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AMERICAN CAPITAL, LTD 10-K 2005
FORM 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

  x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2004

OR

 

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

 

Commission file number 814-00149

 

AMERICAN CAPITAL STRATEGIES, LTD.

 

Delaware   52-1451377
(State or Other Jurisdiction of
Incorporation or Organization)
  (I.R.S. Employer
Identification No.)

 

2 Bethesda Metro Center

14th Floor

Bethesda, Maryland 20814

(Address of principal executive offices)

 

(301) 951-6122

(Registrant’s telephone number, including area code)

 

Securities to be registered pursuant to Section 12(b) of the Act: Not Applicable

 

Securities registered pursuant to section 12(g) of the Act:

 

Title of each class   Name of each exchange
on which registered
Common Stock, $0.01 par value per share   NASDAQ Stock Market

 

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter earlier period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes þ.        No ¨.

 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes þ.        No ¨.

 

As of June 30, 2004, the aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant was approximately $2,106,205,090 based upon a closing price of the Registrant’s common stock of $28.02 per share as reported on the NASDAQ Stock Market on that date. (For this computation, the registrant has excluded the market value of all shares of its common stock reported as beneficially owned by executive officers and directors of the registrant and certain other stockholders; such an exclusion shall not be deemed to constitute an admission that any such person is an “affiliate” of the registrant.)

 

As of February 25, 2005, there were 90,187,152 shares of the Registrant’s common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE. The Registrant’s definitive proxy statement for the 2005 Annual Meeting of Stockholders is incorporated by reference into certain sections of Part III herein.

 

Certain exhibits previously filed with the Securities and Exchange Commission are incorporated by reference into Part IV of this report.

 



PART I

 

Item 1. Business

 

General

 

American Capital Strategies, Ltd. (which is referred throughout this report as “American Capital”, “we” and “us”) is a publicly traded buyout and mezzanine fund that provides investment capital to middle market companies, which we generally consider to be companies with sales between $10 million and $750 million. We invest in senior and mezzanine (subordinated) debt and equity of companies in need of capital for buyouts, growth, acquisitions and recapitalizations. Our ability to fund the entire capital structure is an advantage in completing many middle market transactions. Our wholly-owned operating subsidiary, American Capital Financial Services, Inc., or ACFS, provides financial advisory services to our portfolio companies. We invested on average $38 million in 2004 in each new portfolio company. We generally have not invested more than 5% of our equity capital in one transaction. Our largest investment as of December 31, 2004 has been $83 million. ACFS arranges and secures capital for large transactions, particularly buyouts that we sponsor.

 

Our primary business objectives are to increase our taxable income, net operating income and net asset value by investing in senior debt, subordinated debt and equity of middle market companies with attractive current yields and potential for equity appreciation and realized gains. We are an investor in and sponsor of management and employee buyouts, invest in private equity sponsored buyouts, and provide capital directly to private and small public companies. Historically, a majority of our financings have been to assist in the funding of change of control management buyouts, and we expect that trend to continue. Capital that we provide directly to private and small public companies is used for growth, acquisitions or recapitalizations.

 

We are a Delaware corporation, which was incorporated in 1986. On August 29, 1997, we completed an initial public offering, or IPO, of our common stock and became a non-diversified, closed end investment company, which has elected to be regulated as a business development company, or BDC, under the Investment Company Act of 1940, as amended. On October 1, 1997, we began operations so as to qualify to be taxed as a regulated investment company, or RIC, as defined in Subtitle A, Chapter 1, under Subchapter M of the Internal Revenue Code of 1986, as amended. As a regulated investment company, we are not subject to federal income tax on the portion of our taxable income and capital gains we distribute to our stockholders.

 

Our loans typically range from $5 million to $75 million, mature in five to ten years, and require monthly or quarterly interest payments at fixed rates or variable rates based on the prime or LIBOR rate, plus a margin. We price our debt and equity investments based on our analysis of each transaction. As of December 31, 2004, the weighted average effective interest rate on our debt securities was 12.9%. From our IPO in 1997, through December 31, 2004, we invested over $800 million in equity securities and over $3.8 billion in debt securities of middle market companies, including $141 million in funds committed but undrawn under credit facilities. We are prepared to be a long-term partner with our portfolio companies, thereby positioning us to participate in their future financing needs. As of December 31, 2004, we have invested $930 million in follow-on investments to fund growth, acquisitions or working capital.

 

We generally acquire equity interests in the companies from which we have purchased debt securities with the goal of enhancing our overall return. As of December 31, 2004, we had a fully-diluted weighted average ownership interest of 45% in our portfolio companies. In most cases, we receive rights to require the portfolio company to purchase the warrants and stock held by us, known as put rights, under various circumstances including, typically, the repayment of our loans or debt securities. We may use our put rights to dispose of our equity interest in a business, although our ability to exercise our put rights may be limited or nonexistent if a business is illiquid. In most cases where we invest equity, we receive the right to representation on our portfolio company’s board of directors.

 

The debt structures of our portfolio companies generally provide for scheduled amortization of senior debt, including our senior debt investments, which also helps improve our subordinated debt investments within the

 

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portfolio company’s capital structure. The opportunity to liquidate our investments may occur if a portfolio company refinances our loans, is sold in a change of control transaction or sells its equity in a public offering or if we exercise our put rights. We generally do not have the right to require that a portfolio company undergo an initial public offering by registering securities under the Securities Act of 1933, as amended, but we generally do have the right to sell our equity interests in a public offering by a portfolio company to the extent permitted by the underwriters.

 

Since our IPO in 1997, through December 31, 2004, we have realized $129 million in gross realized gains and $134 million in gross realized losses resulting in $5 million in cumulative net losses, excluding net losses attributable to periodic interest settlements of interest rate swap agreements. We have had 87 exits and prepayments, or over $1.3 billion of our originally invested capital, representing 29% of our total capital invested since our IPO, earning a 16% compounded annual return on these investments from the interest, dividends and fees over the life of the investments.

 

We make available significant managerial assistance to our portfolio companies. Such assistance typically involves closely monitoring its operations, advising the portfolio company’s board on matters such as the business plan and the hiring and termination of senior management, providing financial guidance and participating on the portfolio company’s board of directors. As of December 31, 2004, we had board seats at 78 out of 117 portfolio companies and had board observation rights on 30 of our remaining portfolio companies. We also have an operations team, including ex-CEOs with significant turnaround and bankruptcy experience, that provides intensive operational and managerial assistance. Providing assistance to our portfolio companies serves as an opportunity for us to maximize their value.

 

We have established an extensive referral network comprised of investment bankers, private equity and mezzanine funds, commercial bankers and business and financial brokers. We have a marketing department dedicated to maintaining contact with members of the referral network and receiving opportunities for us to consider. Our marketing department has developed an extensive proprietary database of reported middle market transactions. Based on the data we have gathered, we believe that our market is highly fragmented and we are the leader in the market with a 5% market share. According to our data, the next closet competitor had a 3% market share and the second closest competitor had less than a 2% market share. More than two hundred firms did not close a transaction during 2004 and approximately 46% of the transactions were closed by firms that only completed one or two transactions during 2004. Our marketing department and our various offices received information concerning several thousand transactions for consideration. Most of those transactions did not meet our criteria for initial consideration, but the opportunities that met those criteria were directed to our principals for further review and consideration. We have also developed an internet website that provides businesses an efficient tool for learning about American Capital and our capabilities.

 

Corporate Information

 

Our executive offices are located at 2 Bethesda Metro Center, 14th Floor, Bethesda, Maryland 20814 and our telephone number is (301) 951-6122. In addition to our executive offices, we maintain offices in New York, San Francisco, Los Angeles, Philadelphia, Chicago and Dallas.

 

Our corporate website is located at www.AmericanCapital.com. We make available free of charge on our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.

 

Lending and Investment Decision Criteria

 

We review certain criteria in order to make investment decisions. The list below represents a general overview of the criteria we use in making our lending and investment decisions. Not all criteria are required to be

 

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favorable in order for us to make an investment. Follow-on investments for growth, acquisitions or recapitalizations are based on the same general criteria. Follow-on investments in distress situations are based on the same general criteria but are also evaluated on the potential to preserve prior investments.

 

Operating History. We generally focus on companies that have been in business over 10 years and have an attractive operating history, including generating positive cash flow. We generally target companies with significant market share in their products or services relative to their competitors. In addition, we consider factors such as customer concentration, performance during recessionary periods, competitive environment and ability to sustain margins. As of December 31, 2004, our current portfolio companies had an average age of 35 years with 2004 average sales of $89 million and 2004 average adjusted earnings before interest, taxes, depreciation and amortization, or EBITDA, of $16 million.

 

Growth. We consider a target company’s ability to increase its cash flow. Anticipated growth is a key factor in determining the value ascribed to any warrants and equity interests acquired by us.

 

Liquidation Value of Assets. Although we do not operate as an asset-based lender, liquidation value of the assets collateralizing our loans is a factor in many credit decisions. Emphasis is placed both on tangible assets such as accounts receivable, inventory, plant, property and equipment as well as intangible assets such as brand recognition, market reputation, customer lists, networks, databases and recurring revenue streams.

 

Experienced Management Team. We consider the quality of senior management to be extremely important to the long-term performance of most companies. Therefore, we consider it important that senior management be experienced and properly incentivized through meaningful ownership interest in the company.

 

Exit Strategy. Most of our investments consist of securities acquired directly from their issuers in private transactions. Generally, there are not public markets on which these securities are traded, thus limiting their liquidity. Therefore, we consider it important that a prospective portfolio company have at least one or several methods in which our financing can be repaid and our equity interest purchased. These methods would typically include the sale or refinancing of the business or the ability to generate sufficient cash flow to repurchase our equity securities and repay our debt securities.

 

Investment Portfolio

 

We generally invest in domestic, privately-held middle market companies; however, we also invest in portfolio companies that have securities registered under the Securities Act of 1933, as amended, or in securities of foreign issuers. Also, an existing portfolio company may undergo a public offering and register its securities under the Securities Act of 1933, as amended, subsequent to our initial investment. Our investments in middle market companies are generally in senior and subordinated debt and in preferred and common equity securities. We also invest on a limited basis, through a controlled portfolio company, in unrated bonds and equity traunches of collateralized debt obligations, or CDO’s. We also maintain a diversified investment portfolio, investing in a broad range of industries. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Critical Accounting Policies” for a discussion on how we determine the fair value of our investments.

 

 

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Summaries of our portfolio of securities by investment type as of December 31, 2004 and 2003 at cost and fair value are shown in the following table:

 

     December 31, 2004

   December 31, 2003

COST

         

Senior debt

   25.9%    20.9%

Subordinated debt

   47.7%    54.3%

Preferred equity

   12.4%    12.2%

Equity warrants

   5.8%    7.0%

Common equity

   8.2%    5.6%
     December 31, 2004

   December 31, 2003

FAIR VALUE

         

Senior debt

   26.3%    21.5%

Subordinated debt

   45.5%    54.7%

Preferred equity

   9.4%    7.2%

Equity warrants

   8.5%    10.3%

Common equity

   10.3%    6.3%

 

We use the Global Industry Classification Standards for classifying the industry groupings of our portfolio companies. The following table shows the portfolio composition by industry grouping at cost and at fair value:

 

     December 31, 2004

   December 31, 2003

COST

         

Commercial Services & Supplies

   14.3%    10.0%

Food Products

   8.3%    10.2%

Electrical Equipment

   7.0%    0.6%

Building Products

   6.9%    8.8%

Auto Components

   6.1%    2.9%

Healthcare Equipment & Supplies

   6.0%    3.4%

Machinery

   5.5%    10.9%

Leisure Equipment & Products

   5.1%    5.2%

Household Durables

   4.6%    3.8%

Chemicals

   3.9%    3.3%

Construction & Engineering

   3.7%    3.2%

Road & Rail

   3.6%    6.0%

Textiles, Apparel & Luxury Goods

   3.5%    3.9%

Electronic Equipment & Instruments

   2.9%    2.8%

Healthcare Providers & Services

   2.9%    2.2%

Household Products

   2.6%    2.0%

Aerospace & Defense

   2.1%    4.3%

Construction Materials

   2.1%    1.7%

Diversified Financial Services

   1.7%    3.5%

Personal Products

   1.4%    2.2%

Distributors

   1.4%    1.6%

IT Services

   1.1%    2.4%

Containers & Packaging

   0.9%    1.2%

Computers & Peripherals

   0.8%    1.3%

Pharmaceuticals & Biotechnology

   0.7%    0.0%

Specialty Retail

   0.5%    0.6%

Metals & Mining

   0.0%    0.8%

Media

   0.0%    0.6%

Other

   0.4%    0.6%

 

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     December 31, 2004

    December 31, 2003

 

FAIR VALUE

            

Commercial Services & Supplies

   16.6 %   12.7 %

Food Products

   8.0 %   10.8 %

Auto Components

   7.0 %   3.8 %

Electrical Equipment

   6.9 %   0.6 %

Healthcare Equipment & Supplies

   6.2 %   3.5 %

Household Durables

   5.5 %   4.1 %

Building Products

   5.1 %   6.8 %

Leisure Equipment & Products

   4.8 %   4.8 %

Chemicals

   4.3 %   2.8 %

Machinery

   3.6 %   7.2 %

Construction & Engineering

   3.6 %   3.1 %

Textiles, Apparel & Luxury Goods

   3.5 %   4.2 %

Electronic Equipment & Instruments

   3.4 %   3.1 %

Road & Rail

   2.9 %   5.9 %

Healthcare Providers & Services

   2.6 %   1.7 %

Household Products

   2.6 %   2.1 %

Aerospace & Defense

   2.3 %   5.2 %

Construction Materials

   2.3 %   2.0 %

Diversified Financial Services

   1.7 %   3.7 %

Distributors

   1.3 %   1.6 %

IT Services

   1.2 %   3.0 %

Computers & Peripherals

   1.0 %   1.5 %

Personal Products

   1.0 %   2.3 %

Containers & Packaging

   0.8 %   1.2 %

Pharmaceuticals & Biotechnology

   0.7 %   0.0 %

Specialty Retail

   0.6 %   0.9 %

Beverages

   0.3 %   0.5 %

Media

   0.1 %   0.7 %

Other

   0.1 %   0.2 %

 

The following table shows our portfolio composition by geographic location at cost and at fair value. The geographic composition is determined by the location of the corporate headquarters of the portfolio company.

 

     December 31, 2004

    December 31, 2003

 

COST

            

Mid-Atlantic

   20.3 %   18.1 %

Southwest

   28.2 %   23.0 %

Southeast

   14.2 %   17.4 %

North-Central

   12.8 %   16.5 %

South-Central

   9.6 %   10.7 %

Northwest

   0.9 %   0.0 %

Northeast

   9.2 %   10.1 %

Foreign

   4.8 %   4.2 %
     December 31, 2004

    December 31, 2003

 

FAIR VALUE

            

Mid-Atlantic

   21.8 %   19.0 %

Southwest

   28.4 %   24.0 %

Southeast

   14.5 %   18.9 %

North-Central

   13.5 %   15.9 %

South-Central

   7.8 %   9.7 %

Northwest

   0.9 %   0.0 %

Northeast

   8.6 %   10.1 %

Foreign

   4.5 %   2.4 %

 

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The following table summarizes our unrealized appreciation, depreciation, gains and losses on our investments for the year ended December 31, 2004 and for the period from our IPO of August 29, 1997 through December 31, 2004 (in thousands):

 

     Year Ended
December, 31, 2004


    For period from
IPO through
December 31, 2004


 

Gross unrealized appreciation of portfolio company investments

   $ 192,395     $ 275,979  

Gross unrealized depreciation of portfolio company investments

     (134,726 )     (292,218 )
    


 


Subtotal

     57,669       (16,239 )

Net realized losses of portfolio company investments

     (19,976 )     (5,167 )

Reversal of prior period unrealized depreciation upon a realization

     33,787       —    
    


 


Subtotal

     71,480       (21,406 )

Net unrealized appreciation (depreciation) of interest rate derivatives

     7,758       (15,718 )

Realized losses of interest rate derivatives

     (17,894 )     (17,894 )
    


 


Total

   $ 61,344     $ (55,018 )
    


 


 

Operations

 

Marketing, Origination and Approval Process. To source buyout and financing opportunities, we have a dedicated marketing department, which targets an extensive referral network comprised of investment banks, private equity and mezzanine funds, commercial banks, and business and financial brokers. Our marketing department developed and maintains an extensive proprietary database of reported middle market transactions, which enables us to monitor and evaluate the middle market investing environment. Our financial professionals review thousands of financing memorandums and private placement memorandums sourced from this extensive referral network in search of potential buyout or financing opportunities. Those that pass an initial screen are then evaluated by a team led by one of our financial principals. The financial principal and his or her team, with the assistance from our Financial Accounting and Compliance Team (FACT) and our operations team, along with the oversight of our investment committee, are responsible for structuring, negotiating, pricing and closing the transaction.

 

As of December 31, 2004, we have a group of approximately 130 professionals actively engaged in the origination and approval process of our investing activities, including our 80-member investment team (“Investment Team”), our 16-member operations team (“Operations Team”) and our 29-member FACT group. Our Operations Team assists in initial operational due diligence in addition to providing managerial assistance to portfolio companies, particularly those that are underperforming. FACT is our team of certified public accountants and accounting professionals, who assist in initial accounting due diligence of prospective portfolio companies, portfolio monitoring and quarterly valuations of our portfolio assets. Our Investment Team along with our Operations Team and FACT conduct extensive due diligence of each target company that passes the initial screening process. This includes one or more on-site visits, a review of the target company’s historical and prospective financial information, identifying and confirming pro-forma financial adjustments, interviews with and assessments of management, employees, customers and vendors, review of the adequacy of the target company’s systems, background investigations of senior management and research on the target company’s products, services and industry. We often engage professionals such as environmental consulting firms, accounting firms, law firms, risk management companies and management consulting firms with relevant industry expertise to perform elements of the due diligence.

 

Upon completion of our due diligence, our Investment Team, FACT and Operations Team as well as any consulting firms prepare and generally present an extensive investment committee report containing the due

 

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diligence information to the investment committee for review. Our investment committee (“Investment Committee”) generally includes our executive officers and, on a rotating basis, certain of our managing directors. Our Investment Committee generally approves each investment. Investments exceeding a certain size and certain investments meeting other criteria must also be approved by our board of directors.

 

Portfolio Management. In addition to the extensive due diligence at the time of the original investment decision, we seek to preserve and enhance the performance of our portfolio companies through our active involvement with our portfolio companies. This generally includes attendance at portfolio company board meetings, management consultation and monitoring of the financial performance including covenant compliance. Our Investment Team and FACT regularly review portfolio company monthly financial statements to assess performance and trends, periodically conduct on-site financial and operational reviews and evaluate industry and economic issues that may affect the portfolio company.

 

Operations Team. The Operations Team is led by a managing director and includes seasoned ex-senior managers with extensive operational experience and accounting and financial professionals that generally work with our portfolio companies that are under performing. Portfolio companies that are performing below plan generally require more extensive assistance with enhancing their business plans, marketing strategies, product positioning, evaluating cost structures and recruiting management personnel. The Operations Team works closely with the portfolio company and, in many instances, members of the Operations Team will assist the portfolio company with day-to-day operations.

 

Portfolio Valuation

 

FACT, with the assistance of our Investment Team, subject to the oversight of senior management and our audit and compliance committee, prepares a quarterly valuation of each of our portfolio company investments. Our board of directors approves our portfolio valuations in accordance with our valuation policies. We have also engaged the independent financial advisory firm of Houlihan Lokey Howard & Zukin Financial Advisory, Inc. to assist in this process by reviewing each quarter a selection of our portfolio companies and to report their conclusions to our audit and compliance committee. Annually, Houlihan Lokey reviews all of the portfolio companies that have been a portfolio company for at least one year. For more information regarding our portfolio valuation policies and procedures, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies.”

 

Loan Grading

 

We evaluate and classify all loans based on their current risk profiles. During the valuation process each quarter, a loan grade of 1 to 4 is assigned to each loan. Loans graded 4 involve the least amount of risk of loss, while loans graded 1 have the highest risk of loss. The loan grade is then reviewed and approved by our investment committee. This loan grading process is intended to reflect the performance of the portfolio company’s business, the collateral coverage of the loans and other factors considered relevant. For more information regarding our loan grading practices, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Portfolio Credit Quality.”

 

Competition

 

We compete with a large number of private equity and mezzanine funds and other financing sources, including traditional financial services companies such as finance companies and commercial banks. Some of our competitors are substantially larger and have considerably greater financial resources than we do. Our competitors may have a lower cost of funds and many have access to funding sources that are not available to us. In addition, certain of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships and build their market shares. There is no assurance that the competitive pressures we face will not have a material adverse effect on our

 

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business, financial condition and results of operations. In addition, because of this competition, we may not be able to take advantage of attractive investment opportunities from time to time and there can be no assurance that we will be able to identify and make investments that satisfy our investment objectives or that we will be able to meet our investment goals.

 

Employees

 

As of December 31, 2004, we had 191 employees. We believe that our relations with our employees are excellent.

 

Business Development Company Requirements

 

Qualifying Assets

 

As a business development company, we may not acquire any asset other than qualifying assets, as defined by the 1940 Act, unless, at the time the acquisition is made, the value of our qualifying assets represent at least 70% of the value of our total assets. The principle categories of qualifying assets relevant to our business are the following:

 

    securities purchased in transactions not involving any public offering from an issuer that is an eligible portfolio company. An eligible portfolio company is any issuer that (a) is organized and has its principal place of business in the United States, (b) is not an investment company other than a small business investment company wholly owned by the business development company, and (c) either (i) does not have any class of securities with respect to which a broker or dealer may extend margin credit, (ii) is controlled by the BDC either singly or as part of a group and an affiliated person of the BDC is a member of the issuer’s board of directors, or (iii) has total assets of not more than $4 million and capital and surplus of at least $2 million;

 

    securities received in exchange for or distributed with respect to securities described above, or pursuant to the exercise of options, warrants or rights relating to such securities; and

 

    cash, cash items, government securities, or high quality debt securities maturing in one year or less from the time of investment.

 

We may not change the nature of our business so as to cease to be, or withdraw our election as, a business development company unless authorized by vote of the holders of the majority, as defined in the 1940 Act, of our outstanding voting securities.

 

Since we made our business development company election, we have not made any substantial change in our structure or in the nature of our business.

 

To include certain securities above as qualifying assets for the purpose of the 70% test, a business development company must make available to the issuer of those securities significant managerial assistance, such as providing significant guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company or making loans to a portfolio company. We offer to provide significant managerial assistance to each of our portfolio companies.

 

Temporary Investments

 

Pending investment in other types of qualifying assets, we may invest our otherwise uninvested cash in cash, cash items, government securities, agency paper or high quality debt securities maturing in one year or less from the time of investment in such high quality debt investments, referred to as temporary investments, so that at least 70% of our assets are qualifying assets. Typically, we invest in U.S. treasury bills. Additionally, we may invest in repurchase obligations of a “primary dealer” in government securities (as designated by the Federal

 

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Reserve Bank of New York) or of any other dealer whose credit has been established to the satisfaction of our board of directors. There is no percentage restriction on the proportion of our assets that may be invested in such repurchase agreements. A repurchase agreement involves the purchase by an investor, such as us, of a specified security and the simultaneous agreement by the seller to repurchase it at an agreed upon future date and at a price which is greater than the purchase price by an amount that reflects an agreed-upon interest rate. Such interest rate is effective for the period of time during which the investor’s money is invested in the arrangement and is related to current market interest rates rather than the coupon rate on the purchased security. We require the continual maintenance by our custodian or the correspondent in its account with the Federal Reserve/Treasury Book Entry System of underlying securities in an amount at least equal to the repurchase price. If the seller were to default on its repurchase obligation, we might suffer a loss to the extent that the proceeds from the sale of the underlying securities were less than the repurchase price. A seller’s bankruptcy could delay or prevent a sale of the underlying securities.

 

Leverage

 

For the purpose of making investments and to take advantage of favorable interest rates, we have issued, and intend to continue to issue, senior debt securities and other evidences of indebtedness, up to the maximum amount permitted by the 1940 Act, which currently permits us, as a BDC, to issue senior debt securities and preferred stock, together defined as senior securities in the 1940 Act, in amounts such that our asset coverage, as defined in the 1940 Act, is at least 200% after each issuance of senior securities. Such indebtedness may also be incurred for the purpose of effecting share repurchases. As a result, we are exposed to the risks of leverage. Although we have no current intention to do so, we have retained the right to issue preferred stock. As permitted by the 1940 Act, we may, in addition, borrow amounts up to 5% of our total assets for temporary purposes. As of December 31, 2004, our asset coverage was 220%.

 

Regulated Investment Company Requirements

 

We operate so as to qualify as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986. If we qualify as a regulated investment company and annually distribute to our stockholders in a timely manner at least 90% of our investment company taxable income, we will not be subject to federal income tax on the portion of our taxable income and capital gains we distribute to our shareholders. Taxable income generally differs from net income as defined by generally accepted accounting principles due to temporary and permanent timing differences in the recognition of income and expenses, returns of capital and net unrealized appreciation or depreciation.

 

Generally, in order to maintain our status as a regulated investment company, we must a) continue to qualify as a business development company; b) distribute to our shareholders in a timely manner, at least 90% of our investment company taxable income, as defined by the Internal Revenue Code; c) derive in each taxable year at least 90% of our gross investment company income from dividends, interest, payments with respect to securities loans, gains from the sale of stock or other securities or other income derived with respect to our business of investing in such stock or securities as defined by the Internal Revenue Code; and d) meet investment diversification requirements. The diversification requirements generally require us at the end of each quarter of the taxable year to have (i) at least 50% of the value of our assets consist of cash, cash items, government securities, securities of other regulated investment companies and other securities if such other securities of any one issuer do not represent more than 5% of our assets and 10% of the outstanding voting securities of the issuer and (ii) no more than 25% of the value of our assets invested in the securities of one issuer (other than U.S. government securities and securities of other RICs), or of two or more issuers that are controlled by us and are engaged in the same or similar or related trades or businesses.

 

In addition, with respect to each calendar year, if we distribute or have treated as having distributed (including amounts retained but designated as deemed distributed) in a timely manner 98% of our capital gain net income for each one-year period ending on October 31, and distribute 98% of our investment company net

 

10


ordinary income for such calendar year (as well as any ordinary income not distributed in prior years), we will not be subject to the 4% nondeductible Federal excise tax imposed with respect to certain undistributed income of regulated investment companies.

 

If we fail to satisfy the 90% distribution requirement or otherwise fail to qualify as a regulated investment company in any taxable year, we will be subject to tax in such year on all of our taxable income, regardless of whether we make any distribution to our stockholders. In addition, in that case, all of our distributions to our shareholders will be characterized as ordinary income (to the extent of our current and accumulated earnings and profits). We have distributed and currently intend to distribute sufficient dividends to eliminate our investment company taxable income.

 

Our wholly-owned subsidiary, ACFS, is a corporation under Subchapter C of the Code and is subject to corporate level Federal and state income tax.

 

Investment Objectives and Policies

 

Our primary business objectives are to increase our taxable income, net operating income and net asset value by investing in senior debt, subordinated debt and equity of middle market companies with attractive current yields and potential for equity appreciation and realized gains. The following restrictions, along with these investment objectives, are our only fundamental policies—that is, policies that may not be changed without the approval of the holders of the majority, as defined in the 1940 Act, of our outstanding voting securities. The percentage restrictions set forth below, other than the restriction pertaining to the issuance of senior securities, as well as those contained elsewhere herein, apply at the time a transaction is effected, and a subsequent change in a percentage resulting from market fluctuations or any cause other than an action by us will not require American Capital to dispose of portfolio securities or to take other action to satisfy the percentage restriction:

 

    We will at all times conduct our business so as to retain our status as a BDC. In order to retain that status, we may not acquire any assets (other than non-investment assets necessary and appropriate to our operations as a BDC) if after giving effect to such acquisition the value of our qualifying assets amounts to less than 70% of the value of our total assets. For a summary definition of qualifying assets, see “Business Development Company Requirements.” We believe most of the securities we will acquire (provided that we control, or through our officers or other participants in the financing transaction, make significant managerial assistance available to the issuers of these securities), as well as temporary investments, will generally be qualifying assets. Securities of public companies, on the other hand, are generally not qualifying assets unless they were acquired in a distribution, in exchange for or upon the exercise of a right relating to securities that were qualifying assets.

 

    We may invest up to 100% of our assets in securities acquired directly from issuers in privately-negotiated transactions. With respect to such securities, we may, for the purpose of public resale, be deemed an “underwriter” as that term is defined in the 1933 Act. We may invest up to 50% of our assets to acquire securities of issuers for the purpose of acquiring control (up to 100% of the voting securities) of such issuers. We will not concentrate our investments in any particular industry or group of industries. Therefore, we will not acquire any securities (except upon the exercise of a right related to previously acquired securities) if, as a result, 25% or more of the value of our total assets consists of securities of companies in the same industry.

 

    We may issue senior securities to the extent permitted by the 1940 Act for the purpose of making investments, to fund share repurchases, or for temporary or emergency purposes. As a BDC, we may issue senior securities up to an amount so that the asset coverage, as defined in the 1940 Act, is at least 200% immediately after each issuance of senior securities.

 

   

We will not (a) act as an underwriter of securities of other issuers (except to the extent that we may (i) be deemed an “underwriter” of securities purchased by us that must be registered under the 1933 Act before they may be offered or sold to the public or (ii) underwrite securities to be distributed to or

 

11


 

purchased by stockholders of us in connection with offerings of securities by companies in which we are a stockholder); (b) purchase or sell real estate or interests in real estate or real estate investment trusts (except that we may purchase and sell real estate or interests in real estate in connection with the orderly liquidation of investments and may own the securities of companies or participate in a partnership or partnerships that are in the business of buying, selling or developing real estate); (c) sell securities short (except with regard to managing risks associated with publicly traded securities issued by portfolio companies); (d) purchase securities on margin (except to the extent that we may purchase securities with borrowed money); (e) write or buy put or call options (except (i) to the extent of warrants or conversion privileges in connection with our acquisition financing or other investments, and rights to require the issuers of such investments or their affiliates to repurchase them under certain circumstances, or (ii) with regard to managing risks associated with publicly traded securities issued by portfolio companies); (f) engage in the purchase or sale of commodities or commodity contracts, including futures contracts (except where necessary in working out distressed loan or investment situations); or (g) acquire more than 3% of the voting stock of, or invest more than 5% of our total assets in any securities issued by, any other investment company, except as they may be acquired as part of a merger, consolidation or acquisition of assets. With regard to that portion of our investments in securities issued by other investment companies it should be noted that such investments may subject our shareholders to additional expenses.

 

Investment Advisor

 

We have no investment advisor and are internally managed by our executive officers under the supervision of our board of directors.

 

Item 2. Properties

 

We do not own any real estate or other physical properties materially important to our operation. We lease office space in seven locations for terms ranging up to nine years.

 

Item 3. Legal Proceedings

 

We are involved in routine litigation and administrative proceedings arising in the ordinary course of business. As previously reported in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, the staff of the Securities and Exchange Commission requested that we voluntarily provide certain documents and information as part of an informal, non-public inquiry. The staff has not indicated the subject of the inquiry. We have complied fully with the requests and expect to continue to do so should additional information be requested. In a letter to us, the SEC staff stated, “This inquiry is nonpublic and should not be construed as an indication by the Commission or its staff that any violations of law have occurred, or as an adverse reflection upon any person or security.”

 

In the opinion of management, the ultimate resolution of all such proceedings is not expected to have a material adverse effect on our business, financial condition, or results of operation.

 

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

 

During the fourth quarter of 2004, there were no matters submitted to a vote our security holders through the solicitation of proxies or otherwise.

 

 

12


PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Since our IPO, we have distributed, and currently intend to continue to distribute in the form of dividends, a minimum of 90% of our investment company taxable income on a quarterly basis to our shareholders. We intend to retain long-term capital gains and treat them as deemed distributions for tax purposes. We report the estimated tax characteristics of each dividend when declared, while the actual tax characteristics of dividends are reported annually to each stockholder on Form 1099DIV. For income tax purposes, all of our dividends declared through December 31, 2004 have been distributions of ordinary income for tax purposes. For our dividends declared in 2004 of $2.91 per share, $2.6361 were non-qualifying dividends and $0.2739 were qualifying dividends. Qualified dividend income is generally taxed to stockholders at the rates that apply to net capital gains. There is no assurance that we will achieve investment results or maintain a tax status that will permit any specified level of cash distributions or year-to-year increases in cash distributions. During the fiscal year ended December 31, 2004, we did not purchase any of our shares of common stock.

 

Our common stock is quoted on the NASDAQ Stock Market under the symbol ACAS. As of February 25, 2005, we had 719 shareholders of record. Most of the shares of our common stock are held by brokers and other institutions on behalf of stockholders. We believe that there are approximately 106,000 additional beneficial holders of our common stock. The following table sets forth the range of high and low sales prices of our common stock as reported on the NASDAQ Stock Market and our dividends declared for the period from our IPO through December 31, 2004.

 

     Sale Price

      
     High

   Low

   Dividend Declared

 

1997

                      

Third Quarter (beginning August 29, 1997)

   $ 20.25    $ 15.00    $ 0.00  

Fourth Quarter

   $ 20.75    $ 16.50    $ 0.21  

1998

                      

First Quarter

   $ 22.50    $ 17.25    $ 0.25  

Second Quarter

   $ 24.63    $ 21.25    $ 0.29  

Third Quarter

   $ 24.25    $ 10.13    $ 0.32  

Fourth Quarter

   $ 18.44    $ 9.19    $ 0.48 (1)

1999

                      

First Quarter

   $ 19.00    $ 14.00    $ 0.41  

Second Quarter

   $ 21.25    $ 16.00    $ 0.43  

Third Quarter

   $ 20.00    $ 16.25    $ 0.43  

Fourth Quarter

   $ 23.13    $ 17.88    $ 0.47 (2)

2000

                      

First Quarter

   $ 26.81    $ 20.88    $ 0.45  

Second Quarter

   $ 27.75    $ 19.81    $ 0.49  

Third Quarter

   $ 26.00    $ 21.75    $ 0.49  

Fourth Quarter

   $ 26.00    $ 20.25    $ 0.74 (3)

2001

                      

First Quarter

   $ 27.88    $ 21.88    $ 0.53  

Second Quarter

   $ 28.10    $ 24.25    $ 0.55  

Third Quarter

   $ 29.50    $ 24.14    $ 0.56  

Fourth Quarter

   $ 29.89    $ 24.48    $ 0.66 (4)

 

13


     Sale Price

      
     High

   Low

   Dividend Declared

 

2002

                      

First Quarter

   $ 31.90    $ 26.45    $ 0.59  

Second Quarter

   $ 32.98    $ 24.81    $ 0.63  

Third Quarter

   $ 27.99    $ 17.00    $ 0.66  

Fourth Quarter

   $ 24.54    $ 15.17    $ 0.69 (5)

2003

                      

First Quarter

   $ 25.07    $ 21.41    $ 0.67  

Second Quarter

   $ 29.48    $ 22.41    $ 0.68  

Third Quarter

   $ 28.35    $ 20.75    $ 0.69  

Fourth Quarter

   $ 30.00    $ 24.65    $ 0.75 (6)

2004

                      

First Quarter

   $ 34.91    $ 29.30    $ 0.70  

Second Quarter

   $ 33.65    $ 24.70    $ 0.70  

Third Quarter

   $ 32.30    $ 27.54    $ 0.72  

Fourth Quarter

   $ 33.60    $ 29.23    $ 0.79 (7)

(1) Includes extra dividend of $0.11.
(2) Includes extra dividend of $0.03.
(3) Includes extra dividend of $0.22.
(4) Includes extra dividend of $0.09.
(5) Includes extra dividend of $0.02.
(6) Includes extra dividend of $0.06.
(7) Includes extra dividend of $0.06.

 

The following table summarizes information, as of December 31, 2004, relating to our equity compensation plans pursuant to which grants of options or other rights to acquire shares of our common stock may be granted from time to time. See “Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements” for a description of our equity compensation plans.

 

Plan category


   Number of securities to
be issued upon exercise of
outstanding options,
warrants and rights


   Weighted-average
exercise price of
outstanding options,
warrants and rights


   Number of securities
remaining available for future
issuance under equity
compensation plans


     (in thousands, except per share amounts)

Equity compensation plans approved by security holders (1)

   7,807    $ 24.42    702

Equity compensation plans not approved by security holders (1)

   —        —      —  

 

(1) All of our compensation plans have been approved by our stockholders.

 

 

14


Item 6. Selected Financial Data

 

AMERICAN CAPITAL STRATEGIES, LTD.

Consolidated Selected Financial Data

 

The selected financial data should be read in conjunction with our consolidated financial statements and notes thereto.

 

     Year Ended
December 31,
2004


    Year Ended
December 31,
2003


    Year Ended
December 31,
2002


    Year Ended
December 31,
2001


    Year Ended
December 31,
2000


 
     (in thousands, except per share data)  

Total operating income(1)

   $ 336,082     $ 206,280     $ 147,022     $ 104,237     $ 70,052  

Total operating expenses(2)

     113,851       65,577       44,473       32,612       27,382  
    


 


 


 


 


Operating income before income taxes

     222,231       140,703       102,549       71,625       42,670  

Income tax (provision) benefit

     (2,130 )     —         —         —         2,000  
    


 


 


 


 


Net operating income

     220,101       140,703       102,549       71,625       44,670  

Net realized (loss) gain on investments(1)

     (37,870 )     22,006       (20,741 )     5,369       4,539  

Net unrealized appreciation (depreciation) of investments(1)

     99,214       (44,725 )     (61,747 )     (58,389 )     (53,582 )
    


 


 


 


 


Net increase (decrease) in shareholders’ equity resulting from operations

   $ 281,445     $ 117,984     $ 20,061     $ 18,605     $ (4,373 )
    


 


 


 


 


Per share data:

                                        

Net operating income:

                                        

Basic

   $ 2.88     $ 2.58     $ 2.60     $ 2.27     $ 2.00  

Diluted

   $ 2.83     $ 2.56     $ 2.57     $ 2.24     $ 1.96  

Net earnings (loss):

                                        

Basic

   $ 3.69     $ 2.16     $ 0.51     $ 0.59     $ (0.20 )

Diluted

   $ 3.63     $ 2.15     $ 0.50     $ 0.58     $ (0.20 )

Dividends declared

   $ 2.91     $ 2.79     $ 2.57     $ 2.30     $ 2.17  

Balance Sheet Data:

                                        

Total assets

   $ 3,491,427     $ 2,068,328     $ 1,350,911     $ 909,717     $ 615,069  

Total debt

   $ 1,560,978     $ 840,211     $ 619,964     $ 251,141     $ 155,202  

Total shareholders’ equity

   $ 1,872,426     $ 1,175,915     $ 687,659     $ 640,265     $ 445,167  

Other Data:

                                        

Number of portfolio companies at period end

     117       86       69       55       46  

New investments(3)

   $ 2,017,600     $ 1,083,100     $ 573,500     $ 389,300     $ 275,500  

Equity investment sale proceeds and loan investment sales and repayments(4)

   $ 711,525     $ 390,467     $ 118,560     $ 83,446     $ 34,125  

Net operating income as % of average equity(5)

     14.1 %     13.5 %     14.7 %     13.3 %     13.9 %

Return on average equity(6)

     18.0 %     11.3 %     2.9 %     3.5 %     (1.3 )%

(1) In 2004, we adopted a new accounting method related to the income statement classification of periodic interest rate derivative settlements. In prior periods, we recorded the payments and accrual of periodic interest settlements of interest rate derivative agreements in interest income. Beginning in 2004, we record the accrual of the periodic interest rate settlements of interest rate derivatives in net unrealized appreciation (depreciation) of investments and subsequently record the amount as a realized gain (loss) on investments on the interest settlement date.
(2) In 2003, we adopted Financial Accounting Standards Board (FASB) Statement No. 123 to account for stock-based compensation plans for all stock options granted in 2003 and forward as permitted under FASB Statement No. 148.
(3) Amount of new investments includes amounts as of the investment dates that are committed but unfunded.
(4) Principal amount of loan repayments includes the collection of payment-in-kind notes, payment-in-kind dividends and accreted loan discounts.
(5) Calculated before the effect of net appreciation, depreciation gains and losses of investments. Average equity is calculated based on the quarterly shareholders’ equity balances.
(6) Return represents net increase (decrease) in shareholders’ equity resulting from operations, which includes the effect of net appreciation, depreciation, gains and losses of investments. Average equity is calculated based on the quarterly shareholders’ equity balances.

 

 

15


ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

(Dollars in thousands except per share data)

 

Forward-Looking Statements

 

All statements contained herein that are not historical facts including, but not limited to, statements regarding anticipated activity are forward looking in nature and involve a number of risks and uncertainties. Actual results may differ materially. Among the factors that could cause actual results to differ materially are the following: (i) changes in the economic conditions in which we operate negatively impacting our financial resources; (ii) certain of our competitors have substantially greater financial resources than us reducing the number of suitable investment opportunities offered to us or reducing the yield necessary to consummate the investment; (iii) there is uncertainty regarding the value of our privately held securities that require our good faith estimate of fair value for which a change in estimate could affect our net asset value; (iv) our investments in securities of privately held companies may be illiquid which could affect our ability to realize a gain; (v) our portfolio companies could default on their loans or provide no returns on our investments which could affect our operating results; (vi) we are dependent on external financing to grow our business; (vii) our ability to retain key management personnel; (viii) an economic downturn or recession could impair our portfolio companies and therefore harm our operating results; (ix) our borrowing arrangements impose certain restrictions; (x) changes in interest rates may affect our cost of capital and net operating income; (xi) we cannot incur additional indebtedness unless we maintain an asset coverage of at least 200%, which may affect returns to our shareholders; (xii) we may fail to continue to qualify for our pass-through treatment as a regulated investment company which could have an affect on shareholder return; (xiii) our common stock price may be volatile; and (xiv) general business and economic conditions and other risk factors described in our reports filed from time to time with the Securities and Exchange Commission. We caution readers not to place undue reliance on any such forward-looking statements, which statements are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such, speak only as of the date made.

 

Risk Factors

 

You should carefully consider the risks described below and all other information contained in the annual report on Form 10-K, including our consolidated financial statements and the related notes thereto before making a decision to purchase our common stock. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us, or not presently deemed material by us, may also impair our operations and performance.

 

If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. If that happens, the trading price of our common stock could decline, and you may lose all or part of your investment.

 

We have a limited operating history upon which you can evaluate our business

 

Although we commenced operations in 1986, we materially changed our business plan and format in August 1997 from structuring and arranging financing for buyout transactions on a fee for services basis to primarily being a lender to and investor in middle market companies, which we generally consider to be companies with sales between $10 million and $750 million. Therefore, we have only a limited history of operations as a lender to and investor in middle market companies upon which you can evaluate our business. While we generally have been profitable since August 1997, there can be no assurance that we will remain profitable in future periods, nor can we offer investors any assurance that we will successfully implement our growth strategy. In addition, we have limited operating results under our business plan which would demonstrate the effect of a general economic recession on our business.

 

 

16


We make loans to and investments in middle market borrowers who may default on their loans or provide no return on our investments

 

We invest in and lend to middle market businesses. There is generally no publicly available information about these businesses. Therefore, we rely on our principals, associates, analysts and consultants to investigate these businesses. The portfolio companies in which we invest may have significant variations in operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, may require substantial additional capital to support their operations, to finance expansion or to maintain their competitive position, may otherwise have a weak financial position or may be adversely effected by changes in the business cycle. Our portfolio companies may not meet net income, cash flow and other coverage tests typically imposed by senior lenders. Numerous factors may affect a portfolio company’s ability to repay its loan, including the failure to meet its business plan, a downturn in its industry or negative economic conditions. A deterioration in a portfolio company’s financial condition and prospects may be accompanied by deterioration in the collateral for the loan. We also make unsecured, subordinated loans and invest in equity securities, which involve a higher degree of risk than senior loans.

 

Middle market businesses typically have narrower product lines and smaller market shares than large businesses. They tend to be more vulnerable to competitors’ actions and market conditions, as well as general economic downturns. In addition, portfolio companies may face intense competition, including competition from companies with greater financial resources, more extensive development, manufacturing, marketing, and other capabilities, and a larger number of qualified managerial and technical personnel.

 

These businesses may also experience substantial variations in operating results. Typically, the success of a middle market business also depends on the management talents and efforts of one or two persons or a small group of persons. The death, disability or resignation of one or more of these persons could have a material adverse impact on us. In addition, middle market businesses often need substantial additional capital to expand or compete and will have borrowed money from other lenders.

 

Our senior loans generally are secured by the assets of our borrowers. Our subordinated loans are often secured by the assets of the borrower but our rights to payment and our security interest are usually subordinated to the payment rights and security interests of the senior lender. Therefore, we may be limited in our ability to enforce our rights to collect our loans and to recover any of the loan balance through a foreclosure of collateral.

 

Often, a deterioration in a borrower’s financial condition and prospects is accompanied by a deterioration in the value of the collateral securing its loan. In certain cases, our involvement in the management of our portfolio companies may subject us to additional defenses and claims from borrowers and third parties. These conditions may make it difficult for us to obtain repayment of our loans.

 

There is uncertainty regarding the value of our privately held securities

 

A majority of our portfolio securities are not publicly traded. We value these securities based on a determination of their fair value made in good faith by our board of directors. Due to the uncertainty inherent in valuing securities that are not publicly traded, as set forth in our financial statements, our determinations of fair value may differ materially from the values that would exist if a ready market for these securities existed. Our determinations of the fair value of our investments have a material impact on our net earnings through the recording of unrealized appreciation or depreciation of investments as well as our assessment of interest income recognition. Our net asset value could be materially affected if our determinations regarding the fair value of our investments are materially different from the values that would exist if a ready market existed for these securities.

 

We may not realize gains from our equity investments

 

When we sponsor the buyout of a portfolio company, we invest in the equity securities of the portfolio company. Also, when we make a loan, we generally receive warrants to acquire stock issued by the borrower,

 

17


and we may make direct equity investments. Our goal ultimately is to dispose of these equity interests and realize gains. These equity interests may not appreciate in value and, in fact, may depreciate in value. Accordingly, we may not be able to realize gains from our equity interests.

 

The lack of liquidity of our privately held securities may adversely affect our business

 

Most of our investments consist of securities acquired directly from their issuers in private transactions. Some of these securities are subject to restrictions on resale (including in some instances legal restrictions) or otherwise are less liquid than public securities. The illiquidity of our investments may make it difficult for us to obtain cash equal to the value at which we record our investments if the need arises.

 

We have invested in a limited number of portfolio companies

 

A consequence of a limited number of investments is that the aggregate returns realized by us may be substantially adversely affected by the unfavorable performance of a small number of such investments or a substantial write-down of any one investment. Beyond our regulatory and income tax guidelines, we do not have stringent fixed guidelines for industry diversification, and investments could potentially be concentrated in relatively few industries.

 

We have limited information regarding the companies in which we invest

 

Consistent with our operation as a BDC, our portfolio consists primarily of securities issued by privately held companies. There is generally little or no publicly available information about such companies, and we must rely on the diligence of our employees and the consultants we hire to obtain the information necessary for our decision to invest in them. There can be no assurance that our diligence efforts will uncover all material information about the privately held business necessary to make a fully informed investment decision.

 

Our portfolio companies may be highly leveraged

 

Leverage may have important adverse consequences to these companies and to us as an investor. These companies may be subject to restrictive financial and operating covenants. The leverage may impair these companies’ ability to finance their future operations and capital needs. As a result, these companies’ flexibility to respond to changing business and economic conditions and to business opportunities may be limited. A leveraged company’s income and net assets will tend to increase or decrease at a greater rate than if borrowed money were not used.

 

Our business is dependent on external financing

 

Our business requires a substantial amount of cash to operate. We historically have obtained the cash required for operations through the sale of debt by special purpose affiliates to which we have contributed loan assets originated by us, the sale of certain senior loans originated by us, borrowings by us and the sale of our equity. Our ability to continue to rely on such sources or other sources of capital depends on numerous legal, economic, structural and other factors.

 

Senior Securities. We or our affiliates have issued, and intend to continue to issue, debt securities and other evidences of indebtedness, up to the maximum amount permitted by the 1940 Act. We have also retained the right to issue preferred stock. As a BDC, the 1940 Act permits us to issue debt securities and preferred stock (collectively, “Senior Securities”) in amounts such that our asset coverage, as defined in the 1940 Act, is at least 200% after each issuance of Senior Securities. As a result, we are exposed to the risks of leverage. As permitted by the 1940 Act, we may, in addition, borrow amounts up to five percent of our total assets for temporary purposes.

 

18


Term Debt Securities. Trusts affiliated with us have issued, and we or our affiliates may issue in the future, term debt securities (the “Term Debt Notes”) to institutional investors. As of December 31, 2004, the outstanding balance of the Term Debt Notes issued to institutional investors was $741,783. These notes are secured by loans from our portfolio companies with a principal balance of $1,082,341 as of December 31, 2004. While we have not guaranteed the repayment of Term Debt Notes, we must repurchase the loans if certain representations are breached.

 

Unsecured Debt. On September 8, 2004, we sold an aggregate $167,000 of long-term unsecured five- and seven-year notes to institutional investments in a private placement offering.

 

Revolving Debt Funding Facilities. We depend in part on our three revolving credit facilities to generate cash for funding our investments, two of which are commercial paper conduit securitization facilities. The third facility is a revolving line of credit, with respect to which we are the borrower (the “Revolving Facility”).

 

Our conduit facilities are secured by loans to our portfolio companies, which have been contributed to separate affiliated trusts. While we have not guaranteed the repayment of either conduit facility, we must repurchase the loans if certain representations are breached. As of December 31, 2004, the aggregate commitment of each of our conduit facilities was $850,000 (the “AFT I Facility”) and $125,000 (the “AFT II Facility”), respectively. Collectively, the AFT I Facility, AFT II Facility and Revolving Facility are referred to as the Debt Facilities. The AFT I Facility terminates in August 2005 unless the conduit facility is extended. The AFT II Facility terminates in June 2005 unless the facility is extended.

 

The Revolving Facility is a $70,000 revolving credit facility. As of December 31, 2004, there was no outstanding balance under the Revolving Facility and there are no loans from our portfolio companies pledged as collateral. Our ability to make draws under the Revolving Facility expires in March 2005, unless extended.

 

Short-Term Financings. We have undertaken various short-term financings involving repurchase agreements, where we sell at a discount to face value senior loans or unissued traunches of Term Debt Notes that we have originated and agree to repurchase them at a future date. As of December 31, 2004, we had $28,847 in such borrowings outstanding.

 

Sales of Senior Loans. From time to time, we have sold to other lenders senior loans that we have originated. In certain cases, we have retained servicing rights where we are paid fees to continue to service the loans.

 

A failure to renew our existing Debt Facilities, to continue short-term financings or senior loan sales, to increase our capacity under our existing facilities, to sell additional Term Debt Notes or to add new or replacement debt facilities could have a material adverse effect on our business, financial condition and results of operations. See the description of the Term Debt Notes and the Debt Facilities under “Management’s Discussion and Analysis of Financial Condition And Results of Operations—Financial Condition, Liquidity and Capital Resources.”

 

Common Stock. Because we are constrained in our ability to issue debt for the reasons given above, we are dependent on the issuance of equity as a financing source. We are restricted to issuing equity at prices equal to or above our net asset value at the time of issuance. There can be no assurances that we can issue equity when necessary. If additional funds are raised through the issuance of our common stock or debt securities convertible into or exchangeable for our common stock, the percentage ownership of our stockholders at the time would decrease and they may experience additional dilution. In addition, any convertible or exchangeable securities may have rights, preferences and privileges more favorable than those of our common stock.

 

The following table is designed to illustrate the effect on return to a holder of our common stock of the leverage created by our use of borrowing, at the weighted average interest rate 3.69% for the year ended December 31, 2004 and assuming hypothetical annual returns on our portfolio of minus 15 to plus 15 percent. As

 

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can be seen, leverage generally increases the return to stockholders when the portfolio return is positive and decreases return when the portfolio return is negative. Actual returns may be greater or less than those appearing in the table.

 

Assumed Return on Portfolio
(Net of Expenses)(1)

   15.0%    10.0%    5.0%      —      5.0%    10.0%    15.0%

Corresponding Return to Common Stockholders(2)

   29.5%    20.7%    11.9%    3.1%    5.7%    14.5%    23.2%

(1) The assumed portfolio return is required by regulation of the Securities and Exchange Commission and is not a prediction of, and does not represent, our projected or actual performance.
(2) In order to compute the “Corresponding Return to Common Stockholders,” the “Assumed Return on Portfolio” is multiplied by the total value of our assets at the beginning of the period to obtain an assumed return to us. From this amount, all interest expense accrued during the period is subtracted to determine the return available to stockholders. The return available to stockholders is then divided by the total value of our net assets as of the beginning of the period to determine the “Corresponding Return to Common Stockholders.”

 

We may incur additional debt that could increase your investment risks

 

We or our affiliates borrow money or issue debt securities to provide us with additional funds to invest. Our lenders have fixed dollar claims on our assets or the assets of our affiliates that are senior to the claims of our stockholders and, thus, our lenders have preference over our stockholders with respect to these assets. In particular, the assets that our affiliates have pledged to lenders under certain of our Debt Facilities were sold or contributed to separate affiliated statutory trusts prior to such pledge. While we own a beneficial interest in these trusts, these assets are property of the respective trusts, available to satisfy the debts of the trusts, and would only become available for distribution to our stockholders to the extent specifically permitted under the agreements governing those Debt Facilities. See “Risk Factors—Our Debt Facilities impose certain limitations on us.”

 

Although borrowing money for investment increases the potential for gain, it also increases the risk of a loss. A decrease in the value of our investments will have a sharper impact on the value of our common stock if we borrow money to make investments. Our ability to pay dividends could also be adversely impacted. In addition, our ability to pay dividends or incur additional indebtedness would be restricted if asset coverage is not equal to at least twice our indebtedness. If the value of our assets declines, we might be unable to satisfy that test. If this happens, we may be required to sell some of our investments and repay a portion of our indebtedness at a time when a sale may be disadvantageous. See “Risk Factors—Our business is dependent on external financing—Common Stock.”

 

A change in interest rates may adversely affect our profitability

 

A portion of our income will depend upon the difference between the rate at which we or our affiliated trusts borrow funds and the rate at which we loan these funds. We anticipate using a combination of equity and long- term and short-term borrowings to finance our lending activities. Certain of our borrowings may be at fixed rates and others at variable rates. As of December 31, 2004, we had total borrowings outstanding of $1,560,978, including $1,387,978 of borrowings that have a variable rate of interest generally based on LIBOR or a commercial paper rate. In addition, as a result of our use of interest rate swaps, approximately 24% of the loans in our portfolio were at fixed rates and approximately 76% were at floating rates as of December 31, 2004. We typically undertake to hedge against the risk of adverse movement in interest rates in our Debt Facilities against our portfolio of assets. Hedging activities may limit our ability to participate in the benefits of lower interest rates with respect to the hedged portfolio. As of December 31, 2004, our interest rate agreements had a notional amount of $1,190,855 and a fair value representing a net liability of $15,718. A change in interest rates could have an impact on the fair value of our interest rate hedging agreements that could result in the recording of

 

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unrealized appreciation or depreciation in future periods. Adverse developments resulting from changes in interest rates or hedging transactions could have a material adverse effect on our business, financial condition and results of operations. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Qualitative and Quantitative Disclosures About Market Risk.”

 

An economic downturn could affect our operating results

 

An economic downturn may adversely affect middle market businesses, which are our primary market for investments. Such a downturn could also adversely affect our ability to obtain capital to invest in such companies. These results could have a material adverse effect on our business, financial condition and results of operations.

 

Our Debt Facilities impose certain limitations on us

 

In March 1999, we established the AFT I Facility as a line of credit administered by Wachovia Capital Markets, LLC. The facility, which currently has an aggregate commitment of $850,000 as of December 31, 2004, is not available for further draws in August 2005 unless the facility is extended prior to such date for an additional 364-day period with the consent of the lenders. If the facility is not extended, any principal amounts then outstanding will be amortized over a 24-month period through a termination date in August 2007. The AFT I Facility contains customary default provisions, as well as the following default provisions: a cross-default on our debt of $2.5 million or more, a minimum net worth requirement of $1 billion plus seventy-five percent (75%) of any new equity and subordinated debt, a default triggered by a change of control and a default arising from the termination or resignation of any two of the following executive officers: Malon Wilkus, Ira Wagner and John Erickson.

 

In June 2004, we established the AFT II Facility as a line of credit administered by an affiliate of the Bank of Montreal. The facility has an aggregate commitment of $125,000. Our ability to make draws under the facility expires in June 2005 unless the facility is extended prior to such date for an additional 364-day period at the discretion of the lender. If the facility is not extended, any remaining outstanding principal amount will be amortized over a 24-month period beginning in June 2005. The facility contains customary default provisions, as well as the following default provisions: a cross-default on our debt of $2.5 million or more, a minimum net worth requirement of $1 billion plus seventy-five percent (75%) of any new equity and subordinated debt, a default triggered by a change of control and a default arising from the termination or resignation of any two of the following executive officers: Malon Wilkus, Ira Wagner and John Erickson.

 

In March 2004, we established the Revolving Facility as a line of credit administered by Branch Banking and Trust Company. As of December 31, 2004, the Revolving Facility has an aggregate commitment of $70,000. Our ability to make draws under the Revolving Facility expires in March 2005 unless the Revolving Facility is extended for an additional one-year period prior to such date at the discretion of the lenders. If the Revolving Facility is not renewed, any principal amounts then outstanding will be amortized over a 24-month period beginning in March 2005. The Revolving Facility contains customary default provisions as well as the following default provisions: a cross-default on our debt of $2.5 million or more, a minimum tangible net worth requirement of $975 million plus sixty percent (60%) of any new equity, a default in the event of a change of control and a default arising from the termination or resignation of any two of the following executive officers: Malon Wilkus, Ira Wagner and John Erickson.

 

Trusts affiliated with us have outstanding $741,783 in Term Debt Notes to institutional investors as of December 31, 2004. These securities contain customary default provisions, as well as the following default provisions: a failure on our part, as the originator of the loans securing the Term Debt Notes or as the servicer of these loans, to make any payment or deposit required under related agreements within two business days after the date the payment or deposit is required to be made, or if we alter or amend our credit and collection policy in a manner that could have a material adverse effect on the holders of the Term Debt Notes.

 

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The occurrence of an event of default under our Debt Facilities could lead to termination of those facilities

 

Our Debt Facilities contain certain default provisions, some of which are described in the immediately preceding paragraphs. An event of default under our Debt Facilities could result, among other things, in termination of further funds availability under that facility, an accelerated maturity date for all amounts outstanding under that facility and the disruption of all or a portion of the business financed by that facility. This could reduce our revenues and, by delaying any cash payment allowed to us under our facility until the lender has been paid in full, reduce our liquidity and cash flow.

 

We may experience fluctuations in our quarterly results

 

We could experience fluctuations in our quarterly operating results due to a number of factors including, among others, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our markets, the ability to find and close suitable investments and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

We may fail to continue to qualify for our pass-through tax treatment

 

We have operated since October 1, 1997 so as to qualify to be taxed as a RIC under Subchapter M of the Code and, provided we meet certain requirements under the Code, we can generally avoid corporate level federal income taxes on income distributed to you and other stockholders as dividends. We would cease to qualify for this favorable pass-through tax treatment if we are unable to comply with the source of income, diversification or distribution requirements contained in Subchapter M of the Code, or if we cease to operate so as to qualify as a BDC under the 1940 Act. If we fail to qualify to be taxed as a RIC or to distribute our income to stockholders on a current basis, we would be subject to corporate level taxes which would significantly reduce the amount of income available for distribution to stockholders. The loss of our current tax treatment could have a material adverse effect on the total return, if any, obtainable from an investment in our common stock. See “Business—Business Development Company Requirements” and “Business—Regulated Investment Company Requirements.”

 

There is a risk that you may not receive dividends

 

Since our initial public offering, we have distributed more than 98% of our investment company taxable income, including 98% of our net realized short-term capital gains to our stockholders. Our current intention is to continue these distributions to our stockholders. Net realized long-term capital gains may be retained and treated as a distribution for federal tax purposes, to supplement our equity capital and support growth in our portfolio, unless our board of directors determines in certain cases to make a distribution. We cannot assure you that we will achieve investment results or maintain a tax status that will allow any specified level of cash distributions or year-to-year increases in cash distributions.

 

Our financial condition and results of operations will depend on our ability to manage effectively any future growth

 

We have grown significantly since our IPO in August 1997. Our ability to sustain continued growth depends on our ability to identify, evaluate, finance and invest in suitable companies that meet our investment criteria. Accomplishing such a result on a cost-effective basis is largely a function of our marketing capabilities, our management of the investment process, our ability to provide competent, attentive and efficient services, our access to financing sources on acceptable terms and the capabilities of our technology platform. As we grow, we will also be required to hire, train, supervise and manage new employees. Failure to manage effectively any future growth could have a material adverse effect on our business, financial condition and results of operations.

 

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We are dependent upon our key management personnel for our future success

 

We are dependent for the final selection, structuring, closing and monitoring of our investments on the diligence and skill of our senior management and other management members. Our future success depends to a significant extent on the continued service and coordination of our senior management team, particularly Malon Wilkus, our Chairman, Chief Executive Officer and President, Ira Wagner, our Executive Vice President and Chief Operating Officer and John Erickson, our Executive Vice President and Chief Financial Officer. The departure of any of our executive officers or key employees could materially adversely affect our ability to implement our business strategy, and the departure of any two of Malon Wilkus, Ira Wagner and John Erickson would be a default of the provisions under the Debt Facilities. We do not maintain key man life insurance on any of our officers or employees.

 

We operate in a highly competitive market for investment opportunities

 

We compete with a large number of private equity funds and mezzanine funds, investment banks and other equity and non-equity based investment funds, and other sources of financing, including traditional financial services companies such as commercial banks. Some of our competitors are substantially larger and have considerably greater financial resources than us. Competitors may have lower cost of funds and many have access to funding sources that are not available to us. In addition, certain of our competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships and build their market shares. There is no assurance that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time and there can be no assurance that we will be able to identify and make investments that satisfy our investment objectives or that we will be able to meet our investment goals.

 

Provisions of our Second Amended and Restated Certificate of Incorporation and Second Amended and Restated Bylaws could deter takeover attempts

 

Our Second Amended and Restated Certificate of Incorporation, as amended and Second Amended and Restated Bylaws and the Delaware General Corporation Law contain provisions that may have the effect of discouraging, delaying or making more difficult a change in control and preventing the removal of incumbent directors. The existence of these provisions may negatively impact on the price of our common stock and may discourage third-party bids. These provisions may reduce any premiums paid to our stockholders for shares of our common stock that they own. Furthermore, we are subject to Section 203 of the Delaware General Corporation Law. Section 203 governs business combinations with interested stockholders, and also could have the effect of delaying or preventing a change in control.

 

Changes in laws or regulations governing our operations or our failure to comply with those laws or regulations may adversely affect our business

 

We and our portfolio companies are subject to regulation by laws at the local, state and federal level. These laws and regulations, as well as their interpretation, may be changed from time to time. Accordingly, any change in these laws or regulations or the failure to comply with these laws or regulations could have a material adverse impact on our business. Certain of these laws and regulations pertain specifically to business development companies.

 

We could face losses and potential liability if intrusions, viruses or similar disruptions to our technology jeopardize our confidential information or that of users of our technology

 

Although we have implemented, and will continue to implement, security measures, our technology platform is and will continue to be vulnerable to intrusion, computer viruses or similar disruptive problems

 

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caused by transmission from unauthorized users. The misappropriation of proprietary information could expose us to a risk of loss or litigation.

 

Failure to deploy new capital may reduce our return on equity

 

If we fail to invest our new capital effectively our return on equity may be negatively impacted, which could reduce the price of the shares of our common stock that you own.

 

The market price of our common stock may fluctuate significantly

 

The market price and marketability of shares of our common stock may from time to time be significantly affected by numerous factors, including many over which we have no control and that may not be directly related to us. These factors include the following:

 

    price and volume fluctuations in the stock market from time to time, which are often unrelated to the operating performance of particular companies;

 

    significant volatility in the market price and trading volume of securities of RICs, BDCs or other companies in our sector, which is not necessarily related to the operating performance of these companies;

 

    changes in regulatory policies or tax guidelines, particularly with respect to RICs or BDCs;

 

    changes in earnings or variations in operating results;

 

    any shortfall in revenue or net income or any increase in losses from levels expected by securities analysts;

 

    general economic trends and other external factors; and

 

    loss of a major funding source.

 

Fluctuations in the trading price of our common stock may adversely affect the liquidity of the trading market for our common stock and, in the event that we seek to raise capital through future equity financings, our ability to raise such equity capital.

 

Future sales of our common stock may negatively affect our stock price

 

The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market, or the perception that such sales could occur. These sales also might make it more difficult for us to sell additional equity securities in the future at a time and at a price that we deem appropriate.

 

Our common stock may be difficult to resell

 

Investors may not be able to resell shares of common stock at or above their purchase prices due to a number of factors, including:

 

    actual or anticipated fluctuation in our operating results;

 

    volatility in our common stock price;

 

    changes in expectations as to our future financial performance or changes in financial estimates of securities analysts; and

 

    departures of key personnel.

 

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We may be unable to satisfy regulatory requirements relating to internal controls over financial reporting

 

Our management is responsible for establishing and maintaining adequate internal controls over financial reporting for our company. For the fiscal year ended December 31, 2004, our management concluded that the controls over financial reporting were effective and our auditors issued an attestation report on our management’s assessment and concluded that management’s assessment was fairly stated in all material respects. However, we cannot assure you that there will not be significant deficiencies or material weaknesses in future periods. The existence of significant deficiencies or material weaknesses in future periods could preclude management from concluding in future periods that our controls over financial reporting are effective. If management or our independent auditors ultimately determine that our controls over financial reporting are not effective in future periods, we could be subject to sanctions or investigations by regulatory authorities and it could have an effect on our business and market price of our common stock.

 

Supplemental provisions contained in the forward sale agreements subject us to certain risks

 

Under our forward sale agreements, each forward purchaser has the right to accelerate its forward sale agreement and require us to physically settle on a date specified by such forward purchaser if certain events occur, such as (1) in its judgment, it is unable to continue to borrow a number of shares of our common stock equal to the number of shares to be delivered by us under its forward sale agreement or the cost of borrowing the common stock has increased above a specified amount, (2) we declare any dividend or distribution on shares of our common stock payable in (i) excess of a specified amount, (ii) securities of another company, or (iii) any other type of securities (other than shares of our common stock), rights, warrants or other assets for payment at less than the prevailing market price in such forward purchaser’s judgment, (3) the net asset value per share of our outstanding common stock exceeds a specified percentage of the then applicable forward sales price, (4) our board of directors votes to approve a merger or takeover of us or similar transaction that would require our shareholders to exchange their shares for cash, securities, or other property, or (5) certain other events of default or termination events occur. Such forward purchaser’s decision to exercise its right to require us to settle its forward sale agreement will be made irrespective of our need for capital. In addition, upon certain events of bankruptcy, insolvency or reorganization relating to us, each forward sale agreement will terminate without further liability of either party. Following any such termination, we would not issue any shares and we would not receive any proceeds pursuant to the forward sale agreements.

 

As of December 31, 2004, we had 6,250 shares outstanding under our forward sale agreements. Our forward sale agreements have a termination date of September 24, 2005 but may be settled earlier at our option. Each forward sale agreement will be physically settled. Delivery of our shares on any physical settlement of a forward sale agreement will result in dilution to our basic earnings per share and return on equity.

 

Our employee option plans may not be fully compliant

 

Certain of our employee stock option plans have a provision whereby the exercise price of options granted under the plan will be adjusted downward automatically in the amount of cash dividends paid on our common stock. (The compensation committee of the board of directors may discontinue these adjustments at any time.) While we believe that such adjustments in an option’s exercise price comply with applicable laws including tax and securities law, it is possible that a court or other governmental entity could find otherwise. If that were to happen, we could be required to change our option plans. We may also be required to reverse the adjustments to the exercise prices of outstanding options, compensate our employees for the effect of such reversals and reverse a portion of the option expense previously recorded by us. Such events could have a material impact on our financial statements. In addition, we may find it necessary to develop alternative incentive compensation programs in order to recruit and retain the employees we need to operate our business. Such alternative programs could be more expensive than our existing programs.

 

The following analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto.

 

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Portfolio Composition

 

We are a publicly traded buyout and mezzanine fund that provides investment capital to middle market companies. We invest in senior and subordinated debt and equity of companies in need of capital for buyouts, growth, acquisitions and recapitalizations. Our ability to fund the entire capital structure is an advantage in completing many middle market transactions. Our wholly-owned operating subsidiary, American Capital Financial Services, Inc., or ACFS, provides financial advisory services to our portfolio companies. The total portfolio value of investments was $3,204,292 and $1,911,743 at December 31, 2004 and 2003, respectively. During the years ended December 31, 2004, 2003, and 2002, we made investments totaling $2,017,600, $1,083,100 and $573,500, including $129,500, $39,100 and $36,300, respectively in funds committed but undrawn under credit facilities at the date of the investment. The weighted average effective interest rate on debt securities was 12.9%, 13.5% and 14.3%, at December 31, 2004, 2003, and 2002, respectively.

 

We invest in and sponsor management and employee buyouts, invest in private equity sponsored buyouts, and provide capital directly to private and small public companies. We provide senior debt, mezzanine debt and equity to fund growth, acquisitions and recapitalizations. We also provide capital directly to private and small public companies for growth, acquisitions or recapitalizations.

 

We seek to be a long-term partner with our portfolio companies. As a long-term partner, we will invest capital in a portfolio company subsequent to our initial investment if we believe that it can achieve appropriate returns for our investment. Add-on financings fund (i) strategic acquisitions by the portfolio company of either a complete business or specific lines of a business that are related to the portfolio company’s business, (ii) recapitalization at the portfolio company, (iii) growth at the portfolio company such as product development or plant expansions, or (iv) working capital for portfolio companies, sometimes in distressed situations, that need capital to fund operating costs, debt service, or growth in receivables or inventory.

 

Our investments during the years ended December 31, 2004, 2003 and 2002 were as follows:

 

     Year Ended
December 31, 2004


   Year Ended
December 31, 2003


   Year Ended
December 31, 2002


American Capital Sponsored Buyouts

   $ 689,000    $ 446,600    $ 245,300

Financing for Private Equity Buyouts

     874,700      468,300      197,000

Direct Investments

     17,600      40,000      —  

Add-On Financing for Acquisitions

     120,600      42,500      80,700

Add-On Financing for Recapitalization

     255,300      60,200      22,300

Add-On Financing for Direct Investments

     19,200      —        —  

Add-On Financing for Growth

     5,600      —        4,100

Add-On Financing for Working Capital

     35,600      25,500      24,100
    

  

  

Total

   $ 2,017,600    $ 1,083,100    $ 573,500
    

  

  

 

Critical Accounting Policies

 

Valuation of Investments

 

We value our investment portfolio each quarter. Our FACT group prepares the portfolio company valuations each quarter using the most recent portfolio company financial statements and forecasts. The FACT group will consult with the respective members of our Investment Team who are managing the portfolio company to obtain further updates on the portfolio company performance, including information such as industry trends, new product development, and other operational issues. The valuations are reviewed by senior management and audit committee of our board of directors and presented to the board of directors, which reviews and approves the portfolio valuations in accordance with the following valuation policy.

 

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Investments are carried at fair value, as determined in good faith by our board of directors. Unrestricted securities that are publicly traded are valued at the closing price on the valuation date. For debt and equity securities of companies that are not publicly traded, or for which we have various degrees of trading restrictions, we prepare an analysis consisting of traditional valuation methodologies to estimate the enterprise value of the portfolio company issuing the securities. The methodologies consist of valuation estimates based on: valuations of comparable public companies, recent sales of comparable companies, discounting the forecasted cash flows of the portfolio company, the liquidation or collateral value of the portfolio company’s assets, third party valuations of the portfolio company and the value of recent investments in the equity securities of the portfolio company. We weight some or all of the above valuation methods in order to conclude on our estimate of fair value. In valuing convertible debt, equity or other securities, we value our equity investment based on our pro rata share of the residual equity value available after deducting all outstanding debt from the estimated enterprise value. We value non-convertible debt securities at cost plus amortized original issue discount, or OID, to the extent that the estimated enterprise value of the portfolio company exceeds the outstanding debt of the portfolio company. If the estimated enterprise value is less than the outstanding debt of the company, we reduce the value of our debt investment beginning with the junior most debt such that the enterprise value less the value of the outstanding debt is zero. If there is sufficient enterprise value to cover the face amount of a debt security that has been discounted due to the detachable equity warrants received with that security, that detachable equity warrant will be valued such that the sum of the discounted debt security and the detachable equity warrant equal the face value of the debt security.

 

Due to the uncertainty inherent in the valuation process, such estimates of fair value may differ significantly from the values that would have been used had a ready market for the securities existed, and the differences could be material. Additionally, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different from the valuations currently assigned.

 

Interest and Dividend Income Recognition

 

Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. OID is accreted into interest income using the effective interest method. OID initially represents the value of detachable equity warrants obtained in conjunction with the acquisition of debt securities and loan origination fees that represent yield enhancement. Dividend income is recognized on the ex-dividend date for common equity securities and on an accrual basis for preferred equity securities to the extent that such amounts are expected to be collected. In determining the amount of dividend income to recognize, if any, from cash distributions on common equity securities, we will assess many factors including a portfolio company’s cumulative undistributed income and operating cash flow. Cash distributions from common equity securities received in excess of such undistributed amount are recorded first as a reduction of our investment and then as a realized gain on investment. We stop accruing interest or dividends on our investments when it is determined that the interest or dividend is not collectible. We assess the collectibility of the interest and dividends based on many factors including the portfolio company’s ability to service our loan based on current and projected cash flows as well as the current valuation of the enterprise. For investments with payment-in-kind (PIK) interest or dividends, we base income and dividend accruals on the valuation of the PIK notes or securities received from the borrower. If the portfolio company valuation indicates a value of the PIK notes or securities that is not sufficient to cover the contractual interest or dividend, we will not accrue interest or dividend income on the notes or securities.

 

A change in the portfolio company valuation assigned by us could have an effect on the amount of loans on non-accrual status. Also, a change in a portfolio company’s operating performance and cash flows can impact a portfolio company’s ability to service our debt and therefore could impact our interest recognition.

 

Fee Income Recognition

 

Fees primarily include financial advisory, transaction structuring, financing and prepayment fees. Financial advisory fees represent amounts received for providing advice and analysis to companies and are recognized as

 

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earned provided collection is probable. Transaction structuring and loan financing fees represent amounts received for structuring, financing, and executing transactions and are generally payable only if the transaction closes and are recognized as earned when the transaction is completed. Prepayment fees are recognized as they are received.

 

Stock-based compensation

 

In 2003, we adopted Financial Accounting Standards Board (FASB) Statement No. 123, “Accounting for Stock-Based Compensation” to account for stock-based compensation plans for all stock options granted in 2003 and forward as permitted under FASB Statement No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—An Amendment to FASB Statement No. 123.” In applying FASB Statement No. 123 to all stock options granted in 2003 and forward, the estimated fair value of the stock options are expensed pro rata over the vesting period of the options and are included on our consolidated statements of operations as “Stock-based compensation.” In accordance with FASB Statement No. 123, we elected to continue to apply the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” to all stock options granted prior to January 1, 2003 and provide pro forma disclosure of our consolidated net operating income and net increase in shareholders’ equity resulting from operations calculated as if compensation costs were computed in accordance with FASB Statement No. 123.

 

Derivative Financial Instruments

 

We use derivative financial instruments to manage interest rate risk. We have established policies and procedures for risk assessment and the approval, reporting and monitoring of derivative financial instrument activities. We do not hold or issue derivative financial instruments for speculative purposes. All derivative financial instruments are recorded at fair value with changes in value reflected in net unrealized appreciation or depreciation of investments during the reporting period. The fair value of these instruments is based on the estimated net present value of the future cash flows using the forward interest rate yield curve in effect at the end of the period.

 

Our derivatives are considered economic hedges that do not qualify for hedge accounting under FASB Statement No. 133 “Accounting for Derivative Instruments and Hedging Activities.” In 2004, the Securities and Exchange Commission prescribed new guidance on its interpretations of FASB Statement No. 133 for public investment companies related to the income statement classification of periodic interest rate derivative settlements. In prior periods, we recorded the payments and accrual of periodic interest settlements of interest rate derivative agreements in interest income. Under the new accounting method, we record the accrual of the periodic interest settlements of interest rate derivatives in net unrealized appreciation (depreciation) of investments and subsequently record the amount as a realized gain (loss) on investments on the interest settlement date. We adopted the new accounting method prospectively in 2004. The adoption of this new accounting method did not have any impact on our net increase in shareholders’ equity resulting from operations.

 

Results of Operations

 

Our consolidated financial performance, as reflected in our consolidated statements of operations, is composed of three primary elements. The first element is “Net operating income,” which is primarily the interest, dividends and prepayment fees earned from investing in debt and equity securities and the fees we earn from financial advisory and transaction structuring activities, less our operating expenses and provision for income taxes. The second element is “Net unrealized appreciation (depreciation) of investments,” which is the net change in the estimated fair values of our portfolio investments and the change in the estimated fair value of the future payment streams of our interest rate derivatives, at the end of the period compared with their estimated fair values at the beginning of the period or their stated costs, as appropriate. The third element is “Net realized (loss) gain on investments,” which reflects the difference between the proceeds from an exit of a portfolio investment and the cost at which the investment was carried on our consolidated balance sheets and periodic settlements of interest rate derivatives.

 

 

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The consolidated operating results for the years ended December 31, 2004, 2003, and 2002 are as follows:

 

     Year Ended
December 31, 2004


    Year Ended
December 31, 2003


    Year Ended
December 31, 2002


 

Operating income

   $ 336,082     $ 206,280     $ 147,022  

Operating expenses

     113,851       65,577       44,473  
    


 


 


Operating income before income taxes

     222,231       140,703       102,549  

Provision for income taxes

     (2,130 )     —         —    
    


 


 


Net operating income

     220,101       140,703       102,549  

Net realized (loss) gain on investments

     (37,870 )     22,006       (20,741 )

Net unrealized appreciation (depreciation) of investments

     99,214       (44,725 )     (61,747 )
    


 


 


Net increase in shareholders’ equity resulting from operations

   $ 281,445     $ 117,984     $ 20,061  
    


 


 


 

Fiscal Year 2004 Compared to Fiscal Year 2003

 

Operating Income

 

Total operating income is comprised of two components: interest and dividend income and fee income. For the year ended December 31, 2004, total operating income increased $129,802, or 63%, over the year ended December 31, 2003. Interest and dividend income consisted of the following for the years ended December 31, 2004 and December 31, 2003:

 

     Year Ended
December 31, 2004


   Year Ended
December 31, 2003


 

Interest income on debt securities

   $ 243,328    $ 167,480  

Interest cost of interest rate derivative agreements

     —        (17,214 )

Interest income on bank deposits and employee loans

     981      601  

Dividend income on equity securities

     26,924      8,191  
    

  


Total interest and dividend income

   $ 271,233    $ 159,058  
    

  


 

Interest income on debt securities increased by $75,848, or 45%, to $243,328 for 2004 from $167,480 for 2003, primarily due to an increase in our debt investments, which was partially offset by a decline in the daily weighted average interest rate on our debt investments, excluding the impact of interest rate swaps. Our daily weighted average debt investments at cost increased from $1,219,200 in 2003 to $1,804,000 in 2004 resulting from new loan originations net of loan repayments during the year ended December 31, 2004. The daily weighted average interest rate on debt investments, excluding interest rate swaps, decreased to 13.5% in 2004 from 13.7% in 2003 due partially to an increase in the total senior loans as a percentage of our total loan portfolio; our senior loans generally yield lower rates than our higher yielding subordinated loans. This is partially offset by an increase in interest rates on our variable rate based loans as the weighted average monthly prime lending rate increased from 4.10% in 2003 to 4.40% in 2004 and the average monthly LIBOR rate increased from 1.21% in 2003 to 1.55% in 2004.

 

To match the interest rate basis of our assets and liabilities and to fulfill our obligations under the terms of our revolving debt funding facilities and asset securitizations, we enter into interest rate derivative agreements to hedge securitized debt investments in which we either pay a floating rate based on the prime rate and receive a floating rate based on LIBOR, or pay a fixed rate and receive a floating rate based on LIBOR. Use of the interest rate derivatives enables us to manage the impact of changing interest rates on spreads between the yield on our investments and the cost of our borrowings. Our derivatives are considered economic hedges that do not qualify for hedge accounting under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities.” In 2004, the Commission prescribed new guidance on its interpretations of FASB Statement No. 133

 

29


for public investment companies related to the income statement classification of the periodic interest rate derivative settlements. In prior periods, we recorded the payments and accrual of periodic interest settlements of interest rate derivative agreements in interest income. Under the new accounting method, we record the accrual of the periodic interest settlements of interest rate derivatives in net unrealized appreciation (depreciation) of investments and subsequently record the amount as a net realized gain (loss) on investments on the interest settlement date. We adopted the new accounting method prospectively in 2004. In 2003, the interest cost of interest rate derivative agreements included in interest income was $17,214. In 2004, the total interest rate cost of interest rate derivative agreements included in both net unrealized appreciation (depreciation) of investments and net realized gain (loss) on investments was $21,061.

 

Dividend income on equity securities increased by $18,733 to $26,924 for 2004 from $8,191 for 2003 due primarily to an increase in preferred stock investments and an increase in recurring and non-recurring cash dividends received on common equity investments. We have grown our investments in equity securities to a fair value of $909,680 as of December 31, 2004, a 97% increase over the prior year. Although these investments do not produce a significant amount of current income, we expect to experience future net realized gains from these equity investments if they continue to appreciate in value. In addition, in 2004, we received cash dividends from common equity investments, primarily controlled companies, of $9,062 from six portfolio companies compared to $4,925 from one portfolio company in 2003.

 

Our daily weighted average total debt and equity investments at cost increased from $1,450,600 in 2003 to $2,442,800 in 2004. The daily weighted average yield on total debt and equity investments, excluding the impact of interest rate swaps, decreased from 12.1% in 2003 to 11.1% in 2004 due to the reasons discussed above including an overall increase in equity investments in 2004 that do not produce a current yield.

 

Fee income consisted of the following for the years ended December 31, 2004 and December 31, 2003:

 

     Year Ended
December 31, 2004


   Year Ended
December 31, 2003


Transaction structuring fees

   $ 14,148    $ 12,601

Loan financing fees

     15,367      13,919

Equity financing fees

     9,682      5,375

Financial advisory fees

     8,710      4,737

Prepayment fees

     6,650      3,836

Other structuring fees

     2,466      3,375

Other fees

     7,826      3,379
    

  

Total fee income

   $ 64,849    $ 47,222
    

  

 

Fee income increased by $17,627, or 37%, to $64,849 in 2004 from $47,222 in 2003. In 2004, we recorded $14,148 in transaction structuring fees for thirteen buyouts of new portfolio companies totaling $689,000 of American Capital financing. In 2003, we recorded $12,601 in transaction structuring fees for seven buyouts of new portfolio companies and two existing portfolio companies totaling $446,600 of American Capital financing. The transaction structuring fees were 2.1% and 2.8% of buyouts in 2004 and 2003, respectively. The increase in the loan financing fees was attributable to an increase in new debt investments from $902,600 in 2003 to $1,678,600 in 2004, which is partially offset by an increase in 2004 in the portion of loan origination fees deferred as a discount that are representative of additional yield. The loan financing fees were 0.9% and 1.5% of loan originations in 2004 and 2003, respectively. Equity financing fees increased primarily due to an increase in equity investments during 2004 as compared to 2003. The increase in financial advisory fees is due primarily to the increase in the number of portfolio companies. The prepayment fees of $6,650 in 2004 are the result of the prepayment by seventeen portfolio companies of loans totaling $266,900 compared to prepayment fees of $3,836 in 2003 as the result of the prepayment by ten portfolio companies of loans totaling $136,800.

 

30


Operating Expenses

 

Operating expenses for 2004 increased $48,274, or 74%, over 2003. Our operating leverage decreased to 1.9% in 2004 compared to 2.2% in 2003. Operating leverage is our operating expenses, excluding stock-based compensation and interest expense, divided by our total assets.

 

Interest expense increased from $18,514 for 2003 to $36,851 for 2004. The increase in interest expense is due both to an increase in our weighted average borrowings from $582,200 for 2003 to $999,700 for 2004 and to an increase in our weighted average interest rate on outstanding borrowings, including amortization of deferred finance costs, from 3.18% for 2003 to 3.69% for 2004. As discussed above, the increase in the weighted average interest rate is partially due to an increase in the average monthly LIBOR rate from 1.21% in 2003 to 1.55% in 2004.

 

Salaries and benefits expense increased from $27,950 for 2003 to $40,446 for 2004 due primarily to an increase in employees from 132 at December 31, 2003 to 191 at December 31, 2004 and annual salary rate increases.

 

General and administrative expenses increased from $16,529 for 2003 to $26,487 for 2004 primarily due to higher (i) corporate governance costs associated with the implementation and compliance with the Sarbanes-Oxley Act of 2002, (ii) audit fees, (iii) legal fees, (iv) valuation service fees, (v) due diligence costs related to prospective investment transactions that were terminated by us, and (vi) additional overhead attributable to the increase in the number of employees.

 

Stock-based compensation was $10,067 for 2004 and $2,584 for 2003. In 2003, we adopted FASB Statement No. 123 to account for stock-based compensation plans for all stock options granted in 2003 and forward as permitted under FASB Statement No. 148. Accordingly, stock-based compensation is higher in 2004 since it includes the pro-rata vested expense of grants for two years compared to the pro-rata vested expense of grants for one year in 2003. In addition, the weighted average fair value for dividend adjusted option grants was $12.07 per option in 2004 compared to $10.30 per option in 2003. The increase in the weighted average fair value per option increased in 2004 primarily due to an increase in the average market price of our common stock on the date of grant.

 

Provision for Income Taxes

 

We operate to qualify to be taxed as a regulated investment company, or a RIC, as defined in Subtitle A, Chapter 1, under Subchapter M of the Internal Revenue Code of 1986, as amended. Generally, a RIC is entitled to deduct dividends it pays to its shareholders from its income to determine taxable income. We have distributed and currently intend to distribute sufficient dividends to eliminate our investment company taxable income.

 

Our consolidated operating subsidiary, ACFS, is subject to corporate level federal and state income tax. For the year ended December 31, 2004, we recorded a tax provision of $2,130 attributable primarily to ACFS. For the year ended December 31, 2003, we did not record a tax provision for ACFS primarily due to a net operating loss carry forward that was fully utilized during 2003.

 

 

31


Net Realized Gains (Losses)

 

Our net realized gains (losses) for 2004 and 2003 consisted of the following:

 

     Year Ended
December 31, 2004


    Year Ended
December 31, 2003


 

Weston ACAS Holdings, Inc.

   $ —       $ 24,930  

TransCore Holdings, Inc.

     19,972       —    

Texstars, Inc.

     10,891       —    

ACAS Acquisitions (PaR Systems), Inc.

     9,537       —    

CPM Acquisition Corp.

     —         6,099  

A&M Cleaning Products, Inc.

     —         5,181  

CST Industries, Inc.

     —         4,964  

Atlantech Holding Corp

     4,279       —    

Tube City, Inc.

     —         3,729  

Bankruptcy Management Solutions, Inc.

     2,569       —    

CIVCO Holding, Inc.

     2,123       —    

Roadrunner Freight Systems, Inc.

     1,735       —    

Plastech Engineered Products, Inc.

     745       1,641  

Erie County Plastics Corporation

     1,341       —    

Vigo Remittance Corp

     1,250       —    

Other, net

     4,211       3,828  
    


 


Total gross realized portfolio company gains

     58,653       50,372  
    


 


Chromas Technologies Corp.

     (32,043 )     —    

Fulton Bellows & Components, Inc.

     (14,256 )     (10,911 )

Academy Events Services, LLC

     (14,173 )     —    

Sunvest Industries, Inc.

     (14,032 )     —    

Parts Plus Group, Inc.

     —         (5,384 )

Starcom Holdings, Inc.

     —         (4,533 )

Westwind Group Holdings, Inc.

     —         (3,598 )

New Piper Aircraft, Inc.

     —         (2,231 )

Baran Group, Ltd.

     (2,161 )     —    

ThreeSixty Sourcing, Ltd.

     (1,818 )     —    

Other, net

     (146 )     (1,709 )
    


 


Total gross realized portfolio company losses

     (78,629 )     (28,366 )
    


 


Total net realized portfolio company (losses) gains

     (19,976 )     22,006  
    


 


Interest rate derivative periodic payments

     (17,894 )     —    
    


 


Total net realized (losses) gains

   $ (37,870 )   $ 22,006  
    


 


 

During 2004, we received full repayment of our $27,000 subordinated debt investments in TransCore Holdings, Inc. and sold all of our equity investments in TransCore consisting of our redeemable preferred stock, convertible preferred stock and common stock warrants for $26,409 in proceeds realizing a total gain of $19,972 offset by the reversal of unrealized appreciation of $18,888. The sale proceeds we recognized included proceeds we expect to receive held in escrow of $2,127, and we could receive up to an additional $376 in sale proceeds held in escrow over the next two years.

 

During 2004, we received full repayment of our $20,909 senior and subordinated debt investments in Texstars, Inc. and sold all of our equity investments in Texstars consisting of common stock and common stock warrants for $12,856 in proceeds realizing a total gain of $10,891 offset by the reversal of unrealized appreciation of $9,615. The sale proceeds we recognized included proceeds we expect to receive held in escrow of $1,936, and we could receive up to an additional $215 in sale proceeds held in escrow over the next two years.

 

32


During 2004, we received full repayment of our $22,500 subordinated debt investment in ACAS Acquisitions (PaR Systems), Inc. and received a $10,804 liquidating dividend on our common equity interest as a result of PaR’s sale of an 81% interest in its nuclear equipment and service business, recognizing a total gain of $9,537. We retained an 11% diluted ownership interest in ACAS Acquisitions (PaR Systems), Inc., which was renamed PaR Nuclear Holding Co., Inc. The non-nuclear business segment of ACAS Acquisitions (PaR Systems), Inc. was contributed to a newly created company, PaR Systems, Inc., shares of which were distributed to the existing shareholders. We provided $4,632 in subordinated debt financing to, and retained a 51% diluted ownership in, PaR Systems, Inc.

 

During 2004, we realized a gain of $4,279 from the realization of unamortized OID from the prepayment of debt by Atlantech Holding Corp. for which we received total proceeds of $18,750.

 

During 2004, Bankruptcy Management Solutions, Inc. recapitalized its balance sheet. Pursuant to the recapitalization, Bankruptcy Management repaid its existing debt, including $18,453 of our senior and subordinated debt, by issuing new debt, including $75,000 of debt provided by us, and also paid a cash dividend to its equity holders. We recognized a realized gain of $2,569 from the transaction consisting of $569 from the realization of unamortized OID from the prepayment of the existing debt and $2,000 from a cash dividend on our equity securities in excess of our cost basis.

 

During 2004, Chromas Technologies Corp. entered into an asset purchase agreement whereby substantially all of the assets were sold to and certain of the liabilities were assumed by a purchaser. The net cash proceeds were used to repay a portion of our outstanding loans. As part of the asset purchase agreement, Chromas will receive an additional deferred payment one year from the closing date. All of Chromas’ remaining assets including its right to receive the deferred payment were conveyed to us. Our remaining subordinated debt and equity investments in Chromas were deemed worthless and we recognized a realized loss of $32,043 offset by the reversal of unrealized depreciation of $29,767.

 

During 2004, we sold our senior subordinated debt investment in Fulton Bellows & Components, Inc. for nominal proceeds and recognized a realized loss of $6,818 offset by the reversal of unrealized depreciation of $7,001. In the third quarter of 2004, Fulton’s assets were sold under Section 363 of the Bankruptcy Code, and we received proceeds of $5,917 for partial repayment of our remaining senior debt investments. We recognized a realized loss of $7,438 from the write off of our remaining senior debt investments and common stock warrants partially offset by a reversal of unrealized depreciation of $7,194.

 

During 2004, Academy Event Services, LLC filed for Chapter 11 bankruptcy and the court conducted an auction for the sale of all of its assets during the quarter. We did not receive any proceeds from the auction sale held through the bankruptcy proceedings. Our subordinated debt and equity investments were deemed worthless and we recognized a realized loss of $14,173 offset by the reversal of unrealized depreciation of $7,813.

 

Sunvest Industries, Inc. was a holding company with two wholly-owned operating subsidiaries – Dyna-Fab LLC and Advanced Fabrication Technology LLC (AFT). In the fourth quarter of 2003, Dyna-Fab entered into an asset purchase agreement whereby substantially all of the assets of Dyna-Fab were sold. In the first quarter of 2004, AFT entered into an asset purchase agreement whereby substantially all of the assets of AFT were sold. During 2004, we foreclosed on Sunvest’s and its subsidiaries’ remaining assets including any rights to future payments under the asset purchase agreements. The remaining senior and subordinated debt and equity investments in Sunvest were deemed worthless and we recognized a realized loss of $14,032 offset by the reversal of unrealized depreciation of $14,052 in 2004.

 

In 2004, the Securities and Exchange Commission prescribed new guidance on its interpretations of SFAS No. 133 for public investment companies for the income statement classification of the periodic interest rate derivative settlements. In prior periods, we recorded the payments and accrual of periodic interest settlements of interest rate derivative agreements in interest income. Under the new accounting method, we record the accrual

 

33


of the periodic interest settlements of interest rate derivatives in net unrealized appreciation (depreciation) of investments and subsequently record the amount as a realized gain (loss) on investments on the interest settlement date. We adopted the new accounting method prospectively in 2004. During 2004, we recorded net realized losses of $17,894 for the interest rate derivative periodic settlements.

 

During 2003, we sold all of our equity interest in Weston ACAS Holdings, Inc. consisting of common stock, common stock warrants and preferred stock for $30,950 in cash proceeds and Weston also prepaid its remaining subordinated debt of $6,500, all as part of a recapitalization of Weston that resulted in Weston employees gaining 100% ownership of the company. We recognized a realized gain of $24,930 consisting of a $22,701 gain on the sale of our equity interest and $2,229 on the realization of the unamortized OID offset by the reversal of the unrealized appreciation of $20,822. As part of the recapitalization, we provided $12,750 of new subordinated debt financing to Weston as part of a $25,000 mezzanine debt financing provided by us and another mezzanine investor.

 

During 2003, we exited our investment in CPM Acquisition Corp. through a sale of our common stock warrants and the prepayment of the senior and subordinated debt. We received $30,428 in total proceeds from the sale and recognized a net realized gain of $6,099 offset by the reversal of unrealized appreciation of $3,462. The realized gain was comprised of $2,162 of unamortized OID on the senior and subordinated debt and $3,937 on the common stock warrants. The sale proceeds we recognized included proceeds we expect to receive held in escrow of $458, and we could receive up to an additional $342 in sale proceeds to be held in escrow over the next three years.

 

During 2003, we exited our investment in A&M Cleaning Products, Inc. through a sale of our common stock warrants and redeemable preferred stock and the prepayment of the subordinated debt. We received $14,942 in total proceeds from the sale and recognized a net realized gain of $5,181 offset by the reversal of unrealized appreciation of $4,916. The realized gain was comprised of $653 of unamortized OID on the subordinated debt and $4,528 on the common stock warrants and redeemable preferred stock. The sale proceeds we recognized included proceeds we expect to receive held in escrow of $755, and we could receive up to an additional $293 in sale proceeds held in escrow over the next three years.

 

During 2003, we exited our investment in CST Industries, Inc. through a sale of our common stock and the prepayment of the subordinated debt. We received $14,250 in total proceeds from the sale and recognized a net realized gain of $4,964 offset by the reversal of unrealized appreciation of $3,546. The realized gain was comprised of $804 of unamortized OID on the subordinated debt and $4,160 on the common stock.

 

During 2003, we exited our investment in Tube City, Inc. through a sale of our common stock warrants and the prepayment of the subordinated debt. We received $19,328 in total proceeds from the sale and recognized a net realized gain of $3,729 offset by the reversal of unrealized appreciation of $2,525. The realized gain was comprised of $1,927 of unamortized OID on the subordinated debt and $1,802 on the common stock warrants.

 

During 2003, we sold investments in three portfolio companies for a nominal sales price as part of one sale transaction. We sold our investment in the redeemable and convertible preferred stock of Fulton Bellows & Components, Inc. and recognized a realized loss of $10,911 offset by the reversal of unrealized depreciation of $10,911. We retained our common stock warrant and debt investments in Fulton Bellows. We also sold all of our investments in Parts Plus Group Inc., consisting of senior subordinated debt, redeemable preferred stock and common stock warrants, and recognized a realized loss of $5,384 offset by the reversal of unrealized depreciation of $5,380. We sold all of our investments in Westwind Group Holding, Inc., consisting of redeemable preferred stock and common stock, and recognized a realized a loss $3,598 offset by the reversal of unrealized depreciation of $3,598.

 

During 2003, we completed a recapitalization of Starcom Holdings, Inc. through a newly created company, NewStarcom Holdings, Inc. Under the terms of the recapitalization, we exchanged the existing senior debt of Starcom we purchased on June 30, 2003 for preferred equity in NewStarcom. In addition, American Capital’s

 

34


existing subordinated notes issued by Starcom and its subsidiaries were refinanced with the proceeds of new subordinated notes issued by NewStarcom. Another existing investor in Starcom also exchanged its subordinated notes for preferred equity of NewStarcom and also provided $2,000 of new subordinated debt financing to NewStarcom. We realized a loss of $4,533 to write off our original common equity investment in Starcom as a result of the recapitalization offset by the reversal of unrealized depreciation of $4,530.

 

Unrealized Appreciation and Depreciation of Investments

 

The net unrealized appreciation and depreciation of investments is based on portfolio asset valuations determined by management and approved by our board of directors. The following table itemizes the change in net unrealized appreciation (depreciation) of investments for 2004 and 2003:

 

     Number of
Companies


   Year Ended
December 31, 2004


    Number of
Companies


   Year Ended
December 31, 2003


 

Gross unrealized appreciation of portfolio company investments

   34    $ 192,395     29    $ 86,565  

Gross unrealized depreciation of portfolio company investments

   31      (134,726 )   31      (132,205 )

Reversal of prior period unrealized depreciation (appreciation) upon a realization

   11      33,787     13      (7,864 )
    
  


 
  


Net unrealized appreciation (depreciation) of portfolio company investments

   76      91,456     73      (53,504 )

Interest rate derivative periodic payment accrual

   —        (3,167 )   —        —    

Interest rate derivative agreements

   —        10,925     —        8,779  
    
  


 
  


Net unrealized appreciation (depreciation) of investments

   76    $ 99,214     73    $ (44,725 )
    
  


 
  


 

The fair value of the interest rate derivative agreements represents the estimated net present value of the future cash flows using a forward interest rate yield curve in effect at the end of the period. A negative fair value would represent an amount we would have to pay the other party and a positive fair value would represent an amount we would receive from the other party to terminate the agreement. They appreciate or depreciate based on relative market interest rates and their remaining term to maturity. The change in fair value is recorded as unrealized appreciation (depreciation) of interest rate derivative agreements.

 

As previously discussed, beginning in 2004 we record the accrual of the periodic interest settlements of interest rate swaps in net unrealized appreciation (depreciation) of investments and subsequently record the amount as a realized gain (loss) on investments on the interest settlement date.

 

As part of our quarterly process of valuing our investment portfolio, we engaged Houlihan Lokey Howard & Zukin Financial Advisors, Inc. beginning in the third quarter of 2003 to review independently the determination of fair value of American Capital’s portfolio company investments. Houlihan Lokey is the premier valuation firm in the U.S., engaged in approximately 800 valuation assignments per year for clients worldwide. In 2004, Houlihan Lokey reviewed 100% of our portfolio investments that have been a portfolio company for at least one year. In addition, Houlihan Lokey representatives attend American Capital’s quarterly valuation meetings and provide periodic reports and recommendations to our audit committee with respect to valuation of investments, our valuation models and policies and procedures.

 

In 2004, Houlihan Lokey reviewed our valuations of 85 companies, having $2,115,000 in aggregate fair value as reflected in our financial statements as of the respective fiscal quarter ends. Using methods and techniques that are customary for the industry and that Houlihan Lokey considers appropriate under the circumstances, Houlihan Lokey determined that the aggregate fair value assigned to the portfolio company investments by American Capital was within their reasonable range of aggregate value for such companies.

 

35


Fiscal Year 2003 Compared to Fiscal Year 2002

 

Operating Income

 

Total operating income is comprised of two components: interest and dividend income and fee income. For the year ended December 31, 2003, total operating income increased $59,258, or 40%, over the year ended December 31, 2002. Interest and dividend income consisted of the following for the years ended December 31, 2003 and December 31, 2002:

 

     Year Ended
December 31, 2003


    Year Ended
December 31, 2002


 

Interest income on debt securities

   $ 167,480     $ 129,180  

Interest cost of interest rate derivative agreements

     (17,214 )     (11,153 )

Interest income on bank deposits and employee loans

     601       1,315  

Dividend income on equity securities

     8,191       2,726  
    


 


Total interest and dividend income

   $ 159,058     $ 122,068  
    


 


 

Interest income on debt securities increased by $38,300, or 30%, to $167,480 for 2003 from $129,180 for 2002, primarily due to an increase in our debt investments, which was partially offset by a decline in the daily weighted average interest rate on our debt investments, excluding the impact of interest rate swaps. Our daily weighted average debt investments at cost increased from $855,500 in 2002 to $1,219,200 in 2003 resulting from new loan originations net of loan repayments during the last twelve months ended December 31, 2003. The daily weighted average interest rate on debt investments, excluding interest rate swaps, decreased to 13.7% in 2003 from 15.1% in 2002 due partially to a decrease in the weighted average monthly prime lending rate from 4.68% in 2002 to 4.10% in 2003 and a decrease in the average monthly LIBOR rate from 1.76% in 2002 to 1.21% in 2003. The decrease in the weighted average interest rate on debt securities is also partially due to an increase in the average non-accruing loans from $66,956 in 2002 to $103,998 in 2003.

 

To match the interest rate basis of our assets and liabilities and to fulfill our obligations under the terms of our revolving debt funding facility and asset securitizations, we enter into interest rate swap agreements to hedge securitized debt investments in which we either pay a floating rate based on the prime rate and receive a floating rate based on LIBOR, or pay a fixed rate and receive a floating rate based on LIBOR. Use of the interest rate swaps enables us to manage the impact of changing interest rates on spreads between the yield on our investments and the cost of our borrowings. As a result, both interest income and interest expense are affected by changes in LIBOR. See “Quantitative and Qualitative Disclosure About Market Risk” for a discussion of our use of interest rate swaps to mitigate the impact of interest rate changes on net operating income. The cost of the interest rate swap agreements increased by $6,061, from $11,153 for 2002 to $17,214 for 2003. The daily weighted average interest rate on debt investments at cost, including the impact of interest rate swaps, decreased to 12.3% in 2003 from 13.8% in 2002, due to the reasons noted above and the negative impact of our interest rate swaps.

 

Dividend income on equity securities increased by $5,465 to $8,191 for 2003 from $2,726 for 2002 due primarily to cash dividends of $4,925 received from one portfolio company. Our daily weighted average total debt and equity investments at cost increased from $983,300 in 2002 to $1,450,600 in 2003. The daily weighted average yield on total debt and equity investments, excluding the impact of interest rate swaps, decreased to 12.1% in 2003 from 13.4% in 2002 primarily due to the reasons noted above.

 

 

36


Fee income consisted of the following for the years ended December 31, 2003 and December 31, 2002:

 

     Year Ended
December 31, 2003


   Year Ended
December 31, 2002


Transaction structuring fees

   $ 12,601    $ 4,904

Loan financing fees

     13,919      8,060

Equity financing fees

     5,375      1,796

Financial advisory fees

     4,737      3,781

Prepayment fees

     3,836      1,478

Other structuring fees

     3,375      2,050

Other fees

     3,379      2,885
    

  

Total fee income

   $ 47,222    $ 24,954
    

  

 

Fee income increased by $22,268, or 89%, to $47,222 in 2003 from $24,954 in 2002. In 2003, we recorded $12,601 in transaction fees primarily for seven buyouts of new portfolio companies and two existing portfolio companies totaling $446,600 of American Capital financing. In 2002, we recorded $4,904 for ten buyouts totaling $245,300 of American Capital financing. The transaction structuring fees were 2.8% and 2.0% of buyouts in 2003 and 2002, respectively. The increase in loan financing fees was attributable to an increase in new debt investments from $480,226 in 2002 to $902,600 in 2003 partially offset by an increase in 2003 in the portion of fees deferred as a discount that are representative of additional yield. The loan financing fees were 1.5% and 1.7% of loan originations in 2003 and 2002, respectively. Equity financing fees increased primarily due to an increase in equity investments during 2003 as compared to 2002. The prepayment fees of $3,836 in 2003 are the result of the prepayment by ten portfolio companies of loans totaling $136,800 compared to prepayment fees of $1,478 in 2002 as the result of the prepayment by three portfolio companies of loans totaling $42,900.

 

Operating Expenses

 

Operating expenses for 2003 increased $21,104, or 47%, over 2002. Interest expense increased from $14,321 for 2002 to $18,514 for 2003 due to an increase in our weighted average borrowings from $416,800 for 2002 to $582,200 for 2003, net of a decrease in the weighted average interest rate on outstanding borrowings, including amortization of deferred finance costs, from 3.43% for 2002 to 3.18% for 2003. As discussed above, the decrease in the weighted average interest rate is due to a decrease in the average monthly LIBOR rate from 1.76% in 2002 to 1.21% in 2003.

 

Salaries and benefits expense increased from $18,621 for 2002 to $27,950 for 2003 due primarily to an increase in employees from 108 at December 31, 2002 to 132 at December 31, 2003 and annual salary rate increases.

 

General and administrative expenses increased from $11,531 for 2002 to $16,529 for 2003 primarily due to higher facilities expenses resulting from an increase in the number of employees and additional corporate office space, accounting fees, legal fees, financial reporting expenses, reserves for uncollectible amounts, and insurance expense.

 

Stock-based compensation was $2,584 for the year ended December 31, 2003. In 2003, we adopted SFAS 123 to account for stock-based compensation plans for all stock options granted in 2003 and forward as permitted under SFAS 148.

 

 

37


Net Realized Gains (Losses)

 

Our net realized gains (losses) for 2003 and 2002 consisted of the following:

 

     Year Ended
December 31, 2003


    Year Ended
December 31, 2002


 

Weston ACAS Holdings, Inc.

   $ 24,930     $ 2,425  

CPM Acquisition Corp.

     6,099       —    

A&M Cleaning Products, Inc.

     5,181       —    

CST Industries, Inc.

     4,964       —    

Tube City, Inc.

     3,729       —    

Plastech Engineered Products, Inc.

     1,641       —    

Middleby Corporation

     —         2,444  

IGI, Inc.

     —         1,300  

Other, net

     3,828       1,198  
    


 


Total gross realized portfolio company gains

     50,372       7,367  
    


 


Fulton Bellows & Components, Inc.

     (10,911 )     —    

Parts Plus Group, Inc.

     (5,384 )     —    

Starcom Holdings, Inc.

     (4,533 )     —    

Westwind Group Holdings, Inc.

     (3,598 )     —    

New Piper Aircraft, Inc.

     (2,231 )     —    

Goldman Industrial Group

     —         (25,578 )

Decorative Surfaces International, Inc.

     —         (1,353 )

Biddeford Textile Corp.

     —         (1,100 )

Other, net

     (1,709 )     (77 )
    


 


Total gross realized portfolio company losses

     (28,366 )     (28,108 )
    


 


Total net realized gains (losses)

   $ 22,006     $ (20,741 )
    


 


 

See “Fiscal Year 2004 Compared to Fiscal Year 2003” for discussion on the net realized gains (losses) for the year ended December 31, 2003.

 

In September 2002, we exited our investment in Goldman Industrial Group as a result of the sale of certain of Goldman’s assets under Section 363 of the Bankruptcy Code. Those assets were related to the sale of Bridgeport Machines, Ltd, or BML, and the intellectual property, brand name, and other intangible assets of Bridgeport Machines, Inc. In 2000, we made a $30,000 investment consisting of subordinated debt with common stock warrants in Goldman. We had recorded an unrealized loss of $3,937 in 2001 and an unrealized loss of $21,246 in 2002 for a cumulative unrealized loss of $25,183 through the second quarter of 2002 to adjust our carrying value to fair value. We recognized a net realized loss of $25,578 in 2002 on our investments in $25,000 of the subordinated debt and common stock warrants and recorded an unrealized gain of $25,183 to reverse the previously recorded unrealized loss. The Bridgeport assets were purchased by BPT Holdings, Inc., which was capitalized with $18,000 from us in the form of senior debt, preferred stock and common stock and the assumption of the $30,000 subordinated debt from Goldman. Of our $30,000 investment in Goldman, $5,000 was directly in BML, which was not a party to the Goldman bankruptcy. This investment continued to be recorded at a value of $5,000. The $25,000 balance of the Goldman investment was exchanged for securities in BPT, which were deemed not to have any value and were therefore treated as a realized loss.

 

 

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Unrealized Appreciation and Depreciation of Investments

 

The net unrealized appreciation and depreciation of investments is based on portfolio asset valuations determined by management and approved by our board of directors. The following table itemizes the change in net unrealized (depreciation) appreciation of investments for 2003 and 2002:

 

     Number of
Companies


   Year Ended
December 31, 2003


    Number of
Companies


   Year Ended
December 31, 2002


 

Gross unrealized appreciation of portfolio company investments

   29    $ 86,565     20    $ 80,853  

Gross unrealized depreciation of portfolio company investments

   31      (132,205 )   30      (147,130 )

Reversal of prior period unrealized (appreciation) depreciation upon a realization

   13      (7,864 )   8      31,252  
    
  


 
  


Net unrealized depreciation of portfolio company investments

   73      (53,504 )   58      (35,025 )

Interest rate derivative agreements

   —        8,779     —        (26,722 )
    
  


 
  


Net unrealized depreciation of investments

   73    $ (44,725 )   58    $ (61,747 )
    
  


 
  


 

The fair value of the interest rate derivative agreements represents the estimated net present value of the future cash flows using a forward interest rate yield curve in effect at the end of the period. A negative fair value would represent an amount we would have to pay the other party and a positive fair value would represent an amount we would receive from the other party to terminate the agreement. They appreciate or depreciate based on relative market interest rates and their remaining term to maturity. The change in fair value is recorded as unrealized appreciation (depreciation) of interest rate derivative agreements.

 

Financial Condition, Liquidity, and Capital Resources

 

As of December 31, 2004, we had $58,367 in cash and cash equivalents and $141,895 of restricted cash. Our restricted cash consists primarily of collections of interest and principal payments on assets that are securitized. In accordance with the terms of the related securitized debt agreements, those funds are generally distributed each month to pay interest and principal on the securitized debt. We had outstanding debt secured by our assets of $623,348 under three revolving debt funding facilities, $28,847 under repurchase agreements, $741,783 under five asset securitizations as well as $167,000 in unsecured notes. As of December 31, 2004, we had availability under our revolving debt funding facilities of $421,652 and under forward equity sale agreements of $184,313. During 2004, we principally funded investments using draws on the revolving debt funding facilities, proceeds from asset securitizations, an unsecured debt issuance and equity offerings as well as proceeds from sales of senior loans, repayments of loans and sales of equity investments.

 

We have historically and anticipate continuing to have to issue debt or equity (including under forward equity sale agreements) securities in addition to the above borrowings and forward equity sale agreements to expand our investments in middle market companies. The terms of the future debt and equity issuances cannot be determined and there can be no assurances that the debt or equity markets will be available to us on terms we deem favorable. We expect to continue to raise debt and equity capital during the year ended December 31, 2005 to fund our new investments for 2005.

 

As a regulated investment company, we are required to distribute annually 90% or more of our investment company taxable income and 98% of our net realized short-term capital gains to shareholders. We provide shareholders with the option of reinvesting their distributions in American Capital. In 2004, 2003 and 2002, shareholders reinvested $7,114, $803 and $961, respectively, in dividends. Since our IPO through December 31, 2004, shareholders have reinvested $11,489 of dividends in American Capital. In August 2004, we amended our

 

39


dividend reinvestment plan to provide a 5% discount on shares purchased through the reinvested dividends, effective for dividends paid in December 2004 and thereafter, subject to terms of the plan.

 

Equity Capital Raising Activities

 

On August 2, 2004, we filed a shelf registration statement with the Securities and Exchange Commission, with respect to our debt and equity securities. The shelf registration statement allows us to sell our registered debt or equity securities on a delayed or continuous basis in an amount up to $1,750,000. As of December 31, 2004, our remaining capacity under the shelf registration statement was $1,016,008.

 

In September 2004, we completed a public offering in which 13,225 shares of our common stock, including an underwriters’ over-allotment, were sold at a public offering price of $31.60 per share. Of those shares, 2,500 were offered directly by us and 9,000 were sold by third parties in connection with agreements to purchase common stock from us for future delivery dates pursuant to forward sale agreements.

 

The 9,000 shares of common stock were borrowed from third party market sources by counterparties, or forward purchasers, of the forward sale agreements who then sold the shares to the public. Pursuant to the forward sale agreements, we must sell to the forward purchasers 9,000 shares of our common stock generally at such times as we elect over a one-year period. The forward sale agreements provide for settlement on a settlement date or dates to be specified at our discretion within the duration of the forward sale agreements through a termination date of September 24, 2005. On a settlement date, we will issue shares of our common stock to the forward purchaser at the then applicable forward sale price. The forward sale price was initially $30.18 per share, which was the September 2004 public offering price of such shares less the underwriting discount. The forward sale agreements provide that the initial forward sale price per share will be subject to daily adjustment based on a floating interest factor equal to the federal funds rate, less a spread, and be subject to decrease by $0.73, $0.06, $0.73, $0.75 and $0.77 per share on each of November 10, 2004, December 28, 2004, February 10, 2005, May 11, 2005 and August 10, 2005, respectively. The forward sale price is also subject to decrease if the cost to the forward purchasers of borrowing our common stock exceeds a specified amount. In December 2004, we issued 2,750 shares under the forward sale agreements and received net proceeds of $81,244. We have 6,250 shares available under the forward sale agreements and the forward sale price is $29.49 per share as of December 31, 2004. In February 2005, we issued an additional 1,000 shares under the forward sale agreements and received net proceeds of $29,506.

 

Each forward purchaser under a forward sale agreement has the right to accelerate its forward sale agreement and require us to physically settle on a date specified by such forward purchaser if certain events occur, such as (1) in its judgment, it is unable to continue to borrow a number of shares of our common stock equal to the number of shares to be delivered by us under its forward sale agreement or the cost of borrowing the common stock has increased above a specified amount, (2) we declare any dividend or distribution on shares of our common stock payable in (i) excess of a specified amount, (ii) securities of another company, or (iii) any other type of securities (other than shares of our common stock), rights, warrants or other assets for payment at less than the prevailing market price in such forward purchaser’s judgment, (3) the net asset value per share of our outstanding common stock exceeds a specified percentage of the then applicable forward sales price, (4) our board of directors votes to approve a merger or takeover of us or similar transaction that would require our shareholders to exchange their shares for cash, securities, or other property, or (5) certain other events of default or termination events occur.

 

In accordance with Emerging Issues Task Force (EITF) Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, the forward sale agreements are considered equity instruments and the shares of common stock are not considered outstanding until issued. Also, in accordance with EITF Issue No. 03-06, “Participating Securities and the Two-Class Method Under FASB Statement No. 128”, the forward sale agreements are not considered participating securities for the purpose of determining basic earnings per share under FASB Statement No. 128, “Earnings per Share.”

 

40


However, the dilutive impact of the shares issuable under the forward sale agreements is included in our diluted weighted average shares under the treasury stock method based on the forward sale price deemed to be most advantageous to the counterparties.

 

Our objective with the use of forward sale agreements is to allow us to manage more efficiently our debt to equity ratio, considering applicable statutory requirements and our capital needs associated with funding our investment activities. As a BDC, we are able to issue debt securities and preferred stock in an amount such that our asset coverage is at least 200% of the amount of our outstanding debt securities and preferred stock. Because we do not currently have any preferred stock outstanding, this provision of the 1940 Act effectively limits our ratio of debt to equity at this time to 1:1. However, as a practical matter, in order to provide sufficient flexibility to fund our projected investments and a cushion, we generally keep our debt to equity ratio somewhat below 1:1. As of December 31, 2004 for example, our ratio of debt to equity was 0.83:1.

 

A principal consideration in keeping our debt to equity ratio at less than 1:1 is that given the nature and variability of the equity capital markets, it is not practical to raise equity in frequent small increments, which would match in amount and timing our needs for investment funds. Thus, we are required to raise equity in larger increments than may be immediately invested and therefore we repay advances on our credit facilities with the proceeds of such equity issuances. We then make investments and manage our cash needs by drawing on our credit facilities. The funding sequence of issuing equity, repaying our credit facilities and then drawing on the credit facilities to fund new investments causes our average debt to equity ratio to be materially below 1:1. Moreover, because we cannot be assured that access to equity markets will be available whenever we may need equity capital to make a new investment, we must generally keep our credit availability somewhat higher and our debt to equity ratio materially lower than what would otherwise be if we were more readily assured access to equity capital.

 

The use of forward sale contracts is expected to allow us to deliver common stock and receive cash at our election to the extent covered by outstanding contracts, without undertaking a new offering of common stock. Because we would be more assured of access to equity capital, we expect to be in a position to allow our debt to equity ratio to be closer to 1:1 than without the use of forward sale agreements. During periods in which we have reported earnings, having a higher debt to equity ratio should have a beneficial effect on our overall cost of capital, which could result in increased earnings.

 

For fiscal years 2004, 2003 and 2002, we completed several public offerings of our common stock. The following table summarizes the total shares sold, including shares sold pursuant to the underwriters’ over-allotment options, and the total proceeds we received, net of the underwriters’ discount for the public offerings of our common stock for the fiscal years 2004, 2003 and 2002:

 

     Shares Sold

   Over-allotment
Option Shares Sold


   Proceeds, Net of
Underwriters’ Discount


December 2004 forward sale agreement issuance

   2,750    —      $ 81,244

September 2004 public offering

   2,500    1,725    $ 127,511

July 2004 public offering

   4,000    425    $ 118,325

May 2004 public offering

   6,500    975    $ 183,063

February 2004 public offering

   1,890    284    $ 68,313

November 2003 public offering

   7,600    1,140    $ 223,945

September 2003 public offering

   2,000    188    $ 51,826

March 2003 public offering

   5,800    870    $ 143,356

January 2003 public offering

   4,100    615    $ 102,033

November 2002 public offering

   2,600    390    $ 51,183

July 2002 public offering

   2,900    —      $ 73,084

 

Other Capital Raising Activities

 

In 2004 and 2003, we sold senior loans of our portfolio companies, for which we remain the servicer, for total cash proceeds of $217,375 and $62,184, respectfully. We expect to continue to sell senior loans as a source of new capital to be reinvested into higher yielding investments.

 

41


Debt Capital Raising Activities

 

Our debt obligations consisted of the following as of December 31, 2004 and 2003:

 

Debt


   December 31, 2004

   December 31, 2003

Revolving debt-funding facility, $850,000 commitment

   $ 623,348    $ 116,000

Revolving debt-funding facility, $70,000 commitment

     —        —  

Revolving debt-funding facility, $125,000 commitment

     —        —  

Unsecured debt

     167,000      —  

Repurchase agreements

     28,847      —  

ACAS Business Loan Trust 2000-1 asset securitization

     —        39,348

ACAS Business Loan Trust 2002-1 asset securitization

     2,291      42,861

ACAS Business Loan Trust 2002-2 asset securitization

     44,590      103,164

ACAS Business Loan Trust 2003-1 asset securitization

     110,895      221,298

ACAS Business Loan Trust 2003-2 asset securitization

     174,007      317,540

ACAS Business Loan Trust 2004-1 asset securitization

     410,000      —  
    

  

Total

   $ 1,560,978    $ 840,211
    

  

 

We, through ACS Funding Trust I, an affiliated statutory trust, entered into the AFT I Facility, a revolving debt-funding facility administered by Wachovia Capital Markets, LLC in March 1999. On June 13, 2003, we and ACS Funding Trust I entered into an amended and restated loan funding and service agreement with the existing lenders with an aggregate commitment of $225,000. In 2004, we entered into amendments to the existing amended and restated loan funding facility and servicing agreement increasing the aggregate commitment from $225,000 to $425,000 through August 13, 2004. On August 10, 2004, we entered into a second amended and restated loan funding facility and servicing agreement that increased the aggregate commitment to $600,000. Subsequently, we entered into amendments to the second amended and restated loan funding facility and servicing agreement adding additional lenders to the facility and increasing the maximum availability under the facility to $850,000. Our ability to make draws on the AFT I Facility expires in August 2005 unless extended prior to such date for an additional 364-day period with the consent of the lenders. If the facility is not extended, any principal amounts then outstanding will be amortized over a 24-month period through a termination date in August 2007. As of December 31, 2004, this facility was collateralized by loans from our portfolio companies with a principal balance of $892,687. Interest on borrowings under this facility is paid monthly and is charged at either a one-month LIBOR or a commercial paper rate plus a spread (3.75% at December 31, 2004). We are also charged an unused commitment fee of 0.15%. The facility contains covenants that, among other things, require us to maintain a minimum net worth and restrict the loans securing the facility to certain dollar amounts, concentrations in certain geographic regions and industries, certain loan grade classifications, certain security interests, and interest payment terms.

 

On March 25, 2004, we entered into the Revolving Facility, a $70,000 secured revolving credit facility with a syndication of lenders administered by Branch Banking and Trust Company. The revolving debt funding period expires in March 2005. If the facility is not extended, any remaining outstanding principal amount will be amortized over a 24-month period beginning in March 2005. During the revolving period, interest on borrowings under this facility is charged at either (i) a one-month LIBOR plus 200 basis points or (ii) the greater of the prime rate plus 25 basis points or a federal funds rate plus 125 basis points. During the amortization period, interest on borrowings under this facility is charged at either (i) a one-month LIBOR plus 400 basis points or (ii) the greater of the prime rate plus 125 basis points or a federal funds rate plus 225 basis points. We are also charged an unused commitment fee of 0.25%. As of December 31, 2004, there was no outstanding balance under the Revolving Facility and it was not collateralized by any loans from our portfolio companies. The facility contains covenants that, among other things, require us to maintain a minimum net worth and certain financial ratios.

 

On June 30, 2004, we and an affiliated trust entered into the AFT II Facility, a $125,000 secured revolving credit facility with a lender. The revolving debt funding period expires in June 2005 unless the facility is

 

42


extended prior to such date for an additional 364-day period at the discretion of the lender. If the facility is not extended, any remaining outstanding principal amount will be amortized over a 24-month period beginning in June 2005. Interest on borrowings under this facility is charged at either (i) a one-month LIBOR plus 225 basis points or (ii) a commercial paper rate plus 125 basis points. We are also charged an unused commitment fee of 0.25%. As of December 31, 2004, the facility is collateralized by loans from our portfolio companies with a principal balance of $45,645. The facility contains covenants that, among other things, require us to maintain a minimum net worth and certain financial ratios.

 

On September 8, 2004, we sold an aggregate $167,000 of long-term unsecured five- and seven-year notes to institutional investors in a private placement offering pursuant to a note purchase agreement. The unsecured notes consist of $82,000 of senior notes, Series A and $85,000 of senior notes, Series B. The Series A notes have a fixed interest rate of 5.92% and mature in September 2009. The Series B notes have a fixed interest rate of 6.46% and mature in September 2011.

 

On December 2, 2004, we completed a $410,000 asset securitization. In connection with the transaction, we established ACAS Business Loan Trust 2004-1 (“Trust VI”), an affiliated statutory trust, and contributed to Trust VI $500,000 in loans. Subject to continuing compliance with certain conditions, we will remain as servicer of the loans. Simultaneously with the initial contribution of loans, Trust VI was authorized to issue $302,500 Class A notes, $33,750 Class B notes, $73,750 Class C notes, $50,000 Class D notes, and $40,000 Class E notes. The Class A notes, Class B notes, and Class C notes were issued to institutional investors and the Class D and Class E notes were retained by us. The Class A notes carry an interest rate of 2.66% through the first interest payment date in January 2005 and thereafter a rate of three-month LIBOR plus 32 basis points, the Class B notes carry an interest rate of 2.84% through the first interest payment date and thereafter a rate of three-month LIBOR plus 50 basis points, and the Class C notes carry an interest rate of 3.34% through the first interest payment date and thereafter a rate of three-month LIBOR plus 100 basis points. The loans are secured by loans from our portfolio companies with a principal balance of $500,000 as of December 31, 2004. Early repayments are first applied to the Class A notes, then to the Class B notes and then to the Class C notes. Through January 2007, Trust VI has the option to reinvest any principal collections of its existing loans into purchases of new loans. The Class A notes, Class B notes, and Class C notes mature in October 2017.

 

On December 19, 2003, we completed a $317,500 asset securitization. In connection with the transaction, we established ACAS Business Loan Trust 2003-2 (“Trust V”), an affiliated statutory trust, and contributed to Trust V $398,000 in loans. Subject to continuing compliance with certain conditions, we will remain as servicer of the loans. Simultaneously with the initial contribution of loans, Trust V was authorized to issue $258,000 Class A notes, $40,000 Class B notes, $20,000 Class C notes, $40,000 Class D notes, and $40,000 of Class E notes. The Class A notes, Class B notes and Class C notes were issued to institutional investors and the Class D and Class E notes were retained by us. The Class A notes carry an interest rate of one-month LIBOR plus 48 basis points, the Class B notes carry an interest rate of one-month LIBOR plus 95 basis points, and the Class C notes carry an interest rate of one-month LIBOR plus 175 basis points. The loans are secured by loans from our portfolio companies with a principal balance of $253,394 as of December 31, 2004. Early repayments are first applied to the Class A notes, then to the Class B notes and then to the Class C notes. The Class A notes mature in November 2008, the Class B notes mature in June 2009, and the Class C notes mature in August 2009.

 

On May 21, 2003, we completed a $238,700 asset securitization. In connection with the transaction, we established ACAS Business Loan Trust 2003-1 (“Trust IV”), an affiliated statutory trust, and contributed to Trust IV $308,000 in loans. Subject to continuing compliance with certain conditions, we will remain as servicer of the loans. Simultaneously with the initial contribution of loans, Trust IV was authorized to issue $185,000 Class A notes, $31,000 Class B notes, $23,000 Class C notes and $69,000 Class D notes. The Class A notes, Class B notes and Class C notes were issued to institutional investors and the Class D notes were retained by us. The Class C notes consist of a $17,000 tranche of floating rate notes and a $6,000 tranche of fixed rate notes. The Class A notes carry an interest rate of one-month LIBOR plus 55 basis points and the Class B notes carry an interest rate of one-month LIBOR plus 120 basis points. The floating rate tranche of the Class C notes carries an

 

43


interest rate of one-month LIBOR plus 225 basis points and the fixed rate tranche carries an interest rate of 5.14%. The loans are secured by loans from our portfolio companies with a principal balance of $180,207 as of December 31, 2004. Early repayments are first applied to the Class A notes, then to the Class B notes and then to the Class C notes. The Class A notes mature in March 2008, the Class B notes mature in September 2008 and the Class C notes mature in December 2008.

 

On August 8, 2002, we completed a $157,900 asset securitization. In connection with the transaction, we established ACAS Business Loan Trust 2002-2 (“Trust III”), an affiliated statutory trust, and contributed to Trust III $210,500 in loans. Subject to continuing compliance with certain conditions, we will remain servicer of the loans. Simultaneously with the initial contribution of loans, Trust III was authorized to issue $105,300 Class A notes and $52,600 Class B notes to institutional investors and $52,600 of Class C notes were retained by us. The Class A notes carry an interest rate of one-month LIBOR plus 50 basis points, and the Class B notes carry an interest rate of one-month LIBOR plus 160 basis points. The notes are secured by loans from our portfolio companies with a principal balance of $97,349 as of December 31, 2004. Early repayments are first applied to the Class A notes, and then to the Class B notes. As of December 31, 2004, there are no Class A notes outstanding. The Class B notes mature in January 2008.

 

On March 15, 2002, we completed a $147,300 asset securitization. In connection with the transaction, we established ACAS Business Loan Trust 2002-1 (“Trust II”), an affiliated statutory trust, and contributed to Trust II $196,300 in loans. Subject to continuing compliance with certain conditions, we will remain servicer of the loans. Simultaneously with the initial contribution of loans, Trust II was authorized to issue $98,200 Class A notes and $49,100 Class B notes to institutional investors and $49,100 of Class C notes were retained by us. The Class A notes carry an interest rate of one-month LIBOR plus 50 basis points, and the Class B notes carry an interest rate of one-month LIBOR plus 150 basis points. The notes are secured by loans from our portfolio companies with a principal balance of $51,391 as of December 31, 2004. Early repayments are first applied to the Class A notes, and then to the Class B notes. As of December 31, 2004, there are no Class A notes outstanding. The Class B notes mature in March 2007.

 

On December 20, 2000, we completed a $115,400 asset securitization. In conjunction with the transaction, we established ACAS Business Loan Trust 2000-1 (“Trust I”), an affiliated business trust, and contributed to Trust I $153,700 in loans. Subject to certain conditions precedent, we will remain servicer of the loans. Simultaneously with the initial contribution of loans, Trust I was authorized to issue $69,200 Class A notes and $46,200 Class B notes to institutional investors and $38,300 of Class C notes were retained by us. The Class A notes carry an interest rate of one-month LIBOR plus 45 basis points, and the Class B notes carry an interest rate of one-month LIBOR plus 150 basis points. The notes were secured by loans from our portfolio companies. Early repayments were first applied to the Class A notes, and then to the Class B notes. As of December 31, 2004, there are no Class A or Class B notes outstanding.

 

During 2004 and 2003, we sold at various times all or a portion of certain senior loans and the Class D notes of Trust V and Trust VI under repurchase agreements. The repurchase agreements are financing arrangements, in which we sell the senior loans or Class D notes of term securitizations for a sale price generally ranging from 50% to 75% of the face amount of the loans and we have an obligation to repurchase the loans at the original sale price on a future date. We are required to make payments to the purchaser equal to one-month LIBOR plus 250 basis points of the sales price. The purchaser cannot repledge or sell the loans. We have treated the repurchase agreements as secured financing arrangements with the sale price of the loans included as a debt obligation on our consolidated balance sheets.

 

The weighted average debt balance for the years ended December 31, 2004 and 2003 was $999,700 and $582,200, respectively. The weighted average interest rate on all of our borrowings, including amortization of deferred financing costs, for the years ended December 31, 2004, 2003 and 2002 was 3.69%, 3.18% and 3.43%, respectively.

 

44


As a business development company, our asset coverage, as defined in the Investment Company Act of 1940, must be at least 200% after each issuance of a senior security. As of December 31, 2004 and 2003, our asset coverage was 220% and 240%, respectively.

 

A summary of our contractual payment obligations as of December 31, 2004 are as follows:

 

     Payments Due by Period

Contractual Obligations


   Total

   Less than 1 year

   1-3 years

   4-5 years

   After 5 years

Revolving debt funding facilities

   $ 623,348    $ 43,722    $ 579,626    $ —      $ —  

Notes payable, excluding discounts

     741,917      58,314      106,479      198,772      378,352

Unsecured debt

     167,000      —        —        82,000      85,000

Repurchase agreements

     28,847      28,847      —        —        —  

Interest payments on debt obligations(1)

     217,161      55,457      91,157      48,531      22,016

Operating leases

     25,819      3,419      7,385      7,267      7,748
    

  

  

  

  

Total

   $ 1,804,092    $ 189,759    $ 784,647    $ 336,570    $ 493,116
    

  

  

  

  


(1) For variable rate debt, future interest payments are based on the interest rate as of December 31, 2004.

 

To the extent that we receive unscheduled prepayments of on our debt investments that securitize our debt obligations, we are required to apply those proceeds to our outstanding debt obligations.

 

Off Balance Sheet Arrangements

 

We have non-cancelable operating leases for office space and office equipment. The leases expire over the next nine years and contain provisions for certain annual rental escalations.

 

As of December 31, 2004, we had commitments under loan agreements to fund up to $140,687 to 30 portfolio companies. These commitments are composed of working capital credit facilities and acquisition credit facilities. The commitments are subject to the borrowers meeting certain criteria. The terms of the borrowings subject to commitment are comparable to the terms of other debt securities in our portfolio.

 

As of December 31, 2004, we had a guarantee of $912 for one portfolio company. We entered into the performance guarantee to ensure the portfolio company’s performance under contracts as required by the portfolio company’s customers. We would be required to perform under the guarantee if the portfolio company were unable to meet specific requirements under the related contracts. The performance guarantee will expire upon the performance of the portfolio company. Fundings under the guarantee by us would generally constitute a subordinated debt liability of the portfolio company. As of December 31, 2004 the guarantee had a fair value of $0 in accordance with FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements For Guarantees, Including Indirect Guarantees of Indebtedness of Others.”

 

A summary of our guarantees and loan commitments as of December 31, 2004 are as follows:

 

     Amount of Commitment Expiration by Period

Other Commitments


   Total

   Less than 1 year

   1-3 years

   4-5 years

   After 5 years

Guarantees

   $ 912    $ —      $ —      $ —      $ 912

Loan commitments

     140,687      26,241      50,514      41,422      22,510
    

  

  

  

  

Total

   $ 141,599    $ 26,241    $ 50,514    $ 41,422    $ 23,422
    

  

  

  

  

 

Portfolio Credit Quality

 

Loan Grading and Performance

 

We grade all loans on a scale of 1 to 4. This system is intended to reflect the performance of the borrower’s business, the collateral coverage of the loans and other factors considered relevant.

 

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Under this system, loans with a grade of 4 involve the least amount of risk in our portfolio. The borrower is performing above expectations and the trends and risk factors are generally favorable. For loans graded 3, the borrower is performing as expected and the risk factors are neutral to favorable. All new loans are initially graded 3. Loans graded 2 involve a borrower performing below expectations and indicates that the loan’s risk has increased materially since origination. For loans graded 2, we increase procedures to monitor the borrower and the fair value of the enterprise generally will be lower than when the loan was originated. A loan grade of 1 indicates that the borrower is performing materially below expectations and that the loan risk has substantially increased since origination. Loans graded 1 are not anticipated to be repaid in full and we will reduce the fair value of the loan to the amount we anticipate will be recovered.

 

To monitor and manage the investment portfolio risk, management tracks the weighted average investment and loan grade. The weighted average investment grade was 3.1 and 3.0 as of December 31, 2004 and 2003, respectively. The weighted average loan grade was 3.0 and 3.0 as of December 31, 2004 and 2003, respectively. As of December 31, 2004 and 2003, our investment portfolio was graded as follows:

 

    December 31, 2004

    December 31, 2003

 
Grade

  Investments
at Fair Value


  Percentage of
Total Portfolio


    Loans at
Fair Value


  Percentage
of Total Loan
Portfolio


    Investments
at Fair Value


  Percentage of
Total Portfolio


    Loans at
Fair Value


  Percentage
of Total Loan
Portfolio


 
4   $ 666,534   21.1 %   $ 326,531   14.1 %   $ 418,917   21.7 %   $ 281,591   19.1 %
3     2,088,051   66.2 %     1,624,966   70.3 %     1,186,382   61.4 %     905,068   61.5 %
2     326,454   10.4 %     288,008   12.5 %     313,561   16.2 %     272,123   18.5 %
1     70,922   2.3 %     70,825   3.1 %     13,983   0.7 %     13,983   0.9 %
   

 

 

 

 

 

 

 

    $ 3,151,961   100.0 %   $ 2,310,330   100 %   $ 1,932,843   100.0 %   $ 1,472,765   100.0 %
   

 

 

 

 

 

 

 

 

The amounts above do not include our investments in which we have only invested in the equity securities of the company.

 

The improvement in grade 4 at December 31, 2004 as compared to December 31, 2003 was principally due to strong performance at certain portfolio companies resulting in a net increase of one portfolio company with a grade of 4. During 2004, we exited eight investments that were a grade 4 at the end of the prior year and nine existing or new portfolio companies were upgraded to a grade 4. The improvement in the grade 3 as compared to December 31, 2003 is primarily the result of investments in new portfolio companies made during the year ended December 31, 2004 that still had an investment grade of 3 as of year end. These investments had a fair value of $1,279,593 as of December 31, 2004. The improvement in the grade 3 was partially offset by a net decrease of eighteen existing portfolio companies with a grade 3 compared to December 31, 2003, with six exited investments that were a grade 3 at the end of the prior year, seven portfolio companies downgraded to a grade 2, two portfolio companies downgraded to a grade 1, seven portfolio companies were upgraded to a grade 4 and four portfolio companies upgraded to a grade 3. The increase in the grade 2 as compared to December 31, 2003 is partially due to a net decrease of three existing portfolio companies with a grade 2, with one exited investment that was a grade 2 at the end of the prior year, seven portfolio companies downgraded to a grade 2, five portfolio companies downgraded to a grade 1, and four portfolio companies upgraded to a grade 3. The increase in grade 1 as compared to December 31, 2003 is due to the a net increase of four existing portfolio companies with a grade 1, with two portfolio companies downgraded from a grade 3, five portfolio companies downgraded from a grade 2, and three exited portfolio companies.

 

We stop accruing interest on our investments when it is determined that interest is no longer collectible. Our valuation analysis serves as a critical piece of data in this determination. A significant change in the portfolio company valuation assigned by us could have an effect on the amount of our loans on non-accrual status. At December 31, 2004, loans with ten portfolio companies with a face amount of $87,324 and a fair value of $37,292 were on non-accrual status. Loans with three of the ten portfolio companies are grade 2 loans, and loans with seven of the ten portfolio companies are grade 1 loans. These loans include a total of $74,522 with PIK interest features. At December 31, 2003, loans to ten portfolio companies with a face amount of $98,387 and a

 

46


fair value of $28,947 were on non-accrual status. Loans with five of the ten portfolio companies are grade 2 loans, and loans with five of the ten portfolio companies are grade 1 loans. These loans include a total of $63,698 with PIK interest features.

 

At December 31, 2004 and December 31, 2003, loans on accrual status past due and loans on non-accrual status were as follows:

 

Days Past Due


   Number of
Portfolio Companies


   December 31, 2004

   Number of
Portfolio Companies


   December 31, 2003

Current

   90    $ 2,304,954    68    $ 1,468,481
    
  

  
  

One Month Past Due

          61,200           46,545

Two Months Past Due

          —             5,251

Three Months Past Due

          —             —  

Greater than Three Months Past Due

          14,985           14,161

Loans on Non-accrual Status

          87,324           98,387
         

       

Subtotal

   13      163,509    13      164,344
    
  

  
  

Total

   103    $ 2,468,463    81    $ 1,632,825
    
  

  
  

Past Due and Non-accruing Loans as a Percent of Total Loans

          6.6%           10.1%
         

       

 

The loan balances above reflect the full face value of the note. We believe that debt service collection is probable for our loans that are past due.

 

In the fourth quarter of 2004, we recapitalized one portfolio company by contributing our junior subordinated debt with a cost basis $10,542 and a fair value of $0 into our existing common stock equity. Prior to the recapitalization, the junior subordinated debt was on non-accrual status.

 

In the fourth quarter of 2004, we recapitalized one portfolio company by exchanging our junior subordinated debt with a cost basis and fair value of $2,658 into redeemable preferred stock. Prior to the recapitalization, the junior subordinated note was an accruing loan.

 

In the fourth quarter of 2004, we recapitalized one portfolio company by exchanging our junior subordinated debt with a cost basis of $5,877 and a fair value of $0 into convertible preferred stock. Prior to the recapitalization, the junior subordinated debt was on non-accrual status.

 

In the fourth quarter of 2004, we recapitalized the entire capital structure of one portfolio company. As part of the recapitalization, $6,000 of our senior subordinated note was paid in full through the issuance of $2,807 of redeemable preferred stock with the remainder paid through the issuance of new junior subordinated notes. The fair value of the portion of the senior subordinated note that was exchanged for redeemable preferred stock had a fair value of $0. Prior to the recapitalization, the $6,000 senior subordinated debt was on non-accrual status. Subsequent to the recapitalization, the new junior subordinated note is on non-accrual status.

 

In the fourth quarter of 2004, we recapitalized one portfolio company by contributing our subordinated debt with a cost basis of $11,076 and a fair value of $97 into our existing common stock equity and also exchanging our redeemable preferred stock with a cost basis of $8,000 and a fair value of $0 into common stock. Prior to the recapitalization, the subordinated debt was on non-accrual status.

 

In the second quarter of 2004, we recapitalized an existing portfolio company by purchasing its existing senior debt with a face amount and accrued interest of $22,990 for $17,434. Subsequently, we exchanged $5,556

 

47


of the purchased senior debt discount and $18,206 of our existing senior subordinated debt and accrued interest into $6,142 of new senior subordinated debt and $17,620 of new non-interest bearing junior subordinated debt. Prior to the recapitalization, our existing senior subordinated debt investments were accruing loans. In the third quarter of 2004, we further recapitalized the portfolio company by exchanging the $6,142 of senior subordinated debt and $1,250 cost basis of existing senior debt into new non-interest bearing junior subordinated debt. Prior to the second recapitalization, $6,142 of senior subordinated debt and $1,250 of existing senior debt were accruing loans. The non-interest bearing junior subordinated debt is included in the current loans in the above table.

 

In the first quarter of 2003, we recapitalized one portfolio company by exchanging $13,535 of senior debt into subordinated debt and exchanging $6,222 of subordinated debt into non-income producing preferred stock. Prior to the recapitalization, the subordinated debt was on non-accrual status.

 

In the second quarter of 2003, we purchased senior debt of an existing portfolio company with a face amount of $32,043 for $11,500. In the third quarter of 2003, we exchanged the senior debt for non-income producing preferred stock pursuant to a recapitalization. Under the recapitalization, an existing lender also exchanged its $3,200 of subordinated debt into preferred stock and also funded $2,000 of cash to the newly capitalized entity through new subordinated debt notes. As a result of the recapitalization, our existing subordinated debt of $28,003 was improved in the capital structure and removed from non-accruing loan status.

 

In the third quarter of 2003, we recapitalized one portfolio company by exchanging $19,827 of subordinated debt into non-income producing preferred stock. Prior to the recapitalization, the subordinated debt was on non-accrual status.

 

In the third quarter of 2003, we recapitalized one portfolio company by exchanging $11,914 of interest bearing junior subordinated debt for $11,914 of non-interest bearing junior subordinated debt and purchased $6,500 of non-interest bearing junior subordinated debt. We could receive an additional fee of 14% on the non-interest bearing junior subordinated debt if it is repaid prior to scheduled maturity. Due to the conditional nature of the fee, we will not accrue the fee until it is paid. Prior to the recapitalization, the $11,914 junior subordinated debt was on non-accrual status. As of December 31, 2003, the total non-interest bearing junior subordinated debt is a non-income producing asset and therefore not included in the loans on non-accrual status.

 

In the third quarter of 2003, we recapitalized one portfolio company by exchanging $9,838 of senior and subordinated debt into non-income producing preferred stock. Prior to the recapitalization, the senior and subordinated debt were accruing loans.

 

Credit Statistics

 

We monitor several key credit statistics that provide information about credit quality and portfolio performance. These key statistics include:

 

    Debt to EBITDA Ratio — the sum of all debt with equal or senior security rights to our debt investments divided by the total adjusted earnings before interest, taxes, depreciation and amortization, or EBITDA, of the most recent twelve months or, when appropriate, the forecasted twelve months.

 

    Interest Coverage Ratio — EBITDA divided by the total scheduled cash interest payments required to have been made by the portfolio company during the most recent twelve-month period, or when appropriate, the forecasted twelve months.

 

    Debt Service Coverage Ratio — EBITDA divided by the total scheduled principal amortization and the total scheduled cash interest payments required to have been made during the most recent twelve-month period, or when appropriate, the forecasted twelve months.

 

We require portfolio companies to provide annual audited and monthly unaudited financial statements. Using these statements, we calculate the statistics described above. Buyout and mezzanine funds typically adjust

 

48


EBITDA due to the nature of change of control transactions. Such adjustments are intended to normalize and restate EBITDA to reflect the pro forma results of a company in a change of control transaction. For purposes of analyzing the financial performance of the portfolio companies, we make certain adjustments to EBITDA to reflect the pro forma results of a company consistent with a change of control transaction. We evaluate portfolio companies using an adjusted EBITDA measurement. Adjustments to EBITDA may include anticipated cost savings resulting from a merger or restructuring, costs related to new product development, compensation to previous owners, non-recurring revenues or expenses, and other acquisition or restructuring related items.

 

We track our portfolio investments on a static-pool basis, including based on the statistics described above. A static pool consists of the investments made during a given year. The static pool classification is based on the year the initial investment was made. Subsequent add-on investments are included in the static pool year of the original investment. The Pre-1999 static pool consists of the investments made from the time of our IPO through the year ended December 31, 1998. The following table contains a summary of portfolio statistics as of and for the latest twelve months ended December 31, 2004:

 

Portfolio Statistics(1)
($ in millions, unaudited):


   Static Pool

 
   Pre-1999

    1999

    2000

    2001

    2002

    2003

    2004

    Aggregate

 

Original Investments and Commitments

   $ 334     $ 365     $ 285     $ 367     $ 724     $ 1,004     $ 1,609     $ 4,688  

Total Exits and Prepayments of Original Investments

   $ 103     $ 128     $ 201     $ 196     $ 190     $ 302     $ 229     $ 1,349  

Total Interest, Dividends and Fees Collected

   $ 110     $ 118     $ 73     $ 118     $ 142     $ 149     $ 99     $ 809  

Total Net Realized (Loss) Gain on Investments(2)

   $ (6 )   $ 24     $ (85 )   $ 47     $ (2 )   $ 16     $ 1     $ (5 )

Internal Rate of Return(3)

     8.3 %     5.4 %     (2.3 )%     24.5 %     19.9 %     26.7 %     36.9 %     15.2 %

Current Cost of Investments

   $ 215     $ 227     $ 103     $ 160     $ 534     $ 680     $ 1,317     $ 3,236  

Current Fair Value of Investments(2)

   $ 167     $ 114     $ 89     $ 153     $ 587     $ 738     $ 1,372     $ 3,220  

Net Unrealized Appreciation/(Depreciation)(2)

   $ (48 )   $ (113 )   $ (14 )   $ (7 )   $ 53     $ 58     $ 55     $ (16 )

Non-Accruing Loans at Face

   $ 13     $ 21     $ —       $ 23     $ 30     $ —       $ —       $ 87  

Equity Interest at Fair Value

   $ 18     $ 15     $ 28     $ 38     $ 207     $ 230     $ 374     $ 910  

Debt to EBITDA(4)(5)

     7.8       8.6       5.1       6.1       4.5       4.5       4.5       4.9  

Interest Coverage(4)

     1.5       1.9       2.1       1.8       2.8       2.5       2.6       2.5  

Debt Service Coverage(4)

     1.4       1.5       1.5       1.3       1.9       1.6       1.9       1.8  

Loan Grade(4)

     2.5       1.9       2.7       2.8       3.3       3.1       3.0       3.1  

Average Age of Companies

     43 yrs       54 yrs       29 yrs       47 yrs       33 yrs       24 yrs       38 yrs       35 yrs  

Ownership Percentage

     80 %     75 %     31 %     47 %     46 %     39 %     42 %     45 %

Average Sales(6)

   $ 88     $ 71     $ 93     $ 228     $ 77     $ 90     $ 80     $ 89  

Average EBITDA(7)

   $ 5     $ 5     $ 20     $ 25     $ 11     $ 17     $ 17     $ 16  

Total Sales(6)

   $ 448     $ 600     $ 287     $ 1,969     $ 1,250     $ 2,811     $ 3,286     $ 10,651  

Total EBITDA(7)

   $ 23     $ 33     $ 61     $ 229     $ 171     $ 420     $ 707     $ 1,644  

% of Senior Loans(8)

     54 %     23 %     0 %     28 %     34 %     36 %     38 %     35 %

% of Loans with Lien(8)

     55 %     54 %     51 %     80 %     79 %     85 %     77 %     77 %

(1) Static pool classification is based on the year the initial investment was made. Subsequent add-on investments are included in the static pool year of the original investment.
(2) Excludes net realized losses, fair value and unrealized depreciation on interest rate derivative agreements.
(3) Assumes investments are exited at current fair value.
(4) These amounts do not include investments in which we own only equity.
(5) For portfolio companies with a nominal EBITDA amount, the portfolio company’s maximum debt leverage is limited to 15 times EBITDA.
(6) Sales of the most recent twelve months, or when appropriate, the forecasted twelve months.
(7) EBITDA of the most recent twelve months, or when appropriate, the forecasted twelve months.
(8) As a percentage of our total debt investments.

 

 

49


Impact of Inflation

 

We believe that inflation can influence the value of our investments through the impact it may have on interest rates, the capital markets, the valuations of business enterprises and the relationship of the valuations to underlying earnings.

 

Item 7a. Qualitative and Quantitative Disclosures About Market Risk
  (Dollars in thousands)

 

We consider our principal market risks to be the fluctuations of interest rates and the valuations of our investment portfolio.

 

Interest Rate Risk

 

Because we fund a portion of our investments with borrowings, our net increase in shareholders’ equity resulting from operations is affected by the spread between the rate at which we invest and the rate at which we borrow. We attempt to match-fund our liabilities and assets by financing floating rate assets with floating rate liabilities and fixed rate assets with fixed rate liabilities or equity. We enter into interest rate basis swap agreements to match the interest rate basis of our assets and liabilities, thereby locking in the spread between our asset yield and the cost of our borrowings, and to fulfill our obligations under the terms of our revolving debt funding facilities and asset securitizations. However, our derivatives are considered economic hedges that do not qualify for hedge accounting under FASB Statement No. 133 “Accounting for Derivative Instruments and Hedging Activities.” See footnote 7 to our consolidated financial statements for additional information on the accounting treatment of our interest rate derivative agreements.

 

As a result of our use of interest rate swaps, at December 31, 2004, approximately 24% of our interest bearing assets provided fixed rate returns and approximately 76% of our interest bearing assets provided floating rate returns. Adjusted for the effect of interest rate swaps, at December 31, 2004, we had floating rate investments, tied to LIBOR or the prime lending rate, in debt securities with a face amount of $1,868,834 and had total borrowings outstanding of $1,387,978 that have a variable rate of interest based on LIBOR or a commercial paper rate. Assuming no changes to our consolidated balance sheet at December 31, 2004, a hypothetical increase in LIBOR by 100 basis points would increase our shareholders’ equity resulting from operations by $4,809, or 1.7%, over the next twelve months compared to our 2004 net increase in shareholders’ equity resulting from operations. A hypothetical 100 basis point decrease in LIBOR would decrease our shareholders’ equity resulting from operations by $4,809, or 1.7%, over the next twelve months compared to our 2004 net increase in shareholders’ equity resulting from operations.

 

As of December 31, 2004, we had 48 interest rate derivative agreements with one commercial bank with a short-term debt rating of A-1. Under our interest rate swap agreements, we either pay a floating rate based on the prime rate and receive a floating interest rate based on one-month LIBOR, or pay a fixed rate and receive a floating interest rate based on LIBOR. We also have interest rate swaption agreements where, if exercised, we receive a fixed rate and pay a floating rate based on one-month LIBOR. We also have interest rate cap agreements that entitle us to receive an amount, if any, by which our interest payments on our variable rate debt exceed specified interest rates. For those investments contributed to the term securitizations, the interest swaps enable us to lock in the spread between the asset yield on the investments and the cost of the borrowings under the term securitizations. One-month LIBOR increased from 1.12% at December 31, 2003 to 2.40% at December 31, 2004, and the prime rate increased from 4.00% at December 31, 2003 to 5.25% at December 31, 2004.

 

Periodically, an interest rate swap agreement will also be amended. Any underlying unrealized appreciation or depreciation associated with the original interest rate swap agreement at the time of amendment will be factored into the contractual interest terms of the amended interest rate swap agreement. The contractual terms of the amended interest rate swap agreement are set such that its estimated fair value is equivalent to the estimated fair value of the

 

50


original interest rate swap agreement. No realized gain or loss is recorded upon amendment when the estimated fair values of the original and amended interest rate swap agreement are substantially the same.

 

As of December 31, 2004, our interest rate derivative agreements had a remaining weighted average term of approximately 4.9 years. The following table presents the notional principal amounts of our interest rate derivative agreements by class:

 

     December 31, 2004

Type of Interest Rate Derivative Agreements


   Company Pays

   Company Receives

   Number of
Contracts


   Notional
Amount


Interest rate swaps—Pay fixed, receive LIBOR floating

   4.07%(1)    LIBOR    34    $ 1,019,956

Interest rate swaps—Pay prime floating, receive LIBOR floating

   Prime    LIBOR + 2.73%(1)    7      135,103

Interest rate swaptions—Pay LIBOR floating, receive fixed

   LIBOR    4.38%(1)    2      7,093

Interest rate caps

             5      28,703
              
  

Total

             48    $ 1,190,855
              
  

     December 31, 2003

Type of Interest Rate Derivative Agreements


   Company Pays

   Company Receives

   Number of
Contracts


   Notional
Amount


Interest rate swaps—Pay fixed, receive LIBOR floating

   4.45%(1)    LIBOR    26    $ 731,781

Interest rate swaps—Pay prime floating, receive LIBOR floating

   Prime    LIBOR + 2.73%(1)    10      204,415

Interest rate swaptions – Pay LIBOR floating, receive fixed

   LIBOR    4.37%(1)    2      56,976

Interest rate caps

             5      32,117
              
  

Total

             43    $ 1,025,289
              
  


(1) Weighted average.

 

Portfolio Valuation

 

Investments are carried at fair value, as determined in good faith by our board of directors. Unrestricted securities that are publicly traded are valued at the closing price on the valuation date. For debt and equity securities of companies that are not publicly traded, or for which we have various degrees of trading restrictions, we prepare an analysis consisting of traditional valuation methodologies to estimate the enterprise value of the portfolio company issuing the securities. The methodologies consist of valuation estimates based on: valuations of comparable public companies, recent sales of comparable companies, discounting the forecasted cash flows of the portfolio company, the liquidation or collateral value of the portfolio company’s assets, third party valuations of the portfolio company and the value of recent investments in the equity securities of the portfolio company. We weight some or all of the above valuation methods in order to conclude on our estimate of value. In valuing convertible debt, equity or other securities, we value our equity investment based on our pro rata share of the residual equity value available after deducting all outstanding debt from the estimated enterprise value. We value non-convertible debt securities at cost plus amortized OID to the extent that the estimated enterprise value of the portfolio company exceeds the outstanding debt of the portfolio company. If the estimated enterprise value is less than the outstanding debt of the company, we reduce the value of our debt investment beginning with the junior most debt such that the enterprise value less the value of the outstanding debt is zero. If there is sufficient enterprise value to cover the face amount of a debt security that has been discounted due to the detachable equity

 

51


warrants received with that security, that detachable equity warrant will be valued such that the sum of the discounted debt security and the detachable equity warrant equal the face value of the debt security.

 

Due to the uncertainty inherent in the valuation process, such estimates of fair value may differ significantly from the values that would have been used had a ready market for the securities existed, and the differences could be material. Additionally, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned.

 

52


Item 8. Financial Statements and Supplementary Data

 

Management’s Report on Internal Control over Financial Reporting

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2004 based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2004.

 

Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included elsewhere herein.

 

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Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting

 

The Board of Directors and Shareholders of American Capital Strategies, Ltd.

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that American Capital Strategies, Ltd. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). American Capital Strategies, Ltd.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

 

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

 

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

 

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

 

In our opinion, management’s assessment that American Capital Strategies, Ltd. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, American Capital Strategies, Ltd. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Capital Strategies, Ltd., including the consolidated schedules of investments, as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004, and the consolidated financial highlights for each of the five years in the period then ended, and our report dated March 14, 2005 expressed an unqualified opinion thereon.

 

/s/    Ernst & Young LLP

 

McLean, Virginia

March 14, 2005

 

54


Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Shareholders of American Capital Strategies, Ltd.

 

We have audited the accompanying consolidated balance sheets of American Capital Strategies, Ltd., including the consolidated schedules of investments, as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004, and the consolidated financial highlights for each of the five years in the period then ended. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements, the financial highlights and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements, financial highlights and schedule based on our audits.

 

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

 

In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the consolidated financial position of American Capital Strategies, Ltd. at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, and its consolidated financial highlights for each of the five years in the period then ended, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

As discussed in Note 2 to the consolidated financial statements, effective January 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation.”

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of American Capital Strategies, Ltd.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2005 expressed an unqualified opinion thereon.

 

/s/    Ernst & Young LLP

 

McLean, Virginia

March 14, 2005

 

55


AMERICAN CAPITAL STRATEGIES, LTD.

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

     December 31,

 
     2004

    2003

 

Assets

                

Investments at fair value (cost of $3,236,249 and $2,042,914, respectively)

                

Non-Control/Non-Affiliate investments

   $ 1,157,406     $ 756,158  

Affiliate investments

     408,529       137,917  

Control investments

     1,654,075       1,041,144  

Interest rate derivative agreements

     1,678       3,128  
    


 


Total investments at fair value

     3,221,688       1,938,347  

Cash and cash equivalents

     58,367       8,020  

Restricted cash

     141,895       75,935  

Interest receivable

     22,053       17,636  

Other

     47,424       28,390  
    


 


Total assets

   $ 3,491,427     $ 2,068,328  
    


 


Liabilities and Shareholders’ Equity

                

Debt

   $ 1,560,978     $ 840,211  

Interest rate derivative agreements

     17,396       26,604  

Accrued dividends payable

     5,322       3,957  

Other

     35,305       21,641  
    


 


Total liabilities

     1,619,001       892,413  
    


 


Commitments and Contingencies

                

Shareholders’ equity:

                

Undesignated preferred stock, $0.01 par value, 5,000 shares authorized, 0 issued and outstanding

     —         —    

Common stock, $0.01 par value, 200,000 shares authorized, 88,705 and 66,930 issued, and 88,705 and 65,949 outstanding, respectively

     887       659  

Capital in excess of par value

     2,010,063       1,360,181  

Unearned compensation

     (36,690 )     (21,286 )

Notes receivable from sale of common stock

     (6,845 )     (8,783 )

Distributions in excess of net realized earnings

     (63,032 )     (23,685 )

Net unrealized depreciation of investments

     (31,957 )     (131,171 )
    


 


Total shareholders’ equity

     1,872,426       1,175,915  
    


 


Total liabilities and shareholders’ equity

   $ 3,491,427     $ 2,068,328  
    


 


 

See accompanying notes.

 

56


AMERICAN CAPITAL STRATEGIES LTD.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

 

     Year Ended
December 31,
2004


    Year Ended
December 31,
2003


    Year Ended
December 31,
2002


 

OPERATING INCOME:

                        

Interest and dividend income

                        

Non-Control/Non-Affiliate investments

   $ 113,668     $ 88,833     $ 72,569  

Affiliate investments

     36,326       11,651       1,635  

Control investments

     121,239       75,788       59,017  

Interest rate derivative agreements

           (17,214 )     (11,153 )
    


 


 


Total interest and dividend income

     271,233       159,058       122,068  
    


 


 


Fees

                        

Non-Control/Non-Affiliate investments

     21,688       15,408       9,422  

Affiliate investments

     5,663       2,031       459  

Control investments

     37,498       29,783       15,073  
    


 


 


Total fee income

     64,849       47,222       24,954  
    


 


 


Total operating income

     336,082       206,280       147,022  
    


 


 


OPERATING EXPENSES:

                        

Interest

     36,851       18,514       14,321