenses and counsel fees, would reduce the Fund’s assets by the amounts paid. For a more detailed discussion of such indemnification provisions, see the discussion herein at Item 12, “Indemnification of Directors and Officers.”
Selection of Disinterested Directors. A majority of the Fund’s directors are individuals who are not “interested persons” of the Fund, as that term is defined under the 1940 Act. Although the continued service of all directors will be subject to periodic election by the Fund’s shareholders, the initial selection of directors, including the disinterested directors, was made by the Investment Manager.
Although the fact that the Fund Board (a majority of whose members are disinterested) may mitigate certain conflicts, it will not necessarily prevent or mitigate all conflicts or prevent or mitigate them to the extent desired.
The foregoing list of risk factors does not purport to be a complete enumeration or explanation of the risks involved in an investment in the Fund. No assurance can be made that profits will be achieved or that substantial losses will not be incurred.
Conflicts of Interest.
Description of Small Buyout Portfolios. The Investment Manager serves as investment manager, and affiliates of the Investment Manager serve as general partner, to, inter alia, Siguler Guff Small Buyout Opportunities Fund, LP, Siguler Guff Small Buyout Opportunities Fund II, LP, Siguler Guff Small Buyout Opportunities Fund III, LP, and their parallel funds (the “SBOF Funds”). The Investment Manager and its affiliates also serve as investment manager and/or general partner to certain separate accounts with investment strategies that, in whole or in part, overlap with those of the SBOF Funds (the SBOF Funds and such separate accounts are referred to collectively as the “Small Buyout Portfolios”). The Small Buyout Portfolios invest in investment funds managed by other managers (the “Underlying Funds”) that acquire equity and equity-related investments in lower-middle market companies with characteristics similar to those of the companies to which the Fund will make loans and equity investments. The Small Buyout Portfolios also invest a specified portion of their assets directly in equity and equity-related investments in lower-middle market companies, typically as a “co-investment” made alongside an investment by an Underlying Fund, or potential Underlying Fund, into some of the same portfolio companies. Investments by the Small Buyout Portfolios into Underlying Funds are referred to as “Fund Investments” and investments by the Small Buyout Portfolios directly into lower-middle market companies are referred to as “Direct Investments.” As of December 31, 2017, the Small Buyout Portfolios had an aggregate investment capital of $4.3 billion, of which $1.5 billion had not yet been deployed and $2.9 billion has been invested in Small Buyout Portfolios investments. The Investment Manager or its affiliates may manage additional entities in the future which would be considered Small Buyout Portfolios.
In general, the Small Buyout Portfolios invest in Underlying Funds as limited partners and, as such, do not have the power to direct the day-to-day management of the Underlying Funds, including selection of investments and management of portfolio companies in which the Underlying Funds invest. In many cases, however, the Small Buyout Portfolios are relatively large investors in the Underlying Funds, which give rise to limited governance rights such as seats on advisory boards. Furthermore, when the Small Buyout Portfolios are among the largest investors in an Underlying Fund, the Investment Manager may be able to influence the actions of the Underlying Fund’s general partner, because the general partner appreciates the large investment and hopes that the Small Buyout Portfolios will continue to invest in the general partner’s subsequent investment vehicles. In certain cases, the Investment Manager may obtain specific governance rights with respect to an Underlying Fund or its related entities, such as the right to veto investments proposed to be made by the general partner.
Potential Conflicts Involving the Small Buyout Portfolios. The Investment Manager expects that the majority of the Fund’s investments will be in companies in which an Underlying Fund, or a fund in which a Small Buyout Portfolio is considering investing, holds or is about to acquire a significant (and in most cases controlling) equity investment. Accordingly, the Fund will frequently acquire loans and the Partnership will acquire, in most cases, equity investments, in companies in which the Small Buyout Portfolios hold an indirect equity interest through a Fund Investment in Underlying Funds. In some cases the Small Buyout Portfolios may also own additional equity securities in a Fund portfolio company through a Direct Investment. A company in which an Underlying Fund or a Small Buyout Portfolio indirectly or directly owns securities or will own securities when the Fund completes its investment is referred to as a “Related Company”. A company in which a Small Buyout Portfolio owns securities or will own securities as a Direct Investment when the Fund completes its investment is referred to as a “Direct Related Company”.
Investment by the Fund in Related Companies can give rise to potential conflicts of interest, as described below. To the extent that the Investment Manager believes that successful investments by the Small Buyout Portfolios will create a greater economic benefit to the Investment Manager than successful investments by the Fund (or vice versa), the potential conflicts described would be aggravated, because the Investment Manager would have an economic incentive to favor one party over the other. This divergent economic benefit could occur, for example, because of different compensation arrangements between the Investment Manager and the clients in question, the relative size of the investments involved, or because the relative investment performance of the various vehicles has made it more likely that the Investment Manager or its affiliates will collect more incentive compensation from one client or the other. In addition, the restrictions on affiliated transactions described below, as well as those described under the caption “Regulation”, could prevent the Fund from making certain transactions even when the Investment Manager believes it would be beneficial for the Fund to make such an investment.
Negotiation of Terms and Conditions. Portfolio Investments will consist primarily of debt securities, and the investments in the same companies by Underlying Funds (and, if applicable, Direct Investments by Small Buyout Portfolios) will consist primarily of equity securities. The interests of debt investors differ significantly from the interests of equity investors in the same company. For example, debt investors will seek to negotiate the highest interest rate and fees possible, and negotiate restrictive covenants and events of default to protect their overriding interest in being repaid as scheduled. Equity investors, in contrast, seek the lowest possible interest rate and fees, and less restrictive covenants and events of default. In most cases, however, the general partner of the Underlying Fund, as the “lead investor”, takes primary responsibility for negotiating the terms of the portfolio company’s borrowings, and the Small Buyout Portfolios will have a limited ability to participate in such negotiations. The Investment Manager generally will have broad discretion to negotiate terms and conditions with respect to the Portfolio Investments.
Use of Proceeds. The Investment Manager anticipates that the proceeds of most loans made by the Fund will be used to finance the acquisition of a borrower by a financial sponsor, to refinance existing debt, or to expand the borrower’s business through acquisition or organic growth. The proceeds of some loans, however, may be used in whole or in part to finance distributions to the borrower’s equity investors (a “dividend recapitalization” transaction). The Investment Manager would permit the proceeds of a loan to be used for a dividend recapitalization only if the Investment Manager believes that the borrower will have the ability to service the debt notwithstanding its distribution of the loan proceeds to the equity holders. Financing a dividend recapitalization by a Related Company would benefit the Small Buyout Portfolios, as they would receive a portion of the proceeds of the dividend recapitalization.
Allocation of Equity Investment Opportunities. The Fund will frequently make its investment in a portfolio company at the same time as an equity investment in that portfolio company by the Underlying Fund (and, if applicable, a Direct Investment by a Small Buyout Portfolio). Equity investors typically seek to limit the amount of equity to be acquired by debt investors like the Fund, while the debt investors seek to maximize that amount. To the extent that the Fund secures an equity investment as part of a financing, the amount of equity available to the Small Buyout Portfolios (indirectly through its Fund Investment in the Underlying Fund and/or directly through a Direct Investment) could be reduced.
Investment at Different Levels of the Capital Structure. The Small Buyout Portfolios and the Fund may invest in a broad range of asset classes throughout the corporate capital structure, including investments in loans and debt securities, preferred equity securities and common equity securities. To the extent permitted by applicable law, the Small Buyout Portfolios and the Fund may invest in a portfolio company at a level that is the same as, senior to or subordinate to an investment in the same company made by another fund or account managed by the Investment Manager. This may give rise to actual or potential conflicts of interest, or the appearance of such conflicts of interest. In that regard, actions may be taken for the Small Buyout Portfolios that are adverse to the Fund.
For example, if the Fund were to invest in the debt of a portfolio company in which a Small Buyout Portfolio holds equity or some other interest junior to the Fund’s debt, the interests of the Fund and such Small Buyout Portfolio would be adverse. The Fund would be senior to the Small Buyout Portfolio in the capital structure of such company and, in a distress or workout scenario, the Fund could recover on its investment while the Small Buyout Portfolio may not. It is also possible that the Small Buyout Portfolios could hold securities that are senior to those owned by the Fund although, for the entities and accounts that presently comprise the Small Buyout Portfolios, this is unlikely to occur because the existing Small Buyout Portfolios concentrate on equity investments. These situations would present numerous conflicts or the appearance of conflicts, and the furtherance by the Fund or the Small Buyout Portfolio of their respective interests could cause a decline in the value of the other’s investment.
In a different example, a borrower may default under a loan from the Fund. The Fund generally would have the ability to pursue a number of remedies, including acceleration of the outstanding principal and interest, foreclosing on collateral in the case of a secured loan, and pursuing recovery against the borrower through the civil or bankruptcy courts. Borrowers may at times request that the Fund waive enforcement of a loan covenant or other provision, and the Fund may demand that the borrower compensate the Fund for the waiver through a cash payment or modification of loan terms. Under certain circumstances, the Investment Manager may conclude that restructuring a defaulted loan, or otherwise forbearing from exercising all the remedies available to the Fund as a lender, would ultimately result in a better outcome for the Fund. Such forbearance could benefit the owners of the borrower’s equity securities, which may include the Small Buyout Portfolios in the case of Related Companies.
Certain Policies. In light of these potential conflicts of interest, the Investment Manager will seek prior approval by the Fund Board (including a majority of the disinterested directors) if (a) the Fund invests in a Related Company and (b) the Investment Manager proposes that the Fund engage in any of the following transactions:
·
A loan to a Direct Related Company (other than a loan primarily intended to finance a dividend recapitalization - see below) if the Partnership is not acquiring equity securities with a value equal to at least 10% of the loan amount, or warrants with an exercise price equal to at least 10% of the loan value;
·
If, in connection with a loan to a Direct Related Company, the amount of equity available in the aggregate to the Partnership and one or more Small Buyout Portfolios is limited by the equity sponsor or borrower to less than the aggregate amount desired by the Fund and such Small Buyout Portfolios, the equity securities available to the Partnership will be limited to a maximum of: (a) 10% of the loan amount, plus (b) such additional amounts as are available after all the Small Buyout Portfolios have acquired their desired allocations of the available equity securities. This policy could result in the Partnership receiving an allocation that is less favorable than desired.
·
A loan to a Related Company if 50% or more of the loan proceeds can be used to finance a dividend recapitalization;
·
Following a default by a Related Company, forbearance from exercising one or more material available remedies;
·
Restructuring of an existing loan to a Related Company that changes the interest rate, amortization terms or maturity; or
·
Any investment into a Related Company in which the Small Buyout Portfolios (and any other persons affiliated with the Investment Manager) own in the aggregate 5% or more of the outstanding voting securities.
In addition, the Fund will not invest in a Related Company if:
·
A person who is an affiliate of the Investment Manager is a voting member of the Related Company’s board of directors;
·
The Small Buyout Portfolios (and any other persons affiliated with the Investment Manager) own in the aggregate 25% or more of the Related Company’s outstanding voting securities; or
·
The Small Buyout Portfolios (and any other persons affiliated with the Investment Manager) “control” the Related Company, as that term is defined under the 1940 Act.
In addition, when the Fund invests in a Related Company:
·
The Investment Manager will provide a detailed report to the Fund Board at each regular meeting regarding the Fund’s investments in Related Companies, including the amount and general terms of such investment, the identity of the parties that cause the company to be a Related Company, and the Related Company’s relationship with such parties, and any recent significant developments that could affect the Fund’s ability to be paid on its loan; and
·
The Investment Manager and its affiliates will seek, consistent with their duties to the Small Buyout Portfolios, to make arrangements with the Related Company and its controlling shareholders to reduce the likelihood that personnel of the Investment Manager or its affiliates will receive information that could inhibit the ability of the Fund to enforce its rights against the Related Company.
The Parallel Partnership. The Investment Manager has, with the approval of the Fund Board, established one parallel investment vehicle, SBCOF Parallel Fund LP, a Delaware entity, (the “Parallel Partnership”) which generally invests in each Portfolio Investment, pro rata in accordance with the relative capital commitments of the Partnership and the Parallel Partnership. Employees of the Investment Manager and its affiliates, and independent directors of the Fund, are permitted to invest in the Parallel Partnership. Investors in the Parallel Partnership are not charged a management fee or carried interest on their investment in the Parallel Partnership. The Parallel Partnership will bear its pro rata share of the transaction expenses for Portfolio Investments in which it invests, as well as the Fund’s expenses in connection with investigating investment opportunities that are not consummated (“broken deal” expenses). The Parallel Partnership generally invests in Portfolio Investments on substantially identical terms and conditions, and disposes of each Portfolio Investment at the same time, and on the same terms, as the Fund. However, there may be some variation between the terms upon which the Fund invests and the terms upon which the Parallel Partnership invests, such as variations due to different sizes of investments, or rights that may be exercised by only one investor. In general, if a right can be exercised by only one investor, as between the Fund and the Parallel Partnership, the right will be exercised by the Fund. All transactions by the Parallel Partnership are subject to regular review by the Fund Board.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2.
PROPERTIES
The Fund does not own or lease any real property. The Fund’s office space and equipment are provided by the Investment Manager.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
The Fund is not a party to any legal proceedings.
ITEM 4.
ITEM 4.
MINE SAFETY ISSUES
Not applicable.
PART II.
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
On September 19, 2014, the Fund sold 100,000 Shares to the Partnership in a private offering exempt from the registration requirements of the 1933 Act pursuant to Section 4(a)(2) thereof and Regulation D promulgated thereunder (“Regulation D”) for an aggregate consideration of $25,000. The Partnership is an accredited investor for purposes of Regulation D. The Fund did not engage in any general solicitation or advertising with respect to the private placement and did not offer securities to the public in connection with such issuance and sale.
The Shares are not listed on any securities exchange, and the Fund’s investors are subject to agreements substantially restricting the transferability of their limited partnership interests in the Partnership.
There was one holder of record of the Fund’s Shares at March 29, 2018.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The Fund commenced investment operations on October 13, 2015. The Consolidated Statements of Operations, Per Share and Consolidated Statements of Assets and Liabilities data for the fiscal years ended December 31, 2017, December 31, 2016, and the period ended December 31, 2015, are derived from the Fund’s consolidated financial statements which have been audited. This selected financial data should be read in conjunction with the Fund’s Consolidated Financial Statements and related Notes to Consolidated Financial Statements thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report.
Given the Funds’s similarities to a non-registered close-ended fund, the Fund calculated total return as the change in the Fund's capital over the year/period ended, and adjusted for stockholder contributions and distributions during the year/period. The Fund noted that the total return calculated under the typical method for a registered investment company resulted in a total return of 104.61% as of December 31, 2017, 176.89% as of December 31, 2016 and 6,467,902% as of December 31, 2015. The Fund determined this did not appropriately represent the performance of the Fund, and thus calculated the total return based on the change in value of a theoretical investment at the beginning of the year by geometrically linking the cash flows, which is a method more commonly used by non-registered funds.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The Fund is a specialty finance investment company providing financing and advisory services to carefully selected companies in the lower middle market. The Fund commenced investment operations on October 13, 2015, and its portfolio as of December 31, 2017 (excluding the Money Market Fund) consisted of 11 investments. The Fund is a non-diversified, closed end investment company that has elected to be treated as a BDC under the 1940 Act. The Investment Manager will seek to increase the diversification of the Fund’s portfolio so as to make it possible (during the first quarter of 2018) to meet the RIC diversification requirements under Internal Revenue Code Section 851(b), although there is no assurance that the Fund will meet the RIC requirements at that time. Until the Fund meets the requirements to qualify as a RIC, it will be taxed as an ordinary corporation on its taxable income for that year, regardless whether that income is distributed to the Partnership, and all distributions out of earnings and profits will be taxable to investors as ordinary dividend income (i.e., the Fund will be subject to a double layer of tax).
The Partnership’s investment objective is to achieve attractive risk-adjusted returns by generating current income from debt investments and capital appreciation from equity investments. The Partnership makes its debt investments through the Fund. The Fund primarily invests in carefully selected companies in the lower middle market. The Investment Manager defines the “lower middle market” as privately-owned companies with between $2 to $15 million of EBITDA, and between $10 to $100 million of revenue. Investments generally take the form of mezzanine debt, “unitranche” loans with a first lien on the company’s assets, as well as second lien loans. The Partnership generally seeks to purchase equity securities alongside the Fund’s investments into those same companies, generally with an aggregate cost of up to 20% of the value of the investment. The Partnership also may extend mezzanine financing in forms other than subordinated loans, such as convertible loans and preferred stock. The Fund makes available significant managerial assistance through its officers to certain companies whose securities are held in the Fund’s portfolio, as described in Item 1 under the caption “Regulation.”
CRITICAL ACCOUNTING POLICIES
The Investment Manager has identified the most critical accounting estimates upon which the financial statements depend and determined the critical accounting estimates by considering accounting policies that involve the most complex or subjective decisions or assessments. The critical accounting policies relate to the valuation of investments, the recognition of income and expense, and income taxes.
Valuation of Portfolio Investments
The Financial Accounting Standards Board (“FASB”) ASC 820 Fair Value Measurements and Disclosures (“ASC 820”) defines fair value as the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A liability’s fair value is defined as the amount that would be paid to transfer the liability to a new obligor, not the amount that would be paid to settle the liability with the creditor. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available or reliable, valuation techniques are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the investments or market and the investments’ complexity.
Assets and liabilities recorded at fair value in the Fund’s consolidated financial statements are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by ASC 820 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:
·
Level 1 - Unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.
·
Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data at the measurement date for substantially the full term of the assets or liabilities.
·
Level 3 - Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.
Under ASC 820, the Fund performs detailed valuations of its debt investments for which quotations are not readily available on an individual basis, using bond yield, market and income approaches as appropriate. In certain instances, the Fund may use alternative methodologies, recent purchase transactions, asset liquidation, expected recovery model or other alternative approaches to estimate the fair value.
Investments where market quotations for securities of the same issue are readily available on an exchange are marked-to-market at fair value at the closing price on the financial statement date. Financial instruments with readily available quoted prices generally will have a higher degree of market price observability and a lesser degree of judgment inherent in measuring fair value.
Under the bond yield approach, the Fund uses bond yield models to determine the present value of the future cash flow streams of its debt investments. The Fund reviews various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assesses the information in the valuation process.
Under the market approach, the Fund estimates the enterprise value of the portfolio companies in which it invests. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise value is best expressed as a range of fair values, from which the Fund derives a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, the Fund analyzes various factors, including the portfolio company’s historical and projected financial results. Typically, private companies are valued based on multiples of EBITDA, cash flows, net income or revenues. The Fund generally requires portfolio companies to provide annual audited and quarterly or monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year.
Under the income approach, the Fund generally prepares and analyzes discounted cash flow models based on projections of the future free cash flows of the business.
The fair value of the Fund’s portfolio investments at December 31, 2017 and December 31, 2016 was determined in good faith by the Directors. The Directors are ultimately and solely responsible for the valuation of the portfolio investments at fair value as determined in good faith pursuant to the Fund’s valuation policy and a consistently applied valuation process.
The following table summarizes the level of the Fund’s assets measured at fair value as of December 31, 2017 and December 31, 2016:
At December 31, 2017 and December 31, 2016, 100% of the Fund’s portfolio investments have been classified within Level 3, with the exception of the Money Market Fund. Assumptions used by the Fund due to the lack of observable inputs may significantly impact the resulting fair value and therefore the Fund’s results of operations.
The following table summarizes the significant unobservable inputs the Fund used to value investments categorized within Level 3. The below table is not intended to be all-inclusive, but instead captures the significant unobservable inputs relevant to the determination of fair values:
Not reflected in the table above are Level 3 investments that have been primarily based upon recent transactions totaling $11,595,671 as of December 31, 2017.
Not reflected in the table above are Level 3 investments that have been primarily based upon recent transactions totaling $8,411,791 as of December 31, 2016.
Critical factors in determining the fair value of investments include payment history, collateral position, financial strength of borrower, financial performance relative to covenants, likelihood of sale or acquisition of the borrower, and length of expected holding period of the loan, as well as an evaluation of the general interest rate environment. The actual value realized from investments may differ from management’s estimates and such differences could be material. In addition, such differences would impact the carrying value of investments presented in the financial statements, as well as, the Fund’s change in net assets resulting from operations.
Income and Expense
Interest income is recorded on an accrual basis to the extent that such amounts are expected to be collected. The Fund stops accruing interest on investments when it is determined that interest is no longer collectible. Any resulting discount, or closing fee received, from recording the loan or otherwise purchasing a security at a discount, is accreted into interest income over the life of the loan using the effective-yield method.
The Fund has investments in debt securities which contain payment-in-kind (“PIK”) interest provisions. PIK interest is computed at the contractual rate specified in each investment agreement and added to the principal balance of the investment and recorded as income. The Fund stops accruing PIK interest on investments when it is determined that PIK interest is no longer collectible.
Other income includes the estimated amount of the exit fee due to the Fund in connection with the purchase of the NetFortris Operating Co., Inc. term notes, as well as a prepayment fee received in connection with the sale of the Rudy's Food Products, Inc. and C&M Technologies Group, Inc. senior subordinated notes.
Expenses include investment management fees, organizational costs, legal fees, directors’ fees, audit and tax expenses, interest expense, amortization of deferred financing costs and other general and administrative expenses. Expenses are recognized on an accrual basis.
Income Taxes
On December 22, 2017, H.R. 1, also known as the Tax Cuts and Jobs Act (the “Tax Act”), was enacted, which significantly revised U.S. corporate income tax by, lowering corporate income tax rates. FASB ASC 740, Income Taxes (“ASC 740”), requires the re-measurement of U.S. deferred tax assets and liabilities that existed as of December 22, 2017, to the new federal income tax rate of 21% as well as any federal impact associated with state and local deferred income taxes. As of December 31, 2017, the Company has accounted for the effects of the Tax Act by recording a decrease to its net deferred tax assets of $67,645 and a corresponding decrease of $67,645 to the valuation allowance. As a result, there is a gross impact to the tax provision from the re-measurement of U.S. deferred tax assets at lower enacted tax rates. However, since there is a full valuation allowance being recorded by the Company against its net deferred tax assets as of December 31, 2017, there is no impact on the Company’s tax provision for the year ended December 31, 2017, as a result of the Tax Act.
During the year ended December 31, 2017, December 31, 2016, and period ended December 31, 2015, the Fund did not qualify to be treated as a regulated investment company, or RIC, for federal income tax purposes. As such, the Fund will be treated as a corporation for U.S. federal income tax purposes. It is anticipated that, by the end of the third year of its investment operations, the Fund will seek to meet the requirements, including diversification, gross income, and distribution requirements, to qualify for the special pass-through status available to RICs under the Internal Revenue Code, and thus to be relieved of federal income tax on that part of its net investment income and realized capital gains that it distributes. Unless and until the Fund meets these requirements, it will be taxed as a corporation on its taxable income for that year even if that income is distributed to the Partnership (its sole stockholder), and all distributions out of its earnings and profits will be taxable as dividends to the investors of the Partnership; thus, such income will be subject to two layers of tax (although corporate Limited Partners may be entitled to a dividends-received deduction). There is no assurance that the Fund will meet the requirements to qualify as a RIC or be able to maintain such status.
The Fund accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined on the basis of the differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.
The Fund recognizes deferred tax assets to the extent that it believes these assets are more likely than not to be realized. In making such a determination, the Fund considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations
As of December 31, 2017 and December 31, 2016, the Fund concluded that it was more likely than not that an amount of the deferred tax assets, relating to the period after RIC qualification, would not be utilized. Therefore, the Fund recorded a valuation allowance against its net deferred tax assets, for the years ending December 31, 2017 and December 31, 2016, respectively, representing the portion of net deferred tax assets for which the Fund is not expected to realize a benefit after the Fund meets RIC qualification. If the Fund determines that it would be able to realize net deferred tax assets in the future in excess of their net recorded amount, it would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes.
The Fund records uncertain tax positions in accordance with FASB ASC 740, Income Taxes (“ASC 740”) on the basis of a two-step process whereby (1) it determines whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, it recognizes the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. The Fund has determined that there are no uncertain tax positions that would have a material impact to the financial statements of the Fund, and therefore, no provisions are required to be recorded by the Fund. The Fund does not anticipate significant increases to uncertain tax positions in the next twelve months. The Fund will recognize any interest and penalties, if applicable, for any uncertain tax positions as a component of income tax expense. No interest or penalties were recorded during the years ended December 31, 2017, and December 31, 2016, and period ended December 31, 2015, or accrued for as of December 31, 2017, December 31, 2016 and December 31, 2015.
Results of Operations - For the years ended December 31, 2017 and December 31, 2016, and period ended December 31, 2015
Total investment income for the year ended December 31, 2017 increased to $4,221,130, as compared to $2,048,411 for the year ended December 31, 2016, and $102,611 for the period ended December 31, 2015, which primarily consisted of interest income on investments held during the reporting period due to an increase in the number of investments paying interest, a prepayment fee received from the sale of Rudy's Food Products, Inc. and C&M Technologies Group, Inc., the estimated amount of the exit fee due to the Fund in connection with the purchase of NetFortris Operating Co., Inc., as well as reallocations of investment income due to additional commitments received in 2017 by the Partnership and Parallel Partnership. The average outstanding principal amount of loans made by the Fund (calculated on a monthly basis) during the year ended December 31, 2017 increased to $29,770,694, as compared to $11,299,188 for the year ended December 31, 2016, and $3,971,285 for the period ended December 31, 2015.
As of the years ended December 31, 2017 and December 31, 2016, and the period ended December 31, 2015, all senior subordinated note investments held by the Fund had fixed interest rates. The weighted average interest rate on outstanding senior subordinated loans was 12.08% as of December 31, 2017 as compared to 12.28% as of December 31, 2016, and 12.07% as of December 31, 2015. As of the year ended December 31, 2017, all term note investments held by the Fund had floating interest rates. As of the year ended December 31, 2016 and the period ended December 31, 2015, the Fund did not hold any term notes. The weighted average interest rate on outstanding term loans was 10.33% as of December 31, 2017. Interest is calculated using the effective interest method, and rates earned by the Fund will fluctuate based on factors including, but not limited to, pre-payments of outstanding loans, defaults or uncollectibility of payments, and changes in interest rates.
Total Fund expenses for the year ended December 31, 2017 increased to $1,001,404 as compared to $908,263 for the year ended December 31, 2016, and $627,800 for the period ended December 31, 2015. The expense amount for the year ended December 31, 2017 consisted of investment management fees of $408,448 (gross fees of $416,375 less waived fees of $7,927), professional fees of $296,835, directors’ fees of $171,000, interest expense of $64,220, amortization of deferred financing costs of $38,972 and other general and administrative expenses of $21,929. The expense amount for the year ended December 31, 2016 consisted of investment management fees of $218,230 (gross fees of $295,764 less waived fees of $77,534), professional fees of $508,701, directors’ fees of $172,500, and other general and administrative expenses of $8,832. The expense amount for the period ended December 31, 2015 consisted of investment management fees of $26,195, organizational costs of $342,763, professional fees of $145,000, directors’ fees of $98,926 and other general and administrative expenses of $14,916.
The Fund’s investment management fee for the year ended December 31, 2017, was computed and paid quarterly in arrears in an amount equal to 1.25% per annum of the Fund’s Invested Capital, as measured as of the close of business on the last business day of such quarterly period. On November 9, 2016, the Independent Directors of the Fund’s Board approved amendments to the Investment Management Agreement which included the reduction of the management fee from 1.75% to 1.25% of Invested Capital. Prior to the Independent Director approval of the management fee reduction, the Investment Manager elected to voluntarily waive all management fees greater than 1.25% per annum of the Fund’s invested capital, retroactive to the inception of the Fund. The investment management fee amounted to $408,448 (gross fees of $416,375 less waived fees of $7,927) for the year ended December 31, 2017, as compared to an investment management fee of $218,230 (gross fees of $295,764 less waived fees of $77,534) for the year ended December 31, 2016, and investment management fee of $26,195 for the period ended December 31, 2015. “Invested Capital” means the cost basis of the portfolio investments of the Fund (excluding cash and cash equivalents) that have not been written off or disposed of, including portfolio investments acquired with borrowed funds.
The Fund’s professional fees for the years ended December 31, 2017 and December 31, 2016, and period ended December 31, 2015, were comprised of legal, audit, tax and other professional fees. Other general and administrative expenses included miscellaneous other expenses related to the operation of the Fund.
Net investment income/(loss) for the year ended December 31, 2017 was $1,932,026, as compared to $747,927 for the year ended December 31, 2016, and ($525,189) for the period ended December 31, 2015. The increase in net investment income was due to the increase in the number of investments that pay interest during the reporting period, the sale of Rudy’s Food Products, Inc. and C&M Technologies Group, Inc., the estimated amount of the exit fee due to the Fund in connection with the purchase of NetFortris Operating Co., Inc. as well as reallocations of investment income received in 2017 by the Partnership and Parallel Partnership. The Fund continues to make investments in income-producing assets.
Net realized gain/(loss) during the year ended December 31, 2017 amounted to $158,125. There were no realized/unrealized gains or losses from investments during the year ended December 31, 2016 or period ended December 31, 2015. Net increase/(decrease) in net assets resulting from operations for the year ended December 31, 2017 was $2,090,151 as compared to $747,927 for the year ended December 31, 2016 and ($525,189) for the period ended December 31, 2015.
Due to additional commitments received in 2017 by the Partnership and Parallel Partnership, portfolio investments and items of income and expense were reallocated between the Fund, the Partnership and the Parallel Partnership to reflect committed capital ownership percentages as of the final closing, which occurred on September 29, 2017. Prior to the final closing, portfolio investments and items of income and expense were allocated according to the committed capital ownership percentages as of the final closing. Following the final closing, reallocation of portfolio investments and items of income and expense between the Fund, the Partnership and the Parallel Partnership has occurred. As a result, included in the 2017 Consolidated Statements of Operations for the year ended December 31, 2017 are reallocations of $77,702 (reallocations of investment income totaling $90,814 and reallocations of expenses totaling $13,112).
Financial Condition, Liquidity, and Capital Resources
During the year ended December 31, 2017, the Fund was wholly owned by the Partnership. The Partnership is expected, but not required, to make further contributions of capital to the Fund in an aggregate amount that will not exceed the Partnership’s partners’ capital commitments to the Partnership. As of December 31, 2017 the Partnership (excluding the Parallel Partnership) had received subscriptions for capital in the amount of $112,960,000, of which $42,924,800 had been called and received and of which $34,331,057 was contributed to the Fund. As of December 31, 2017, $70,035,200 of capital remains uncalled by the Partnership.
At December 31, 2017, the Fund had adequate resources consisting of cash on hand, a Money Market Fund and expected future capital contributions from the Partnership that could be used to fund future obligations. The Fund, based upon the investments held at December 31, 2017, expects to receive approximately $3,900,000 in scheduled interest payments over the next year. The future capital contributions and scheduled interest payments are sufficient to meet the requirements of anticipated investments and operational expenses of the Fund over the next year.
As of December 31, 2017, 14.8% of the Fund’s net assets consisted of cash and as of December 31, 2016, 0.7% of the Fund’s net assets consisted of cash. During the year ended December 31, 2017, the Fund invested its assets in senior subordinated notes, term notes and a Money Market Fund and during the year ended December 31, 2016, the Fund invested its assets in senior subordinated notes and a Money Market Fund. During the year ended December 31, 2017, the Fund made its first distribution to the Partnership in the amount of $7,311,442. The principal balance and fair value of loans in the Fund’s investment portfolio at December 31, 2017 and December 31, 2016 was $34,877,049 and $34,384,355, and $23,527,112 and $23,149,094, respectively.
The Fund’s consolidated financial statements include portfolio investments at fair value of $41,154,948 at December 31, 2017 and $23,211,946 at December 31, 2016. The portfolio investments represent 140% of net assets at December 31, 2017 and 129% of net assets at December 31, 2016 and their fair values have been determined in good faith by the Fund’s Board of Directors. Because of the inherent uncertainty of valuation, the determined values may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material. Because the Fund’s investments consist of privately negotiated transactions, investments in these assets are considered to be illiquid.
With respect to leverage, on August 8, 2017, the Fund, the Partnership, and Parallel Partnership, entered into a credit facility of short term borrowings (the “Credit Facility”) to fund the operations of the Fund, Partnership, and Parallel Partnership. Please see Contractual Obligations below for additional information about the Credit Facility.
The Fund is required to maintain a minimum asset coverage ratio (total assets-to-debt outstanding) of 2.00 under the 1940 Act. As of December 31, 2017, the Fund had an asset coverage ratio of 2.75.
On March 28, 2018, the Fund rebalanced its portfolio by distributing $19,612,095 of assets ($17,519,751 of senior subordinated notes and $2,092,344 of term notes) to the Partnership. This rebalancing was completed to help enable the Fund to qualify as a regulated investment company for federal income tax purposes.
Contractual Obligations
The Fund has entered into certain contracts under which it has future commitments. Payments under the Investment Management Agreement, pursuant to which Siguler Guff Advisers has agreed to serve as our investment adviser, are equal to a percentage of the net invested capital of the Fund, including assets acquired with borrowed funds, if any. The Investment Management Agreement will continue in effect until June 8, 2018. Thereafter, regardless of the dissolution of the Fund, if not terminated, the Investment Management Agreement shall continue automatically for successive periods of a year each. Either party may terminate the Investment Management Agreement without penalty on least 60 days’ written notice to the other party. The Fund has also entered into a Custodian Agreement, pursuant to which Citi Private Bank has agreed to serve as the Fund’s custodian (the “Custodian”). The Fund pays the Custodian such fees as have been agreed between the Fund and the Custodian, as described in the Custodian Agreement which Fund has determined are commercially reasonable in its sole discretion.
On August 8, 2017, the Fund, the Partnership, and Parallel Partnership, entered into a Credit Facility in the amount of $10,000,000, collateralized by the unfunded Committed Equity Capital of the Limited Partners of the Partnership and Parallel Partnership. On December 15, 2017, the Credit Facility was amended and increased to $40,000,000. The Credit Facility is intended to fund the operations of the Fund, Partnership, and Parallel Partnership, and is scheduled to expire on August 8, 2018, subject to extension. In consideration for establishing the Credit Facility, the Partnership and Parallel Partnership paid a Facility Fee in the amount of 0.25% times the maximum commitment amount. The Credit Facility is stated at its outstanding principal amount and bears interest on the outstanding principal amount at a rate per annum equal to LIBOR plus 1.55%. In addition, an unused commitment fee equal to 0.25% per annum times the difference between the total commitment amount and the average daily outstanding amount of principal is incurred as an expense. As of December 31, 2017, the Credit Facility held an outstanding balance of $21,700,000, of which the Fund’s portion was $16,800,000 at a rate of between 2.78% and 3.11%.
As mentioned in the above paragraph, the Fund does bear interest on its outstanding principal amount and is subject to certain fees and costs that could affect its liquidity and cash flows. As of December 31, 2017, the Fund had incurred financing obligations with respect to interest on borrowings, undrawn fees or unused commitment fees that could have an impact on liquidity cash flows.
Taxation of the Fund as a RIC
Consequences of Converting From an Ordinary Corporation to a RIC. In order to qualify as a RIC, the Fund must, at the end of the first year in which it so qualifies, have no accumulated earnings and profits from years in which it was not taxed as a RIC. To meet this requirement, the Fund must, before the end of the first year in which it qualifies as a RIC, distribute as dividends all of its accumulated earnings and profits. In addition to the foregoing, pursuant to the Treasury regulations, the Fund must either (i) recognize gain on the disposition of any asset during the subsequent recognition period (generally 10 years) (the “Recognition Period”) beginning on the first day of the first taxable year for which the Fund qualifies for pass-through status as a RIC that is held by the Fund as of the beginning of such Recognition Period, to the extent of the excess of (a) the fair market value of such asset as of the beginning of such Recognition Period over (b) the Fund’s adjusted tax basis in such asset as of the beginning of such Recognition Period (such excess, hereinafter, “built-in gain”), taxable at the highest regular corporate rates or (ii) elect to immediately recognize and pay tax on any such built-in gain with respect to any of its portfolio holdings and, as described above, distribute the earnings and profits from such deemed sales. As a RIC, the Fund generally would not be able to use any net operating loss carryforwards relating to periods prior to the first year in which the Fund qualifies as a RIC.
RIC Qualification Requirements. In order to qualify as a RIC under Subchapter M of the Code, the Fund must, among other things, (1) at all times during the taxable year, have a valid and effective election to be a BDC under Sections 6(f) and 54 of the 1940 Act; (2) derive at least 90% of its gross income for each taxable year from dividends, interest, payments with respect to securities loans, gains from the sale or other disposition of stock, securities or foreign currencies, or other income (including gains from options, futures and forward contracts) derived with respect to its business of investing in such stock, securities or currencies, and net income derived from an interest in a qualified publicly traded partnership (as defined in Section 851(h) of the Code); (3) diversify its holdings so that, at the end of each quarter of each taxable year: (a) at least 50% of the value of the Fund’s total assets is represented by (i) cash and cash items, U.S. government securities, and securities of other RICs, and (ii) other securities (counting each investment in such other securities only if the value of such securities does not exceed 5% of the value of the Fund’s total assets and the Fund does not own more than 10% of the outstanding voting securities of the issuer of such securities), and (b) not more than 25% of the value of the Fund’s total assets is invested in (i) the securities (other than U.S. government securities and securities of other RICs) of any one issuer, (ii) the securities (other than securities of other RICs) of two or more issuers that the Fund controls (defined as 20% or more of the voting power) and that are engaged in the same, similar, or related trades or businesses, or (iii) the securities of one or more qualified publicly traded partnerships; and (4) file an election to be a RIC.
If the Fund qualifies as a RIC and properly distributes to its shareholders each taxable year an amount equal to or exceeding the sum of (1) 90% of its “investment company taxable income” as that term is defined in the Code (which includes, among other things, dividends, taxable interest, and the excess of any net short-term capital gains over net long-term capital losses, as reduced by certain deductible expenses) without regard to the deduction for dividends paid and (2) 90% of the excess of its gross tax-exempt interest, if any, over certain disallowed deductions, the Fund generally will not be subject to U.S. federal income tax on any income of the fund, including “net capital gain” (the excess of net long-term capital gain over net short-term capital loss), distributed to the shareholders. However, if the Fund meets such distribution requirements and, thus, is eligible for pass-through status, but chooses to retain some portion of its investment company taxable income or net capital gain, it generally will be subject to U.S. federal income tax at regular corporate income tax rates on the amount retained. A distribution of warrants or equity investments to its shareholders will be treated as a sale by the Fund of such assets with the excess of the fair market value of those assets over their tax basis being the amount of the income or gain to the Fund arising from the distribution.
If, after initially qualifying as a RIC, the Fund fails to qualify as a RIC that is eligible for pass-through status for any taxable year, it will be treated as a U.S. corporation subject to U.S. federal income tax, thereby subjecting any income earned by the Fund to tax at the corporate level and to a further tax at the shareholder level when such income is distributed. In such a case, there may be substantial tax and other costs associated with re-qualifying as a RIC.
If the Fund qualifies as a RIC, the Fund will be subject to a nondeductible 4% excise tax (“Excise Tax”) to the extent it fails to distribute by the end of any calendar year at least 98% of its ordinary income for such calendar year and 98.2% of its capital gain net income for the one-year period ending on October 31 of such calendar year, plus certain other undistributed amounts. For these purposes, any taxable income retained by the Fund, and on which it pays federal income tax, will be treated as having been distributed.
The Fund currently intends to distribute in each year for which it qualifies as a RIC substantially all of its net investment income and capital gain net income so as not to be subject to either federal income tax or Excise Tax.
Tax Status. The Fund must meet a number of requirements, described above under the caption “Taxation” to qualify for the pass-through status as a RIC and, if qualified, to continue to so qualify. If the Fund experiences difficulty in meeting the diversification requirement for any fiscal quarter of its taxable year, it may accelerate capital calls or, if available, borrowings in order to increase the portion of the Fund’s total assets represented by cash, cash items and U.S. government securities as of the close of the following fiscal quarter and thus attempt to meet the diversification requirement. The Fund, however, would incur additional interest and other expenses in connection with any such accelerated borrowings, and increased investments by the Fund in cash, cash items and U.S. government securities (whether the funds to make such investments are derived from called equity capital or from accelerated borrowings) are likely to reduce the Fund’s return. Furthermore, there can be no assurance that the Fund would be able to meet the diversification requirements through such actions. Failure to qualify as a RIC would deny the Fund pass-through status and, in a year in which the Fund has taxable income, would have a significant adverse effect on the returns of the Fund.
When the Fund elects to convert its status from that of an ordinary, or C, corporation to that of a RIC, it must choose either to (i) pay tax whenever an asset is sold during the subsequent “conversion period” (generally, ten years) following the conversion on the amount of gain which would have been realized had the asset been sold on the conversion date, or (ii) treat the entire amount of “built-in gain” as income at the time of conversion.
Effect of Certain Investments and Investment Practices. The Fund’s activities generally may be unlike the typical activities engaged in by most investment companies that seek to qualify as RICs for federal income tax purposes. Certain aspects of these activities may at times make it more difficult for the Fund to satisfy the requirements for qualifying as a RIC than is the case for other investment companies. For example, because the Fund generally will call capital from the Partnership on an “as needed” basis and will have relatively few investments in its early period of operations, the Fund will not be holding substantial amounts of “cash and cash items” that could be counted towards the Fund’s RIC diversification requirements. As noted above, it is anticipated that the Fund will not meet the RIC requirements (and in particular the diversification requirement) until the third year of its investment operations, and there is no assurance that the Fund will meet the requirements to qualify as a RIC within that timeframe.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The Fund is subject to financial market risks, including changes in interest rates. Changes in interest rates may affect both the cost of funding and our interest income from portfolio investments. The Fund’s risk management processes and procedures are designed to identify and analyze risk, to set appropriate policies and limits and to continually monitor these risks and limits by means of administrative and information systems and other policies and programs. The investment income will be affected by changes in various interest rates, including LIBOR and prime rates, to the extent the debt investments include floating interest rates. In addition, the investments are carried at fair value as determined in good faith by the Board of Directors. The valuation methodology utilizes discount rates in part in valuing our investments, and changes in those discount rates may have an impact on the valuation of our investments.
The Fund’s business activities entail various elements of risk. The Fund considers the principal types of market risk to be interest rate risk, credit risk and valuation risk. Accordingly, the Fund’s risk management procedures are designed to identify and analyze the Fund’s risks, to set appropriate polices and limits and to continually monitor these.
The Fund intends to manage its risk by maintaining a portfolio that is diverse by industry, size of investment, and borrowers. The Fund has limited exposure to public market price fluctuations as the Fund invests in the debt of private business enterprises. The equity investment accompanying most debt investments (which, if it becomes publicly-traded, is subject to enhanced market risk) is generally made by the Partnership.
The Fund’s sensitivity to changes in interest rates is regularly monitored and analyzed by measuring the characteristics of assets and liabilities. The Fund uses various methods to assess interest rate risk in terms of the potential effect on interest income and investment valuation. The Fund’s valuation methodology utilizes discount rates as part of valuing its investments and changes in those discount rates, and interest rates in general, would be expected to have an impact on the valuation of investments. Assuming no changes in investment and capital structure, a hypothetical increase in discount rates of 100 basis points would decrease the Fund’s net assets resulting from operations by an estimated $1,109,000.
As previously discussed in Contractual Obligations under Item 7 of this 10-K, the Fund entered into a Credit Facility agreement on August 8, 2017 and amended on December 15, 2017, and as of December 31, 2017, held an outstanding balance of $16,800,000. Because the Fund has elected to use leverage in the form of a Credit Facility, its sensitivity to changes in interest rates and other risks could be substantially greater. Assuming no changes in the Credit Facility structure, a hypothetical increase in discount rates of 100 basis points would decrease the Fund’s net assets resulting from operations by an estimated $44,000.
The Fund intends to manage credit risk through diversification, and continually monitors the financial condition of its borrowers and reports thereon to the Fund’s Board of Directors.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholder of Siguler Guff Small Business Credit Opportunities Fund, Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated statements of assets and liabilities, including the consolidated schedules of portfolio investments, of Siguler Guff Small Business Credit Opportunities Fund, Inc. and its subsidiaries as of December 31, 2017 and 2016, and the related consolidated statements of operations, changes in net assets and cash flows for each of the two years in the period ended December 31, 2017, and for the period October 13, 2015 (inception) through December 31, 2015, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of their operations, changes in their net assets and their cash flows for each of the two years in the period ended December 31, 2017 and for the period October 13, 2015 (inception) through December 31, 2015 in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“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 of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated 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 regarding the amounts and disclosures in the consolidated 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 consolidated financial statements. Our procedures included confirmation of investments owned as of December 31, 2017 and 2016 by correspondence with the custodian. We believe that our audits provide a reasonable basis for our opinion.
/s/ PriceWaterhouseCoopers LLP
New York, New York
March 29, 2018
We have served as the Company’s auditor since 2015.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Consolidated Statements of Assets and Liabilities
The accompanying notes are an integral part of these consolidated financial statements.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Consolidated Schedules of Portfolio Investments
December 31, 2017
Notes:
(1)
The Company classifies its investments in accordance with the requirements of the 1940 Act. Under the 1940 Act, "Control Investments" are defined as investments in companies in which the Company owns more than 25% of the voting securities or has rights to maintain greater than 50% of the board representation; "Affiliate Investments" are defined as investments in companies in which the Company owns between 5% and 25% of the voting securities; and "Non-Control/Non-Affiliate Investments" are defined as investments that are neither Control Investments nor Affiliate Investments. The Portfolio Investments are classified as Non-Control/Non-Affiliate Investments.
(2)
The Portfolio Investments are valued using unobservable inputs (Level 3). Refer to Note 2 in the accompanying notes to the consolidated financial statements for more information.
(3)
The Portfolio Investments have a stated payment-in-kind interest income rate of up to 2.00% which is not reflected in the stated interest rate.
(4)
The interest rate of this investment is equal to LIBOR plus 9.50%.
(5)
The interest rate of this investment is equal to the greater of LIBOR plus 8.40% or 8.90% through the fiscal quarter ending December 31, 2017. Thereafter, the interest rate is equal to the greater of LIBOR plus 8.40% or 8.90% if the senior leverage ratio is greater than or equal to 3.50x, the greater of LIBOR plus 9.00% or 9.50% if the senior leverage ratio is less than 3.50x and greater than or equal to 3.00x or the greater of LIBOR plus 9.50% or 10.00% if the senior leverage ratio is less than 3.00x. The senior leverage ratio is equal to total obligations minus total cash divided by EBITDA of the portfolio investment.
(6)
The interest rate of this investment is equal to LIBOR plus 9.00%.
The accompanying notes are an integral part of these consolidated financial statements.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Consolidated Schedules of Portfolio Investments
December 31, 2016
Notes:
(1)
The Company classifies its investments in accordance with the requirements of the 1940 Act. Under the 1940 Act, "Control Investments" are defined as investments in companies in which the Company owns more than 25% of the voting securities or has rights to maintain greater than 50% of the board representation; "Affiliate Investments" are defined as investments in companies in which the Company owns between 5% and 25% of the voting securities; and "Non-Control/Non-Affiliate Investments" are defined as investments that are neither Control Investments nor Affiliate Investments. The Portfolio Investments are classified as Non-Control/Non-Affiliate Investments.
(2)
The Portfolio Investments are valued using unobservable inputs (Level 3). Refer to Note 2 in the accompanying notes to the consolidated financial statements for more information.
(3)
The Portfolio Investments have a stated payment-in-kind interest income rate of up to 2.00% which is not reflected in the stated interest rate.
The accompanying notes are an integral part of these consolidated financial statements.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Consolidated Statements of Operations
The accompanying notes are an integral part of these consolidated financial statements.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Consolidated Statements of Changes in Net Assets
The accompanying notes are an integral part of these consolidated financial statements.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these consolidated financial statements.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
1.
Business and Organization
Siguler Guff Small Business Credit Opportunities Fund, Inc. (“SBCOF” or the “Company”), was incorporated in Maryland on July 7, 2014 as a non-diversified, closed-end management investment company and has elected status as a business development company (a “BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”) on July 1, 2015. Siguler Guff Advisers, LLC (the “Investment Manager”) serves as the Company’s Investment Manager. The Investment Manager is an investment adviser registered with the U.S. Securities and Exchange Commission, pursuant to the 1940 Act. One hundred percent of the stock of the Company is held by Siguler Guff Small Business Credit Opportunities Fund, LP (the “Partnership”). Prior to commencing its operations on October 13, 2015, the Company had no operations other than the issuance to the Partnership of 100,000 shares of common stock, $0.001 par value for $25,000 in September 2014.
Since the Partnership owns one hundred percent of the stock of the Company, the term of the Company will be the same as that of the Partnership. The term of the Partnership will continue until the later to occur of: (a) September 17, 2026, or (b) the date of which all the Partnership’s assets have been distributed and the Partnership’s obligations (including contingent obligations) have terminated, unless the Partnership is sooner dissolved in accordance with Article 9 of its Partnership Agreement dated July 9, 2014 and amended as of July 12, 2017. The term may be extended for up to three additional years with the consent of the Advisory Board.
The Company’s investment objective is to achieve attractive risk-adjusted returns by generating current income from debt investments. There can be no assurance that the Company will attain its investment objective. The Company will typically invest in U.S. companies in the lower middle market segment. The Investment Manager defines the “lower middle market” as privately-owned companies with between $2 to $15 million of earnings before interest, taxes, depreciation, and amortization (“EBITDA”), and between $10 to $100 million of revenue. Investments take the form of mezzanine debt as well as some “unitranche” loans with a first lien on a company’s assets, as well as second lien loans. The Partnership generally seeks to purchase equity securities alongside the Company’s investments into those same companies, generally with an aggregate cost of up to 20% of the value of the Company’s total investment. The Company also may extend mezzanine financing in forms other than subordinated loans, such as convertible loans and preferred stock.
The Company jointly co-invests in investments alongside the Partnership and Siguler Guff SBCOF Parallel Fund, LP (the “Parallel Partnership”) and may co-invest with other investment funds managed by or otherwise affiliated with the Investment Manager (collectively, the “Affiliated Funds”). The Company and the Affiliated Funds generally invest pro-rata and pari passu with each other in investments, except when tax, regulatory or investment restrictions prevent the Company or the Affiliated Funds from investing. The General Partner of the Partnership and Parallel Partnership is an Affiliate of the Investment Manager.
The Company is subject to certain investment guidelines and restrictions as set forth in its registration statement filed with the U.S. Securities and Exchange Commission on Form 10.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
2.
Summary of Significant Accounting Policies
Basis of Accounting
These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates and such differences could be material. The most significant estimates inherent in the preparation of the Company's consolidated financial statements are the valuation of investments and revenue recognition.
The Company is an investment company and follows the accounting and reporting guidance as prescribed by Financial Accounting Standards Board ("FASB") Accounting Standards Codification (“ASC”) 946, Financial Services - Investment Companies (“ASC 946”).
The financial statements include portfolio investments at fair value of $41,154,948 at December 31, 2017 and $23,211,946 at December 31, 2016. The portfolio investments represent 140% of net assets at December 31, 2017 and 129% of net assets at December 31, 2016 and their fair values have been determined in good faith by the Company's Board of Directors (“Directors”). Because of the inherent uncertainty of valuation, the determined values may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.
Consolidation
The Company has certain wholly-owned subsidiaries, including subsidiaries that are not consolidated for U.S. federal income tax purposes, which hold certain portfolio investments of the Company. These subsidiaries are consolidated with the Company for accounting purposes, and the portfolio investments held by the subsidiaries are included in the Company's consolidated financial statements as investments. All significant intercompany balances and transactions have been eliminated. The investments held through the subsidiaries are reflected in the Consolidated Schedule of Portfolio Investments in addition to any investments the Company holds directly. As provided under Regulation S-X and ASC 946, the Company will generally not consolidate its investment in a company other than a wholly-owned investment company or a controlled operating company whose business consists of providing services to the Company. Accordingly, the Company consolidated the results of certain of its wholly-owned subsidiaries in its financial statements.
Valuation of Portfolio Investments
The FASB ASC 820, Fair Value Measurements and Disclosures ("ASC 820") defines fair value as the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A liability's fair value is defined as the amount that would be paid to transfer the liability to a new obligor, not the amount that would be paid to settle the liability with the creditor. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available or reliable, valuation techniques are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the investments or market and the investments' complexity.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
Assets and liabilities recorded at fair value in the Company's consolidated financial statements are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by ASC 820 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:
·
Level 1 - Unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.
·
Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data at the measurement date for substantially the full term of the assets or liabilities.
·
Level 3 - Unobservable inputs that reflect management's best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.
Under ASC 820, the Company performs detailed valuations of its debt investments for which quotations are not readily available on an individual basis, using bond yield, market and income approaches as appropriate. In certain instances, the Company may use alternative methodologies, including recent purchase transactions, asset liquidation, expected recovery model or other alternative approaches to estimate the fair value.
Investments where market quotations for securities of the same issue are readily available on an exchange are marked-to-market at fair value at the closing price on the financial statement date. Financial instruments with readily available quoted prices generally will have a higher degree of market price observability and a lesser degree of judgment inherent in measuring fair value.
Under the bond yield approach, the Company uses bond yield models to determine the present value of the future cash flow streams of its debt investments. The Company reviews various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assesses the information in the valuation process.
Under the market approach, the Company estimates the enterprise value of the portfolio companies in which it invests. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise value is best expressed as a range of fair values, from which the Company derives a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, the Company analyzes various factors, including the portfolio company's historical and projected financial results. Typically, private companies are valued based on multiples of EBITDA, cash flows, net income or revenues. The Company generally requires portfolio companies to provide annual audited and quarterly or monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year.
Under the income approach, the Company generally prepares and analyzes discounted cash flow models based on projections of the future free cash flows of the business.
The fair value of the Company's portfolio investments at December 31, 2017 and December 31, 2016 was determined in good faith by the Directors. The Directors are ultimately responsible for the valuation of the portfolio investments at fair value as determined in good faith pursuant to the Company's valuation policy. Because of the inherent uncertainty of valuation, these estimated fair values do not necessarily represent amounts that might be ultimately realized and the differences could be material.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
The following table summarizes the level of the Company’s assets measured at fair value as of December 31, 2017 and December 31, 2016:
At December 31, 2017 and December 31, 2016, 100% of the Company’s Portfolio Investments have been classified within Level 3, with the exception of the Money Market Fund. Assumptions used by the Company due to the lack of observable inputs may significantly impact the resulting fair value and therefore the Company's results of operations.
The following table summarizes the significant unobservable inputs the Company used to value investments categorized within Level 3. The below table is not intended to be all-inclusive, but instead captures the significant unobservable inputs relevant to the determination of fair values:
Not reflected in the table above are Level 3 investments that have been primarily valued based upon recent transactions totaling $11,595,671 as of December 31, 2017.
Not reflected in the table above are Level 3 investments that have been primarily valued based upon recent transactions totaling $8,411,791 as of December 31, 2016.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
The following is a rollforward of the portfolio investments in which significant unobservable inputs (Level 3) were used in determining fair value:
Fair Value Measurements using Significant Unobservable Inputs (Level 3)
Net change in unrealized gain/(loss) and net realized gain/(loss), if any, on Level 3 Portfolio Investments in the table above are included in the accompanying Consolidated Statement of Operations. For the years ended December 31, 2017 and December 31, 2016, the Company has a net change in unrealized gain/(loss) of $0 on Level 3 portfolio investments still held by the Company as of the financial statement date.
Investments
Security transactions are accounted for on the trade date unless there are substantial conditions to the purchase. Realized gains or losses are measured by the difference between the net proceeds from the repayment or sale and the amortized cost basis of the investment. Unrealized gains or losses primarily reflect the change in investment values, including the reversal of previously recorded unrealized gains or losses when gains or losses are realized. Realized gains or losses on the disposition of investments are calculated using the specific identification method.
Cash
Cash is comprised of deposit accounts held at one United States financial institution. During the year, the balances held at the financial institution may at times exceed federally insured limits.
Income and Expense
Interest income is recorded on an accrual basis to the extent that such amounts are expected to be collected. The Company stops accruing interest on investments when it is determined that interest is no longer collectible. Fees received upon closing a transaction generally are treated as a reduction in the cost basis of the investment. Any resulting discount, or closing fee received, from recording the loan or otherwise purchasing a security at a discount, is accreted into interest income over the life of the loan using the effective-yield method.
The Company has investments in debt securities which contain payment-in-kind ("PIK") interest provisions. PIK interest is computed at the contractual rate specified in each investment agreement and added to the principal balance of the investment and recorded as interest income. The Company stops accruing PIK interest on investments when it is determined that PIK interest is no longer collectible.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
Other income includes the estimated amount of the exit fee due to the Company in connection with the purchase of the NetFortris Operating Co., Inc. term notes as well as a prepayment fee received in connection with the sale of the Rudy's Food Products, Inc. and C&M Technologies Group, Inc. senior subordinated notes.
Expenses include investment management fees, organizational costs, legal fees, directors' fees, audit and tax service expenses, interest expense and other general and administrative expenses. Expenses are recognized on an accrual basis.
Reallocations
Additional Limited Partners may be admitted to the Partnership and existing Limited Partners may increase their Capital Commitments, with the consent of the General Partner at any time up to and including the Final Closing. Each Capital Commitment of such additional Limited Partner and each increased Capital Commitment, shall be treated as having been made, as of the Initial Closing date for all purposes of the Agreement.
Due to additional commitments received in 2017 by the Partnership and Parallel Partnership, portfolio investments and items of income and expense have been reallocated between the Company, the Partnership and the Parallel Partnership to reflect committed capital ownership percentages as of the Final Closing, which occurred on September 29, 2017.
Prior to the Final Closing, portfolio investments and items of income and expense were allocated according to the committed capital ownership percentages as of the latest Closing. Following the Final Closing, reallocation of portfolio investments and items of income and expense between the Company, the Partnership and the Parallel Partnership has occurred.
As a result, included in the Consolidated Statements of Operations for the year ended December 31, 2017 are reallocations of amounts previously included in the Consolidated Statements of Operations for the year ended December 31, 2016. Below is a summary of such adjustments:
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
Income Taxes
On December 22, 2017, H.R. 1, also known as the Tax Cuts and Jobs Act (the “Tax Act”), was enacted, which significantly revised U.S. corporate income tax by, lowering corporate income tax rates. FASB ASC 740, Income Taxes (“ASC 740”), requires the re-measurement of U.S. deferred tax assets and liabilities that existed as of December 22, 2017, to the new federal income tax rate of 21% as well as any federal impact associated with state and local deferred income taxes. As of December 31, 2017, the Company has accounted for the effects of the Tax Act by recording a decrease to its net deferred tax assets of $67,645 and a corresponding decrease of $67,645 to the valuation allowance. As a result, there is a gross impact to the tax provision from the re-measurement of U.S. deferred tax assets at lower enacted tax rates. However, since there is a full valuation allowance being recorded by the Company against its net deferred tax assets as of December 31, 2017, there is no impact on the Company’s tax provision for the year ended December 31, 2017, as a result of the Tax Act.
During the years ended December 31, 2017 and December 31, 2016 and the period ended December 31, 2015, the Company did not qualify to be treated as a regulated investment company, or RIC, for federal income tax purposes. As such, the Company will be treated as a corporation for U.S. federal income tax purposes. It is anticipated that, commencing during the first quarter of 2018, the Company will seek to meet the requirements, including diversification, gross income, and distribution requirements, to qualify for the special pass-through status available to RICs under the Internal Revenue Code, and thus to be relieved of federal income tax on that part of its net investment income and realized capital gains that it distributes. Unless and until the Company meets these requirements, it will be taxed as a corporation on its taxable income for that year even if that income is distributed to the Partnership (its sole stockholder), and all distributions out of its earnings and profits will be taxable as dividends to the investors of the Partnership; thus, such income will be subject to two layers of tax (although corporate Limited Partners may be entitled to a dividends-received deduction). There is no assurance that the Company will meet the requirements to qualify as a RIC or be able to maintain such status.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
Income taxes payable/(receivable) and prepaid taxes, including deferred benefits, consists of the following:
The provision for income taxes is composed of the following charges/(benefits):
(1)
The current federal income tax (benefit)/expense, for the year ended December 31, 2016, is net of the use of federal net operating losses totaling $45,939.
(2)
The current state income tax (benefit)/expense, for the year ended December 31, 2016, is net of the use of state net operating losses totaling $41,822.
The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined on the basis of the differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
The deferred tax assets and liabilities have been recognized in the Consolidated Statement of Assets and Liabilities as follows:
The Company recognizes deferred tax assets to the extent that it believes these assets are more likely than not to be realized. In making such a determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations.
As of December 31, 2017 and December 31, 2016, the Company concluded that it was more likely than not that an amount of the deferred tax assets, relating to the period after RIC qualification, would not be utilized. Therefore, the Company recorded a valuation allowance of $130,190 and $168,986 against its net deferred tax assets, for the years ending December 31, 2017 and December 31, 2016, respectively, representing the portion of net deferred tax assets for which the Company is not expected to realize a benefit after the Company meets RIC qualification. If the Company determines that it would be able to realize net deferred tax assets in the future in excess of their net recorded amount, it would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes.
As of December 31, 2017 and December 31, 2016, the Company had no federal or state net operating loss carryforwards.
The effective tax rate varied from the statutory federal income tax rates. The effective tax rate is affected by a number of factors, the most significant of which has been the state income taxes, changes in tax law and valuation allowance related to our deferred tax assets.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
The Company records uncertain tax positions in accordance with ASC 740 on the basis of a two-step process whereby (1) it determines whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, it recognizes the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. The Company has determined that there are no uncertain tax positions that would have a material impact to the financial statements of the Company, and therefore, no provisions are required to be recorded by the Company. The Company does not anticipate significant increases to uncertain tax positions in the next twelve months. The Company will recognize any interest and penalties, if applicable, for any uncertain tax positions as a component of income tax expense. No interest or penalties were recorded during the year ended December 31, 2017 or accrued for as of December 31, 2017 and December 31, 2016.
The Company files tax returns as prescribed by the tax laws of the jurisdictions in which it operates. In the normal course of business, the Company is subject to examination by federal, state, local and foreign jurisdictions, where applicable. At December 31, 2017, no examinations were being conducted by the Internal Revenue Service or any other taxing authority. Under the respective statute of limitations, tax years beginning in 2015 remain subject to examination by the various tax jurisdictions.
Other Receivable
Included in other receivable is the estimated amount of the exit fee due to the Company in connection with the purchase of the NetFortris Operating Co., Inc. term notes. The exit fee rate is 2.75% per year of the outstanding principal balance of the term notes through the fiscal quarter ending December 31, 2017. Thereafter, the exit fee rate is 2.75% per year of the outstanding principal balance of the term notes if the senior leverage ratio of the portfolio investment is greater than or equal to 3.50x, 1.25% per year of the outstanding principal balance of the term notes if the senior leverage ratio of the portfolio investment is less than 3.50x and greater than or equal to 3.00x or 0.25% per year of the outstanding principal balance of the term notes if the senior leverage ratio of the portfolio investment is less than 3.00x. The exit fee accrues monthly and will be repaid in addition to the principal at the maturity date, or if repaid earlier.
Investor Note Credit Facility
On August 8, 2017, the Company, Partnership and Parallel Partnership entered into a credit facility of short term borrowings (the “Credit Facility”) in the amount of $10,000,000 collateralized by the unfunded Committed Equity Capital of the Limited Partners of the Partnership and Parallel Partnership. On December 15, 2017, the Credit Facility was amended and increased to $40,000,000. The Credit Facility is intended to fund the operations of the Company, Partnership and Parallel Partnership and is scheduled to expire on August 8, 2018, subject to extension. In consideration for establishing the Credit Facility, the Partnership and Parallel Partnership paid a Facility Fee in the amount of 0.25% times the maximum commitment amount. The Credit Facility is stated at its outstanding principal amount and bears interest on the outstanding principal amount at a rate per annum equal to LIBOR plus 1.55%. In addition, an unused commitment fee equal to 0.25% per annum times the difference between the total commitment amount and the average daily outstanding amount of principal is incurred as an expense. As of December 31, 2017, the Credit Facility held an outstanding balance of $21,700,000 of which the Company’s portion was $16,800,000 at a rate between 2.78% and 3.11%. The weighted average interest rate from the date of the first drawdown was 2.86%. The balance presented on the Consolidated Statement of Assets and Liabilities approximates its fair value, which would be categorized as Level 3 within the fair value hierarchy.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
The Company is required to maintain a minimum asset coverage ratio (total assets-to-debt outstanding) of 2.00 under the 1940 Act. As of December 31, 2017, the Company had an asset coverage ratio of 2.75.
Deferred Financing Costs
Deferred financing costs consist of fees and expenses paid in connection with the closing of and amendment to the Company’s Credit Facility. These costs are amortized using the straight-line method over the term of the Credit Facility. Deferred financing costs related to the Credit Facility are presented on the Company’s Consolidated Statement of Assets and Liabilities.
Recent Accounting Pronouncements
In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606) ("ASU 2014-09"). Under ASU 2014-09, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The amendments in ASU 2014-09 are effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations, which clarifies the guidance in ASU 2014-09 and has the same effective date as the original standard. In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, an update on identifying performance obligations and accounting for licenses of intellectual property. In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients, which includes amendments for enhanced clarification of the guidance. In December 2016, the FASB issued ASU 2016-20, Technical Corrections and Improvements to Revenue from Contracts with Customers (Topic 606), the amendments in this update are of a similar nature to the items typically addressed in the technical corrections and improvements project. Additionally, in February 2017, the FASB issued ASU 2017-05, Other Income - Gains and Losses from the Derecognition of Nonfinancial Assets (subtopic 610-20): Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets, an update clarifying that a financial asset is within the scope of Subtopic 610-20 if it is deemed an “in-substance non-financial asset.” The Company is currently assessing the impact of ASU 2014-09 and does not believe that there would be a material impact on the Consolidated Financial Statements.
3.
Portfolio Investments
The terms and conditions of the portfolio investments, including restrictions on resale, are subject to the terms of the companies’ purchase and sale agreements, limited partnership agreements, private placement memoranda and other governing documents.
Purchases of investments for the year ended December 31, 2017 totaled $26,020,030 with an additional $1,461,296 being reallocated from the Parallel Partnership due to the reallocation of Portfolio Investments (see Note 2). Sales of investments for the year ended December 31, 2017 totaled $9,961,129. Purchases of investments for the year ended December 31, 2016 totaled $10,351,699. There were no sales, repayments or other exits of investments for the year ended December 31, 2016.
At December 31, 2017 and December 31, 2016, the cost of portfolio investments for federal income tax purposes was $30,498,160 and $23,324,043, respectively. There was no aggregate or net unrealized appreciation/(depreciation) of portfolio investments for federal income tax purposes.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
The Company’s investment holdings are illiquid, with the exception of the Money Market Fund, and are subject to redemption/resale restrictions in accordance with their respective agreements.
The Company’s investments are subject to general economic, political and market risk. These factors may affect the level and volatility of prices and the liquidity of Portfolio Investments, which could adversely affect the Company’s profitability or result in losses.
In addition, the Company is subject to credit risk (the risk that an issuer or borrower will default in the payment of principal and/or interest on an instrument), interest rate risk (the risks associated with market changes in interest rates), illiquidity risk/risks of investing in smaller and lower middle market size companies (the risk that the value of Portfolio Investment will decline sharply after its purchase, whether because of adverse developments affecting that security or a general withdrawal of capital from the small and lower middle market) and concentration/lack of diversification risk (various factors, including prevailing market conditions, available investment opportunities, regulatory constraints, constraints imposed by certain portfolio companies, and the timing of investments, may prevent the Investment Manager from diversifying the Company’s portfolio or may result in the Company’s portfolio not being as diversified as the Investment Manager may otherwise prefer).
Lastly, the Company is subject to subordination of interest risk. Portfolio Investments may be in subordinated loans, structurally subordinated loans, mezzanine loans and other structured investments and preferred equity interests or equity interests of an issuer. These Portfolio Investments will be subordinated to the senior obligations of the property or issuer, either contractually, structurally or inherently due to the nature of the securities. Greater credit risks are usually attached to these subordinated investments than to investments in senior obligations. In addition, these securities may not be protected by financial or other covenants, such as limitations upon additional indebtedness, typically protecting the senior debt, and may have limited liquidity.
The Company’s risk of loss related to any one investment is generally limited to its aggregate investment in such Portfolio Investment.
4.
Capital Stock
The Company is owned entirely by the Partnership, to which the Company sold 100,000 shares (“Initial Shares”), at a price of $0.25 per share in an offering exempt from the registration requirements of the Securities Act of 1933, as amended (“1933 Act”) pursuant to Section 4(a)(2) and Regulation D (“Regulation D”) thereof. The Partnership offers and sells limited partnership interests (the “Interests”) to investors (the “Limited Partners”) in an offering exempt from the registration requirements of the 1933 Act pursuant to Regulation D, and will sell its Interests in offerings solely to persons that are both “accredited investors”, as that term is defined in Regulation D, and “qualified purchasers” within the meaning of the 1940 Act. To the extent called for by the Company, the Partnership, subject to its approval of the need for such funds, may make further contributions to the capital of the Company to the extent of the Limited Partners’ capital commitment to the Partnership (“Committed Equity Capital”). Total Committed Equity Capital of the Partnership is $112,960,000. Total contributed capital to the Partnership through December 31, 2017 was $42,924,800, of which $34,331,057 was contributed to the Company.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
Two Limited Partners of the Partnership have Committed Equity Capital in excess of ten percent of the total Committed Equity Capital of the Partnership, which cumulatively represent approximately 29% of the total Committed Equity Capital of the Partnership. The concentration of these partners’ Committed Equity Capital could have a material effect on the Partnership and the Company in the event of default or other actions by these partners.
As of December 31, 2017 and December 31, 2016, there were 10,000,000 shares of $0.001 par value common stock authorized, and 100,000 shares issued and outstanding.
5.
Distributions
Distributions are declared at the sole discretion of the Directors. On October 18, 2017, the Company declared and paid its first distribution to the Partnership in the amount of $7,311,442 or $73.11 per share. From inception through December 31, 2017, the Company has distributed $7,311,442 to the Partnership.
6.
Related Party Transactions
The Company has a Board of Directors, a majority of whom are directors that are not “interested persons” of the Company, as defined in the 1940 Act (the “Independent Directors”). During the years ended December 31, 2017 and December 31, 2016 and the period ended December 31, 2015, the Independent Directors received compensation from the Company aggregating to $171,000, $172,500 and $98,926, respectively.
The General Partner of the Partnership and Parallel Partnership has committed $10,000 each to the Partnership and Parallel Partnership, and Affiliates of the General Partner have committed $300,000 and $12,030,000 to the Partnership and Parallel Partnership, respectively.
Due from Affiliate represents amounts paid on behalf of the Company by the Parallel Partnership in connection with the purchase of underlying investments and income and expenses paid or received on behalf of the Company as a result of reallocations (see Note 2).
Due to Affiliate represents amounts paid on behalf of the Company by the Investment Manager in connection with expenses paid on behalf of the Company.
7.
Fees and Expenses
As compensation for its services, the Investment Manager will receive an investment management fee from the Company (the “Investment Management Fee”). For the period from October 13, 2015 (commencement of operations) through November 8, 2016, the Investment Management Fee was paid by the Company quarterly in arrears in an amount equal to 1.75% per annum of the Company’s Invested Capital, as measured as of the close of business on the last business day of such quarterly period. “Invested Capital” means the cost basis of the portfolio investments of the Company (excluding cash and cash equivalents) that have not been written off or disposed of, including portfolio investments acquired with borrowed funds. On March 29, 2016, the Investment Manager voluntarily reduced the Investment Management Fee to 1.25% per annum (effective as of the commencement of the Company’s operations). The Investment Manager has no ability to claw back any Investment Management Fees waived. On November 9, 2016, the Independent Directors amended the Investment Management Agreement reducing the Investment Management Fee from 1.75% to 1.25% per annum of the Company’s Invested Capital, as measured as of the close of business on the last business day of such quarterly period.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
For the year ended December 31, 2017, the amended Investment Management Fee rate of 1.25% was in effect and as such, $7,927 of Investment Management Fees were waived as a result of reallocations (see Note 2). For the year ended December 31, 2016, the Investment Manager waived $77,534 of Investment Management Fees. For the period ended December 31, 2015, there were no Investment Management Fees waived.
The General Partner of the Partnership and Parallel Partnership also receives from the Partnership a share of any profits derived from the investments held by the Partnership and Parallel Partnership, including those of the Company.
8.
Contingencies
In the normal course of business, the Company enters into contracts that contain a variety of representations and warranties which provide general indemnifications. The Company’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Company that have not yet occurred. However, based on experience, the Investment Manager expects the risk of loss to be remote.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
9.
Financial Highlights
The following per share data and ratios have been derived from information provided in the consolidated financial statements. The following is a schedule of consolidated financial highlights for a common share outstanding for the years ended December 31, 2017 and December 31, 2016 and the period ended December 31, 2015.
Given the Company’s similarities to a non-registered close-ended fund, the Company calculated total return as the change in the Company's capital over the year/period ended, and adjusted for stockholder contributions and distributions during the year/period. The Company noted that the total return calculated under the typical method for a registered investment company resulted in a total return of 104.61% as of December 31, 2017, 176.89% as of December 31, 2016 and 6,467,902% as of December 31, 2015. The Company determined this did not appropriately represent the performance of the Company, and thus calculated the total return based on the change in value of a theoretical investment at the beginning of the year by geometrically linking the cash flows, which is a method more commonly used by non-registered funds.
The average outstanding borrowings has been calculated from the date of the first drawdown.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
10.
Selected Quarterly Financial Data (Unaudited)
Selected unaudited quarterly financial data for the years ended December 31, 2017 and December 31, 2016 are presented below:
Given the Company’s similarities to a non-registered close-ended fund, the Company calculated total return as the change in the Company's capital over the period ended, and adjusted for stockholder contributions and distributions during the period. The Comapny noted that the total return calculated under the typical method for a registered investment company resulted in a total return of 104.61% as of December 31, 2017, 56.40% as of September 30, 2017, 53.23% as of June 30, 2017, 37.47% as of March 31, 2017, 176.89% as of December 31, 2016, 95.62% as of September 30, 2016, 63.00% as of June 30, 2016 and 50.73% as of March 31, 2016. The Fund determined this did not appropriately represent the performance of the Company, and thus calculated the total return based on the change in value of a theoretical investment at the beginning of the year by geometrically linking the cash flows, which is a method more commonly used by non-registered funds.
The number of Portfolio Investments at period end excludes the investment in the Money Market Fund.
Siguler Guff Small Business Credit Opportunities Fund, Inc.
Notes to Consolidated Financial Statements
December 31, 2017
11.
Subsequent Events
On January 16, 2018, the Company purchased $6,777,750 of senior subordinated notes in Chairman’s Foods, LLC. On March 28, 2018, the Company sold $2,148,905 of senior subordinated notes in Chairman’s Foods, LLC to an affiliated entity.
On February 6, 2018, the Company purchased $2,614,709 of term notes in Environmental Group Holdings, LLC. On March 28, 2018, the Company sold $1,307,355 of term notes in Environmental Group Holdings, LLC to an affiliated entity.
On February 15, 2018, the Company purchased $5,388,730 of senior subordinated notes in AAMP Holdings, Inc.
On February 16, 2018, the Company made a distribution to the Partnership in the amount of $4,383,035, bringing total distributions to the Partnership since inception to $11,694,477.
On March 28, 2018, the Company rebalanced its portfolio by distributing $19,612,095 of assets ($17,519,751 of senior subordinated notes and $2,092,344 of term notes) to the Partnership, which was performed to enable the Company to be qualified as a regulated investment company for federal income tax purposes.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING OR FINANCIAL DISCLOSURE
None.
ITEM 9A
ITEM 9A
CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
At the end of the period covered by this report, Management carried out an evaluation under the supervision and with the participation of its President and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation, the President and Chief Financial Officer have concluded that the Fund’s disclosure controls and procedures were effective in ensuring that information required to be disclosed was recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and in providing reasonable assurance that information required to be disclosed by the Fund in such reports is accumulated and communicated to the Fund’s management, including its President and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Changes in Internal Control over Financial Reporting
For the year ended December 31, 2017, there have been no changes in the Fund’s internal control over financial reporting that materially affected, or are reasonably likely to materially affect, the Fund’s internal control over financial reporting.
Management’s Annual Report on Internal Control Over Financial Reporting
Management of the Fund is responsible for establishing and maintaining effective internal control over financial reporting. The Fund’s internal control over financial reporting is a process that is implemented under the supervision of the Fund’s President and Chief Financial Officer to provide reasonable assurance with respect to the reliability and accuracy of financial reporting, and the preparation of its consolidated financial statements for reporting purposes are completed in accordance with generally accepted accounting principles (GAAP). We conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has determined that the Fund’s internal control over financial reporting as of December 31, 2017 was effective.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, 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.
ITEM 9B
ITEM 9B
OTHER INFORMATION
On September 29, 2017, the Partnership held its final close and will no longer be accepting or seeking additional commitments from investors.
As discussed in the Fund’s Form 8-K filed with the SEC on March 27, 2018, the Fund’s Board of Directors elected Ilomai Kurrik as Secretary and Chief Legal Officer of the Fund, effective March 22, 2018, replacing Sandip Kakar who stepped down as Secretary and Chief Legal Officer. Mr. Kakar was elected as Assistant Secretary of the Fund by the Fund’s Board of Directors on March 22, 2018, and will remain affiliated with the Fund.
No material changes have been made to the procedures with respect to the recommendation and nomination of members to the Fund’s Board of Directors.
PART III
ITEM 10
ITEM 10
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Directors
The directors of the Fund are:
(1)
Because of Messrs. Siguler’s and Kester’s positions with the Investment Manager, they are “interested persons” of the Fund.
Each director serves until the next annual meeting of shareholders and until his or her successors are duly elected and qualified. The Fund is not required under Maryland law to hold annual meetings of shareholders unless less than a majority of the directors shall have been elected to office by a vote of a majority of the Shares.
Certain Governance Matters
The Fund has adopted a Code of Ethics that is applicable to all of its officers. A free copy of the Code of Ethics may be requested by contacting the Chief Compliance Officer of the Fund, Dan Whitcomb, who may be reached at compliance@sigulerguff.com and 212-332-5100.
The directors of the Fund that are not “interested persons” of the Fund, as defined under the Investment Company Act of 1940 (the “Independent Directors”), constitute its Audit Committee. The Audit Committee reviews the scope and results of the Fund’s annual audit with the Fund’s independent registered public accounting firm and recommends the engagement of the independent registered public accounting firm. The Audit Committee Charter requires that the Fund Board determines whether one or more members of the Audit Committee will be a designated “financial expert” as defined in rules adopted by the Securities and Exchange Commission. The Fund Board has designated Mr. Markby, an independent director and Chairman of the Audit Committee, as an audit committee financial expert.
Section 16(a) Beneficial Ownership
Executive Officers
The following are the executive officers of the Fund, and the two investment professionals with primary responsibility, together with Mr. Greene, for the management of the Fund’s portfolio.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Executive officers of the Fund do not receive any compensation for their services to the Fund. Accordingly, the Fund does not have a standing compensation committee that determines the compensation of executive officers.
Compensation of Directors
For the fiscal year ending December 31, 2017, each Independent Director of the Fund was compensated with a $50,000 annual fee, payable quarterly. The Independent Directors were also compensated at a rate of $1,000 per meeting attended in person. For the fiscal year ending 2017, the Independent Directors were paid $2,000 each for their in person attendance at two meetings. Additional compensation was paid for Committee Chairs in the amounts of $10,000 for the Audit Committee Chair, and $5,000 for the Nominating and Corporate Governance Committee Chair. Those directors who are not independent directors (i.e. officers of Siguler Guff) did not receive compensation for their services as directors.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS
As of March 29, 2018, there were 100,000 Shares issued and outstanding, all owned by the Fund’s sole direct shareholder, the Partnership.
Under the Partnership’s Agreement of Limited Partnership (as amended and/or restated from time to time), the Partnership may take no action as shareholder of the Fund without first soliciting and/or taking instructions from the Partnership’s limited partners, to the same extent as if such limited partners were shareholders of the Fund, with ownership interests therein identical to their respective ownership of limited partnership interests in the Partnership. Accordingly, for purposes of the tables below, the respective ownership of limited partnership interests by the limited partners of the Partnership is addressed as if such limited partner owned an identical pro rata interest in the outstanding shares of the Fund.
(1)
The shares of Common Stock that are directly beneficially owned by Siguler Guff Small Business Credit Opportunities Fund, LP may be deemed to be indirectly beneficially owned by Siguler Guff SBCOF GP, LLC, as its general partner, Siguler Guff Capital, LP, as the managing member of Siguler Guff SBCOF GP, LLC.
(2)
The shares of Common Stock that are directly beneficially owned by Siguler Guff Small Business Credit Opportunities Fund, LP may be deemed to be indirectly beneficially owned by Donald Spencer, Andrew Guff and George W. Siguler, as the control persons of Siguler Guff Capital, LP. Messrs. Spencer, Guff and Siguler may be deemed to have voting and investment control over the shares of Common Stock held by Siguler Guff Small Business Credit Opportunities Fund, LP, however each of them disclaims beneficial ownership of such shares except to the extent of his pecuniary interest therein.
(3)
Ilmarinen Mutual Pension Insurance Company, The Hanover Insurance Company, Westfield Insurance Company, Minnesota Life Insurance Company, MCA Fund IV LP, and Sean Greene indirectly beneficially own shares of Common Stock by virtue of their ownership of interests in Siguler Guff Small Business Credit Opportunities Fund, LP.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Transactions With Related Persons.
See “Conflicts of Interest” within Item 1A.
Review and Approval or Ratification of Transactions with Related Persons
The Fund Board has adopted a policy that any transaction with a “related person” that would require disclosure under Item 404 of Regulation S-K must be approved by a majority of the Fund’s directors who have no interest in the transaction, and a majority of the Fund’s disinterested directors, taking into account, among such other factors as the directors deem appropriate, whether the transaction is on terms no less favorable than terms generally available to an unrelated party under the same or similar circumstances, and the extent of the related person’s interest in the transaction.
Indebtedness of Management
None.
Transactions With Promoters
The Investment Manager may be deemed a promoter of the Fund. The Fund is a party to an Investment Management Agreement with the Investment Manager pursuant to which the Investment Manager will, subject to the investment policies and guidelines established by the Fund Board, identify, evaluate, structure and close the investments to be made by the Fund, arrange debt financing for the Fund, provide portfolio management and servicing of loans held in the Fund’s portfolio, and administer the Fund’s day-to-day affairs.
The Fund pays all of its operating expenses except those specifically required to be borne by the Investment Manager, including: (i) costs related to the organization of the Fund and the offer and placement of its shares, including legal and accounting fees; (ii) costs related to the acquisition, ownership and sale of Fund investments (including hedging and derivative transactions), including brokerage commissions, transaction taxes and due diligence, travel, investment banking, legal, accounting, custodian and research expenses, including all such costs with respect to transactions that are not consummated to the extent that such costs are not reimbursed by entities in which the Fund invests or proposes to invest; (iii) transfer, registration and similar expenses incurred by the Fund; (iv) expenses allocable to the Fund as a partner or investor in Fund investments; (v) legal fees and expenses incurred in connection with the review and negotiation of the terms and conditions of Fund investments; (vi) SEC fees and expenses, including the expenses of compliance with SEC rules and regulations, and any fees and expenses of state securities regulatory authorities; (vii) costs of proxy solicitations; (viii) costs of meetings of shareholders and the Fund Board; (ix) charges and expenses of the Fund’s custodian, transfer and dividend disbursing agents; (x) compensation and expenses of the Fund’s directors who are not interested persons of the Fund, the Investment Manager or the placement agent, and of any of the Fund’s officers who are not interested persons of the Investment Manager, and expenses of directors in attending Fund Board or shareholder meetings; (xi) costs of any certificates representing the shares of capital stock of the Fund; (xii) fees and expenses of consultants, contractors, experts or custodians retained by the Fund; (xiii) auditing and tax preparation expenses; (xiv) interest expenses; (xv) costs of indemnification arrangements to which the Fund is a party and premiums for liability insurance; (xvi) all extraordinary expenses, such as litigation and indemnification costs and expenses, judgments and settlements; (xvii) the Investment Management Fee (as defined below); (xviii) any taxes levied upon the Fund; (xix) costs of preparing, printing and distributing reports to shareholders; (xx) costs of stationery and supplies; (xxi) the costs of membership by the Fund in any trade organizations; and (xxii) costs of any service providers engaged by the Fund.
The expenses to be borne by the Investment Manager are limited to the following: (i) compensation and expenses of the Investment Manager’s officers, directors and employees that relate to the services provided to the Fund and other normal and routine administrative expenses that relate to the services provided to the Fund; provided, however, that the Investment Manager shall not be required to pay (and if paid by the Investment Manager, the Investment Manager shall be reimbursed by the Fund for payments of) any fees or expense required to be borne by the Fund pursuant to the preceding paragraph; (ii) the cost of adequate office space for the Fund and all necessary office equipment and services, including telephone service, heat, utilities and similar items; and (iii) the cost of providing the Fund with such corporate, administrative and clerical personnel (including officers and directors of the Fund who are interested persons of the Investment Manager and are acting in their respective capacities as officers and directors) as the Fund Board of directors reasonably deems necessary or advisable to perform the services required to be performed by the Investment Manager under the Investment Management Agreement.
As compensation for its services to the Fund, the Investment Manager receives an Investment Management Fee from the Fund. The Investment Management Fee is paid by the Fund and computed and paid quarterly in arrears in an amount equal to 1.25% per annum of the Fund’s Invested Capital (as defined below), as measured as of the close of business on the last business day of such quarterly period. “Invested Capital” means the cost basis of the portfolio investments of the Fund (excluding cash and cash equivalents) that have not been written off or disposed of, including portfolio investments acquired with borrowed funds.
One hundred percent (100%) of all directors’ fees, consulting and monitoring fees, advisory board or investment committee fees, commitment fees, break-up fees and advisory fees received by the Investment Manager or its affiliates in respect of the Fund’s portfolio investments shall be applied to reduce subsequent payments of the Investment Management Fee by the Fund.
Under the Investment Management Agreement, the Investment Manager will not be liable for any error in judgment or mistake of law or for any loss suffered by the Fund in connection with the Investment Management Agreement, except a loss resulting from willful misfeasance, bad faith or gross negligence on the part of the Investment Manager in the performance of its duties or from reckless disregard of its duties and obligations under the Investment Management Agreement. The Investment Management Agreement will continue in effect for a period longer than two years from its date of execution only if such continuation is approved at least annually by the Fund Board or a majority of outstanding voting securities of the Fund, and by a majority of the directors who are not parties to the Investment Management Agreement or interested persons of such parties. The Investment Management Agreement is terminable by vote of the Fund Board or by the holders of a majority of the Interests, at any time without penalty, on 60 days’ written notice to the Investment Manager. The Investment Management Agreement may also be terminated by the Investment Manager on 60 days’ written notice to the Fund, and will terminate automatically upon its assignment.
Director Independence
Three of the five directors of the Fund are not “interested persons” of the Fund, as defined under the 1940 Act. Those three directors are Mona Aboelnaga Kanaan, Julian Markby and Gregory J. Ricca.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Independent Registered Public Accounting Firm. Effective June 2015, PricewaterhouseCoopers LLP (together with its affiliates, referred to as “PwC”) was appointed as the Fund’s independent registered public accounting firm. The Audit Committee has considered the independence of PwC, and has concluded that the provision of non-audit services by PwC is compatible with maintaining auditor independence. The Fund Board intends to engage only independent auditors in keeping with the qualifications of accountants under Regulation S-X.
In its meeting of December 14, 2017, the audit committee of the Fund (the “Audit Committee”), which consists of all of the independent directors, after considering a report from the Chief Financial Officer of the Fund determined to pre-approve the engagement of PwC to perform services that had not yet been identified up to a limit of $75,000 and to authorize the Chair of the Audit Committee to approve any additional engagement beyond the $75,000 limit.
The following is a summary of the aggregate fees payable by the Fund to PwC for the fiscal years ended December 31, 2017 and December 31, 2016.
Audit Fees: Audit fees consist of fees billed for professional services rendered for the quarterly reviews and audit of the financial statements and services that are normally provided by PwC in connection with statutory and regulatory filings. Audit fees accrued during the fiscal years ended December 31, 2017 and December 31, 2016 were $125,000 for the year end audit and $25,000 per quarter for each of the quarterly reviews.
Tax Services Fees: Tax services fees consist of fees billed for professional tax services. These services also include assistance regarding federal, state, and local tax compliance. There were $15,000 and $20,000 in tax services and fees accrued during the fiscal years ended December 31, 2017 and December 31, 2016, which represented work related to preparation of tax returns, the Fund’s RIC qualification, excise tax distribution requirements, form extensions, etc.
All Other Fees: Other fees would include fees for products and services other than the services reported above, of which there were none in the fiscal years ended December 31, 2017 and December 31, 2016.
PART IV
ITEM 15
ITEM 15
EXHIBITS, FINANCIAL STATEMENTS SCHEDULES
(a)
1. Index to Financial Statements and Financial Statement Schedules
Report of Independent Registered Public Accounting Firm
Consolidated Statements of Assets and Liabilities as of December 31, 2017 and December 31, 2016
Consolidated Schedules of Portfolio Investments as of December 31, 2017 and December 31, 2016
Consolidated Statements of Operations for the Years Ended December 31, 2017, December 31, 2016, and the period October 13, 2015 through December 31, 2015
Consolidated Statements of Changes in Net Assets for the Years Ended December 31, 2017, December 31, 2016, and the period October 13, 2015 through December 31, 2015
Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, December 31, 2016, and the period October 13, 2015 through December 31, 2015
Notes to Consolidated Financial Statements
No schedules are required because the required information is included in the financial statements and the notes thereto.
(a)
2. Exhibits
See Exhibit Index following signature page in this Form 10-K, which Exhibit Index is incorporated herein by reference.
ITEM 16
10-K SUMMARY
Not Applicable as there are no additional items to mention.
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized.
SIGULER GUFF SMALL BUSINESS CREDIT OPPORTUNITIES FUND, INC.
(Registrant)
By:
/s/ Sean Greene
By:
/s/ Jun Isoda
Sean Greene
Jun Isoda
President
Chief Financial Officer
Date: March 29, 2018
Date: March 29, 2018
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 capacities and on the dates indicated.
SIGULER GUFF SMALL BUSINESS CREDIT OPPORTUNITIES FUND, INC.
EXHIBIT INDEX
TO
FORM 10-K
For the year ended December 31, 2017