- Quarterly Report (10-Q)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)


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

For the quarterly period ended September 30, 2008


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

For the transition period to

Commission file number: 814-00729

Highland Distressed Opportunities, Inc.

(Exact Name of Registrant as Specified in Charter)


Delaware		205423854
(State or Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

NexBank Tower
13455 Noel Road, Suite 800
Dallas, Texas 75240
(Address of Principal Executive Offices)
(877) 247-1888
(Registrant’s Telephone Number, Including Area Code)

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 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.


Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ (Do not check if a smaller reporting company)		Smaller Reporting Company o

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

On November 6, 2008, there were 17,716,771 shares outstanding of the Registrant’s common stock, $0.001 par value per share.

Highland Distressed Opportunities, Inc.

Table of Contents


		Page
PART I	Financial Information
Item 1.	Financial Statements	3
	Schedule of Investments—As of September 30, 2008 (unaudited)	3
	Statement of Assets and Liabilities—As of September 30, 2008 (unaudited) and December 31, 2007	7
	Statement of Operations—For the three and nine months ended September 30, 2008 (unaudited) and September 30, 2007 (unaudited)	8
	Statement of Changes in Stockholders’ Equity (Net Assets)—For the nine months ended September 30, 2008 (unaudited)	9
	Statement of Cash Flows—For the nine months ended September 30, 2008 (unaudited) and September 30, 2007 (unaudited)	10
	Notes to Financial Statements (unaudited)	11
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	25
Item 4.	Controls and Procedures	26
PART II	Other Information
Item 1.	Legal Proceedings	27
Item 1A.	Risk Factors	27
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	27
Item 3.	Defaults Upon Senior Securities	27
Item 4.	Submission of Matters to a Vote of Security Holders	27
Item 5.	Other Information	27
Item 6.	Exhibits	27
	Signatures	28
EX-31.1
EX-31.2
EX-32.1



*	Commencement of operations

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SCHEDULE OF INVESTMENTS



As of September 30, 2008 (unaudited)		Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)
Senior Loans (a) - 89.0%

AEROSPACE - 3.0%
IAP Worldwide Services, Inc. First Lien Term Loan, 8.06%, 12/30/12, PIK		4,560,462		4,570,745		3,534,358


BROADCASTING - 15.0%
Comcorp Broadcasting, Inc.
Revolving Loan, 8.15%, 04/03/13 (b) (c) (d)		1,800,821		1,800,821		1,546,905
Term Loan, 8.31%, 04/03/13 (b) (d)		18,849,521		18,508,999		16,191,739

				20,309,820		17,738,644


CABLE/WIRELESS VIDEO - 3.4%
WideOpen West Finance, LLC Second Lien Term Loan, 9.49%, 06/29/15, PIK		5,213,592		5,129,063		4,040,534


CONSUMER NON-DURABLES - 2.3%
Totes Isotoner Corp. Second Lien Term Loan, 9.88%, 01/31/14		3,377,228		3,401,668		2,786,213


DIVERSIFIED MEDIA - 1.1%
Penton Media, Inc. Second Lien Term Loan, 7.80%, 02/01/14		2,000,000		2,037,420		1,350,000


ENERGY - 7.1%
Resolute Aneth, LLC Second Lien Term Loan, 7.30%, 06/26/13		4,000,000		4,000,000		3,520,000
TARH E&P Holdings, L.P. First Lien Term Loan, 7.30%, 06/29/12		5,000,000		5,000,000		4,862,500

				9,000,000		8,382,500


FINANCIAL - 5.0%
Emerson Reinsurance Ltd. Tranche C Term Loan, 8.07%, 12/15/11		1,500,000		1,494,621		1,282,500
Flatiron Re Ltd.
Closing Date Term Loan, 8.02%, 12/29/10		64,177		64,673		59,685
Delayed Draw Term Loan, 8.02%, 12/29/10		31,086		31,326		28,910
Kepler Holdings Ltd. Term Loan, 9.31%, 06/30/09		5,000,000		5,010,515		4,500,000

				6,601,135		5,871,095


FOOD/TOBACCO - 6.2%
Wm. Wrigley Jr. Company Tranche B, 07/25/14 (e)		7,500,000		7,275,000		7,384,875


FOREST PRODUCTS/CONTAINERS - 0.2%
Tegrant Corp. Second Lien Term Loan, 9.27%, 03/08/15		1,000,000		1,000,000		200,000


GAMING/LEISURE - 14.0%
Fontainebleau Florida Hotel, LLC Tranche C Term Loan, 8.82%, 06/06/12		6,000,000		6,000,000		5,460,000
Harrah’s Operating Co. Term B-2 Loan, 5.80%, 01/28/15		4,975,000		4,680,813		4,089,848
Lake at Las Vegas Joint Venture/ LLV-1,LLC
Term Loan, 15.60%, 06/20/12, PIK (f)		32,377,252		28,269,771		6,219,350
Revolving Loan Credit-Linked Deposit, 16.10%, 06/20/12 (f)		3,611,111		3,611,111		794,444

				42,561,695		16,563,642

See accompanying Notes to Financial Statements.

SCHEDULE OF INVESTMENTS



As of September 30, 2008 (unaudited) (continued)		Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)
Senior Loans (continued)

HEALTHCARE - 5.3%
Applied Biosystems Term Loan, 09/30/15 (e)		2,000,000		1,960,000		1,895,000
Aveta Inc.
MMM Original Term Loan, 9.21%, 08/22/11		1,864,296		1,654,277		1,612,616
NAMM New Term Loan, 9.21%, 08/22/11		276,950		245,751		239,562
NAMM Original Term Loan, 9.21%, 08/22/11		499,051		442,832		431,679
PHMC Acquisition Term Loan, 9.21%, 08/22/11		1,527,833		1,355,722		1,321,576
LifeCare Holdings, Inc. Term Loan, 7.96%, 08/11/12		982,278		962,926		820,202

				6,621,508		6,320,635


HOUSING - 7.1%
MetroFlag BP, LLC / Metroflag Cable, LLC Second Lien Term Loan, 12.43%, 01/06/09		5,000,000		5,000,000		3,675,000
MPH Mezzanine II, LLC Mezzanine 2B, 8.28%, 02/09/08 (b) (f)		10,000,000		10,000,000		—
MPH Mezzanine III, LLC Mezzanine 3, 9.28%, 02/09/08 (b) (f)		4,000,000		4,000,000		—
Pacific Clarion, LLC Term Loan, 15.00%, 01/23/09 (b) (g)		4,950,573		4,925,214		4,731,263

				23,925,214		8,406,263


INFORMATION TECHNOLOGY - 4.1%
Sungard Data Systems Inc. Incremental Term Loan Facility, 02/28/14 (e)		5,000,000		4,950,000		4,820,850


RETAIL - 2.0%
Claire’s Stores, Inc. Term B Loan, 05/29/14 (e)		3,979,849		3,213,728		2,416,644


SERVICE - 10.1%
LVI Services, Inc. Tranche B Term Loan, 8.06%, 11/16/11		9,401,516		9,336,653		6,933,618
NES Rentals Holdings, Inc. Permanent Second Lien Term Loan, 9.50%, 07/20/13		2,000,000		2,029,400		1,460,000
Penhall International Co. Term Loan, 10.13%, 04/01/12, PIK		5,456,661		5,392,908		3,546,830

				16,758,961		11,940,448


TRANSPORTATION - AUTOMOTIVE - 0.3%
BST Safety Textiles Acquisition GmbH Second Lien Facility, 12.10%, 06/30/09		665,500		666,191		395,972


UTILITY - 2.8%
Texas Competitive Electric Holdings Co., LLC Initial Tranche B-2 Term Loan, 6.21%, 10/10/14		3,979,900		3,817,672		3,363,015

Total Senior Loans				161,839,820		105,515,688

See accompanying Notes to Financial Statements.

SCHEDULE OF INVESTMENTS



As of September 30, 2008 (unaudited) (continued)		Highland Distressed Opportunities, Inc.


	Principal ($)		Cost ($)		Value ($)
Corporate Notes and Bonds - 36.5%

BROADCASTING - 0.3%
Young Broadcasting, Inc. 10.00%, 03/01/11		2,000,000		1,993,563		300,000


DIVERSIFIED MEDIA - 5.5%
Baker & Taylor, Inc. 11.50%, 07/01/13 (h)		8,300,000		8,751,839		6,515,500


FINANCIAL - 1.3%
HUB International Holdings, Inc. 10.25%, 06/15/15 (h)		2,000,000		1,560,702		1,590,000


FOOD/TOBACCO - 2.5%
Pinnacle Foods Group, Inc. 10.63%, 04/01/17		4,000,000		4,036,250		3,020,000


HEALTHCARE - 19.5%
Argatroban Royalty Sub, LLC 18.50%, 09/21/14 (h)		3,921,541		3,921,541		3,941,149
Azithromycin Royalty Sub, LLC 16.00%, 05/15/19 (h)		5,000,000		4,975,230		5,025,000
Celtic Pharma Phinco B.V. 17.00%, 06/15/12, PIK (h)		9,744,782		9,295,195		9,647,334
Cinacalcet Royalty Sub, LLC 15.50%, 03/30/17, PIK (h)		1,038,750		988,390		1,028,362
Ledgemont Royalty Sub, LLC 16.00%, 11/05/24 (h)		2,500,000		2,500,000		2,512,500
Molecular Insight Pharmaceuticals, Inc. 11.10%, 11/01/12 (h) (i)		1,000,000		1,014,950		1,022,500

				22,695,306		23,176,845


HOUSING - 4.1%
Realogy Corp.
10.50%, 04/15/14		5,000,000		4,962,982		2,225,000
12.38%, 04/15/15		7,500,000		4,103,669		2,587,500

				9,066,651		4,812,500


INFORMATION TECHNOLOGY - 2.2%
Freescale Semiconductor, Inc.
9.13%, 12/15/14 (h)		800,000		548,547		508,000
10.13%, 12/15/16		3,200,000		3,200,000		2,064,000

				3,748,547		2,572,000


TRANSPORTATION – AUTOMOTIVE - 1.1%
Delphi Corp.
6.55%, 06/15/06 (f)		1,500,000		1,151,250		187,500
6.50%, 05/01/09 (f)		2,500,000		1,850,000		312,500
6.50%, 08/15/13 (f)		2,667,000		1,861,483		346,710
7.13%, 05/01/29 (f)		3,500,000		2,565,250		437,500
Motor Coach Industries International, Inc. 11.25%, 05/01/09 (f)		12,000,000		10,999,042		60,000

				18,427,025		1,344,210

Total Corporate Notes and Bonds				70,279,883		43,331,055

See accompanying Notes to Financial Statements.

SCHEDULE OF INVESTMENTS



As of September 30, 2008 (unaudited) (continued)		Highland Distressed Opportunities, Inc.


	Shares		Cost ($)		Value ($)
Claims - 1.1%

AEROSPACE - 1.1%
Northwest Airlines, Inc.
ALPA Trade Claim, 08/21/13		3,000,000		458,969		120,000
Bell Atlantic Trade Claim, 08/21/13		2,500,000		457,052		100,000
EDC Trade Claims, 08/21/13		2,500,000		470,351		100,000
Flight Attendant Claim, 08/21/13		5,326,500		788,491		213,060
GE Trade Claim, 08/21/13		1,500,000		288,981		60,000
IAM Trade Claim, 08/21/13		4,728,134		772,421		189,125
Pinnacle Trade Claim, 08/21/13		8,433,116		1,606,633		337,325
Retiree Claim, 08/21/13		3,512,250		519,924		140,490

Total Claims				5,362,822		1,260,000


Common Stocks - 20.4%

BROADCASTING - 5.6%
Communications Corp. of America (b) (d) (j)		1,256,635		7,187,203		6,584,767


HEALTHCARE - 14.7%
Genesys Ventures IA, LP (b) (d) (j)		12,000,000		12,000,000		17,412,000


WIRELESS COMMUNICATIONS - 0.1%
ICO Global Communications (j)		138,632		500,000		151,109


Total Common Stocks				19,687,203		24,147,876


Total Investments - 147.0%				257,169,728		174,254,619


Other Assets & Liabilities, Net - (47.0)%						(55,714,284	)


Net Assets - 100.0%						118,540,335


(a)		Senior loans in which Highland Distressed Opportunities, Inc. (the “Company”) invests generally pay interest at rates which are periodically determined by reference to a base lending rate plus a premium (unless otherwise identified by footnote (f), all senior loans carry a variable rate interest). These base lending rates are generally (i) the Prime Rate offered by one or more major United States banks, (ii) the lending rate offered by one or more European banks such as the London Interbank Offered Rate (“LIBOR”) or (iii) the Certificate of Deposit rate. Rate shown represents the weighted average rate at September 30, 2008. Senior loans, while exempt from registration under the Securities Act of 1933 (the “1933 Act”), contain certain restrictions on resale and cannot be sold publicly. Senior secured floating rate loans often require prepayments from excess cash flow or permit the borrower to repay at its election. The degree to which borrowers repay, whether as a contractual requirement or at their election, cannot be predicted with accuracy. As a result, the actual remaining maturity may be substantially less than the stated maturity shown.

(b)		Represents fair value as determined by the Company’s investment adviser, in good faith, pursuant to the policies and procedures approved by the Company’s Board of Directors (the “Board”). Securities with a total aggregate market value of $46,466,674 or 39.2% of net assets were fair valued as of September 30, 2008.

(c)		Senior loan asset has additional unfunded loan commitments. See Note 6.

(d)		Affiliated issuer. See Note 7.

(e)		All or a portion of this position has not settled. Contract rates do not take effect until settlement date.

(f)		The issuer is in default of certain debt covenants. Income is not being accrued.

(g)		Fixed rate senior loan.

(h)		Securities exempt from registration under Rule 144A of the 1933 Act. These securities may only be resold, in transactions exempt from registration, to qualified institutional buyers. At September 30, 2008, these securities amounted to $31,790,345 or 26.8% of net assets.

(i)		Floating rate note. The interest rate shown reflects the rate in effect at September 30, 3008.

(j)		Non-income producing security.

PIK		Payment-in-Kind. All or a portion of the stated interest rate may be PIK interest.

See accompanying Notes to Financial Statements.

STATEMENT OF ASSETS AND LIABILITIES

Highland Distressed Opportunities, Inc.


	As of
	September 30, 2008			As of
	(unaudited)			December 31, 2007
	($)			($)
Assets:
Investments in:
Unaffiliated issuers, at value (cost $217,672,705 and $345,348,887, respectively)		132,519,208			284,085,088
Affiliated issuers, at value (cost $39,497,023 and $26,677,127, respectively)		41,735,411			27,901,063

Total investments, at value (cost $257,169,728 and $372,026,014, respectively)		174,254,619			311,986,151
Cash and cash equivalents		—			4,291,098
Foreign currency (cost $3,176 and $0, respectively)		3,102			—
Receivable for:
Investments sold		17,716,081			24,628,173
Dividend and interest		4,506,802			5,951,790
Other assets		154,586			66,712

Total assets		196,635,190			346,923,924


Liabilities:
Due to Custodian		3,224,095			—
Notes payable (Note 4)		49,000,000			142,000,000
Net discount and unrealized depreciation on unfunded transactions		11,863			16,228
Payables for:
Investments purchased		24,299,665			19,387,884
Investment advisory fee (Note 3)		919,733			1,812,285
Administration fee (Note 3)		160,953			317,150
Incentive fee (Note 3)		—			383,951
Interest expense (Note 4)		195,259			759,465
Directors’ fees (Note 3)		2,006			592
Accrued expenses and other liabilities		281,281			231,317

Total liabilities		78,094,855			164,908,872

Stockholders’ equity (net assets)		118,540,335			182,015,052


Composition of stockholders’ equity (net assets):
Common Stock, par value $.001 per share: 550,000,000 common stock authorized, 17,716,771 common stock outstanding		17,717			17,717
Paid-in capital		253,163,644			253,163,644
Undistributed net investment income		965,144			3,420,147
Accumulated net realized gain/(loss) on unaffiliated investments, total return swaps and foreign currency transactions		(52,679,469	)		(14,547,689	)
Net unrealized appreciation/(depreciation) on investments, unfunded transactions and translation of assets and liabilities denominated in foreign currency		(82,926,701	)		(60,038,767	)

Stockholders’ equity (net assets)		118,540,335			182,015,052


Net Asset Value Per Share (Net Assets/Common Stock Outstanding)		6.69			10.27

See accompanying Notes to Financial Statements.

STATEMENT OF OPERATIONS

Highland Distressed Opportunities, Inc.


	For the Three Months Ended						For the Nine Months Ended
	September 30, 2008			September 30, 2007			September 30, 2008			September 30, 2007 ^(a)
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
	($)			($)			($)			($)
Investment Income:
Interest income from unaffiliated issuers		2,758,382			9,345,514			17,089,645			19,796,684
Interest income from affiliated issuers (Note 7)		1,328,066			—			1,328,066			—
Unaffiliated dividends (net of foreign taxes withheld)		—			175,702			40,685			954,901

Total investment income		4,086,448			9,521,216			18,458,396			20,751,585


Expenses:
Investment advisory fees (Note 3)		919,733			2,207,594			3,566,640			4,493,525
Incentive fees (Note 3)		—			—			1,680,346			1,326,507
Administration fees (Note 3)		160,953			386,356			624,162			786,367
Accounting service fees		41,777			37,934			119,027			89,063
Transfer agent fees		8,241			8,192			23,367			19,233
Professional fees		243,867			133,266			582,386			234,356
Directors’ fees		4,927			10,334			16,788			24,263
Custody fees		6,427			15,450			28,573			38,673
Registration fees		6,032			8,072			18,065			8,072
Reports to stockholders		20,583			10,982			41,554			49,371
Delaware franchise tax expense		9,115			27,357			38,951			48,455
Organization expense (Note 3)		—			—			—			170,383
Rating agency fees		10,386			24,506			40,148			32,497
Interest expense (Note 4)		615,401			3,083,273			2,726,479			5,216,061
Other expense		66,552			46,785			258,070			80,954

Total operating expenses		2,113,994			6,000,101			9,764,556			12,617,780
Fees and expenses waived or reimbursed by Investment Adviser (Note 3)		—			(744,834	)		(809,977	)		(3,594,496	)

Net expenses		2,113,994			5,255,267			8,954,579			9,023,284

Net investment income		1,972,454			4,265,949			9,503,817			11,728,301


Net Realized and Unrealized Gain/(Loss) on Investments:
Net realized gain/(loss) on unaffiliated investments		(5,099,876	)		(7,645,111	)		(38,131,772	)		(7,401,030	)
Net realized gain/(loss) on total return swaps		—			137,821			—			172,955
Net realized gain/(loss) on foreign currency transactions		(3	)		18,914			(8	)		(26,660	)
Net change in unrealized appreciation/(depreciation) on investments		(3,971,133	)		(22,906,625	)		(22,875,246	)		(29,833,092	)
Net change in unrealized appreciation/(depreciation) on unfunded transactions		(1,807	)		—			(11,863	)		—
Net change in unrealized appreciation/(depreciation) on translation of assets and liabilities denominated in foreign currency		(2,794	)		8,611			(825	)		38,362

Net realized and unrealized gain/(loss) on investments		(9,075,613	)		(30,386,390	)		(61,019,714	)		(37,049,465	)

Net decrease in stockholders’ equity (net assets) resulting from operations		(7,103,159	)		(26,120,441	)		(51,515,897	)		(25,321,164	)


^(a)		Highland Distressed Opportunities, Inc. commenced operations on January 18, 2007.

See accompanying Notes to Financial Statements.

STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (NET ASSETS)



For the Nine Months Ended September 30, 2008 (unaudited)		Highland Distressed Opportunities, Inc.


																Total
							Undistributed			Undistributed			Net Unrealized			Stockholders’
	Common Stock				Paid-in Capital		Net Investment			Net Realized			Appreciation/			Equity
	Shares		Amount		in Excess of Par		Income			Gain/(Loss)			(Depreciation)			(Net Assets)

Balance at December 31, 2007		17,716,771	$	17,717	$	253,163,644	$	3,420,147		$	(14,547,689	)	$	(60,038,767	)	$	182,015,052
Distributions declared		—		—		—		(11,958,820	)		—			—			(11,958,820	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations		—		—		—		9,503,817			(38,131,780	)		(22,887,934	)		(51,515,897	)

Balance at September 30, 2008		17,716,771	$	17,717	$	253,163,644	$	965,144		$	(52,679,469	)	$	(82,926,701	)	$	118,540,335

See accompanying Notes to Financial Statements.

STATEMENT OF CASH FLOWS

Highland Distressed Opportunities, Inc.


	For the			For the
	Nine Months Ended			Nine Months Ended
	September 30, 2008			September 30, 2007 ^(a)
	(unaudited)			(unaudited)
	($)			($)
Cash Flow Provided by (Used in) Operating Activities:
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations		(51,515,897	)		(25,321,164	)
Adjustments to reconcile net increase/(decrease) in stockholders’ equity (net assets) resulting from operations:
Net realized (gain)/loss on investments, total return swaps and foreign currency transactions		38,131,780			7,254,735
Net change in unrealized (appreciation)/depreciation on investments, unfunded transactions and translation of assets and liabilities denominated in foreign currency		22,887,934			29,794,730
Purchase of investments securities		(95,806,986	)		(1,078,148,157	)
Proceeds from disposition of investment securities, total return swaps and foreign currency transactions		173,428,162			672,568,075
Net amortization/(accretion) of premium/(discount)		(896,662	)		(804,006	)
Net realized and change in unrealized gain/(loss) on foreign currency		(833	)		38,362
(Increase)/Decrease in dividends, interest and fees receivable		1,444,988			(6,643,588	)
(Increase)/Decrease in receivable for investments sold		6,912,092			(45,153,853	)
(Increase)/Decrease in other assets		(87,874	)		(278,297	)
Increase/(Decrease) in payable for investments purchased		4,911,781			46,630,844
Increase/(Decrease) in payables to related parties		(1,439,928	)		1,848,427
Increase/(Decrease) in interest payable		(564,206	)		868,643
Increase/(Decrease) in other liabilities		42,378			154,468

Net Cash Flow Provided by (Used in) Operating Activities		97,446,729			(397,190,781	)


Cash Flows Provided by (Used in) Financing Activities:
Net proceeds from issuance of common stock		—			251,852,704
Increase/(Decrease) in notes payable		(93,000,000	)		165,000,000	^(b)
Increase in due to custodian		3,224,095			—
Increase in accrued offering cost		—			50,240
Distributions paid in cash		(11,958,820	)		(7,936,487	)

Net Cash Flow Provided by (Used in) Financing Activities		(101,734,725	)		408,966,457

Net Increase (Decrease) in Cash, Cash Equivalents and Foreign Currency		(4,287,996	)		11,775,676


Cash, Cash Equivalents and Foreign Currency:
Beginning of the period		4,291,098			—
End of the period		3,102			11,775,676


Supplemental Information:
Interest paid during the period		3,290,685			4,347,418


^(a)		Highland Distressed Opportunities, Inc. commenced operations on January 18, 2007.

^(b)		On January 18, 2007, $4 million was borrowed from affiliate and repaid in March 2007. See Note 9 for details.

See accompanying Notes to Financial Statements.

NOTES TO FINANCIAL STATEMENTS (unaudited)


September 30, 2008		Highland Distressed Opportunities, Inc.

Note 1. Organization

Highland Distressed Opportunities, Inc. (the “Company”), is a non-diversified closed-end company that has filed an election to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”). The Company was incorporated under the laws of Delaware on August 22, 2006. In addition, for tax purposes, the Company intends to elect to be treated as a regulated investment company, or RIC, under the Internal Revenue Code of 1986 (the “Code”). The Company’s investment objective is total return generated by both capital appreciation and current income. The Company intends to invest primarily in financially-troubled or distressed companies that are either middle-market companies or unlisted companies by investing in senior secured debt, mezzanine debt and unsecured debt, each of which may include an equity component, and in equity investments.

The Company commenced operations on January 18, 2007. On February 27, 2007, the Company closed its initial public offering (“IPO” or the “Offering”) and sold 17,000,000 shares of its common stock at a price of $15.00 per share, less an underwriting discount and commissions totaling $0.675 per share. The Company received $243,525,000 in total net proceeds from the Offering, before expenses.

On March 23, 2007, the Company issued 284,300 shares of common stock to cover the underwriters’ partial exercise of the over-allotment option on the Offering and received approximately $4,072,698 in net proceeds after deducting underwriting discounts and commissions.

Note 2. Significant Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ materially.

Interim unaudited financial statements are prepared in accordance with GAAP for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X, as appropriate. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, and reclassifications considered necessary for the fair presentation of financial statements for the periods presented, have been included. The unaudited interim financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K, as filed with the Securities and Exchange Commission (“SEC”). Interim results are not necessarily indicative of results for a full year.

The following are significant accounting policies consistently followed by the Company in preparation of its financial statements:

(a) Investments in financial instruments

Investment transactions are recorded on the trade date.

The Company will use the following valuation methods to determine either current market value for investments for which market quotations are available, or if not available, then fair value, as determined in good faith pursuant to policies and procedures approved by the Company’s Board of Directors (the “Board”):

Market Quotations Available

The market value of each security listed or traded on any recognized securities exchange or automated quotation system will be the last reported sale price at the relevant valuation date on the composite tape or on the principal exchange on which such security is traded. If no sale is reported on that date, the Company utilizes, when available, pricing quotations from principal market makers. Such quotations may be obtained from third-party pricing services or directly from investment brokers and dealers in the secondary market. Generally, the Company’s loan and bond positions are not traded on exchanges and consequently are valued based on market prices received from third-party pricing services or broker-dealer sources. The valuation of certain securities for which there is no market may take into account appraisal reports from independent valuation firms. Short-term debt securities having a remaining maturity of 60 days or less when purchased and debt securities originally purchased with maturities in excess of 60 days but which currently have maturities of 60 days or less may be valued at cost adjusted for amortization of premiums and accretion of discounts.

NOTES TO FINANCIAL STATEMENTS (unaudited) (continued)


September 30, 2008		Highland Distressed Opportunities, Inc.

Market Quotations Not Available

The Company will take the following steps each time it determines its net asset value in order to determine the value of its securities for which market quotations are not readily available, as determined in good faith pursuant to policies and procedures approved by the Board:

	1.		The valuation process begins with each portfolio company or investment being initially valued by the investment professionals responsible for the portfolio investment.

	2.		Preliminary valuation conclusions will then be documented and discussed with Highland Capital Management, L.P.’s (the “Investment Adviser”) senior management.

	3.		The valuation committee, comprised of the Investment Adviser’s investment professionals and other senior management, will then review these preliminary valuations. An independent valuation firm engaged by the Company’s Board will review all of these preliminary valuations each quarter.

	4.		Finally, the Board discusses valuations and determines the fair value of each investment in the Company’s portfolio in good faith, pursuant to policies and procedures approved by the Board, based on the input of the valuation committee and an independent valuation firm.

Determination of fair values is uncertain because it involves subjective judgments and estimates not easily substantiated by auditing procedures.

Adoption of Statement of Financial Accounting Standards No. 157 “Fair Value Measurement” (“FAS 157”):

In September 2006, the Financial Accounting Standards Board (“FASB”) issued FAS 157, “Fair Value Measurement,” which is effective for financial statements issued for fiscal years beginning after November 15, 2007. FAS 157 defines how fair value should be determined for financial reporting purposes, establishes a framework for measuring fair value under GAAP, and requires additional disclosures about the use of fair value measurements, but is not expected to result in any changes to the fair value measurements of the Company’s investments. FAS 157 requires companies to provide expanded information about the assets and liabilities measured at fair value and the potential effect of these fair valuations on net assets.

The Company has adopted FAS 157 as of January 1, 2008. The Company has performed an analysis of all existing investments and derivative instruments to determine the significance and character of all inputs to their fair value determination. Based on this assessment, the adoption of FAS 157 did not have any material effect on the Company’s net asset value. However, the adoption of FAS 157 does require the Company to provide additional disclosures about the inputs used to develop the measurements and the effect of certain measurements on changes in net assets for the reportable periods as contained in the Company’s periodic filings. The three levels of the fair value hierarchy established under FAS 157 are described below:

	•		Level 1 — Quoted unadjusted prices for identical instruments in active markets to which the Company has access at the date of measurement;

	•		Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Level 2 inputs are those in markets for which there are few transactions, the prices are not current, little public information exists or instances where prices vary substantially over time or among brokered market makers; and

	•		Level 3 — Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. Unobservable inputs are those inputs that reflect the Company’s own assumptions that market participants would use to price the asset or liability based on the best available information.

NOTES TO FINANCIAL STATEMENTS (unaudited) (continued)


September 30, 2008		Highland Distressed Opportunities, Inc.

The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those securities. A summary of the inputs used to value the Company’s assets as of September 30, 2008 as follows:


Assets at Fair Value	Total		Level 1		Level 2		Level 3
Portfolio Investments	$	174,254,619	$	151,109	$	62,075,593	$	112,027,917
Cash, cash equivalents and foreign currency		3,102		3,102		—		—

Total	$	174,257,721	$	154,211	$	62,075,593	$	112,027,917

The Company did not have any liabilities that were measured at fair value on a recurring basis at September 30, 2008.

The tables below set forth a summary of changes in the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2008.


	For the Three Months Ended
	September 30, 2008
Assets at Fair Value Using Unobservable Inputs (Level 3)	Portfolio Investments
Balance as of June 30, 2008	$	46,033,783
Transfers in/(out) of Level 3		60,383,855
Net amortization/(accretion) of premium/(discount)		41,054
Net realized gains/(losses)		(2,027,172	)
Net unrealized gains/(losses)		520,631
Net purchases and sales *		7,075,766

Balance as of September 30, 2008	$	112,027,917


	For the Nine Months Ended
	September 30, 2008
Assets at Fair Value Using Unobservable Inputs (Level 3)	Portfolio Investments
Balance as of December 31, 2007	$	37,888,863
Transfers in/(out) of Level 3		85,188,420
Net amortization/(accretion) of premium/(discount)		333,542
Net realized gains/(losses)		(2,027,172	)
Net unrealized gains/(losses)		(21,971,482	)
Net purchases and sales *		12,615,746

Balance as of September 30, 2008	$	112,027,917


*		Includes any applicable borrowings and/or paydowns made on revolving credit facilities held in the Company’s investment portfolio.

The net unrealized losses presented in the tables above relate to investments that are still held at September 30, 2008, and the Company presents these unrealized losses on the Statement of Operations as net change in unrealized appreciation/(depreciation) on investments.

Investments designated as Level 3 may include assets valued using quotes or indications furnished by brokers which are based on models or estimates and may not be executable prices. In light of the developing market conditions, the Investment Adviser continues to search for observable data points and evaluate broker quotes and indications received for portfolio investments. As a result, with respect to certain investments for which there is currently limited market visibility or activity, for the quarter ended September 30, 2008, approximately $60,383,855 of the Company’s portfolio investments were transferred from Level 2 to Level 3.

(b)		Net asset value per share

		The net asset value per share disclosed on the Statement of Assets and Liabilities is calculated by dividing the net assets attributable to the shares of the Company’s common stock by the number of such shares outstanding at period-end.

(c)		Securities transactions

		All securities transactions are accounted for on a trade-date basis. Gains or losses on the sale of investments are calculated by using the specific identification method.

NOTES TO FINANCIAL STATEMENTS (unaudited) (continued)


September 30, 2008		Highland Distressed Opportunities, Inc.

(d)		Interest income

		Interest income, adjusted for amortization of premium and accretion of discount, is recorded on an accrual basis. Origination, closing and/or commitment fees associated with investments in portfolio companies are accreted into interest income over the respective terms of the applicable loans. Upon the prepayment of a loan or debt security, any prepayment penalties and unamortized loan origination, closing and commitment fees are recorded as interest income. Payment-in-Kind (“PIK”) interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To maintain the Company’s status as a RIC, this non-cash source of income must be paid out to stockholders in the form of distributions, even though the Company has not yet collected cash. For the three months ended September 30, 2008, approximately $0.1 million of PIK interest income was recorded.

(e)		Taxation — general

		The Company intends to comply with the applicable provisions of the Code pertaining to regulated investment companies to make distributions of taxable income sufficient to relieve it from substantially all Federal income and excise taxes. However, depending on the level of taxable income earned in a year, the Company may choose to carry forward taxable income in excess of distributions and pay the 4% excise tax on the difference. Additionally, the Company is subject to franchise taxes in the state of Delaware.

		In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 provides guidance on how uncertain tax positions should be recognized, measured, presented, and disclosed in the financial statements. FIN 48 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Company’s tax returns to determine whether the tax positions are “more-likely-than-not” of being sustained by the applicable tax authorities. Tax positions not deemed to satisfy the “more-likely-than-not” threshold would be recorded as a tax benefit or expense in the current year. FASB required adoption of FIN 48 for fiscal years beginning after December 15, 2006, and FIN 48 is to be applied to all open tax years as of the effective date. However, on December 22, 2006, the SEC delayed the required implementation date of FIN 48 for business development companies until March 31, 2007. As of December 31, 2007, the Company adopted FIN 48 for all subsequent reporting periods and management has determined that there is no material impact on the financial statements.

(f)		Taxation of distributions

		Book and tax basis differences relating to stockholder distributions and other permanent book and tax differences are reclassified to paid-in capital. In addition, the character of income and gains to be distributed is determined in accordance with income tax regulations that may differ from GAAP.

(g)		Payment of distributions

		Distributions to common stockholders are recorded as of the date of declaration. The amount to be paid out as a distribution is determined by the Board each quarter and is generally based upon the earnings estimated by management. Net realized capital gains, if any, are distributed at least annually. The determination of the tax attributes of the Company’s distributions is made annually as of the end of the Company’s fiscal year based upon its taxable income for the full year and distributions paid during the full year, therefore, a determination of tax attributes made on a quarterly basis may not be representative of the actual tax attributes of its distributions for a full year.

(h)		Foreign currency

		The accounting records of the Company are maintained in U.S. dollars. All assets and liabilities denominated in foreign currencies are translated into U.S. dollars based on the rate of exchange of such currencies against U.S. dollars on the date of valuation. The Company’s investments in foreign securities may involve certain risks such as foreign exchange restrictions, expropriation, taxation or other political, social or economic risks, all of which could affect the market and/or credit risk of the investment. In addition, changes in the relationship of foreign currencies to the U.S. dollar can significantly affect the value of these investments and therefore the earnings of the Company.

(i)		Forward contracts

		The Company may enter into forward exchange contracts in order to hedge against foreign currency risk. These contracts are marked-to-market by recognizing the difference between the contract exchange rate and the current market rate as unrealized appreciation or depreciation. Realized gains or losses are recognized when contracts are settled.

NOTES TO FINANCIAL STATEMENTS (unaudited) (continued)


September 30, 2008		Highland Distressed Opportunities, Inc.

(j)		Investment in swap agreements

		Swap agreements are recorded at fair value as estimated by management in good faith. The net unrealized gain or loss on swap agreements is recorded as an asset or liability on the Statement of Assets and Liabilities. The change in unrealized gain or loss is recorded in the Statement of Operations. Cash paid or received on net settlements is recorded as realized gain or loss in the Statement of Operations.

(k)		Cash and cash equivalents

		Cash and cash equivalents consist of demand deposits and highly liquid investments with original maturities of three months or less when purchased. Cash and cash equivalents are carried at cost which approximates fair value as of September 30, 2008.

(l)		Registration expenses

		The Company records registration expenses related to shelf filings as prepaid assets. These expenses are charged as a reduction of capital upon utilization, in accordance with Section 8.24 of the AICPA Audit and Accounting Guide for Investment Companies.

(m)		Incentive fee expense recognition

		The realized capital gain component of the incentive fee (the “Capital Gains Fee”) is payable in arrears as of the end of each calendar year (or upon termination of the investment advisory agreement, as of the termination date.) The Capital Gains Fee is estimated as of the end of the each calendar quarter based on the Company’s realized capital gains, if any, net of all realized capital losses, unrealized capital depreciation and fees paid on such net capital gains, computed on a cumulative basis. To the extent that Capital Gains Fees are earned by the Investment Adviser, an accrual is made in the amount of the estimated Capital Gains Fee. Because unrealized losses may fluctuate from quarter to quarter, the accrual, if any, may fluctuate as well. There were no Capital Gains Fees paid or accrued for the quarter ended September 30, 2008. (See Note 3 for additional information.)

Note 3. Agreements

The Company has entered into an Investment Advisory and Management Agreement with the Investment Adviser, under which the Investment Adviser, subject to the overall supervision of the Company’s Board, manages the day-to-day operations of, and provides investment advisory services to, the Company. For providing these services, the Investment Adviser receives a base management fee and an incentive fee from the Company.

The base management fee is equal to 2.00% per annum of the Company’s Managed Assets. Managed Assets are the value of total assets of the Company less all accrued liabilities of the Company (other than the aggregate amount of any outstanding borrowings, preferred stock issuances, or other instruments or obligations constituting financial leverage). The base management fee is payable quarterly in arrears; however, the Investment Adviser contractually agreed to waive or reimburse the Company for all base management fees during the first three months of the Company’s operations and half of all the base management fees during the next three months of the Company’s operations. This contractual waiver expired on August 31, 2007.

The incentive fee consists of two components: (1) the Pre-Incentive Fee Net Investment Income and (2) the Capital Gains Fee. Pre-Incentive Fee Net Investment Income is calculated and payable quarterly in arrears. For this purpose, Pre-Incentive Fee Net Investment Income means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence and consulting fees or other fees that we receive from portfolio companies) accrued during the calendar quarter, minus the Company’s operating expenses for the quarter (including the base management fee, any expenses payable under the administration agreement, and any interest expense and dividends paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-Incentive Fee Net Investment Income includes, in the case of investments with a deferred interest feature (such as market discount, debt instruments with PIK interest, preferred stock with PIK dividends and zero coupon securities), accrued income that we have not yet received in cash. The Investment Adviser is not under any obligation to reimburse the Company for any part of the incentive fee it received that was based on accrued income that we never received as a result of a default by an entity on an obligation that resulted in the accrual of such income. Pre-Incentive Fee Net Investment Income does not include any realized capital gains, realized and unrealized capital losses or unrealized capital appreciation or depreciation.

Pre-Incentive Fee Net Investment Income, expressed as a rate of return on the value of the Company’s net assets at the end of the immediately preceding calendar quarter, is compared to the “hurdle rate” of 1.75% per quarter (7.00% annualized) (the “Hurdle Rate”). The Company will pay the Investment Adviser an incentive fee with respect to the Company’s Pre-Incentive Fee Net Investment Income in each calendar quarter as follows: (1) no incentive fee in any calendar quarter in which Pre-Incentive Fee Net Investment Income does not exceed the Hurdle Rate; (2) 100% of Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the Hurdle Rate but is less than 2.1875% in any calendar quarter (8.75% annualized) (the “Catch-up Provision”); and (3) 20% of the amount of Pre-Incentive Fee Net Investment Income, if any, that exceeds 2.1875% in any calendar quarter (8.75% annualized). With respect to the Company’s Pre-Incentive Fee Net Investment Income from the Company’s commencement of operations until December 31, 2007, the Investment Adviser voluntarily agreed to waive or reimburse the Catch-Up Provision, provided, however, that for such period the Company will pay the Investment Adviser 20% of Pre-Incentive Fee Net Investment Income with respect to that portion of such Pre-Incentive Fee Net Investment Income, if any, that exceeds the Hurdle Rate, but is less than 2.1875% in any calendar quarter (8.75% annualized).

NOTES TO FINANCIAL STATEMENTS (unaudited) (continued)


September 30, 2008		Highland Distressed Opportunities, Inc.

These calculations are appropriately prorated for any period of less than three months and adjusted for any share issuances or repurchases during the relevant quarter.

The second part of the incentive fee (the “Capital Gains Fee”) is determined and payable in arrears as of the end of each calendar year (or upon termination of the Investment Advisory and Management Agreement), beginning on December 31, 2007, and is calculated at the end of each applicable year by subtracting (A) the sum of the Company’s cumulative aggregate realized capital losses and aggregate unrealized capital depreciation from (B) the Company’s cumulative aggregate realized capital gains, in each case calculated from the date of the IPO of the Company’s shares. If such amount is positive at the end of such year, then the Capital Gains Fee for such year is equal to 20% of such amount, less the aggregate amount of Capital Gains Fees paid in all prior years. If such amount is negative, then there is no Capital Gains Fee for such year. For the three months ended September 30, 2008 or for the nine months ended September 30, 2008, no capital gains incentive fees were earned by the Investment Adviser.

Pursuant to a separate administration agreement, the Investment Adviser furnishes the Company with office facilities, equipment and clerical, bookkeeping and recordkeeping services at such facilities. Under the administration agreement, the Investment Adviser also performs, or oversees the performance of, the Company’s required administrative services, which include, among other things, being responsible for the financial records that the Company is required to maintain, monitoring portfolio and regulatory compliance matters and preparing reports to the Company’s stockholders and reports filed with the SEC. In addition, the Investment Adviser assists the Company in determining, and arranging for the publishing of, the Company’s net asset value, overseeing the preparation and filing of tax returns and the printing and disseminating of reports to stockholders, and generally overseeing the payment of expenses and the performance of administrative and professional services rendered to the Company by others. For providing these services, the Investment Adviser receives an annual administration fee, payable quarterly in arrears at an annual rate of 0.35% of the Company’s Managed Assets. Under a separate sub-administration agreement, the Investment Adviser has delegated certain administrative functions to PNC Global Investment Servicing Inc. (formerly PFPC Inc.). The administration agreement may be terminated by either party without penalty upon 60 days’ written notice to the other party. For the three months ended September 30, 2008, the Investment Adviser earned administration fees of approximately $0.2 million.

The Investment Adviser paid to the underwriters an additional sales load of $0.15 per share, for a total sales load of $0.825 per share. The Company will pay this amount to the Investment Adviser, together with an interest factor, pursuant to an Agreement Regarding Payment of Sales Load (i) if during either the period commencing with the date of the IPO through the end of the Company’s first fiscal year or during the period of the Company’s second fiscal year (each a “Measuring Period”), the sum of (a) the Company’s aggregate distributions to its stockholders plus (b) the change in the Company’s net assets, equals or exceeds 7.00% of the net assets of the Company at the beginning of such Measuring Period (but after adjusting, if necessary, the net assets of the Company at the end of such Measuring Period as follows: by subtracting the net proceeds of any of the Company’s stock issuances, and by adding the amount of any of the Company’s stock repurchases, that occurred during such Measuring Period) and without taking into account any accrual for the total payment amount; or (ii) upon the Company’s liquidation. If neither (i) nor (ii) above has occurred by the conclusion of the second Measuring Period, then the Agreement Regarding Payment of Sales Load shall terminate on such date, without the Company having any payment obligation to the Investment Adviser. As of September 30, 2008, the Company was under no obligation to make a payment to the Investment Adviser.

Note 4. Credit Facility

In accordance with the 1940 Act, with certain limited exceptions, the Company is only allowed to borrow amounts such that its asset coverage, as defined in the 1940 Act, is at least 200% after such borrowing. On June 27, 2008, the Company entered into a Revolving Credit and Security Agreement (the “Credit Agreement”) with Liberty Street Funding LLC, as conduit lender, and The Bank of Nova Scotia, acting through its New York agency, as secondary lender and agent. Under the Credit Agreement, the Company may borrow on a revolving basis up to $100 million, subject to the satisfaction of certain conditions including compliance with borrowing base tests and asset coverage limits. The Credit Agreement imposes stricter limitations than the 1940 Act requiring generally that asset coverage be at least 300% after a borrowing. The Credit Agreement expires in December 2008 and borrowings thereunder are secured by substantially all of the assets in the Company’s portfolio, including cash and cash equivalents. The interest rate charged is based on prevailing commercial paper rates plus commitment and utilization fees. However, if the commercial paper market is at any time unavailable, the interest rate is, at the Company’s election, based on the prevailing Eurodollar rate, Federal Funds rate or the agent’s reference rate, in each case plus an applicable spread and commitment and utilization fees. The Company pays a commitment fee at the annual rate of 0.70% on the total commitment amount, and a utilization fee at the annual rate of 0.30% on outstanding borrowings. The Credit Agreement contains customary events of default (with grace periods where customary) including, among other things, failure to pay interest or principal when due and failure to comply with certain asset coverage and borrowing base tests. Management is currently in negotiations with the facility provider to extend the facility. Given the unprecedented conditions in the financial system currently, it is not possible for management to predict if and when the facility provider will extend the facility.

NOTES TO FINANCIAL STATEMENTS (unaudited) (continued)


September 30, 2008		Highland Distressed Opportunities, Inc.

At September 30, 2008, the Company had borrowings outstanding under the Credit Agreement of $49 million. The interest rate charged on this loan as of September 30, 2008 was approximately 3.28%. The average daily loan balance during the three months ended September 30, 2008 on the facility was approximately $48.8 million at a weighted average interest rate of approximately 2.90%. Interest expense incurred during the quarter ended September 30, 2008 was approximately $0.6 million.

Note 5. Net Asset Value Per Share

At September 30, 2008, the Company’s total net assets and net asset value per share were $118,540,335 and $6.69, respectively.

Note 6. Unfunded Loan Commitments

As of September 30, 2008, the Company’s portfolio had unfunded loan commitments of approximately $0.1 million. Unfunded loan commitments are marked to fair value along with the funded portion of the respective loans, in accordance with the Company’s valuation policy discussed in Note 2(a).


Borrower	Unfunded Loan Commitment
Comcorp Broadcasting, Inc.	$	84,131

	$	84,131

Unfunded loan commitments are marked to market on the relevant day of valuation in accordance with the Company’s valuation policies. Any applicable unrealized gain/(loss) and unrealized appreciation/(depreciation) on unfunded loan commitments are recorded on the Statement of Assets and Liabilities and the Statement of Operations, respectively. As of September 30, 2008, the Company recognized net unrealized depreciation on unfunded transactions of approximately $11,863. The net change in unrealized depreciation on unfunded transactions for the three and nine months ended September 30, 2008 was approximately $1,807 and $11,863, respectively, and is recorded in the Statement of Operations.

Note 7. Transactions in Securities of Affiliated Issuers

Under Section 2(a)(3) of the Investment Company Act of 1940, a portfolio company is defined as “affiliated” if a company owns five percent or more of its voting stock. The Company held at least five percent of the outstanding voting stock of the following portfolio companies as of September 30, 2008:


Issuer	Shares		Principal ($)		Market Value ($)
Comcorp Broadcasting, Inc.
Revolving Loan			$	1,800,821	$	1,546,905
Term Loan			$	18,849,521		16,191,739
Communications Corp. of America		1,256,635				6,584,767
Genesys Limited		12,000,000				17,412,000

Total					$	41,735,411

Note 8. Portfolio Information

For the nine months ended September 30, 2008, the cost of purchases and proceeds from sales of securities, excluding short-term obligations, were approximately $95,806,986 and $173,428,162, respectively.

Note 9. Affiliated Transactions

On January 18, 2007, the Company issued a promissory note payable to the Investment Adviser in the amount of $4 million with interest at 4.87% per annum, compounded semi-annually. The promissory note was paid off on March 8, 2007. The average daily balance on the promissory note for the time it was held was $4 million at a weighted average interest rate of 5.00%.

NOTES TO FINANCIAL STATEMENTS (unaudited) (continued)


September 30, 2008		Highland Distressed Opportunities, Inc.

Note 10. Financial Highlights

The following is a schedule of financial highlights for the nine months ended September 30, 2008, period ended September 30, 2007 and the period ended December 31, 2007:


	Nine Months Ended			Nine Months Ended			Year Ended
	September 30, 2008			September 30, 2007 ^(a)			December 31, 2007 ^(a)
Net asset value, beginning of period	$	10.27		$	14.33	(b)	$	14.33	(b)

Net investment income		0.54			0.67			0.97
Net realized and unrealized loss on investments		(3.44	)		(2.32	)		(4.43	)

Total from investment operations		(2.90	)		(1.65	)		(3.46	)
Common Stock Offering Cost		—			(0.07	)		(0.07	)
Capital Contribution		—			0.26	(c)		0.26	(c)
Distributions Paid		(0.68	)		(0.53	)		(0.79	)

Net asset value, end of period	$	6.69		$	12.34		$	10.27


Market price per share, beginning of period	$	8.57		$	15.00		$	15.00
Market price per share, end of period	$	2.97		$	12.85		$	8.57

Total investment return (d)
Based on net asset value per share		(26.30	)%(e)		(10.42	)%(e)		(23.30	)%(e)
Based on market price per share		(60.79	)%(e)		(10.88	)%(e)		(38.85	)%(e)

Net assets, end of period (f)	$	118,540		$	218,595		$	182,015
Ratios to Average Net Assets/Supplemental Data:
Total operating expense including interest expense		9.09	%		8.78	%(g)		9.54	%(g)
Total operating expenses excluding interest expense		6.55	%		5.15	%(g)		5.74	%(g)
Interest expense		2.54	%		3.63	%(g)		3.80	%(g)
Waiver/reimbursement		0.75	%		2.50	%(g)		2.24	%(g)
Net expense (h)		8.34	%		6.28	%(g)		7.30	%(g)
Net investment income		8.85	%		8.16	%(g)		8.77	%(g)
Portfolio turnover rate		41	%(e)		166	%(e)		224	%(e)
Debt:
Total loan outstanding, end of period (f)	$	49,000		$	165,000		$	142,000
Asset Coverage per $1000 indebtedness, end of period	$	3,419	(i)	$	2,325	(i)	$	2,282	(i)


(a)		The Company commenced operations on January 18, 2007.

(b)		Net asset value at the beginning of the period reflects the deduction of the one-time initial sales load in connection with the offering.

(c)		On February 20, 2007, the Investment Adviser contributed an additional $87,596 in capital to the Company prior to the Offering. No additional shares were issued in the transaction. The contribution per share is based on the pre-offering share amount of 333,333.33.

(d)		Total investment return based on market value may result in substantially different returns than investment return based on net asset value, because market value can be significantly greater or less than the net asset value. Investment return assumes reinvestment of distributions.

(e)		Not annualized.

(f)		Dollars in thousands.

(g)		Ratios to average net assets are calculated using the net assets for the period starting from the Offering on February 27, 2007 through December 31, 2007.

(h)		Net expense ratio has been calculated after applying any waiver/reimbursement.

(i)		Calculated by subtracting the Company’s total liabilities (not including any bank loans and senior securities) from the Company’s total assets, and dividing such amounts by the principal amount of the debt outstanding.

NOTES TO FINANCIAL STATEMENTS (unaudited) (continued)


September 30, 2008		Highland Distressed Opportunities, Inc.

Note 11. Income Tax Information and Distributions to Stockholders

On September 9, 2008, the Company’s Board declared a third quarter distribution of $0.15 per share, which was paid on September 30, 2008 to common stockholders of record on September 19, 2008.

Reclassifications are made to the Company’s capital accounts for permanent tax differences to reflect income and gains available for distribution (or available capital loss carryforwards) under income tax regulations.

The tax character of distributions paid during the period ended December 31, 2007, the most recent tax year, were as follows:


Distributions paid from:	2007
Ordinary income *	$	13,915,795
Long-term capital gains	$	—


*		For tax purposes short-term capital gains distributions, if any, are considered ordinary income distributions.

As of December 31, 2007, the most recent tax year end, the components of distributable earnings on a tax basis were as follows:


Capital loss carryforward **	$	(9,946,969	)
Undistributed ordinary income	$	3,525,488
Undistributed long-term capital gains	$	—
Net unrealized appreciation/(depreciation)	$	(60,038,767	)


**		The accumulated losses of $9,946,969 to offset future capital gains, if any, expire on December 31, 2015.

Note 12. New Accounting Interpretations and Standards

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“FAS 161”). FAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008. FAS 161 requires enhanced disclosures about the Company’s derivative and hedging activities, but is not expected to result in any changes to such activities. At this time, the Company is evaluating the implications of FAS 161 to determine the impact, if any, on the Company’s financial statements.

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

Some of the statements in this report constitute forward-looking statements, which relate to future events or the future performance or financial condition of Highland Distressed Opportunities, Inc. (the “Company,” “we,” “us” and “our”). The forward-looking statements contained in this report involve risks and uncertainties, including statements as to:

o		our future operating results;

o		our business prospects and the prospects of our portfolio companies;

o		the impact of investments that we expect to make;

o		our contractual arrangements and relationships with third parties;

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

o		our expected financings and investments;

o		the adequacy of our cash resources and working capital;

o		the timing of cash flows, if any from the operations of our portfolio companies; and

o		the ability of our investment adviser to locate suitable investments for us and to monitor and administer our investments.

We may use words such as “anticipates,” “believes,” “expects,” “intends,” “will,” “should,” “may,” “plans,” “could,” “estimates,” “potential,” “continue,” “target,” or the negative of these terms or other similar expressions to identify forward-looking statements. Our actual results could differ materially from those projected in the forward-looking statements for any reason. We have based the forward-looking statements included in this report on information available to us on the date of this report, 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 Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K.

Overview

We were incorporated in Delaware on August 22, 2006 and initially funded on January 18, 2007. We commenced material operations on February 27, 2007. Our investment objective is total return generated by both capital appreciation and current income. We will seek to achieve this objective by investing in financially-troubled or distressed companies that are either middle-market companies or unlisted companies by investing in senior secured debt, mezzanine debt and unsecured debt, each of which may include an equity component, and in equity investments.

Generally, distressed companies are those that (i) are facing financial or other difficulties and (ii) are or have been operating under the provisions of the U.S. Bankruptcy Code or other similar laws or, in the near future, may become subject to such provisions or otherwise be involved in a restructuring of their capital structure. We use the term “middle-market” to refer to companies with annual revenues between $50 million and $1 billion. We use the term “unlisted” to refer to companies not listed on a national securities exchange (for example, companies whose securities are quoted on the over-the-counter bulletin board or through Pink Sheets LLC would not be “listed” on a national securities exchange, although they may be considered “public” companies).

We have elected to be regulated as a business development company (a “BDC”) under the Investment Company Act of 1940 (the “1940 Act”). As a BDC, we are required to comply with certain regulatory requirements. For instance, we are generally prohibited from acquiring assets other than “qualifying assets” unless, after giving effect to the acquisition, at least 70% of our total assets are qualifying assets. Qualifying assets generally include securities of “eligible portfolio companies” (as defined in the 1940 Act), cash, cash equivalents, U.S. government securities and high-quality debt instruments maturing in one year or less from the time of investment. Additionally, we will elect to be treated as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986 (the “Code”).

On February 26, 2007, the Company closed its initial public offering (“IPO” or the “Offering”) and sold 17,000,000 shares of its common stock at a price of $15.00 per share, less an underwriting discount and commissions totaling $0.675 per share. We commenced material operations on February 27, 2007 as we received $243,525,000 in total net proceeds from the IPO. On March 23, 2007, the Company issued 284,300 shares of common stock to cover the underwriters’ partial exercise of the over-allotment option on the Offering and received approximately $4,072,698 in net proceeds after deducting underwriting discounts and commissions.

Portfolio and Investment Activity

The following table summarizes the historical composition of our investment portfolio, exclusive of cash and cash equivalents, as a percentage of total investments.


				Corporate
	Senior Loans			Notes and Bonds			Claims			Equity Interests
September 30, 2008		60.5	%		24.9	%		0.7	%		13.9	%
June 30, 2008		68.1	%		27.0	%		0.2	%		4.7	%
March 31, 2008		49.7	%		40.4	%		0.5	%		9.4	%
December 31, 2007		48.4	%		34.8	%		0.5	%		16.3	%
September 30, 2007		50.3	%		34.4	%		1.2	%		14.1	%
June 30, 2007		45.9	%		35.4	%		0.8	%		17.9	%
March 31, 2007		76.7	%		21.1	%		0.8	%		1.4	%

Bank debt typically accrues interest at variable rates determined by reference to a base lending rate, such as LIBOR or prime rate, and typically will have maturities of 3 to 5 years. Corporate notes and bonds will typically accrue interest at fixed rates and have stated maturities at origination that range from 5 to 10 years. At September 30, 2008, the weighted average cost yield of our portfolio investments, exclusive of cash and cash equivalents, was approximately 6.8%. At September 30, 2008, the weighted average cost yield of our investments in senior loans and corporate notes and bonds was approximately 7.4%. Yields are computed assuming a fully settled portfolio; using interest rates as of the report date and include amortization of senior loan discount points, original issue discount and market premium or discount; weighted by their respective costs when averaged.

As of September 30, 2008, approximately 54.3% of our portfolio consisted of investments in 10 issuers. Additional information regarding these specific investments has been outlined below. This additional information is limited to publicly available information, and does not address the creditworthiness or financial viability of the issuer, or the future plans of the Company as it relates to a specific investment. Furthermore, while the objective of the Company is to invest primarily in financially-troubled or distressed companies, the Company can and does invest in issuers that are not financially-troubled or distressed at the time of investment. The Company may have sold some, or all, of the positions outlined below subsequent to September 30, 2008.

Azithromycin Royalty Sub, LLC

The Azithromycin Royalty Sub, LLC, a wholly-owned subsidiary of InSite Vision Inc., was established to issue senior secured bonds backed by the royalty cash stream from the sales of azithromycin ophthalmic solution, a branded pharmaceutical sold under the brand name AzaSite® and marketed by Inspire Pharmaceuticals, Inc. The solution is used to treat conjunctivitis. The Azithromycin Royalty Sub, LLC is entitled to minimum cash flows from Inspire Pharmaceuticals over the next five years and the entity is obligated to utilize any cash flows in excess of interest expense to pay down principal. More information can be found at www.azasite.com.

Baker & Taylor, Inc.

Baker & Taylor, Inc. (“B&T”) is engaged in the distribution of books, music, video and game products. In addition, unique information services built around the B&T’s proprietary databases as well as specialized consulting and outsourcing services are provided to customers. Customers include retailers (including Internet retailers), public, academic and school libraries and various departments of federal and local governments. B&T distributes its products throughout the United States and worldwide.

Celtic Pharma Phinco B.V.

Celtic Pharmaceuticals Phinco B.V. (“Celtic Pharma”) is a private investment fund with a mandate to purchase a diversified portfolio of novel pharmaceutical products in the later stages of development that have already demonstrated initial proof of principle efficacy in human clinical trials. Celtic Pharma has $250 million of equity commitments in addition to raising $156 million of high-yield bonds. Celtic Pharma has invested in nine drug programs since its 2004 inception. More information can be found at www.celticpharma.com.

Comcorp Broadcasting, Inc.

Comcorp Broadcasting, Inc. (“ComCorp”) is a privately-held regional broadcasting company based in Lafayette, LA. ComCorp operates 23 TV stations in 10 markets in Texas, Louisiana, and Indiana. ComCorp filed for bankruptcy in June 2006 after it was unable to meet its ongoing debt obligations. ComCorp, and its direct and indirect subsidiaries, exited bankruptcy with an effective date of October 4, 2007 under reorganization plans filed (“Plans”) with the United States Bankruptcy Court in the Western District of Louisiana (Case No. 06-50410). Copies of the Plans and the Confirmation Orders may be downloaded, without cost, at www.kccllc.net/cca, or be requested free of charge by calling Kurtzman Carson Consultants LLC at 1-866-381-9100.

Fontainebleau Florida Hotel, LLC

Fontainebleau Resorts, LLC. (“Fontainebleau”) is led by Chairman Jeffrey Soffer, who also serves as Chief Executive Officer of Turnberry, Ltd., a creator of luxury condominium and condominium-hotel developments, and President and Chief Financial Officer Glenn Schaeffer, a former Chief Executive Officer of Mandalay Resort Group. Fontainebleau Miami Beach is a resort located in Miami Beach, Florida. Fontainebleau plans to renovate and expand this property into a 22-acre destination resort. More information can be found at www.bleaumiamibeach.com.

Genesys Ventures IA, LP

Genesys Ventures IA, LP, a limited partnership with Genesys Capital Partners of Toronto, Onterio, was established to hold the preferred equity of three late-stage venture companies: Epocal, Inc., Affinium Pharmaceuticals, Ltd., and NeurAxon, Inc. Epocal, Inc. is a point of care diagnostic company that designs and manufactures blood gas, electrolyte and metabolite testing devices. Affinium Pharmaceuticals, Inc. is a pharmaceutical company focused on the discovery, development and commercialization of novel anti-infective medicines stemming from the bacterial fatty acid synthesis II pathway. NeurAxon, Inc. is a CNS (central nervous system) research and development company that is currently developing new drugs for the treatment of pain and other CNS disorders such as epliepsy and depression. More information can be found at www.epocal.com, www.afnm.com, and www.nrxn.com.

Lake at Las Vegas Joint Venture, LLC

Lake at Las Vegas Joint Venture, LLC (“LLV”) is a 3,592-acre resort and destination community and is one of the larger master-planned communities in Las Vegas, NV. The development is located approximately 17 miles from the Las Vegas strip. On July 17, 2008, LLV filed to reorganize under Chapter 11 of the Bankruptcy Code, citing a combination of poor liquidity, substantial debt service, extremely challenging real estate market conditions and other legal and financial issues. More information can be found at www.lakelasvegas.com, at www.kccllc.net/llv, or by calling Kurtzman Carson Consultants LLC at 1-866-248-3389.

LVI Services, Inc.

LVI Services, Inc. (“LVI”) is a remediation and facility services firm serving commercial, industrial, retail, government, healthcare and education end markets. From a nationwide branch network, LVI provides asbestos abatement, soft and structural demolition, mold remediation, emergency response, fireproofing, decontamination and decommissioning, lead-based paint abatement and infection control. More information can be found at www.lviservices.com.

TARH E&P Holdings, L.P.

Texas American Resources E&P Holdings (TARH) is a privately-held, independent energy company headquartered in Austin, TX. It focuses on the acquisition and exploitation of proved or near-proved oil and natural gas assets located in the mature producing basins of the onshore Texas and Rocky Mountain regions.

Wm. Wrigley Jr. Company

Wm. Wrigley Jr. Company (“Wrigley”) is a recognized leader in confections with a wide range of product offerings including gum, mints, hard and chewy candies, lollipops, and chocolate. Wrigley distributes its world-famous brands in more than 180 countries. On October 6, 2008, Wrigley was acquired by Mars, Incorporated, a privately-held maker of global candy brands, in a transaction valued at approximately $23 billion. The combined entity creates the largest global confectionary and consumer goods business.

Results of Operations

Results comparisons are for the three and nine months ended September 30, 2008 and 2007. These comparisons between current and prior periods may not necessarily be meaningful as we initially funded on January 18, 2007 (commencement of operations).

Operating results for the three and nine months ended September 30, 2008 and September 30, 2007 are as follows:


	For the Three Months						For the Nine Months
	Ended September 30,						Ended September 30,
	2008			2007			2008			2007
Total investment income	$	4,086,448		$	9,521,216		$	18,458,396		$	20,751,585
Net expenses	$	(2,113,994	)	$	(5,255,267	)	$	(8,954,579	)	$	(9,023,284	)
Net investment income	$	1,972,454		$	4,265,949		$	9,503,817		$	11,728,301
Net realized and unrealized gain/(loss) on investments	$	(9,075,613	)	$	(30,386,390	)	$	(61,019,714	)	$	(37,049,465	)
Net increase/(decrease) in stockholders’ equity (net assets) resulting from operations	$	(7,103,159	)	$	(26,120,441	)	$	(51,515,897	)	$	(25,321,164	)

Investment Income

We primarily generate revenue in the form of interest income on the debt securities that we own, dividend income on any common or preferred stock that we own, and capital gains, if any, on investment securities that we acquire and subsequently sell. We also may acquire investments, which may pay cash or in-kind dividends on a recurring or otherwise negotiated basis. Investment income for the three and nine months ended September 30, 2008 was approximately $4.1 million and $18.5 million, respectively, of which approximately $0.0 million and $0.1 million, respectively, was attributable to invested cash and cash equivalents and approximately $4.1 million and $18.4 million, respectively, was attributable to portfolio investments. For the three and nine months ended September 30, 2008, of the approximately $4.1 million and $18.4 million, respectively, in investment income from investments other than cash and cash equivalents, approximately $0.1 million and $2.2 million, respectively, of PIK interest income was recorded. In comparison, investment income for the three and nine months ended September 30, 2007 was approximately $9.5 million and $20.8 million, respectively, of which approximately $0.1 million and $0.8 million, respectively, was attributable to invested cash and cash equivalents and approximately $9.4 million and $20.0 million, respectively, was attributable to portfolio investments.

Operating Expenses

Operating expenses for the three and nine months ended September 30, 2008 were approximately $2.1 million and $9.8 million, respectively. These amounts consisted of advisory fees of approximately $0.9 million and $3.6 million, incentive fees of $0 and approximately $1.7 million, interest expense and credit facility fees of approximately $0.6 million and $2.7 million, and administrative fees, accounting fees, professional fees, directors’ fees, taxes and other expenses of approximately $0.6 million and $1.8 million, respectively, for the three and nine months ended September 30, 2008. For the comparative three and nine month periods a year earlier, operating expenses were approximately $6.0 million and $12.6 million, respectively. Included in operating expenses were advisory fees of approximately $2.2 million and $4.5 million, incentive fees of $0 and approximately $1.3 million, interest expense and credit facility fees of approximately $3.1 million and $5.2 million, and administrative fees, accounting fees, professional fees, directors’ fees, taxes and other expenses of approximately $0.7 million and $1.6 million, respectively, for the three and nine months ended September 30, 2007. Additionally, for the three and nine months ended September 30, 2008, the Investment Adviser voluntarily waived incentive fees of $0 and approximately $0.8 million, respectively.

Net Investment Income

The Company’s net investment income for the three and nine months ended September 30, 2008 was approximately $2.0 million and $9.5 million, respectively, versus net investment income of approximately $4.3 million and $11.7 million, respectively, for the three and nine months ended September 30, 2007.

Net Unrealized Appreciation/Depreciation on Investments

For the three and nine months ended September 30, 2008, the Company’s investments had net unrealized depreciation of approximately $4.0 million and $22.9 million, respectively. This compares to net unrealized depreciation on the Company’s investments of approximately $22.9 million and $29.8 million, respectively, for the three and nine months ended September 30, 2007.

Net Realized Gains/Losses

For the three and nine months ended September 30, 2008, the Company had net realized losses on investments of approximately $5.1 million and $38.1 million, respectively, compared to net realized losses on investments of approximately $7.5 million and $7.3 million, respectively, for the three and nine months ended September 30, 2007.

Net Increase/Decrease in Stockholders’ Equity (Net Assets) from Operations

For the three and nine months ended September 30, 2008, the Company had a net decrease in stockholders’ equity (net assets) resulting from operations of approximately $7.1 million and $51.5 million, respectively, compared to a net decrease in stockholders’ equity (net assets) resulting from operations of approximately $26.1 million and $25.3 million, respectively, for the three and nine months ended September 30, 2007. For the three and nine months ended September 30, 2008, the decrease in stockholders’ equity (net assets) resulting from operations was primarily attributable to net unrealized depreciation on investments, as discussed above.

Financial Condition, Liquidity and Capital Resources

We remain committed to our total return investment objective by pursuing risk-adjusted returns across market cycles and will continue to focus on positioning our portfolio to benefit in weakened credit markets. In light of the broader unprecedented market dislocation that began at the end of the third quarter and continues into the fourth quarter, we are encouraged by the opportunities at hand in the current market environment as well as those that may be presented. Until such time as we believe favorable to profit from the market correction, the Investment Adviser is opportunistically de-levering the Company’s investment portfolio with the objective of positioning the Company for such circumstances. During the quarter ended September 30, 2008, liquidity and capital resources were generated primarily from cash flows from operations, including investment sales and prepayments and income earned from investments and cash equivalents. In June of this year, the Company entered into a new credit facility with Liberty Street Funding LLC, as conduit lender, and The Bank of Nova Scotia, acting through its New York agency, as secondary lender and agent. The Company may borrow up to $100 million under the facility, subject to the satisfaction of certain conditions including compliance with borrowing base tests and asset coverage limits. The facility expires December 1, 2008. We are currently in negotiations with the facility provider to extend the facility. Given the unprecedented conditions in the financial system currently, it is not possible for management to predict if and when the facility provider will extend the facility. At September 30, 2008, the Company had $49.0 million in borrowings outstanding. During the fourth quarter, we intend to use excess funds to primarily repay borrowings under our credit facility, make strategic investments to seek to meet our investment objectives and strategies, to make cash distributions to holders of our common stock and to pay fees and our operating expenses. During the nine months ended September 30, 2008, the Company generated approximately $97.4 million in cash flows from operations, of which $93.0 million was used to repay borrowings under its credit facilities and approximately $12.0 million used to make cash distributions to holders of our common stock.

Off-Balance Sheet Arrangements

At September 30, 2008, we did not have any off-balance sheet liabilities or other contractual obligations that are reasonably likely to have a current or future material effect on our financial condition, other than the investment advisory and management agreement and the administration agreement described above.

Distributions

We have qualified and elected to be taxed as a regulated investment company, or RIC, under Subchapter M of the Code. In order to maintain our status as a RIC, we are required to meet specified source-of-income and asset diversification requirements and must distribute annually at least 90% of our investment company taxable income. Additionally, we must distribute at least 98% of our income (both ordinary income and net capital gains) to avoid an excise tax. We intend to continue to qualify for the tax treatment applicable to RICs under the Code, and, among other things, continue to make the requisite distributions to our stockholders which will relieve the Company from federal income taxes.

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 when applicable to us as a business development company under the Investment Company Act of 1940 and due to provisions in our credit facilities. If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including possible loss of our status as a regulated investment company. We cannot assure stockholders that they will receive any distributions or distributions at a particular level.

On September 5, 2008, the Company’s Board declared a third quarter distribution of $0.1500 per share ($2,657,516), which was paid on September 30, 2008 to common stockholders of record on September 19, 2008. The Company has established an “opt out” dividend reinvestment plan (the “Plan”) for its common stockholders. As a result, if the Company declares a cash distribution in future periods, a stockholder’s cash distribution will be automatically reinvested in additional shares of the Company’s common stock unless the stockholder specifically “opts out” of the Plan and elects to receive cash distributions. For the third quarter 2008 distribution, holders of approximately 1,613,998 shares participated in the Plan. As a result, of the $2,657,516 total amount distributed, approximately $242,100 was used by the Plan agent to purchase shares in the open market, including fractions, on behalf of the Plan participants. On June 6, 2008, the Company’s Board declared a second quarter distribution of $0.2625 per share ($4,650,652), which was paid on June 30, 2008 to common stockholders of record on June 20, 2008. On March 7, 2008, the Company’s Board declared a first quarter distribution of $0.2625 per share ($4,650,652), which was paid on March 31, 2008 to common stockholders of record on March 20, 2008.

Recently Issued Accounting Pronouncements

See Note 12: New Accounting Interpretations and Standards in the accompanying notes to financial statements for details of recently issued accounting pronouncements and their expected impact on the Company’s financial statements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are subject to financial market risks, including changes in interest rates and the valuations of our investment portfolio.

As of September 30, 2008, approximately 85.4% of our portfolio, exclusive of cash and cash equivalents, was invested in debt securities. This exposes the Company to a great degree of default risk with respect to the issuers in our portfolio. Although defaults were at historic lows during 2007, they have increased in 2008 and may increase in the future. New derivative products are available to hedge against default risk; however, the Company did not hedge its exposure during the quarter ended September 30, 2008 as these hedges may be imperfect, unavailable or too costly.

As of September 30, 2008, approximately 58.4% and 27.0% of our portfolio, exclusive of cash and cash equivalents, was invested in securities that paid floating and fixed rates of interest, respectively. Increases or decreases in market interest rates may potentially affect the Company’s net asset value. When interest rates decline, the value of fixed rate securities in the Company’s portfolio may be expected to rise. Conversely, when interest rates rise, the value of fixed rate portfolio securities may decline. The sensitivity of the Company’s net asset value to changes in interest rates will increase to the extent that it holds a higher percentage of its portfolio in fixed rate investments.

Increases or decreases in market interest rates may also affect the Company’s distributions. While the Company does not disclose whether it will be able to maintain historic distribution levels in the future, it is clear that for a portfolio holding a large percentage of floating rate investments, a decrease in market interest rates may have a negative impact on yield. There tends to be a lag in the effect of a decline in market interest rates has on the yield of floating rate investments. This is due to the resetting of the base rate underlying the individual investment, which typically happens every sixty to ninety days depending on the terms. As of September 30, 2008 the average days for the underlying senior loans in the Company’s portfolio base rate to reset was approximately 55.3 days.

Additionally, beginning in August 2008, the market rate of interest that serves as the referenced base rate for many of the Company’s individual investments began to experience significant volatility. This instability may potentially have a negative impact on the Company’s future distribution levels. Furthermore, given that the cost of borrowings under the Company’s credit facility is also based on prevailing interest rates, the expenses incurred as a result of the Company’s utilization of leverage may exceed the income earned from investments.

Item 4. Controls and Procedures

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15 of the Securities Exchange Act of 1934). Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our current disclosure controls and procedures are effective in timely alerting them of material information relating to the Company that is required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934.

There have been no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are not a defendant in any material pending legal proceeding, and no such material proceedings are known to be contemplated.

Item 1A. Risk Factors

In addition to the other information set forth in this Item and elsewhere in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which could materially affect our business, financial condition or operating results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

The Company may invest in securities related to royalty securitizations, which means that these securities are secured by royalties derived from licenses of intellectual property including patents, trademarks and copyrights. Such investments may include either the debt or equity of royalty securitizations.

The risks of investing in these securities include the risks of investing in the underlying industry. In addition, these types of securities are currently not widely recognized or understood and the Company may not be able to sell the securities when it wants to do so. Each security will include different risk factors specific to that transaction.

For securities related to pharmaceutical royalty streams, the payments from the securities rely on milestone payments and/or a royalty stream from an underlying drug which may or may not have received approval of the Food and Drug Administration (“FDA”). If the underlying drug does not receive FDA approval, it could negatively impact the securities, including the payments of principal and/or interest on any debt securities. Where FDA approval has not been received, if forecasts of future sales of that drug may not be accurate, it could negatively impact the securities, including the payments of principal and/or debt on any debt securities. In addition, the introduction of new drugs onto the market could negatively impact the securities, since that may decrease sales and/or prices of the underlying drug. Changes to Medicare reimbursement or third party payor pricing could negatively impact the securities, since they could negatively impact the prices and/or sales of the underlying drug. There is also the risk that the licensing agreement that governs the payment of royalties may terminate, which could negatively impact the securities. There is also the risk that litigation involving the underlying drug could negatively impact the securities, including the payments of principal and/or interest on any debt securities.

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

We did not sell any securities during the period covered in this report that were not registered under the Securities Act of 1933.

We did not repurchase any shares of our common stock during the period covered by this report.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

Not applicable.

Item 5. Other Information

Not applicable.

Item 6. Exhibits and Financial Statement Schedules

(a) Exhibits


Exhibit No.		Description
3.1		Amended and Restated Articles of Incorporation of the Company.(2)

3.2		Bylaws of the Company.(1)

4.1		Form of Specimen Certificate.(2)

10.1		Form of Investment Advisory and Management Agreement between Company and Highland Capital Management, L.P.(1)

10.2		Form of Administration Services Agreement between Company and Highland Capital Management, L.P.(2)

10.3		Form of Sub-Administration Services Agreement between Highland Capital Management, L.P. and PFPC Inc.(1)

10.4		Form of Custodian Services Agreement between Company and PFPC Trust Company.(1)

10.5		Form of Transfer Agency Services Agreement between Company and PFPC Inc.(1)

10.6		Form of Accounting Services Agreement.(1)

10.7		Form of Structuring Fee Agreement between the Investment Adviser and Citigroup Global Markets Inc.(2)

10.8		Form of Structuring Fee Agreement between the Investment Adviser and Merrill Lynch & Co.(2)

10.9		Form of Structuring Fee Agreement between the Investment Adviser and Wachovia Capital Markets, LLC.(2)

10.10		Form of Agreement Regarding Payment of Sales Load.(2)

10.11		Amendment No.1 to the Administration Services Agreement dated as of June 6, 2008.(3)

10.12		Revolving Credit and Security Agreement among the Company, Liberty Street Funding LLC and The Bank of Nova Scotia dated as of June 27, 2008.(3)

31.1		Certification of Chief Executive Officer of Periodic Report Pursuant to Rule 13a-14(a) and Rule 15d-14(a)(3).(4)

31.2		Certification of Chief Financial Officer of Periodic Report Pursuant to Rule 13a-14(a) and Rule 15d-14(a)(3).(4)

32.1		Certification of CEO and CFO Pursuant to 18 U.S.C. Section 1350.(4)


(1)		Previously filed in Pre-Effective Amendment No. 1 to the Company’s Initial Registration Statement on Form N-2, File No. 333-137435, filed on January 18, 2007.

(2)		Previously filed in Pre-Effective Amendment No. 3 to the Company’s Initial Registration Statement on Form N-2, File No. 333-137435, filed on February 16, 2007.

(3)		Previously filed with the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2008, File No. 814-00729, filed on August 8, 2008.

(4)		Filed herewith.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunder duly authorized.

HIGHLAND DISTRESSED OPPORTUNITIES, INC.
(Registrant)



Dated: November 6, 2008		/s/ James D. Dondero

		James D. Dondero
		President (Principal Executive Officer)

		/s/ M. Jason Blackburn

		M. Jason Blackburn
	Secretary and Treasurer (Principal Financial and Accounting Officer)