PCAP Patriot Capital Funding (MM)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

 

 

Form 10-K

 

 

 

COMMISSION FILE NUMBER: 0-51459

 

 

PATRIOT CAPITAL FUNDING, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

 

 

 

 

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE:

(203) 429-2700

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

 

 

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

NONE

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  YES  o      NO  þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  YES  o      NO  þ

 

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 periods as the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES  þ      NO  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   þ

 

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):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act)  YES  o      NO  þ

 

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant as of June 30, 2008 was approximately $122,000,000.

 

The registrant had 20,950,501 outstanding shares of common stock as of March 12, 2009.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive Proxy Statement relating to the 2009 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission, are incorporated by reference in Part III of this Annual Report on Form 10-K as indicated herein.

 

 

TABLE OF CONTENTS

 

ITEM 1.   Business

 

In light of the unprecedented instability in the financial markets and the severe slowdown in the overall economy, we do not have adequate liquidity, including access to the debt and equity capital markets, to operate our business in the manner in which we have historically operated. As a result, our short-term business focus has shifted from making debt and equity investments to preserving our liquidity position. In this regard, we are currently negotiating the renewal of the liquidity facility, which matures in April 2009, supporting our second amended and restated securitization revolving credit facility with certain liquidity banks. In the event that the liquidity banks do not renew the liquidity facility, the terms of the second amended and restated securitization revolving credit facility require that all principal and interest collected from the debt investments secured by the facility must be used to pay down amounts outstanding under the facility by April 2011. Because substantially all of our debt investments are secured by our second amended and restated securitization revolving credit facility, we cannot provide any assurance that we would have sufficient cash and liquid assets to fund normal operations and dividend distributions to our stockholders during the period of time when we are required to repay amounts outstanding under the second amended and restated securitization revolving credit facility if such amounts became due. If the liquidity facility is not renewed, we believe that we may be able to negotiate an arrangement with the lenders of the second amended and restated securitization revolving credit facility for repayment terms that do not require us to use all principal and interest collected from the debt investments secured by the facility to pay down amounts outstanding thereunder, however, we cannot provide any assurance that we will be able to do so. As a result, if the Company was unable to (i) renew the liquidity facility supporting our second amended and restated securitization revolving credit facility or (ii) negotiate an arrangement with the lenders of the second amended and restated securitization revolving credit facility for repayment terms that do not require us to use all principal and interest collected from the debt investments secured by the facility to pay down amounts outstanding thereunder there would be a significant adverse impact on our financial position and operating results.

 

Moreover, because of the uncertainty surrounding the renewal of the liquidity facility, our independent registered public accounting firm has issued an opinion on our consolidated financial statements that states that the consolidated financial statements were prepared assuming we will continue as a going concern, however the opinion further states that the uncertainty regarding the renewal of the liquidity facility raises substantial doubt about our ability to continue as a going concern. In addition, our board of directors has postponed making a decision regarding the declaration of our first quarter 2009 dividend until we have more information on whether the liquidity facility will be renewed.

 

Finally, even if the liquidity facility is renewed and, as a result, the reason for the going concern qualification contained in the opinion of our independent registered public accounting firm is resolved, our ability to operate our business in the manner in which we have historically operated which is described in detail below, will be constrained until our ability to access the debt and equity capital markets improves.

 

General

 

We are a specialty finance company that provides customized financing solutions to small- to mid-sized companies. Our ability to invest across a company’s capital structure, from senior secured loans to equity securities, allows us to offer a comprehensive suite of financing solutions, including “one-stop” financings. Our “one-stop” financing typically includes a revolving line of credit, one or more senior secured term loans and a subordinated debt investment. We also make equity co-investments of generally up to $3.0 million and investments in broadly syndicated loans. We primarily finance privately-held companies in transactions initiated by private equity sponsors.

 

Our investment objective is to generate both current cash income and capital appreciation. To accomplish this objective, we seek to provide our stockholders with current income primarily from the interest on our debt investments and related origination fees, and to enable our stockholders to participate in the capital

appreciation and potential long-term growth of our portfolio companies through warrants and other equity interests we acquire.

 

We typically make investments of $3 million to $20 million in companies with $10 million to $100 million in annual revenues that operate in diverse industry sectors. As of December 31, 2008, we had debt investments in 32 portfolio companies with an aggregate fair value of $308.1 million, and warrants to purchase shares of common stock in two portfolio companies and equity investments (other than warrants) in 21 portfolio companies with an aggregate fair value of $14.3 million.

 

As of December 31, 2008, senior secured revolving lines of credit, senior secured term loans, junior secured term loans, subordinated debt and equity investments comprised approximately 3.2%, 45.4%, 18.0%, 29.0%, and 4.4%, respectively, of our investment portfolio at fair value. For the year ended December 31, 2008, the weighted average yield on all of our outstanding debt investments was approximately 12.1%.

 

We are a closed-end, non-diversified investment company that has elected to be treated as a business development company under the Investment Company Act of 1940, or the 1940 Act. We are internally managed by our executive officers under the supervision of our board of directors. As a result, we do not pay investment advisory fees, but instead we incur the operating costs associated with employing investment and portfolio management professionals.

 

As a business development company, we are required to comply with numerous regulatory requirements. We finance our investments using debt and equity. However, our ability to use debt is limited in certain significant respects. See “Business — Regulations — Regulation as a Business Development Company.” We have elected to be treated for federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code, or the Code. See “Business — Regulations — Taxation as a Regulated Investment Company.” As a RIC, we generally will not have to pay corporate-level federal income taxes on any net ordinary income or capital gains that we distribute to our stockholders as dividends if we meet certain source-of-income, income distribution and asset diversification requirements.

 

Corporate History and Information

 

We were founded in November 2002 by Richard P. Buckanavage, our president and chief executive officer, Timothy W. Hassler, our chief investment officer, and Compass Group Investments, Inc., a private investment firm providing capital to middle market companies. Prior to our founding, Mr. Buckanavage was a managing director and the head of debt sales at GE Capital Markets, Inc. and Mr. Hassler was a director in the capital markets division of U.S. Bank National Association. Messrs. Buckanavage and Hassler have more than 35 years of combined experience lending to, and investing in, small- to mid-sized companies.

 

Since we commenced investment operations in 2003, and prior to our initial public offering in 2005, we conducted our business through two separate entities, Patriot Capital Funding, Inc. and Wilton Funding, LLC. Patriot Capital Funding, Inc. originated, arranged and serviced the investments made by Wilton Funding, LLC, which invested in debt instruments and warrants of U.S.-based companies. In connection with the consummation of our initial public offering, Wilton Funding, LLC merged with and into Patriot Capital Funding, Inc.

 

Our principal executive offices are located at 274 Riverside Avenue, Westport, Connecticut 06880 and our telephone number is (203) 429-2700. We maintain a website on the Internet at www.patcapfunding.com . We make available free of charge through our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Information contained on our website is not incorporated by reference into this annual report on Form 10-K and you should not consider information contained on our website to be part of this annual report on Form 10-K.

Our Business Strategy

 

Our investment objective is to generate both current cash income and capital appreciation through debt and equity investments in small- to mid-sized companies. We have adopted the following business strategy to achieve our investment objective:

 

 

Investment Critera

 

Our management team has identified the following investment criteria and guidelines that it believes are important in evaluating prospective portfolio companies. Our management team uses these criteria and guidelines in evaluating investment opportunities for us. However, not all of these criteria and guidelines were, or will be, met in connection with each of our investments.

 

 

 

Underwriting Process and Investment Approval

 

An initial evaluation of each potential investment is performed by one of our investment professionals. To the extent a potential investment appears to meet our investment criteria, a pre-screening memorandum is prepared and presented to our investment committee detailing some or all of the following information:

 

 

If our investment committee votes to proceed, we submit a non-binding proposal to the prospective private equity sponsor and/or potential portfolio company. Once the private equity sponsor and/or potential

portfolio company agree to the terms and conditions outlined in our financing proposal, we commence our full due diligence assessment, including:

 

 

Upon completion of a satisfactory due diligence review, a full investment memorandum is prepared and distributed to the investment committee for final approval of the proposed investment. The investment committee is able to request additional due diligence or modify the financing structure or terms of the proposed investment. The approval of the investment committee is required before we proceed with any investment. Upon receipt of such approval, we proceed to document and, upon satisfaction of applicable closing conditions, fund the investment.

 

Our investment committee consists of our president and chief executive officer, Mr. Buckanavage, our chief investment officer, Mr. Hassler, our executive vice president and chief compliance officer, Clifford L. Wells, and our executive vice president and managing director, Matthew R. Colucci.

 

All actions described above that require the approval of our investment committee must be approved by each member of our investment committee at a meeting at which at least a majority of the members of our investment committee is present.

 

Investments

 

We generally target investments of approximately $3 million to $20 million in companies with annual revenues between $10 million and $100 million. Our ability to invest across a company’s capital structure, from senior secured loans to equity securities allows us to offer companies a comprehensive suite of financing solutions, including “one-stop” financing. Our “one-stop” financing typically includes a revolving line of credit, one or more senior secured term loans and a subordinated debt investment. Our loans may include both debt and equity components. The debt instruments provide for returns in the form of interest payments, including payment-in-kind or PIK interest, while the equity instruments, such as warrants and non-control, equity co-investments, provide us with an opportunity to participate in the capital appreciation of the portfolio company and, to a lesser extent, returns in the form of dividend payments, as well as payment-in-kind or PIK dividends.

 

Debt Investments

 

We tailor the terms of our debt investments to the facts and circumstances of the transaction and prospective portfolio company, negotiating a structure that seeks to protect our rights and manage our risk while creating incentives for the portfolio company to achieve its business plan. For example, we seek to limit the downside risks of our investments by:

 

 

 

Senior Secured Loans

 

Our senior secured loans generally have terms of 4 to 7 years, provide for a variable or fixed interest rate and are secured by a first priority security interest in all existing and future assets of the borrower. We generally only invest in senior secured loans of a portfolio company in conjunction with an investment in a junior secured loan, subordinated debt investment or a “one-stop” financing. Our senior secured loans may take many forms, including revolving lines of credit, term loans and acquisition lines of credit.

 

Junior Secured Loans

 

Our junior secured loans generally have terms of 5 to 7.5 years, provide for a variable or fixed interest rate and are secured by a second priority security interest in all existing and future assets of the borrower. We may invest in junior secured loans, such as “last out” senior notes or second lien notes, on a stand-alone basis, or in conjunction with a senior secured loan, a subordinated debt investment or a “one-stop” financing.

 

Subordinated Debt

 

Our subordinated debt investments generally have terms of 5 to 7.5 years and provide for a fixed interest rate. A portion of our subordinated debt investments may be secured by a second priority security interest in the assets of the borrower. We may make subordinated debt investments on a stand-alone basis, or in conjunction with a senior secured loan, a junior secured loan or a “one-stop” financing. Our subordinated debt investments can include an equity component, such as warrants to purchase common stock in the portfolio company, and payment-in-kind, or PIK, interest, which represents contractual interest accrued and added to the principal balance that generally becomes due at maturity.

 

“One-Stop” Financing

 

Our “one-stop” financing typically includes a revolving line of credit, one or more senior secured term loans and a subordinated debt investment. We believe our ability to provide “one-stop” financing sets us apart from other lenders who focus on only one or two layers of the capital structure. Subsequent to our closing of a “one-stop” financing, we may seek to exit lower yielding tranches of the financing by arranging for replacement financing by another lender.

 

Broadly Syndicated Loans

 

In addition to the investments described above, we also make investments in broadly syndicated loans. A syndicated loan is a loan that is provided by a group of lenders and is structured, arranged and administered by one or several commercial or investment banks known as arrangers. Our syndicated loans generally have terms of 4 to 7.5 years, provide for a variable or fixed interest rate and are secured by a first or second priority security interest in all existing and future assets of the borrower.

 

Equity Investments

 

When we provide a “one-stop” financing or when we make a subordinated debt investment, we may acquire warrants to purchase common stock or other equity interests in the portfolio company. The warrants we receive in connection with these investments generally are detachable and require only a nominal cost to exercise. In addition, we may from time to time make non-control, equity co-investments of generally up to $3.0 million in companies in conjunction with private equity sponsors. We generally seek to structure our equity investments, such as warrants and direct equity co-investments, to provide us with minority rights provisions and event-driven puts. We also seek to obtain registration rights in connection with these investments, which may include demand and “piggyback” registration rights. Certain equity investments include payment-in-kind or PIK dividends, which represent contractually deferred dividends added to the balance of our equity investment.

Portfolio Management

 

We generally employ several methods of evaluating and monitoring the performance of our portfolio companies, which, depending on the particular investment, may include the following specific processes, procedures and reports:

 

 

In connection with the monitoring of our portfolio companies, each debt investment we hold is rated based upon the following five-level numeric investment rating system:

 

 

 

 

In the event that we determine that an investment is underperforming, or circumstances suggest that the risk associated with a particular investment has significantly increased, we undertake more aggressive monitoring of the affected portfolio company. While our investment rating system identifies the relative risk for each investment, the rating alone does not dictate the scope and/or frequency of any monitoring that we perform. The frequency of our monitoring of an investment is determined by a number of factors, including, but not limited to, the trends in the financial performance of the portfolio company, the investment structure and the type of collateral securing our investment, if any.

 

Regulations

 

Regulation as a Business Development Company

 

We have elected to be regulated as a business development company under the 1940 Act. The 1940 Act requires that a majority of our directors be persons other than “interested persons,” as that term is defined in the 1940 Act. In addition, the 1940 Act provides that we may not change the nature of our business so as to cease to be, or to withdraw our election as, a business development company, unless approved by a majority of our outstanding voting securities.

 

Qualifying Assets

 

Under the 1940 Act, a business development company may not acquire any asset other than assets of the type listed in Section 55(a) of the 1940 Act, which are referred to as qualifying assets, unless, at the time the acquisition is made, qualifying assets represent at least 70% of the company’s total assets. The principal categories of qualifying assets relevant to our business are any of the following:

 

(1) Securities purchased in transactions not involving any public offering from the issuer of such securities, which issuer (subject to certain limited exceptions) is an eligible portfolio company, or from

any person who is, or has been during the preceding 13 months, an affiliated person of an eligible portfolio company, or from any other person, subject to such rules as may be prescribed by the SEC. An eligible portfolio company is defined in the 1940 Act as any issuer which:

 

(a) is organized under the laws of, and has its principal place of business in, the United States;

 

(b) is not an investment company (other than a small business investment company wholly owned by the business development company) or a company that would be an investment company but for certain exclusions under the 1940 Act; and

 

(c) satisfies any of the following:

 

(i) does not have any class of securities listed on a national securities exchange;

 

(ii) has a class of securities listed on a national securities exchange, but has an aggregate market value of outstanding voting and non-voting common equity of less than $250 million;

 

(iii) is controlled by a business development company or a group of companies including a business development company and the business development company has an affiliated person who is a director of the eligible portfolio company; or

 

(iv) is a small and solvent company having total assets of not more than $4 million and capital and surplus of not less than $2 million.

 

(2) Securities of any eligible portfolio company which we control.

 

(3) Securities purchased in a private transaction from a U.S. issuer that is not an investment company or from an affiliated person of the issuer, or in transactions incident thereto, if the issuer is in bankruptcy and subject to reorganization or if the issuer, immediately prior to the purchase of its securities was unable to meet its obligations as they came due without material assistance other than conventional lending or financing arrangements.

 

(4) Securities of an eligible portfolio company purchased from any person in a private transaction if there is no ready market for such securities and we already own 60% of the outstanding equity of the eligible portfolio company.

 

(5) Securities received in exchange for or distributed on or with respect to securities described in (1) through (4) above, or pursuant to the exercise of warrants or rights relating to such securities.

 

(6) Cash, cash equivalents, U.S. government securities or high-quality debt securities maturing in one year or less from the time of investment.

 

In addition, a business development company must have been organized and have its principal place of business in the United States and must be operated for the purpose of making investments in the types of securities described in (1), (2) or (3) above.

 

Managerial Assistance to Portfolio Companies

 

In order to count portfolio securities as qualifying assets for the purpose of the 70% test, we must either control the issuer of the securities or must offer to make available to the issuer of the securities (other than small and solvent companies described above) significant managerial assistance; except that, where we purchase such securities in conjunction with one or more other persons acting together, one of the other persons in the group may make available such managerial assistance. Making available managerial assistance means, among other things, any arrangement whereby the business development company, through its directors, officers or employees, offers to provide, and, if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company.

Common Stock

 

We are not generally able to issue and sell our common stock at a price below net asset value per share. We may, however, sell our common stock, warrants, options or rights to acquire our common stock, at a price below the current net asset value of the common stock if our board of directors determines that such sale is in our best interests and that of our stockholders, and our stockholders approve such sale. In any such case, the price at which our securities are to be issued and sold may not be less than a price which, in the determination of our board of directors, closely approximates the market value of such securities (less any distributing commission or discount). On June 24, 2008, our stockholders approved proposals that (1) authorize us to sell shares of our common stock below the then current net asset value per share of our common stock in one or more offerings for a period of one year ending on the earlier of June 23, 2009 or the date of our 2009 annual meeting of stockholders and (2) authorize us to issue securities to subscribe to, convert to, or purchase shares of our common stock in one or more offerings. We may also make rights offerings to our stockholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act.

 

Senior Securities

 

We are permitted, under specified conditions, to issue multiple classes of debt and one class of stock senior to our common stock if our asset coverage, as defined in the 1940 Act, is at least equal to 200% immediately after each such issuance. In addition, while any senior securities remain outstanding (other than senior securities representing indebtedness issued in consideration of a privately arranged loan which is not intended to be publicly distributed), we must make provisions to prohibit any distribution to our stockholders or the repurchase of such securities or shares unless we meet the applicable asset coverage ratios at the time of the distribution or repurchase. We may also borrow amounts up to 5% of the value of our total assets for temporary or emergency purposes without regard to asset coverage.

 

Code of Ethics

 

We have adopted a code of ethics pursuant to Rule 17j-1 under the 1940 Act that establishes procedures for personal investments and restricts certain personal securities transactions. Personnel subject to the code may invest in securities for their personal investment accounts, including securities that may be purchased or held by us, so long as such investments are made in accordance with the code’s requirements. The code of ethics is available on our website on the Internet at www.patcapfunding.com.

 

Proxy Voting Policies and Procedures

 

We vote proxies relating to our portfolio securities in the best interest of our stockholders. We review on a case-by-case basis each proposal submitted to a stockholder vote to determine its impact on the portfolio securities held by us. Although we generally vote against proposals that may have a negative impact on our portfolio securities, we may vote for such a proposal if there exists compelling long-term reasons to do so.

 

Our proxy voting decisions are made by the investment professionals who are responsible for monitoring each of our investments. To ensure that our vote is not the product of a conflict of interest, we require that: (i) anyone involved in the decision making process disclose to our chief compliance officer any potential conflict that he or she is aware of and any contact that he or she has had with any interested party regarding a proxy vote; and (ii) employees involved in the decision making process or vote administration are prohibited from revealing how we intend to vote on a proposal in order to reduce any attempted influence from interested parties.

 

Stockholders may obtain information regarding how we voted proxies with respect to our portfolio securities by making a written request for proxy voting information to: Chief Compliance Officer, Patriot Capital Funding, Inc., 274 Riverside Avenue, Westport, CT 06880.

Other

 

We are prohibited under the 1940 Act from knowingly participating in certain transactions with our affiliates without the prior approval of our board of directors who are not interested persons and, in some cases, prior approval by the SEC.

 

We are periodically examined by the SEC for compliance with the 1940 Act.

 

We are required to provide and maintain a bond issued by a reputable fidelity insurance company to protect us against larceny and embezzlement. Furthermore, as a business development company, we are prohibited from protecting any director or officer against any liability to us or our stockholders arising from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office.

 

We are required to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, review these policies and procedures annually for their adequacy and the effectiveness of their implementation, and to designate a chief compliance officer to be responsible for administering the policies and procedures.

 

Taxation as a Regulated Investment Company

 

We have elected to be taxed as a RIC under Subchapter M of the Code. As long as we qualify as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders on a timely basis.

 

Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation until realized. Dividends declared and paid by us in a year generally differ from taxable income for that year as such dividends may include the distribution of current year taxable income or the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital.

 

To maintain RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any). In order to avoid certain excise taxes imposed on RICs, we must distribute, with respect to each calendar year, an amount at least equal to the sum of (1) 98% of our ordinary income for the calendar year, (2) 98% of our capital gains in excess of capital losses for the one-year period ending on October 31 of the calendar year and (3) any ordinary income and net capital gains for the preceding years that were not distributed during such years. To the extent our taxable earnings for a fiscal tax year fall below the total amount of our distributions for that fiscal year, a portion of those distributions may be deemed a return of capital to our stockholders.

 

We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a business development company under the 1940 Act and due to provisions in our second amended and restated securitization revolving credit facility. If we do not distribute a certain percentage of our taxable income annually, we will suffer adverse tax consequences, including possible loss of our status as a RIC. We cannot assure stockholders that they will receive any distributions at a particular level.

 

Pursuant to a recent revenue procedure issued by the Internal Revenue Service, or the IRS, the IRS has indicated that it will treat distributions from certain publicly traded RICs (including business development companies) that are paid part in cash and part in stock as dividends that would satisfy the RIC’s annual distribution requirements. In order to qualify for such treatment, the revenue procedure requires that at least 10% of the total distribution be paid in cash and that each stockholder have a right to elect to receive its entire distribution in cash. If too many stockholders elect to receive cash, each stockholder electing to receive cash

must receive a proportionate share of the cash to be distributed (although no stockholder electing to receive cash may receive less than 10% of such stockholder’s distribution in cash). This revenue procedure applies to distributions made during 2009. In light of the uncertainty in the financial markets and the economy, we may determine to make dividend distributions partly in cash and shares as an additional measure to preserve liquidity.

 

Determination of Net Asset Value

 

We determine the net asset value per share of our common stock on a quarterly basis. We disclose these net asset values in the periodic reports we file with the SEC. The net asset value per share is equal to the value of our total assets minus liabilities and any preferred stock outstanding divided by the total number of shares of common stock outstanding.

 

Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value as is determined in good faith by the board of directors. Since there is typically no readily available market value for the investments in our portfolio, we value substantially all of our portfolio investments at fair value as determined in good faith by our board of directors pursuant to a valuation policy and a consistently applied valuation process. Because of the inherent uncertainty in determining the fair value of investments that do not have a readily available market value, the fair value of our investments determined in good faith by our board of directors may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.

 

In September 2006, the Financial Accounting Standards Board issued Statement of Financial Standards No. 157 — Fair Value Measurements , or SFAS 157, which became effective for fiscal years beginning after November 15, 2007. SFAS 157 defines fair value as the price at which an asset could be exchanged in a current transaction between knowledgeable, willing parties. A liability’s fair value is defined as the amount that would be paid to transfer the liability to a new obligor, not the amount that would be paid to settle the liability with the creditor. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation techniques are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the investments or market and the investments’ complexity.

 

Assets and liabilities recorded at fair value in the consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:

 

Level 1 — Unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

 

Level 2 — Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data at the measurement date for substantially the full term of the assets or liabilities.

 

Level 3 — Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

 

Concurrent with our adoption of SFAS 157, effective January 1, 2008, we augmented the valuation techniques we use to estimate the fair value of our debt investments where there is not a readily available market value (Level 3). Prior to January 1, 2008, we estimated the fair value of our Level 3 debt investments by first estimating the enterprise value of the portfolio company which issued the debt investment. To estimate the enterprise value of a portfolio company, we analyzed various factors, including the portfolio companies historical and projected financial results. Typically, private companies are valued based on multiples of

EBITDA (Earning Before Interest, Taxes, Depreciation and Amortization), cash flow, net income, revenues or, in limited instances, book value.

 

In estimating a multiple to use for valuation purposes, we looked to private merger and acquisition statistics, discounted public trading multiples or industry practices. In some cases, we considered the best valuation methodology may have been a discounted cash flow analysis based on future projections. If a portfolio company was distressed, a liquidation analysis may have provided the best indication of enterprise value. If there was adequate enterprise value to support the repayment of our debt, the fair value of the Level 3 loan or debt security normally corresponded to cost plus the amortized original issue discount unless the borrower’s condition or other factors lead to a determination of fair value at a different amount.

 

Beginning on January 1, 2008, we also introduced a bond-yield model to value these investments based on the present value of expected cash flows. The primary inputs into the model are market interest rates for debt with similar characteristics and an adjustment for the portfolio company’s credit risk. The credit risk component of the valuation considers several factors including financial performance, business outlook, debt priority and collateral position.

 

The fair value of our investments at December 31, 2008, and December 31, 2007 was determined in good faith by our board of directors. Duff & Phelps, LLC, an independent valuation firm (“Duff & Phelps”), provided third party valuation consulting services to us which consisted of certain mutually agreed upon limited procedures, (which limited procedures did not include any audit, review, compilation, or examination or attestation under auditing standards generally accepted in the United States of America), that we engaged them to perform. During the three months ended December 31, 2008 and 2007, we asked Duff & Phelps to perform the limited procedures on investments in 12 and 15, respectively, portfolio companies comprising approximately 38% and 49%, respectively, of the total investments at fair value. Upon completion of their limited procedures at December 31, 2008 and 2007, respectively, Duff & Phelps concluded that the fair value of those investments subjected to the limited procedures did not appear to be unreasonable. During the years 2008 and 2007, Duff & Phelps performed the limited procedures on 100% of our portfolio companies with debt investments, excluding broadly syndicated loans. Our board of directors is solely responsible for the valuation of our portfolio investments at fair value as determined in good faith pursuant to our valuation policy and consistently applied valuation process.

 

Our board of directors undertakes a multi-step valuation process each quarter in connection with determining the fair value of our investments:

 

 

Determination of the fair value involves subjective judgments and estimates not susceptible to substantiation by auditing procedures. Accordingly, under current auditing standards, the notes to our financial statements refer to the uncertainty with respect to the possible effect of such valuations, and any change in such valuations, on our financial statements.

 

Competition

 

We compete for investments with a number of business development companies and other investment funds (including private equity funds and mezzanine funds), as well as traditional financial services companies

such as commercial banks and other sources of financing. Many of these entities have greater financial and managerial resources than we do. We believe we compete with these entities primarily on the basis of our willingness to make smaller investments, the experience and contacts of our management team, our responsive and efficient investment analysis and decision-making processes, our comprehensive suite of customized financing solutions and the investment terms we offer. We do not seek to compete primarily on the interest rates we offer to potential portfolio companies, and we believe that some of our competitors make senior secured loans, junior secured loans and subordinated debt investments with interest rates that are comparable to or lower than the rates we offer.

 

Employees

 

As of December 31, 2008, we had 13 employees, including investment and portfolio management professionals, and operations professionals.

 

 

Risk Factors

 

Investing in our common stock involves a number of significant risks. We cannot assure you that we will achieve our investment objective. You should consider carefully the risks described below and all other information contained in this annual report on Form 10-K, including our financial statements and the related notes.

 

There is substantial doubt about our ability to continue as a going concern.

 

Our independent registered public accounting firm has issued an opinion on our consolidated financial statements that states that the consolidated financial statements were prepared assuming we will continue as a going concern and further states that the uncertainty regarding the renewal of our liquidity facility raises substantial doubt about our ability to continue as a going concern. Specifically, we are currently negotiating the renewal of the liquidity facility, which matures in April 2009, supporting our second amended and restated securitization revolving credit facility with certain liquidity banks. In the event that the liquidity banks do not renew the liquidity facility, the terms of the second amended and restated securitization revolving credit facility require that all principal and interest collected from the debt investments secured by the facility must be used to pay down amounts outstanding under the facility by April 2011. Because substantially all of our debt investments are secured by our second amended and restated securitization revolving credit facility, we cannot provide any assurance that we would have sufficient cash and liquid assets to fund normal operations and dividend distributions to our stockholders during the period of time when we are required to repay amounts outstanding under the second amended and restated securitization revolving credit facility if such amounts became due. If the liquidity facility is not renewed, we believe that we may be able to negotiate an arrangement with the lenders of the second amended and restated securitization revolving credit facility for repayment terms that do not require us to use all principal and interest collected from the debt investments secured by the facility to pay down amounts outstanding thereunder, however, we cannot provide any assurance that we will be able to do so. As a result, if the Company was unable to (i) renew the liquidity facility supporting our second amended and restated securitization revolving credit facility or (ii) negotiate an arrangement with the lenders of the second amended and restated securitization revolving credit facility for repayment terms that do not require us to use all principal and interest collected from the debt investments secured by the facility to pay down amounts outstanding thereunder there would be a significant adverse impact on our financial position and operating results.

 

We are currently in a period of capital markets disruption and recession and we do not expect these conditions to improve in the near future. These conditions could adversely affect our financial position and operating results and impair our portfolio companies’ financial positions and operating results, which could, in turn, harm our financial position and operating results.

 

The capital markets have been experiencing extreme volatility and disruption since mid-2007 and the U.S. economy has entered into a recession. Disruptions in the capital markets have increased the spread

between the yields realized on risk-free and higher risk securities, resulting in illiquidity in parts of the capital markets. We believe these conditions may continue for a prolonged period of time or worsen in the future. A prolonged period of market illiquidity may have an adverse effect on our business, financial condition, and results of operations. Unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us. In this regard, we can provide no assurance that the liquidity facility associated with our second amended and restated securitization revolving credit facility will be renewed when it matures in April 2009. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Borrowings” for a more detailed discussion of the liquidity facility. These events, including the non-renewal of the liquidity facility, could limit our investment originations, limit our ability to grow and pay dividends and negatively impact our operating results.

 

In addition, many of our portfolio companies are susceptible to economic slowdowns or recessions. An economic slowdown or recession, including the current one and any future slowdowns or recessions, may affect the ability of our portfolio companies to repay our loans or engage in a liquidity event such as a sale, recapitalization or initial public offering. Our nonperforming assets are likely to increase and the value of our portfolio is likely to decrease during these periods. Adverse economic conditions also may decrease the value of any collateral securing some of our loans. These conditions could lead to losses of value in our portfolio and a decrease in our revenues, net income and assets.

 

Because we must distribute at least 90% of our taxable income to our stockholders in connection with our election to be treated as a RIC, we will continue to need additional capital to finance our growth. If additional funds are unavailable or not available on favorable terms, our ability to grow will be impaired.

 

In order to qualify for the tax benefits available to RICs, we must distribute to our stockholders at least 90% of our annual taxable income. As a result, we will likely need to raise capital from other sources to grow our business. As a business development company, we generally are required to meet a coverage ratio of total assets, less liabilities and indebtedness not represented by senior securities to total senior securities, which includes all of our borrowings and any preferred stock we may issue in the future, of at least 200%. This requirement limits the amount that we may borrow. Because we will continue to need capital to grow our investment portfolio, this limitation may prevent us from incurring debt and require us to raise additional equity at a time when it may be disadvantageous to do so. We cannot assure you that debt and equity financing will be available to us on favorable terms, if at all. If additional funds are not available to us, we could be forced to curtail or cease new investment activities, and our net asset value could decline.

 

Regulations governing our operation as a business development company will affect our ability to, and the way in which we, raise additional capital.

 

Our business will require capital. We may acquire additional capital from the following sources:

 

Senior Securities and Other Indebtedness.   We may issue debt securities or preferred stock and/or borrow money from banks or other financial institutions, which we refer to collectively as senior securities, up to the maximum amount permitted by the 1940 Act. If we issue senior securities, including debt or preferred stock, we will be exposed to additional risks, including the following:

 

 

 

Additional Common Stock.   We are not generally able to issue and sell our common stock at a price below net asset value per share. We may, however, sell our common stock, warrants, options or rights to acquire our common stock, at a price below the current net asset value of the common stock if our board of directors determines that such sale is in our best interests and that of our stockholders, and our stockholders approve such sale. In this regard, on June 24, 2008, our stockholders approved proposals that (1) authorize us to sell shares of our common stock below the then current net asset value per share of our common stock in one or more offerings for a period of one year ending on the earlier of June 23, 2009 or the date of our 2009 annual meeting of stockholders and (2) authorize us to issue securities to subscribe to, convert to, or purchase shares of our common stock in one or more offerings. In any such case, the price at which our securities are to be issued and sold may not be less than a price which, in the determination of our board of directors, closely approximates the market value of such securities (less any distributing commission or discount). We may also make rights offerings to our stockholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act. If we raise additional funds by issuing more common stock or senior securities convertible into, or exchangeable for, our common stock, the percentage ownership of our stockholders at that time would decrease and they may experience dilution. Moreover, we can offer no assurance that we will be able to issue and sell additional equity securities in the future, on favorable terms or at all.

 

Securitization of Loans.   In addition to issuing securities to raise capital, we will continue to seek to securitize our loans to generate cash for funding new investments. To securitize loans, we would generally create a wholly-owned subsidiary and contribute a pool of loans to the subsidiary. This could include the sale of interests in the subsidiary on a non-recourse basis to purchasers who we would expect to be willing to accept a lower interest rate to invest in investment grade loan pools, and we retain a portion of the equity in the securitized pool of loans. An inability to successfully securitize our loan portfolio could limit our ability to grow our business, fully execute our business strategy and adversely affect our earnings, if any. Moreover, the securitization of our loan portfolio might expose us to losses as the residual loans in which we do not sell interests will tend to be those that are riskier and more apt to generate losses.

 

Stockholders may incur dilution if we sell shares of our common stock in one or more offerings at prices below the then current net asset value per share of our common stock or issue securities to subscribe to, convert to or purchase shares of our common stock.

 

At our 2008 annual meeting of stockholders, our stockholders approved two proposals designed to allow us to access the capital markets in ways that we were previously unable to as a result of restrictions that, absent stockholder approval, apply to business development companies under the 1940 Act. Specifically, our stockholders approved proposals that (1) authorize us to sell shares of our common stock below the then current net asset value per share of our common stock in one or more offerings for a period of one year ending on the earlier of June 23, 2009 or the date of our 2009 annual meeting of stockholders and (2) authorize us to issue securities to subscribe to, convert to, or purchase shares of our common stock in one or more offerings. Any decision to sell shares of our common stock below the then current net asset value per share of our common stock or securities

to subscribe to, convert to, or purchase shares of our common stock would be subject to the determination by our Board of Directors that such issuance is in our and our stockholders’ best interests.

 

If we were to issue shares of our common stock below net asset value per share, such sales would result in an immediate dilution to existing common stockholders. This dilution would include reduction in the net asset value per share as a result of the issuance of shares at a price below the then current net asset value per share of our common stock and a proportionately greater decrease in a stockholder’s interest in our earnings and assets and voting interest in us than the increase in our assets resulting from such issuance. In addition, if we issue securities to subscribe to, convert to or purchase shares of common stock, the exercise or conversion of such securities would increase the number of outstanding shares of our common stock. Any such exercise would be dilutive on the voting power of existing stockholders, and could be dilutive with regard to dividends and our net asset value, and other economic aspects of the common stock. Because the number of shares of common stock that could be so issued and the timing of any issuance is not currently known, the actual dilutive effect cannot be predicted.

 

We are dependent upon our key investment personnel for our future success.

 

We depend on the diligence, skill and network of business contacts of the investment professionals we employ for the sourcing, evaluation, negotiation, structuring and monitoring of our investments. Our future success will also depend, to a significant extent, on the continued service and coordination of our senior management team, particularly, Richard P. Buckanavage, our president and chief executive officer, and Timothy W. Hassler, our chief investment officer. The departure of Mr. Buckanavage, Mr. Hassler or any member of our senior management team could have a material adverse effect on our ability to achieve our investment objective. In addition, if both of Messrs. Buckanavage and Hassler cease to be employed by us, the lender under our second amended and restated securitization revolving credit facility could, absent a waiver or cure, terminate the facility.

 

Our business model depends to a significant extent upon strong referral relationships with private equity sponsors, and our inability to maintain or develop these relationships, or the failure of these relationships to generate investment opportunities, could adversely affect our business.

 

We expect that members of our management team will maintain their relationships with private equity sponsors, and we will rely to a significant extent upon these relationships to provide us with potential investment opportunities. If our management team fails to maintain its existing relationships or develop new relationships with other sponsors or sources of investment opportunities, we will not be able to grow our investment portfolio. In addition, individuals with whom members of our management team have relationships are not obligated to provide us with investment opportunities, and, therefore, there is no assurance that such relationships will generate investment opportunities for us.

 

We operate in a competitive market for investment opportunities.

 

We compete for investments with other business development companies and other investment funds (including private equity funds and mezzanine funds), as well as traditional financial services companies such as commercial banks and other sources of funding. Many of our competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, some competitors may have a lower cost of funds and access to funding sources that are not available to us, including from federal government agencies through federal rescue programs such as the U.S. Department of the Treasury’s Financial Stability Plan (which was formerly known as the Trouble Asset Relief Program). In addition, some of our competitors may have higher risk tolerances or different risk assessments. These characteristics could allow our competitors to consider a wider variety of investments, establish more relationships and offer better pricing and more flexible structuring than us. We may lose investment opportunities if we do not match our competitors’ pricing, terms and structure. If we are forced to match our competitors’ pricing, terms and structure, we may not be able to achieve acceptable returns on our investments or may bear substantial risk of capital loss. Furthermore, many of our competitors have greater experience operating under, or are not subject to, the regulatory restrictions that the 1940 Act imposes on us as a business development company.

We cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time, and we cannot assure you that we will continue to be able to identify and make investments that are consistent with our investment objective.

 

The agreements governing our second amended and restated securitization revolving credit facility contain various covenants and provide for certain minimum financial covenants.

 

We have entered into a second amended and restated securitization revolving credit facility with an entity affiliated with BMO Capital Markets Corp. and Branch Banking and Trust Company. The agreements governing this facility contain customary default provisions such as the termination or departure of both Messrs. Buckanavage and Hassler, a material adverse change in our business and the failure to maintain certain minimum loan quality and performance standards. An event of default under the facility would result, among other things, in termination of the availability of further funds under the facility and an accelerated maturity date for all amounts outstanding under the facility, which would likely disrupt our business and, potentially, the portfolio companies whose loans we financed through the facility. This could reduce our revenues and, by delaying any cash payment allowed to us under the facility until the lender has been paid in full, reduce our liquidity and cash flow and impair our ability to grow our business and maintain our status as a RIC. If we default under certain provisions, the facility also limits our ability to declare dividends. As of December 31, 2008, we were in technical default of one of the debt covenants under the Amended Securitization Facility, which was cured within the timeframe allowed by the facility.

 

Each loan origination under the facility is subject to the satisfaction of certain conditions. We cannot assure you that we will be able to borrow funds under the facility at any particular time or at all. For a discussion of the possible occurrence of an event that will result in the termination of the availability of further funds under the facility and the requirement to immediately repay amounts outstanding under the facility over a period of two years, see “Risk Factors — There is substantial doubt about our ability to continue as a going concern.”

 

We will be subject to corporate-level income tax if we fail to maintain our status as a RIC under Subchapter M of the Code.

 

To maintain RIC tax treatment under the Code, we must meet the following annual distribution, income source and asset diversification requirements.

 

 

If we fail to qualify for RIC tax treatment for any reason and are subject to corporate income tax, the resulting corporate taxes could substantially reduce our net assets, the amount of income available for distribution and the amount of our distributions.

We may in the future choose to pay dividends in our own stock, in which case you may be required to pay tax in excess of the cash you receive.

 

We may distribute taxable dividends that are payable in part in our stock. Under a recently issued IRS revenue procedure, up to 90% of any such taxable dividend for 2009 could be payable in our stock. Taxable stockholders receiving such dividends would be required to include the full amount of the dividend as ordinary income (or as long-term capital gain to the extent such distribution is properly designated as a capital gain dividend) to the extent of our current and accumulated earnings and profits for United States federal income tax purposes. As a result, a U.S. stockholder may be required to pay tax with respect to such dividends in excess of any cash received. If a U.S. stockholder sells the stock it receives as a dividend in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of our stock at the time of the sale. Furthermore, with respect to non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of our stockholders determine to sell shares of our stock in order to pay taxes owed on dividends, it may put downward pressure on the trading price of our stock.

 

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

 

For federal income tax purposes, we will include in income certain amounts that we have not yet received in cash, such as original issue discount, which may arise if we receive warrants in connection with the origination of a loan or possibly in other circumstances, such as in connection with the receipt of contractual payment-in-kind, or PIK, interest or dividends, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term or contractually deferred dividends added to our equity investment in the portfolio company. Such original issue discount or contractual payment-in-kind arrangements will result in the recognition of income before we receive any corresponding cash payments. We also may be required to include in income certain other amounts that we will not receive in cash.

 

Since, in certain cases, we may recognize income before or without receiving cash representing such income, we may have difficulty meeting the annual distribution requirement necessary to maintain RIC tax treatment under the Code. Accordingly, we may have to sell some of our investments at times and/or at prices we would not consider advantageous, raise additional debt or equity capital or reduce new investment originations for this purpose. If we are not able to obtain cash from other sources, we may fail to qualify for RIC tax treatment and thus become subject to corporate-level income tax. For additional discussion regarding the tax implications of a RIC, please see “Business — Regulations — Taxation as a Regulated Investment Company.”

 

We borrow money, which magnifies the potential for gain or loss on amounts invested and may increase the risk of investing in us.

 

Borrowings, also known as leverage, magnify the potential for gain or loss on amounts invested and, therefore, increase the risks associated with investing in us. We borrow from and issue senior debt securities to banks and other lenders. Holders of these senior securities have fixed dollar claims on our assets that are superior to the claims of our common stockholders. If the value of our assets increases, then leveraging would cause the net asset value attributable to our common stock to increase more sharply than it would have had we not leveraged. Conversely, if the value of our assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged. Similarly, any increase in our income in excess of interest payable on the borrowed funds would cause our net income to increase more than it would without the leverage, while any decrease in our income would cause net income to decline more sharply than it would have had we not borrowed. Such a decline could negatively affect our ability to make common stock dividend payments. Leverage is generally considered a speculative investment technique.

Changes in interest rates may affect our cost of capital and net investment income.

 

Because we borrow to fund our investments, a portion of our income is dependent upon the difference between the interest rate at which we borrow funds and the interest rate at which we invest these funds. A portion of our investments will have fixed interest rates, while a portion of our borrowings will likely have floating interest rates. As a result, a significant change in market interest rates could have a material adverse effect on our net investment income. In periods of rising interest rates, our cost of funds could increase, which would reduce our net investment income. We may hedge against interest rate fluctuations by using standard hedging instruments such as futures, options and forward contracts, subject to applicable legal requirements, including without limitation, all necessary registrations (or exemptions from registration) with the Commodity Futures Trading Commission. These activities may limit our ability to participate in the benefits of lower interest rates with respect to the hedged portfolio. Adverse developments resulting from changes in interest rates or hedging transactions could have a material adverse effect on our business, financial condition and results of operations. Also, we have limited experience in entering into hedging transactions, and we will initially have to rely on outside parties with respect to the use of such financial instruments or develop such expertise internally.

 

A significant portion of our investment portfolio is and will continue to be recorded at fair value as determined in good faith by our board of directors and, as a result, there is and will continue to be uncertainty as to the value of our portfolio investments.

 

Under the 1940 Act, we are required to carry our portfolio investments at market value or, if there is no readily available market value, at fair value as determined by our board of directors. We are not permitted to maintain a general reserve for anticipated losses. Instead, we are required by the 1940 Act to specifically value each individual investment and record an unrealized loss for any asset we believe has decreased in value. Typically there is not a public market for the securities of the privately-held companies in which we have invested and will generally continue to invest. As a result, we value our investments in privately-held companies on a quarterly basis based on a determination of their fair value made in good faith and in accordance with the written guidelines established by our board of directors. In accordance with Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” we principally utilize the market approach to estimate the fair value of our equity investments where there is not a readily available market and we principally utilize the income approach to estimate the fair value of our debt investments where there is not a readily available market. Under the market approach, we estimate the enterprise value of the portfolio companies in which we invest. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise value is best expressed as a range of fair values from which we derive a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, we analyze various factors, including the portfolio company’s historical and projected financial results. We generally require portfolio companies to provide annual audited and quarterly and monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year. Typically, private companies are valued based on multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), cash flows, net income, revenues, or in limited cases, book value. The private equity industry uses financial measures such as EBITDA in order to assess a portfolio company’s financial performance and to value a portfolio company. When using EBITDA to determine enterprise value, we may adjust EBITDA for non-recurring items. Such adjustments are intended to normalize EBITDA to reflect the portfolio company’s earnings power. Adjustments to EBITDA may include compensation to previous owners, acquisition, recapitalization, restructuring related items and, one-time non-recurring income or expense items.

 

Under the income approach, we generally prepare and analyze discounted cash flow models based on our projections of the future free cash flows of the business. We also use bond yield models to determine the present value of the future cash flow streams of our debt investments. We review various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assess the information in the valuation process.

 

The types of factors that may be considered in determining the fair value of our investments include the nature and realizable value of any collateral, the portfolio company’s earnings and its ability to make payments

on its indebtedness, the markets in which the portfolio company does business, comparison to publicly traded companies, discounted cash flow and other relevant factors. Because such valuations, and particularly valuations of private securities and private companies, are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. Our net asset value could be adversely affected if our determinations regarding the fair value of our investments were materially higher than the values that we ultimately realize upon the disposal of such securities.

 

The lack of liquidity in our investments may adversely affect our business.

 

We generally make investments in private companies.   Substantially all of these securities are subject to legal and other restrictions on resale or are otherwise less liquid than publicly traded securities. The illiquidity of our investments may make it difficult for us to sell such investments if the need arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we had previously recorded our investments. We may also face other restrictions on our ability to liquidate an investment in a portfolio company to the extent that we have material non-public information regarding such portfolio company.

 

We may experience fluctuations in our quarterly results.

 

We could experience fluctuations in our quarterly operating results due to a number of factors, including our ability to make investments in companies that meet our investment criteria, the interest rate payable on the debt securities we acquire, the level of our expenses, prepayments of our debt securities, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our markets and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods.

 

Changes in laws or regulations governing our operations may adversely affect our business.

 

We and our portfolio companies are subject to local, state and federal laws and regulations. These laws and regulations, as well as their interpretation, may be changed from time to time. Accordingly, any change in these laws or regulations could have a material adverse affect on our business.

 

Our board of directors may change our operating policies and strategies without prior notice or stockholder approval, the effects of which may be adverse.

 

Our board of directors has the authority to modify or waive our current operating policies and strategies without prior notice and without stockholder approval. We cannot predict the effect any changes to our current operating policies and strategies would have on our business, operating results and value of our stock. However, the effects might be adverse, which could negatively impact our ability to pay dividends and cause you to lose all or part of your investment.

 

Our investments in portfolio companies may be risky, and we could lose all or part of our investment.

 

Investing in small- to mid-sized companies involves a number of significant risks. Among other things, these companies:

 

 

 

Our portfolio is and may continue to be concentrated in a limited number of portfolio companies and industries, which will subject us to a risk of significant loss if any of these companies defaults on its obligations under any of its debt instruments or by a downturn in the particular industry.

 

Our portfolio is and may continue to be concentrated in a limited number of portfolio companies and industries. Beyond the asset diversification requirements associated with our qualification as a RIC, we do not have fixed guidelines for diversification, and while we are not targeting any specific industries, our investments are, and could continue to be, concentrated in relatively few industries (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a schedule of investments by sector using Moody’s Industry Classifications). As a result, the aggregate returns we realize may be significantly adversely affected if a small number of investments perform poorly or if we need to write down the value of any one investment. Additionally, a downturn in any particular industry in which we are invested could also significantly impact the aggregate returns we realize.

 

Price declines and illiquidity in the large corporate leverage loan market have adversely affected, and may continue to adversely affect, the fair value of our syndicated loan portfolio, reducing our net asset value through increased net unrealized depreciation.

 

The continuing unprecedented declines in prices and illiquidity in the large corporate leverage loan market have resulted in significant unrealized depreciation in our syndicated loan portfolio. Conditions in the large corporate leverage loan market may continue to deteriorate which could cause pricing levels to continue to decline. As a result, we may continue to suffer additional unrealized losses and could incur significant realized losses in future periods in connection with the sale of our syndicated loans, which could have a material adverse impact on our business, financial condition and results of operations.

 

Our portfolio companies may incur debt that ranks equally with, or senior to, our investments in such companies.

 

We invest primarily in senior secured loans, junior secured loans and subordinated debt issued by small- to mid-sized companies. Our portfolio companies may have, or may be permitted to incur, other debt that ranks equally with, or senior to, the debt in which we invest. By their terms, such debt instruments may entitle the holders to receive payment of interest or principal on or before the dates on which we are entitled to receive payments with respect to the debt instruments in which we invest. Also, in the event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company, holders of debt instruments ranking senior to our investment in that portfolio company would typically be entitled to receive payment in full before we receive any distribution. After repaying such senior creditors, such portfolio company may not have any remaining assets to use for repaying its obligation to us. In the case of debt ranking equally with debt instruments in which we invest, we would have to share on an equal basis any distributions with other

creditors holding such debt in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy of the relevant portfolio company.

 

Second priority liens on collateral securing loans that we make to our portfolio companies may be subject to control by senior creditors with first priority liens. If there is a default, the value of the collateral may not be sufficient to repay in full both the first priority creditors and us.

 

Certain loans that we make to portfolio companies may be secured on a second priority basis by the same collateral securing senior secured debt of such companies. The first priority liens on the collateral will secure the portfolio company’s obligations under any outstanding senior debt and may secure certain other future debt that may be permitted to be incurred by the portfolio company under the agreements governing the loans. The holders of obligations secured by the first priority liens on the collateral will generally control the liquidation of and be entitled to receive proceeds from any realization of the collateral to repay their obligations in full before us. In addition, the value of the collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. There can be no assurance that the proceeds, if any, from the sale or sales of all of the collateral would be sufficient to satisfy the loan obligations secured by the second priority liens after payment in full of all obligations secured by the first priority liens on the collateral. If such proceeds are not sufficient to repay amounts outstanding under the loan obligations secured by the second priority liens, then we, to the extent not repaid from the proceeds of the sale of the collateral, will only have an unsecured claim against the portfolio company’s remaining assets, if any.

 

The rights we may have with respect to the collateral securing the loans we make to our portfolio companies with senior debt outstanding may also be limited pursuant to the terms of one or more intercreditor agreements that we enter into with the holders of senior debt. Under such an intercreditor agreement, at any time that obligations that have the benefit of the first priority liens are outstanding, any of the following actions that may be taken in respect of the collateral will be at the direction of the holders of the obligations secured by the first priority liens: the ability to cause the commencement of enforcement proceedings against the collateral; the ability to control the conduct of such proceedings; the approval of amendments to collateral documents; releases of liens on the collateral; and waivers of past defaults under collateral documents. We may not have the ability to control or direct such actions, even if our rights are adversely affected.

 

There may be circumstances where our debt investments could be subordinated to claims of other creditors or we could be subject to lender liability claims.

 

Even though we may have structured certain of our investments as senior loans, if one of our portfolio companies were to go bankrupt, depending on the facts and circumstances, including the extent to which we actually provided managerial assistance to that portfolio company, a bankruptcy court might re-characterize our debt investment and subordinate all or a portion of our claim to that of other creditors. We may also be subject to lender liability claims for actions taken by us with respect to a borrower’s business or instances where we exercise control over the borrower. It is possible that we could become subject to a lender’s liability claim, including as a result of actions taken in rendering significant managerial assistance.

 

We may not control any of our portfolio companies.

 

We may not control any of our portfolio companies, even though we may have board representation or board observation rights and our debt agreements may contain certain restrictive covenants. As a result, we are subject to the risk that a portfolio company in which we invest may make business decisions with which we disagree and the management of such company, as representatives of the equity stockholders, may take risks or otherwise act in ways that do not serve our interests as debt investors.

 

Defaults by our portfolio companies will harm our operating results.

 

A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, termination of its loans and foreclosure on its secured assets, which could trigger cross-defaults under other agreements and jeopardize the portfolio company’s ability to meet its

obligations under the debt investments that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting portfolio company.

 

Prepayments of our debt investments by our portfolio companies could adversely impact our results of operations and reduce our return on equity.

 

We are subject to the risk that the investments we make in our portfolio companies may be repaid prior to maturity. When this occurs, we will generally reinvest these proceeds in temporary investments, pending their future investment in new portfolio companies. These temporary investments will typically have substantially lower yields than the debt being prepaid and we could experience significant delays in reinvesting these amounts. Any future investment in a new portfolio company may also be at lower yields than the debt that was repaid. As a result, our results of operations could be materially adversely affected if one or more of our portfolio companies elects to prepay amounts owed to us. Additionally, prepayments could negatively impact our return on equity, which could result in a decline in the market price of our common stock.

 

We may not realize gains from our equity investments.

 

Certain investments that we have made in the past and may make in the future include warrants or other equity securities. In addition, we may from time to time make non-control, equity co-investments in companies in conjunction with private equity sponsors. Our goal is ultimately to realize gains upon our disposition of such equity interests. However, the equity interests we receive may not appreciate in value and, in fact, may decline in value. Accordingly, we may not be able to realize gains from our equity interests, and any gains that we do realize on the disposition of any equity interests may not be sufficient to offset any other losses we experience. We also may be unable to realize any value if a portfolio company does not have a liquidity event, such as a sale of the business, recapitalization or public offering, which would allow us to sell the underlying equity interests.

 

There is a risk that you may not receive dividends or that our dividends may not grow over time.

 

We cannot assure you that we will achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions. In addition, due to the asset coverage test applicable to us as a business development company and financial covenants contained in our loan agreements, we may be limited in our ability to make distributions.

 

Investing in our shares may involve an above average degree of risk.

 

The investments we make in accordance with our investment objective may result in a higher amount of risk than alternative investment options and volatility or loss of principal. Our investments in portfolio companies may be highly speculative and aggressive, and therefore, an investment in our shares may not be suitable for someone with lower risk tolerance.

 

The market price of our common stock may fluctuate significantly.

 

The market price and liquidity of the market for shares of our common stock may be significantly affected by numerous factors, some of which are beyond our control and may not be directly related to our operating performance. These factors include:

 

 

 

Shares of closed-end investment companies, including BDCs, may trade at a discount to their net asset value.

 

Shares of closed-end investment companies, including BDCs, may trade at a discount from net asset value. This characteristic of closed-end investment companies and BDCs is separate and distinct from the risk that our net asset value per share may decline. We cannot predict whether our common stock will trade at, above or below net asset value. In recent quarters, the price of our common stock has traded at prices below our net asset value. It should be noted that substantially all of the other BDCs share prices have also traded at prices below their net asset value.

 

In addition, if our common stock trades below net asset value, we will generally not be able to issue additional common stock at the market price unless our stockholders approve such a sale and our Board of Directors makes certain determinations. See “Risk Factors — Stockholders may incur dilution if we sell shares of our common stock in one or more offerings at prices below the then current net asset value per share of our common stock or issue securities to subscribe to, convert to or purchase shares of our common stock” for a discussion of proposals approved by our stockholders that permit us to issue shares of our common stock below net asset value.

 

Our common stock could be delisted from the Nasdaq Global Select Market if we are unable to maintain our compliance with Nasdaq listing requirements.

 

In recent months, many public companies whose securities trade on the Nasdaq Global Select Market have experienced significant volatility and sharp declines in their stock prices. In general, in order to meet Nasdaq’s continued listing standards, the closing bid of a company’s common stock must be at least $1.00 per share. Recently, a large number of companies have seen their common stock trade at prices below $1.00 per share. In recognition of this, on October 16, 2008, Nasdaq made a rule filing with the SEC to temporarily suspend its bid price continued listing requirement until January 16, 2009. On December 19, 2008, Nasdaq further extended this time period through April 20, 2009.

 

Absent Nasdaq’s recent actions, if the closing bid price per share for our common stock were to fall below $1.00 per share for 30 consecutive business days, we would receive notification from Nasdaq indicating that we are not in compliance with Nasdaq Marketplace Rule 4450(a)(5). In accordance with NASDAQ Marketplace Rule 4450(e)(2), we would then be provided 180 calendar days to regain compliance.

 

To regain compliance with the minimum bid price requirement, the closing bid price of our common stock must remain at $1.00 per share or more for a minimum of ten consecutive business days. If we were unable to regain compliance, we would be able to apply to list our common stock on the Nasdaq Capital Market and Nasdaq will determine whether we meet the Nasdaq Capital Market initial listing criteria as set forth in Nasdaq Marketplace Rule 4310(c), except for the minimum bid price requirement. If we were able to meet the Nasdaq Capital Market initial listing criteria, Nasdaq may notify us that we have been granted an additional 180 calendar days to come into compliance with the minimum bid price requirement. If we were not able to meet the initial listing criteria, Nasdaq may provide us with written notification that our common stock would be delisted. At that time, we would be permitted to appeal Nasdaq’s determination to delist our common stock to a Nasdaq Listings Qualifications Panel.

 

Delisting from the Nasdaq could have an adverse effect on our business and on the trading of our common stock. If a delisting of our common stock from Nasdaq were to occur, our common stock would trade

on the Over-the-Counter Bulletin Board or on the “pink sheets” maintained by the National Quotation Bureau, Inc. Such alternatives generally are considered to be less efficient markets, and our stock price, as well as the liquidity of our common stock, could be affected adversely.

 

Terrorist attacks, acts of war or natural disasters may affect any market for our common stock, impact the businesses in which we invest and harm our business, operating results and financial condition.

 

Terrorist acts, acts of war or natural disasters may disrupt our operations, as well as the operations of the businesses in which we invest. Such acts have created, and continue to create, economic and political uncertainties and have contributed to global economic instability. Future terrorist activities, military or security operations, or natural disasters could further weaken the domestic/global economies and create additional uncertainties, which may negatively impact the businesses in which we invest directly or indirectly and, in turn, could have a material adverse impact on our business, operating results and financial condition. Losses from terrorist attacks and natural disasters are generally uninsurable.

 

Certain provisions of our restated certificate of incorporation and restated bylaws as well as the Delaware General Corporation Law could deter takeover attempts and have an adverse impact on the price of our common stock.

 

Our restated certificate of incorporation and our restated bylaws as well as the Delaware General Corporation Law contain provisions that may have the effect of discouraging a third party from making an acquisition proposal for us. These anti-takeover provisions may inhibit a change in control in circumstances that could give the holders of our common stock the opportunity to realize a premium over the market price for our common stock.

 

 

Not applicable.

 

 

We do not own any real estate or other physical properties materially important to our operations. Currently, we lease office space in Westport, Connecticut for our corporate headquarters and an additional office in New York, New York.

 

 

Although we may, from time to time, be involved in litigation arising out of our operations in the normal course of business or otherwise, we are currently not a party to any pending material legal proceedings.

 

 

No matters were submitted to a vote of stockholders during the quarter ended December 31, 2008.

PART II

 

 

Price Range of Common Stock

 

Our common stock trades on the Nasdaq Global Select Market under the symbol “PCAP”. The following table sets forth, for each fiscal quarter during the last two fiscal years, the range of high and low closing

prices of our common stock as reported on the Nasdaq Global Select Market. The stock quotations are interdealer quotations and do not include markups, markdowns or commissions.

 

 

As of March 3, 2009, we had 34 stockholders of record of our common stock. In addition, we believe we had approximately 16,000 beneficial owners, whose shares of common stock are held in the names of brokers, dealers and clearing agencies.

 

Sales of Unregistered Securities

 

During the years ended December 31, 2008 and 2007, we issued a total of 177,000 and 158,000, respectively, shares of our common stock under our dividend reinvestment plan pursuant to an exemption from the registration requirements of the Securities Act of 1933. The aggregate offering price for the shares of our common stock sold under the dividend reinvestment plan was approximately $1.1 million and $2.2 million during the years ended December 31, 2008 and 2007, respectively.

 

Dividends

 

Our quarterly dividends, if any, will be determined by our board of directors. Historically, our board of directors has declared our quarterly dividends prior to the completion of the fiscal quarter to which such dividends relate. However, our board of directors has postponed making a decision regarding the declaration of the first quarter 2009 dividend until it has more information on whether the liquidity facility will be renewed. Moreover, in light of the unprecedented uncertainty regarding the financial markets and the economy, our board of directors is considering whether to alter its historical dividend declaration practice and declare dividends subsequent to the completion of the fiscal quarter to which such dividends relate.

 

We have elected to be taxed as a RIC under Subchapter M of the Code. As long as we qualify for RIC tax benefits, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders on a timely basis. Our second amended and restated securitization revolving credit facility limits our ability to declare dividends if we default under certain provisions. In addition, the asset coverage test applicable to us as a business development company may limit our ability to pay dividends.

 

As a business development company that has elected to be treated as a RIC, we are required to (1) distribute, with respect to each taxable year, at least 90% of our investment company taxable income in order to deduct any amounts (including net capital gains) distributed (or deemed distributed) to stockholders and (2) distribute, with respect to each calendar year, (actually or on a deemed basis) at least 98% of our income (both ordinary income and net capital gains) to avoid an excise tax. We will incur corporate-level tax on any taxable income or gains earned or realized in a taxable year and not distributed with respect to such year.

The following table summarizes our dividends declared during the last two fiscal years:

 

 

We have adopted a dividend reinvestment plan that provides for reinvestment of our distributions on behalf of our stockholders, unless a stockholder elects to receive cash. As a result, if our board of directors authorizes, and we declare, a cash dividend, then our stockholders who have not “opted out” of our dividend reinvestment plan will have their cash dividends automatically reinvested in additional shares of our common stock, rather than receiving the cash dividends. Stockholders who receive dividends in the form of stock will be subject to the same federal, state and local tax consequences as stockholders who elect to receive their dividends in cash. We have the option to satisfy the share requirements of the dividend reinvestment plan through the issuance of new shares of our common stock or through open market purchases of our common stock by the administrator of the dividend reinvestment plan. The number of newly issued shares to be issued to a stockholder is determined by dividing the total dollar amount of the dividend payable to such stockholder by the market price per share of our common stock at the close of regular trading on The Nasdaq Global Select Market on the dividend payment date. Shares purchased in open market transactions by the administrator of the dividend reinvestment plan will be allocated to a stockholder based upon the average purchase price, excluding any brokerage charges or other chargers, of all shares of common stock purchased with respect to the dividend. See “Business — Regulations — Taxation as a Regulated Investment Company for a discussion of a recent revenue procedure issued by the IRS.

 

Stock Performance Graph

 

The following graph compares the yearly percentage change in the cumulative stockholder return on our common stock from July 28, 2005 to December 31, 2008 with (i) the Nasdaq Composite Index, and (ii) the Patriot Capital Funding Peer Group index. This comparison assumes $100.00 was invested on July 28, 2005 (the date our common stock began to trade on the Nasdaq National Market (now known as the Nasdaq Global Select Market) in connection with our initial public offering) in our common stock and in the comparison groups and assumes the reinvestment of all cash dividends prior to any tax effect.

 

The comparisons in the graph below are based on historical data and are not intended to forecast the possible future performance of our common stock.

 

COMPARISON OF 42 MONTH CUMULATIVE TOTAL RETURN*

Among Patriot Capital Funding, Inc., The NASDAQ Composite Index
And A Peer Group

 

 

*$100 invested on 7/28/05 in stock or 6/30/05 in index, including reinvestment of dividends.
Fiscal year ending December 31.

 

 

 

 

You should read this selected consolidated financial data in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto included elsewhere in this annual report on Form 10-K. The selected consolidated financial data at and for the fiscal years ended December 31, 2008, 2007, 2006, 2005 and 2004 have been derived from our audited financial statements. Certain reclassifications have been made to the prior period financial information to conform to the current period presentation.

 

 

 

 

 

 

The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this annual report on Form 10-K.

 

This annual report on Form 10-K contains forward-looking statements regarding the plans and objectives of management for future operations. This information may involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by any forward-looking statements. Forward-looking statements, which involve assumptions and describe our future plans, strategies and expectations, are generally identifiable by use of the words “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “believe,” “intend” or “project” or the negative of these words or other variations on these words or comparable terminology. These forward-looking statements are based on assumptions that may be incorrect, and we cannot assure you that these projections included in these forward-looking statements will come to pass. Our actual results could differ materially from those expressed or implied by the forward-looking statements as a result of various factors.

 

We have based the forward-looking statements included in this annual report on Form 10-K on information available to us on the date of this annual report on Form 10-K, and we assume no obligation to update any such forward-looking statements. Although we undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events or otherwise, you are advised to consult any additional disclosures that we may make directly to you or through reports that we in the future may file with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.

 

General

 

We are a specialty finance company that provides customized financing solutions to small- to mid-sized companies. Our ability to invest across a company’s capital structure, from senior secured loans to equity securities, allows us to offer a comprehensive suite of financing solutions, including “one-stop” financing. In August 2005, we completed an initial public offering of shares of our common stock for net proceeds (including underwriters’ exercise of their over-allotment) of approximately $106.1 million. On July 27, 2005, we elected to be treated as a business development company under the 1940 Act. We have also elected to be treated as a RIC under Subchapter M of the Code. Pursuant to this election, we generally will not have to pay corporate-level taxes on any income or gains we distribute (actually or as a deemed dividend) to our stockholders as dividends, provided that we satisfy certain requirements.

 

Since we commenced investment operations in 2003, our business had been conducted through two separate entities, Patriot Capital Funding, Inc. and Wilton Funding, LLC. Patriot Capital Funding, Inc. originated, arranged and serviced the investments made by Wilton Funding, LLC, which invested in debt instruments and warrants of U.S.-based companies. For such services, Patriot Capital Funding, Inc. was entitled to receive placement fees and servicing fees from Wilton Funding, LLC’s portfolio companies and investment origination fees and asset management fees from Wilton Funding, LLC. On July 27, 2005, Wilton Funding, LLC merged with and into Patriot Capital Funding, Inc. and then we effected a stock split. Upon completion of the merger and stock split, we had 3,847,902 shares of common stock outstanding prior to shares issued in the initial public offering. Prior to the completion of the initial public offering, Compass Group Investments, Inc. beneficially owned all of our outstanding shares of stock.

 

The discussion herein of our financial statements reflect the combined operations of Patriot Capital Funding, Inc. and Wilton Funding, LLC prior to the merger and our consolidated results of our operations thereafter.

Going Concern

 

Our independent registered public accounting firm has issued an opinion on our consolidated financial statements that states that the consolidated financial statements were prepared assuming we will continue as a going concern and further states that the uncertainty regarding the renewal of our liquidity facility raises substantial doubt about our ability to continue as a going concern. Specifically, we are currently negotiating the renewal of the liquidity facility, which matures in April 2009, supporting our second amended and restated securitization revolving credit facility with certain liquidity banks. In the event that the liquidity banks do not renew the liquidity facility, the terms of the second amended and restated securitization revolving credit facility require that all principal and interest collected from the debt investments secured by the facility must be used to pay down amounts outstanding under the facility by April 2011. Because substantially all of our debt investments are secured by our second amended and restated securitization revolving credit facility, we cannot provide any assurance that we would have sufficient cash and liquid assets to fund normal operations and dividend distributions to our stockholders during the period of time when we are required to repay amounts outstanding under the second amended and restated securitization revolving credit facility if such amounts became due. If the liquidity facility is not renewed, we believe that we may be able to negotiate an arrangement with the lenders of the second amended and restated securitization revolving credit facility for repayment terms that do not require us to use all principal and interest collected from the debt investments secured by the facility to pay down amounts outstanding thereunder, however, we cannot provide any assurance that we will be able to do so. As a result, if the Company was unable to (i) renew the liquidity facility supporting our second amended and restated securitization revolving credit facility or (ii) negotiate an arrangement with the lenders of the second amended and restated securitization revolving credit facility for repayment terms that do not require us to use all principal and interest collected from the debt investments secured by the facility to pay down amounts outstanding thereunder there would be a significant adverse impact on our financial position and operating results. The consolidated financial statements included in Item 8 herein do not include any adjustments that might result from this uncertainty.

 

Portfolio Composition

 

Our primary business is lending to and investing in small- to mid-sized businesses through investments in senior secured loans, junior secured loans, subordinated debt investments and equity-based investments, including warrants. The fair value of our portfolio was $322.4 million and $384.7 million at December 31, 2008 and December 31, 2007, respectively. The decrease in the value of our portfolio during 2008 was primarily attributable to lower investment originations, higher repayments and unrealized losses on our investments. The increase in the value of our portfolio during 2007 was primarily attributable to newly-originated investments.

 

Total portfolio investment activity as of the fiscal year ended December 31, 2008 and December 31, 2007, respectively, was as follows:

 

 

The level of investment activity for investments funded and principal repayments for our investments can vary substantially from period to period depending on the number and size of investments that we make and

many other factors, including the amount of debt and equity capital available to us and small- to mid-sized companies, the level of merger and acquisition activity for such companies, the general economic environment, and the competitive environment for the types of investments we make.

 

As of December 31, 2008 and December 31, 2007, the composition of our portfolio at fair value was as follows:

 

 

For the years ended December 31, 2008 and 2007, the weighted average yield on all of our outstanding debt investments was approximately 12.1% and 12.4%, respectively. Yields are computed using actual interest income earned for the respective year, including amortization of loan fees and original issue discount, divided by the weighted average fair value of debt investments. As of December 31, 2008, $123.5 million of our portfolio investments at fair value were at fixed interest rates, which represented approximately 38% of our total portfolio of investments at fair value. As of December 31, 2007, $138.0 million of our portfolio investments at fair value were at fixed interest rates, which represented approximately 36% of our total portfolio of investments at fair value. We generally structure our subordinated debt investments at fixed rates, while many of our senior secured and junior secured loans are, and will be, at variable rates.

 

During 2006 through 2008, we, through our special purpose subsidiary, entered into eight interest rate swap agreements. Our swap agreements have a fixed rate range of 3.3% to 5.2% on an initial notional amount of $53.6 million. The swap agreements expire on various dates between three and five years from issuance. The swaps were put into place to hedge against changes in variable interest payments on a portion of our outstanding borrowings. For the year ended December 31, 2008, net unrealized depreciation attributed to the swaps was approximately $2.3 million. For the year ended December 31, 2007, net unrealized depreciation attributed to the swaps was approximately $775,000. For the year ended December 31, 2006, net unrealized appreciation attributed to the swaps was approximately $13,000. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in the benefits of lower rates with respect to the outstanding borrowings.

 

The composition of our investment portfolio by industry sector, using Moody’s Industry Classifications as of December 31, 2008 and December 31, 2007 at cost and fair value was as follows:

 

 

 

 

At December 31, 2008 and December 31, 2007, our two largest investments represented approximately 14% and 12%, respectively, of the total investment portfolio at fair value. Investment income, consisting of interest, dividends, fees, and recognition of gains on equity interests, can fluctuate dramatically upon repayment of an investment or sale of an equity interest. Revenue recognition in any given period can be highly concentrated among several customers. During the years ended December 31, 2008, 2007 and 2006, we did not record investment income from any customer in excess of 10.0% of total investment income.

 

At December 31, 2008 and 2007, our equity investments consisted of common and preferred stock, LLC membership interests and warrants to acquire equity interests in certain of our portfolio companies. Warrants to acquire equity interests allow us to participate in the potential appreciation in the value of the portfolio company, while minimizing the amount of upfront cost to us.

 

Asset Quality — Debt Portfolio

 

We utilize a standard investment rating system for our entire portfolio of debt investments. Investment Rating 1 is used for investments that exceed expectations and/or capital gain is expected. Investment Rating 2 is used for investments that are generally performing in accordance with expectations. Investment Rating 3 is used for performing investments that require closer monitoring. Investment Rating 4 is used for investments performing below expectations where a higher risk of loss exists. Investment Rating 5 is used for investments performing significantly below expectations where we expect a loss.

The following table shows the distribution of our debt investments on the 1 to 5 investment rating scale at fair value as of December 31, 2008 and December 31, 2007:

 

 

Loans and Debt Securities on Non-Accrual Status

 

Interest income is recorded on an accrual basis to the extent that such amounts are expected to be collected. When a loan becomes 90 days or more past due, or if the Company otherwise does not expect the debtor to be able to service its debt or other obligations, the Company will place the loan on non-accrual status and cease recognizing interest income on that loan until the borrower has demonstrated the ability and intent to pay contractual amounts due. At December 31, 2008, we had loans from three of our portfolio companies on non-accrual status. At December 31, 2007, none of our loans were on non-accrual status.

 

Results of Operations

 

The principal measure of our financial performance is net income (loss), which includes net investment income (loss), net realized gain (loss) and net unrealized appreciation (depreciation). Net investment income (loss) is the difference between our income from interest, dividends, fees, and other investment income and our operating expenses. Net realized gain (loss) on investments is the difference between the proceeds received from dispositions of portfolio investments and their stated cost. Net unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio. Net unrealized appreciation (depreciation) on interest rate swaps is the net change in the fair value of our outstanding swap agreements.

 

Comparison of the year ended December 31, 2008 and December 31, 2007

 

Total Investment Income

 

Total investment income included interest and dividend income on our investments, fee income and other investment income. Fee income consists principally of loan and arrangement fees, annual administrative fees, unused fees, prepayment fees, amendment fees, equity structuring fees and waiver fees. Other investment income consists primarily of the accelerated recognition of deferred financing fees received from our portfolio companies on the repayment of the entire outstanding investment, the sale of the investment or reduction of available credit.

 

Total investment income for the years ended December 31, 2008 and December 31, 2007 was $42.3 million and $39.0 million, respectively. For the year ended December 31, 2008, this amount consisted of interest income of $142,000 from cash and cash equivalents, $40.0 million of interest and dividend income from portfolio investments (which included $5.5 million in payment-in-kind or PIK interest and dividends), $1.4 million in fee income and $750,000 in other investment income. For the year ended December 31, 2007, this amount primarily consisted of interest income of $255,000 from cash and cash equivalents, $36.9 million of interest and dividend income from portfolio investments (which included $3.9 million in payment-in-kind or PIK interest and dividends), $1.3 million in fee income and $535,000 in other investment income.

 

The increase in our total investment income for the year ended December 31, 2008 as compared to the year ended December 31, 2007 is primarily attributable to an increase in the weighted average fair value balance outstanding of our interest-bearing investment portfolio during the year ended December 31, 2008, partially

offset by a decrease in the weighted average yield of our investments. The weighted average yield decreased primarily as a result of an overall decrease in market interest rates. During the year ended December 31, 2008, the weighted average fair value balance outstanding of our interest-bearing investment portfolio was approximately $336.8 million as compared to approximately $298.5 million during the year ended December 31, 2007. Total investments have decreased from $384.7 million at December 31, 2007 to $322.4 million at December 31, 2008, primarily due to an increase in payoffs recorded in 2008 in the amount of $27.7 million and an increase of $36.4 million in unrealized depreciation for the year ended December 31, 2008. However, the weighted average balance outstanding increased in 2008 as a result of the following: the majority of the net originations in 2007, $127.5 million, occurred in the third and fourth quarters of 2007; the majority of the unrealized depreciation recorded in 2008, $40.0 million, was recorded in the third and fourth quarters of 2008. These factors contributed to influencing the increase in the weighted average balance for 2008.

 

Expenses

 

Expenses included compensation expense, interest on our outstanding indebtedness, professional fees, and general and administrative expenses.

 

Expenses for the years ended December 31, 2008 and 2007 were $16.6 million and $16.2 million, respectively. Expenses increased for the year ended December 31, 2008 as compared to the year ended December 31, 2007 primarily as a result of increased interest expense in the amount of $737,000, increased professional fees in the amount of $748,000 and increased general and administrative expense in the amount of $308,000. Those increases were partially offset by lower compensation expense in the amount of $1.4 million. The lower compensation expense was principally attributable to the elimination of bonus accruals during the third and fourth quarters of 2008 given the impact of the current market environment on our financial performance in 2008 and the recognition that bonus awards for 2008 would be smaller than previously anticipated. The higher interest expense is attributable to an increase in the weighted average borrowings outstanding under our $225.0 million amended and restated securitization revolving credit facility, which were approximately $141.5 million in 2008 as compared to $106.0 million in 2007, and an increase in interest rates on our outstanding indebtedness during the third and fourth quarters of 2008. Such borrowings were primarily used to fund investments. The increase in general and administrative expenses is primarily a result of higher costs for benefits, proxy solicitation fees and printing costs. The increase in professional fees expense is primarily due to increases in the fees we incurred in 2008 related to accounting and compliance costs in connection with the adoption of Statement of Financial Standards No. 157 — Fair Value Measurements , on January 1, 2008 and the write-off of legal and accounting costs related to the 2008 filing of a shelf registration statement pursuant to which we have not sold any securities. In prior periods, we capitalized such expenses and expensed them in connection with securities offerings pursuant to such shelf registration statements.

 

Realized Gain (Loss) on Sale of Investments

 

Net realized gain (loss) on sale of investments is the difference between the proceeds received from dispositions of portfolio investments and their stated cost. During the year ended December 31, 2008, we realized losses of $883,000, principally from the sale of two syndicated debt investments and the cancellation of warrants which the Company had previously written down to zero, which were partially offset by the sale of an equity investment. During the year ended December 31, 2007, we realized gains of $92,000 principally due to the sale of equity warrants from one of our portfolio investments.

 

Net Change in Unrealized Appreciation or Depreciation on Investments

 

We determine the value of each investment in our portfolio on a quarterly basis, and changes in value result in unrealized appreciation or depreciation being recognized in our statement of operations. Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value as determined in good faith by our board of directors. Since there is typically no readily available market value for the investments in our portfolio, we value substantially all of our portfolio investments at fair value as determined in good faith by our board of directors pursuant to written guidelines established by our board of directors and a consistently

applied valuation process. See “Business — Determination of Net Asset Value” for a discussion of our valuation policy and process. At December 31, 2008 and 2007, portfolio investments recorded at fair value were approximately 91.0% and 96.6% of our total assets, respectively. Because of the inherent uncertainty of determining the fair value of investments that do not have a readily available market, the fair value of our investments determined in good faith by the board of directors may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.

 

There is no single standard for determining fair value in good faith. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment while employing a consistently applied valuation process for the types of investments we make. We specifically value each individual investment on a quarterly basis. Changes in the fair value of our investments are recorded in the statement of operations as net change in unrealized appreciation or depreciation.

 

In accordance with Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”), we principally utilize the market approach to estimate the fair value of our equity investments where there is not a readily available market and we principally utilize the income approach to estimate the fair value of our debt investments where there is not a readily available market. Under the market approach, we estimate the enterprise value of the portfolio companies in which we invest. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise value is best expressed as a range of fair values, from which we derive a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, we analyze various factors, including the portfolio company’s historical and projected financial results. We generally require portfolio companies to provide annual audited and quarterly and monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year. Typically, private companies are valued based on multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), cash flows, net income, revenues, or in limited cases, book value. The private equity industry uses financial measures such as EBITDA in order to assess a portfolio company’s financial performance and to value a portfolio company. When using EBITDA to determine enterprise value, we may adjust EBITDA for non-recurring items. Such adjustments are intended to normalize EBITDA to reflect the portfolio company’s earnings power. Adjustments to EBITDA may include compensation to previous owners, acquisition, recapitalization, restructuring related items, and one-time non-recurring income or expense items.

 

In determining a multiple to use for valuation purposes, we look to private merger and acquisition statistics, discounted public trading multiples or industry practices. In estimating a reasonable multiple, we consider not only the fact that our portfolio company may be a private company relative to a peer group of public comparables, but we also consider the size and scope of our portfolio company and its specific strengths and weaknesses. In some cases, the best valuation methodology may be a discounted cash flow analysis based on future projections. If a portfolio company is distressed, a liquidation analysis may provide the best indication of enterprise value.

 

The fair value of equity interests in portfolio companies is determined based on various factors, including the enterprise value remaining for equity holders after the repayment of the portfolio company’s debt and other preference capital, and other pertinent factors such as recent offers to purchase a portfolio company, recent transactions involving the purchase or sale of the portfolio company’s equity securities, or other liquidation events. The determined fair values of equity securities are generally discounted to account for restrictions on resale and minority ownership positions.

 

Under the income approach, we generally prepare and analyze discounted cash flow models based on our projections of the future free cash flows of the business. We also use bond yield models to determine the present value of the future cash flow streams of our debt investments. We review various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assess the information in the valuation process.

 

The fair value of our loan or debt security is principally determined from the results generated under the income approach unless the borrower’s condition or other factors lead to a determination of fair value at a different amount using multiple valuation methods

 

Duff & Phelps, LLC, an independent valuation firm (“Duff & Phelps”), provided third party valuation consulting services to us which consisted of certain limited procedures that we engaged them to perform. During the three months ended December 31, 2008 and 2007, we asked Duff & Phelps to perform the limited procedures on investments in 12 and 15, respectively, portfolio companies comprising approximately 38% and 49%, respectively, of the total investments at fair value. Upon completion of their limited procedures at December 31, 2008 and 2007, respectively, Duff & Phelps concluded that the fair value of those investments subjected to the limited procedures did not appear to be unreasonable. During the years 2008 and 2007, Duff & Phelps performed the limited procedures on 100% of our portfolio companies with debt investments, excluding broadly syndicated loans. Our board of directors is solely responsible for the valuation of our portfolio investments at fair value as determined in good faith pursuant our valuation policy and consistently applied valuation process.

 

Net unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains and losses are realized. During the year ended December 31, 2008, we recorded net unrealized depreciation of $40.0 million on our investments and during the year ended December 31, 2007, we recorded net unrealized depreciation of $3.6 million on our investments. For the year ended December 31, 2008, a portion of our net unrealized depreciation, approximately $5.6 million, resulted from the decrease in quoted market prices on our syndicated loan portfolio as a result of the disruption in the credit markets for broadly syndicated loans; approximately $27.5 million resulted from a decline in the financial performance of our portfolio companies; and approximately $6.9 million resulted from the January 1, 2008 adoption of SFAS 157. During the year ended December 31, 2007, we recorded net unrealized depreciation of $3.6 million on our investments. A substantial portion of the unrealized depreciation recorded during 2007 resulted from an increase in the number of our portfolio companies requiring closer monitoring or performing below expectations and, to a lesser extent, from quoted market prices below par on our syndicated loan portfolio as a result of the disruption in the financial and credit markets for large syndicated loans.

 

Unrealized Appreciation (Depreciation) on Interest Rate Swaps

 

Net unrealized appreciation (depreciation) on interest rate swaps represents the change in value of our swap agreements. For the year ended December 31, 2008, we recorded an unrealized depreciation of approximately $2.3 million on our interest rate swap agreements as compared to $775,000 of unrealized depreciation in the comparable period in 2007. The 2008 and 2007 unrealized depreciation in the value of our interest rate swap agreements resulted from the volatility in interest rates during both years.

 

Net Income (Loss) from Operations

 

Net loss was $17.5 million for the year ended December 31, 2008 as compared to net income of $18.4 million for the year ended December 31, 2007. The $35.9 million decrease in net income was primarily a result of an increase in net realized and unrealized loss in the amount of $38.9 million, partially offset by a $3.0 million increase in net investment income.

 

Comparison of the year ended December 31, 2007 and December 31, 2006

 

Total Investment Income

 

Total investment income included interest and dividend income on our investments, fee income and other investment income. Fee income consists principally of loan and arrangement fees, annual administrative fees, unused fees, prepayment fees, amendment fees, equity structuring fees and waiver fees. Other investment income consists primarily of the accelerated recognition of deferred financing fees received from our portfolio companies on the repayment of the entire outstanding investment, the sale of the investment or reduction of available credit.

 

Total investment income for the years ended December 31, 2007 and December 31, 2006 was $39.0 million and $26.5 million, respectively. For the year ended December 31, 2007, this amount consisted of interest income of $255,000 from cash and cash equivalents, $36.9 million of interest and dividend income from portfolio investments (which included $3.9 million in payment-in-kind or PIK interest and dividends), $1.3 million in fee income and $535,000 in other investment income. For the year ended December 31, 2006,

this amount primarily consisted of interest income of $423,000 from cash and cash equivalents, $25.0 million of interest and dividend income from portfolio investments (which included $2.4 million in payment-in-kind or PIK interest and dividends), $270,000 in fee income and $848,000 in other investment income.

 

The increase in our total investment income for the year ended December 31, 2007 as compared to the year ended December 31, 2006 is primarily attributable to an increase in the weighted average fair value balance outstanding of our interest-bearing investment portfolio during the year ended December 31, 2007. During the year ended December 31, 2007, the weighted average fair value balance outstanding of our interest-bearing investment portfolio was approximately $298.5 million as compared to approximately $192.5 million during the year ended December 31, 2006. The primary reason behind the increase in total investment income was an increase in interest income due to the increase in the size of our investment portfolio, partially offset by a decrease in the weighted average yield of our investments, and an increase in fee income due to an increase in prepayment penalties and structuring fees as well as higher fees for amendments. The weighted average yield decreased as a result of a shift in our portfolio mix towards more senior secured investments and an overall decrease in market interest rates.

 

Expenses

 

Expenses included compensation expense, interest on our outstanding indebtedness, professional fees, and general and administrative expenses.

 

Expenses for the years ended December 31, 2007 and 2006 were $16.2 million and $11.5 million, respectively. Expenses increased for the year ended December 31, 2007 as compared to the year ended December 31, 2006 primarily as a result of increased compensation expense in the amount of $1.5 million, increased interest expense in the amount of $3.1 million and increased general and administrative expense in the amount of $269,000. Those increases were offset by lower professional fees expense in the amount of $159,000. The higher compensation expense is due to the increase in salaries of existing employees, higher bonus accruals and the addition of new employees during the year. The higher interest expense is attributable to an increase in the weighted average borrowings outstanding under our $175.0 million amended and restated securitization revolving credit facility, which were approximately $106.0 million in 2007 as compared to $55.3 million in 2006, and an increase in interest rates on our outstanding indebtedness during the third and fourth quarters of 2007. Such borrowings were primarily used to fund investments. The increase in general and administrative expenses is primarily a result of higher costs for benefits and travel attributable to the increase in employees and computer software expense. The decrease in professional fees expense is primarily due to decreases in the fees we incurred in 2006 related to our initial compliance with Section 404 of the Sarbanes-Oxley Act of 2002.

 

Realized Gain (Loss) on Sale of Investments

 

Net realized gain (loss) on sale of investments is the difference between the proceeds received from dispositions of portfolio investments and their stated cost. During the year ended December 31, 2007, we realized gains of $92,000, principally due to the sale of equity warrants from one of our portfolio investments. During the year ended December 31, 2006, we sold our investment in Interstate Highway Sign Corporation and realized a net loss of $3.3 million.

 

Net Change in Unrealized Appreciation or Depreciation on Investments

 

We determine the value of each investment in our portfolio on a quarterly basis, and changes in value result in unrealized appreciation or depreciation being recognized in our statement of operations. Value, as defined in Section 2(a)(41) of the 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value as determined in good faith by our board of directors. Since there is typically no readily available market value for the investments in our portfolio, we value substantially all of our portfolio investments at fair value as determined in good faith by our board of directors pursuant to our valuation policy and a consistently applied valuation process. See “Business — Determination of Net Asset Value” for a discussion of our valuation policy and process. At December 31, 2007 and 2006, portfolio investments recorded at fair value were approximately 96.6% and 95.1% of our total assets, respectively. Because of the inherent uncertainty of determining the fair value of

investments that do not have a readily available market, the fair value of our investments determined in good faith by the board of directors may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.

 

Net unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains and losses are realized. During the year ended December 31, 2007, we recorded net unrealized depreciation of $3.6 million on our investments and during the year ended December 31, 2006, we recorded net unrealized appreciation of $3.8 million on our investments, which primarily related to one investment which was sold during the year at a realized loss of $3.3 million and the reversal of the previously recorded unrealized loss related thereto. A substantial portion of the unrealized depreciation recorded during 2007 resulted from an increase in the number of our portfolio companies requiring closer monitoring or performing below expectations and, to a lesser extent, from quoted market prices below par on our syndicated loan portfolio as a result of disruption in the financial and credit markets for large syndicated loans. Sustained market disruptions in the large corporate leverage loan market could continue to have a downward impact on the amount of unrealized depreciation we record on our syndicated loans.

 

Unrealized Appreciation (Depreciation) on Interest Rate Swaps

 

Net unrealized depreciation on interest rate swaps represents the change in value of our swap agreements. For the year ended December 31, 2007, we recorded an unrealized depreciation of approximately $775,000 on our interest rate swap agreements as compared to $13,000 in unrealized appreciation in the comparable period in 2006. The 2007 unrealized depreciation in the value of our interest rate swap agreements resulted from the volatility in interest rates during the year.

 

Net Income from Operations

 

Net income was $18.4 million for the year ended December 31, 2007 as compared to $15.6 million for the year ended December 31, 2006. The $2.8 million increase in net income was primarily a result of an increase in investment income of $12.5 million in 2007, partially offset by an increase in operating expenses in the amount of $4.7 million and an increase in net realized and unrealized loss in the amount of $4.9 million.

 

Financial Condition, Liquidity and Capital Resources

 

Cash, Cash Equivalents and Restricted Cash

 

At December 31, 2008 and 2007, we had $6.4 million and $789,000, respectively, in cash and cash equivalents. In addition, at December 31, 2008 and 2007, we had $22.2 million and $10.5 million, respectively, in restricted cash which we maintained in accordance with the terms of our second amended and restated securitization revolving credit facility with an entity affiliated with BMO Capital Markets Corp. and Branch Banking and Trust Company. A portion of these funds were released or available to us on January 12, 2009 and January 14, 2008, respectively.

 

For the year ended December 31, 2008, net cash provided by operating activities totaled $19.9 million, compared to net cash provided by operating activities of $22.8 million for the comparable 2007 period. This change was due primarily to a decrease in net income, a decrease in interest receivable, an increase in unrealized loss on investments, an increase in unrealized loss on swaps, and an increase in unearned income. Those amounts were offset by a decrease in realized loss on investments, and an increase in PIK interest and dividends. Cash provided by (used for) investing activities totaled $27.1 million and ($127.6) million for the years ended December 31, 2008 and 2007, respectively. This change was principally due to lower investment origination in the amount of $118.0 million, and an increase of $27.7 million in investment repayments and an increase in sales of investments in the amount of $8.9 million. Cash provided by (used for) financing activities totaled ($41.3) million and $101.3 million in the years ended December 31, 2008 and 2007, respectively. This change was principally due to a net decrease of $68.8 million in our borrowings, an increase in restricted cash of $6.3 million, an increase in distributions paid in the amount of $6.1 million, and a decrease in net proceeds from the sale of common stock of $60.5 million.

 

Liquidity and Capital Resources

 

Prior to our initial public offering, our primary sources of capital had been from Compass Group Investments, Inc. which provided us with a $30.1 million equity investment, a $400,000 demand note and a $2.0 million secured revolving line of credit and an unaffiliated lender which provided us with a line of credit under which we had the ability to borrow up to $120.0 million, subject to certain conditions. On August 2, 2005, we completed an initial public offering of 7,190,477 shares of our common stock and on August 15, 2005, the underwriters exercised their option to purchase an additional 1,078,572 shares of common stock. We received net proceeds after underwriters’ commissions, discounts and fees of $106.1 million. Concurrent with our initial public offering, we entered into a securitization revolving credit facility, which we subsequently amended and restated on several occasions. See “— Borrowings.”

 

On June 14, 2006, we closed a follow-on public offering of 3,600,000 shares of common stock and received gross proceeds of $39.1 million less underwriters’ commissions and discounts, and fees of $2.4 million. On January 17, 2007, we closed a shelf offering of 2,370,000 shares of common stock and received gross proceeds of $33.7 million less underwriters’ commissions and discounts, and fees of $2.0 million. On October 2, 2007, we closed a shelf offering of 2,300,000 shares of common stock and received gross proceeds of $30.5 million less underwriters’ commissions and discounts, and fees of $1.6 million.

 

We have historically relied on cash generated from our operations and debt and equity financings to fund our business. We primarily use these funds to make investments in portfolio companies in accordance with our investment objective, to pay our operating expenses and to make cash distributions to the holders of our common stock. To fund growth in our investment portfolio in the future, we will need to raise additional capital from various sources, including the equity markets and the securitization or other debt-related markets, which may or may not be available on favorable terms, if at all.

 

Since the turmoil in the financial markets, which began in mid-2007, we have taken a number of steps to help ensure the continued availability of liquidity. First, we increased the borrowing availability under our securitization revolving credit facility from $175 million to $225 million in April 2008. Second, we obtained stockholder approval at our 2008 annual meeting of stockholders to, subject to approval from our board of directors, (i) issue securities to subscribe to, convert to, or purchase shares of our common stock and (ii) sell shares of our common stock below the then current net asset value per share in one or more offerings for a period of one year ending on the earlier of June 23, 2009 or the date of our 2009 annual meeting of stockholders. Third, we have largely curtailed our investment originations that fall outside the parameters of our second amended and restated securitization facility.

 

However, in light of the recent worsening of the conditions in the financial markets and the U.S. economy overall, we are considering other measures to help ensure adequate liquidity, including the sale of selected portfolio investments, forming and licensing a Small Business Investment Company subsidiary, further operating expense reductions, lowering our dividends and availing ourselves to a recent IRS revenue procedure that will allow us to maintain our RIC status through the payment of dividends partly in cash and partly in shares of our common stock. We cannot provide any assurance that these measures will provide sufficient sources of liquidity to support our operations and growth given the unprecedented instability in the financial markets and the weak U.S. economy.

 

Moreover, the second amended and restated securitization revolving credit facility contains certain requirements, including minimum equity capital, rating and yield, and limitations on loan size, and each loan origination under the facility is subject to certain conditions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Borrowings.” In particular, the second amended and restated securitization revolving credit facility provides that our borrowings thereunder may not exceed our total stockholders’ equity, which was $180.1 million at December 31, 2008.

 

In addition, as a business development company, we generally are required to meet a coverage ratio of total assets less liabilities and indebtedness not represented by senior securities, to total senior securities, which includes all of our borrowings and any preferred stock we may issue in the future, of at least 200%. As of December 31, 2008, this ratio was 211%.

We are currently negotiating with the lenders under the second amended and restated securitization revolving credit facility to renew the liquidity facility under the second amended and restated securitization revolving credit facility which is set to expire in April 2009. Failure to renew the Liquidity Facility may negatively impact our liquidity position. See “Risk Factors — There is substantial doubt about our ability to continue as a going concern” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Borrowings” and “— Regulated Investment Company Status and Dividends.”

 

Borrowings

 

Securitization Revolving Credit Facility.   On September 18, 2006, we, through a consolidated wholly-owned, bankruptcy remote, special purpose subsidiary of ours, entered into an amended and restated securitization revolving credit facility (the “Securitization Facility”), with an entity affiliated with BMO Capital Markets Corp. (formerly Harris Nesbitt Corp.). The Securitization Facility allowed the special purpose subsidiary to borrow up to $140 million through the issuance of notes to a multi-seller commercial paper conduit administered by the affiliated entity. The Securitization Facility also required bank liquidity commitments (“Liquidity Facility”) to provide liquidity support to the conduit. The liquidity facility was provided by the lender that participated in the Securitization Facility for a period of 364-days and was renewable annually thereafter at the option of the lender. On May 2, 2007, we amended the Securitization Facility to lower the interest rate payable on any outstanding borrowings under the Securitization Facility from the commercial paper rate plus 1.35% to the commercial paper rate plus 1.00% during the period of time we were permitted to make draws under the Securitization Facility. The amendment also reduced or eliminated certain restrictions pertaining to certain loan covenants. On August 31, 2007, we amended the Securitization Facility to increase our borrowing capacity thereunder by $35 million. The amendment also extended the commitment termination date from July 23, 2009 to July 22, 2010 and reduced or eliminated certain restrictions pertaining to certain loan covenants. The Securitization Facility provided for the payment by us to the lender of a monthly fee equal to 0.25% per annum on the unused amount of the Securitization Facility.

 

On April 11, 2008, we entered into a second amended and restated securitization facility (the “Amended Securitization Facility”) with an entity affiliated with BMO Capital Markets Corp. and Branch Banking and Trust Company. The Amended Securitization Facility amended and restated the Securitization Facility to, among other things: (i) increase the borrowing capacity from $175 million to $225 million; (ii) extend the maturity date from July 22, 2010 to April 11, 2011 (unless extended prior to such date for an additional 364-day period with the consent of the lenders thereto); (iii) increase the interest rate payable under the facility from the commercial paper rate plus 1.00% to the commercial paper rate plus 1.75% on up to $175 million of outstanding borrowings and the LIBOR rate plus 1.75% on up to $50 million of outstanding borrowings; and (iv) increase the unused commitment fee from 0.25% per annum to 0.30% per annum.

 

The Amended Securitization Facility permits draws under the facility until April 10, 2009, unless the Lenders extend the Liquidity Facility underlying the Amended Securitization Facility for an additional 364 day period. If the Liquidity Facility is not extended, the Amended Securitization Facility enters into a 24-month amortization period whereby all principal, interest and fee payments received by us in conjunction with collateral pledged under the Amended Securitization Facility, less a monthly servicing fee payable to us, are required to be used to repay outstanding borrowings under the Amended Securitization Facility. Any remaining outstanding borrowings would be due and payable on the commitment termination date, which is currently April 11, 2011. Because substantially all of our debt investments are secured by the Amended Securitization Facility, we cannot provide any assurance that we would have sufficient cash and liquid assets to fund normal operations and dividend distributions to our stockholders during the period of time when we are required to repay amounts outstanding under the Amended Securitization Facility, if such amounts became due. As a result, we may be required to severely limit or otherwise cease making cash distributions to our stockholders. In addition, we may be required to sell a portion of our investments to satisfy our obligation to repay such outstanding principal amount prior to April 2011.

 

Similar to the Securitization Facility, the Amended Securitization Facility contains restrictions pertaining to the geographic and industry concentrations of funded loans, maximum size of funded loans, interest rate payment frequency of funded loans, maturity dates of funded loans and minimum equity requirements. These

restrictions may affect the amount of notes our special purpose subsidiary may issue from time to time. The Amended Securitization Facility also contains certain requirements relating to portfolio performance, including required minimum portfolio yield and limitations on delinquencies and charge-offs, violation of which could result in the early termination of the Amended Securitization Facility. The Amended Securitization Facility also requires the maintenance of a Liquidity Facility. The Liquidity Facility is provided by the Lenders that participate in the Securitization Facility for a period of 364-days and is renewable annually thereafter at the option of the lenders. The Liquidity Facility is scheduled to be renewed in April 2009. If the Liquidity Facility is not renewed, our ability to draw under the Amended Securitization Facility would end and the amortization period under the Amended Securitization Facility would commence. The Amended Securitization Facility is secured by all of the loans held by our special purpose subsidiary. At December 31, 2008, the maximum borrowings available to us under the facility is limited to the amount of stockholders’ equity, $180.1 million. As of December 31, 2008, we were in technical default of one of the debt covenants under the Amended Securitization Facility, which was cured within the timeframe allowed by the facility.

 

As of December 31, 2008, $162.6 million was outstanding under the Amended Securitization Facility. The weighted average interest rate during the years ended December 31, 2008 and 2007 was 5.3% and 6.6%, respectively. At December 31, 2008, the interest rate was 3.6%.

 

During 2006 through 2008, we, through our special purpose subsidiary, entered into eight interest rate swap agreements. Our swap agreements have a fixed rate range of 3.3% to 5.2% on an initial notional amount totaling $53.6 million. The swap agreements expire five years from issuance. The swaps were put into place to hedge against changes in variable interest payments on a portion of our outstanding borrowings. For the year ended December 31, 2008, net unrealized depreciation attributed to the swaps was approximately $2.3 million. For the year ended December 31, 2007, net unrealized depreciation attributed to the swaps was approximately $775,000. For the year ended December 31, 2006, net unrealized appreciation attributed to the swaps was approximately $13,000. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in the benefits of lower rates with respect to the outstanding borrowings.

 

Regulated Investment Company Status and Dividends

 

Effective as of August 1, 2005, we elected to be treated as a RIC under Subchapter M of the Code. As long as we qualify as a RIC, we will not be taxed on our investment company taxable income or realized net capital gains, to the extent that such taxable income or gains are distributed, or deemed to be distributed, to stockholders on a timely basis.

 

Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation, until realized. Dividends declared and paid by us in a year may differ from taxable income for that year as such dividends may include the distribution of current year taxable income, the distribution of prior year taxable income carried forward into and distributed in the current year. Distributions also may include returns of capital.

 

To maintain RIC tax treatment, we must, among other things, distribute, with respect to each taxable year, at least 90% of our investment company taxable income (i.e., our net ordinary income and our realized net short-term capital gains in excess of realized net long-term capital losses, if any). In order to avoid certain excise taxes imposed on RICs, we must distribute, with respect to each calendar year, an amount at least equal to the sum of (1) 98% of our ordinary income for the calendar year, (2) 98% of our capital gains in excess of capital losses for the one-year period ending on October 31 of the calendar year and (3) any ordinary income and net capital gains for preceding years that were not distributed during such years. To the extent our taxable earnings for a fiscal tax year falls below the total amount of our distributions for that fiscal year, a portion of those distributions may be deemed a return of capital to our stockholders.

 

We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In particular, we expect our investment

origination activity in 2009 to be hindered by our inability currently to access the public equity markets and limitations on our ability to use debt and equity capital to fund our investment activities. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a business development company under the 1940 Act and due to provisions in the Amended Securitization Facility. In this regard, if the lenders under the Amended Securitization Facility do not renew the Liquidity Facility, we may be required to dedicate a significant portion of our operating cash flow to repay the principal amount outstanding under the Amended Securitization Facility by April 2011. As a result, we may be required to severely limit or otherwise cease making distributions to our stockholders. If we do not distribute at least a certain percentage of our taxable income annually, we will suffer adverse tax consequences, including possible loss of our status as a RIC. We cannot assure stockholders that they will receive any distributions or distributions at a particular level.

 

Off-Balance Sheet Arrangements

 

We are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our portfolio companies. These instruments include commitments to extend credit and involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. We attempt to limit our credit risk by conducting extensive due diligence, negotiating appropriate financial covenants and obtaining collateral where necessary. As of December 31, 2008, we had unused commitments to extend credit to our portfolio companies of $23.8 million, which are not reflected on our balance sheet.

 

In connection with our second amended and restated securitization revolving credit facility, our consolidated special purpose subsidiary may be required under certain circumstances to enter into interest rate swap agreements or other interest rate hedging transactions. Patriot Capital Funding, Inc., has agreed to guarantee the payment of certain swap breakage costs that may be payable by our special purpose subsidiary in connection with any such interest rate swap agreements or other interest rate hedging transactions. At December 31, 2008, we had eight interest rate swap agreements outstanding.

 

Contractual Obligations

 

The following table reflects a summary of our contractual cash obligations and other commercial commitments as of December 31, 2008:

 

 

 

 

Recent Developments

 

On March 3, 2009, the Board of Directors granted an award of 446,250 shares of restricted stock to our executive officers with a fair value of $1.27 per share (the closing price of the common stock at the date of grant). The total fair value of $567,000 will be expensed over four years.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the period reported. On an ongoing basis, our management evaluates its estimates and assumptions, which are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. Changes in our estimates and assumptions could materially impact our results of operations and financial condition.

 

Going Concern

 

A fundamental principle of the preparation of financial statements in accordance with accounting principles generally accepted in the United States of America is the assumption that an entity will continue in existence as a going concern, which contemplates continuity of operations and the realization of assets and settlement of liabilities occurring in the ordinary course of business. This principle is applicable to all entities except for entities in liquidation or entities for which liquidation appears imminent. In accordance with this requirement, our policy is to prepare our consolidated financial statements on a going concern basis unless we intend to liquidate or have no other alternative but to liquidate. As a result of the uncertainty regarding the renewal of the liquidity facility supporting our second amended and restated securitization revolving credit facility, there is substantial doubt about our ability to continue as a going concern. While we have prepared our consolidated financial statements on a going concern basis, if we are unable to renew the liquidity facility, our ability to continue as a going concern may be impacted. Therefore, we may not be able to realize our assets and settle our liabilities in the ordinary course of business. Our consolidated financial statements included in this annual report on Form 10-K do not reflect any adjustments that might specifically result from the outcome of this uncertainty.

 

Valuation of Portfolio Investments

 

The most significant estimate inherent in the preparation of our financial statements is the valuation of investments for which there is no readily available market value and the related amounts of unrealized appreciation and depreciation on those investments.

 

Under SFAS 157, we principally utilize the market approach to estimate the fair value of our equity investments where there is not a readily available market and we also utilize the income approach to estimate the fair value of our debt investments where there is not a readily available market. Under the market approach, we estimate the enterprise value of the portfolio companies in which we invest. There is no one methodology to estimate enterprise value and, in fact, for any one portfolio company, enterprise value is best expressed as a range of fair values, from which we derive a single estimate of enterprise value. To estimate the enterprise value of a portfolio company, we analyze various factors, including the portfolio company’s historical and projected financial results. We generally require portfolio companies to provide annual audited and quarterly and monthly unaudited financial statements, as well as annual projections for the upcoming fiscal year. Typically, private companies are valued based on multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), cash flows, net income, revenues, or in limited cases, book value.

 

Under the income approach, we generally prepare and analyze discounted cash flow models based on our projections of the future free cash flows of the business. We also use bond yield models to determine the

present value of the future cash flow streams of our debt investments. We review various sources of transactional data, including private mergers and acquisitions involving debt investments with similar characteristics, and assess the information in the valuation process.

 

Fee Income Recognition

 

We receive a variety of fees in the ordinary course of our business, including arrangement fees and loan fees. We account for our fee income in accordance with Emerging Issues Task Force Issue 00-21 “Accounting for Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 addresses certain aspects of a company’s accounting for arrangements containing multiple revenue-generating activities. In some arrangements, the different revenue-generating activities (deliverables) are sufficiently separable and there exists sufficient evidence of their fair values to separately account for some or all of the deliverables (i.e., there are separate units of accounting). EITF 00-21 states that the total consideration received for the arrangement be allocated to each unit based upon each unit’s relative fair value. In other arrangements, some or all of the deliverables are not independently functional, or there is not sufficient evidence of their fair values to account for them separately. In determining fair value of various fee income we receive, we will first rely on data compiled through our investment and syndication activities and secondly on independent third party data. The timing of revenue recognition for a given unit of accounting will depend on the nature of the deliverable(s) in that accounting unit (and the corresponding revenue recognition model) and whether the general conditions for revenue recognition have been met. Fee income for which fair value cannot be reasonably ascertained is recognized using the interest method in accordance with Statement of Financial Accounting Standards No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases,” (“SFAS No. 91”). We have historically recognized fee income in accordance with SFAS No. 91. In addition, we capitalize and offset direct loan origination costs against the origination fees received and only defer the net fee.

 

Payment-in-Kind or PIK Interest and Dividends

 

We include in income certain amounts that we have not yet received in cash, such as contractual payment-in-kind or PIK interest or dividends, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term or contractually deferred dividends added to our equity investment in the portfolio company. We will cease accruing PIK interest if we do not expect the portfolio company to be able to pay all principal and interest due, and we will cease accruing PIK dividends if we do not expect the portfolio company to be able to make PIK dividend payments in the future. In certain cases, a portfolio company makes principal payments on its loan prior to making payments to reduce the PIK loan balances and, therefore, the PIK portion of a portfolio company’s loan can increase while the total outstanding amount of the loan to that portfolio company may stay the same or decrease. Accrued PIK interest and dividends represented $6.6 million or 2.0% of our portfolio of investments at fair value as of December 31, 2008 and $4.7 million or 1.2% of our portfolio of investments at fair value as of December 31, 2007. The net increase in loan and equity balances as a result of contracted PIK arrangements are separately identified on our statements of cash flows.

 

PIK related activity for the year ended December 31, 2008 was as follows:

 

Interest and Dividend Income Recognition

 

Interest income is recorded on an accrual basis to the extent that such amounts are expected to be collected. When a loan or debt security becomes 90 days or more past due, or if we otherwise do not expect the debtor to be able to service its debt or other obligations, we will generally place the loan or debt security on non-accrual status and cease recognizing interest income on that loan or debt security until the borrower has demonstrated the ability and intent to pay contractual amounts due. At December 31, 2008, we had loans from three of our portfolio companies on non-accrual status. At December 31, 2007, none of our loans were greater than 90 days past due or on non-accrual status.

 

New Accounting Pronouncements

 

In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 161, “Disclosures about Derivative Instruments and Hedging Activities,” (“SFAS 161”). SFAS 161 requires specific disclosures regarding the location and amounts of derivative instruments in our financial statements; how derivative instruments and related hedged items are accounted for; and how derivative instruments and related hedged items affect our financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Early application is permitted. Because SFAS 161 impacts our disclosure and not our accounting treatment for derivative instruments and related hedged items, our adoption of SFAS 161 is not expected to impact the results of operations or financial condition.

 

 

Our business activities contain elements of market risk including interest rates. We consider the management of risk essential to conducting our business. Accordingly, our risk management systems and procedures are designed to identify and analyze our risks, to set appropriate policies and limits and to continually monitor these risks and limits by means of reliable administrative and information systems and other policies and programs. Our investment income is affected by changes in various interest rates, including LIBOR and prime rates. Approximately 38% of our investment portfolio at fair value bears interest at fixed rates, with the remainder at floating rates.

 

Because we borrow money to make investments, our net investment income is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest these funds. As a result, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our net investment income. In periods of rising interest rates, our cost of funds would increase, which would reduce our net investment income. Our interest rates on our borrowings are based on commercial paper rates. We have and may continue to use interest rate risk management techniques in an effort to limit our exposure to interest rate fluctuations. Such techniques may include various interest rate hedging activities to the extent permitted by the 1940 Act. We have analyzed the potential impact of changes in interest rates on interest income net of interest expense. Assuming that the balance sheet were to remain constant and no actions were taken to alter the existing interest rate sensitivity, a hypothetical immediate 1% change in interest rates would have affected investment income by approximately $1.8 million and interest expense by approximately $1.2 million. Although management believes that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of the assets on the balance sheet and other business developments that could affect net increase in assets resulting from operations, or net income. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by this estimate.

 

Index to Consolidated Financial Statements

 

 

Board of Directors and Stockholders of

Patriot Capital Funding, Inc.

 

We have audited the accompanying consolidated balance sheets of Patriot Capital Funding, Inc. (a Delaware Corporation) (the “Company”) including the consolidated schedule of investments, as of December 31, 2008 and 2007, and the related consolidated statements of operations, cash flows, changes in net assets and the financial highlights (included in Note 14) for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the financial position of Patriot Capital Funding, Inc. as of December 31, 2008 and 2007, and the results of its operations, cash flows, changes in net assets and its financial highlights for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America.

 

The accompanying consolidated financial statements have been prepared assuming that Patriot Capital Funding, Inc. will continue as a going concern. As discussed in Note 2 to the accompanying consolidated financial statements, the Company is currently negotiating the renewal of the liquidity facility supporting the Company’s second amended and restated securitization revolving credit facility (the “Facility”) which matures on April 11, 2009. In the event that the liquidity facility is not renewed, the terms of the Facility require that all principal, interest and fees collected from the debt investments pledged under the Facility must be used to pay down amounts outstanding under the liquidity facility by April 11, 2011. Because substantially all of the Company’s debt investments are pledged under the Facility, the Company may not have sufficient cash and liquid assets to fund its normal operations. Therefore, the Company may not be able to realize its assets and settle its liabilities in the ordinary course of business. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to this matter are described in Note 2 to the accompanying consolidated financial statements. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

As discussed in Note 4 to the accompanying consolidated financial statements, in 2008 the Company adopted Statement of Financial Accounting Standards No. 157 — Fair Value Measurements.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Patriot Capital Funding, Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 13, 2009 expressed an unqualified opinion.

 

New York, New York

March 13, 2009

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors and Stockholders of

Patriot Capital Funding, Inc.

 

We have audited Patriot Capital Funding, Inc.’s (a Delaware Corporation) (the “Company”) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Fram ework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Patriot Capital Funding, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on Patriot Capital Funding, Inc.’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, Patriot Capital Funding, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by COSO.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Patriot Capital Funding, Inc., including the consolidated schedule of investments, as of December 31, 2008 and 2007, and the related consolidated statements of operations, cash flows, changes in net assets and the financial highlights (included in Note 14) for each of the three years in the period ended December 31, 2008 and our report dated March 13, 2009 expressed an unqualified opinion and included explanatory paragraphs regarding the Company’s ability to continue as a going concern and the Company’s adoption of Statement of Financial Accounting Standards No. 157 — Fair Value Measurements .

 

New York, New York

March 13, 2009

PATRIOT CAPITAL FUNDING, INC.

 

 

See Notes to Consolidated Financial Statements

PATRIOT CAPITAL FUNDING, INC.