Great Elm Capital Corp. annual report, FY2022

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Great Elm Capital Corp. — FY2022 Form 10-K

Reporting period: Year ended December 31, 2022; filed March 2, 2023. This is an annual filing, not a standalone fourth-quarter report. Great Elm is an externally managed business development company (BDC) and regulated investment company (RIC) investing in middle-market debt and income-generating equity, with a growing focus on specialty finance.

Financial performance and position

  • Investment income: $24.4 million, down 3.3% from $25.3 million in 2021. Interest income was $18.7 million; dividend income was $4.4 million; other income was $1.4 million. Reported income included $1.3 million of non-cash PIK income, versus $5.5 million in 2021.
  • Net investment income: $10.5 million, or $1.67 per share, compared with $12.3 million, or $3.02 per share, in 2021. Net investment income was 12.30% of average net assets, down from 14.02%.
  • Net result: Net realized investment losses were $126.0 million, partly offset by $100.0 million of net unrealized appreciation, producing a $26.0 million net realized and unrealized loss. Net assets decreased from operations by $15.6 million. NAV per share fell from $16.63 to $11.16; total return was -22.17% based on NAV and -46.53% based on market value, assuming reinvested distributions.
  • Expenses: Net expenses were $13.7 million after a $4.9 million incentive-fee waiver, compared with $12.9 million in 2021. Interest expense rose to $10.7 million from $10.4 million. The expense ratio was 22.14% before, and 16.43% after, the waiver.
  • Portfolio: Investments totaled $301.1 million at fair value, including $76.1 million of short-term investments; excluding short-term investments, portfolio fair value was $225.0 million. Debt investments were $185.0 million and equity/other investments $40.0 million. Specialty finance represented 25.89% of portfolio fair value excluding short-term investments.
  • Liquidity and cash flow: Year-end cash and cash equivalents were $0.6 million, with $6.3 million in money market investments and $69.8 million in Treasury bills. Operating cash flow was negative $41.8 million, including $149.5 million of investment purchases and $113.0 million of investment sale and principal-payment proceeds. Financing provided $33.2 million, including $37.5 million from common-stock issuance and $10.0 million of revolving-credit borrowings, offset by $13.0 million of distributions.
  • Debt and coverage: Contractual debt principal was approximately $155.9 million: $45.6 million of 6.75% notes due 2025, $42.8 million of 6.50% notes due 2024, $57.5 million of 5.875% notes due 2026, and $10.0 million drawn on a revolving facility maturing May 2024. Asset coverage was 154.4%, versus a 150% minimum. The revolver is secured by substantially all Company assets. On March 1, 2023, the Company repaid $5.0 million on the revolver.

Changes from 2021

  • Net investment income declined by $1.8 million. Management attributed lower interest income primarily to Avanti Communications, placed on non-accrual and restructured in April 2022; interest income from Avanti was approximately $0.1 million in 2022 versus $6.2 million in 2021.
  • The Avanti restructuring drove approximately $111 million of previously recognized unrealized losses into realized losses. Related reversals of unrealized depreciation contributed to the year’s positive unrealized appreciation; these are accounting reclassifications and do not eliminate the economic loss.
  • Investment acquisitions fell to $150.1 million from $214.9 million, while dispositions fell to $112.6 million from $135.8 million. End-of-period weighted average yield on debt investments increased to 12.43% from 10.81%.
  • Net assets increased to $84.8 million from $74.6 million, chiefly supported by $38.9 million of net common-stock issuance, despite operating and distribution outflows. The June 2022 rights offering raised $37.5 million gross; the Company also completed a six-for-one reverse stock split in February 2022.
  • Quarterly distributions were reduced from $0.60 per share in the first quarter of 2022 to $0.45 for each of the next three quarters. The Board set the first-quarter 2023 distribution at $0.35 per share, payable in cash and stated to be from distributable earnings.

Outlook, risks and unusual items

  • Management stated that available liquidity and capital resources were sufficient for obligations over the next 12 months and foreseeable future. No earnings or investment-return guidance was provided. The Company expects continued investment in specialty finance and says those investments may be less correlated with liquid credit markets.
  • Material risks include concentrated exposure to a limited number of portfolio companies and industries, borrower defaults and restructurings, illiquid and Level 3 valuations, competition for investments, leverage and refinancing, and the potential for reduced distributions. The auditor identified fair value of Level 3 investments as a critical audit matter; those investments totaled $136.4 million at year-end.
  • Variable-rate debt investments had approximately $100.8 million of principal. The filing’s sensitivity analysis estimates that a 1-percentage-point reference-rate increase would raise annual net investment income by about $1.0 million, and a 1-point decrease would reduce it by about $1.0 million, assuming no other changes and no floating-rate Company borrowings. Rising rates may also increase borrower stress and funding costs.
  • Stockholders approved an amendment resetting the capital-gains incentive-fee calculation to April 1, 2022, excluding $163.2 million of pre-April 2022 historical losses. GECM also waived $4.9 million of previously accrued incentive fees. The change may permit future capital-gains fees despite those prior losses.
  • The Company reported litigation matters, including a portfolio-related Delaware action and a Texas dispute in bankruptcy proceedings; it described its intended defenses but did not state a clear quantified loss estimate. It also had $19.9 million of unfunded loan commitments and said available liquid assets were sufficient to meet them.
  • RIC status depends on income, diversification and distribution requirements. Non-cash PIK/OID income, investment illiquidity, and debt covenants may complicate required distributions. Failure to maintain RIC status could result in corporate-level tax. The filing states disclosure controls and internal control over financial reporting were effective; the auditor did not provide an internal-control attestation.

Investor verification priorities

  • Review Avanti’s restructuring, realized-loss accounting, remaining Avanti exposure and the valuation assumptions supporting the portfolio.
  • Confirm headroom under the 150% asset-coverage threshold and the revolver’s separate net-asset, asset-coverage and bank-asset-coverage covenants; assess upcoming 2024–2026 maturities and refinancing options.
  • Assess whether net investment income and cash receipts support distributions, particularly given PIK income, falling quarterly distributions and interest expense.
  • Examine Level 3 valuation inputs, concentrated specialty-finance and industry exposures, and the quality and performance of controlled portfolio companies.
  • Evaluate the impact of the incentive-fee amendment and waiver, including potential future fees, and review the legal proceedings and unfunded commitments.