Item 2.
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Management’s Discussion and Analysis of Financial Condition and Results of Operations
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In this Quarterly Report on Form 10-Q, “KCAP
Financial,” “Company,” “we,” “us,” and “our” refer to KCAP Financial, Inc.,
and its wholly-owned subsidiary.
The information contained in this section
should be read in conjunction with our financial statements and notes thereto appearing elsewhere in this Quarterly Report. In
addition, some of the statements in this report constitute forward-looking statements. The matters discussed in this Quarterly
Report, as well as in future oral and written statements by management of KCAP Financial, that are forward-looking statements are
based on current management expectations that involve substantial risks and uncertainties which could cause actual results to differ
materially from the results expressed in, or implied by, these forward-looking statements. Forward-looking statements relate to
future events or our future financial performance. We generally identify forward-looking statements by terminology such as “may,”
“will,” “should,” “expects,” “plans,” “anticipates,” “could,”
“intends,” “target,” “projects,” “believes,” “estimates,” “predicts,”
“potential” or “continue” or the negative of these terms or other similar words. Important assumptions
include our ability to originate new investments, achieve certain margins and levels of profitability, the availability of funds
under our credit facility, the availability of additional capital, and the ability to maintain certain debt to asset ratios. In
light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this Quarterly Report should
not be regarded as a representation by us that our plans or objectives will be achieved. The forward-looking statements contained
in this Quarterly Report include statements as to:
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•
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our future operating results;
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•
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our business prospects and the prospects of our existing and prospective portfolio companies;
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•
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the return or impact of current and future investments;
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•
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our contractual arrangements and other relationships with third parties;
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•
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the dependence of our future success on the general economy and its impact on the industries in which we invest;
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•
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the financial condition and ability of our existing and prospective portfolio companies to achieve their objectives;
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•
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our expected financings and investments;
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•
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our regulatory structure and tax treatment;
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•
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our ability to operate as a business development company and a registered investment company, including the impact of changes
in laws or regulations governing our operations, or the operations of our portfolio companies;
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•
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the adequacy of our cash resources and working capital;
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•
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the timing of cash flows, if any, from the operations of our portfolio companies;
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•
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the impact of a protracted decline in the liquidity of credit markets on our business;
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•
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the impact of fluctuations in interest rates on our business;
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•
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the valuation of our investments in portfolio companies, particularly those having no liquid trading market;
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•
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our ability to recover unrealized losses;
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•
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market conditions and our ability to access additional capital; and
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•
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the timing, form and amount of any dividend distributions.
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There are a number of important risks and
uncertainties that could cause our actual results to differ materially from those indicated by such forward-looking statements.
For a discussion of factors that could cause our actual results to differ from forward-looking statements contained in this Quarterly
Report, please see the discussion in Part II, “Item 1A. Risk Factors”, and in Part I, “Item 1A. Risk Factors”
in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. You should not place undue reliance on these forward-looking
statements. The forward-looking statements made in this Quarterly Report relate only to events as of the date on which the statements
are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after
the date this Quarterly Report is filed with the SEC.
GENERAL
We are an internally managed, non-diversified
closed-end investment company that is regulated as a business development company (“BDC”) under the Investment Company
Act of 1940. We originate, structure, and invest in senior secured term loans, mezzanine debt and selected equity securities primarily
in privately-held middle market companies. We define the middle market as comprising companies with earnings before interest, taxes,
depreciation and amortization (“EBITDA”) of $10 million to $50 million and/or total debt of $25 million to $150 million.
Our investment objective is to generate
current income and capital appreciation from investments made in senior secured term loans, mezzanine debt and selected equity
investments in privately-held middle market companies.
Katonah Debt Advisors, L.L.C., a registered
investment adviser, and its asset manager affiliates (collectively, “Katonah Debt Advisors”) is a wholly-owned portfolio
company. Katonah Debt Advisors manages collateralized loan obligation funds (“CLO Funds”) which invest in broadly syndicated
loans, high-yield bonds and other credit instruments. On February 29, 2012, we purchased Trimaran Advisors, L.L.C. (“Trimaran
Advisors”), a registered investment adviser and CLO manager similar to Katonah Debt Advisors that had assets under management
of approximately $1.4 billion, for total consideration of $13.0 million in cash and 3,600,000 shares of our common stock. Contemporaneously
with the acquisition of Trimaran Advisors, we acquired from Trimaran Advisors equity interests in certain CLO Funds managed by
Trimaran Advisors for an aggregate purchase price of $12.0 million in cash. As of September 30, 2012, Katonah Debt Advisors and
Trimaran Advisors are our only wholly-owned portfolio companies (collectively, “Asset Manager Affiliates”) and have
approximately $3.3 billion of par value assets under management.
The Company also expects to receive distributions
of recurring fee income and to generate capital appreciation from its investments in the asset management businesses of the Asset
Manager Affiliates.
The Company has elected to be treated as
a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”).
To qualify as a RIC, the Company must, among other things, meet certain source-of-income and asset diversification requirements
and distribute at least 90% of our net ordinary income and realized short-term capital gains in excess of realized net long-term
capital losses, if any. As a RIC, the Company generally will not have to pay corporate-level taxes on any income that it distributes
in a timely manner to its stockholders.
Our common stock is traded on The NASDAQ
Global Select Market under the symbol “KCAP.” The net asset value per share of our common stock at September 30, 2012
was $7.82. On September 30, 2012, the last reported sale price of a share of our common stock on The NASDAQ Global Select Market
was $9.26.
KEY QUANTITATIVE AND QUALITATIVE FINANCIAL MEASURES AND INDICATORS
Net Asset Value
Our net asset value per share was $7.82
and $7.85 as of September 30, 2012 and December 31, 2011, respectively. As we must report our assets at fair value for each reporting
period, net asset value also represents the amount of stockholder’s equity per share for the reporting period. Our net asset
value is comprised mostly of investment assets less debt and other liabilities. The table below sets forth information relating
to our net asset value and net asset value per share.
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September 30, 2012 (unaudited)
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December 31, 2011
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Fair Value ¹
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Per Share ¹
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Fair Value ¹
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Per Share ¹
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Investments at fair value:
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Investments in time deposits
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$
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501,475
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$
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0.02
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$
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229,152
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$
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0.01
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Investments in money market accounts
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4,850,220
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0.18
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31,622,134
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1.38
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Investments in debt securities
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135,477,765
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5.12
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114,673,506
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4.99
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Investments in CLO Fund securities
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67,784,447
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2.56
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48,438,317
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2.11
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Investments in equity securities
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6,911,736
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0.26
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6,040,895
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0.26
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Investments in Asset Manager Affiliates
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73,989,000
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2.80
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40,814,000
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1.78
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Cash
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2,413,104
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0.09
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2,555,259
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0.11
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Restricted Cash
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6,093,126
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0.23
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—
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-
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Other assets
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4,920,379
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0.19
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3,760,398
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0.16
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Total Assets
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$
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302,941,252
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$
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11.45
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$
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248,133,661
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$
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10.79
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Borrowings
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$
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28,000,000
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$
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1.06
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$
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—
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$
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-
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Other liabilities
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8,043,003
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0.30
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7,607,719
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0.33
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Convertible Senior Notes
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60,000,000
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2.27
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60,000,000
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2.61
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Total Liabilities
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$
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96,043,003
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$
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3.63
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$
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67,607,719
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$
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2.94
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NET ASSET VALUE
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$
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206,898,249
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$
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7.82
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$
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180,525,942
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$
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7.85
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¹
Our
balance sheet at fair value and resultant net asset value are calculated on a basis consistent with accounting principles generally
accepted in the United States of America ("GAAP"). Our per share presentation of such amounts (other than net asset value
per share) is an internally derived non-GAAP performance measure calculated by dividing the applicable balance sheet amount by
outstanding shares. We believe that the per share amounts for such balance sheet items are helpful in analyzing our balance sheet
both quantitatively and qualitatively in that our shares may trade based on a percentage of net asset value and individual investors
may weight certain balance sheet items differently in performing an analysis of the Company.
Leverage
We use borrowed funds, known as leverage,
to make investments and to attempt to increase returns to our shareholders by reducing our overall cost of capital. As a BDC, we
are limited in the amount of leverage we can incur under the 1940 Act. We are only allowed to borrow amounts such that our asset
coverage, as defined in the 1940 Act, equals at least 200% immediately after such borrowing. As of September 30, 2012, we had approximately
$88 million of outstanding borrowings and our asset coverage ratio of total assets to total borrowings was 335%, compliant with
the minimum asset coverage level of 200% generally required for a BDC by the 1940 Act. We may also borrow amounts of up to 5% of
the value of our total assets for temporary purposes.
At December 31, 2010, we had approximately
$87 million of outstanding indebtedness through a secured credit facility. On January 31, 2011, we repaid in full the outstanding
balance under this facility and the facility was terminated. As a result, approximately $73 million of collateral previously securing
the facility was released to us and we also received a $2 million cash settlement from the lenders to settle litigation previously
initiated by us against the lenders. In order to pay off this facility, we utilized proceeds received from the paydown, amortization
or sale of portfolio loan investments totaling approximately $133 million together with available cash.
On March 16, 2011, we issued $55 million
in aggregate principal amount of unsecured 8.75% convertible senior notes due March 15, 2016 (“Convertible Senior Notes”).
On March 23, 2011, pursuant to an over-allotment option, we issued an additional $5 million of such Convertible Senior Notes for
a total of $60 million in aggregate principal amount. The net proceeds for the Convertible Senior Notes, following underwriting
expenses, were approximately $57.7 million. Interest on the Convertible Senior Notes is paid semi-annually in arrears on March
15 and September 15, at a rate of 8.75%, commencing September 15, 2011. The Notes mature on March 15, 2016 unless converted earlier.
The Convertible Senior Notes are senior unsecured obligations of the Company.
The Convertible Senior Notes are convertible
into shares of Company’s common stock based on an initial conversion rate of 120.2202 shares of common stock per $1,000 principal
amount of Convertible Senior Notes, which is equivalent to an initial conversion price of approximately $8.3181 per share of common
stock. The conversion rate is subject to customary anti-dilution adjustments, including for any cash dividends or distributions
paid on shares of our common stock in excess of a quarterly dividend of $0.17 per share, but will not be adjusted for any accrued
and unpaid interest. In addition, if certain corporate events occur prior to the maturity date of the Convertible Senior Notes,
the conversion rate will be increased for converting holders.
On February 24, 2012, we entered into a
Note Purchase Agreement with Credit Suisse AG, Cayman Islands Branch (“CS”), Credit Suisse Securities (USA) LLC, as
arranger, The Bank of New York Mellon Trust Company, National Association, as collateral administrator and collateral agent, and
KCAP Funding, a special-purpose bankruptcy remote wholly-owned subsidiary of ours, under which we may obtain up to $30 million
in financing (the “Facility”). The scheduled maturity date for the Facility is December 20, 2014. Interest on the Facility
is LIBOR + 300 basis points and payable quarterly.
Advances under the Facility are used by
us primarily to make additional investments. The Facility is secured by loans that the Company currently owns and a security interest
in our right to receive certain management fees. Our borrowings under the Facility are effected through KCAP Funding.
As of September 30, 2012, there was an
outstanding balance under the Facility of $28,000,000 and we are in compliance with all its debt covenants. As of September 30,
2012, we had restricted cash balances of approximately $6.1 million which we maintained in accordance with the terms of the Facility.
Subject to prevailing market conditions,
we intend to grow our portfolio of assets by raising additional capital, including through the prudent use of leverage available
to us. As a result, we may seek to enter into new agreements with other lenders or into other financing arrangements as market
conditions permit.
Investment Portfolio Summary Attributes as of and for the
Nine Months
ended September 30, 2012
Our investment portfolio generates net
investment income which is generally used to pay principal and interest on our borrowings and to fund our dividend. Our investment
portfolio consists of three primary components: debt securities, CLO Fund securities and our investments in the Asset Manager Affiliates.
We also have investments in equity securities of approximately $7 million, which comprises approximately 2% of our investment portfolio.
Below are summary attributes for each of our primary investment portfolio components (see “—Investment Securities”
for a more detailed description) as of and for the nine months ended September 30, 2012:
Debt Securities
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represent approximately 45% of total assets;
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represent credit instruments issued by corporate borrowers;
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primarily senior secured and junior secured loans (49% and 27% of debt securities, respectively);
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spread across 24 different industries and 53 different entities;
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average balance per investment of approximately $3 million;
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all but five issuers (representing less than 1% of total investments at fair value) are current on their debt service obligations;
and
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weighted average interest rate of 8.1% on income producing debt investments.
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CLO Fund Securities
(as of the last monthly trustee report
prior to September 30, 2012 unless otherwise specified)
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represent approximately 22% of total assets at September 30, 2012;
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87% of CLO Fund securities represent investments in subordinated securities or equity securities issued by CLO Funds and 13%
of CLO Fund securities are rated notes;
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all CLO Funds invest primarily in credit instruments issued by corporate borrowers;
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13 different CLO Fund securities; 10 of such CLO Fund securities are managed by our Asset Manager Affiliates; and
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two CLO Fund securities, not managed by our Asset Manager Affiliates, representing a fair value of $1.5 million, are not currently
providing a dividend payment to the Company.
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Asset Manager Affiliates
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represent approximately 24% of fair value of total assets;
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represent our 100% ownership of the equity interest of two profitable CLO Fund managers focused on corporate credit investing;
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have approximately $3.3 billion of assets under management;
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receive contractual and recurring asset management fees based on par value of managed investments;
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may receive an incentive fee provided that the CLO Fund achieves a minimum designated return on investment;
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dividends paid by our Asset Manager Affiliates are recognized as dividend income from affiliate asset manager on our statement
of operations and are an additional source of income to pay our dividend;
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for the nine months ended September 30, 2012, our Asset Manager Affiliates had EBITDA of approximately $3 million; and
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for the nine months ended September 30, 2012, our Asset Manager Affiliates made a distribution of $2,950,000 to the Company
in the form of a dividend which is recognized as current earnings to the Company.
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Revenue
Revenues consist primarily of investment
income from interest and dividends on our investment portfolio and various ancillary fees related to our investment holdings.
Interest from Investments in Debt Securities
.
We generate interest income from our investments in debt securities which consist primarily of senior and junior secured loans.
Our debt securities portfolio is spread across multiple industries and geographic locations, and as such, we are broadly exposed
to market conditions and business environments. As a result, although our investments are exposed to market risks, we continuously
seek to limit concentration of exposure in any particular sector or issuer.
Dividends from Investments in CLO Fund
Securities
. We generate dividend income from our investments in the securities of CLO Funds (typically preferred shares or
subordinated securities) managed by our Asset Manager Affiliates and selective investments in securities issued by funds managed
by other asset management companies. CLO Funds managed by our Asset Manager Affiliates invest primarily in broadly syndicated non-investment
grade loans, high-yield bonds and other credit instruments of corporate issuers. The Company distinguishes CLO Funds managed by
its Asset Manager Affiliates as “CLO Fund securities managed by affiliates.” in its financial statements. The underlying
assets in each of the CLO Funds in which we have an investment are generally diversified secured or unsecured corporate debt. Our
CLO Fund securities that are subordinated securities or preferred shares (“junior securities”) are subordinated to
senior note holders who typically receive a return on their investment at a fixed spread relative to the LIBOR index. The CLO Funds
are leveraged funds and any excess cash flow or “excess spread” (interest earned by the underlying securities in the
fund less payments made to senior bond holders and less fund expenses and management fees) is paid to the holders of the CLO Fund’s
subordinated securities or preferred shares. The level of excess spread from CLO Fund securities can be impacted from the timing
and level of the resetting of the benchmark interest rate for the underlying assets (which reset at various times throughout the
quarter) in the CLO Fund and the related CLO Fund note liabilities (which reset at each quarterly distribution date); in periods
of short-term and volatile changes in the benchmark interest rate, the levels of excess spread and distributions to us can vary
significantly. In addition, the failure of CLO Funds in which we invest to comply with certain financial covenants may lead to
the temporary suspension or deferral of cash distributions to us.
For non-junior class CLO Fund securities,
such as our investment in the class B-2L notes of the Katonah 2007-1 CLO, interest is earned at a fixed spread relative to the
LIBOR index.
Dividends from Asset Manager Affiliates.
We generate dividend income from our investment in our Asset Manager Affiliates, which are wholly-owned and manage CLO Funds that
invest primarily in broadly syndicated non-investment grade loans, high yield bonds and other credit instruments issued by corporations.
As managers of CLO Funds, our Asset Manager Affiliates receive contractual and recurring management fees as well as an expected
one-time structuring fee from the CLO Funds for their management and advisory services. In addition, our Asset Manager Affiliates
may also earn income related to net interest on assets accumulated for future CLO issuances on which they have provided a first
loss guaranty in connection with loan warehouse arrangements for their CLO Funds. Our Asset Manager Affiliates generate annual
operating income equal to the amount by which their fee income exceeds their operating expenses. The annual management fees which
our Asset Manager Affiliates receive are generally based on a fixed percentage of the par value of assets under management and
are recurring in nature for the term of the CLO Fund so long as the Asset Manager Affiliates manage the fund. As a result, the
annual management fees earned by our Asset Manager Affiliates generally are not subject to market value fluctuations in the underlying
collateral. Our Asset Manager Affiliates may receive incentive fees provided such CLO Funds have achieved a minimum investment
return to holders of their subordinated securities or preferred shares.
Capital Structuring Service Fees
.
We may earn ancillary structuring and other fees related to the origination, investment, disposition or liquidation of debt and
investment securities.
Expenses
We are internally managed and directly
incur the cost of management and operations; as a result, we incur no management fees or other fees to an external investment adviser.
Our expenses consist primarily of interest expense on outstanding borrowings, compensation expense and general and administrative
expenses, including professional fees.
Interest and Amortization of Debt Issuance
Costs
. Interest expense is dependent on the average outstanding balance on our borrowings and the base index rate for the period.
Debt issuance costs represent fees and other direct costs incurred in connection with the Company’s borrowings. These amounts
are capitalized and amortized ratably over the contractual term of the borrowing.
Compensation Expense
. Compensation
expense includes base salaries, bonuses, stock compensation, employee benefits and employer-related payroll costs. The largest
components of total compensation costs are base salaries and bonuses; generally, base salaries are expensed as incurred and annual
bonus expenses are estimated and accrued. Our compensation arrangements with our employees contain a significant profit sharing
and/or performance based bonus component. Therefore, as our net revenues increase, our compensation costs may also rise. In addition,
our compensation expenses may also increase to reflect increased investment in personnel as we grow our products and businesses.
Professional Fees and General and Administrative
Expenses
. The balance of our expenses include professional fees (primarily legal, accounting, valuation and other professional
services), occupancy costs and general administrative and other costs.
Net Change in Unrealized Appreciation (Depreciation) on Investments
During the three months ended September
30, 2012, the Company’s investments had a net increase in unrealized appreciation of approximately $6.0 million. During the
nine months ended September 30, 2012, the Company’s investments had a net increase in unrealized depreciation of approximately
$1.8 million. During the three months ended September 30, 2011, the Company’s investments had a net increase in unrealized
depreciation of approximately $6.0 million. During the nine months ended September 30, 2011, the Company’s investments had
a net increase in unrealized appreciation of approximately $11 million.
The net increase in unrealized appreciation
of approximately $6.0 million for the three months ended September 30, 2012 is primarily due to (i) an approximate $900,000 net
increase in the unrealized appreciation of certain loans and equity positions as a result of credit considerations and current
market conditions; (ii) a net increase of approximately $3.8 million in the unrealized appreciation of CLO Fund securities; and
(iii) an approximate increase of $1.3 million in the unrealized depreciation of our Asset Manager Affiliates.
The net increase in unrealized depreciation
of approximately $1.8 million for the nine months ended September 30, 2012 is primarily due to (i) an approximate $2.4 million
net increase in the unrealized depreciation of certain loans and equity positions as a result of credit considerations and current
market conditions; (ii) a net increase of approximately $6.4 million in the unrealized appreciation of CLO Fund securities; and
(iii) an approximate increase of $5.7 million in the unrealized depreciation of our Asset Manager Affiliates.
Net Change in Net Assets Resulting From Operations
The net change in net assets resulting
from operations for the three months ended September 30, 2012 and 2011 was an increase of approximately $9 million and a decrease
of $1 million, respectively, or $0.35 and $0.06 per share, respectively. The net change in net assets resulting from operations
for the nine months ended September 30, 2012 and 2011 was an increase of approximately $12 million and $9 million, respectively,
or $0.45 and $0.39 per share, respectively.
Net Investment Income and Net Realized Gains (Losses)
Net investment income and net realized
gains (losses) represents the net change in net assets resulting from operations before net unrealized appreciation or depreciation
on investments. For the three months ended September 30, 2012, net investment income and net realized gains were approximately
$3 million, or $0.13 per share. For the three months ended September 30, 2011, net investment income and net realized gains were
approximately $4 million or $0.18 per share. For the nine months ended September 30, 2012, net investment income and net realized
gains were approximately $13 million, or $0.51 per share. For the nine months ended September 30, 2011, net investment income and
net realized losses were approximately $2 million or $0.08 per share.
Dividends
For the three months ended September 30,
2012, we declared a $0.24 dividend per share. As a result, there was a dividend distribution of approximately $6.3 million for
the third quarter declaration, which was booked in the fourth quarter. We intend to continue to distribute quarterly dividends
to our stockholders. To avoid certain excise taxes imposed on RICs, we currently intend to distribute during each calendar year
an amount at least equal to the sum of:
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•
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98% of our ordinary net taxable income for the calendar year;
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•
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98.2% of our capital gains, if any, in excess of capital losses for the one-year period ending on October 31 of the calendar
year; and
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•
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any net ordinary income and net capital gains for the preceding year that were not distributed during such year.
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The amount of our declared dividends, as
evaluated by management and approved by our Board of Directors, is based on our evaluation of both distributable income for tax
purposes and GAAP net investment income (which excludes unrealized gains and losses). Generally, we seek to fund our dividends
from GAAP current earnings, primarily from net interest and dividend income generated by our investment portfolio and without a
return of capital or a high reliance on realized capital gains. The following table sets forth the quarterly dividends declared
by us since the most recent completed calendar year, which represent an amount equal to our estimated net investment income for
the specified quarter, including income distributed from the Asset Manager Affiliates received by the Company, if any, plus a portion
of any prior year undistributed amounts of net investment income distributed in subsequent years:
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Dividend
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Declaration
Date
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|
|
Record
Date
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Pay Date
|
|
2012:
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|
|
|
|
|
|
|
|
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|
|
|
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|
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Third quarter
|
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$
|
0.24
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9/17/2012
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10/10/2012
|
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10/29/2012
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Second quarter
|
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0.24
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6/18/2012
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7/6/2012
|
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7/27/2012
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First quarter
|
|
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0.18
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3/16/2012
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4/6/2012
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4/27/2012
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|
|
|
|
|
Total declared in 2012
|
|
$
|
0.66
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2011:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fourth quarter
|
|
$
|
0.18
|
|
|
|
12/12/2011
|
|
|
|
12/23/2011
|
|
|
|
1/27/2012
|
|
Third quarter
|
|
|
0.18
|
|
|
|
9/15/2011
|
|
|
|
10/10/2011
|
|
|
|
10/28/2011
|
|
Second quarter
|
|
|
0.17
|
|
|
|
6/13/2011
|
|
|
|
7/8/2011
|
|
|
|
7/29/2011
|
|
First quarter
|
|
|
0.17
|
|
|
|
3/21/2011
|
|
|
|
4/8/2011
|
|
|
|
4/29/2011
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total declared in 2011
|
|
$
|
0.70
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Due to our ownership of our Asset Manager
Affiliates and certain timing, structural and tax considerations, our dividend distributions may include a return of capital for
tax purposes. For the nine months ended September 30, 2012, our Asset Manager Affiliates had approximately $3.0 million of EBITDA
and made a distribution of $2,950,000 to us. For the nine months ended September 30, 2011, our Katonah Debt Advisors earned approximately
$1 million of pre-tax net income and made no distributions to us. We did not acquire Trimaran Advisors until February 2012. Dividends
are recorded as declared (where declaration date represents ex-dividend date) by our Asset Manager Affiliates as income on our
statement of operations. It is anticipated that our Asset Manager Affiliates may make further dividend distributions to us during
2012.
INVESTMENT PORTFOLIO
Investment Objective
Our investment objective is to generate current
income and capital appreciation from the investments made by our middle market business in senior secured term loans, mezzanine
debt and selected equity investments in privately-held middle market companies. The Company also expects to receive distributions
of recurring fee income and to generate capital appreciation from its investments in the asset management businesses of the Asset
Manager Affiliates. We intend to grow our portfolio of assets by raising additional capital, including through the prudent use
of leverage available to us. We primarily invest in first and second lien term loans which, because of their priority in a company’s
capital structure, we expect will have lower default rates and higher rates of recovery of principal if there is a default and
which we expect will create a stable stream of interest income. While our primary investment focus is on making loans to, and selected
equity investments in, privately-held middle market companies, we may also invest in other investments such as loans to larger,
publicly-traded companies, high-yield bonds and distressed debt securities. We may also receive warrants or options to purchase
common stock in connection with our debt investments. In addition, we may also invest in debt and equity securities issued by CLO
Funds managed by our Asset Manager Affiliates or by other asset managers.
The following table shows the Company’s
portfolio by security type at September 30, 2012 and December 31, 2011:
|
|
September 30, 2012 (unaudited)
|
|
|
December 31, 2011
|
|
Security Type
|
|
Cost
|
|
|
Fair Value
|
|
|
%¹
|
|
|
Cost
|
|
|
Fair Value
|
|
|
%¹
|
|
Time Deposits
|
|
$
|
501,475
|
|
|
$
|
501,475
|
|
|
|
-
|
%
|
|
$
|
229,152
|
|
|
$
|
229,152
|
|
|
|
-
|
%
|
Money Market Account
|
|
|
4,850,220
|
|
|
|
4,850,220
|
|
|
|
2
|
|
|
|
31,622,134
|
|
|
|
31,622,134
|
|
|
|
18
|
|
Senior Secured Loan
|
|
|
73,626,439
|
|
|
|
65,868,804
|
|
|
|
32
|
|
|
|
54,045,184
|
|
|
|
45,259,328
|
|
|
|
25
|
|
Junior Secured Loan
|
|
|
53,570,960
|
|
|
|
37,237,835
|
|
|
|
18
|
|
|
|
58,936,728
|
|
|
|
47,300,172
|
|
|
|
26
|
|
Mezzanine Investment
|
|
|
8,518,913
|
|
|
|
9,401,536
|
|
|
|
5
|
|
|
|
10,931,428
|
|
|
|
11,588,115
|
|
|
|
6
|
|
Senior Subordinated Bond
|
|
|
21,846,118
|
|
|
|
22,577,830
|
|
|
|
11
|
|
|
|
9,997,898
|
|
|
|
10,125,891
|
|
|
|
6
|
|
CLO Fund Securities
|
|
|
85,506,168
|
|
|
|
67,784,447
|
|
|
|
33
|
|
|
|
66,528,482
|
|
|
|
48,438,317
|
|
|
|
27
|
|
Equity Securities
|
|
|
17,012,236
|
|
|
|
6,911,736
|
|
|
|
3
|
|
|
|
16,559,610
|
|
|
|
6,040,895
|
|
|
|
3
|
|
Preferred
|
|
|
400,000
|
|
|
|
391,760
|
|
|
|
-
|
|
|
|
400,000
|
|
|
|
400,000
|
|
|
|
-
|
|
Asset Manager Affiliates
|
|
|
83,203,884
|
|
|
|
73,989,000
|
|
|
|
36
|
|
|
|
44,338,301
|
|
|
|
40,814,000
|
|
|
|
23
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
349,036,413
|
|
|
$
|
289,514,643
|
|
|
|
140
|
%
|
|
$
|
293,588,917
|
|
|
$
|
241,818,004
|
|
|
|
134
|
%
|
¹ Calculated as a percentage of net asset value.
Investment Securities
We invest in senior secured loans, mezzanine
debt and, to a lesser extent, equity of middle market companies in a variety of industries. However, we may invest in other industries
if we are presented with attractive opportunities. We generally target companies that generate positive cash flows because we look
to cash flows as the primary source for servicing debt.
We employ a disciplined approach in the selection
and monitoring of our investments. Generally, we target investments that will provide a current return through interest income
to provide for stability in our net income and place less reliance on realized capital gains from our investments. Our investment
philosophy is focused on preserving capital with an appropriate return profile relative to risk. Our investment due diligence and
selection generally focuses on an underlying issuer’s net cash flow after capital expenditures to service its debt rather
than on multiples of net income, valuations or other broad benchmarks which frequently miss the nuances of an issuer’s business
and prospective financial performance. We also generally avoid concentrations in any one industry or issuer. We manage risk through
a rigorous credit and investment underwriting process and an active portfolio monitoring program.
Our Board of Directors is ultimately and
solely responsible for making a good faith determination of the fair value of portfolio investments on a quarterly basis. Debt
and equity securities for which market quotations are readily available are generally valued at such market quotations. Debt and
equity securities that are not publicly traded or whose market price is not readily available are valued by the Board of Directors
based on detailed analyses prepared by management, the Valuation Committee of the Board of Directors, and, in certain circumstances,
third parties with valuation expertise. Valuations are conducted by management on 100% of the investment portfolio at the end of
each quarter. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available
market value, the fair value of our investments may differ materially from the values that would have existed had a ready market
existed for such investments. Further, such investments may be generally subject to legal and other restrictions on resale or otherwise
less liquid than publicly traded securities. In addition, changes in the market environment and other events may occur over the
life of the investments that may cause the value realized on such investments to be different from the currently assigned valuations.
We derive fair value for our illiquid investments
that do not have indicative fair values based upon active trades primarily by using a present value technique that discounts the
estimated contractual cash flows for the underlying assets with discount rates imputed by broad market indices, bond spreads and
yields for comparable issuers relative to the subject assets (the “Market Yield Approach”) and also consider recent
loan amendments or other activity specific to the subject asset. Discount rates applied to estimated contractual cash flows for
an underlying asset vary by specific investment, industry, priority and nature of the debt security (such as the seniority or security
interest of the debt security) and are assessed relative to two indices, a leveraged loan index and a high-yield bond index, at
the valuation date. We have identified these two indices as benchmarks for broad market information related to our loan and debt
investments. Because we have not identified any market index that directly correlates to the loan and debt investments held by
us and therefore use the two benchmark indices, these market indices may require significant adjustment to better correlate such
market data for the calculation of fair value of the investment under the Market Yield Approach. Such adjustments require judgment
and may be material to the calculation of fair value. Further adjustments to the discount rate may be applied to reflect other
market conditions or the perceived credit risk of the borrower. When broad market indices are used as part of the valuation methodology,
their use is subject to adjustment for many factors, including priority, collateral used as security, structure, performance and
other quantitative and qualitative attributes of the asset being valued. The resulting present value determination is then weighted
along with any quotes from observable transactions and broker/pricing quotes. If such quotes are indicative of actual transactions
with reasonable trading volume at or near the valuation date that are not liquidation or distressed sales, relatively more reliance
will be put on such quotes to determine fair value. If such quotes are not indicative of market transactions or are insufficient
as to volume, reliability, consistency or other relevant factors, such quotes will be compared with other fair value indications
and given relatively less weight based on their relevancy. The appropriateness of specific valuation methods and techniques may
change as market conditions and available data change.
The majority of our investment portfolio
is composed of debt and equity securities with unique contract terms and conditions and/or complexity that requires a valuation
of each individual investment that considers multiple levels of market and asset specific inputs, including historical and forecasted
financial and operational performance of the individual investment, projected cash flows, market multiples, comparable market transactions,
the priority of the security compared with those of other securities for such issuers, credit risk, interest rates and independent
valuations and reviews.
Loans and Debt Securities.
To the extent that our investments are exchange
traded and are priced or have sufficient price indications from normal course trading at or around the valuation date (financial
reporting date), such pricing will determine fair value. Pricing service marks from third party pricing services may be used as
an indication of fair value, depending on the volume and reliability of the marks, sufficient and reasonable correlation of bid
and ask quotes, and, most importantly, the level of actual trading activity. However, most of our investments are illiquid investments
with little or no trading activity. Further, we have been unable to identify directly comparable market indices or other market
guidance that correlate directly to the types of investments we own. As a result, for most of our assets, we determine fair value
using alternative methodologies and models using available market data, as adjusted, to reflect the types of assets we own, their
structure, qualitative and credit attributes and other asset specific characteristics.
We derive fair value for our illiquid investments
that do not have indicative fair values based upon active trades primarily by using the Market Yield Approach and also consider
recent loan amendments or other activity specific to the subject asset. Discount rates applied to estimated contractual cash flows
for an underlying asset vary by specific investment, industry, priority and nature of the debt security (such as the seniority
or security interest of the debt security) and are assessed relative to two indices, a leveraged loan index and a high-yield bond
index, at the valuation date. We have identified these two indices as benchmarks for broad market information related to our loan
and debt investments. Because we have not identified any market index that directly correlates to the loan and debt investments
held by us and therefore use the two benchmark indices, these market indices may require significant adjustment to better correlate
such market data for the calculation of fair value of the investment under the Market Yield Approach. Such adjustments require
judgment and may be material to the calculation of fair value. Further adjustments to the discount rate may be applied to reflect
other market conditions or the perceived credit risk of the borrower. When broad market indices are used as part of the valuation
methodology, their use is subject to adjustment for many factors, including priority, collateral used as security, structure, performance
and other quantitative and qualitative attributes of the asset being valued. The resulting present value determination is then
weighted along with any quotes from observable transactions and broker/pricing quotes. If such quotes are indicative of actual
transactions with reasonable trading volume at or near the valuation date that are not liquidation or distressed sales, relatively
more reliance will be put on such quotes to determine fair value. If such quotes are not indicative of market transactions or are
insufficient as to volume, reliability, consistency or other relevant factors, such quotes will be compared with other fair value
indications and given relatively less weight based on their relevancy.
Equity and Equity-Related Securities.
Our equity and equity-related securities
in portfolio companies for which there is no liquid public market are carried at fair value based on the enterprise value of the
portfolio company, which is determined using various factors, including EBITDA, cash flows from operations less capital expenditures
and other pertinent factors, such as recent offers to purchase a portfolio company’s securities or other liquidation events.
The determined fair values are generally discounted to account for restrictions on resale and minority ownership positions. The
values of our equity and equity-related securities in public companies for which market quotations are readily available are based
upon the closing public market price on the balance sheet date. Securities that carry certain restrictions on sale are typically
valued at a discount from the public market value of the security.
The significant inputs used to determine
the fair value of equity and equity-related securities include prices, earnings, EBITDA and cash flows after capital expenditures
for similar peer comparables and the investment entity itself. Equity and equity-related securities are classified as Level III
as described in—“Critical Accounting Policies—Valuation of Portfolio Investments” below), when there is
limited activity or less transparency around inputs to the valuation given the lack of information related to such equity investments
held in nonpublic companies. Significant assumptions observed for comparable companies as applied to relevant financial data for
the specific investment. Such assumptions, such as model discount rates or price/earnings multiples, vary by the specific investment,
equity position and industry and incorporate adjustments for risk premiums, liquidity and company specific attributes. Such adjustments
require judgment and may be material to the calculation of fair value.
At September 30, 2012 and December 31, 2011,
our investments in income producing loans and debt securities, excluding CLO Fund securities, had a weighted average interest rate
of approximately 8.1% and 8.4%, respectively.
The investment portfolio (excluding the
Company’s investments in its Asset Manager Affiliates and CLO Funds) at September 30, 2012 was spread across 24 different
industries and 53 different entities with an average balance per entity of approximately $3 million. As of September 30, 2012,
all but five of our portfolio companies (representing less than 1% of total investments at fair value) were current on their debt
service obligations. Our portfolio, including the CLO Funds in which it invests, and the CLO Funds managed by our Asset Manager
Affiliates consist almost exclusively of credit instruments issued by corporations.
We may invest up to 30% of our investment
portfolio in opportunistic investments in high-yield bonds, debt and equity securities of CLO Funds, distressed debt or equity
securities of public companies. At September 30, 2012, approximately 23% of our total assets were foreign assets (including our
investments in CLO Funds, which are typically domiciled outside the U.S.).
At September 30, 2012, our ten largest
portfolio companies represented approximately 56% of the total fair value of our investments. Our largest investment is comprised
of our wholly-owned Asset Manager Affiliates and represented 26% of the total fair value of our investments. Excluding our Asset
Manager Affiliates and CLO Fund securities, our ten largest portfolio companies represent approximately 20% of the total fair value
of our investments.
CLO Fund Securities
We typically make a minority investment
in the subordinated securities or preferred stock of CLO Funds raised and managed by our Asset Manager Affiliates and may selectively
invest in securities issued by CLO Funds managed by other asset management companies. As of September 30, 2012, we had approximately
$68 million invested in CLO Fund securities, including those issued by funds managed by our Asset Manager Affiliates.
The CLO Funds managed by our Asset Manager
Affiliates invest primarily in broadly syndicated non-investment grade loans, high-yield bonds and other credit instruments of
corporate issuers. The underlying assets in each of the CLO Funds in which we have an investment are generally diversified secured
or unsecured corporate debt.
Our CLO Fund investments as of September
30, 2012 and December 31, 2011 are as follows:
|
|
|
|
|
|
|
September 30, 2012 (unaudited)
|
|
|
December 31, 2011
|
|
CLO Fund Securities
|
|
Investment
|
|
%
1
|
|
|
Cost
|
|
|
Fair Value
|
|
|
Cost
|
|
|
Fair Value
|
|
Grant Grove CLO, Ltd.
|
|
Subordinated Securities
|
|
|
22.2
|
%
|
|
$
|
4,958,483
|
|
|
$
|
3,063,189
|
|
|
$
|
4,893,552
|
|
|
$
|
3,042,400
|
|
Katonah III, Ltd.
3
|
|
Preferred Shares
|
|
|
23.1
|
|
|
|
4,476,930
|
|
|
|
1,500,000
|
|
|
|
4,476,930
|
|
|
|
1,000
|
|
Katonah V, Ltd.
3
|
|
Preferred Shares
|
|
|
26.7
|
|
|
|
3,320,000
|
|
|
|
1,000
|
|
|
|
3,320,000
|
|
|
|
1,000
|
|
Katonah VII CLO Ltd.
2
|
|
Subordinated Securities
|
|
|
16.4
|
|
|
|
4,575,493
|
|
|
|
2,274,631
|
|
|
|
4,614,123
|
|
|
|
2,358,700
|
|
Katonah VIII CLO Ltd.
2
|
|
Subordinated Securities
|
|
|
10.3
|
|
|
|
3,457,305
|
|
|
|
2,101,905
|
|
|
|
3,450,583
|
|
|
|
1,888,700
|
|
Katonah IX CLO Ltd.
2
|
|
Preferred Shares
|
|
|
6.9
|
|
|
|
2,075,887
|
|
|
|
1,511,277
|
|
|
|
2,060,697
|
|
|
|
1,336,800
|
|
Katonah X CLO Ltd.
2
|
|
Subordinated Securities
|
|
|
33.3
|
|
|
|
11,906,371
|
|
|
|
8,826,471
|
|
|
|
11,840,297
|
|
|
|
8,645,600
|
|
Katonah 2007-1 CLO Ltd.
2
|
|
Preferred Shares
|
|
|
100.0
|
|
|
|
31,078,634
|
|
|
|
27,683,357
|
|
|
|
30,659,688
|
|
|
|
24,488,400
|
|
Katonah 2007-1 CLO Ltd.
2
|
|
Class B-2L Notes
|
|
|
100.0
|
|
|
|
1,237,364
|
|
|
|
8,690,000
|
|
|
|
1,212,612
|
|
|
|
6,675,717
|
|
Trimaran CLO IV, Ltd.
2
|
|
Preferred Shares
|
|
|
18.9
|
|
|
|
5,115,600
|
|
|
|
3,312,321
|
|
|
|
—
|
|
|
|
—
|
|
Trimaran CLO V, Ltd.
2
|
|
Subordinate Notes
|
|
|
20.8
|
|
|
|
5,055,800
|
|
|
|
3,107,504
|
|
|
|
—
|
|
|
|
—
|
|
Trimaran CLO VI, Ltd.
2
|
|
Income Notes
|
|
|
16.2
|
|
|
|
4,200,900
|
|
|
|
2,715,803
|
|
|
|
—
|
|
|
|
—
|
|
Trimaran CLO VII, Ltd.
2
|
|
Income Notes
|
|
|
10.5
|
|
|
|
4,047,400
|
|
|
|
2,996,989
|
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
|
|
|
|
|
$
|
85,506,167
|
|
|
$
|
67,784,447
|
|
|
$
|
66,528,482
|
|
|
$
|
48,438,317
|
|
¹ Represents percentage of class held.
² An affiliate CLO Fund managed by an Asset Manager Affiliate.
³ As of September 30, 2012, this CLO Fund security was
not providing a dividend distribution.
Our investments in CLO Fund securities are
carried at fair value, which is based either on (i) the present value of the net expected cash inflows for interest income
and principal repayments from underlying assets and cash outflows for interest expense, debt paydown and other fund costs for the
CLO Funds that are approaching or past the end of their reinvestment period and therefore are selling assets and/or using principal
repayments to pay down CLO Fund debt (or will begin to do so shortly), and for which there continue to be net cash distributions
to the class of securities owned by us, or (ii) a discounted cash flow model that utilizes prepayment and loss assumptions based
on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable
yields for similar securities or preferred shares to those in which we have invested. We recognize unrealized appreciation or depreciation
on our investments in CLO Fund securities as comparable yields in the market change and/or based on changes in net asset values
or estimated cash flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool. As each investment
in CLO Fund securities ages, the expected amount of losses and the expected timing of recognition of such losses in the underlying
collateral pool are updated and the revised cash flows are used in determining the fair value of the CLO Fund investments. We determine
the fair value of our investments in CLO Fund securities on a security-by-security basis.
Due to the individual attributes of each
CLO Fund security, they are classified as a Level III (as described in—“Critical Accounting Policies—Valuation
of Portfolio Investments” below) investment unless specific trading activity can be identified at or near the valuation date.
When available, Level II (as described in “—Critical Accounting Policies—Valuation of Portfolio Investments”
below) market information will be identified, evaluated and weighted accordingly in the application of such data to the present
value models and fair value determination. Significant assumptions to the present value calculations include default rates, recovery
rates, prepayment rates, investment/reinvestment rates and spreads and the discount rate by which to value the resulting underlying
cash flows. Such assumptions can vary significantly, depending on market data sources which often vary in depth and level of analysis,
understanding of the CLO market, detailed or broad characterizations of the CLO market and the application of such data to an appropriate
framework for analysis. The application of data points are based on the specific attributes of each individual CLO Fund security’s
underlying assets, historic, current and prospective performance, vintage, and other quantitative and qualitative factors that
would be evaluated by market participants. We evaluate the source of market data for reliability as an indicative market input,
consistency amongst other inputs and results and also the context in which such data is presented.
For rated note tranches of CLO Fund securities
(those above the junior class) without transactions to support a fair value for the specific CLO Fund and tranche, fair value is
based on discounting estimated bond payments at current market yields, which may reflect the adjusted yield on the leveraged loan
index for similarly rated tranches, as well as prices for similar tranches for other CLO Funds, and also considers other factors
such as the default and recovery rates of underlying assets in the CLO Fund, as may be applicable. Such model assumptions may vary
and incorporate adjustments for risk premiums and CLO Fund specific attributes. Such adjustments require judgment and may be material
to the calculation of fair value.
The unaudited table below summarizes certain
attributes of each CLO Fund as per their most recent trustee reports as of September 30, 2012:
CLO Fund Securities
1
|
|
Number of
Securities
|
|
|
Number of
Issuers
|
|
|
Number of
Industries
|
|
|
Average Security
Position Size
|
|
|
Average Issuer
Position Size
|
|
Grant Grove CLO, Ltd.
2
|
|
|
295
|
|
|
|
234
|
|
|
|
32
|
|
|
$
|
942,963
|
|
|
$
|
1,188,778
|
|
Katonah III, Ltd.
2
|
|
|
81
|
|
|
|
43
|
|
|
|
19
|
|
|
|
1,257,104
|
|
|
|
2,368,033
|
|
Katonah V, Ltd.
2
|
|
|
104
|
|
|
|
61
|
|
|
|
27
|
|
|
|
456,489
|
|
|
|
778,277
|
|
Katonah VII CLO Ltd.
|
|
|
159
|
|
|
|
133
|
|
|
|
30
|
|
|
|
1,648,367
|
|
|
|
1,970,604
|
|
Katonah VIII CLO Ltd.
|
|
|
194
|
|
|
|
158
|
|
|
|
31
|
|
|
|
1,827,296
|
|
|
|
2,243,642
|
|
Katonah IX CLO Ltd.
|
|
|
224
|
|
|
|
185
|
|
|
|
30
|
|
|
|
1,787,487
|
|
|
|
2,164,309
|
|
Katonah X CLO Ltd.
|
|
|
240
|
|
|
|
202
|
|
|
|
29
|
|
|
|
1,942,848
|
|
|
|
2,308,335
|
|
Katonah 2007-1 CLO Ltd.
|
|
|
195
|
|
|
|
167
|
|
|
|
28
|
|
|
|
1,525,100
|
|
|
|
1,780,805
|
|
Trimaran CLO IV, Ltd.
|
|
|
122
|
|
|
|
99
|
|
|
|
22
|
|
|
|
2,390,645
|
|
|
|
2,946,047
|
|
Trimaran CLO V, Ltd.
|
|
|
146
|
|
|
|
116
|
|
|
|
23
|
|
|
|
1,927,047
|
|
|
|
2,425,421
|
|
Trimaran CLO VI, Ltd.
|
|
|
168
|
|
|
|
130
|
|
|
|
25
|
|
|
|
1,736,073
|
|
|
|
2,243,540
|
|
Trimaran CLO VII, Ltd.
|
|
|
186
|
|
|
|
147
|
|
|
|
28
|
|
|
|
2,542,219
|
|
|
|
3,216,685
|
|
¹ All data from most recent Trustee reports as of September
30, 2012.
² Managed by non-affiliates as of September 30, 2012.
In May 2009, we purchased the class B-2L
notes of the Katonah 2007-1 CLO investment managed by Katonah Debt Advisors (“Katonah 2007-1 B-2L”). We purchased Katonah
2007-1 B-2L for 10% of the par value. The fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L
investment as of September 30, 2012 were approximately $8.7 million, $1.2 million, and $7.5 million, respectively, and at December
31, 2011, the fair value, cost basis, and aggregate unrealized appreciation of the Katonah 2007-1 B-2L investment were $6.7 million,
$1.2 million, and $5.5 million, respectively. Both the B-2L notes and preferred shares of Katonah 2007-1 are owned 100% by us and
Katonah 2007-1 is current in the payment of all quarterly distributions in respect of the B-2L notes and the preferred shares.
All CLO Funds managed by Asset Manager Affiliates
are currently making quarterly dividend distributions to us and are paying all senior and subordinate management fees to our Asset
Manager Affiliates. With the exception of the Katonah III, Ltd. CLO Fund and the Katonah V, Ltd. CLO Fund, all third-party managed
CLO Funds held as investments are making quarterly dividend distributions to us.
Asset Manager Affiliates
Our Asset Manager Affiliates are our wholly-owned
asset management companies that manage CLO Funds that invest in broadly syndicated loans, high yield bonds and other credit instruments.
The CLO Funds managed by our Asset Manager Affiliates consist exclusively of credit instruments issued by corporations. As of September
30, 2012, our Asset Manager Affiliates had approximately $3.3 billion of par value of assets under management on which they earn
management fees, and were valued at approximately $74 million.
As a manager of the CLO Funds, our Asset
Manager Affiliates receive contractual and recurring management fees as well as an expected one-time structuring fee from the CLO
Funds for its management and advisory services. In addition, our Asset Manager Affiliates may also earn income related to net interest
on assets accumulated for future CLO issuances on which it has provided a first loss guaranty in connection with loan warehouse
arrangements for its CLO Funds. Our Asset Manager Affiliates generate annual operating income equal to the amount by which its
fee income exceeds its operating expenses.
The annual management fees which our Asset
Manager Affiliates receive are generally based on a fixed percentage of the par value of assets under management and are recurring
in nature for the term of the CLO Fund so long as the Asset Manager Affiliates manage the fund. As a result, the annual management
fees earned by our Asset Manager Affiliates are not subject to market value fluctuations in the underlying collateral. The annual
management fees our Asset Manager Affiliates receive have two components: a senior management fee and a subordinated management
fee. Currently, all CLO Funds managed by Asset Manager Affiliates are paying both their senior and subordinated management fees
on a current basis.
Our Asset Manager Affiliates may receive
incentive fees from CLO Funds they manage provided such CLO Funds have achieved a minimum investment return to holders of their
subordinated securities or preferred shares.
Subject to market conditions, we expect to
continue to make investments in CLO Funds managed by our Asset Manager Affiliates, which we believe will provide us with a current
cash investment return. We believe that these investments will provide our Asset Manager Affiliates with greater opportunities
to access new sources of capital which will ultimately increase our Asset Manager Affiliates’ assets under management and
resulting management fee income.
The revenue that our Asset Manager Affiliates
generate through the fees they receive for managing CLO Funds and after paying the expenses pursuant to an overhead allocation
agreement with the Company associated with its operations, including compensation of its employees, may be distributed to us. Cash
distributions of our Asset Manager Affiliates’ net income are recorded as “dividends from an affiliate asset managers”
in our financial statements when declared. As with all other investments, the fair value for Asset Manager Affiliates is determined
quarterly. Our investment in our Asset Manager Affiliates is carried at fair value, which is determined after taking into consideration
a percentage of assets under management and a discounted cash flow model incorporating different levels of discount rates depending
on the hierarchy of fees earned (including the likelihood of realization of senior, subordinate and incentive fees) and prospective
modeled performance. Such valuation includes an analysis of comparable asset management companies. The Asset Manager Affiliates
are classified as a Level III investment as described in—“Critical Accounting Policies—Valuation of Portfolio
Investments” below). Any change in value from period to period is recognized as net change in unrealized appreciation or
depreciation.
PORTFOLIO AND INVESTMENT ACTIVITY
Total portfolio investment activity (excluding
activity in time deposit and money market investments) for the nine months ended September 30, 2012 (unaudited) and for the year
ended December 31, 2011 was as follows:
|
|
Debt Securities
|
|
|
CLO Fund
Securities
|
|
|
Equity Securities
|
|
|
Asset Manager
Affiliates
|
|
|
Total Portfolio
|
|
Fair Value at December 31, 2010
|
|
$
|
91,042,928
|
|
|
$
|
53,031,000
|
|
|
$
|
4,688,832
|
|
|
$
|
41,493,000
|
|
|
$
|
190,255,760
|
|
2011 Activity:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Purchases / originations /draws
|
|
$
|
81,815,921
|
|
|
$
|
—
|
|
|
$
|
3,218,151
|
|
|
$
|
(194,027
|
)
|
|
$
|
84,840,045
|
|
Pay-downs / pay-offs / sales
|
|
|
(56,944,765
|
)
|
|
|
(1,935,000
|
)
|
|
|
(141,769
|
)
|
|
|
—
|
|
|
|
(59,021,534
|
)
|
Net accretion of interest
|
|
|
156,180
|
|
|
|
1,398,283
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1,554,463
|
|
Net realized losses
|
|
|
(17,261,608
|
)
|
|
|
(1,215,000
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
(18,476,608
|
)
|
Increase (decrease) in fair value
|
|
|
15,864,850
|
|
|
|
(2,840,966
|
)
|
|
|
(1,724,319
|
)
|
|
|
(484,973
|
)
|
|
|
10,814,592
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair Value at December 31, 2011
|
|
|
114,673,506
|
|
|
|
48,438,317
|
|
|
|
6,040,895
|
|
|
|
40,814,000
|
|
|
|
209,966,718
|
|
Year to Date 2012 Activity:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Purchases / originations /draws
|
|
|
72,168,533
|
|
|
|
12,000,000
|
|
|
|
452,627
|
|
|
|
38,865,582
|
|
|
|
123,486,742
|
|
Pay-downs / pay-offs / sales
|
|
|
(45,248,621
|
)
|
|
|
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(45,248,621
|
)
|
Net accretion of interest
|
|
|
194,116
|
|
|
|
977,685
|
|
|
|
—
|
|
|
|
—
|
|
|
|
1,171,801
|
|
Net realized losses
|
|
|
(3,462,835
|
)
|
|
|
|
|
|
|
—
|
|
|
|
—
|
|
|
|
(3,462,835
|
)
|
Increase (decrease) in fair value
|
|
|
(2,846,934
|
)
|
|
|
6,368,445
|
|
|
|
418,214
|
|
|
|
(5,690,582
|
)
|
|
|
(1,750,857
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair Value at September 30, 2012
|
|
$
|
135,477,765
|
|
|
$
|
67,784,447
|
|
|
$
|
6,911,736
|
|
|
$
|
73,989,000
|
|
|
$
|
284,162,948
|
|
The level of investment activity for investments
funded and principal repayments for our investments can vary substantially from period to period depending on the number and size
of investments that we invest in or divest of, and many other factors, including the amount and competition for the debt and equity
securities available to middle market companies, the level of merger and acquisition activity for such companies and the general
economic environment.
RESULTS OF OPERATIONS
The principal measure of our financial performance
is the net increase (decrease) in net assets resulting from operations which includes net investment income (loss) and
net realized and unrealized appreciation (depreciation). Net investment income (loss) is the difference between our income from
interest, dividends, fees, and other investment income and our operating expenses. Net realized gain (loss) on investments,
is the difference between the proceeds received from dispositions of portfolio investments and their amortized cost. Net change
in unrealized appreciation (depreciation) on investments is the net change in the fair value of our investment portfolio.
Set forth below is a discussion of our
results of operations for the three and nine months ended September 30, 2012 and 2011.
Investment Income
Investment income is primarily dependent
on the composition and credit quality of our investment portfolio. Generally, our debt securities portfolio is expected to generate
predictable, recurring interest income in accordance with the contractual terms of each loan. Corporate equity securities may pay
a dividend and may increase in value for which a gain may be recognized; generally such dividend payments and gains are less predictable
than interest income on our loan portfolio.
Dividends from CLO Fund securities are
dependent on the performance of the underlying assets in each CLO Fund; interest payments, principal amortization and prepayments
of the underlying loans in each CLO Fund are primary factors which determine the level of income on our CLO Fund securities. The
level of excess spread from CLO Fund securities can be impacted by the timing and level of the resetting of the benchmark interest
rate for the underlying assets (which reset at various times throughout the quarter) in the CLO Fund and the related CLO Fund note
liabilities (which reset at each quarterly distribution date); in periods of short-term and volatile changes in the benchmark interest
rate, the levels of excess spread and distributions to us can vary significantly.
Investment income for the three months
ended September 30, 2012 and 2011 was approximately $10 million and $7 million, respectively. Of these amounts, approximately $4
million and $3 million was attributable to interest income on our loan and bond investments, respectively. For the three months
ended September 30, 2012 and 2011, approximately $6 million and $4 million of investment income is attributable to dividends earned
on CLO equity investments, respectively.
Investment income for the nine months ended
September 30, 2012 and 2011 was approximately $27 million and $21 million, respectively. Of these amounts, approximately $9 million
and $7 million was attributable to interest income on our loan and bond investments, respectively. For the nine months ended September
30, 2012 and 2011, approximately $15 million and $11 million of investment income is attributable to dividends earned on CLO equity
investments, respectively.
The increase in our interest income for
the three and nine months ended September 30, 2012 as compared to the three and nine months ended September 30, 2011 was primarily
attributable to a higher average level of outstanding debt securities.
The increase in investment income from
CLO Fund securities for the three and nine months ended September 30, 2012 as compared to the three and nine months ended September
30, 2011 was largely attributable to our acquisition of equity interests in CLO Funds managed by Trimaran Advisors in connection
with our acquisition of Trimaran Advisors in February 2012.
During the nine months ended September
30, 2011, we received a $2 million cash settlement to settle litigation previously initiated by us against the lenders related
to our secured credit facility which we fully repaid on January 31, 2011. Upon receipt, this settlement was recognized as other
income during the nine months ended September 30, 2011.
Dividends from Asset Manager Affiliates
Distributions of net income from our Asset
Manager Affiliates are recorded as “dividends from affiliate asset managers” in our financial statements. The Company
intends to distribute to its shareholders the accumulated undistributed net income of the Asset Manager Affiliates in the future.
For purposes of calculating distributable tax income for required quarterly dividends as a RIC, the Asset Manager Affiliates’
net income is further reduced by approximately $5.5 million per annum for tax goodwill amortization resulting from the acquisition
of Katonah Debt Advisors by us prior to our initial public offering and our recent acquisition of Trimaran Advisors. As a result,
the amount of our declared dividends, as evaluated by management and approved by our Board of Directors, is based on our evaluation
of both distributable income for tax purposes and GAAP net investment income (which excludes unrealized gains and losses).
As of September 30, 2012, our investment
in the Asset Manager Affiliates was valued at approximately $74 million. For the three months ended September 30, 2012 and 2011,
our Asset Manager Affiliates had EBITDA of approximately $2 million and $570,000, respectively. For the nine months ended September
30, 2012 and 2011, our Asset Manager Affiliates had pre-tax net income before net capital losses of approximately $2.9 million
and $1 million, respectively. For the three months ended September 30, 2012 and 2011, our Asset Manager Affiliates made distributions
of net income of $925,000 and $510,000, respectively. For the nine months ended September 30, 2012 and 2011, our Asset Manager
Affiliates made distributions of net income of $2,950,000 and $1,160,000, respectively. The distributions from our Asset Manager
Affiliates in 2012 represent a portion of the expected net income for our Asset Manager Affiliates for the year ending December
31, 2012.
The increase in distributions from our
Asset Manager Affiliates for the three and nine months ended September 30, 2012 as compared to the three and nine months ended
September 30, 2011 was largely attributable to our acquisition of Trimaran Advisors in February 2012.
Expenses
Total expenses for the three months ended
September 30, 2012 and 2011 were approximately $3 million and $3 million, respectively. Interest expense and amortization on debt
issuance costs for the period, which includes facility and program fees on the unused loan balance, were approximately $2 million
and $1 million, respectively, on average debt outstanding of $86 million and $60 million, respectively. Approximately $385,000
and $985,000, respectively, of expenses were attributable to employment compensation, including salaries, bonuses and stock option
expense for the three months ended September 30, 2012 and 2011. For the three months ended September 30, 2012, other expenses included
approximately $1 million for professional fees, insurance, administrative and other. For the three months ended September 30, 2011,
other expenses included approximately $797,000 for professional fees, insurance, administrative and other. For the three months
ended September 30, 2012 and 2011, administrative and other costs (including occupancy expense, insurance, technology and other
office expenses) totaled approximately $305,000 and $221,000, respectively.
Total expenses for the nine months ended
September 30, 2012 and 2011 were approximately $10 million and $9 million, respectively. Interest expense and amortization on debt
issuance costs for the period, which includes facility and program fees on the unused loan balance, were approximately $5 million
and $3 million, respectively, on average debt outstanding of $74 million and $52 million, respectively. Approximately $2 million
and $3 million, respectively, of expenses were attributable to employment compensation, including salaries, bonuses and stock option
expense for the nine months ended September 30, 2012 and 2011. For the nine months ended September 30, 2012, other expenses included
approximately $3 million for professional fees, insurance, administrative and other. For the nine months ended September 30, 2011,
other expenses included approximately $3 million for professional fees, insurance, administrative and other. For the nine months
ended September 30, 2012 and 2011, administrative and other costs (including occupancy expense, insurance, technology and other
office expenses) totaled approximately $1 million and $751,000, respectively.
Interest and compensation expense are generally
expected to be our largest expenses each period. Interest expense is dependent on the average outstanding principal balance on
our borrowings and the related interest rate for the period. Compensation expense includes base salaries, bonuses, stock compensation,
employee benefits and employer related payroll costs. The largest components of total compensation costs are base salaries and
bonuses; generally, base salaries are expensed as incurred and bonus expenses are estimated and accrued since bonuses are generally
paid annually.
Professional fee expenses for the nine months
ended September 30, 2012 are higher by approximately $360,000 relative to the same prior year period primarily due to an increase
in professional fees related to additional legal, accounting, and valuation costs connected to our acquisition of Trimaran Advisors.
Net Unrealized (Depreciation) Appreciation on Investments
During the three months ended September
30, 2012, our total investments had a increase in net unrealized appreciation of approximately $6.0 million. During the three months
ended September 30, 2011, our total investments had an increase in net unrealized depreciation of approximately $5.7 million. For
the three months ended September 30, 2012, our Asset Manager Affiliates had an increase in net unrealized appreciation of approximately
$1.3 million. For the three months ended September 30, 2011, our Asset Manager Affiliates had an increase in net unrealized appreciation
of approximately $470,000. For the three months ended September 30, 2012, our middle market portfolio of debt securities, equity
securities, and CLO Fund securities had a net increase in unrealized appreciation due to fair value adjustments of approximately
$4.7 million. For the three months ended September 30, 2011, our middle market portfolio of debt securities, equity securities,
and CLO Fund securities had a net increase in unrealized depreciation due to fair value adjustments of approximately $6.1 million.
During the nine months ended September
30, 2012, our total investments had an increase in net unrealized depreciation of approximately $1.7 million. During the nine months
ended September 30, 2011, our total investments had an increase in net unrealized appreciation of approximately $10.9 million.
For the nine months ended September 30, 2012, our Asset Manager Affiliates had an increase in net unrealized depreciation of approximately
$5.7 million. For the nine months ended September 30, 2011, our Asset Manager Affiliates had an increase in net unrealized appreciation
of approximately $1.3 million. For the nine months ended September 30, 2012, our middle market portfolio of debt securities, equity
securities, and CLO Fund securities had a net increase in unrealized appreciation due to fair value adjustments of approximately
$4.0 million. For the nine months ended September 30, 2011, our middle market portfolio of debt securities, equity securities,
and CLO Fund securities had a net increase in unrealized appreciation due to fair value adjustments of approximately $9.6 million.
Net Increase (Decrease) in Net Assets Resulting From Operations
For the three and nine months ended September
30, 2012 the net change in net assets resulting from operations was an approximate increase of $9 million and $12 million, or $0.35
and $0.45 per share, respectively. The net change in net assets resulting from operations for the three and nine months ended September
30, 2011 was an approximate decrease of $1 million, or $0.06 per share, and an approximate increase of $9 million, or $0.39 per
share, respectively.
FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES
Liquidity is a measure of our ability to
meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, pay dividends
to our stockholders and other general business needs. We recognize the need to have funds available for operating our business
and to make investments. We seek to have adequate liquidity at all times to cover normal cyclical swings in funding availability
and to allow us to meet abnormal and unexpected funding requirements. We plan to satisfy our liquidity needs through normal operations
with the goal of avoiding unplanned sales of assets or emergency borrowing of funds.
As of September 30, 2012 and December 31,
2011 the fair value of investments and cash were as follows:
|
|
Investments at Fair Value
|
|
|
|
September 30, 2012
|
|
|
December 31, 2011
|
|
Security Type
|
|
(unaudited)
|
|
|
|
|
|
|
|
|
|
|
|
Cash
|
|
$
|
2,413,104
|
|
|
$
|
2,555,259
|
|
Time Deposits
|
|
|
501,475
|
|
|
|
229,152
|
|
Money Market Accounts
|
|
|
4,850,220
|
|
|
|
31,622,134
|
|
Senior Secured Loan
|
|
|
65,868,804
|
|
|
|
45,259,328
|
|
Junior Secured Loan
|
|
|
37,237,835
|
|
|
|
47,300,172
|
|
Mezzanine Investment
|
|
|
9,401,536
|
|
|
|
11,588,115
|
|
Senior Subordinated Bond
|
|
|
22,577,830
|
|
|
|
10,125,891
|
|
CLO Fund Securities
|
|
|
67,784,447
|
|
|
|
48,438,317
|
|
Equity Securities
|
|
|
6,911,736
|
|
|
|
6,040,895
|
|
Preferred
|
|
|
391,760
|
|
|
|
400,000
|
|
Affiliate Asset Managers
|
|
|
73,989,000
|
|
|
|
40,814,000
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
291,927,747
|
|
|
$
|
244,373,263
|
|
We use borrowed funds, known as “leverage,”
to make investments and to attempt to increase returns to our shareholders by reducing our overall cost of capital. As a BDC, we
are limited in the amount of leverage we can incur under the 1940 Act. We are only allowed to borrow amounts such that our asset
coverage, as defined in the 1940 Act, equals at least 200% immediately after such borrowing. As of September 30, 2012, we had approximately
$88 million of outstanding borrowings and our asset coverage ratio of total assets to total borrowings was 335%, compliant with
the minimum asset coverage level of 200% generally required for a BDC by the 1940 Act. We may also borrow amounts of up to 5% of
the value of our total assets for temporary purposes.
At December 31, 2010, we had approximately
$87 million of outstanding indebtedness through a secured credit facility. On January 31, 2011, we repaid in full the outstanding
balance under this facility and terminated this facility. On March 16, 2011, we issued $55 million in aggregate principal amount
of unsecured 8.75% convertible senior notes due March 15, 2016 (“Convertible Senior Notes”). On March 23, 2011, pursuant
to an over-allotment option, we issued an additional $5 million of such Convertible Senior Notes for a total of $60 million in
aggregate principal amount.
On February 24, 2012, we entered into a
Note Purchase Agreement with Credit Suisse AG, Cayman Islands Branch (“CS”), Credit Suisse Securities (USA) LLC, as
arranger, The Bank of New York Mellon Trust Company, National Association, as collateral administrator and collateral agent, and
KCAP Funding, a special-purpose bankruptcy remote wholly-owned subsidiary of the Company, under which we may obtain up to $30 million
in financing (the “Facility”). The scheduled maturity date for the Facility is December 20, 2014. Interest on the Facility
is LIBOR + 300 basis points and payable quarterly.
Advances under the Facility are used by
us primarily to make additional investments. The Facility is secured by loans that it currently owns and a security interest in
our right to receive certain management fees. Our borrowings under the Facility are effected through KCAP Funding.
As of September 30, 2012, there was an
outstanding balance of $28,000,000 under the Facility and we are in compliance with all its debt covenants. As of September 30,
2012, we had restricted cash balances of approximately $6.1 million which we maintained in accordance with the terms of the Facility.
As of September 30, 2012, we had total
outstanding indebtedness of approximately $88 million. As of September 30, 2012, we had cash, time deposits, and money market accounts
of approximately $5 million which will fund future investments and operational needs.
Subject to prevailing market conditions,
we intend to grow our portfolio of assets by raising additional capital, including through the prudent use of leverage available
to us. As a result, we may seek to enter into new agreements with other lenders or into other financing arrangements as market
conditions permit. Such financing arrangements may include a new secured and/or unsecured credit facility, the issuance of preferred
securities or debt guaranteed by the Small Business Administration.
If our common stock trades below our net
asset value per share, we will generally not be able to issue additional common stock at the market price unless our shareholders
approve such a sale and our Board of Directors makes certain determinations. A proposal, approved by our shareholders at our June
2012 annual meeting of stockholders, authorizes us to sell shares of our common stock below the then current net asset value per
share of our common stock in one or more offerings for the period ending on the earlier of (i) June 15, 2013, the one year anniversary
of our 2012 annual meeting of shareholders, or (ii) the date of our 2013 annual meeting of shareholders. We would need similar
future approval from our shareholders to issue shares below the then current net asset value per share any time after the expiration
of the current approval.
COMMITMENTS AND OFF-BALANCE SHEET ARRANGEMENTS
We are a party to financial instruments
with off-balance sheet risk in the normal course of business in order to meet the needs of our investment in portfolio companies.
Such instruments include commitments to extend credit and may involve, in varying degrees, elements of credit risk in excess of
amounts recognized on our balance sheet. Prior to extending such credit, we attempt to limit our credit risk by conducting extensive
due diligence, obtaining collateral where necessary and negotiating appropriate financial covenants. As of September 30, 2012 and
December 31, 2011, we had committed to make a total of approximately $0 and $2 million, respectively, of investments.
CRITICAL ACCOUNTING POLICIES
The financial statements are based on the
selection and application of critical accounting policies, which require management to make significant estimates and assumptions.
Critical accounting policies are those that are both important to the presentation of our financial condition and results of operations
and require management’s most difficult, complex, or subjective judgments. Our critical accounting policies are those applicable
to the basis of presentation, valuation of investments, and certain revenue recognition matters as discussed below.
Basis of Presentation
The accompanying unaudited financial statements
have been prepared on the accrual basis of accounting in conformity with GAAP for interim financial information. Accordingly, they
do not include all of the information and footnotes required for annual financial statements. The unaudited interim financial statements
and notes thereto should be read in conjunction with the financial statements and notes thereto in the Company’s Form 10-K
for the fiscal year ended December 31, 2011, as filed with the Commission.
Valuation of Portfolio Investments
The most significant estimate inherent in
the preparation of our financial statements is the valuation of investments and the related amounts of unrealized appreciation
and depreciation of investments recorded.
Value, as defined in Section 2(a)(41)
of 1940 Act, is (1) the market price for those securities for which a market quotation is readily available and (2) for
all other securities and assets, fair value as determined in good faith by our Board of Directors pursuant to procedures approved
by our Board of Directors. Our valuation policy is intended to provide a consistent basis for determining the fair value of the
portfolio based on the nature of the security, the market for the security and other considerations including the financial performance
and enterprise value of the portfolio company. Because of the inherent uncertainty of valuation, the Board of Directors’
determined values may differ significantly from the values that would have been used had a ready market existed for the investments,
and the differences could be material.
We are, for GAAP purposes, an investment
company under the AICPA Audit and Accounting Guide for Investment Companies. As a result, we reflect our investments on our balance
sheet at their estimated fair value with unrealized gains and losses resulting from changes in fair value reflected as a component
of unrealized gains or losses on our statements of operations. Fair value is the amount that would be received to sell the investments
in an orderly transaction between market participants at the measurement date (i.e., the exit price). Additionally, we do not consolidate
majority or wholly-owned and controlled investments.
Effective January 1, 2008 we adopted
Fair Value Measurements and Disclosures
, which among other things, requires enhanced disclosures about financial instruments
carried at fair value. See Note 4 to the financial statements for the additional information about the level of market observability
associated with investments carried at fair value.
We have valued our investments, in the absence
of observable market prices, using the valuation methodologies described below applied on a consistent basis. For some investments
little market activity may exist; management’s determination of fair value is then based on the best information available
in the circumstances, and may incorporate management’s own assumptions and involves a significant degree of management’s
judgment.
Our investments in CLO Fund securities
are carried at fair value, which is based either on (i) the present value of the net expected cash inflows for interest income
and principal repayments from underlying assets and the cash outflows for interest expense, debt paydown and other fund costs for
the CLO Funds which are approaching or past the end of their reinvestment period and therefore begin to sell assets and/or use
principal repayments to pay-down CLO Fund debt, and for which there continue to be net cash distributions to the class of we securities
own, or (ii) a discounted cash flow model that utilizes prepayment and loss assumptions based on historical experience and
projected performance, economic factors, the characteristics of the underlying cash flow and comparable yields for similar securities
or preferred shares to those in which the Company has invested. We recognize unrealized appreciation or depreciation on our investments
in CLO Fund securities as comparable yields in the market change and/or based on changes in net asset values or estimated cash
flows resulting from changes in prepayment or loss assumptions in the underlying collateral pool. As each investment in CLO Fund
securities ages, the expected amount of losses and the expected timing of recognition of such losses in the underlying collateral
pool are updated and the revised cash flows are used in determining the fair value of the CLO Investment. We determine the fair
value of our investments in CLO Fund securities on a security-by-security basis.
Our investment in our Asset Manager Affiliates
is carried at fair value, which is determined after taking into consideration a percentage of assets under management and a discounted
cash flow model incorporating different levels of discount rates depending on the hierarchy of fees earned (including the likelihood
of realization of senior, subordinate and incentive fees) and prospective modeled performance. Such valuation includes an analysis
of comparable asset management companies. Our investment in our Asset Manager Affiliates is classified as a Level III investment
(as described below). Any change in value from period to period is recognized as net change in unrealized appreciation or depreciation.
Fair values of other investments for which
market prices are not observable are determined by reference to public market or private transactions or valuations for comparable
companies or assets in the relevant asset class and or industry when such amounts are available. Generally these valuations are
derived by multiplying a key performance metric of the investee company or asset (e.g., EBITDA) by the relevant valuation multiple
observed for comparable companies or transactions, adjusted by management for differences between the investment and the referenced
comparable. Such investments may also be valued at cost for a period of time after an acquisition as the best indicator of fair
value. If the fair value of such investments cannot be valued by reference to observable valuation measures for comparable companies,
then the primary analytical method used to estimate the fair value is a discounted cash flow method and/or cap rate analysis. A
sensitivity analysis is applied to the estimated future cash flows using various factors depending on the investment, including
assumed growth rates (in cash flows), capitalization rates (for determining terminal values) and appropriate discount rates to
determine a range of reasonable values or to compute projected return on investment.
We derive fair value for our illiquid loan
investments that do not have indicative fair values based upon active trades primarily by using the Market Yield Approach, and
also consider recent loan amendments or other activity specific to the subject asset as described above. Other significant assumptions,
such as coupon and maturity, are asset-specific and are noted for each investment in the Schedules of Investments. Our Board of
Directors may consider other methods of valuation to determine the fair value of investments as appropriate in conformity with
GAAP.
The determination of fair value using this
methodology takes into consideration a range of factors, including but not limited to the price at which the investment was acquired,
the nature of the investment, local market conditions, trading values on public exchanges for comparable securities, current and
projected operating performance and financing transactions subsequent to the acquisition of the investment. This valuation methodology
involves a significant degree of management’s judgment.
After our adoption of
Fair Value Measurements
and Disclosures,
investments measured and reported at fair value are classified and disclosed in one of the following categories:
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Level I – Unadjusted quoted prices are available in active markets for identical investments as of the reporting date.
The type of investments included in Level I include listed equities and listed securities. As required by
Fair Value Measurements
and Disclosures
, the Company does not adjust the quoted price for these investments, even in situations where the Company holds
a large position and a sale could reasonably affect the quoted price.
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Level II – Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable
as of the reporting date. Such inputs may be quoted prices for similar assets or liabilities, quoted markets that are not active,
or other inputs that are observable or can be corroborated by observable market data for substantially the full character of the
financial instrument, or inputs that are derived principally from, or corroborated by, observable market information. Investments
which are generally included in this category include illiquid corporate loans and bonds and less liquid, privately held or restricted
equity securities for which some level of recent trading activity has been observed.
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Level III – Pricing inputs are unobservable for the investment and includes situations where there is little, if any,
market activity for the investment. The inputs may be based on the Company’s own assumptions about how market participants
would price the asset or liability or may use Level II inputs, as adjusted, to reflect specific investment attributes relative
to a broader market assumption. These inputs into the determination of fair value may require significant management judgment or
estimation. Even if observable market data for comparable performance or valuation measures (earnings multiples, discount rates,
other financial/valuation ratios, etc.) are available, such investments are grouped as Level III if any significant data point
that is not also market observable (private company earnings, cash flows, etc.) is used in the valuation methodology.
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In certain cases, the inputs used to measure
fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair
value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the
significance of a particular input to the fair value measurement in its entirety requires judgment, and it considers factors specific
to the investment. Substantially all of our investments are classified as Level III.
Our Board of Directors may consider other
methods of valuation to determine the fair value of investments as appropriate in conformity with GAAP.
Interest Income
Interest income, adjusted for amortization
of premium and accretion of discount, is recorded on the accrual basis to the extent that such amounts are expected to be collected.
We generally place a loan on non-accrual status and cease recognizing interest income on such loan or security when a loan or security
becomes 90 days or more past due or if we otherwise do not expect the debtor to be able to service its debt obligations. Non-accrual
loans remain in such status until the borrower has demonstrated the ability and intent to pay contractual amounts due or such loans
become current. As of September 30, 2012, five issuers representing less than 1% of our total investments at fair value were on
non-accrual status. As of December 31, 2011, three issuers representing less than 1% of our total investments at fair value were
on non-accrual status.
Dividend Income from CLO Fund Securities
We generate dividend income from our investments
in the most junior class of securities of CLO Funds (typically preferred shares or subordinated securities) managed by the Asset
Manager Affiliates and selective investments in securities issued by funds managed by other asset management companies using the
effective interest method based on anticipated yield and estimated cash flows as updated quarterly for changes in prepayments,
re-investment, credit losses and other items that may impact distributions. Our CLO Fund junior class securities are subordinated
to senior note holders who typically receive a return on their investment at a fixed spread relative to the LIBOR index. The CLO
Funds are leveraged funds and any excess cash flow or “excess spread” (interest earned by the underlying securities
in the fund less payments made to senior note holders and less fund expenses and management fees) is paid to the holders of the
CLO Fund’s subordinated securities or preferred shares. The level of excess spread from CLO Fund securities can be impacted
from the timing and level of the resetting of the benchmark interest rate for the underlying assets (which reset at various times
throughout the quarter) in the CLO Fund and the related CLO Fund note liabilities (which reset at each quarterly distribution date);
in periods of short-term and volatile changes in the benchmark interest rate, the levels of excess spread and distributions to
us can vary significantly. In addition, the failure of CLO Funds in which we invest to comply with certain financial covenants
may lead to the temporary suspension or deferral of cash distributions to us. We make estimated interim accruals of such dividend
income based on recent historical distributions and CLO Fund performance and adjust such accruals on a quarterly basis to reflect
actual distributions.
For non-junior class CLO Fund securities,
such as our investment in the class B-2L notes of Katonah 2007-1 CLO, interest is earned at a fixed spread relative to the LIBOR
index.
Dividends from Asset Manager Affiliates
We record dividend income from our Asset
Manager Affiliates on the declaration date, which represents the ex-dividend date.
Payment in Kind Interest
We may have loans in our portfolio that contain
a payment-in-kind (“PIK”) provision. 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 our RIC status, this non-cash source
of income must be paid out to stockholders in the form of dividends, even though we have not yet collected the cash.
Fee Income
Fee income includes fees, if any, for due
diligence, structuring, commitment and facility fees, and fees, if any, for transaction services and management services rendered
by us to portfolio companies and other third parties. Commitment and facility fees are generally recognized as income over the
life of the underlying loan, whereas due diligence, structuring, transaction service and management service fees are generally
recognized as income when the services are rendered.
Management Compensation
We may, from time to time, issue stock
options or restricted stock under our equity compensation plan to officers and employees for services rendered to us. We follow
Compensation – Stock Compensation
, a method by which the fair value of options or restricted stock is determined and
expensed. We use a Binary Option Pricing Model (American, call option) as its valuation model to establish the expected value of
all stock option grants.
We are internally managed and therefore do
not incur management fees payable to third parties.
United States Federal Income Taxes
The Company has elected and intends to continue
to qualify for the tax treatment applicable to RICs under Subchapter M of the Code and, among other things, intends to make the
required distributions to its stockholders as specified therein. In order to qualify as a RIC, the Company is required to timely
distribute to its stockholders at least 90% of investment company taxable income, as defined by the Code, for each year. Depending
on the level of taxable income earned in a tax year, we may choose to carry forward taxable income in excess of current year distributions
into the next tax year and pay a 4% excise tax on such income, to the extent required.
Dividends
Dividends and distributions to common stockholders
are recorded on the ex-dividend date. The amount to be paid out as a dividend is determined by the Board of Directors each quarter
and is generally based upon the earnings estimated by management for the period and year.
We have adopted a dividend reinvestment plan
that provides for reinvestment of our distributions on behalf of our stockholders, unless a stockholder “opts out”
of the plan to receive cash in lieu of having their cash dividends automatically reinvested in additional shares of our common
stock.
Recent Accounting Pronouncements
Improved Disclosures Regarding Fair Value
Measurements.
In January 2010, the FASB issued Accounting Standards Update No. 2010-06,
Fair
Value Measurements and Improving Disclosures About Fair Value Measurements (Topic 820),
which provides for improving disclosures
about fair value measurements, primarily significant transfers in and out of Levels I and II, and activity in Level III fair value
measurements. The new disclosures and clarifications of existing disclosures are effective for the interim and annual reporting
periods beginning after December 15, 2009, while the disclosures about the purchases, sales, issuances, and settlements in
the roll forward activity in Level 3 fair value measurements are effective for fiscal years beginning after December 15, 2010
and for the interim periods within those fiscal years. Except for certain detailed Level III disclosures, which are effective for
fiscal years beginning after December 15, 2010 and interim periods within those years, the new guidance became effective for
the Company’s fiscal 2010 second quarter. The adoption of this disclosure-only guidance is included in Note 4 “—Investments”
and did not have a material impact on the Company’s financial results.
In May 2011, the FASB issued FASB Accounting
Standards Update (“ASU”) 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement
and Disclosure Requirements in GAAP and IFRS. The amendments in this ASU generally represent clarifications of Topic 820, but also
include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair
value measurements has changed. This ASU results in common principles and requirements for measuring fair value and for disclosing
information about fair value measurements in accordance with GAAP and IFRS. The amendments in this ASU are to be applied prospectively
and are effective during interim and annual periods beginning after December 15, 2011. Management currently believes that the adoption
of this ASU will not have a material impact on the Company’s operating results, financial position or cash flows.