Good morning, ladies and gentlemen, and thank you for standing by. At this time, I would like to welcome everyone to the Stellus Capital Investment Corporation third quarter 2020 results conference call. [Operator Instructions]. This conference is being recorded today, Friday, October 30, 2020. It is now my pleasure to turn the call over to Mr. Robert Ladd, Chief Executive Officer of Stellus Capital Investment Corporation. Mr. Ladd, you may now begin your conference.

Okay. Thank you, Ryan, and good morning, everyone. Thank you for joining the call. Welcome to our conference call covering the quarter ended September 30, 2020. Joining me this morning is Todd Huskinson, our Chief Financial Officer, who will cover important information about forward-looking statements and then later, an overview of our financial information.

Thank you, Rob. I'd like to remind everyone that today's call is being recorded. Please note that this call is the property of Stellus Capital Investment Corporation and that any unauthorized broadcast of this call in any form is strictly prohibited. Audio replay of the call will be available by using the telephone number and PIN provided in our press release announcing this call. I'd also like to call your attention to the customary safe harbor disclosure in our press release regarding forward-looking information. Today's conference call may also include forward-looking statements and projections, and we ask that you refer to our most recent filing with the SEC for important factors that could cause actual results to differ materially from these projections. We will not update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at www.stelluscapital.com under the Public Investors link or call us at (713) 292-5400. At this time, I'd like to turn the call back over to our Chief Executive Officer, Robert Ladd.

Okay. Thank you, Todd. At the outset, I'd just say having now gone through 2 plus quarters of the impact of COVID-19, I'm glad to report our portfolio is stable and all borrowers on accrual have made their scheduled principal and interest payments for the third quarter. I will discuss the portfolio, including asset quality in more detail shortly as well as an outlook and also the dividend status. The first Todd will cover our operating results for the quarter.

Thank you, Rob. From an operations standpoint, we generated net investment income of $0.27 per share, which more than covered our regular third quarter distribution of $0.25 per share. Core net investment income which includes taxes for the third quarter was $0.29 per share. In addition, valuation on our portfolio increased by approximately $2.1 million or $0.11 per share, and this, along with realized gains of $0.01 per share, resulted in total earnings for the quarter of $0.39 per share. Normally, we would have declared a single quarterly distribution of $0.25 per share, which would have resulted in a $0.14 per share increase in net asset value for the quarter from $13.34 to $13.48. However, to complete the distribution of spillover income from 2019 in a timely manner, consistent with maintaining our qualification for taxation as a regulated investment company and to eliminate our liability for corporate level U.S. federal income tax, we are required to declare an additional $0.31 per share of distributions by September 15. As a result, net asset value declined to $13.17 per share at the end of the quarter. I'd like to note that these distributions constitute all remaining distributions for the year. So our fourth quarter net asset value will not be further reduced by distributions paid in the fourth quarter. And with that, I'll turn it back over to Rob.

Okay. Thank you very much, Todd. I'd like to now cover the following areas: Our portfolio and asset quality, liquidity, and outlook for the balance of the quarter and then discuss dividends. So with respect to portfolio and asset quality, again, I'm pleased to report that most of our portfolio companies, operations are stable and managing well in the current environment. Overall, our asset quality is stable at a 2 out of our 1 to 5 investment rating system or effectively on plan. 90% of our portfolio is rated at 2 or better or on plan or better. And therefore, 10% is the portfolio is rated at 3 or below, which is below plan. Nonaccrual loans comprise only 1.5% of fair value of the total loan portfolio and no loans have been added to nonaccrual status since April 1. We continue to make good diversification with the largest industry sector at 18% of the total at fair value, September 30, the average investment per company is about $9.4 million, and our largest investment is $21.6 million, both numbers at fair value, and 62 of the 66 portfolio companies are backed by private equity firm. We are seeing interesting opportunities if the world has gotten a little bit clear, and we're beginning to invest selectively. During the third quarter, we made investments in 2 new and 3 existing portfolio companies, which totaled about $19 million. We also received repayments of $40 million, including 4 full repayments and a number of partial repayments, several of which were revolver repayments. As a result, we ended the quarter with an investment portfolio at fair value of $622.4 million in 66 portfolio companies, down from $641 million at June 30. From a capital management standpoint, working closely with our bank group, we extended the revolving…

[Operator Instructions]. We will take our first question today and that is from Bryce Rowe with National Securities.

Rob and Todd, maybe first, I can start on the liquidity profile. Todd, just curious how much cash is sitting in the SBIC right now and was wondering if you possibly anticipate drawing debentures to fund some of this potential activity here in the fourth quarter.

Sure. Thank you, Bryce. So we have roughly $25 million today of cash in SBIC 1. We have 2 licenses. And so a lot of cash in SBIC 1, that we would expect to use to recycle into new investments. And then with SBIC 2, we've got the ability to draw debentures there in SBIC 2 as well. And so I think the way to think about it is, the pipeline, as Rob mentioned, is full, and we have a lot of interesting opportunities, a number of which are SBIC qualifying. And so I think we would use combination both of the cash that's in SBIC 1 as well as drawing debentures in SBIC 2 to fund that activity.

That's great info. And then I wanted to -- maybe, Rob, we've talked about this in the past. But maybe get your updated thoughts around it. So you obviously had the good fortune to amend and extend the credit facility here in the most recent quarter. And one of those amendments, I guess, included the requirement by that bank group to have the 2022 baby bonds redeemed by March of 2022, ahead of their maturity later in the year of 2022. So I'm just kind of curious how you're thinking about the potential redemption of those bonds. I know we're still a good year plus away from needing to do that. But potentially, the market is open to some type of activity that would allow you to redeem and maybe upsize to create more of a capital structure that is more heavily weighted towards that unsecured type of debt.

Sure, Bryce. Yes. So as a reminder, we have $49 million of unsecured notes that mature in September of '22. So there's 18 months left, 2 years left, but 18 months left and pursuant to the bank requirement. And so as I said earlier in the year, one of our goals in the second half of 2020 would be to possibly have a new fixed income offering. So we've been patient. And as you know, a number of companies raised unsecured notes at much higher coupons than you could do today. So fortunately, that's paid off so far. We haven't quite gotten there, but we're getting closer. And so I would think over the next 90 days or so, we'll certainly be looking at it. Because we have the time and we have meaningful liquidity, as indicated earlier, we have roughly $63 million of liquidity, including our unused remaining facility on our bank, credit agreement that we want to be patient about this. So it may be that this moves into 2021 as an event, but we'll certainly take care of this in advance of the March '22 date through a combination of new offering and certainly meaningful liquidity we've developed. Don't expect any difficulty in being able to do that.

We'll move on to our next question, and that is from Christopher Nolan from Ladenburg Thalmann.

Rob, I noticed that on a fair value basis, the portfolio is sort of increasingly favoring first lien debt, lower second lien debt. Is that a trend that we should see continuing going forward? Or is it just sort of opportunistic?

Yes. Thank you, Chris. So this has been a rotation that we've now been working on over the last 2 to 2.5 years. So you should expect it to continue. It'd be unlikely we participate in any mezzanine financing. We are looking at some second liens and where we think they have the right capital structure and owner. But you should expect the vast majority of our investing at this point will be first lien unitranche debt. And then hopefully we always try to purchase a small piece of equity at the same time. So that's going to comprise most of the portfolio going forward.

And then my follow-up question is actually for Todd. The interest income was slightly up quarter-over-quarter, but the portfolio of investment volumes were down and the yields seem to be flat. What was driving the -- I would think the interest income would have gone down with all of that, but stayed relatively steady. I'm just trying to see why.

Yes. Chris, I don't know that there's a specific reason other than fee income. So we had a number of payoffs in the quarter, as Rob mentioned, and had some additional fee income. And some of that fee income is included up in the interest income line item as well. So that's likely what's driving it.

We'll move on to our next question, and that is from Robert Dodd with Raymond James.

Congratulations on the quarter. First, maybe for Todd and then a question for you, Rob. Based on where you stand today on estimated spillover kind of going into 2021. Can you give us any color on, obviously, your dividend for 2020, the taxes, was essentially driven by having to distribute spillover. So what's the minimum distribution requirement for 2021 as spillover stands today? And is that consistent with, obviously, the covenants based dividend, if not, what discussions have been had as to how you want to handle that?

Yes. Thank you, Robert. So I guess one of the things I will tell you and the groups that we've learned is it's difficult to predict spillover income until the end of the year, of course. And so I think what I can tell you is I would expect there still to be meaningful spillover income from 2020, 2021, maybe not quite as much as the current year. But I still think -- I guess what I would say is it's still meaningful income spilled over to '21. I'm not sure if the current dividends, the normal dividends would cover it or there would need to be something special, just don't know that.

Okay. That's your point. It is hard to predict almost a year. So Rob, on the market, right, obviously, you're talking about the activity is in -- what are you seeing in terms of, if you can, quality deals, terms, pricing? And what industries are making up more of -- perhaps more of your phone call, the incoming, not necessarily ones you consider, but what -- can you give us any color about between different industries that are coming up. Do the terms vary considerably by industry type succession? Any color would be very helpful.

Sure, Robert. So as I said earlier, we're seeing a number of interesting opportunities. We've always been very selective in our investing and continue, probably even more selective than ever. But what we found are those businesses that are really business-to-business continue to do well. And as a result, most of our portfolio continues to do well. And then there are the companies that we're seeing, part of this flow we're seeing are those that are doing very well during COVID-19 related to social media and other aspects and technology and applications. So I'd say that a great deal of activity, if it's helpful and our pipeline is over 10 companies that we're looking at today and various stages of diligence. So its business that have done well throughout the COVID period are expected to do well, knowing that COVID pandemic impact is not over. And then very active private equity world, and we operate in the lower middle market, which would have an average EBITDA of probably between $10 million and $20 million. In terms of the quality of the transactions, they're the ones that we're looking at are excellent in terms of the capital structures. And as you've seen over the last few years, the minimum equity check in a company would be at least 40% of the capitalization and more typically 50%. So the capitalization structures continue to be good, strong. We only are involved in transactions that have meaningful covenants. I'd say pricing did increase certainly during the summer months, and then -- but we're getting pretty close now for an attractive opportunity really to close the pre-COVID levels. It could be some slight margin improvement, but closer to pre-COVID levels than not. So we're encouraged, and this would be reflected in the nation's economy generally and some of the industries and industry sectors are doing relatively well in this more difficult time. So -- and this would be, I'd say, lastly, this is a meaningful change from July. It's in the summer months as the world is becoming clearer to people. It was people are looking at add-on acquisitions and something that already looked at pre-COVID and investors were certainly cautious. And today, we're in a much more robust environment. I think also to be fair that there is some additional interest between now and 12/31 for tax reasons. So we're seeing some businesses that are likely to be sold and closed by the end of the year where people can at least lock in what they think is the capital gains tax rate. So that's increasing activity as well.

I appreciate that color. I kind of want to try to follow-up that. Of those 10, I mean, depending on the election result, which hopefully, we'll know next week, could some -- if it goes one way, capital gains, taxes might not change it because the other way there could be a change. So is some of that pipeline contingent on an election result? Or do you just think once the process has been started, people are just more likely to go through it? Or is there some risk of volatility depending on what happens next week?

Yes. So I'd say, one, it's not the majority of the transactions, but I'd say that I would expect they would close and regardless of the outcome of the election.

And we'll move on to our next question then and that is from Ryan Lynch with KBW.

Kind of wanted to follow-up on some of Robert's questions regarding the kind of the pipeline that you guys are seeing. I know you mentioned you're starting to see a big increase in opportunities. But can you clarify, are opportunities in the pipeline that you guys are seeing just a big increase from what you were seeing this summer, which had very little deal activity? Or are you starting to see a pipeline in opportunities when the market return to what we saw kind of pre-COVID?

Ryan, it's a good question. I would say pre-COVID. And again, it's hard to tease out a little bit might be the desire to get something closed at the end of the year. So I think that's skewing it a little bit. But there are a number of businesses and sectors in the country that are doing well and private equity funds. So a requisite too and some would be adding to an existing platform. So I'd say, certainly, our pipeline is about as good as it's been in some time. This could also be the impact of somewhat of a pent-up demand or people had not been investing since the March to September, August time frame. So I think you've got some of that that's skewing it. So maybe the best way to say it is approaching much more normalcy to where we were pre-COVID in terms of activity.

And then from an investment philosophy standpoint, do you guys expect to change the way you guys are looking at new deals, whether it's specific industry, specific credits, where you guys invest in the capital structure given that, while we're still kind of in the thick of things in the middle of the downturn, hopefully, that will be over sooner rather than later will be coming out. And the investment philosophy, something should be or could be different before you go into a cycle or when you're kind of a cycle is elongated, maybe you should be doing more defensive, hiring the capital structure type of investing, but then in the bottom of the cycle or potentially coming out of the cycle, you can get more aggressive, secondly, more cyclical industries. Do you guys anticipate shifting your focus at all to kind of go with that philosophy? Or is it just too early in the downturn to do anything like that?

Well, I'd say a few things. So we're as selective as we've ever been. And so I'd say we're more selective than even normal, just given the overall situation the country is in and uncertainty. But having said that, through that even more refined lens, we're finding a number of interesting opportunities with good private equity firms who are good owners of these businesses. Another thing I would say is that our underwriting philosophy has been, really since the beginning, going back almost 20 years as a group, pre-Stellus is that we try to underwrite any company for that there is a recession. Maybe not the first quarter, but certainly within the next -- within the first 18 months or so or 2 years. So we're underwriting the companies as we have a recession and how did they perform historically, if company didn't exist in a previous recession, how did their sector perform? And if the sector didn't exist, what's a proxy for that sector through recession. So that's the lens we're looking at these companies from the start. And then I would say, occasionally, we'll look at something that's cyclical and thinking that they were trending up from there, but we really try to avoid those type of businesses. And I would just say this, if we were looking at something that was tied to a cycle and its industry, the leverage would be low from the start, regardless of the time we would enter it. So again, very selective, but it's helpful. We are seeing really nice interesting companies, good owners, good management teams, a track record due to the COVID. One thing we'll be cautious about is how much of this is really good performance in this business is tied directly to COVID and therefore what's the effect after COVID is the effect is much less. So having that lens on at the same time.

At this time, there are no further questions. I will now turn the conference back over to Mr. Ladd for any closing remarks.

Okay. Thank you. Thank you, everyone, for your support and listening in today, and we look forward to speaking with you in the spring. And again, we expect to be back to you in January with more news about the dividends for next year.

Thank you, ladies and gentlemen. This concludes today's conference. All participants may now disconnect.