SEC Filing - Logan Ridge Finance Corporation

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10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarter Ended September 30, 2013

¨	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934


Commission File Number	Exact name of registrants as specified in their charters, addresses of principal executive offices, telephone numbers and states or other jurisdictions of incorporation or organization	I.R.S. Employer Identification Number
814-01022	Capitala Finance Corp. 4201 Congress St., Suite 360 Charlotte, North Carolina Telephone: (704) 376-5502 State of Incorporation: Maryland	90-0945675
814-01021	CapitalSouth Partners Fund II Limited Partnership 4201 Congress St., Suite 360 Charlotte, North Carolina Telephone: (704) 376-5502 State of Formation: North Carolina	55-0793325
814-01023	CapitalSouth Partners SBIC Fund III, L.P. 4201 Congress St., Suite 360 Charlotte, North Carolina Telephone: (704) 376-5502 State of Formation: Delaware	20-8426667

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.


Capitala Finance Corp.		Yes ¨ No x
CapitalSouth Partners Fund II Limited Partnership		Yes ¨ No x
CapitalSouth Partners SBIC Fund III, L.P.		Yes ¨ No x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).


Capitala Finance Corp.		Yes ¨ No ¨
CapitalSouth Partners Fund II Limited Partnership		Yes ¨ No ¨
CapitalSouth Partners SBIC Fund III, L.P.		Yes ¨ No ¨

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


Capitala Finance Corp.	Large accelerated filer	¨	Accelerated filer	¨

	Non-accelerated filer	x	Smaller reporting company	¨


CapitalSouth Partners Fund II Limited Partnership	Large accelerated filer	¨	Accelerated filer	¨

	Non-accelerated filer	x	Smaller reporting company	¨


CapitalSouth Partners SBIC Fund III, L.P.	Large accelerated filer	¨	Accelerated filer	¨

	Non-accelerated filer	x	Smaller reporting company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).


Capitala Finance Corp.		Yes ¨ No x
CapitalSouth Partners Fund II Limited Partnership		Yes ¨ No x
CapitalSouth Partners SBIC Fund III, L.P.		Yes ¨ No x

The number of shares of Capitala Finance Corp.’s common stock, $0.01 par value, outstanding as of November 14, 2013 was 12,974,420.

TABLE OF CONTENTS


		Page

PART I	FINANCIAL INFORMATION		3

Item 1.	Financial Statements		3

	Consolidated Statements of Assets and Liabilities as of September 30, 2013 (unaudited) and December 31, 2012		3

	Consolidated Statements of Operations for the three and nine months ended September 30, 2013 and 2012 (unaudited)		4

	Consolidated Schedules of Investments as of September 30, 2013 (unaudited) and December 31, 2012		5

	Consolidated Statements of Changes in Net Assets for the nine months ended September 30, 2013 and 2012 (unaudited)		14

	Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012 (unaudited)		15

	Notes to Consolidated Financial Statements as of September 30, 2013 (unaudited)		16

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		28

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		39

Item 4.	Controls and Procedures		39

PART II	OTHER INFORMATION		39

Item 1.	Legal Proceedings		39

Item 1A.	Risk Factors		40

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		58

Item 3.	Defaults upon Senior Securities		58

Item 4.	Mine Safety Disclosures		58

Item 5.	Other Information		58

Item 6.	Exhibits		59

Signatures			60

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

Capitala Finance Corp.

Consolidated Statements of Assets and Liabilities

(in thousands, except share and per share data)


	As of
	September 30, 2013		December 31, 2012
	(unaudited)		(combined)
ASSETS

Investments at fair value
Non-control/non-affiliate investments (amortized cost of $63,469 and $61,609, respectively)	$	79,008	$	78,769
Affiliate investments (amortized cost of $145,591 and $122,655, respectively)		168,143		136,809
Control investments (amortized cost of $59,242 and $43,434, respectively)		83,826		68,353

Total investments at fair value (amortized cost of $268,302 and $227,698, respectively)		330,977		283,931
Cash and cash equivalents		133,525		30,467
Interest and dividend receivable		2,315		1,917
Due from related parties		1,782		1,494
Deferred financing fees (net of accumulated amortization of $2,420 and 1,898, respectively)		4,667		4,583
Other assets		2		—

Total assets	$	473,268	$	322,392


LIABILITIES
SBA debentures payable	$	202,200	$	177,200
Due to related parties		503		197
Accounts payable and accrued expenses		843		2,562

Total liabilities	$	203,546	$	179,959


NET ASSETS
General partner’s capital	$	—	$	282
Limited partners’ capital		—		77,358
Common stock, par value $.01, 100,000,000 common shares authorized, 12,974,420 and 0 common shares issued and outstanding, respectively		130		—
Additional paid in capital		190,158		—
Accumulated net realized earnings		16,759		8,560
Net unrealized appreciation on investments		62,675		56,233

Total net assets		269,722		142,433



Total liabilities and net assets	$	473,268	$	322,392


Net asset value per share	$	20.79		N/A

See accompanying notes to consolidated financial statements.

N/A – Not Applicable

Capitala Finance Corp.

Consolidated Statements of Operations

(in thousands, except share and per share data)

(unaudited)


	For the three months ended September 30					For the nine months ended September 30
	2013			2012		2013			2012
INVESTMENT INCOME
Loan interest, fee and dividend income:
Non-control/Non-affiliate investments	$	2,063		$	2,094	$	6,112		$	6,425
Affiliate investments		2,825			2,815		9,067			6,987
Control investments		3,215			1,247		5,305			3,126

Total loan interest, fee and dividend income		8,103			6,156		20,484			16,538

Payment-in-kind interest income:
Non-control/Non-affiliate investments		45			42		132			143
Affiliate investments		114			148		268			376
Control investments		263			235		692			595

Total payment-in-kind interest income		422			425		1,092			1,114

Income from pass-through entities:
Non-control/Non-affiliate investments		—			—		5			—
Affiliate investments		210			—		1,543			171
Control investments		—			—		23			—

Total income from pass-through entities		210			—		1,571			171
Interest income from cash and cash equivalents		66			33		141			112

Total investment income		8,801			6,614		23,288			17,935


EXPENSES
Interest expense and amortization of deferred financing fees		2,237			2,029		6,527			5,794
Management fees		980			1,314		2,994			2,992
Other expenses		147			1		382			118

Total expenses		3,364			3,344		9,903			8,904


NET INVESTMENT INCOME		5,437			3,270		13,385			9,031


REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain (loss) from investments
Non-control/Non-affiliate investments		6,011			196		6,011			528
Affiliate investments		(4,140	)		—		(4,140	)		—
Control investments		—			—		364			—

Total realized gain from investments		1,871			196		2,235			528
Net unrealized appreciation on investments		601			7,312		6,442			21,315

Net gain on investments		2,472			7,508		8,677			21,843


NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS	$	7,909		$	10,778	$	22,062		$	30,874


NET INCREASE IN NET ASSETS PER SHARE RESULTING FROM OPERATIONS – BASIC AND DILUTED	$	0.61			N/A	$	1.70			N/A

WEIGHTED AVERAGE COMMON STOCK OUTSTANDING - BASIC AND DILUTED		12,974,420			N/A		12,974,420			N/A

See accompanying notes to consolidated financial statements.

N/A – Not Applicable

Capitala Finance Corp.

Consolidated Schedule of Investments

(in thousands, except for units)

September 30, 2013

(unaudited)


Company ^{(4, 5)}	Industry	Investment Interest Rate / Maturity	Principal Amount		Cost		Fair Value		% of Net Assets

Non-control/Non-affiliated investments - 29.3%

AAE Acquisition, LLC	Industrial Equipment Rental	Senior Secured Term Debt (12% Cash, Due 5/6/15)	$	19,000	$	18,992	$	19,000		7.0	%

AAE Acquisition, LLC	Industrial Equipment Rental	Membership Units (10,964 units)		—		25		3,500		1.3	%

						19,017		22,500		8.3	%


American Exteriors, LLC	Replacement Window Manufacturer	Senior Secured Debt (14.0% Cash, Due 6/30/14)		4,565		3,365		4,565		1.7	%

American Exteriors, LLC ⁽¹⁾	Replacement Window Manufacturer	Jr. Convertible Note (10.0% Cash, Due 6/30/15)		600		416		600		0.2	%

American Exteriors, LLC	Replacement Window Manufacturer	Common Stock Warrants (15% fully diluted)		—		—		1,394		0.5	%

						3,781		6,559		2.4	%


Boot Barn Holding Corporation	Western Wear Retail	Common Stock (2,400 shares)		—		2,400		5,071		1.9	%

						2,400		5,071		1.9	%


Caregiver Services, Inc.	In-Home Healthcare Services	Common Stock (293,186 shares)		—		258		270		0.1	%

Caregiver Services, Inc.	In-Home Healthcare Services	Common Stock Warrants (2.98% fully diluted)		—		264		604		0.2	%

						522		874		0.3	%


Immersive Media Tactical Solutions, LLC	Specialty Defense Contractor	Senior Secured Term Debt (13% Cash, Due 10/6/16)		2,000		2,000		1,956		0.7	%

Immersive Media Tactical Solutions, LLC	Specialty Defense Contractor	Common Unit Warrants (12% fully diluted)		—		—		766		0.3	%

						2,000		2,722		1.0	%


Medical Depot, Inc.	Medical Device Manufacturer	Subordinated Debt (14% Cash, Due 10/11/16)		4,667		4,667		4,667		1.7	%

Medical Depot, Inc.	Medical Device Manufacturer	Series C Convertible Preferred Stock (740 shares)		—		1,333		1,788		0.7	%

						6,000		6,455		2.4	%


Naples Lumber & Supply Co ⁽¹⁾	Building Supplies	Subordinated Debt (6% cash, Due 2/15/14)		1,969		1,309		1,969		0.7	%

Naples Lumber & Supply Co	Building Supplies	Common Stock Warrants (10% fully diluted)		—		—		—		0.0	%

						1,309		1,969		0.7	%


Precision Manufacturing, LLC	Industrial Boiler Manufacturer	Senior Secured Term Debt (13% Cash, Due 2/10/17)		2,500		2,500		2,447		0.9	%

Precision Manufacturing, LLC	Industrial Boiler Manufacturer	Membership Unit Warrants (6.65% fully diluted)		—		—		—		0.0	%

						2,500		2,447		0.9	%


Southern Pump & Tank Company, LLC ⁽¹⁾	Petroleum Equipment Supplier	Senior Secured Term Debt (13% Cash, 6% PIK, Due 6/15/14)		3,974		3,213		3,481		1.3	%

Southern Pump & Tank Company, LLC	Petroleum Equipment Supplier	Common Stock Warrants (10% fully diluted)		—		—		—		0.0	%

						3,213		3,481		1.3	%


Stoddard Hill Media Holdings, LLC	IT Hosting Services	Class D Preferred Units (132,159 shares)		—		300		587		0.2	%

						300		587		0.2	%


Company ^{(4, 5)}	Industry	Investment Interest Rate / Maturity	Principal Amount		Cost		Fair Value		% of Net Assets

Tenere, Inc.	Industrial Manufacturing	Senior Secured Term Debt (11% Cash, 2% PIK, Due 5/30/18)		3,396		3,396		3,396		1.3	%

						3,396		3,396		1.3	%


Worklife America, Inc.	Professional Employer Organization	Senior Secured Debt (12% Cash, Due 12/28/16)		19,031		19,031		19,031		7.1	%

Worklife America, Inc.	Professional Employer Organization	Common Unit Warrants (3.84% ownership)		—		—		3,351		1.3	%

Worklife America, Inc.	Professional Employer Organization	Preferred Unit Warrants (3.84% ownership)		—		—		565		0.2	%

						19,031		22,947		8.6	%



Sub Total Non-control/Non-affiliated investments						63,469		79,008		29.3	%


Affiliate investments - 62.3%

Chef’N Corporation	Culinary Products	Subordinated Debt (15% Cash, 3% optional PIK, Due 5/16/18)	$	6,300	$	6,300	$	6,300		2.3	%

Chef’N Corporation	Culinary Products	Series A Preferred Stock (1,000,000 shares)		—		1,000		3,893		1.5	%

						7,300		10,193		3.8	%


City Gear, LLC	Footwear Retail	Subordinated Debt (13% Cash, Due 9/28/16)		8,231		8,231		8,231		3.0	%

City Gear, LLC ⁽⁶⁾	Footwear Retail	Preferred Membership Units (scheduled 9% dividend)		—		1,269		1,412		0.5	%

City Gear, LLC	Footwear Retail	Membership Unit Warrants (14.152% fully diluted)		—		—		1,803		0.7	%

						9,500		11,446		4.2	%


Corporate Visions, Inc.	Sales & Marketing Services	Subordinated Debt (14% Cash, 2% PIK, Due 3/22/18)		11,117		11,117		11,117		4.1	%

Corporate Visions, Inc.	Sales & Marketing Services	Common Stock (2,206,463 shares)		—		2,576		8,140		3.0	%

Corporate Visions, Inc.	Sales & Marketing Services	Common Stock Warrant (302,534 shares)		—		—		1,641		0.6	%

						13,693		20,898		7.7	%


GA Communications, Inc.	Advertising & Marketing Services	Series A-1 Preferred Stock (1,998 shares)		—		1,998		2,324		0.9	%

GA Communications, Inc.	Advertising & Marketing Services	Series B-1 Common Stock (200,000 shares)		—		2		2,746		1.0	%

						2,000		5,070		1.9	%


Impresa Aerospace Holdings, LLC ^{(2, 3)}	Aerospace Parts Manufacturer	Subordinated Debt (9% Cash, 6% PIK, Due 4/28/16)		12,320		12,299		7,910		2.9	%

Impresa Aerospace Holdings, LLC	Aerospace Parts Manufacturer	Class A Membership Units (1,006,621 shares)		—		900		—		0.0	%

Impresa Aerospace Holdings, LLC	Aerospace Parts Manufacturer	Class C Membership Units (362,416 shares)		—		362		—		0.0	%

Impresa Aerospace Holdings, LLC	Aerospace Parts Manufacturer	Class F Membership Units (257,235 shares)		—		262		—		0.0	%

						13,823		7,910		2.9	%


J&J Produce Holdings, Inc.	Produce Distribution	Subordinated Debt (13% Cash, Due 7/16/18)		5,182		5,182		5,182		1.9	%

J&J Produce Holdings, Inc.	Produce Distribution	Common Stock (8,182 shares)		—		818		1,096		0.5	%

J&J Produce Holdings, Inc.	Produce Distribution	Common Stock Warrants (4,318 shares)		—		—		604		0.2	%

						6,000		6,882		2.6	%


LJS Partners, LLC	QSR Franchisor	Common Stock (1,500,000 shares)		—		1,500		14,904		5.5	%

						1,500		14,904		5.5	%


MJC Holdings, LLC	Specialty Clothing	Subordinated Debt (12% Cash, 2% PIK, Due 1/16/18)		7,500		7,500		7,500		2.8	%


Company ^{(4, 5)}	Industry	Investment Interest Rate / Maturity	Principal Amount		Cost		Fair Value		% of Net Assets

MJC Holdings, LLC	Specialty Clothing	Series A Preferred Units (2,000,000 shares)		—		2,000		3,673		1.3	%

						9,500		11,173		4.1	%


MMI Holdings, LLC	Medical Device Distributor	Subordinated Debt (6% Cash, Due 8/15/15)		400		388		400		0.1	%

MMI Holdings, LLC	Medical Device Distributor	Senior Secured Debt (12% Cash, Due 10/17/14)		2,600		2,600		2,600		1.0	%

MMI Holdings, LLC	Medical Device Distributor	Preferred Units (1,000 shares)		—		1,052		1,200		0.5	%

MMI Holdings, LLC	Medical Device Distributor	Common Units (120 shares)		—		—		128		0.0	%

						4,040		4,328		1.6	%


MTI Holdings, LLC	Retail Display & Security Services	Subordinated Debt (12% Cash, Due 11/1/18)		8,000		8,000		8,000		3.0	%

MTI Holdings, LLC	Retail Display & Security Services	Capital Units (2,000,000 units)		—		2,000		2,000		0.7	%

						10,000		10,000		3.7	%


Pickaway Plains Ambulance Services, Inc. ^(1, 2)	Medical Transportation Services	Senior Secured Term Debt (13.0% Cash, Due 12/31/15)		1,548		—		—		0.0	%

Pickaway Plains Ambulance Services, Inc.	Medical Transportation Services	Common Stock Warrants (5% fully diluted)		—		—		—		0.0	%

						—		—		0.0	%


Source Capital ABUTEC, LLC	Oil & Gas Services	Senior Secured Debt (10% Cash, Due 12/28/17)		1,000		1,000		998		0.4	%

Source Capital ABUTEC, LLC	Oil & Gas Services	Subordinated Debt (12% Cash, 3% PIK, Due 12/28/17)		4,093		4,093		4,021		1.4	%

Source Capital ABUTEC, LLC	Oil & Gas Services	Preferred Membership Units (15.5% ownership)		—		1,239		500		0.2	%

						6,332		5,519		2.0	%


Source Capital Penray, LLC	Automotive Chemicals & Lubricants	Subordinated Debt (13% Cash, Due 2/17/17)		2,500		2,500		2,447		0.9	%

Source Capital Penray, LLC	Automotive Chemicals & Lubricants	Membership Units (136.12 units)		—		750		446		0.2	%

Source Capital Penray, LLC	Automotive Chemicals & Lubricants	Common Stock Warrants (6.65% fully diluted)		—		—		247		0.1	%

						3,250		3,140		1.2	%


Source Capital SSCR, LLC	Suntan Lotion Manufacturer	Senior Secured Term Debt (12% Cash, Due 7/6/17)		15,000		15,000		15,000		5.6	%

Source Capital SSCR, LLC	Suntan Lotion Manufacturer	Preferred Membership Units (14.44% interest)		—		1,770		37		0.0	%

Source Capital SSCR, LLC	Suntan Lotion Manufacturer	Membership Unit Warrants (1.37% interest)		—		—		2		0.0	%

						16,770		15,039		5.6	%


Source Recycling, LLC ⁽²⁾	Metal Recycler	Subordinated Debt (13% Cash, Due 9/2/16)		5,000		5,000		3,031		1.1	%

Source Recycling, LLC	Metal Recycler	Membership Units (68,658 shares)		—		1,540		—		0.0	%

Source Recycling, LLC	Metal Recycler	Membership Unit Warrants (.97% fully diluted)		—		—		—		0.0	%

						6,540		3,031		1.1	%


Sparus Holdings	Energy Services	Subordinated Debt (12% Cash, Due 3/18/14)		7,150		7,150		7,150		2.7	%

Sparus Holdings	Energy Services	Series B Preferred Stock (5,704 shares)		—		1,173		1,415		0.5	%

Sparus Holdings	Energy Services	Common Stock Warrants (3,491 shares)		—		—		—		0.0	%

						8,323		8,565		3.2	%


STX Healthcare Management Services, Inc. ⁽¹⁾	Dentistry Services	Subordinated Debt (14% Cash, Due 7/31/15)		7,425		7,425		7,425		2.8	%


Company ^{(4, 5)}	Industry	Investment Interest Rate / Maturity	Principal Amount		Cost		Fair Value		% of Net Assets

STX Healthcare Management Services, Inc.	Dentistry Services	Common Stock (1,200,000 shares)		—		1,200		926		0.3	%

STX Healthcare Management Services, Inc.	Dentistry Services	Common Stock Warrants (1,154,254 shares)		—		218		983		0.4	%

						8,843		9,334		3.5	%


Take 5 Oil Change, LLC	Quick Lube Services	Common Stock (10,692 shares)		—		1,069		1,523		0.6	%

						1,069		1,523		0.6	%


TCSafety, Inc.	Oil & Gas Services	Subordinated Debt (12% Cash, 2% PIK, Due 11/22/18)		12,027		12,027		12,027		4.5	%

TCSafety, Inc.	Oil & Gas Services	Class A Common Stock (2,100 shares)		—		2,100		2,100		0.8	%

						14,127		14,127		5.2	%


V12 Holdings	Data Processing & Digital Marketing	Bridge Note (0% Cash, Due 12/31/14)		663		361		663		0.2	%

V12 Holdings	Data Processing & Digital Marketing	Tier 2 Note (0% Cash, Due 12/31/14)		81		44		81		0.0	%

V12 Holdings	Data Processing & Digital Marketing	Senior Subordinated Note (0% Cash, Due 12/31/14)		3,598		2,369		3,598		1.3	%

V12 Holdings	Data Processing & Digital Marketing	Tier 3 Note (0% Cash, Due 12/31/14)		314		207		314		0.1	%

V12 Holdings	Data Processing & Digital Marketing	Jr. Subordinated Note (0% Cash, Due 12/31/14)		2,750		—		405		0.2	%

V12 Holdings	Data Processing & Digital Marketing	Tier 4 Note (0% Cash, Due 12/31/14)		243		—		—		0.0	%

V12 Holdings	Data Processing & Digital Marketing	Series A-1 Preferred Stock (11,025 shares)		—		—		—		0.0	%

V12 Holdings	Data Processing & Digital Marketing	Series A-3 Preferred Stock (204,082 shares)		—		—		—		0.0	%

V12 Holdings	Data Processing & Digital Marketing	Series A-5 Preferred Stock (8,409 shares)		—		—		—		0.0	%

V12 Holdings	Data Processing & Digital Marketing	Common Stock Warrants (880,541 shares)		—		—		—		0.0	%

						2,981		5,061		1.9	%



Sub Total Affiliate investments					$	145,591	$	168,143		62.3	%


Control investments - 31.1%

Best In Class	Corporate Fulfillment	Subordinated Debt (12.5% Cash, Due 12/31/13)	$	1,455	$	1,413	$	1,455		0.5	%

Best In Class	Corporate Fulfillment	Class A Preferred Units (178 shares)		—		626		647		0.3	%

Best In Class	Corporate Fulfillment	Class B Preferred Units (91 shares)		—		50		91		0.0	%

						2,089		2,193		0.8	%


CableOrganizer Acquisition, LLC	Computer Supply Retail	Senior Secured Term Debt (12% Cash, 4% PIK, Due 5/24/18)		6,518		6,518		6,518		2.4	%

CableOrganizer Acquisition, LLC	Computer Supply Retail	Common Stock (193,333 shares)		—		1,125		1,031		0.4	%

						7,643		7,549		2.8	%


KBP Investments, LLC ⁽⁶⁾	QSR Franchisee	Class A Preferred Stock (scheduled 10% dividend)		—		8,269		8,269		3.1	%

KBP Investments, LLC	QSR Franchisee	Class A Common Stock (380,413 shares)		—		—		20,701		7.7	%

						8,269		28,970		10.8	%


Market E, Inc.	Online Travel Sales & Marketing	Senior Secured Debt (10% Cash, 9% PIK, Due 12/31/13)		3,014		2,897		2,504		0.9	%

Market E, Inc.	Online Travel Sales & Marketing	Class A Preferred Stock (540 shares)		—		240		—		0.0	%


Company ^{(4, 5)}	Industry	Investment Interest Rate / Maturity	Principal Amount		Cost		Fair Value		% of Net Assets

Market E, Inc.	Online Travel Sales & Marketing	Class B Preferred Stock (2,170 shares)		—		965		—		0.0	%

Market E, Inc.	Online Travel Sales & Marketing	Class A Common Stock (540 shares)		—		—		—		0.0	%

						4,102		2,504		0.9	%


Micro Precision, LLC	Conglomerate	Subordinated Debt (10% Cash, Due 9/16/16)		1,862		1,862		1,862		0.7	%

Micro Precision, LLC	Conglomerate	Subordinated Debt (14% Cash, 4% PIK, Due 9/16/16)		3,525		3,525		3,525		1.3	%

Micro Precision, LLC	Conglomerate	Common Stock (47 shares)		—		1,629		2,164		0.8	%

						7,016		7,551		2.8	%


Navis Holdings, Inc.	Textile Equipment Manufacturer	Senior Secured Term (14% Cash, 3% PIK, Due 2/1/16)		6,735		6,735		6,735		2.5	%

Navis Holdings, Inc.	Textile Equipment Manufacturer	Class A Preferred Stock (1,000 shares)		—		1,000		1,154		0.4	%

Navis Holdings, Inc.	Textile Equipment Manufacturer	Common Stock (300,000 shares)		—		1		1,412		0.5	%

						7,736		9,301		3.4	%


On-Site Fuel Services, Inc.	Fuel Transportation Services	Subordinated Debt (14% Cash, 4% PIK, Due 12/19/16)		4,799		4,799		4,799		1.8	%

On-Site Fuel Services, Inc.	Fuel Transportation Services	Series A Preferred Stock (32,797 shares)		—		3,278		3,022		1.1	%

On-Site Fuel Services, Inc. ⁽⁶⁾	Fuel Transportation Services	Series B Preferred Stock (14% scheduled cash dividend, 4% PIK dividend)		—		2,365		2,365		0.9	%

On-Site Fuel Services, Inc.	Fuel Transportation Services	Common Stock (33,107 shares)		—		33		—		0.0	%

						10,475		10,186		3.8	%


Print Direction, Inc. ⁽¹⁾	Printing Services	Subordinated Debt (12% Cash, 6% PIK, Due 7/25/2018)		4,356		4,322		4,356		1.6	%

Print Direction, Inc. ⁽¹⁾	Printing Services	Subordinated Debt (14% Cash, Due 7/31/18)		4,600		4,600		4,600		1.7	%

Print Direction, Inc.	Printing Services	Common Stock (19,363 shares)		—		2,990		6,336		2.4	%

Print Direction, Inc.	Printing Services	Common Stock Warrants (3% fully diluted)		—		—		280		0.1	%

						11,912		15,572		5.8	%



Sub Total Control investments					$	59,242	$	83,826		31.1	%


TOTAL INVESTMENTS - 122.7%					$	268,302	$	330,977		122.7	%

(1)	The maturity date of the original investment has been extended

(2)	Due to deterioration in credit quality, this investment is on non-accrual status

(3)	Due to deterioration in credit quality, the subordinated debt interest rate has been amended from its original 14% cash and 3% PIK

(4)	All debt investments are income producing. Equity and warrant investments are non-income producing, unless otherwise noted.

(5)	Percentages are based on net assets of $269,722 as of September 30, 2013.

(6)	The equity investment is income producing.

See accompanying notes to consolidated financial statements.

Capitala Finance Corp.

Consolidated Schedule of Investments

(in thousands, except for units)

December 31, 2012


Company (3, 4)	Industry	Investment Interest Rate / Maturity	Principal Amount		Cost		Fair Value		% of Net Assets
Non-control/Non-affiliated investments - 55.3%
AAE Acquisition, LLC	Industrial Equipment Rental	Senior Secured Term Debt (13% Cash, Due 5/6/15)	$	14,500	$	14,488	$	14,500		10.2	%
AAE Acquisition, LLC	Industrial Equipment Rental	Membership Units (10,964 units)		—		25		3,501		2.4	%

						14,513		18,001		12.6	%

American Exteriors, LLC (1, 2)	Replacement Window Manufacturer	Senior Secured Debt (14.0% Cash, Due 6/30/14)		4,565		3,365		5,137		3.6	%
American Exteriors, LLC	Replacement Window Manufacturer	Jr. Convertible Note (10.0% Cash, Due 6/30/15)		125		—		125		0.1	%
American Exteriors, LLC	Replacement Window Manufacturer	Common Stock Warrants (15% fully diluted)		—		—		323		0.2	%

						3,365		5,585		3.9	%

Boot Barn Holding Corporation	Western Wear Retail	Subordinated Debt (12.5% Cash, Due 12/12/16)		15,000		15,000		15,000		10.5	%
Boot Barn Holding Corporation	Western Wear Retail	Common Stock (2,400 shares)		—		2,400		4,928		3.5	%

						17,400		19,928		14.0	%

Caregiver Services, Inc.	In-Home Healthcare Services	Common Stock (146,593 shares)		—		140		116		0.1	%
Caregiver Services, Inc.	In-Home Healthcare Services	Common Stock Warrants (1.49% fully diluted)		—		—		259		0.2	%

						140		375		0.3	%


Highwinds Capital, Inc.	Usenet Hosting Services	Common Stock (33,176 shares)		—		—		4,739		3.3	%
Highwinds Capital, Inc.	Usenet Hosting Services	Common Stock Warrants (1,087 shares)		—		—		1,475		1.0	%

						—		6,214		4.3	%

Immersive Media Tactical Solutions, LLC	Specialty Defense Contractor	Senior Secured Term Debt (13% Cash, Due 10/6/16)		1,300		1,300		467		0.3	%
Immersive Media Tactical Solutions, LLC	Specialty Defense Contractor	Common Unit Warrants (12% fully diluted)		—		—		—		0.0	%

						1,300		467		0.3	%

Medical Depot, Inc.	Medical Device Manufacturer	Subordinated Debt (14% Cash, Due 10/11/16)		4,667		4,667		4,667		3.3	%
Medical Depot, Inc.	Medical Device Manufacturer	Series C Convertible Preferred Stock (740 shares)		—		1,333		1,619		1.1	%

						6,000		6,286		4.4	%

Naples Lumber & Supply Co	Building Supplies	Subordinated Debt (6% Cash, Due 2/15/14)		984		394		972		0.7	%
Naples Lumber & Supply Co	Building Supplies	Common Stock Warrants (5% fully diluted)		—		—		—		0.0	%

						394		972		0.7	%

Precision Manufacturing, LLC	Industrial Boiler Manufacturer	Senior Secured Term Debt (13% Cash, Due 2/10/17)		2,500		2,500		2,447		1.7	%
Precision Manufacturing, LLC	Industrial Boiler Manufacturer	Membership Unit Warrants (6.65% fully diluted)		—		—		213		0.2	%

						2,500		2,660		1.9	%

Southern Pump & Tank Company, LLC (1, 2)	Petroleum Equipment Supplier	Senior Secured Term Debt (13% Cash, 6% PIK, Due 6/15/14)		1,679		1,679		1,679		1.2	%
Southern Pump & Tank Company, LLC (1, 2)	Petroleum Equipment Supplier	Senior Secured Term Debt (4% Cash, 6% PIK, Due 6/15/14)		877		644		877		0.6	%
Southern Pump & Tank Company, LLC (1, 2)	Petroleum Equipment Supplier	Senior Secured Term Debt (13% Cash, 6% PIK, Due 6/15/14)		124		124		124		0.1	%
Southern Pump & Tank Company, LLC	Petroleum Equipment Supplier	Common Stock Warrants (8% fully diluted)		—		—		—		0.0	%

						2,447		2,680		1.9	%

Stoddard Hill Media Holdings, LLC	IT Hosting Services	Class D Preferred Units (132,159 shares)		—		300		372		0.3	%

						300		372		0.3	%

Worklife America, Inc.	Professional Employer Organization	Senior Secured Debt (12% Cash, Due 12/28/16)		13,250		13,250		13,250		9.3	%
Worklife America, Inc.	Professional Employer Organization	Common Unit Warrants (3% fully diluted)		—		—		1,909		1.4	%


Company (3, 4)	Industry	Investment Interest Rate / Maturity	Principal Amount		Cost		Fair Value		% of Net Assets
Worklife America, Inc.	Professional Employer Organization	Preferred Unit Warrants (3% fully diluted)		—		—		70		0.0	%

						13,250		15,229		10.7	%

Sub Total Non-control/Non-affiliated investments					$	61,609	$	78,769		55.3	%

Affiliate investments - 96.1%
Chef'N Corporation	Culinary Products	Subordinated Debt (15% Cash, 3% optional PIK, Due 5/16/18)	$	6,300	$	6,300	$	6,300		4.4	%
Chef'N Corporation	Culinary Products	Series A Preferred Stock (1,000,000 shares)		—		1,000		2,469		1.7	%

						7,300		8,769		6.1	%

City Gear, LLC	Footwear Retail	Subordinated Debt (13% Cash, Due 9/28/16)		4,231		4,231		4,231		3.0	%
City Gear, LLC (5)	Footwear Retail	Preferred Membership Units (scheduled 9% dividend)		—		1,269		1,825		1.3	%
City Gear, LLC	Footwear Retail	Membership Unit Warrants (9.817% fully diluted)		—		—		1,074		0.7	%

						5,500		7,131		5.0	%

Corporate Visions, Inc.	Sales & Marketing Services	Common Stock (2,000,000 shares)		—		2,000		5,928		4.2	%
Corporate Visions, Inc.	Sales & Marketing Services	Common Stock Warrants (302,534 shares)		—		—		1,079		0.7	%

						2,000		7,008		4.9	%

Fresh Food Concepts, Inc.	Salsa Manufacturer	Subordinated Debt (13% Cash, 4% PIK, Due 11/30/15)		3,240		3,240		—		0.0	%
Fresh Food Concepts, Inc.	Salsa Manufacturer	Class A Common Units (1,500 units)		—		1,500		—		0.0	%
Fresh Food Concepts, Inc.	Salsa Manufacturer	Class C Common Unit Warrants (165 units)		—		43		—		0.0	%

						4,783		—		0.0	%

GA Communications, Inc.	Advertising & Marketing Services	Subordinated Debt (12.5% Cash, Due 4/14/17)		13,000		13,000		13,000		9.2	%
GA Communications, Inc.	Advertising & Marketing Services	Series A-1 Preferred Stock (1,998 shares)		—		1,998		2,194		1.5	%
GA Communications, Inc.	Advertising & Marketing Services	Series B-1 Common Stock (200,000 shares)		—		2		3,260		2.3	%

						15,000		18,454		13.0	%

Impresa Aerospace Holdings, LLC (3)	Aerospace Parts Manufacturer	Subordinated Debt (12% Cash, 3% PIK, Due 4/28/16)		8,699		8,699		5,219		3.7	%
Impresa Aerospace Holdings, LLC	Aerospace Parts Manufacturer	Class A Membership Units (900,000 units)		—		900		—		0.0	%
Impresa Aerospace Holdings, LLC	Aerospace Parts Manufacturer	Class C Membership Units (317,114 shares)		—		317		—		0.0	%

						9,916		5,219		3.7	%

J&J Produce Holdings, Inc.	Produce Distribution	Subordinated Debt (13% Cash, Due 7/16/18)		5,182		5,182		5,182		3.6	%
J&J Produce Holdings, Inc.	Produce Distribution	Common Stock (8,182 shares)		—		818		1,005		0.7	%
J&J Produce Holdings, Inc.	Produce Distribution	Common Stock Warrants (4,318 shares)		—		—		535		0.4	%

						6,000		6,722		4.7	%

LJS Partners, LLC	QSR Franchisor	Common Stock (1,500,000 units)		—		1,500		15,112		10.6	%

						1,500		15,112		10.6	%

MJC Holdings, LLC	Specialty Clothing	Subordinated Debt (12% Cash, 2% PIK, Due 1/16/18)		7,571		7,571		7,571		5.4	%
MJC Holdings, LLC	Specialty Clothing	Series A Preferred Units (2,000,000 units)		—		2,000		2,762		1.9	%

						9,571		10,333		7.3	%

MMI Holdings, LLC	Medical Device Distributor	Subordinated Debt (6% Cash, Due 8/15/15)		200		200		200		0.1	%
MMI Holdings, LLC	Medical Device Distributor	Senior Secured Debt (12% Cash, Due 10/17/14)		2,600		2,600		2,600		1.9	%
MMI Holdings, LLC	Medical Device Distributor	Preferred Units (500 units)		—		500		575		0.4	%
MMI Holdings, LLC	Medical Device Distributor	Common Units (45 shares)		—		—		187		0.1	%

						3,300		3,562		2.5	%

Pickaway Plains Ambulance Services, Inc. (1, 2)	Medical Transportation Services	Senior Secured Term Debt (13.0% Cash, Due 12/31/15)		1,248		—		—		0.0	%
Pickaway Plains Ambulance Services, Inc.	Medical Transportation Services	Common Stock Warrants (4% fully diluted)		—		—		—		0.0	%

						—		—		0.0	%

Source Capital ABUTEC, LLC	Oil & Gas Services	Senior Secured Debt (10% Cash, Due 12/28/17)		1,000		1,000		1,000		0.7	%


Company (3, 4)	Industry	Investment Interest Rate / Maturity	Principal Amount		Cost		Fair Value		% of Net Assets
Source Capital ABUTEC, LLC	Oil & Gas Services	Subordinated Debt (12% Cash, 3% PIK, Due 12/28/17)		4,000		4,000		4,000		2.8	%
Source Capital ABUTEC, LLC	Oil & Gas Services	Preferred Membership Units (15.5% ownership)		—		1,240		1,240		0.9	%

						6,240		6,240		4.4	%

Source Capital Penray, LLC	Automotive Chemicals & Lubricants	Subordinated Debt (13% Cash, Due 2/17/17)		2,500		2,500		2,447		1.7	%
Source Capital Penray, LLC	Automotive Chemicals & Lubricants	Membership Units (136.12 units)		—		750		539		0.4	%
Source Capital Penray, LLC	Automotive Chemicals & Lubricants	Common Stock Warrants (6.65% fully diluted)		—		—		297		0.2	%

						3,250		3,283		2.3	%

Source Capital SSCR, LLC	Suntan Lotion Manufacturer	Senior Secured Term Debt (12% Cash, Due 7/6/17)		12,000		12,000		11,777		8.3	%
Source Capital SSCR, LLC	Suntan Lotion Manufacturer	Preferred Membership Units (14.91% fully diluted)		—		1,425		1,116		0.8	%
Source Capital SSCR, LLC	Suntan Lotion Manufacturer	Membership Unit Warrants (1.0% fully diluted)		—		—		—		0.0	%

						13,425		12,893		9.1	%

Source Recycling, LLC	Metal Recycler	Subordinated Debt (13% Cash, Due 9/2/16)		4,900		4,900		2,931		2.1	%
Source Recycling, LLC	Metal Recycler	Membership Units (68,658 shares)		—		1,391		—		0.0	%
Source Recycling, LLC	Metal Recycler	Common Unit Warrants (1.0% fully diluted)		—		—		—		0.0	%

						6,291		2,931		2.1	%

Sparus Holdings	Energy Services	Subordinated Debt (12% Cash, Due 3/18/14)		7,000		7,000		7,000		4.9	%
Sparus Holdings	Energy Services	Series B Preferred Stock (5,704 shares)		—		500		287		0.2	%
Sparus Holdings	Energy Services	Common Stock Warrants (3,491 shares)		—		—		—		0.0	%

						7,500		7,287		5.1	%

STX Healthcare Management Services, Inc.	Dentistry Services	Subordinated Debt (14% Cash, Due 7/31/15)		6,625		6,593		6,625		4.6	%
STX Healthcare Management Services, Inc.	Dentistry Services	Common Stock (1,200,000 shares)		—		1,200		680		0.5	%
STX Healthcare Management Services, Inc.	Dentistry Services	Common Stock Warrants (845,784 shares)		—		218		680		0.5	%

						8,011		7,984		5.6	%

Take 5 Oil Change, LLC	Quick Lube Services	Senior Secured Debt (10% Cash, Due 11/28/16)		12,000		12,000		12,000		8.4	%
Take 5 Oil Change, LLC	Quick Lube Services	Common Stock (10,692 shares)		—		1,069		1,248		0.9	%

						13,069		13,248		9.3	%

V12 Holdings	Data Processing & Digital Marketing	Bridge Note (0% Cash, Due 12/31/14)		280		—		280		0.2	%
V12 Holdings	Data Processing & Digital Marketing	Tier 2 Note (0% Cash, Due 12/31/14)		34		—		34		0.0	%
V12 Holdings	Data Processing & Digital Marketing	Senior Subordinated Note (0% Cash, Due 12/31/14)		2,200		—		—		0.0	%
V12 Holdings	Data Processing & Digital Marketing	Tier 3 Note (0% Cash, Due 12/31/14)		380		—		297		0.2	%
V12 Holdings	Data Processing & Digital Marketing	Jr. Subordinated Note (0% Cash, Due 12/31/14)		33		—		26		0.0	%
V12 Holdings	Data Processing & Digital Marketing	Tier 4 Note (0% Cash, Due 12/31/14)		194		—		—		0.0	%
V12 Holdings	Data Processing & Digital Marketing	Series A-1 Preferred Stock (11,025 shares)		—		—		—		0.0	%
V12 Holdings	Data Processing & Digital Marketing	Series A-3 Preferred Stock (204,082 shares)		—		—		—		0.0	%
V12 Holdings	Data Processing & Digital Marketing	Series A-5 Preferred Stock (8,409 shares)		—		—		—		0.0	%
V12 Holdings	Data Processing & Digital Marketing	Common Stock Warrants (880,541 shares)		—		—		—		0.0	%

						—		637		0.4	%

Sub Total Affiliate investments					$	122,655	$	136,809		96.1	%

Control investments - 47.9%
Best In Class	Corporate Fulfillment	Subordinated Debt (12.5% Cash, Due 12/31/13)	$	728	$	728	$	728		0.5	%
Best In Class	Corporate Fulfillment	Class A Preferred Units (89 units)		—		272		381		0.3	%
Best In Class	Corporate Fulfillment	Class B Preferred Units (45 units)		—		—		56		0.0	%

						1,000		1,165		0.8	%


Company (3, 4)	Industry	Investment Interest Rate / Maturity	Principal Amount		Cost		Fair Value		% of Net Assets
KBP Investments, LLC (5)	QSR Franchisee	Class A Preferred Stock (10% scheduled dividend)		—		7,938		7,938		5.6	%
KBP Investments, LLC	QSR Franchisee	Class A Common Stock (380,413 shares)		—		331		22,011		15.4	%

						8,269		29,949		21.0	%

Market E, Inc.	Online Travel Sales & Marketing	Senior Secured Debt (10% Cash, 9% PIK, Due 12/31/13)		921		1,178		1,178		0.8	%
Market E, Inc.	Online Travel Sales & Marketing	Class A Preferred Stock (240 shares)		—		240		—		0.0	%
Market E, Inc.	Online Travel Sales & Marketing	Class B Preferred Stock (964 shares)		—		965		243		0.2	%
Market E, Inc.	Online Travel Sales & Marketing	Class A Common Stock (240 shares)		—		—		—		0.0	%

						2,383		1,421		1.0	%

Micro Precision, LLC	Conglomerate	Subordinated Debt (10% Cash, Due 9/16/16)		1,862		1,862		1,862		1.3	%
Micro Precision, LLC	Conglomerate	Subordinated Debt (14% Cash, 4% PIK, Due 9/16/16)		3,427		3,427		3,427		2.4	%
Micro Precision, LLC	Conglomerate	Series A Preferred Units (47 shares)		—		1,629		3,276		2.3	%

						6,918		8,565		6.0	%

Navis Holdings, Inc.	Textile Equipment Manufacturer	Senior Secured Term (14% Cash, 3% PIK, Due 2/1/16)		6,602		6,600		6,602		4.6	%
Navis Holdings, Inc.	Textile Equipment Manufacturer	Class A Preferred Stock (1,000 shares)		—		1,000		1,101		0.8	%
Navis Holdings, Inc.	Textile Equipment Manufacturer	Common Stock (300,000 shares)		—		1		731		0.5	%

						7,601		8,434		5.9	%

On-Site Fuel Services, Inc.	Fuel Transportation Services	Subordinated Debt (14% Cash, 4% PIK, Due 12/19/16)		4,656		4,656		4,656		3.3	%
On-Site Fuel Services, Inc.	Fuel Transportation Services	Series A Preferred Stock (32,797 shares)		—		3,302		2,309		1.6	%
On-Site Fuel Services, Inc. (5)	Fuel Transportation Services	Series B Preferred Stock (14% scheduled cash dividend, 4% PIK dividend)		—		2,341		587		0.4	%
On-Site Fuel Services, Inc.	Fuel Transportation Services	Common Stock (33,107 shares)		—		33		1,492		1.1	%

						10,332		9,044		6.4	%

Print Direction, Inc.	Printing Services	Subordinated Debt (12% Cash, 6% PIK, Due 9/27/13)		2,549		2,549		2,550		1.8	%
Print Direction, Inc.	Printing Services	Subordinated Debt (7.75% Cash, Due 9/27/13)		454		454		454		0.3	%
Print Direction, Inc.	Printing Services	Subordinated Debt (12% Cash, 6% PIK, Due 9/27/13)		763		763		763		0.5	%
Print Direction, Inc.	Printing Services	Common Stock (14,603 shares)		—		1,575		4,418		3.1	%

						5,341		8,185		5.7	%

Vita Nonwovens	Textile Manufacturer	Subordinated Debt (14% Cash, 4% PIK, Due 8/31/17)		1,115		1,115		1,115		0.8	%
Vita Nonwovens	Textile Manufacturer	Class A Preferred United (475,000 units)		—		475		475		0.3	%

						1,590		1,590		1.1	%

Sub Total Control investments					$	43,434	$	68,353		47.9	%

TOTAL INVESTMENTS - 199.3%					$	227,698	$	283,931		199.3	%

(1)	The maturity date of the original investment has been extended

(2)	Due to deterioration in credit quality, this investment is on non-accrual status

(3)	All debt investments are income producing. Equity and warrant investments are non-income producing, unless otherwise noted.

(4)	Percentages are based on net assets of $142,433 as of December 31, 2012.

(5)	The equity investment is income producing.

See accompanying notes to consolidated financial statements.

Capitala Finance Corp.

Consolidated Statements of Changes in Net Assets

(in thousands)

(unaudited)


							Common Stock				Additional		Accumulated			Net Unrealized
	General			Limited			Number of		Par		Paid in		Net Realized			Appreciation on
	Partner			Partners			Shares		Value		Capital		Earnings			Investments		Total

BALANCE, January 1, 2012	$	209		$	70,366			—	$	—	$	—	$	7,783		$	21,176		99,535
Partners’ capital contributions		73			6,992			—		—		—		—			—		7,065
Distribution to partners		—			—			—		—		—		(11,121	)		—		(11,121	)
Net investment income		—			—			—		—		—		9,031			—		9,031
Net realized gain on portfolio investments		—			—			—		—		—		528			—		528
Net change in unrealized appreciation on portfolio investments		—			—			—		—		—		—			21,315		21,315


BALANCE, September 30, 2012	$	282		$	77,358			—	$	—	$	—	$	6,221		$	42,491	$	126,352


BALANCE, January 1, 2013	$	282		$	77,358			—	$	—	$	—	$	8,560		$	56,233	$	142,433
Partners’ capital contributions		—			24,852			—		—		—		—			—		24,852
Distribution to partners		—			—			—		—		—		(7,421	)		—		(7,421	)
Formation transactions		(282	)		(102,210	)		8,974,420		90		114,198		—			—		11,796
Public offering of common stock		—			—			4,000,000		40		75,960		—			—		76,000
Net investment income		—			—			—		—		—		13,385			—		13,385
Net realized gain on portfolio investments		—			—			—		—		—		2,235			—		2,235
Net change in unrealized appreciation on portfolio investments		—			—			—		—		—		—			6,442		6,442


BALANCE, September 30, 2013	$	—		$	—			12,974,420	$	130	$	190,158	$	16,759		$	62,675	$	269,722

See accompanying notes to consolidated financial statements.

Capitala Finance Corp.

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)


	Nine Months			Nine Months
	Ended			Ended
	September 30, 2013			September 30, 2012

CASH FLOWS FROM OPERATING ACTIVITIES
Net increase in net assets resulting from operations	$	22,062		$	30,874
Adjustments to reconcile net increase in net assets resulting from operations to net cash used in operating activities:
Purchase of portfolio investments		(75,817	)		(45,027	)
Repayments of portfolio investments		50,209			12,056
Net realized gain on portfolio investments		(2,235	)		(528	)
Increase in net unrealized appreciation on portfolio investments		(6,442	)		(21,315	)
Payment-in-kind interest accrued, net of payments received		(930	)		(1,057	)
Accretion of original issue discount on portfolio investments		(35	)		(56	)
Amortization of deferred financing fees		522			472
Changes in assets and liabilities:
Interest and dividends receivable		(398	)		(1,216	)
Due from related parties		(288	)		(38	)
Accounts payable and accrued expenses		(1,719	)		(1,290	)
Due to related parties		306			388
Other assets		(2	)		—

NET CASH USED IN OPERATING ACTIVITIES		(14,767	)		(26,737	)


CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of SBA-guaranteed debentures		25,000			35,000
Partners’ capital contributions		24,852			7,065
Proceeds from IPO, net of underwriting expense		76,000			—
Distributions paid		(7,421	)		(11,121	)
Deferred financing fees paid		(606	)		(849	)

NET CASH PROVIDED BY FINANCING ACTIVITIES		117,825			30,095


NET INCREASE IN CASH AND CASH EQUIVALENTS		103,058			3,358
CASH AND CASH EQUIVALENTS, beginning of period		30,467			24,181

CASH AND CASH EQUIVALENTS, end of period	$	133,525		$	27,539


SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

Cash paid for interest	$	7,828		$	4,350


SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING TRANSACTIONS

In-kind contribution of assets	$	11,796		$	—

See accompanying notes to consolidated financial statements.

CAPITALA FINANCE CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2013

(unaudited)

Note 1. Organization

Capitala Finance Corp. (the “Company”, “we”, “us”, and “our”) is a newly formed, externally managed non-diversified closed-end management investment company incorporated in Maryland that has elected to be treated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). We commenced operations on May 24, 2013 and completed our initial public offering (“IPO”) on September 30, 2013. The Company is managed by Capitala Investment Advisors, LLC (the “Investment Advisor”), an investment adviser that is registered as an investment adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and Capitala Advisors Corp. (the “Administrator”) provides the administrative services necessary for us to operate. In addition, for U.S. federal income tax purposes, the Company intends to elect to be treated as a regulated investment company (“RIC”) commencing with our tax year ending December 31, 2013, under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”).

The Company was formed for the purpose of (i) acquiring, through a series of transactions, an investment portfolio from the following entities: CapitalSouth Partners Fund I Limited Partnership (“Fund I”); CapitalSouth Partners Fund II Limited Partnership (“Fund II”); CapitalSouth Partners Fund III, L.P. (“Fund III Parent”); CapitalSouth Partners SBIC Fund III, L.P. (“Fund III”) and CapitalSouth Partners Florida Sidecar Fund I, L.P. (“Florida Sidecar” and, collectively with Fund I, Fund II, Fund III and Fund III Parent, the “Legacy Funds”); (ii) raising capital in the IPO and (iii) continuing and expanding the business of the Legacy Funds by making additional debt and equity investments in smaller and lower middle market companies.

The Company’s investment objective is to generate both current income and capital appreciation through debt and equity investments. Both directly and through our subsidiaries that are licensed by the U.S. Small Business Administration (“SBA”) under the Small Business Investment Company (“SBIC”) Act, we offer customized financing to business owners, management teams and financial sponsors for change of ownership transactions, recapitalizations, strategic acquisitions, business expansion and other growth initiatives. We invest primarily in traditional mezzanine, senior subordinated and unitranche debt, as well as senior and second-lien loans and, to a lesser extent, equity securities issued by smaller and lower middle-market companies.

On September 24, 2013, the Company acquired 100% of the limited partnership interests in Fund II, Fund III and Florida Sidecar and each of their respective general partners, as well as certain assets from Fund I and Fund III Parent, in exchange for an aggregate of 8,974,420 shares of the Company’s common stock (the “Formation Transactions”). Fund II, Fund III and Florida Sidecar became the Fund’s wholly-owned subsidiaries. Fund II and Fund III retained their SBIC licenses, continue to hold their existing investments and continue to make new investments. The IPO consisted of the sale of 4,000,000 shares of the Company’s common stock at a price of $20.00 per share resulting in net proceeds to the Company of $76,000,000, after deducting underwriting fees and commissions totaling $4,000,000. The other costs of the IPO were borne by the limited partners of the Legacy Funds. As of September 30, 2013, the Company had 12,974,420 shares of common stock outstanding.

Note 2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying financial statements have been prepared on the accrual basis of accounting in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”). Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with U.S. GAAP are omitted. The financial statements of the Company include the accounts of the Company and its wholly-owned subsidiaries as described in the Formation Transactions presented in Note 1. The transactions related to Fund II, Fund III, and the Florida Sidecar constitute an exchange of shares between entities under common control and will be accounted for in accordance with ASC 805, Business Combinations. As such, the Company’s results of operations and cash flows for the three and nine month periods ended September 30, 2013 are presented as if the aforementioned transactions had occurred as of January 1, 2013. In addition, the results of the Company’s operations and cash flows for the three and nine month periods ended September 30, 2012 and the Company’s financial position as of December 31, 2012 have been presented on a combined basis in order to provide comparative information with respect to prior periods. The Formation Transactions also included an asset acquisition of certain assets in Fund I and Fund III Parent. In accordance with ASC 805, Business Combinations, the assets acquired were recorded at fair value at the date of acquisition, September 24, 2013.

The Company’s financial position as of September 30, 2013 is presented on a consolidated basis. The effects of all intercompany transactions between the Company and its subsidiaries (Fund II, Fund III, and the Florida Sidecar) have been eliminated in consolidation. All financial data and information included in these financial statements have been presented on the basis described above. In the opinion of management, the financial statements reflect all adjustments that are necessary for the fair presentation of financial results as of and for the periods presented.

Use of Estimates in the Preparation of Financial Statements

The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Cash and Cash Equivalents

The Company considers cash equivalents to be highly liquid investments with original maturities of three months or less at the date of purchase. Cash and cash equivalents include deposits in money market accounts. The Company deposits its cash in financial institutions and, at times, such balances may be in excess of the Federal Deposit Insurance Corporation (“FDIC”) insurance limits.

Investment Classification

In accordance with the provisions of the 1940 Act, the Company classifies investment by level of control. As defined in the 1940 Act, “Control Investments” are investments in those companies that the Company is deemed to “Control.” “Affiliate Investments” are investments in those companies that are “Affiliated Companies” of the Company, as defined in the 1940 Act, other than Control Investments. “Non-Control/Non-Affiliate Investments” are those investments that are neither control Investments nor affiliate Investments. Generally under the 1940 Act, the Company is deemed to control a company in which it has invested if the Company owns more than 25% of the voting securities of such company and/or has greater than 50% representation on its board or has the power to exercise control over management or policies of such portfolio company. The Company is deemed to be an affiliate of a company in which the Company has invested if it owns between 5% and 25% of the voting securities of such company.

Valuation of Investments

The Company applies fair value accounting to all of its financial instruments in accordance with the 1940 Act and ASC Topic 820 - Fair Value Measurements and Disclosures. ASC 820 defines fair value, establishes a framework used to measure fair value and requires disclosures for fair value measurements. In accordance with ASC 820, the Company has categorized its financial instruments carried at fair value, based on the priority of the valuation technique, into a three-level fair value hierarchy as discussed in Note 3.

In determining fair value, our board of directors uses various valuation approaches, and engages a third-party valuation firm, which provides an independent review of certain investments. In accordance with U.S. GAAP, a fair value hierarchy for inputs is used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available.

Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the board of directors. Unobservable inputs reflect the board of directors’ assumptions about the inputs market participants would use in pricing the asset or liability developed based upon the best information available in the circumstances

The availability of valuation techniques and observable inputs can vary from security to security and is affected by a wide variety of factors including, the type of security, whether the security is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Those estimated values do not necessarily represent the amounts that may be ultimately realized due to the occurrence of future circumstances that cannot be reasonably determined. Because of the inherent uncertainty of valuation, those estimated values may be materially higher or lower than the values that would have been used had a market for the securities existed. Accordingly, the degree of judgment exercised by the board of directors in determining fair value is greatest for securities categorized in Level 3. In certain cases, the inputs used to measure fair

value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls, is determined based on the lowest level input that is significant to the fair value measurement.

Fair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the Company’s own assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date. We use prices and inputs that are current as of the measurement date, including periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many securities. This condition could cause a security to be reclassified to a lower level within the fair value hierarchy.

Valuation Techniques

Senior and Subordinated Secured Loans

The Company’s portfolio primarily consists of private debt instruments (“Level 3 debt”). We consider our Level 3 debt to be performing loans if the borrower is not in default, the borrower is remitting payments in a timely manner, the loan is in covenant compliance or is otherwise not deemed to be impaired. In determining the fair value of the performing Level 3 debt, the Company’s board of directors considers fluctuations in current interest rates, the trends in yields of debt instruments with similar credit ratings (if applicable), the financial condition of the borrower, economic conditions and other relevant factors, both qualitative and quantitative. In the event that a Level 3 debt instrument is not performing, as defined above, the board of directors will evaluate the value of the collateral utilizing the same framework described above for a performing loan to determine the value of the Level 3 debt instrument.

This evaluation will be updated no less than quarterly for Level 3 debt instruments that are not performing, and more frequently for time periods where there are significant changes in the collateral or significant changes in the perceived performance of the underlying portfolio company. The collateral value will be analyzed on an ongoing basis using internal metrics, appraisals, third-party valuation agents and other data as may be acquired and analyzed by our management and board of directors.

Equity Investments in Private Companies

Our board of directors determines the fair value of its investments in private companies by incorporating valuations that consider the evaluation of financing and sale transactions with third-parties, expected cash flows and market-based information, including comparable transactions, and performance multiples, among other factors, and may use third-party valuation agents. Such non-public investments are included in Level 3 of the fair value hierarchy.

Warrants

Our board of directors will ascribe value to warrants based on the fair value of holdings to which they are associated that can include discounted cash flow analyses, option pricing models, comparable analyses and other techniques as deemed appropriate. Such warrants are included in Level 3 of the fair value hierarchy to the extent issued by non-public companies.

Revenue Recognition

The Company’s revenue recognition policies are as follows:

Interest Income and Paid-in Kind Interest: Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. The company has loans in the portfolio that contain a payment-in-kind (“PIK”) provision. The PIK interest, which represents contractually deferred interest added to the loan balance that is generally due at maturity, is recorded on the accrual basis to the extent that such amounts are expected to be collected. PIK interest is not accrued if the Company does not expect the issuer to be able to pay all principal and interest when due.

Non-accrual income: Generally, when interest and/or principal payments on a loan become past due, or if the Company otherwise does not expect the borrower to be able to service its debt and other obligations, the Company will place the loan on non-accrual status, and will generally cease recognizing interest income on that loan for financial reporting purposes, until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. The Company writes off any previously accrued and uncollected interest when it is determined that interest is no longer considered collectible. Non-accrual loans are returned to accrual status when all past due principal and interest are current and, in management’s judgment, are likely to remain current.

Gains and Losses on investment sales and paydowns: Realized gains and losses on investments are recognized using the specific identification method.

Dividend Income: Dividend income is recognized on the date dividends are declared.

Other Income: Origination, amendment, closing and/or commitment fees associated with investments in portfolio companies are recognized as income when the investment transaction closes. Prepayment penalties received by the Company for debt instruments repaid prior to maturity date are recorded as income upon receipt.

Deferred Financing Fees

Costs incurred to issue the SBA-guaranteed debentures payable are capitalized and are amortized over the term of the debt agreements under the straight-line method, which does not differ materially from the effective interest method.

Commitments and Contingencies

As of September 30, 2013 and December 31, 2012, the Company had no outstanding unfunded commitments.

In the ordinary course of its business, the Company may enter into contracts or agreements that contain indemnifications or warranties. Future events could occur that lead to the execution of these provisions against the Company. Based on its history and experience, management feels that the likelihood of such an event is remote.

In the ordinary course of business, the Company may directly or indirectly be a defendant or plaintiff in legal actions with respect to bankruptcy, insolvency or other types of proceedings. Such lawsuits may involve claims that could adversely affect the value of certain financial instruments owned by the Company.

Income Taxes

The Company intends to elect to be treated for federal income tax purposes, and intends to qualify annually thereafter, as a RIC under Subchapter M of the Code and, among other things, intends to make the requisite distributions to its stockholders which will relieve the Company from federal income taxes. Therefore, no provision has been recorded for federal income taxes.

In order to qualify as a RIC, among other requirements, the Company is required to timely distribute to its stockholders at least 90.0% of its investment company taxable income, as defined by the Code, for each fiscal tax year. The Company will be subject to a nondeductible U.S. federal excise tax of 4.0% on undistributed income if it does not distribute at least 98.0% of its ordinary income in any calendar year and 98.2% of its capital gain net income for each one-year period ending on October 31.

Depending on the level of taxable income earned in a tax year, the Company may choose to carry forward taxable income in excess of current year dividend distributions into the next tax year and pay a 4.0% excise tax on such income, as required. To the extent that the Company determines that its estimated current year annual taxable income will be in excess of estimated current year dividend distributions for excise tax purposes, the Company accrues excise tax, if any, on estimated excess taxable income as taxable income is earned.

In accordance with certain applicable Treasury regulations and private letter rulings issued by the Internal Revenue Service, a RIC may treat a distribution of its own stock as fulfilling its RIC distribution requirements if each stockholder may elect to receive his or her entire distribution in either cash or stock of the RIC subject to a limitation on the aggregate amount of cash to be distributed to all stockholders, which limitation must be at least 20.0% of the aggregate declared distribution. If too many stockholders elect to receive cash, each stockholder electing to receive cash will receive a pro rata amount of cash (with the balance of the distribution paid in stock). In no event will any stockholder, electing to receive cash, receive less than 20.0% of his or her entire distribution in cash. If these and certain other requirements are met, for U.S federal income tax purposes, the amount of the dividend paid in stock will be equal to the amount of cash that could have been received instead of stock.

ASC 740, Income Taxes, provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the financial statements. ASC 740 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s tax returns to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authority. Tax positions deemed to meet a “more-likely-than-not” threshold would be recorded as a tax benefit or expense in the current period. The Company recognizes interest and penalties, if any, related to unrecognized tax benefits as income tax expense in the consolidated statements of operations. As of September 30, 2013 and December 31, 2012, there were no uncertain tax positions.

Dividends

Dividends to common stockholders are recorded on the ex-dividend date. The amount to be paid out as a dividend is determined by the board of directors. Net capital gains, if any, are generally distributed at least annually, although we may decide to retain such capital gains for reinvestment.

We have adopted an “opt out” dividend reinvestment plan for our common stockholders. As a result, if we declare a cash dividend or other distribution, each stockholder that has not “opted out” of our dividend reinvestment plan will have its dividends automatically reinvested in additional shares of our common stock rather than receiving cash dividends. Stockholders who receive distributions in the form of shares of common stock will be subject to the same federal, state and local tax consequences as if they received cash distributions.

Company Investment Risk, Concentration of Credit Risk, and Liquidity Risk

The Investment Advisor has broad discretion in making investments for the Company. Investments will generally consist of debt and equity instruments that may be affected by business, financial market or legal uncertainties. Prices of investments may be volatile, and a variety of factors that are inherently difficult to predict, such as domestic or international economic and political developments, may significantly affect the results of the Company’s activities and the value of its investments. In addition, the value of the Company’s portfolio may fluctuate as the general level of interest rates fluctuate.

The value of the Company’s investments in loans may be detrimentally affected to the extent, among other things, that a borrower defaults on its obligations, there is insufficient collateral and/or there are extensive legal and other costs incurred in collecting on a defaulted loan, observable secondary or primary market yields for similar instruments issued by comparable companies increase materially or risk premiums required in the market between smaller companies, such as our borrowers, and those for which market yields are observable increase materially.

The Investment Advisor may attempt to minimize this risk by maintaining low loan-to-liquidation values with each loan and the collateral underlying the loan.

The Company’s assets may, at any time, include securities and other financial instruments or obligations that are illiquid or thinly traded, making purchase or sale of such securities and financial instruments at desired prices or in desired quantities difficult. Furthermore, the sale of any such investments may be possible only at substantial discounts, and it may be extremely difficult to value any such investments accurately.

Note 3. Investments

The composition of our investments as of September 30, 2013, at amortized cost and fair value were as follows (dollars in thousands):


	Investments at Amortized Cost		Amortized Cost Percentage of Total Portfolio			Investments at Fair Value		Fair Value Percentage of Total Portfolio
Senior Secured Debt	$	87,247		32.5	%	$	88,232		26.7	%
Subordinated Debt		127,104		47.4			123,633		37.3
Equity and Warrants		53,951		20.1			119,112		36.0

Total	$	268,302		100.0	%	$	330,977		100.0	%

The composition of our investments as of December 31, 2012, at amortized cost and fair value were as follows (dollars in thousands):


	Investments at Amortized Cost		Amortized Cost Percentage of Total Portfolio			Investments at Fair Value		Fair Value Percentage of Total Portfolio
Senior Secured Debt	$	72,728		32.0	%	$	73,638		25.9	%
Subordinated Debt		109,030		47.9			101,659		35.8
Equity and Warrants		45,940		20.1			108,634		38.3

Total	$	227,698		100.0	%	$	283,931		100.0	%

As noted above, the Company values all investments in accordance with ASC 820. ASC 820 requires enhanced disclosures about assets and liabilities that are measured and reported at fair value. As defined in ASC 820, fair value is the price 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.

ASC 820 establishes a hierarchal disclosure framework which prioritizes and ranks the level of market price observability of inputs used in measuring investments at fair value. Market price observability is affected by a number of factors, including the type of investment and the characteristics specific to the investment. Investments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value.

Based on the observability of the inputs used in the valuation techniques, the Company is required to provide disclosures on fair value measurements according to the fair value hierarchy. The fair value hierarchy ranks the observability of the inputs used to determine fair values. Investments carried at fair value are classified and disclosed in one of the following three categories:

•

Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.

•

Level 2—Valuations based on inputs other than quoted prices in active markets, which are either directly or indirectly observable.

•

Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

In addition to using the above inputs in investment valuations, the Company continues to employ the valuation policy approved by the board of directors that is consistent with ASC 820 (See Note 2). Consistent with our Company’s valuation policy, we evaluate the source of inputs, including any markets in which our investments are trading, in determining fair value.

In estimating fair value of portfolio investments, the Company starts with the cost basis of the investment, which includes the amortized OID and payment-in-kind income, if any. The transaction price is typically the best estimate of fair value at inception. When evidence supports a subsequent change to the carrying value from the original transaction price, adjustments are made to reflect the expected fair values.

The following valuation methodologies are utilized by the company in estimating fair value and are summarized as follows:

Enterprise Value Waterfall Approach

The enterprise value waterfall approach determines an enterprise value based on EBITDA multiples of publicly traded companies that are considered similar to the subject portfolio companies. The Company considers a variety of items in determining a reasonable pricing multiple, including operating results, budgeted projections, growth, size, risk, profitability, leverage, management depth, diversification, market position, supplier or customer dependence, asset utilization, liquidity metrics, and access to capital markets. EBITDA of the portfolio company is adjusted for non-recurring items in order to reflect a normalized level of earnings that is representative of future earnings. The enterprise value is adjusted for financial instruments with seniority to the Company’s ownership and for the effect of any instrument which may dilute the Company’s investment in the portfolio company. The adjusted enterprise value is then apportioned based on the seniority and privileges of the Company’s investments within the portfolio company.

Income Approach

The income approach utilizes a discounted cash flow methodology in which the Company estimates fair value based on the present value of a stream of contractual cash flows discounted at a market rate of interest. The determination of a discount rate, or required rate of return, takes into account the portfolio company’s fundamentals and perceived credit risk. The income approach is typically utilized for debt-only investments in which the Company determines it is reasonably likely that all cash flows will be collected in accordance with the debt agreement.

Asset Approach

The asset approach values an investment based on the greater of the enterprise value or the underlying collateral securing the investment. See discussion of determining enterprise value above. This approach is used when the debt is not performing in accordance with its contractual terms or when the Company has reason to believe that it will not collect all principal and interest in accordance with the contractual terms of the debt agreement. As of September 30, 2013, there were three portfolio companies with securities valued at $10.9 million using the asset approach.

The following table presents fair value measurements of investments, by major class, as of September 30, 2013 (dollars in thousands), according to the fair value hierarchy:


	Fair Value Measurements
	Level 1		Level 2		Level 3		Total
Senior Secured Debt	$	—	$	—	$	88,232	$	88,232
Subordinated Debt		—		—		123,633		123,633
Equity and Warrants		—		—		119,112		119,112

Total	$	—	$	—	$	330,977	$	330,977

The following table presents fair value measurements of investments, by major class, as of December 31, 2012 (dollars in thousands), according to the fair value hierarchy:


	Fair Value Measurements
	Level 1		Level 2		Level 3		Total
Senior Secured Debt	$	—	$	—	$	73,638	$	73,638
Subordinated Debt		—		—		101,659		101,659
Equity and Warrants		—		—		108,634		108,634

Total	$	—	$	—	$	283,931	$	283,931

The following table provides a reconciliation of the beginning and ending balances for investments that use Level 3 inputs for the nine months ended September, 2013 (dollars in thousands):


	Senior Secured Debt			Subordinated Debt			Equity and Warrants			Total
Balance as of January 1, 2013	$	73,638		$	101,659		$	108,634		$	283,931
Change in classification due to restructure		6,735			(6,735	)		—			—
Repayments		(22,958	)		(20,004	)		(7,247	)		(50,209	)
Purchases		24,775			44,459			6,583			75,817
Purchase related to asset acquisition		5,601			2,353			3,842			11,796
Payment in-kind interest accrued, net of payments received		362			568			—			930
Accretion of original issue discount		4			31			—			35
Gain/(loss) on sale		—			(2,597	)		4,832			2,235
Increase in net unrealized appreciation		75			3,899			2,468			6,442

Balance as of September 30, 2013	$	88,232		$	123,633		$	119,112		$	330,977

The following table provides a reconciliation of the beginning and ending balances for investments that use Level 3 inputs for the nine months ended September 30, 2012 (dollars in thousands):


	Senior Secured Debt			Subordinated Debt			Equity and Warrants			Total
Balance as of January 1, 2012	$	40,357		$	114,736		$	57,638		$	212,731
Change in classification due to restructure		14,520			(14,520	)		—			—
Repayments		(8,650	)		(2,694	)		(712	)		(12,056	)
Purchases		15,920			21,019			8,088			45,027
Payment in-kind interest accrued, net of payments received		271			786			—			1,057
Accretion of original issue discount		3			53			—			56
Gain/(loss) on sale		—			—			528			528
Increase in net unrealized appreciation		2,363			2,723			16,229			21,315

Balance as of September 30, 2012	$	64,784		$	122,103		$	81,711		$	268,658

The net change in unrealized appreciation on investments held as of September 30, 2013 and 2012, was $4.2 million and $20.8 million, respectively, and is included in net unrealized appreciation on investments in the consolidated statements of operations.

The valuation techniques and significant unobservable inputs used in recurring Level 3 fair value measurements of assets as of September 30, 2013 were as follows (dollars in thousands, except EBITDA amounts):

Fair Value

Valuation Approach

Level 3 Input

Range of Inputs

Weighted
Average

Subordinated debt and second lien notes

106,631

Income

Required Rate of Return

Leverage Ratio

Adjusted EBITDA

8.0% - 19.0%

1.3x – 5.1x

$1.7 million-$23.5 million

14.4%

3.2x

$7.9 million

Subordinated debt and second lien notes

17,002

Asset and
Enterprise Value
Waterfall

Adjusted EBITDA Multiple

Adjusted EBITDA

4.9x – 5.0x

$1.6 million - $4.0 million

5.0x

$3.1 million

Senior debt and first lien notes

82,247

Income

Required Rate of Return

Leverage Ratio

Adjusted EBITDA

11.0% - 17.0%

0.1x – 5.2x

$1.5 million- $16.9 million

13.0%

3.2x

$8.3 million

Senior debt and first lien notes

5,985

Asset and
Enterprise Value
Waterfall

Adjusted EBITDA Multiple

Adjusted EBITDA

5.0x – 6.8x

$0.8 million - $1.3 million

6.0x

$1.1 million

Equity shares and warrants

119,112

Asset and
Enterprise Value
Waterfall

Adjusted EBITDA Multiple

Adjusted EBITDA

2.5x – 9.5x

$1.6 million -$36.3 million

6.9x

$13.4 million

The significant unobservable inputs used in the valuation of the Company’s debt and equity investments are required rate of return, adjusted EBITDA, EBITDA multiples, and leverage. Changes in any of these unobservable inputs could have a significant impact on the Company’s estimate of fair value. An increase (decrease) in required rate of return or leverage will result in a lower (higher) estimate of fair value while an increase (decrease) in adjusted EBITDA or EBITDA will result in a higher (lower) estimate of fair value.

Note 4. Agreements

On September 24, 2013, the Company entered into an investment advisory agreement (the “Investment Advisory Agreement”) with our Investment Advisor, which was approved by the Board of Directors of the Company on June 10, 2013. The initial term of the Investment Advisory Agreement is two years, with automatic, one-year renewals at the end of each year subject to certain approvals by our board of directors and/or our stockholders. Subject to the overall supervision of our Board of Directors, our investment adviser manages our day-to-day operations, and provides investment advisory and management services to us. Under the terms of our Investment Advisory Agreement, The Investment Advisor:

•

determines the composition of our portfolio, the nature and timing of the changes to our portfolio and the manner of implementing such changes;

•

identifies, evaluates and negotiates the structure of the investments we make (including performing due diligence on our prospective portfolio companies);

•

closes and monitors the investments we make; and

•

provides us with other investment advisory, research and related services as we may from time to time require.

The Investment Advisor’s services under the Investment Advisory Agreement are not exclusive, and it is free to furnish similar services to other entities so long as its services to us are not impaired.

Pursuant to the Investment Advisory Agreement, we have agreed to pay the Investment Advisor a fee for investment advisory and management services consisting of two components — a base management fee and an incentive fee.

The base management fee is calculated at an annual rate of 1.75% of our gross assets, which is our total assets as reflected on our Statements of Assets and Liabilities and includes any borrowings for investment purposes. Although we do not anticipate making significant investments in derivative financial instruments, the fair value of any such investments, which will not necessarily equal their notional value, will be included in our calculation of gross assets. For services rendered under the Investment Advisory Agreement, the base management fee is payable quarterly in arrears. The base management fee will initially be calculated based on the value of our gross assets at the end of the first calendar quarter subsequent to our IPO, and thereafter based on the average value of our gross assets at the end of the two most recently completed calendar quarters, and appropriately adjusted for any share issuances or repurchases during the current calendar quarter. For the first twelve months following our IPO, the Investment Advisor has agreed to waive the portion of the base management fee payable on cash and cash equivalents held at the Company level, excluding cash and cash equivalents held by the Legacy Funds that were acquired by the Company in connection with the Formation Transactions.

Prior to the formation transaction, the management fee charged by each Legacy Fund for each fiscal quarter was the lesser of (a) an amount equal to an annual rate of .625% of the sum of (i) the Legacy fund’s regulatory capital and (ii) the amount of an assumed two tiers of outstanding leverage based on such regulatory capital, or (b) an amount negotiated between the General Partner and the Management Company. The management fee was reduced by certain fees ultimately received by the Management Company from the portfolio companies. Payments of the management fee were made quarterly in advance. Certain direct expenses such as legal, audit, tax, and limited partner expense were the responsibility of the Legacy Fund.

The incentive fee consists of the following two parts:

The first part of the incentive fee is calculated and payable quarterly in arrears based on our pre-incentive fee net investment income for the immediately preceding calendar quarter. For this purpose, pre-incentive fee net investment income means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence and consulting fees or other fees that we receive from portfolio companies) accrued during the calendar quarter, minus our operating expenses for the quarter (including the base management fee, expenses payable under the Administration Agreement to our Administrator, and any interest expense and dividends paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-incentive fee net investment income includes, in the case of investments with a deferred interest feature (such as original issue discount, debt instruments with PIK interest and zero coupon securities), accrued income that we have not yet received in cash. Pre-incentive fee net investment income does not include any realized capital gains, computed net of all realized capital losses or unrealized capital appreciation or depreciation. Pre-incentive fee net investment income, expressed as a rate of return on the value of our net assets at the end of the immediately preceding calendar quarter, is compared to a hurdle of 2.0% per quarter (8.0% annualized). Our net investment income used to calculate this part of the incentive fee is also included in the amount of our gross assets used to calculate the 1.75% base management fee. We pay the Investment Advisor an incentive fee with respect to our pre-incentive fee net investment income in each calendar quarter as follows:

•

no incentive fee in any calendar quarter in which our pre-incentive fee net investment income does not exceed the hurdle of 2.0%;

•

100% of our pre-incentive fee net investment income with respect to that portion of such pre-incentive fee net investment income, if any, that exceeds the hurdle but is less than 2.5% in any calendar quarter (10.0% annualized). We refer to this portion of our pre-incentive fee net investment income (which exceeds the hurdle but is less than 2.5%) as the “catch-up.” The “catchup” is meant to provide our investment adviser with 20% of our pre-incentive fee net investment income as if a hurdle did not apply if this net investment income exceeds 2.5% in any calendar quarter; and

•

20% of the amount of our pre-incentive fee net investment income, if any, that exceeds 2.5% in any calendar quarter (10.0% annualized) is payable to Capitala Investment Advisors (once the hurdle is reached and the catch-up is achieved, 20% of all preincentive fee investment income thereafter is allocated to the Investment Advisor).

The second part of the incentive fee is determined and payable in arrears as of the end of each calendar year (or upon termination of the Investment Advisory Agreement, as of the termination date), commencing with the 2013 calendar year, and will equal 20% of our realized capital gains, if any, on a cumulative basis from inception through the end of each calendar year, computed net of all realized capital losses and unrealized capital depreciation on a cumulative basis, less the aggregate amount of any previously paid capital gain incentive fees with respect to each of the investments in our portfolio, provided that, the incentive fee determined as of December 31, 2013 will be calculated for a period of shorter than twelve calendar months to take into account any realized capital gains computed net of all realized capital losses and unrealized capital depreciation from the inception of the Company.

We will defer cash payment of the portion of any incentive fee otherwise earned by our Investment Advisor that would, when taken together with all other incentive fees paid to our Investment Advisor during the most recent 12 full calendar month period ending on or prior to the date such payment is to be made, exceed 20% of the sum of (a) our pre-incentive fee net investment income during such period, (b) our net unrealized appreciation or depreciation during such period and (c) our net realized capital gains or losses during such period. Any deferred incentive fees will be carried over for payment in subsequent calculation periods to the extent such payment is payable under the Investment Advisory Agreement. Such deferred amounts will be calculated using a period of shorter than 12 full calendar months until 12 full calendar months have passed since completion of our IPO.

For the three months ended September 30, 2013 and 2012 we incurred $1.0 million and $1.3 million in base management fees, respectively. For each of the nine month periods ending September 30, 2013 and 2012 we incurred $3.0 million in base management fees, respectively.

On September 24, 2013, the Company entered into a separate administration agreement (the “Administration Agreement”) with Capitala Advisors Corp., our Administrator, pursuant to which our Administrator has agreed to furnish us with office facilities, equipment and clerical, bookkeeping and record keeping services at such facilities. Our Administrator also performs, or oversees the performance of, our required administrative services, which include, among other things, being responsible for the financial records that we are required to maintain and preparing reports to our stockholders. In addition, our Administrator assists us in determining and publishing our net asset value, oversees the preparation and filing of our tax returns and the printing and dissemination of reports to our stockholders, and generally oversees the payment of our expenses and the performance of administrative and professional services rendered to us by others.

Payments under the Administration Agreement are equal to an amount based upon our allocable portion of our Administrator’s overhead in performing its obligations under the Administration Agreement, including rent, the fees and expenses associated with performing compliance functions and our allocable portion of the compensation of our chief financial officer, chief compliance officer and our allocable portion of the compensation of any administrative support staff. Under the Administration Agreement, our Administrator will also provide on our behalf managerial assistance to those portfolio companies that request such assistance. The Administration Agreement will have an initial term of two years and may be renewed with the approval of our Board of Directors. The Administration Agreement may be terminated by either party without penalty upon 60 days’ written notice to the other party. To the extent that our Administrator outsources any of its functions, we will pay the fees associated with such functions on a direct basis without any incremental profit to our Administrator. Stockholder approval is not required to amend the Administration Agreement.

The Administration Agreement provides that, absent willful misfeasance, bad faith or negligence in the performance of its duties or by reason of the reckless disregard of its duties and obligations, our Administrator and its officers, managers, partners, agents, employees, controlling persons, members and any other person or entity affiliated with it are entitled to indemnification from the Company. for any damages, liabilities, costs and expenses (including reasonable attorneys’ fees and amounts reasonably paid in settlement) arising from the rendering of our Administrator’s services under the Administration Agreement or otherwise as Administrator for the Company.

Note 5. Related Party Transactions

At September 30, 2013 and December 31, 2012, the Company had the following receivables from (payables to) related parties relating to certain capital contributions, management fees, and reimbursable expenses:


	September 30, 2013			December 31, 2012
CapitalSouth Corporation	$	256		$	256
Phoenix Holdings-NC, Inc.		(486	)		(161	)
Shareholders/Limited Partners		275			138
Capital South Fund III, L.P.		1,046			1,062
Other		188			2

Total	$	1,279		$	1,297

These amounts are reflected in the accompanying statements of financial position under the captions, “Due from related parties” and “Due to related parties.”

At times, the Company maintains deposit accounts and certificates of deposit with financial institutions that are shareholders of the Company or were limited partners of a legacy fund prior to the formation transaction. Total deposits with these financial institutions were approximately $13.7 million and $30.3 million at September 30, 2013 and December 31, 2012, respectively.

Note 6. Borrowings

SBA Debentures

The Company, through its two wholly-owned subsidiaries, uses debenture leverage provided through the SBA to fund a portion of its investment portfolio. As of September 30, 2013, the Company has issued $202.2 million of SBA-guaranteed debentures. The Company has issued all SBA-guaranteed debentures that were permitted under each of the Legacy Funds’ respective SBIC licenses (as applicable), and there are no unused SBA debenture commitments remaining.

For the three and nine months ended September 30, 2013, we recorded $2.2 million and $6.5 million, respectively, of interest and financing expenses related to the SBA guaranteed debenture, of which $2.0 million and $6.0 million, respectively, was attributable to interest expense and $0.2 million and $0.5 million, respectively, of amortization of commitment and upfront fees. For the three and nine months ended September 30, 2012, we recorded $2.0 million and $5.8 million, respectively, of interest and financing expenses related to the SBA guaranteed debenture, of which $1.8 million and $5.3 million, respectively, was attributable to interest expense and $0.2 million and $0.5 million, respectively, of amortization of commitment and upfront fees. The weighted average interest rate for all SBA-guaranteed debentures as of September 30, 2013 and December 31, 2012 was 3.57% and 3.74%, respectively.

As of September 30, 2013 and December 31, 2012, the Company’s issued and outstanding SBA-guaranteed debentures mature as follows (dollars in thousands):


Date of Pooling	Fixed Maturity Date	Interest Rate			September 30, 2013		December 31, 2012
September 1, 2004	September 1, 2014		4.120	%	$	2,000	$	2,000
September 1, 2004	September 1, 2014		4.684	%		8,000		8,000
September 1, 2005	September 1, 2015		4.941	%		8,000		8,000
September 1, 2005	September 1, 2015		5.524	%		2,000		2,000
September 1, 2006	September 1, 2016		5.535	%		11,500		11,500
March 1, 2009	March 1, 2019		4.620	%		5,000		5,000
September 1, 2010	September 1, 2020		3.215	%		3,000		3,000
September 1, 2010	September 1, 2020		3.215	%		4,000		4,000
September 1, 2010	September 1, 2020		3.215	%		4,000		4,000
September 1, 2010	September 1, 2020		3.215	%		4,000		4,000
September 1, 2010	September 1, 2020		3.215	%		4,000		4,000
March 1, 2011	March 1, 2021		4.084	%		15,700		15,700
March 1, 2011	March 1, 2021		4.084	%		5,000		5,000
March 1, 2011	March 1, 2021		4.084	%		5,000		5,000
March 1, 2011	March 1, 2021		4.084	%		4,000		4,000
March 1, 2011	March 1, 2021		4.084	%		18,000		18,000
March 1, 2011	March 1, 2021		4.084	%		14,000		14,000
March 1, 2012	March 1, 2022		2.766	%		25,000		25,000
March 1, 2012	March 1, 2022		2.766	%		35,000		35,000
March 1, 2013	March 1, 2023		2.351	%		25,000		—

					$	202,200	$	177,200

ASC Topic 820 requires disclosure of the fair value of financial instruments for which it is practical to estimate such value. The Company estimates that the fair value of its SBA-guaranteed debentures is approximately $209.1 million and $185.8 million as of September 30, 2013 and December 31, 2012, respectively. The fair value estimate was based on future contractual cash payments discounted at market interest rates to borrow from the SBA as of the measurement date. Because the market interest rate is considered an unobservable input, SBA-guaranteed debentures are considered a level 3 financial instrument in the fair value hierarchy.

Note 7. Directors Fees

Our independent directors receive an annual fee of $50,000. They also receive $5,000 plus reimbursement of reasonable out-of-pocket expenses incurred in connection with attending each board meeting, and also receive $5,000 plus reimbursement of reasonable out-of-pocket expenses incurred in connection with attending each committee meeting. In addition, the chairman of the audit committee receives an annual fee of $10,000 and each chairman of any other committee receives an annual fee of $5,000 for their additional services, if any, in these capacities. No compensation is expected to be paid to directors who are “interested persons” of the Company, as such term is defined in Section 2(a)(19) of the 1940 Act.

Note 8. Stockholders’ Equity

On September 24, 2013, we issued 8,974,420 shares of common stock to the limited partners of the Legacy Funds, in exchange for 100% of their membership interests or certain investment assets of such Legacy Fund, as the case may be. On September 30, 2013, we issued 4,000,000 shares of common stock in connection with the closing of our IPO. The shares issued in the IPO were priced at $20.00 per share. We received proceeds of $76.0 million in the IPO, net of underwriters’ discounts and commissions of $4.0 million. The limited partners of the Legacy Funds bore the other $1.75 million in out of pocket expenses associated with the offering.

Note 9. Earnings Per Share

In accordance with the provisions of ASC 260, Earnings per Share, basic earnings per share is computed by dividing earnings available to common shareholders by the weighted average number of shares outstanding during the period. Other potentially dilutive common shares, and the related impact to earnings, are considered when calculating earnings per share on a diluted basis. As of September 30, 2013, there were no dilutive shares.

The following information sets forth the computation of the weighted average basic and diluted net increase in net assets per share from operations for the three and nine months ended September 30, 2013 and 2012 (dollars in thousands except share and per share data):


	For the three months ended				For the nine months ended
Basic and diluted	September 30, 2013		September 30, 2012		September 30, 2013		September 30, 2012
Net increase in net assets from operations	$	7,909	$	10,778	$	22,062	$	30,874
Weighted average common shares outstanding		12,974,420		N/A		12,974,420		N/A
Net increase in net assets per share from operations-basic and diluted	$	0.61		N/A	$	1.70		N/A

Note 10. Dividend

The Company’s dividends and distributions are recorded on the record date. Shareholders have the option to receive payment of the dividend in cash, shares of common stock, or a combination of cash and common stock.

Note 11. Financial Highlights

The following is a schedule of financial highlights for the nine months ended September 30, 2013 (dollars in thousands, except share and per share data):


	September 30, 2013
Per share data:
Net asset value at beginning of period(1)	$	17.74

Net investment income(2)		1.03
Net realized gain on investments		0.17
Net unrealized appreciation on investments		0.50

Net increase in stockholders’ equity		1.70


Capital contributions from partners		1.92
Capital distributions to partners		(0.57	)

Net asset value at end of period	$	20.79
Net assets at end of period	$	269,722
Shares outstanding at end of period		12,974,420
Per share market value at end of period	$	19.20
Total return based on market value(3)		(4.00	)%
Ratio/Supplemental data:
Ratio of net investment income to average, net assets(1)(5)		7.14	%
Ratio of operating expenses to average net assets(1)(5)		1.80	%
Ratio of incentive management fees to average net assets(1)(5)		—	%
Ratio of debt related expenses to average net assets(1)(5)		3.48	%
Ratio of total expenses to average net assets(1)(5)		5.29	%
Portfolio turnover rate(4)		2.27	%

(1)

Net asset value as of January 1, 2013 and average net assets for the nine months ended September 30, 2013 are presented as if the Offering and Formation Transactions had occurred on January 1, 2013. See Note 2 for a further description of the basis of presentation of the Company’s financial statements

(2)	Net investment income per share is calculated using the weighted average shares outstanding during the period.

(3)

Total investment return is calculated assuming a purchase of common shares at the IPO offering price per share at September 25, 2013 of $20.00 and a sale at the current market value on the last day of the period reported. Dividends and distributions, if any, are assumed for purposes of this calculation to be reinvested at prices obtained under the Company’s dividend reinvestment plan. Total investment return does not reflect brokerage commissions. Total investment returns covering less than a full period are not annualized.

(4)	Portfolio turnover rate is calculated using the lesser of year-to-date sales or year-to-date purchases over the average of the invested assets at fair value.

(5)	Ratios are annualized.

Note 12. Subsequent Events

Management has evaluated subsequent events through the date of issuance of the consolidated financial statements included herein. There have been no subsequent events that occurred during such period that would be required to be recognized in the consolidated financial statements as of and for the three and nine month periods ended September 30, 2013.

On October 28, 2013, the Company invested $6.0 million in Crowley Holdings Inc. in Series A Preferred Equity, secured by underlying subordinated debt, earning 10% cash and 2% PIK.

On October 28, 2013, the Company invested $2.06 million in Source Capital SSCR, LLC in subordinated debt, earning 14% cash and 5% PIK.

On November 1, 2013, the Company invested $11.1 million in TCE Holding Company, with $9.6 million in subordinated debt, earning 12% cash and 2% PIK, and $1.5 million in common stock.

On November 11, 2013, the Company’s Board of Directors declared a quarterly dividend of $0.47 per share payable on December 30, 2013 to holders of record as of December 10, 2013.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with our financial statements and related notes and other financial information appearing elsewhere in this Quarterly Report on Form 10-Q.

Except as otherwise specified, references to “we,” “us,” “our” or the “Company”, refer to Capitala Finance Corp.

This Quarterly Report, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve substantial risks and uncertainties. These forward-looking statements are not historical facts, but rather are based on current expectations, estimates and projections about the Company, our current and prospective portfolio investments, our industry, our beliefs, and our assumptions. Words such as “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” “continue,” “believes,” “seeks,” “estimates,” “would,” “could,” “should,” “targets,” “projects,” and variations of these words and similar expressions are intended to identify forward-looking statements.

The forward-looking statements contained in this Quarterly Report on Form 10-Q involve risks and uncertainties, including statements as to:

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our future operating results;

•

our business prospects and the prospects of our portfolio companies;

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the impact of investments that we expect to make;

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our contractual arrangements and relationships with third parties;

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the dependence of our future success on the general economy and its impact on the industries in which we invest;

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the ability of our portfolio companies to achieve their objectives;

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our expected financings and investments;

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our ability to obtain exemptive relief from the SEC to co-invest and to engage in joint restructuring transactions or joint follow-on investments;

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the adequacy of our cash resources and working capital; and

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the timing of cash flows, if any, from the operations of our portfolio companies.

These statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements, including without limitation:

•

an economic downturn could impair our portfolio companies’ ability to continue to operate or repay their borrowings, which could lead to the loss of some or all of our investments in such portfolio companies;

•

a contraction of available credit and/or an inability to access the equity markets could impair our lending and investment activities;

•

interest rate volatility could adversely affect our results, particularly if we use leverage as part of our investment strategy; and

•

the risks, uncertainties and other factors we identify in “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.

Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also could be inaccurate. Important assumptions include our ability to originate new loans and investments, certain margins and levels of profitability and the availability of additional capital. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this Quarterly Report on Form 10-Q should not be regarded as a representation by us that our plans and objectives will be achieved. These risks and uncertainties include those described or identified in “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law or Securities and Exchange Commission (“SEC”) rule or regulation.

OVERVIEW

We are a Maryland corporation that has elected to be treated as a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”). Our investment objective is to generate both current income and capital appreciation through debt and equity investments. We are managed by Capitala Investment Advisors (the “Investment Advisor”), and Capitala Advisors Corp. (the “Administrator”) provides the administrative services necessary for us to operate.

We provide capital to smaller and lower middle-market companies in the United States, with a non-exclusive emphasis on the Southeast, Southwest and Mid-Atlantic regions. We invest primarily in companies with a history of earnings growth and positive cash flow, proven management teams, product or service with competitive advantages and industry-appropriate margins. We primarily invest in companies with between $5 million and $30 million in trailing twelve month EBITDA.

We invest in mezzanine and senior subordinated debt investments that are secured by subordinated liens on all of our borrowers’ assets and, to a lesser extent, in senior, cash flow-based “unitranche” securities. Most of our debt investments are coupled with equity interests, whether in the form of detachable “penny” warrants or equity co-investments made pari passu with our borrowers’ financial sponsors.

Corporate History

Immediately prior to our initial public offering (“IPO”), through a series of transactions (the “Formation Transactions”), we acquired all the equity interests in CapitalSouth Partners Fund II Limited Partnership (“Fund II”), CapitalSouth Partners SBIC Fund III, L.P. (“Fund III”), CapitalSouth Partners Florida Sidecar Fund I, L.P. (“Florida Sidecar”) and each such fund’s respective general partners, as well as certain assets from CapitalSouth Partners Fund I Limited Partnership (“Fund I”) and CapitalSouth Partners Fund III, L.P. (“Fund III Parent”, and together with Fund I, Fund II, Fund III and Florida Sidecar, the “Legacy Funds”), which collectively constitute our portfolio. The investments included in our portfolio had a collective fair value of approximately $315.6 million as of June 30, 2013, as determined by our board of directors based on management’s internal analysis and positive assurance from a third-party independent valuation firm. At the time of the Formation Transactions, our portfolio consisted of: (1) approximately $326.3 million in investments; (2) an aggregate of approximately $67.1 million in cash,

interest receivable and other assets; and (3) liabilities of approximately $202.2 million of SBA-guaranteed debt payable. In connection with our acquisition of our portfolio, we issued an aggregate of approximately 9.0 million shares of our common stock to the investors in the Legacy Funds. We have two SBIC-licensed subsidiaries that have elected to be treated as BDCs under the 1940 Act. We may also seek other forms of leverage and borrow funds to make investments, including before we have fully invested the proceeds of this offering.

Revenues

We generate revenue primarily from the periodic cash interest we will collect on our debt investments. In addition, most of our debt investments offer the opportunity to participate in a borrower’s equity performance through warrant participation, direct equity ownership or otherwise, which we expect to result in revenue in the form of dividends and/or capital gain. Further, we may generate revenue in the form of commitment, origination, structuring or diligence fees, monitoring fees, fees for providing managerial assistance and possibly consulting fees and performance-based fees. These fees will be recognized as they are earned.

Expenses

Our primary operating expenses include the payment of investment advisory fees to our investment adviser, Capitala Investment Advisors, LLC, our allocable portion of overhead and other expenses incurred by our Administrator in performing its obligations under the Administration Agreement and other operating expenses as detailed below. Our investment advisory fee will compensate our investment adviser for its work in identifying, evaluating, negotiating, closing, monitoring and servicing our investments. We will bear all other expenses of our operations and transactions, including (without limitation):

•

the cost of our organization;

•

the cost of calculating our net asset value, including the cost of any third-party valuation services;

•

the cost of effecting sales and repurchases of our shares and other securities;

•

interest payable on debt, if any, to finance our investments;

•

fees payable to third parties relating to, or associated with, making investments, including fees and expenses associated with performing due diligence reviews of prospective investments and advisory fees;

•

transfer agent and custodial fees;

•

fees and expenses associated with marketing efforts;

•

costs associated with our reporting and compliance obligations under the 1940 Act, the Exchange Act, other applicable federal and state securities laws and ongoing stock exchange listing fees;

•

federal, state and local taxes;

•

independent directors’ fees and expenses;

•

brokerage commissions;

•

costs of proxy statements, stockholders’ reports and other communications with stockholders;

•

fidelity bond, directors’ and officers’ liability insurance, errors and omissions liability insurance and other insurance premiums;

•

direct costs and expenses of administration, including printing, mailing, telephone and staff;

•

fees and expenses associated with independent audits and outside legal costs; and

•

all other expenses incurred by either our Administrator or us in connection with administering our business, including payments under the Administration Agreement that will be based upon our allocable portion of overhead and other expenses incurred by our Administrator in performing its obligations under the Administration Agreement, including rent, the fees and expenses associated with performing compliance functions, and our allocable portion of any costs of compensation and related expenses of our chief compliance officer and our chief financial officer and any administrative support staff.

Critical Accounting Policies and Use of Estimates

In the preparation of our unaudited financial statements and related disclosures, we have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States (“U.S. GAAP”). Our significant accounting policies are described in Note 2 to the Consolidated Financial Statements. While all of these policies are important to understanding our financial statements, certain accounting policies and estimates are considered critical due to their impact on the reported amounts of assets and liabilities at the date of the unaudited financial statements and the reported amounts of revenues and expenses for the periods covered by such financial statements. We have identified investment valuation and revenue recognition as our most critical accounting estimates. We continuously evaluate our estimates, including those related to the matters described below. Because of the nature of the judgment and assumptions we make, actual results could differ material from those estimates under different assumptions or conditions. A discussion of our critical accounting policies follows.

Valuation of Investments

The Company applies fair value accounting to all of its financial instruments in accordance with the 1940 Act and ASC Topic 820 - Fair Value Measurements and Disclosures. ASC 820 defines fair value, establishes a framework used to measure fair value and requires disclosures for fair value measurements. In accordance with ASC 820, the Fund has categorized its financial instruments carried at fair value, based on the priority of the valuation technique, into a three-level fair value hierarchy as discussed in Note 3.

In determining fair value, our board of directors uses various valuation approaches, and engages a third-party independent valuation firm, which provides positive assurance on the investments they review. In accordance with U.S. GAAP, a fair value hierarchy for inputs is used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available.

Level 1 – Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not applied to Level 1 securities. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment.

Level 2 – Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.

Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

Valuation Techniques

Senior and Subordinated Secured Loans

The Fund’s portfolio primarily consists of private debt instruments (“Level 3 debt”). We consider our Level 3 debt to be performing loans if the borrower is not in default, the borrower is remitting payments in a timely manner, the loan is in covenant compliance or is otherwise not deemed to be impaired. In determining the fair value of the performing Level 3 debt, the Company’s board of directors considers fluctuations in current interest rates, the trends in yields of debt instruments with similar credit ratings (if applicable), the financial condition of the borrower, economic conditions and other relevant factors, both qualitative and quantitative. In the event that a Level 3 debt instrument is not performing, as defined above, the board of directors will evaluate the value of the collateral utilizing the same framework described above for a performing loan to determine the value of the Level 3 debt instrument.

Equity Investments in Private Companies

Warrants

Our board of directors will ascribe value to warrants based on fair value holdings that can include discounted cash flow analyses, option pricing models, comparable analyses and other techniques as deemed appropriate. Such warrants are included in Level 3 of the fair value hierarchy to the extent issued by non-public companies.

Revenue Recognition

The Company’s revenue recognition policies are as follows:

Gains and Losses on investment sales and paydowns: Realized gains and losses on investments are recognized using the specific identification method.

Dividend Income: Dividend income is recognized on the date dividends are declared.

Portfolio and Investment Activity

As of September 30, 2013, our portfolio consisted of investments in 40 portfolio companies with a fair value of approximately $331.0 million.

During the three months ended September 30, 2013, we made approximately $34.2 million of investments in new or existing portfolio companies and had approximately $23.1 million in aggregate amount of exits and repayments resulting in net investments of approximately $11.1 million for the period. During the three months ended September 30, 2012, we made approximately $23.3 million of investments in new or existing portfolio companies and had approximately $3.3 million in aggregate amount of exits and repayments resulting in net investments of approximately $20.0 million for the period.

During the nine months ended September 30, 2013, we made approximately $75.8 million of investments in new or existing portfolio companies and had approximately $50.2 million in aggregate amount of exits and repayments resulting in net investments of approximately $25.6 million for the period. During the nine months ended September 30, 2012, we made approximately $45.0 million of investments in new or existing portfolio companies and had approximately $12.1 million in aggregate amount of exits and repayments resulting in net investments of approximately $32.9 million for the period.

As of September 30, 2013, our average portfolio company investment and our largest portfolio company investment at amortized cost and fair value was approximately $6.7 million and $8.3 million, and $19.0 million and $29.0 million, respectively. As of September 30, 2013, the Company had approximately $133.5 million of cash and cash equivalents. As of December 31, 2012, our average portfolio company investment and our largest portfolio company investment at amortized cost and fair value was approximately $6.0 million and $7.5 million, and $17.4 million and $29.9 million, respectively. As of December 31, 2012, the Company had $30.5 million of cash and cash equivalents

The following table summarizes the amortized cost and the fair value of investments and cash and cash equivalents as of September 30, 2013 (dollars in thousands):


	Investments at Amortized Cost		Amortized Cost Percentage of Total Portfolio			Investments at Fair Value		Fair Value Percentage of Total Portfolio
Senior Secured Debt	$	87,247		21.7	%	$	88,232		19.0	%
Subordinated Debt		127,104		31.7			123,633		26.6
Equity and Warrants		53,951		13.4			119,112		25.6
Cash and Cash Equivalents		133,525		33.2			133,525		28.8

Total	$	401,827		100.0	%	$	464,502		100.0	%

The following table summarizes the amortized cost and the fair value of investments and cash and cash equivalents as of December 31, 2012 (dollars in thousands):


	Investments at Amortized Cost		Amortized Cost Percentage of Total Portfolio			Investments at Fair Value		Fair Value Percentage of Total Portfolio
Senior Secured Debt	$	72,728		28.2	%	$	73,638		23.4	%
Subordinated Debt		109,030		42.2			101,659		32.3
Equity and Warrants		45,940		17.8			108,634		34.6
Cash and Cash Equivalents		30,467		11.8			30,467		9.7

Total	$	258,165		100.0	%	$	314,398		100.0	%

As of September 30, 2013, our income-bearing investment portfolio, which represented nearly 64.0% of our total portfolio, had a weighted average yield based upon cost of our portfolio investments of approximately 13.8% all bearing a fixed rate of interest. As of December 31, 2012, our income-bearing investment portfolio, which represented nearly 62% of our total portfolio, had a weighted average yield based upon cost of our portfolio investments of approximately 13.5% all bearing a fixed rate of interest.

The following table shows the portfolio composition by industry grouping at fair value (dollars in thousands):


	September 30, 2013					December 31, 2012
	Investments at Fair Value		Percentage of Total Portfolio			Investments at Fair Value		Percentage of Total Portfolio
QSR Franchisee	$	28,970		8.8	%	$	29,950		10.5	%
Professional Employer Organization		22,948		6.9			15,229		5.4
Industrial Equipment Rental		22,500		6.8			18,001		6.4
Sales & Marketing Services		20,898		6.3			7,008		2.5
Oil & Gas Services		19,646		5.9			6,240		2.2
Printing Services		15,572		4.7			8,185		2.9
Suntan Lotion Manufacturer		15,040		4.5			12,892		4.5
QSR Franchisor		14,904		4.5			15,112		5.3
Footwear Retail		11,445		3.5			7,131		2.5
Specialty Clothing		11,173		3.4			10,333		3.6
Culinary Products		10,194		3.1			8,769		3.1
Fuel Transportation Services		10,185		3.1			9,043		3.2
Retail IT & Security Solutions		10,000		3.0			—		—
Dentistry Services		9,334		2.8			7,984		2.8
Textile Equipment Manufacturer		9,301		2.8			8,433		3.0
Energy Services		8,566		2.6			7,287		2.6
Aerospace Parts Manufacturer		7,910		2.4			5,219		1.8
Conglomerate		7,551		2.3			8,565		3.0
Computer Supply Retail		7,549		2.3			—		—
Produce Distribution		6,881		2.1			6,722		2.4
Replacement Window Manufacturer		6,559		2.0			5,585		2.0
Medical Device Manufacturer		6,454		2.0			6,286		2.2
Western Wear Retail		5,071		1.5			19,928		7.0
Advertising & Marketing Services		5,070		1.5			18,453		6.5
Data Processing & Digital Marketing		5,061		1.5			637		0.2
Medical Device Distributor		4,328		1.3			3,561		1.3
Petroleum Equipment Supplier		3,481		1.0			2,681		0.9
Industrial Manufacturing		3,396		1.0			—		—
Automotive Chemicals & Lubricants		3,140		0.9			3,283		1.2
Metal Recycler		3,031		0.9			2,931		1.0
Specialty Defense Contractor		2,722		0.8			467		0.2
Online Travel Sales & Marketing		2,504		0.8			1,421		0.5
Industrial Boiler Manufacturer		2,447		0.7			2,660		0.9
Corporate Fulfillment		2,193		0.7			1,165		0.4
Building Supplies		1,969		0.6			972		0.3
Quick Lube Services		1,523		0.5			13,248		4.7
In-Home Healthcare Services		874		0.3			374		0.1
IT Hosting Services		587		0.2			372		0.1
Usenet Hosting Services		—		—			6,214		2.2
Textile Manufacturer		—		—			1,590		0.6

Total	$	330,977		100.0	%	$	283,931		100.0	%

All investments made by the Company as of September 30, 2013 and December 31, 2012 were made in portfolio companies located in the U.S. The geographic composition is determined by the location of the corporate headquarters of the portfolio company, which may not be indicative of the primary source of the portfolio company’s business. The following table shows the portfolio composition by geographic region at fair value at September 30, 2013 and December 31, 2012 (dollars in thousands):


	At September 30, 2013					At December 31, 2012
	Investments at Fair Value		Percentage of Total Portfolio			Investments at Fair Value		Percentage of Total Portfolio
South	$	225,255		68.0	%	$	202,429		71.3	%
West		63,135		19.1			47,931		16.9
Northeast		22,097		6.7			18,419		6.5
Midwest		20,490		6.2			15,152		5.3

Total	$	330,977		100.0	%	$	283,931		100.0	%

The Investment Advisor regularly assesses the risk profile of each of our investments and rates each of them based on the following categories, which we refer to as the Investment Advisor’s investment credit rating:


Credit Rating		Definition

1		Investments that are performing above expectations.

2		Investments that are performing within expectations, with risks that are neutral or favorable compared to risks at the time of origination. All new loans are rated ‘2’.

3		Investments that are performing below expectations and that require closer monitoring, but where no loss of interest, dividend or principal is expected. Companies rated ‘3’ may be out of compliance with financial covenants, however, loan payments are generally not past due.


Credit Rating		Definition

4		Investments that are performing below expectations and for which risk has increased materially since origination. Some loss of interest or dividend is expected but no loss of principal. In addition to the borrower being generally out of compliance with debt covenants, loan payments may be past due (but generally not more than 180 days past due).

5		Investments that are performing substantially below expectations and whose risks have increased substantially since origination. Most or all of the debt covenants are out of compliance and payments are substantially delinquent. Some loss of principal is expected.

The following table shows the distribution of our investments on the 1 to 5 investment performance rating scale at fair value as of September 30, 2013 (dollars in thousands):


Investment Performance Rating	Investments at Fair Value		Percentage of Total Investments
1	$	159,969		48.3	%
2		124,046		37.5
3		33,517		10.1
4		13,445		4.1
5		—		—

Total	$	330,977		100.0	%

The following table shows the distribution of our investments on the 1 to 5 investment performance rating scale at fair value as of December 31, 2012 (dollars in thousands):


Investment Performance Rating	Investments at Fair Value		Percentage of Total Investments
1	$	172,598		60.8	%
2		80,676		28.4
3		21,870		7.7
4		8,787		3.1
5		—		—

Total	$	283,931		100.0	%

The Company had non-accrual loans outstanding with a fair market value of $10.9 million and $5.1 million as of September 30, 2013 and December 31, 2012, respectively.

Results of Operations

Operating results for the three and nine months ended September 30, 2013 and 2012 are as follows (dollars in thousands):


	For the three months ended
	September 30, 2013		September 30, 2012
Total investment income	$	8,801	$	6,614
Total expenses, net		3,364		3,344

Net investment income		5,437		3,270
Net realized gains		1,871		196
Net unrealized gains (losses)		601		7,312

Net increase (decrease) in net assets resulting from operations	$	7,909	$	10,778


	For the nine months ended
	September 30, 2013		September 30, 2012
Total investment income	$	23,288	$	17,935
Total expenses, net		9,903		8,904

Net investment income		13,385		9,031
Net realized gains		2,235		528
Net unrealized gains (losses)		6,442		21,315

Net increase in net assets resulting from operations	$	22,062	$	30,874

Investment income

The composition of our investment income for the three and nine months ended September 30, 2013 and 2012 was as follows (dollars in thousands):


	For the three months ended
	September 30, 2013		September 30, 2012
Loan interest, fee and dividend income	$	8,103	$	6,156
Payment-in-kind interest income		422		425
Interest from cash and cash equivalents		66		33
Income from pass-through entities		210		—

Total Investment Income	$	8,801	$	6,614

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