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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2023

OR

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER: 000-56378

STELLUS PRIVATE CREDIT BDC

(Exact name of registrant as specified in its charter)

Delaware (State or other Jurisdiction of Incorporation or Organization)		87-6878660 (I.R.S. Employer Identification No.)
4400 Post Oak Parkway, Suite 2200 Houston, TX	77027
(Address of Principal Executive Offices)	(Zip Code)

Registrant’s telephone number, including area code: (713) 292-5400

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Shares of Beneficial Interest, par value $0.01 per share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ☐    No ☒

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ☐    No ☒

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes ☒    No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes ☒    No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer	☐	Accelerated filer	☐
Non-accelerated filer	☒	Smaller reporting company	☐
		Emerging growth company	☒

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.    ☐

Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. Yes ☐    No ☒

If securities are registered pursuant to Section 12(b) of the Act, indicate by check mark whether the financial statements of the registrant included in the filing reflect the correction of an error to previously issued financial statements. ☐

Indicate by check mark whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the registrant’s executive officers during the relevant recovery period pursuant to § 240.10D-1(b). ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes ☐    No ☒

The aggregate market value of the registrant’s Common Shares of Beneficial Interest held by non-affiliates of the registrant as of June 30, 2023 was: has not been provided because there is no established market for the registrant’s Common Shares of Beneficial Interest.

The number of shares of the issuer’s Common Shares of Beneficial Interest, $0.01 par value per share, outstanding as of March 11, 2024 was 7,317,102,

STELLUS PRIVATE CREDIT BDC

TABLE OF CONTENTS

	Page
PART I
Item 1. Business	3
Item 1A. Risk Factors	37
Item 1B. Unresolved Staff Comments	63
Item 1C. Cybersecurity	64
Item 2. Properties	64
Item 3. Legal Proceedings	64
Item 4. Mine Safety Disclosures	65
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	65
Item 6. Reserved	68
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations	69
Item 7A. Quantitative and Qualitative Disclosures About Market Risk	84
Item 8. Financial Statements and Supplementary Data	85
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	131
Item 9A. Controls and Procedures	131
Item 9B. Other Information	131
PART III
Item 10. Directors, Executive Officers and Corporate Governance	132
Item 11. Executive Compensation	138
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	138
Item 13. Certain Relationships and Related Transactions, and Director Independence	140
Item 14. Principal Accounting Fees and Services	142
PART IV
Item 15. Exhibits and Financial Statement Schedules	143
Item 16. Form 10-K Summary	145
Signatures	146

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PART I

Item 1. Business

Our Company

Stellus Private Credit BDC (“we”, “us”, “our” and the “Company”) was formed on December 7, 2021 as a Delaware statutory trust. We are an externally managed, closed-end, non-diversified investment management company that has elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). We originate and invest primarily in lower middle-market companies (“LMM”) in the U.S. LMM companies are generally defined as having EBITDA (earnings before interest, taxes, depreciation, and amortization) between $5 million and $50 million.

Our investment activities are managed by our investment advisor, Stellus Private BDC Advisor, LLC, a Delaware limited liability company (the “Advisor”), a majority-owned subsidiary of Stellus Capital Management, LLC (“Stellus Capital Management”) an investment adviser that is registered with the U.S. Securities and Exchange Commission (the “SEC”) under the Investment Advisers Act of 1940 (the “Advisers Act”). Stellus Capital Management serves as our administrator (the “Administrator”) pursuant to an administration agreement (the “Administration Agreement”). The Administrator may retain a sub-administrator to perform any or all of its obligations under the Administration Agreement.

We source investments primarily through the extensive network of relationships that the senior investment professionals of the Advisor and Stellus Capital Management have developed with financial sponsor firms, financial institutions, lower middle-market companies, management teams and other professional intermediaries. The companies in which we invest are typically highly leveraged, and, in most cases, our investments in such companies will not be rated by national rating agencies. If such investments were rated, we believe that they would likely receive a rating that is often referred to as “junk.”

As a BDC, we are required to comply with certain regulatory requirements. For instance, as a BDC, we may not acquire any assets other than “qualifying assets” specified in the 1940 Act unless, at the time the acquisition is made, at least 70% of our total assets are qualifying assets. Qualifying assets include investments in “eligible portfolio companies.” Under the relevant SEC rules, the term “eligible portfolio company” includes all private operating companies, operating companies whose securities are not listed on a national securities exchange, and certain public operating companies that have listed their securities on a national securities exchange and have a market capitalization of less than $250 million, in each case organized and with their principal of business in the United States.

On May 9, 2022, we received an exemptive order (the “Order”) from the SEC that permits us to co-invest with additional types of private funds, other BDCs, and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management, subject to the conditions included therein. Additionally, the Order provided added relief which allows us, subject to the satisfaction of certain conditions, to co-invest in existing portfolio companies with certain affiliates that are private funds if such private funds did not have an investment in such existing portfolio company. Pursuant to the Order, a “required majority” (as defined in Section 57(o) of the 1940 Act) of our Independent Trustees must make certain conclusions in connection with a co-investment transaction, including (1) the terms of the proposed transaction, including the consideration to be paid, are reasonable and fair to us and our shareholders and do not involve overreaching of us or our shareholders on the part of any person concerned and (2) the transaction is consistent with the interests of our shareholders and is consistent with our investment objectives and strategies. We co-invest, subject to the conditions in the Order, with private credit funds managed by Stellus Capital Management that have an investment strategy that is similar or identical to our investment strategy, and we may co-invest with other BDCs and registered investment companies managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management in the future. We believe that such co-investments may afford it additional investment opportunities and an ability to achieve greater diversification.

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In addition, the Company qualifies and has elected to be treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”), for U.S. federal income tax purposes. So long as we continue to qualify as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to shareholders as dividends on a timely basis.

Under the provisions of the 1940 Act, we are permitted, as a BDC that has satisfied certain requirements, to issue senior securities in amounts such that our asset coverage ratio, as defined in the 1940 Act, equals at least 150% of our gross assets less all liabilities and indebtedness not represented by senior securities, after each issuance of senior securities. As of December 31, 2023 and December 31, 2022, our asset coverage ratio was 210% and 200%, respectively. The amount of leverage that we employ at any time depends on our assessment of the market and other factors at the time of any proposed borrowing.

Our principal executive office is currently located at 4400 Post Oak Parkway, Suite 2200, Houston, TX 77027, and our telephone number is (713) 292-5400. We maintain a website on the Internet at www.stelluscapital.com. Information contained on our website is not incorporated by reference into this Annual Report on Form 10-K and you should not consider information contained on our website to be part of this Annual Report on Form 10-K.

Private Offerings

We are conducting a private offering (the “Private Offering”) of our common shares of beneficial interest (“Common Shares”) to accredited investors in reliance on exemptions from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”). We issue our Common Shares in the Private Offering, pursuant to subscription agreements, from time to time at a price per share generally equal to the net asset value per share for our Common Shares, provided that we retain the right, if determined by us in our sole discretion, to accept subscriptions and issue Common Shares, in amounts to be determined to be appropriate by us.

The purchase of our Common Shares is intended to be a long-term investment. We do not intend to complete a liquidity event within any specific time period, if at all. We also do not intend to list our Common Shares on a national securities exchange.

Summary Risk Factors

Investing in our securities involves a high degree of risk. You should carefully consider the information in “Item 1A. Risk Factors”, including, but not limited to, the following risks:

● The capital markets may experience periods of disruption and instability. Such market conditions may materially and adversely affect debt and equity capital markets, which may have a negative impact on our business and operations.

● We are exposed to risks associated with changes in interest rates.

● We are dependent upon key personnel of the Advisor and its affiliates for our future success. If Stellus Capital Management were to lose any of its key personnel, our ability to achieve our investment objective could be significantly harmed.

● Our business model depends to a significant extent upon strong referral relationships. Any inability of the Investment Team (as defined below) to maintain or develop these relationships, or the failure of these relationships to generate investment opportunities, could adversely affect our business.

● Our incentive fee may induce the Advisor to make speculative investments.

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● We will be subject to U.S. federal income tax at corporate rates if we are unable to maintain our tax treatment as a RIC under Subchapter M of the Code.

● We may have difficulty paying our required distributions if we recognize income before, or without, receiving cash representing such income.

● Because we finance our investments with borrowed money, the potential for gain or loss on amounts invested in us is magnified and may increase the risk of investing in us.

● Substantially all of our assets may be required to be subject to security interests under future debt financing arrangements and, if we default on our obligations thereunder, we may suffer adverse consequences, including foreclosure on our assets. Most of our portfolio investments are recorded at fair value as determined in good faith by our Board and, as a result, there may be uncertainty as to the value of our portfolio investments.

● If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud. As a result, shareholders could lose confidence in our financial and other public reporting, which would harm our business and the trading price of our Common Shares.

● Because we intend to distribute substantially all of our income to our shareholders to obtain and maintain our status as a RIC, we will continue to need additional capital to finance our growth. If additional funds are unavailable or not available on favorable terms, our ability to grow may be impaired.

● The time and resources that the Investment Team devotes to us may be diverted, and we may face additional competition due to the fact that the Investment Team is not prohibited from raising money for, or managing, another entity that makes the same types of investments that we target.

● If we do not invest a sufficient portion of our assets in qualifying assets, we could violate the 1940 Act provisions applicable to BDCs or be precluded from investing according to our current business strategy.

● The failure in cyber security systems, as well as the occurrence of events unanticipated in our disaster recovery systems and management continuity planning, could impair our ability to conduct business effectively.

● Our investments in private LMM portfolio companies are risky, and we could lose all or part of our investment.

● Price declines and illiquidity in the corporate debt markets may adversely affect the fair value of our portfolio investments, reducing our net asset value through increased net unrealized depreciation.

● Because we generally do not hold controlling equity interests in our portfolio companies, we may not be able to exercise control over our portfolio companies or to prevent decisions by management of our portfolio companies that could decrease the value of our investments.

Portfolio Composition

We originate and invest primarily in privately-held middle-market companies (typically those with $5.0 million to $50.0 million of EBITDA (earnings before interest, taxes, depreciation and amortization)) through first lien (including unitranche), second lien, and unsecured debt financing, often times with a corresponding equity investment.

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The following table provides a summary of our portfolio investments as of December 31, 2023:

	As of
	December 31, 2023
	($ in millions)
Number of investments in portfolio companies		39
Fair value(a)	$	208.6
Cost	$	206.5
% of portfolio at fair value – first lien debt(b)		95.0	%
% of portfolio at fair value – unsecured debt		0.0	%
% of portfolio at fair value – equity		5.0	%
Weighted-average annual yield(c)		11.9	%

(a) As of December 31, 2023, $189.8 million of our debt investments at fair value were at floating interest rates, which represented 96% of our total portfolio of debt investments at fair value.

(b) Includes unitranche investments, which account for 4.8% of our portfolio at fair value.

(c) The weighted average yield on all of our debt investments as of December 31, 2023 was approximately 12.5%, of which approximately 11.8% was current cash interest. The weighted average yield on all of our investments, including non-income producing equity positions, as of December 31, 2023 was approximately 11.9%. The weighted average yield of our debt investments is not the same as a return on investment for our stockholders but, rather, relates to a portion of our investment portfolio and is calculated before the payment of all of our and our subsidiaries’ fees and expenses. The weighted average yield was computed using the effective interest rates for all of our debt investments, which represents the interest rate on our debt investments restated as an interest rate payable annually in arrears and is computed including cash and payment in kind, or Payment-In-Kind (“PIK”) interest, as well as accretion of original issue discount. There can be no assurance that the weighted average yield will remain at its current level.

The Investment Team

The Advisor’s investment team (the “Investment Team”), which is composed of the same members of the Stellus Capital Management team described below, has an extensive track record demonstrating their ability to originate, structure, execute and realize private credit investments. Senior members of the Investment Team have invested over $8.7 billion of capital across over 350 portfolio companies since 2004. The Investment Team, through Stellus Capital Management, has managed LMM credit portfolios through multiple financial market cycles including the COVID-19 pandemic and the 2008 financial crisis. The Investment Team manages Stellus Capital Investment Corporation (“SCIC”), a publicly traded BDC listed on the New York Stock Exchange (NYSE: SCM), as well as a series of commingled institutional private credit funds, and certain investor-specific private credit vehicles.

Stellus Private BDC Adviser, LLC and Stellus Capital Management

Our investment activities are managed by Stellus Private BDC Adviser, LLC, a majority owned subsidiary of Stellus Capital Management, a Houston, Texas-based independent investment management firm formed in January 2012 in connection with the spin-out of the Direct Capital Unit from D. E. Shaw & Co., L.P. and its associated investment funds, (the “D. E. Shaw group”), a global investment and technology development firm. Stellus Capital Management manages approximately $2.9 billion in assets as of December 31, 2023. Stellus Capital Management serves as the Company’s administrator (the “Administrator”) pursuant to an administration agreement (the “Administration Agreement”). The Administrator may retain a sub-administrator to perform any or all of its obligations under the Administration Agreement.

The senior investment professionals of Stellus Capital Management have an average of over 35 years of investing, corporate finance, restructuring, consulting and accounting experience and have worked together at several companies. The Stellus Capital Management senior investment professionals have a wide range of experience in middle-market investing, including originating, structuring and managing loans and debt securities through market cycles. The Stellus Capital Management senior investment professionals continue to provide investment sub-advisory services to the D. E. Shaw group. 

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In addition to serving as our Administrator, Stellus Capital Management currently manages a publicly traded BDC and private credit funds that have an investment strategy that is similar to, overlapping with or identical to our investment strategy. We received an Order from the SEC, which permits us to co-invest with investment funds managed by Stellus Capital Management or an adviser that is controlled, controlling, or under common control with Stellus Capital Management, where doing so is consistent with our investment strategy as well as applicable law (including the terms and conditions of the exemptive order issued by the SEC). We believe that such co-investments may afford us additional investment opportunities and an ability to achieve greater diversification.

Investment Approach

The primary goal of our LMM lending strategy is to generate stable cash flow and preserve capital through what the Advisor believes is superior credit selection and risk mitigation. The Investment Team has continuously refined this strategy since 2004 while maintaining a consistent focus on the LMM, providing flexible financing solutions with an emphasis on senior secured loans. We will focus on investing in LMM companies that generate between $5 million and $50 million of EBITDA. We will seek to invest in businesses with strong operating and financial fundamentals, high quality management teams, sustainable competitive advantages and the ability to deleverage over the investment hold period through high levels of free cash flow generation. We expect to build a portfolio across a multitude of industry sectors, geographies within our target market, and financial sponsors. The Investment Team has historically led or co-led most of its investments and has not actively participated in broadly syndicated transactions.

We intend to invest in a diverse group of sectors where the Investment Team has built an expertise. These industries may include, but are not limited to: business services; healthcare & pharmaceuticals; aerospace & defense; beverage & food; media; software; consumer goods; finance; education; high tech industries; capital equipment; retail; transportation & logistics; containers, packaging & glass; software; environmental industries; construction & building; consumer services; industrial services; and chemicals, plastics & rubber. We generate returns through a combination of: (i) contractual interest payments; (ii) origination fees; (iii) pre-payment penalties; and (iv) in certain situations, capital gains corresponding to equity co-investments in a portfolio company, usually on terms similar to the controlling private equity sponsor and in connection with our loan to such portfolio company. The typical term of the loans is expected to be five years with an average duration of two to three years. The Investment Team focuses on directly originated and highly negotiated transactions with a primary focus on financial sponsor-backed LMM companies. We believe these investments typically exhibit attractive risk-reward characteristics with favorable terms and tighter covenants. Although a significant portion of loans are expected to be for acquisition financing in support of leveraged buyouts by well-established, high quality sponsors, we may also seek to provide loans to fund growth initiatives and/or re-financings.

We believe LMM companies have been and continue to be underserved by credit providers due to their relatively small size and the corresponding illiquidity of their debt. This segment is one of the most active for M&A deal flow, driven primarily by significant amounts of uninvested cash in private equity funds that target LMM companies. Regulatory changes enacted since the 2008 financial crisis have exacerbated the supply-demand credit shortfall with traditional capital providers such as commercial banks reducing their LMM lending activity or exiting the market altogether at an accelerated rate. We believe it is well-positioned to capitalize on the current market dynamics with the Advisor’s seasoned and cohesive team of investment and portfolio management professionals and its ability to act as a flexible capital provider.

We believe we have a competitive advantage over many other sources of LMM financing given that the Investment Team has earned a reputation as a thoughtful and disciplined provider of solutions in addition to capital. The Investment Team seeks to select investments that have the most attractive risk-reward characteristics through a well-established origination and sourcing process. During the course of deploying over $8.0 billion since 2004, the senior members of the Investment Team have developed a broad network of contacts diversified by geography and industry. The senior members of the Investment Team have dedicated geographic marketing responsibilities, and the majority have focused on their respective regions for over 11 years.

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Once an opportunity is identified, the Investment Team adheres to a disciplined investment process that has been continually refined since 2004. The Investment Team assesses each opportunity independently, often leveraging a sponsor’s expertise and resources, to gain a complete understanding of the investment merits and potential downside risks. This intensive and highly iterative due diligence process has led to strong risk-adjusted returns with low historical default rates and strong recovery rates.

After closing a transaction, the members of the Investment Team responsible for originating and closing the transaction will typically remain responsible for managing the investment through realization and work with the finance and operations team to closely monitor performance. This active approach enables us to react quickly when a portfolio company is underperforming. The Investment Team has extensive restructuring experience to resolve potential issues and has demonstrated their ability to take a proactive, hands-on approach in work-out situations.

Our Business Strategy

Investment Objective

Overview

Our investment objectives are to maximize the total return to our shareholders in the form of current income and capital appreciation. We will aim to achieve our investment objectives by providing loans to LMM companies in the U.S. The Investment Team has demonstrated an extensive track record of executing transactions in the LMM over the past 19 years. Their ability to successfully invest through different market cycles is attributable to a strict adherence to the strategic principles that they employ. The Investment Team’s investment philosophy emphasizes stable cash flow generation and capital preservation through what the Advisor believes is superior credit selection and risk mitigation. This approach has been continuously refined and improved by the Investment Team since 2004, while investing over $8.7 billion of capital during their tenure at both the D. E. Shaw group and Stellus Capital Management. These investments are consistent with our strategy. We expect our targeted portfolio to provide downside protection through conservative cash flow and asset coverage requirements, priority in the capital structure, information requirements, board observation rights and strong financial covenant packages.

We expect to invest, under normal circumstances, at least 80% of our net assets (plus any borrowings for investment purposes), directly or indirectly in private credit obligations and related instruments. We define “credit obligations and related instruments” for this purpose as any fixed-income instrument, including loans to, and bonds and preferred stock of, portfolio companies and other instruments that provide exposure to such fixed-income instruments. Derivative instruments will be counted towards our 80% policy to the extent they have economic characteristics similar to private credit obligations. To the extent we determine to invest indirectly in private credit obligations and related instruments, we may invest through certain synthetic instruments, which we will value at market value or, if no market value is ascertainable, at fair value for the purpose of complying with the above mentioned policy. We will notify our shareholders at least 60 days prior to any change to the 80% investment policy described above.

As a matter of fundamental policy, we may not invest 25% or more of our total assets (measured at the time of purchase) in equity securities and unsecured debt. This fundamental policy cannot be changed without the affirmative vote or consent of a “majority of the outstanding voting securities” (as such term is defined in the 1940 Act) of the Company.

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The Investment Team seeks to invest in businesses with strong operating and financial fundamentals, high quality management teams, sustainable competitive advantages and the ability to deleverage over the investment hold period through high levels of free cash flow generation. We target LMM companies with between $5 million and $50 million of EBITDA with leverage ratios generally ranging between 2.0x and 5.0x. The Investment Team will seek to structure the loans primarily with a floating interest rate tied to the Secured Overnight Financing Rate (“SOFR”), or other alternative reference rates recommended by applicable market regulators, along with an up-front fee and prepayment penalties. The interest generated from these investments primarily takes the form of cash and we will distribute quarterly cash income to our shareholders. The typical term of the loans are five years with an average realized duration of two to three years. The companies in which we invest are typically leveraged, and, in most cases, our investments in such companies will not be rated by national rating agencies. If such investments were rated, we believe that they would likely receive a rating below investment grade (i.e., below BBB or Baa), which are often referred to as “junk.”

We primarily invests in sectors where the Investment Team has built extensive expertise and long-standing relationships with management teams, sponsors and service providers. These industries may include, but are not limited to: business services; healthcare & pharmaceuticals; aerospace & defense; beverage & food; media; software; consumer goods; finance; education; high tech industries; capital equipment; retail; transportation & logistics; containers, packaging & glass; software; environmental industries; construction & building; consumer services; industrial services; and chemicals, plastics & rubber. Although a significant portion of loans are for acquisition financing in support of leveraged buyouts by well-established, high quality sponsors, we may also seek to provide loans to fund growth initiatives and/or re-financings.

Highlights of the Our investment strategy are as follows:

● Focus on the U.S. Lower Middle Market. We will invest in the LMM, where the Investment Team has focused since 2004 at the D. E. Shaw group and continuing at Stellus Capital Management. We believe that the Investment Team’s consistent participation as a middle market lender differentiates it from recent entrants who may be regarded by borrowers as untested and potentially unpredictable through a market downturn. We also believes that businesses in the LMM often have limited access to public markets and will benefit from reliable lending partnerships. Based on the Investment Team’s experience, fewer capital providers and less aggregate capital is available for financing LMM companies today, as compared to the time period prior to the 2008 financial crisis. Due to an increasingly stringent regulatory environment, many financing providers have chosen to focus on large, liquid corporate loans and managing capital markets transactions, rather than lending to LMM businesses.

● Relationship Based Sourcing Approach. With an average of over 34 years of principal investing, corporate finance, restructuring and accounting experience, the senior members of the Investment Team have demonstrated investment expertise throughout the balance sheet and in a variety of situations, including financial sponsor buyouts, growth capital, debt re-financings, balance sheet recapitalizations and acquisition financings. The Investment Team has developed a reputation as a thoughtful and proactive partner to sponsors and has executed transactions with more than 180 different private equity firms since 2004. We are often a preferred partner for transactions having cultivated many longstanding relationships with private equity sponsors and providing creative input and solutions throughout the investment process. These relationships are the result of a long history of working together and crafting solutions to meet the needs of the sponsors and their portfolio companies.

The Investment Team is able to identify attractive investments through a proactive, relationship-driven sourcing effort. Sponsored investments are sourced from long-standing relationships and new interactions with referral sources and equity sponsors who view the Investment Team as a collaborative partner in the transaction. The senior members of the Investment Team are assigned dedicated geographic regions to develop and cultivate deep relationships with private equity firms. The majority have covered their respective regions for over 11 years and have focused on extensive calling and marketing efforts via speaking engagements, sponsorships, industry events, and referrals to broaden their relationship network. Existing relationships are constantly cultivated through transactional work and other personal contact. We believe that the combination of the deep relationships and focused geographical coverage is highly valuable as it provides the Investment Team with a strong competitive advantage.

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Lastly, the Investment Team has also developed a network of relationships beyond private equity firms including: (i) portfolio companies of private equity firms; (ii) management teams and entrepreneurs; (iii) other lending firms with complementary strategies; (iv) investment banks; (v) corporate operating advisers and other financial advisers; and (vi) various other intermediaries, including consultants, attorneys and other service providers.

● Maintain Disciplined Underwriting Standards. The Investment Team employs a highly involved and iterative underwriting process with an intense focus on risk management. The Investment Team includes a detailed qualitative analysis of each opportunity with investments ultimately made in businesses with strong fundamentals that can be verified in a thorough, hands-on diligence process. A credit metrics evaluation and extensive risk-reward analysis is performed on each investment. The Investment Team also recognizes that seniority in the capital structure influences investment risk and seeks to structure its loans accordingly. These highly negotiated terms include appropriate interest rates, amortization terms and financial covenants. These protections enable us to take action in the event that a portfolio company’s results deviate negatively from expectations.

The Investment Team’s disciplined underwriting process has been refined by decades of private lending, workout and restructuring experience across multiple credit cycles. The Investment Team has also successfully leveraged its extensive track record to continuously refine its risk management and work out processes through in-depth analysis of prior investments, particularly underperforming transactions.

● Utilize Extensive In-House Loan Administration, Risk Management and Portfolio Management Infrastructure. We rely on Stellus Capital Management and the Advisor’s compliance-oriented culture and robust infrastructure and risk management processes to structure, execute, monitor and manage its loan portfolio. Members of the finance and operations team led by Mr. Huskinson were responsible for building out and maintaining oversight of the loan administration platform at the D. E. Shaw group for seven years prior to the Stellus Capital Management spin-out and the aggregate team has more than 125 years of combined relevant industry experience.

Further, the Investment Team applies a rigorous and hands-on approach to post-investment monitoring and risk management of borrowers in the portfolio. The Investment Team reviews the financial performance of the portfolio companies on a monthly basis for the majority of its investments and maintains an ongoing dialogue with management. The Investment Team believes that once an investment is made, continuous monitoring of the underlying business is essential. In general, the original deal team remains with an investment from origination through its full life cycle and work closely with the finance and operations team to closely monitor business performance through a variety of means, including formal reporting requirements and quarterly portfolio reviews. The Investment Team believes active participation will keep us appraised of the activities of our portfolio companies. Through this approach, when a portfolio company is underperforming or varies negatively from plan, investment professionals have restructuring experience to work to resolve any issues and preserve the investment.

Investment Process

The Investment Team has a highly involved and iterative investment process that is core to its culture and the basis for its historically strong returns. The senior members of the Investment Team have invested and managed principal investments together for more than a decade and have refined this process through multiple industry and financial market cycles. This rigorous approach begins with a significant network of relationships to source investment opportunities and extends into a proven, repeatable process for the analysis, approval, documentation and monitoring of investments. 

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Sourcing

The senior members of the Investment Team have been actively lending to the LMM for over a decade giving it a competitive advantage in sourcing opportunities. This commitment to LMM differentiates the Investment Team from other participants. The Investment Team utilizes a comprehensive process to originate loans and has developed a broad network of contacts diversified by geography and industry. The Investment Team believes a central part of its successful approach has been to form and cultivate long-term relationships with key deal sources, including private equity firms, investment banks and other senior lenders. The Investment Team complements this network with other deal sources to bolster its access to transactions, including management teams and entrepreneurs, portfolio companies of private equity firms, complementary investment firms seeking co-investors, corporate operating advisers and various industry service providers.

The Investment Team is viewed as a collaborative partner in evaluating opportunities and has earned a reputation as a thoughtful and disciplined provider of capital and solutions. For these reasons, the Investment Team is often the preferred lender to leading private equity firms and in many cases provided the “first and last look” on potential transactions. The deep relationships with financial sponsors are often developed through difficult or underperforming transactions where the Investment Team is able to demonstrate its work-out capabilities by leveraging their extensive restructuring experience. This synergistic partnership is illustrated by the Investment Team’s history of executing multiple financing transactions with repeat sponsors.

In addition to the Investment Team’s existing relationships, each senior member covers a distinct region within the U.S. to identify opportunities and cultivate new relationships. The Investment Team also focuses extensive marketing efforts on speaking engagements, sponsorships, industry events and referrals to constantly expand their network. The Investment Team anticipates its broad network of deal origination contacts will provide us with a continuous source of investment opportunities.

Screening and Due Diligence

The Investment Team seeks to identify potential investments that have the most attractive risk-reward characteristics. The Investment Team’s due diligence process and portfolio management process have led to low historical default rates and strong recovery rates. The Investment Team has also leveraged its extensive track record by thoroughly analyzing past transactions and developing guidelines and “best practices”.

The Investment Team follows a multi-phase approval process once a potential investment is identified. All opportunities must first undergo an initial informal review led by the investment professional that sourced the opportunity. Most potential deals do not pass this initial screening stage. Those potential opportunities that pass this stage are assigned a three-to-four-person deal team, which typically includes a partner, a managing director, a vice president and an associate. This deal team typically is responsible for the investment through the entire investment lifecycle from diligence to exit.

After the initial screening, the deal team begins to underwrite the potential deal, which typically includes an analysis of the company’s historical financials, industry drivers and outlook, competitive landscape, customer concentration, asset coverage, projected financials, credit metrics, management team, track record and funding capabilities of the private equity sponsor. To complete this and subsequent diligence, the Investment Team utilizes a number of diligence resources which include: (i) internally-developed credit analytical framework; (ii) third party research; (iii) industry experts; (iv) internal information sharing systems; and (v) the restructuring and turnaround expertise of its investment professionals. In addition to conducting its own independent analysis, the Investment Team reviews and analyzes the work completed by the sponsor in order to better understand the risks and merits of an opportunity.

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If the deal team determines the potential investment merits consideration, it is presented and evaluated at the weekly managing directors meeting. At this meeting, the deal team presents their findings and also discusses a due diligence plan going forward, as well as the pricing and the structure of the loan. While this is not a formal Investment Committee meeting, it is a key part of the process and allows all members of the Investment Team to review the transaction and provide input on key diligence and potential credit risks. A summary of each deal discussed in the managing directors meeting is included in the weekly Investment Committee meeting agenda. At the Investment Committee meeting, the deal teams and Investment Committee discuss each opportunity, key diligence areas, next steps in the process, and investment sizing.

If the Investment Team believes the opportunity merits further review, the deal team prepares and presents a pre-screen memorandum to the Investment Committee. The pre-screen memorandum generally describes the potential transaction as well as includes a description of the risks and benefits, due diligence findings to-date, multiple scenario financial projections, proposed structure and pricing, and potential returns for the proposed investment.

Upon review of the pre-screen memorandum, if the Investment Committee decides to proceed with an investment opportunity, the deal team (i) continues its diligence and deal structuring plans; (ii) works to complete its comprehensive industry and company diligence; and (iii) prepares a Credit Approval Memorandum for review by the Investment Committee. The Credit Approval Memorandum is a full update to the pre-screen memorandum and contains more deal-specific detail, including an update on the diligence process, any changes to the structure and pricing of the proposed investment, and a complete financial modeling scenario analysis. Upon unanimous approval by the Investment Committee of the proposed investment, terms and structure, the Investment Team moves forward into finalizing and closing negotiations with the prospective portfolio company. In addition, for all investment opportunities, the Investment Team employs outside counsel to assist in the preparation and negotiation of legal documentation and to review any tax considerations.

Structuring

We seek to provide financing solutions to LMM companies, with an emphasis on senior secured loans. Debt investments are expected to entail cash interest based on a floating interest rate. The Investment Team is also often able to negotiate and receive a corresponding equity co-investment alongside the financial sponsor. This component is expected to represent less than 5% of the total portfolio and is consistent with the structure of past investments made by the Investment Team.

In addition to the economic terms, the Investment Team negotiates a full suite of covenants and other contractual rights in connection with debt investments that provide protection for us while allowing a reasonable amount of flexibility for the portfolio company enabling the sponsor and management team to execute on its strategic and growth initiatives. Such covenants may include affirmative and negative covenants, default penalties, lien protection and change of control provisions. Additionally, the Investment Team may require financial covenants and terms that restrict an issuer’s use of leverage, limit asset sales and capital expenditures and allow Stellus to engage proactively if a company’s financial performance deteriorates. Lastly, the Investment Team seeks to obtain comprehensive information rights including access to management, financial statements and budgets and, in many cases, board observation rights.

Monitoring and Risk Management

Upon completing a transaction, the Investment Team applies a rigorous hands-on approach to post-investment monitoring and risk management of borrowers in the portfolio. A particular point of focus for the Investment Team is the continuous assessment of potential new risks and reassessment of risks identified in the underwriting process. The deal team reviews financial performance on a monthly basis and maintains an ongoing dialogue with management. Administrator’s loan administration process is responsible for recording the loans initially and tracking all changes to loan terms to ensure that they are accurately reflected in the books and records of the Company. Members of the finance and operations team led the build-out and maintained oversight of the loan administration platform at the D. E. Shaw group for seven years and the aggregate team has more than 125 years of combined relevant industry experience.

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The Investment Team structures investments with terms and conditions that require the timely delivery and access to critical financial and business information on portfolio companies. Specifically, the Investment Team monitoring practices typically consist of the following:

§ Regular Investment Committee updates. Key portfolio company developments are discussed each week as part of the standard Investment Committee agenda. ​

§	Written reports. The deal teams provide written updates to the Investment Committee as appropriate for material events that impact portfolio company performance or valuation. In addition, deal teams provide a written summary after each portfolio company board meeting.
§	Quarterly and annual full portfolio review. Messrs. Ladd and Huskinson work with the deal teams to perform quarterly and annual reviews of every portfolio company. The examinations typically include a written performance and valuation update, as well as a credit-specific discussion on each portfolio company.

The Investment Team also tracks developments in the broader market as part of its monitoring process. The Investment Team has a wealth of information on the competitive landscape, industry trends, relative valuation metrics, and analyses that assist in the execution of the investment strategy. The Investment Team’s extensive communications with sponsors and financial intermediaries further allow it to monitor market and industry trends that could affect portfolio investments.

In addition to extensive monitoring system, the Investment Team employs a comprehensive investment rating system to characterize and monitor the credit profile and expected level of returns on each portfolio investment. This system utilizes a five-level numeric rating scale as follows:

§ Investment Rating 1 is for loans that are performing above expectations and whose risks remain favorable compared to the expected risk at the time of the original investment.