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AMERICAN CAPITAL, LTD 10-K 2007
FORM 10-K
Table of Contents


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, 2006

 

OR

 

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

 

Commission file number 814-00149

 

 

LOGO

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   The NASDAQ Stock Market LLC
    (NASDAQ Global Select Market)

 

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

 

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

 

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x        Accelerated filer ¨        Non-accelerated filer ¨.

 

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

 

As of June 30, 2006, the aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant was approximately $4.6 billion based upon a closing price of the Registrant’s common stock of $33.48 per share as reported on The NASDAQ Global Select 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 January 31, 2007, there were 153,162,889 shares of the Registrant’s common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE. The Registrant’s definitive proxy statement for the 2007 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.



Table of Contents

AMERICAN CAPITAL STRATEGIES, LTD.

 

TABLE OF CONTENTS

 

PART I.

         

Item 1.

  

Business

   3

Item 1A.

  

Risk Factors

   17

Item 1B.

  

Unresolved Staff Comments

   25

Item 2.

  

Properties

   25

Item 3.

  

Legal Proceedings

   26

Item 4.

  

Submission of Matters to a Vote of Security Holders

   26

PART II.

         

Item 5.

  

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

   27

Item 6.

  

Selected Financial Data

   30

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operation

   31

Item 7A.

  

Quantitative and Qualitative Disclosure About Market Risk

   63

Item 8.

  

Financial Statements and Supplementary Data

   64

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   134

Item 9A.

  

Controls and Procedures

   134

Item 9B.

  

Other Information

   134

PART III.

    

Item 10.

  

Directors and Executive Officers of the Registrant

   135

Item 11.

  

Executive Compensation

   135

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   135

Item 13.

  

Certain Relationships and Related Transactions

   135

Item 14.

  

Principal Accountant Fees and Services

   135

PART IV.

         

Item 15.

  

Exhibits and Financial Statement Schedules

   135

Signatures

   139

 

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Table of Contents

PART I

 

Item 1. Business

 

General

 

American Capital Strategies, Ltd. (which is referred throughout this report as “American Capital”, “we” and “us”) is the largest business development company (“BDC”) and is the second largest U.S. publicly traded alternative asset manager. We, both directly and through our global asset management business, are an investor in management and employee buyouts, private equity buyouts and early stage and mature private and public companies. 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 private and public companies with attractive current yields and/or potential for equity appreciation and realized gains and by investing in our alternative asset manager business. Our business consists of two primary segments—our investment portfolio and our alternative asset management business.

 

American Capital Fund

 

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

 

American Capital 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 and sponsor management and employee buyouts, invest in private equity sponsored buyouts and provide capital directly to early stage and mature private and small public companies. In addition, we invest in commercial mortgage backed securities (“CMBS”) and collateralized debt obligation (“CDO”) securities and invest in investment funds managed by us. We invest primarily 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. Currently, we will invest up to $750 million in a single middle market transaction in North America. Our largest investment at cost as of December 31, 2006, excluding investment funds, was $247 million. Our largest investment in an investment fund at cost as of December 31, 2006, was $654 million. As of December 31, 2006, our average investment size, at fair value, was $43 million, or 0.5% of total assets.

 

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. From our IPO in 1997, through December 31, 2006, we invested over $3 billion in equity securities and over $10 billion in debt securities of middle market companies as well as CMBS and CDO securities, including approximately $446 million in funds committed but undrawn under credit facilities and equity commitments. Our loans typically range from $5 million to $100 million, mature in five to ten years, and require monthly or quarterly interest payments at fixed rates or variable rates generally based on the London Interbank offered rate (“LIBOR”) rate, plus a margin. We price our debt and equity investments based on our analysis of each transaction. As of December 31, 2006, the weighted average effective interest rate on our debt securities was 12.3%.

 

We will invest in the equity capital of portfolio companies that we purchase through an American Capital sponsored buyout. We also may acquire minority equity interests in the companies from which we have provided debt financing with the goal of enhancing our overall return. As of December 31, 2006, we had a fully-diluted weighted average ownership interest of 41% in our private finance portfolio companies with a total equity investment at fair value of over $2.8 billion.

 

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We often sponsor One-Stop Buyouts in which we provide most if not all of the senior debt, subordinated debt and equity financing in the transaction. In certain occasions, we may initially fund all of the senior debt at closing and syndicate it to third party lenders post closing. We have a loan syndications group that arranges to have all or part of the senior loans syndicated to other third party lenders.

 

The opportunity to be repaid or exit our investments may occur if a portfolio company refinances our loans, is sold in a change of control transaction, sells its equity in a public offering or if we exercise our put rights. Since our IPO in 1997, through December 31, 2006, we have realized $635 million in gross realized gains and $420 million in gross realized losses resulting in $215 million in cumulative net gains, excluding net losses attributable to periodic interest settlements of interest rate swap agreements and taxes on net gains. We have had 164 exits and repayments of over $4.7 billion of our originally invested capital, representing 35% of our total capital committed since our IPO, earning a 17% compounded annual return on these investments from the interest, dividends and fees over the life of the investments.

 

As a BDC, we are required by law to make significant managerial assistance available to certain of 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 a portfolio company’s board of directors. As of December 31, 2006, we had board seats at 95 out of 188 portfolio companies and had board observation rights on 32 of our remaining portfolio companies. We also have an operations team, including ex-CEOs with significant turnaround and bankruptcy experience, which provides intensive operational and managerial assistance. Providing assistance to our portfolio companies serves as an opportunity for us to maximize their value.

 

We also invest in non-investment grade tranches of CMBS and CDO securities, which means that nationally recognized statistical rating organizations rate them below the top four investment-grade rating categories (i.e., “AAA” through “BBB”). Non-investment grade CMBS and CDO securities have a higher risk of loss but usually provide a higher yield than do investment grade securities. Through December 31, 2006, we had made $494 million and $192 million of CMBS and CDO investments, respectively.

 

Public Manager of Funds of Alternative Assets

 

We are a leading global alternative asset manager with $9.8 billion in assets under management as of December 31, 2006, including $2.5 billion under management of third party funds. In addition to managing American Capital’s assets and providing management services to portfolio companies of American Capital, we have successfully launched our initiative to be a publicly traded alternative asset manager of additional third party funds. During 2005 and 2006, we launched our first three alternative asset funds in addition to American Capital—European Capital Limited (“ECAS”), American Capital Equity I, LLC (“ACE I”) and ACAS CLO 2007-1, Ltd. (“ACAS CLO”). We manage these funds either through consolidated operating subsidiaries or wholly-owned portfolio companies. We refer to the asset management business throughout this report to include both the asset management conducted by both our consolidated operating subsidiaries and our wholly-owned asset management portfolio companies.

 

Through our asset management business, we earn base management fees based on the size of our funds and incentive income based on the performance of our funds. In addition, we may invest directly into our alternative asset funds and earn investment income from our principal investments in those funds. We intend to grow our existing funds, while continuing to create innovative products to meet the increasing demand of sophisticated investors for superior risk-adjusted investment returns.

 

We expect to continue to develop our asset management business as a publicly traded manager of funds of alternative assets. Our corporate development team and marketing department conduct market research and due diligence to identify industry and geographic sectors of alternative assets that have attractive investment attributes and where we can create an alternative asset fund with attractive return prospects. In addition to

 

4


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alternative asset funds focused on a specific industry or geographic location, we will also identify potential alternative asset funds that will investment in a specific security type such as first lien debt, second lien debt, real estate loans or equity securities. As particular funds are selected, we hire investment professionals with experience in the proposed asset class for the alternative asset fund. American Capital may make initial investments directly in the assets of a proposed alternative asset fund. Those assets may either be sold or contributed to the proposed alternative asset fund upon formation of the fund. It is expected that separate alternative asset funds would then be established, which would raise capital, a portion of which could be funded by us. We would expect to enter into asset management agreements with the alternative asset fund either by a wholly-owned consolidated operating subsidiary or a wholly-owned portfolio company. The following additional alternative asset funds are in various stages of development as of December 31, 2006:

 

   

American Capital Real Estate

 

   

European Capital Equity I

 

   

American Capital Equity II

 

   

American Capital Financial

 

   

American Capital Special Situations

 

   

American Capital Energy

 

   

American Capital Technology

 

We expect to continue developing the alternative asset funds listed above in 2007 and 2008. We also have identified other alternative asset funds to develop that we will begin the early stages of development in 2007.

 

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 the middle market is highly fragmented and we are the leader in the market with a 3% market share. According to our data, no other competitor had more than a 2% market share. Based on our data, more than two hundred firms did not close a transaction during 2006 and approximately 45% of the transactions that closed were closed by firms that only completed one or two transactions during 2006. 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 an efficient tool to businesses 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, Dallas, Palo Alto, London and Paris.

 

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 have used in making our lending and investment decisions. Not all criteria are

 

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Table of Contents

required to be 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 middle market 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, 2006, our current portfolio companies had an average age of 33 years with 2006 average sales of $132 million and 2006 average adjusted earnings before interest, taxes, depreciation and amortization (“EBITDA”) of $24 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.

 

CMBS and CDO Criteria. We receive extensive underwriting information regarding the mortgage loans and other securities comprising a CMBS or CDO pool from the issuer. We then work with the issuer, the investment bank, and the rating agencies to underwrite the collateral securing our investment. For instance, when we re-underwrite the underlying commercial mortgage loans securing a CMBS transaction, we visit the underlying property, analyze the estimate of cash flow and debt service coverage, assess the collateral value and loan-to-value ratios, and review the loan documents and third party reports such as appraisals and environmental reports. We study the local real estate market trends and form an opinion as to whether the loan as originally underwritten by the issuer is sound. Based on the findings of our diligence procedures, we may reject certain mortgage loans from inclusion in the pool.

 

American Capital 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 (the “Securities Act”), or in securities of foreign issuers. Also, an existing portfolio company may undergo a public offering and register its securities under the Securities Act, 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 in unrated bonds and equity tranches of CMBS and CDOs. We maintain a diversified investment portfolio, investing in a broad range of industries as well as limiting the amount of our investment concentration in any one portfolio company. As of December 31, 2006, we had investments in 188 portfolio companies.

 

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The composition summaries of our investment portfolio as of December 31, 2006 and 2005 at cost and fair value as a percentage of total investments, excluding derivative agreements, are shown in the following table:

 

     December 31, 2006

    December 31, 2005

 
COST             

Senior debt

   32.8 %   29.3 %

Subordinated debt

   28.2 %   36.9 %

Preferred equity

   15.1 %   17.1 %

Common equity

   12.5 %   9.7 %

CMBS & CDO securities

   8.5 %   2.2 %

Equity warrants

   2.9 %   4.8 %
     December 31, 2006

    December 31, 2005

 
FAIR VALUE             

Senior debt

   31.1 %   29.5 %

Subordinated debt

   26.3 %   35.2 %

Preferred equity

   15.2 %   15.2 %

Common equity

   15.1 %   12.0 %

CMBS & CDO securities

   8.3 %   2.3 %

Equity warrants

   4.0 %   5.8 %

 

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 as a percentage of total investments, excluding derivative agreements:

 

     December 31, 2006

    December 31, 2005

 

COST

            

Commercial Services & Supplies

   14.3 %   12.9 %

Diversified Financial Services

   13.2 %   6.5 %

Real Estate

   6.6 %   1.6 %

Healthcare Providers & Services

   6.1 %   2.1 %

Food Products

   5.8 %   6.0 %

Healthcare Equipment & Supplies

   4.7 %   3.8 %

Electrical Equipment

   4.2 %   7.4 %

Diversified Consumer Services

   4.0 %   —    

Construction & Engineering

   3.9 %   3.7 %

Containers & Packaging

   3.8 %   7.2 %

Auto Components

   3.8 %   5.0 %

Household Durables

   3.7 %   1.7 %

Leisure Equipment & Products

   3.1 %   6.1 %

Building Products

   2.8 %   6.1 %

Internet & Catalog Retail

   2.8 %   2.1 %

IT Services

   1.7 %   2.5 %

Software

   1.6 %   2.5 %

Pharmaceuticals

   1.5 %   —    

Energy Equipment & Services

   1.5 %   0.4 %

Oil, Gas & Consumable Fuels

   1.5 %   —    

Textiles, Apparel & Luxury Goods

   1.2 %   2.9 %

Computers & Peripherals

   1.2 %   2.1 %

Personal Products

   1.2 %   1.8 %

Electronic Equipment & Instruments

   0.8 %   3.1 %

 

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Table of Contents
     December 31, 2006

    December 31, 2005

 

Construction Materials

   0.8 %   1.5 %

Road & Rail

   0.7 %   1.7 %

Distributors

   0.6 %   1.0 %

Machinery

   0.5 %   3.2 %

Diversified Telecommunication Services

   0.5 %   —    

Chemicals

   0.4 %   2.5 %

Household Products

   0.4 %   0.7 %

Media

   0.4 %   0.5 %

Aerospace & Defense

   0.1 %   1.1 %

Other

   0.6 %   0.3 %
     December 31, 2006

    December 31, 2005

 

FAIR VALUE

            

Commercial Services & Supplies

   14.6 %   14.4 %

Diversified Financial Services

   14.3 %   6.5 %

Real Estate

   6.4 %   1.6 %

Healthcare Providers & Services

   6.0 %   1.9 %

Food Products

   5.2 %   5.4 %

Electrical Equipment

   5.0 %   7.3 %

Healthcare Equipment & Supplies

   4.9 %   4.0 %

Diversified Consumer Services

   4.1 %   —    

Containers & Packaging

   4.0 %   7.2 %

Construction & Engineering

   3.8 %   3.8 %

Auto Components

   3.6 %   5.5 %

Household Durables

   3.0 %   1.7 %

Building Products

   2.7 %   5.7 %

Internet & Catalog Retail

   2.7 %   2.1 %

Oil, Gas & Consumable Fuels

   2.7 %   —    

Leisure Equipment & Products

   2.5 %   5.7 %

Energy Equipment & Services

   1.8 %   0.4 %

IT Services

   1.7 %   2.6 %

Software

   1.6 %   2.5 %

Computers & Peripherals

   1.4 %   1.8 %

Pharmaceuticals

   1.3 %   —    

Textiles, Apparel & Luxury Goods

   0.9 %   3.1 %

Electronic Equipment & Instruments

   0.8 %   3.8 %

Distributors

   0.6 %   1.0 %

Diversified Telecommunication Services

   0.6 %   —    

Personal Products

   0.5 %   1.0 %

Road & Rail

   0.4 %   1.4 %

Construction Materials

   0.4 %   1.4 %

Machinery

   0.4 %   2.5 %

Media

   0.4 %   0.5 %

Aerospace & Defense

   0.4 %   1.1 %

Household Products

   0.3 %   0.8 %

Chemicals

   0.2 %   2.7 %

Other

   0.8 %   0.6 %

 

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The following table shows the portfolio composition by geographic location at cost and at fair value as a percentage of total investments, excluding CDOs, CMBS and derivative agreements. The geographic composition is determined by the location of the corporate headquarters of the portfolio company.

 

     December 31, 2006

    December 31, 2005

 
COST             

Southwest

   25.3 %   22.7 %

Southeast

   18.1 %   14.9 %

Mid-Atlantic

   17.3 %   21.2 %

International

   11.0 %   7.9 %

Northeast

   10.9 %   13.3 %

South-Central

   9.6 %   6.0 %

North-Central

   7.1 %   13.2 %

Northwest

   0.7 %   0.8 %
     December 31, 2006

    December 31, 2005

 
FAIR VALUE             

Southwest

   24.2 %   21.6 %

Mid-Atlantic

   17.8 %   22.6 %

Southeast

   17.4 %   14.7 %

International

   11.7 %   7.3 %

South-Central

   10.7 %   5.2 %

Northeast

   10.2 %   13.1 %

North-Central

   7.4 %   14.7 %

Northwest

   0.6 %   0.8 %

 

The following table summarizes our unrealized appreciation, depreciation, gains and losses on our investments for the year ended December 31, 2006 and for the period from our IPO of August 29, 1997 through December 31, 2006 (in millions):

 

     Year Ended
December 31, 2006


    For period from
IPO through
December 31, 2006


 

Gross unrealized appreciation of portfolio company investments

   $ 785     $ 620  

Gross unrealized depreciation of portfolio company investments

     (381 )     (377 )
    


 


Subtotal

     404       243  

Net realized gains of portfolio company investments

     175       215  

Reversal of prior period net unrealized appreciation upon a realization

     (128 )     —    
    


 


Subtotal

     451       458  

Net unrealized (depreciation) appreciation of interest rate derivatives

     (11 )     5  

Net unrealized appreciation for foreign currency translation

     32       32  

Net realized gain (loss) of interest rate derivatives

     15       (12 )

Taxes on realized gains

     (17 )     (17 )
    


 


Total net gain on investments

   $ 470     $ 466  
    


 


 

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Assets under Management Investment Portfolio

 

We are a leading global alternative asset manager. Currently, through our asset management business, we will invest up to $750 million in a single middle market transaction in North America and up to €400 million in Europe. As of December 31, 2006 and 2005, our assets at fair value under management were as follows (in millions):

 

     December 31, 2006

   December 31, 2005

American Capital Strategies, Ltd. (1)

   $ 7,305    $ 4,923

European Capital Limited

     1,423      213

American Capital Equity I, LLC

     803      —  

ACAS CLO 2007-1, Ltd.

     268      —  
    

  

Total

   $ 9,799    $ 5,136
    

  


(1) Excludes our 2006 and 2005 investment in ECAS of $751 million and $178 million, respectively.

 

During 2005, we launched our first alternative asset fund in addition to American Capital—ECAS, a company incorporated in Guernsey. ECAS is a private equity fund that invests in and sponsors management and employee buyouts, invests in private equity buyouts and provides capital directly to private and mid-sized public companies primarily in Europe. ECAS has €750 million of equity commitments that were fully funded as of December 31, 2006 and has a €900 million multi-currency revolving secured credit facility. We provided €521 million of the equity commitments and third party institutional investors provided the €229 million of remaining equity commitments.

 

Our wholly-owned consolidated operating subsidiary, European Capital Financial Services (Guernsey) Limited (“ECFS”) manages ECAS for a management fee equal to 1.25% of the greater of ECAS’ weighted average gross assets or €750 million. In addition, ECAS reimburses ECFS for all costs and expenses incurred by ECFS during the term of the agreement. Also pursuant to the investment management agreement, ECFS received 18.75 million warrants to purchase preferred shares of ECAS representing 20% of ECAS’ preferred shares on a fully-diluted basis. The initial exercise price of the warrants is €10 per share, which is the same per share price that the original investors purchased their preferred shares in the initial offering. The per share exercise price on the warrants has been reduced by dividends declared on the preferred shares and will be reduced to reflect the amount of any future dividends on the preferred shares. In the event that ECAS issues additional preferred shares, ECFS will receive additional warrants to purchase preferred shares in ECAS so that at all times the warrants issued to ECFS as manager are not less than 20% of ECAS’ preferred shares on a fully-diluted basis. In the event that ECAS undertakes an initial public offering and legal requirements effectively prevent ECAS from being able to issue additional warrants to ECFS, then ECAS will pay ECFS an incentive management fee in cash. The incentive management fee would be subject to a cumulative hurdle rate of 2% per quarter of ECAS’ pre-incentive fee net income as a return on quarterly average net asset value, determined on a cumulative basis through the end of quarter. The incentive management fee, if any, would be earned and payable as follows: (i) no incentive management fee in any calendar quarter in which ECAS’ pre-incentive fee net income does not exceed the cumulative hurdle rate or (ii) 100% of the amount of ECAS’ pre-incentive management fee net income, if any, that exceeds the cumulative hurdle rate but is less than 2.5% per quarter, plus 20% of the amount of ECAS’ pre-incentive fee net income, if any, that is equal to or exceeds 2.5%.

 

As of December 31, 2006, ECAS has made forty investments totaling approximately $1.8 billion. As of December 31, 2006, ECFS has opened offices in London and Paris and hired staff of 54 investment professionals and support personnel.

 

ACE I is a newly established private equity fund with $1 billion of equity commitments. On October 1, 2006, we entered into a purchase and sale agreement with ACE I for the sale of approximately 30% of our equity investments (other than warrants issued with debt investments) in 96 portfolio companies for $671 million. ACE I will co-invest with American Capital in an amount equal to 30% of our future equity investments until the

 

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$329 million remaining commitment is exhausted. As of December 31, 2006, ACE I had $243 million of unfunded equity commitments outstanding. American Capital Equity Management LLC (“ACEM”), a wholly-owned portfolio company, manages ACE I in exchange for a 2% annual management fee on the net cost basis of ACE I and a 10% to 30% carried interest in the net profits of ACE I, subject to certain hurdles. Subsequent to its initial purchase of $671 million of investments from American Capital, ACE I made investments totaling $86 million through December 31, 2006.

 

ACAS CLO is a fund that is in a “warehouse” stage as of December 31, 2006, that invests in middle market senior loans. It is expected to complete a securitization at either the end of the first quarter or beginning of the second quarter of 2007. American Capital Asset Management, LLC (“ACAM”), a wholly-owned portfolio company, is the manager of ACAS CLO during the “warehouse” stage. We expect ACAM to be appointed as the manager of ACAS CLO post-securitization. The fees earned by ACAM during the warehouse stage are not significant. We may invest in the non-rated equity tranche of ACAS CLO upon its securitization.

 

We consolidate a controlled company that manages a fund if it is determined that all or substantially all of the services being provided to the fund are also being indirectly provided to American Capital through our ownership interest in the fund. We do not consolidate a controlled company that manages a fund if it does not provide all or substantially all of its services directly or indirectly to American Capital. If we have wholly-owned management portfolio companies, we would expect that these portfolio companies would pay dividends to us each quarter to the extent of their earnings, if any. Our wholly-owned management portfolio companies do not have employees. American Capital employees provide the services to these wholly-owned management portfolio companies to enable them to carry out their asset management responsibilities in return for a fee based on the cost of the services provided.

 

The following table sets forth certain information with respect to our funds under management as of December 31, 2006.

 

   

American Capital


  ECAS

  ACE I

  ACAS CLO

Fund type

 

Public Alternative Asset Manager and Fund

  Private Fund   Private Fund   Private Fund

Established

 

1986

  2005   2006   2006

Assets under management

 

$7.3 Billion(1)

  $1.4 Billion   $0.8 Billion   $0.3 Billion

Investment types

 

Senior & Subordinated Debt, Equity, CMBS and CDO

  Senior & Subordinated
Debt and Equity
  Equity   Senior Debt

Capital type

 

Permanent

  Permanent   Finite Life   Finite Life

(1) Excludes our investment in ECAS of $751 million.

 

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, 2006, we have a group of 267 professionals actively engaged in the origination and approval process of our investing activities, including our 182-member investment team (“Investment Team”),

 

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our 25-member operations team (“Operations Team”) and our 60-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 valuation 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 present an extensive investment committee report containing the due diligence information to our investment committee for review. Our investment committee, which includes various of our senior officers depending on the nature of the proposed investment generally must approve each investment. Investments exceeding a certain size or meeting certain other criteria must also be approved by our Board of Directors. Our investment committee is supported by a dedicated staff that focuses on the due diligence and other research done with regard to each proposed investment.

 

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 under management through our active involvement with the portfolio companies. Also as a BDC, we are required by law to offer significant managerial assistance to certain of 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, who 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 certain instances, members of the Operations Team will assist the portfolio company with day-to-day operations.

 

Finance and Treasury Group: Our Finance and Treasury Group, which had 39 employees as of December 31, 2006, is principally responsible for raising debt and equity capital to fund our investments. Through December 31, 2006, we had completed 24 follow-on equity offerings since our IPO. With regard to debt financing, this group had primary responsibility for initiating and administering our eight term debt securitizations of loan and debt investments and our various other revolving and term debt facilities. In addition, our Finance and Treasury Group is responsible for investor relations and financial planning and budgeting.

 

Syndications Team: Our six-person Syndications Team is responsible for arranging syndications of senior debt of our portfolio companies either at closing or subsequent to the closing of a senior financing transaction. They perform a variety of functions relating to the marketing and completing of such transactions.

 

Financial Accounting and Reporting Staff: Our Financial and Reporting Staff, which had 50 employees as of December 31, 2006, is responsible for the accounting of our financial performance, including financial reporting to our stockholders and regulatory bodies. Among its tasks are loan and investment accounting and billing, accounts payable, tax compliance and controller functions.

 

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Legal, Compliance and Internal Audit Staffs: Our Legal Department provides extensive legal support to our capital raising and investing activities, is involved in our stockholder and regulatory reporting and manages the outside law firms that provide transactional, litigation and regulatory services to us. We also have an internal audit function, which reports directly to the Audit and Compliance Committee of our Board of Directors. In addition, as required by the Securities and Exchange Commission, or SEC, we have appointed a chief compliance officer, who is responsible for administering our code of ethics and conduct and our legal compliance activities. As of December 31, 2006, a total of 26 employees worked on these staffs.

 

Human Resource Department: Our Human Resources Department, which had 20 employees as of December 31, 2006, assists in recruiting, hiring, reviewing and establishing and administering compensation programs for our employees. In addition, the Human Resources Department is available to the Investment Team and the Operations Group to assist with executive management and other human resources issues at portfolio companies.

 

Information Technology Department: Our Information Technology Department, which had 28 employees as of December 31, 2006, assists in implementing and maintaining communication and technological resources for our operations.

 

Corporate Development Staff: Our Corporate Development Staff is responsible for researching and developing acquisition opportunities and new business initiatives, including developing new alternative asset funds.

 

Portfolio Valuation

 

FACT, with the assistance of our Investment Team, and subject to the oversight of senior management and the Audit and Compliance Committee, prepares a quarterly valuation of each of our portfolio company investments. Our Board of Directors approves our portfolio valuations as required by the 1940 Act. 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 the Audit and Compliance Committee. Annually, Houlihan Lokey reviews all of the portfolio companies that have been portfolio companies for at least one year and that have a fair value in excess of $10 million. 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.”

 

Competition

 

We compete with hundreds 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 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, 2006, we had 484 employees. We believe that our relations with our employees are excellent.

 

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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 (“Qualifying Assets”), 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 principal categories of qualifying assets relevant to our business are the following:

 

   

securities purchased in transactions not involving any public offering from:

 

  a) an issuer that (i) is organized and has its principal place of business in the United States, (ii) is not an investment company other than a small business investment company wholly owned by the business development company, and (iii) does not have any class of securities listed on a national securities exchange; or

 

  b) an issuer that satisfies the criteria set forth in clauses (a) (i) and (ii) above but not clause (a)(iii), so long as, at the time of purchase, we own at least 50% of (i) the greatest amount of equity securities of the issuer, including securities convertible into such securities and (ii) the greatest amount of certain debt securities of such issuer, held by us at any point in time during the period when such issuer was an eligible portfolio company, except that options, warrants, and similar securities which have by their terms expired and debt securities which have been converted, or repaid or prepaid in the ordinary course of business or incident to a public offering of securities of such issuer, shall not be considered to have been held by us, and we are one of the 20 largest holders of record of such issuer’s outstanding voting securities;

 

   

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 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

 

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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, 2006, our asset coverage was 211%.

 

Regulated Investment Company Requirements

 

We operate so as to qualify as a RIC under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). 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 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 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. We may elect to not distribute all of our investment company taxable income and pay the excise tax on the undistributed amount.

 

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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 consolidated subsidiaries, American Capital Financial Services, Inc. (“ACFS”) and ECFS, are corporations subject to corporate level federal, state or other local income tax in their respective tax jurisdictions.

 

Investment Objectives

 

Our primary business objectives as a BDC 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/or potential for equity appreciation and realized gains. Our investment objectives provide that:

 

   

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, other than OTC and pink sheet stocks, 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 Securities 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 Securities Act before they may be offered or sold to the public or (ii) underwrite securities to be distributed to or purchased by stockholders of us in connection with offerings of securities by companies in which we are a stockholder); (b) sell securities short (except with regard to managing risks associated with publicly traded securities issued by portfolio companies); (c) purchase securities on margin (except to the extent that we may purchase securities with borrowed money); (d) 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); (e) engage in the purchase or sale of commodities or

 

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commodity contracts, including futures contracts (except where necessary in working out distressed loan or investment situations); or (f) 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 (as defined in the 1940 Act), 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.

 

The percentage restrictions set forth above, 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 us to dispose of portfolio securities or to take other action to satisfy the percentage restriction.

 

The above investment objectives have been set by our Board of Directors and do not require stockholder consent to be changed.

 

Investment Advisor

 

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

 

Item 1A. Risk Factors

 

You should carefully consider the risks described below and all other information contained in this annual report on Form 10-K, including our consolidated financial statements and the related notes thereto before making a decision to purchase our securities. 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 securities could decline, and you may lose all or part of your investment.

 

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. 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. 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.

 

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.

 

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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 may or may not be secured by the assets of the borrower; however if a subordinated loan is secured, 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.

 

There is uncertainty regarding the value of our privately held securities

 

All or substantially all 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 have a limited operating and investment history in certain segments of our business

 

Since our IPO in 1997, we have primarily been an investor in domestic, privately-held middle market companies, which we consider to be companies with sales between $10 million and $750 million. We have begun, or have announced plans to begin, investing in other investment categories, including CMBS, CDOs, earlier stage technology companies, special situation companies and, through our investment in ECAS, in European-based businesses. We have limited or no operating history in making such investments. We have also begun, or announced plans to begin, our new business of managing other alternative asset funds in addition to the investments on our balance sheet. We are conducting this business through either consolidated operating subsidiaries or newly created wholly-owned portfolio companies. There can be no assurances that these new business initiatives will be profitable in future periods, nor can we offer investors any assurances that we will successfully implement these new strategies.

 

Investment in non-investment grade commercial mortgage-backed securities and collateralized debt obligations may be illiquid, may have a higher risk of default, and may not produce current returns

 

The CMBS and CDO securities in which we invest are not investment grade, which means that nationally recognized statistical rating organizations rate them below the top four investment-grade rating categories (i.e., “AAA” through “BBB”), and are sometimes referred to as “junk bonds.” Non-investment grade CMBS and CDO bonds and preferred shares tend to be less liquid, may have a higher risk of default and may be more difficult to value. Non-investment grade securities usually provide a higher yield than do investment grade securities, but with the higher return comes greater risk of default. In addition, the fair value of these securities may change as interest rates change over time. Economic recessions or downturns may cause defaults or losses on collateral securities to increase. Non-investment grade securities are considered speculative, and their capacity to pay principle and interest in accordance with the terms of their issue is not ensured.

 

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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 may receive warrants to acquire stock issued by the borrower, 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 limited public 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, 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.

 

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.

 

A failure to renew our existing credit facilities, to continue short-term financings, 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.”

 

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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 6.28% for the year ended December 31, 2006, and assuming hypothetical annual returns on our portfolio of minus 15 to plus 15 percent. As 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)

     –34.8 %   –25.4 %   –15.9 %   –6.5 %   2.9 %   12.3 %   21.7 %

(1) The assumed portfolio return is required by regulation of the SEC 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.”

 

Because we are subject to regulatory restrictions on the amount of debt we can issue, 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.

 

A change in interest rates may adversely affect our profitability

 

Because we fund a portion of our investments with borrowings, our profitability 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 also enter into interest rate 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.

 

An increase in interest rates could reduce the spread between the rate at which we invest and the rate at which we borrow, and thus, adversely affect our profitability, if we have not appropriately match-funded our liabilities and assets or hedged against such event. Alternatively, our interest rate hedging activities may limit our ability to participate in the benefits of lower interest rates with respect to the hedged portfolio. In addition, a change in interest rates could also have an impact on the fair value of our interest rate swap agreements that could result in the recording of unrealized appreciation or depreciation in future periods. For example, a decline, or a flattening, of the forward interest rate yield curve will typically result in the recording of unrealized depreciation of our interest rate swap agreements. Therefore, adverse developments resulting from changes in interest rates 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” and Note 12 to our consolidated financial statements for additional information on interest rate swap agreements.

 

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A change in foreign exchange rates may adversely affect our profitability

 

We may invest in debt securities that are denominated in currencies other than the U.S. dollar. In addition, we may invest in the equity of portfolio companies whose functional currency is not the U.S. dollar. Our domestic portfolio companies may also transact a significant amount of business in foreign countries and therefore their profitability may be impacted by changes in foreign currency exchange rates. The functional currency of our portfolio company ECAS is the Euro, and ECAS has investments in other European currencies, including the British Pound. An adverse change in foreign currency exchange rates may have a material adverse impact on our business, financial condition and results of operations.

 

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

 

We have two revolving credit facilities, one of which is a commercial paper conduit securitization facility (the “AFT I Facility”) and the other of which is an unsecured revolving line of credit (the “Revolving Facility”). Collectively, the AFT I Facility and Revolving Facility are referred to as the Debt Facilities.

 

Our AFT I Facility is a line of credit administered by Wachovia Capital Markets, LLC that currently has an aggregate commitment of $1.3 billion as of December 31, 2006. Our AFT I Facility is secured by loans to our portfolio companies, which have been contributed to a separate affiliated trust. This affiliated trust is consolidated in our financial statements. While we have not guaranteed the repayment of the AFT I Facility, we must repurchase the loans if certain representations are breached. The AFT I Facility contains customary default provisions, as well as the following default provisions: a cross-default on our debt of $2.5 billion or more, a minimum net worth requirement of $1 billion plus seventy-five percent (75%) of any new equity and subordinated debt and a default triggered by a change of control.

 

Our Revolving Facility is a $900 million unsecured revolving line of credit administered by Wachovia that may be expanded through new or additional commitments up to $1.2 billion in accordance with the terms and conditions set forth in the related agreement. The Revolving Facility contains customary default provisions as well as the following default provisions: a cross-default on our debt of $5 billion or more, a minimum net worth requirement of $1.8 billion plus seventy-five percent (75%) of any new equity and subordinated debt and a default in the event of a change of control.

 

Trusts affiliated with us have issued term debt securities (“Term Debt Notes”) to institutional investors with an outstanding balance of $1.7 billion as of December 31, 2006. These affiliated trusts are consolidated in our financial statements. 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.

 

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.

 

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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 a separate affiliated statutory trust prior to such pledge. While we own a beneficial interest in these trusts, these assets are property of the trust, available to satisfy the debts of the trust, 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 our net asset value 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.”

 

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, the timing of the recognition of fee income from closing investment transactions 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 90% of our investment company taxable income, including 90% 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.

 

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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 investments 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.

 

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. The departure of any of our executive officers or key employees could materially adversely affect our ability to implement our business strategy. 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 and delaying or making more difficult a change in control. The existence of these provisions may negatively impact 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, federal and foreign 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 BDCs.

 

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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 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 effectively 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 securities that you own.

 

The market price of our common stock may fluctuate significantly

 

The market price and marketability of shares of our securities 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.

 

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.

 

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

 

We periodically complete public offerings where shares of our common stock are sold in which a portion of the shares are offered directly by us and a portion of the shares are sold by third parties, or forward purchasers, in

 

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connection with agreements to purchase common stock from us for future delivery dates pursuant to forward sale agreements. As of December 31, 2006, there were no forward sale agreements outstanding. Under forward sale agreements that we may enter into, each forward purchaser would have 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 would 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.

 

We have experienced rapid growth, which may be difficult to sustain and which may place significant demands on our administrative, operational and financial resources

 

Our assets under management have grown significantly from approximately $0.9 billion as of December 31, 2001 to $9.8 billion as of December 31, 2006. Our rapid growth has caused, and if it continues will continue to cause, significant demands on our legal, accounting and operational infrastructure, and increased expenses. The complexity of these demands, and the expense required to address them, is a function not simply of the amount by which our assets under management have grown, but of significant differences in the investing strategies of our different funds and portfolio companies. In addition, we are required to continuously develop our systems and infrastructure in response to the increasing sophistication of the investment management market and legal, accounting and regulatory developments.

 

Our future growth will depend, among other things, on our ability to maintain an operating platform and management system sufficient to address our growth and will require us to incur significant additional expenses and to commit additional senior management and operational resources. As a result, we face significant challenges:

 

   

in maintaining adequate financial and business controls,

 

   

implementing new or updated information and financial systems and procedures, and

 

   

in training, managing and appropriately sizing our work force and other components of our business on a timely and cost-effective basis.

 

There can be no assurance that we will be able to manage our expanding operations effectively or that we will be able to continue to grow, and any failure to do so could adversely affect our ability to generate revenue and control our expenses.

 

Item 1B. Unresolved Staff Comments

 

None.

 

Item 2. Properties

 

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

 

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Item 3. Legal Proceedings

 

Neither we, nor any of our consolidated subsidiaries, are currently subject to any material litigation nor, to our knowledge, is any material litigation threatened against us or any consolidated subsidiary, other than routine litigation and administrative proceedings arising in the ordinary course of business. Such proceedings are not expected to have a material adverse effect on the business, financial conditions, or results of our operations.

 

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

 

During the fourth quarter of 2006, there were no matters submitted to a vote of our security holders through the solicitation of proxies or otherwise.

 

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PART II

 

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

 

Since we became a RIC, 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. All of our dividends declared through December 31, 2006, have been distributions of ordinary income for tax purposes. For our dividends declared in 2006 of $3.33 per share, $3.25 were non-qualifying dividends and $0.08 were qualifying dividends. 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.

 

For our tax year ended September 30, 2006, we retained and did not distribute our taxable long-term capital gains and paid a federal income tax thereon on behalf of our stockholders. Stockholders of record as of September 30, 2006, should report their share of such capital gain and their share of the federal income tax paid for our tax year ending September 30, 2006. Stockholders must include on their income tax return for 2006 their share of our taxable net long-term capital gain and may take a credit for the tax paid on that gain by us on the stockholder’s behalf. Stockholders should increase the tax basis of their investment in American Capital stock by the excess of their share of the taxable net long–term capital gain over the amount of the federal income tax paid on their behalf. The total taxable net long-term capital gain realized and retained by us for our tax year ending September 30, 2006, was $0.29 per share, and the tax credit was at a 35% rate, which is equivalent to $0.10 per share. The increase in the stockholder’s tax basis in our stock is equivalent to $0.19 per share, and to the extent a stockholder’s capital gains tax rate is less than 35%, the tax credit may reduce other taxes owed or be refunded. See “Risk Factors-We may fail to continue to qualify for our pass-through tax treatment” and “Business-Regulated Investment Company Requirements.”

 

Our stock transfer agent, registrar and dividend reinvestment plan administrator is Computershare Investor Services. Information request for Computershare Investor Services can be sent to P.O. Box 43010, Providence, RI 02940 and their telephone number is 1-800-733-5001.

 

At the option of a holder of record of common stock, all cash distributions can be reinvested automatically under our dividend reinvestment plan in additional whole and fractional shares. A stockholder whose shares are held in the name of a broker or other nominee should contact the broker or other nominee regarding participation in our dividend reinvestment plan on the stockholder’s behalf.

 

Pursuant to our dividend reinvestment plan, a stockholder whose shares are registered in his own name may “opt’ in to the plan and elect to reinvest all or a portion of their dividends in shares of our common stock by providing the required enrollment notice to Computershare Investor Services. Stockholders whose shares are held in the name of a broker or the nominee of a broker may have distributions reinvested only if such service is provided by the broker or the nominee, or if the broker or the nominee permits participation in our dividend reinvestment plan. Stockholders whose shares are held in the name of a broker or other nominee should contact the broker or nominee for details. When we declare a dividend, stockholders who are participants in our dividend reinvestment plan receive the equivalent of the amount of the dividend or distribution in shares of our common stock. Our dividend reinvestment plan administrator buys shares in the open market, on The NASDAQ Global Select Market or elsewhere. Shares will generally be purchased from us as a newly issued or treasury shares at a 5% discount from the market value. You can find out more information about this plan by reading our Second Amended and Restated Dividend Reinvestment Plan.

 

Our common stock historically trades at prices above our net asset value per share. There can be no assurance, however, that such premium to net asset value will continue. For the last three fiscal years ended December 31, 2006, we have not sold any equity securities that were not registered under the Securities Act.

 

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Quarterly Stock Prices and Dividend Declarations

 

Our common stock is quoted on The NASDAQ Global Select Market under the symbol ACAS. As of February 14, 2007, we had 951 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 currently over 257,000 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 Global Select Market and our dividends declared for the fiscal years ended December 31, 2005 and 2006.

 

     Sale Price

      
     High

   Low

   Dividend Declared

 

2005

                      

First Quarter

   $ 35.70    $ 29.51    $ 0.73  

Second Quarter

   $ 36.49    $ 31.01    $ 0.75  

Third Quarter

   $ 39.61    $ 34.24    $ 0.78  

Fourth Quarter

   $ 39.10    $ 34.65    $ 0.82 (1)

2006

                      

First Quarter

   $ 37.80    $ 34.40    $ 0.80  

Second Quarter

   $ 35.50    $ 29.65    $ 0.82  

Third Quarter

   $ 39.74    $ 33.04    $ 0.83  

Fourth Quarter

   $ 46.45    $ 38.72    $ 0.88  

(1) Includes extra dividend of $0.03.

 

Equity Compensation Plan Information

 

The following table summarizes information, as of December 31, 2006, 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 millions, except per share amounts)

Equity compensation plans approved by security holders(1)

   14.5    $ 32.94    3.2

Equity compensation plans not approved by security holders(1)

   —        —      —  

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

 

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Purchases of Equity Securities

 

The following table provides information for the year ended December 31, 2006, regarding shares of our common stock that were purchased under a non-qualified deferred compensation plan, which is administered by a third party trustee. Our Compensation and Corporate Governance Committee of our Board of Directors is the administrator of the plan. The purpose of this plan is to grant bonus awards to our employees. The Compensation and Corporate Governance Committee determines cash bonus awards, including vesting schedules. The cash bonus awards are invested by the trust in shares of our common stock that are purchased in the open market.

 

     Total number
of shares
purchased


   Weighted-average
price paid per
share


     (in millions, except per share amounts)

1/1/2006 - 1/31/2006

   —      $ —  

2/1/2006 - 2/28/2006

   —        —  

3/1/2006 - 3/31/2006

   —        —  

4/1/2006 - 4/30/2006

   —        —  

5/1/2006 - 5/31/2006

   2.2      34.03

6/1/2006 - 6/30/2006

   0.5      34.08

7/1/2006 - 7/31/2006

   —        —  

8/1/2006 - 8/31/2006

   0.1      36.16

9/1/2006 - 9/30/2006

   —        —  

10/1/2006 - 10/31/2006

   —        —  

11/1/2006 - 11/30/2006

   0.5      42.17

12/1/2006 - 12/31/2006

   —        —  
    
  

     3.3    $ 35.32
    
  

 

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Item 6. Selected Financial Data

 

AMERICAN CAPITAL STRATEGIES, LTD.

Consolidated Selected Financial Data

(in millions, except per share data)

 

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

 

   

Year Ended December 31,


 
   

    2006    


   

    2005    


   

    2004    


   

    2003    


   

    2002    


 

Total operating income(1)

  $ 860     $ 555     $ 336     $ 206     $ 147  

Total operating expenses(2)(3)

    424       228       114       65       44  
   


 


 


 


 


Operating income before income taxes

    436       327       222       141       103  

Income tax provision

    (11 )     (13 )     (2 )     —         —    
   


 


 


 


 


Net operating income

    425       314       220       141       103  

Net realized gain (loss) on investments(1)

    173       36       (38 )     22       (21 )
   


 


 


 


 


Net realized earnings(1)

    598       350       182       163       82  

Net unrealized appreciation (depreciation) of investments(1)

    297       15       99       (45 )     (62 )

Cumulative effect of accounting change(3)

    1       —         —         —         —    
   


 


 


 


 


Net increase in net assets resulting from operations

  $ 896     $ 365     $ 281     $ 118     $ 20  
   


 


 


 


 


Per share data:

                                       

Net operating income:

                                       

Basic

  $ 3.15     $ 3.16     $ 2.88     $ 2.58     $ 2.60  

Diluted

  $ 3.11     $ 3.10     $ 2.83     $ 2.56     $ 2.57  

Net earnings:

                                       

Basic

  $ 6.63     $ 3.68     $ 3.69     $ 2.16     $ 0.51  

Diluted

  $ 6.55     $ 3.60     $ 3.63     $ 2.15     $ 0.50  

Dividends declared

  $ 3.33     $ 3.08     $ 2.91     $ 2.79     $ 2.57  

Balance sheet data:

                                       

Total assets

  $ 8,609     $ 5,449     $ 3,491     $ 2,068     $ 1,351  

Total debt

  $ 3,926     $ 2,467     $ 1,561     $ 840     $ 620  

Total shareholders’ equity

  $ 4,342     $ 2,898     $ 1,872     $ 1,176     $ 688  

Other data (unaudited):

                                       

Number of portfolio companies at period end

    188       141       117       86       69  

New investments(4)

  $ 5,136     $ 3,714     $ 2,018     $ 1,083     $ 574  

Equity investment sale proceeds and loan investment sales and repayments(5)

  $ 3,447     $ 1,455     $ 712     $ 390     $ 119  

Net operating income return on average equity at cost(6)

    12.0 %     13.6 %     14.1 %     13.5 %     14.7 %

Earnings return on average equity(7)

    24.6 %     15.9 %     18.0 %     11.3 %     2.9 %

Assets under management

  $ 9,799     $ 5,136     $ 3,220     $ 1,935     $ 1,281  

(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, 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.
(3) In 2006, we adopted FASB Statement No. 123 (revised 2004), Share-Based Payment, a revision to FASB Statement No. 123. We adopted FASB Statement No. 123(R) using the “modified prospective” method. Under the modified prospective method, the consolidated financial statements for prior fiscal years do not reflect any restated amounts. When recognizing compensation cost under FASB Statement No. 123, we elected to adjust the compensation costs for forfeitures when the unvested awards were actually forfeited. However, under FASB Statement No. 123(R), we are required to estimate forfeitures of unvested awards when recognizing compensation cost. Upon the adoption of FASB Statement 123(R) on January 1, 2006, we recorded a cumulative effect of a change in accounting principle, net of related tax effects, to adjust compensation cost for the difference in compensation costs recognized in prior periods had forfeitures been estimated during those periods of $1 million, or $0.01 per basic share and $0.01 per diluted share.
(4) Amount of new investments includes amounts as of the investment dates that are committed but unfunded.
(5) Principal amount of loan repayments includes the collection of payment-in-kind notes, payment-in-kind dividends and accreted loan discounts.
(6) Calculated before the effect of net appreciation, depreciation gains and losses of investments. Average equity is calculated based on the quarterly shareholders’ equity balances.
(7) Return represents net increase in net assets 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.

 

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ITEM 7. Management’s Discussion And Analysis Of Financial Condition And Results Of Operation

(in millions, 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; (xiv) our strategy of becoming an asset manager of funds of alternative assets may not be successful and therefore have a negative impact on our results of operation and (xv) 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.

 

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.

 

American Capital Portfolio Composition

 

We are a publicly traded buyout and mezzanine fund that provides investment capital to middle market companies. We invest primarily in senior and subordinated debt and equity of companies in need of capital for buyouts, growth, acquisitions and recapitalizations. We also invest in non-investment grade CMBS and CDO securities. The total portfolio value of our investments was $8.1 billion and $5.1 billion as of December 31, 2006 and 2005, respectively. During the years ended December 31, 2006, 2005, and 2004, we made new investments totaling $5.1 billion, $3.7 billion and $2.0 billion, including $372 million, $784 million and $130 million, respectively, in funds committed but undrawn under credit facilities and subscription agreements at the date of the investment. The weighted average effective interest rate on our debt securities was 12.3%, 12.8% and 12.9%, at December 31, 2006, 2005 and 2004, respectively.

 

We invest in and sponsor management and employee buyouts, invest in private equity sponsored buyouts, provide capital directly to early stage and mature private and small public companies, invest in CMBS and CDO securities and invest in investment funds managed by us. We provide senior debt, mezzanine debt and equity to fund buyouts, growth, acquisitions and recapitalizations. We also provide capital directly to private and small public companies for buyouts, growth, acquisitions and 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

 

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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.

 

The type and aggregate dollar amount of our new investments during the years ended December 31, 2006, 2005 and 2004 were as follows (in millions):

 

     Year Ended December 31,

     2006

   2005

   2004

American Capital Sponsored Buyouts

   $ 2,200    $ 1,588    $ 689

Financing for Private Equity Buyouts

     1,043      701      875

Direct Investments

     263      218      10

Investments in Managed Funds

     —        617      —  

CMBS Investments

     414      81      —  

CDO/CLO Investments

     146      19      27

Add-On Financing for Acquisitions

     584      157      121

Add-On Financing for Recapitalization

     442      266      255

Add-On Financing for Growth

     2      5      5

Add-On Financing for Working Capital in Distressed Situations

     21      15      18

Add-On Financing for Working Capital

     21      47      18
    

  

  

Total

   $ 5,136    $ 3,714    $ 2,018
    

  

  

 

During the years ended December 31, 2006, 2005 and 2004, we received cash proceeds from exits and repayments of portfolio investments, excluding repayments of bridge notes and accrued payment-in-kind (“PIK”) interest from ECAS, as follows (in millions):

 

     Year Ended December 31,

     2006

   2005

   2004

Principal Prepayments

   $ 1,223    $ 688    $ 382

Senior Loan Syndications

     456      340      217

Scheduled Principal Amortization

     64      57      37

Payment of Accrued PIK Interest and Dividends and Original Issue Discount

     73      34      18

Sale of Equity Investments

     1,102      195      58
    

  

  

Total

   $ 2,918    $ 1,314    $ 712
    

  

  

 

Critical Accounting Policies

 

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP’). The preparation of the financial statements in accordance with GAAP requires the use of estimates and assumptions that could affect the reported amounts of assets, liabilities, revenues, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time the consolidated financial statements are prepared. Actual results could differ from these estimates. A summary of our significant accounting policies is presented in Note 2 to our consolidated financial statements. Management believes that the following accounting policies are the most affected by judgments, estimates and assumptions. Management has reviewed these critical accounting policies and related disclosures with our independent auditor and the Audit and Compliance Committee of our Board of Directors.

 

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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 our senior management and the Audit and Compliance 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.

 

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, third party sale offers, potential strategic buyer analysis 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 original issue discount (“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 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. For CMBS and CDO securities, we prepare a fair value analysis that is based on a discounted cash flow model that utilizes prepayment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow and comparable yields for similar securities, when available.

 

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.

 

Consolidation

 

Under the investment company rules and regulations pursuant to Article 6 of Regulation S-X and the AICPA Audit and Accounting Guide for Investment Companies, we are precluded from consolidating any entity other than another investment company. An exception to this general principle occurs if the investment company has an investment in an operating company that provides services to the investment company. Our consolidated financial statements include the accounts of our operating companies, ACFS and ECFS, as either all or substantially all of the services provided by these operating companies are to us or portfolio companies in which we have a significant interest. If our ownership interest in a portfolio company that a consolidated operating subsidiary manages or provides services to were to decrease, the operating subsidiary may no longer provide all or substantially all of its services directly or indirectly to us, resulting in the deconsolidation of such operating subsidiary at that time. For example, if our ownership interest in ECAS were to decrease, we may have to deconsolidate ECFS at that time. Our investments in other investment companies or funds are recorded as investments in the accompanying consolidated financial statements and are not consolidated. We also have wholly-owned affiliated statutory trusts that were established to facilitate secured borrowing arrangements

 

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whereby assets were transferred to the affiliated statutory trusts and notes were sold by the trusts. These transfers of assets to the trusts are treated as secured borrowing arrangements in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, and our consolidated financial statements include the accounts of our affiliated statutory trusts established for secured financing arrangements. We also have established trusts to fund deferred compensation plans for employees. Our consolidated financial statements include the accounts of these trusts. All intercompany accounts have been eliminated in consolidation.

 

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 or realized. 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 amounts 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 PIK interest and 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. For CMBS and CDO securities, we recognize income using the effective interest method, using the anticipated yield over the projected life of the investment.

 

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.

 

Asset Management and Other Fee Income Recognition

 

Fees primarily include portfolio company management, asset management, transaction structuring, financing and prepayment fees. Portfolio company management fees, which are generally recurring in nature, represent amounts received for providing advice and analysis to our middle market portfolio companies. Asset management fees represent fees for providing investment advisory services to investment funds. Portfolio company management and asset management fees are recognized as earned provided collection is probable. Transaction structuring and 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 FASB Statement No. 123, Accounting for Stock-Based Compensation, to account for stock-based compensation plans for all shares 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 the accompanying consolidated statements of operations in “Salaries, benefits and stock-based compensation.” In accordance with FASB Statement No. 123, we elected to continue to apply the provisions of

 

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Accounting Principle 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 net assets resulting from operations calculated as if compensation costs were computed in accordance with FASB Statement No. 123.

 

In December 2004, the FASB issued FASB Statement No. 123 (revised 2004), Share-Based Payment, a revision to FASB Statement No. 123. FASB Statement No. 123(R) also supersedes APB Opinion No. 25 and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in FASB Statement No. 123(R) is similar to the approach described in FASB Statement No. 123. However, FASB Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. In the first quarter of 2006, we adopted FASB Statement No. 123(R) using the “modified prospective” method. Under the modified prospective method, the consolidated financial statements for prior year interim periods and fiscal years will not reflect any restated amounts.

 

All of our stock options granted prior to January 1, 2003 that were accounted for under APB Opinion No. 25 and not expensed in our consolidated statements of operations were fully vested as of December 31, 2005 and therefore, no additional stock compensation costs for those stock option grants will be recorded subsequent to the adoption of FASB Statement No. 123(R). When recognizing compensation cost under FASB Statement No. 123, we elected to adjust the compensation costs for forfeitures when the unvested awards were actually forfeited. However, under FASB Statement No. 123(R), we are required to estimate forfeitures of unvested awards when recognizing compensation cost. Upon the adoption of FASB Statement 123(R) on January 1, 2006, we recorded a cumulative effect of a change in accounting principle, net of related tax effects, to adjust compensation cost for the difference in compensation costs recognized in prior periods had forfeitures been estimated during those periods of $1 million, or $0.01 per basic and diluted share. We calculated the compensation costs that would have been recognized in prior periods and for the fiscal year 2006 using an estimated annual forfeiture rate of 6.7%.

 

The following table reflects the weighted average fair value per option granted during 2006, 2005 and 2004, as well as the weighted average assumptions used in determining those fair values using the Black-Scholes pricing model.

 

     Year ended December 31,

 
     2006

    2005

    2004

 

Options granted (in millions)

     7.1       4.2       2.7 (1)

Fair value on grant date

   $ 2.93     $ 4.95     $ 11.49  

Dividend yield

     8.8 %     9.1 %     0.7 %

Expected volatility

     22 %     34 %     38 %

Risk-free interest rate

     4.6 %     4.0 %     3.7 %

Expected life (years)

     5.1       5.0       5.9  

(1) During the year ended December 31, 2004, the fair value of 0.2 million stock option grants was estimated using a dividend yield assumption of 10.7% and the fair value of the remaining 2.5 million stock option grants was estimated using a dividend yield assumption of 0%.

 

For our stock option plans approved by our shareholders in 2003 and forward, the plans provide that unless the Compensation and Corporate Governance Committee of our Board of Directors determines otherwise, the exercise price of the stock options will be automatically reduced by the amount of any cash dividends paid on our common stock after the option is granted but before it is exercised. Beginning in 2005, the Compensation and Corporate Governance Committee determined that it would no longer reduce the exercise price of the stock options by the amount of any cash dividends paid on our common stock. Prior to 2005, in determining the fair value of the options under these plans on the date of grant, we assumed that the exercise price of the stock options would be automatically reduced by the amount of any cash dividends paid on our common stock until it is exercised. To incorporate the value of this feature within the fair value of a stock option grant in a

 

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Black-Scholes option pricing model, the dividend yield was assumed to be 0%. However, the fair value of these stock options granted in 2004 determined on the date of grant has not been adjusted for this change in the dividend yield assumption in accordance with FASB Statement No. 123(R).

 

As of December 31, 2006, the total compensation cost related to non-vested stock option awards not yet recognized was $53 million that has a weighted average period to be recognized of 3.3 years. For the year ended December 31, 2006, we recorded stock-based compensation expense of $16 million attributable to our stock options.

 

Deferred Compensation Plans

 

In the first quarter of 2006, we established a non-qualified deferred compensation plan (the “Plan”) for the purpose of granting bonus awards to our domestic employees. The Plan does not permit diversification and must be settled by the delivery of a fixed number of shares of our common stock. The awards under the Plan are accounted for as a grant of unvested stock. We record stock-based compensation expense based on the fair market value of our stock on the date of grant. The compensation cost for awards with service conditions is recognized using the straight-line attribution method over the requisite service period. The compensation cost for awards with performance and service conditions are recognized using the accelerated attribution method over the requisite service period.

 

For the year ended December 31, 2006, we recorded stock-based compensation expense of $19 million attributable to the Plan. As of December 31, 2006, the total compensation cost related to non-vested bonus awards not yet recognized was $95 million that has a weighted average period to be recognized of 4.1 years.

 

Derivative Financial Instruments

 

We use derivative financial instruments primarily to manage interest rate risk and also to fulfill our obligation under the terms of our revolving credit facilities and asset securitizations. 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. We record the accrual of the periodic interest settlements of interest rate derivatives in net unrealized appreciation or (depreciation) of investments and subsequently record the amount as a realized gain or loss on investments on the interest settlement date.

 

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 portfolio company management, asset management, financing and transaction structuring activities, less our operating expenses and provision for income taxes. The second element is “Net realized gain (loss) on investments,” which reflects the difference between the proceeds from an exit of an investment and the cost at which the investment was carried on our consolidated balance sheets and periodic settlements of derivatives. The third element is “Net unrealized appreciation (depreciation) of investments,” which is the net change in the estimated fair values of our 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. Our net realized earnings is comprised of our net operating income and net realized gain (loss) on investments.

 

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The consolidated operating results for the years ended December 31, 2006, 2005 and 2004 are as follows (in millions):

 

     Year Ended December 31,

 
     2006

     2005

     2004

 

Operating income

   $ 860      $ 555      $ 336  

Operating expenses

     424        228        114  
    


  


  


Operating income before income taxes

     436        327        222  

Provision for income taxes

     (11 )      (13 )      (2 )
    


  


  


Net operating income

     425        314        220  

Net realized gain (loss) on investments

     173        36        (38 )
    


  


  


Net realized earnings

     598        350        182  

Net unrealized appreciation of investments

     297        15        99  

Cumulative effect of accounting change

     1        —          —    
    


  


  


Net increase in net assets resulting from operations

   $ 896      $ 365      $ 281  
    


  


  


 

Fiscal Year 2006 Compared to Fiscal Year 2005

 

Operating Income

 

Total operating income is comprised of two components: interest and dividend income and asset management and other fee income. For the year ended December 31, 2006, total operating income increased $305 million, or 55%, over the year ended December 31, 2005.

 

Interest and dividend income consisted of the following for the years ended December 31, 2006 and 2005 (in millions):

 

     Year Ended
December 31,


     2006

     2005

Interest income on debt securities

   $ 531      $ 383

Interest income on bank deposits and employee loans

     8        4

Dividend income on equity securities

     130        39
    

    

Total interest and dividend income

   $ 669      $ 426
    

    

 

Interest income on debt securities increased by $148 million, or 39%, to $531 million for 2006 from $383 million for 2005, 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. Our daily weighted average debt investments at cost increased from $2,949 million in 2005 to $4,274 million in 2006 resulting from new loan originations net of loan repayments during the year ended December 31, 2006.

 

The daily weighted average effective interest rate on debt investments decreased to 12.4% in 2006 from 13.0% in 2005 due primarily to an increase in our investment in CMBS securities, an increase in total senior loans as a percentage of our total loan portfolio and a contraction of the spreads over LIBOR for our new loan originations due to increased competition in the marketplace. Our weighted average investments in CMBS securities was $248 million in 2006; we made our first investment in CMBS securities at the end of December 2005. Our overall effective interest rate on our CMBS investments is lower than our overall effective interest rate on our total senior and subordinated loans to our portfolio companies. Our senior loans as a percentage of our total loans at cost, excluding CMBS securities, increased to 54% as of December 31, 2006 from 44% as of December 31, 2005. Our senior loans generally yield lower rates than our subordinated loans, but they are typically variable rate based loans, which do not require the use of interest rate basis swap agreements thereby reducing our overall interest swap costs. We attempt to match-fund our liabilities and assets by financing floating

 

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rate assets with floating rate liabilities and fixed rate assets with fixed rate liabilities or equity. We enter into interest rate 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. Excluding the impact of the interest rate swap agreements, our daily weighted average effective interest rate for 2006 decreased 60 basis points to 12.4% as compared to 13.0% in the prior year. However, including the impact of interest rate basis swap agreements, our daily weighted average effective interest rate for 2006 decreased only 10 basis points to 12.6% as compared to 12.7% in the prior year.

 

Our derivatives are considered economic hedges that do not qualify for hedge accounting under FASB Statement No. 133. 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. In 2006 and 2005, the total interest benefit (cost) of interest rate derivative agreements included in both net realized gain (loss) on investments and unrealized appreciation (depreciation) of investments was $6 million and ($9 million), respectively. The favorable change from interest rate derivative agreements is due primarily to the increase in the average LIBOR rate in 2006.

 

Dividend income on equity securities increased by $91 million to $130 million for 2006 from $39 million for 2005, due primarily to an increase in preferred stock investments and an increase in dividends from common equity investments. We have grown our investments in equity securities, excluding CMBS and CDO securities, to a fair value of $2.8 billion as of December 31, 2006, a 64% 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, we received cash dividends from common equity investments of $34 million from ten portfolio companies in 2006 compared to $2 million from three portfolio companies in 2005. Included in the $34 million of dividend income from common equity investments in 2006 was $20 million of dividends from our investment in ECAS.

 

Our daily weighted average total debt and equity investments at cost increased from $4,056 million in 2005 to $6,427 million in 2006. The daily weighted average yield on total debt and equity investments decreased from 10.4% in 2005 to 10.3% in 2006 due primarily to the decreases in our weighted average interest rate on debt investments discussed above. Including the interest benefit (cost) of interest rate derivative agreements that are included in net realized gain (loss) on investments and net unrealized appreciation (depreciation) of investments on the consolidated statements of operations, our daily weighted average yield on total debt and equity investments increased 20 basis points to 10.4% in 2006 as compared to the prior year in part due to the higher dividends on common equity securities in 2006.

 

Asset management and other fee income consisted of the following for the years ended December 31, 2006 and 2005 (in millions):

 

       Year Ended
December 31,


       2006

     2005

Asset management fees and reimbursements

     $ 43      $ 14

Transaction structuring fees

       38        28

Equity financing fees

       29        25

Portfolio company management and administrative fees

       24        19

Loan financing fees

       24        18

Prepayment fees

       10        11

Other

       23        14
      

    

Asset management and other fee income

     $ 191      $ 129
      

    

 

Asset management fees and reimbursements primarily represent fees recognized for providing advisory and management services to ECAS pursuant to investment management and services agreements that commenced in

 

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the fourth quarter of 2005. In connection with these agreements with ECAS, we recognized $13 million of management fees and $28 million for reimbursements of costs and expenses in 2006 for salaries, employee benefits and general and administrative expenses compared to $3 million for management fees and $11 million for reimbursements of costs and expenses in 2005.

 

In 2006, we recorded $38 million in transaction structuring fees for 17 American Capital sponsored buyout investments and three add-on financings for acquisitions totaling $2,298 million of American Capital financing. In 2005, we recorded $28 million in transaction structuring fees for 18 buyout investments and two add-on financings for acquisitions totaling $1,662 million of American Capital financing. The transaction structuring fees were 1.7% of American Capital financing in both 2006 and 2005, respectively.

 

Equity financing fees for the year ended December 31, 2006 increased $4 million over the comparable period in 2005. The increase in equity financing fees was attributable to an increase in new equity investments from $760 million in 2005 to $1,048 million in 2006. Equity financing fees were 2.8% and 3.3% of equity financing in 2006 and 2005, respectively.

 

Portfolio company management and administrative fees for the year ended December 31, 2006 increased $5 million, or 26%, over the comparable period in 2005. The increase in management and administrative fees is attributable primarily to the increase in the number of portfolio companies under management.

 

Loan financing fees for the year ended December 31, 2006 increased $6 million, or 33%, over the comparable period in 2005. The increase in the loan financing fees was attributable to an increase in new debt investments from $2,257 million in 2005 to $3,527 million in 2006. The loan financing fees were 0.7% and 0.8% of loan originations in 2006 and 2005, respectively. Loan fees we receive that are representative of additional yield are deferred as a discount and accreted into interest income and are not recorded as fee income.

 

The prepayment fees of $10 million in 2006 are the result of the prepayment by 26 portfolio companies of loans totaling $486 million compared to prepayment fees of $11 million in 2005 as the result of the prepayment by 20 portfolio companies of loans totaling $445 million. Prepayment fees were 2.0% and 2.5% in 2006 and 2005, respectively, of loans that contained prepayment fee provisions.

 

Operating Expenses

 

Total operating expenses for 2006 increased $196 million, or 86%, over 2005. Our operating leverage was 2.0% and 1.9% for December 31, 2006 and 2005, respectively. Operating leverage is our operating expenses, excluding stock-based compensation, interest expense and operating expenses reimbursed under management agreements, divided by our total assets at period end.

 

Interest expense increased from $101 million for 2005 to $190 million for 2006. The increase in interest expense is due both to an increase in our weighted average borrowings from $1,892 million for 2005 to $3,021 million for 2006 and to an increase in our weighted average interest rate on outstanding borrowings, including amortization of deferred finance costs, from 5.32% for 2005 to 6.28% for 2006. As discussed above, the increase in the weighted average interest rate is primarily due to an increase in the average LIBOR rates in 2006.

 

Salaries, benefits and stock-based compensation expense increased 87% from $86 million for 2005 to $161 million in the comparable period in 2006. Salaries, benefits and stock-based compensation consisted of the following for the years ended December 31, 2006 and 2005 (in millions):

 

       Year Ended
December 31,


       2006

     2005

Salaries

     $ 109      $ 64

Benefits

       13        8

Stock-based compensation

       39        14
      

    

Total salaries, benefits and stock-based compensation

     $ 161      $ 86
      

    

 

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The total increase is due primarily to an increase in employees from 308 at December 31, 2005 to 484 at December 31, 2006 and annual salary rate increases. The increase in the number of employees is due to our growth as we have added investment professionals and administrative staff as we continue to build our investment platform and our asset management business, including the opening of one new office during 2006 and two new offices during 2005.

 

General and administrative expenses increased from $41 million for 2005 to $73 million for 2006 primarily due to additional overhead attributable to the increase in the number of employees and the opening of new offices, including higher employee recruiting costs and rent expense. In addition, we experienced higher legal and accounting fees and board of director fees due primarily to a new board of director retention plan implemented in 2006.

 

Provision for Income Taxes

 

We operate to qualify to be taxed as a RIC under the Code. 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. However, we are subject to a nondeductible federal excise tax of 4% on our undistributed investment company taxable income if we do not distribute at least 98% of our investment company ordinary taxable income in any calendar year, 98% of our capital gain net income for each one-year period ending on October 31 and any shortfall in distributing taxable income from the prior calendar year. For calendar years 2006 and 2005, we retained $108 million and $48 million of our investment company ordinary taxable income, respectively, and accrued a federal excise tax of $4 million and $2 million, respectively, which is included in our provision for income taxes.

 

Our consolidated operating subsidiaries, ACFS and ECFS, are subject to corporate level federal, state and local income tax in their respective jurisdictions. For 2006 and 2005, we recorded a tax provision of $7 million and $11 million, respectively, attributable to our operating subsidiaries.

 

Net Realized Gains (Losses)

 

Our net realized gains (losses) for 2006 and 2005 consisted of the following (in millions):

 

     Year Ended December 31,

     2006

   2005

Sale to American Capital Equity I, LLC

   $   59    $   —  

KAC Holdings, Inc.

     47      —  

WWC Acquisitions, Inc.

     38      —  

Iowa Mold Tooling Co., Inc.

     36      —  

3SI Acquisition Holdings, Inc.

     27      —  

ASC Industries, Inc.

     25      —  

Jones Stephens Corp.

     25      —  

Bankruptcy Management Solutions, Inc.

     22      —  

Network for Medical Communication & Research, LLC

     22      —  

Aeriform Corporation

     6      —  

Escort, Inc.

     6      52

PaR Nuclear Holding Company

     5      —  

BC Natural Foods, LLC

     5      1

Edge Products, LLC

     4      —  

American Driveline Systems, Inc.

     3      —  

Alemite Holdings, Inc.

     2      —  

Dynisco Parent, Inc.

     2      —  

 

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     Year Ended December 31,

 
     2006

    2005

 

Roadrunner Freight Systems, Inc.

     —         26  

CIVCO Holding, Inc.

     —         13  

Automatic Bar Controls, Inc.

     1       12  

The Tensar Corporation

     —         11  

Chronic Care Solutions, Inc.

     1       6  

HMS Healthcare, Inc.

     —         6  

Vigo Remittance Corp.

     —         4  

Cycle Gear, Inc.

     —         4  

The Lion Brewery, Inc.

     —         2  

Bumble Bee Seafoods, L.P.

     —         2  

Kelly Aerospace, Inc.

     —         2  

ACS PTI, Inc.

     —         2  

Other, net

     20       4  
    


 


Total gross realized portfolio gains

   $ 356     $ 147  
    


 


Flexi-Mat Holdings, Inc.

     (31 )     —    

Weber Nickel Technologies, Ltd.

     (29 )     —    

Stravina Holdings, Inc.

     (19 )     (1 )

American Decorative Surfaces International, Inc.

     (16 )     (23 )

UAV Corporation

     (15 )     —    

nSpired Holdings, Inc.

     (14 )     —    

Halex Holdings, Inc.

     (11 )     —    

Precitech, Inc.

     (8 )     —    

Auxi Health, Inc.

     (8 )     —    

Logex Corporation

     (7 )     —    

S-Tran Holdings, Inc.

     (7 )     (22 )

Optima Bus Corporation

     (6 )     (14 )

KIC Holdings, Inc.

     (5 )     (15 )

Euro-Caribe Packing Company, Inc.

     (5 )     —    

Hartstrings LLC

     —         (8 )

MBT International, Inc.

     —         (6 )

Aeriform Corporation

     —         (4 )

Euro-Pro Operating LLC

     —         (2 )

Other, net

     —         (7 )
    


 


Total gross realized portfolio losses

   $ (181 )   $ (102 )
    


 


Total net realized portfolio gains

     175       45  

Interest rate derivative periodic receipts (payments), net

     6       (10 )

Interest rate derivative termination receipts, net

     9       1  

Taxes on net realized gains

     (17 )     —    
    


 


Total net realized gains

   $ 173     $ 36  
    


 


 

On October 1, 2006, we entered into a purchase and sale agreement with ACE I for the sale of approximately 30% of our equity investments (other than warrants issued with debt investments) in 96 portfolio companies. ACE I is a newly established private equity fund with $1 billion of equity commitments. The aggregate purchase price was $671 million, subject to certain adjustments. ACE I will co-invest with us in an amount equal to 30% of our future equity investments until the $329 million remaining commitment is exhausted. A wholly-owned portfolio company, ACEM, will manage ACE I in exchange for a 2% annual management fee on the net cost basis of ACE I and a 10% to 30% carried interest in the net profits of ACE I, subject to certain hurdles. We recorded a total net realized gain of $59 million upon the sale of the $671 million

 

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of investments. In accordance with FASB Statement No. 140, we included in our sale proceeds the fair value of the management agreement associated with the $671 million of investments sold. The fair value of this portion of the contract was determined to be $16 million and was treated as being contributed to ACEM as our cost basis in our investment in ACEM. As a result, our $59 million of net realized gain on the transaction includes $16 million of a realized gain for the value of a portion of the management agreement received as sale proceeds.

 

During 2006, we received full repayment of our remaining $23 million subordinated debt investment in KAC Holdings, Inc. and sold all of our common and preferred equity investment for $65 million in proceeds realizing a total gain of $47 million offset by a reversal of unrealized appreciation of $49 million. The gain that we recognized includes escrowed proceeds of $5 million, which we expect to receive.

 

During 2006, we received full repayment of our $33 million senior and subordinated debt investment in WWC Acquisitions, Inc. and sold all of our common equity investment for $51 million in proceeds realizing a total gain of $38 million offset by a reversal of unrealized appreciation of $42 million. The gain that we recognized includes escrowed proceeds of $2 million, which we expect to receive. We provided the purchasers with $96 million of new senior debt financing at market terms.

 

During 2006, we received full repayment of our remaining $16 million subordinated debt investment in Iowa Mold Tooling Co., Inc. and sold all of our common and preferred equity for $78 million in proceeds realizing a total gain of $36 million offset by a reversal of unrealized appreciation of $21 million. The gain that we recognized includes escrowed proceeds of $5 million, which we expect to receive.

 

During 2006, we received full repayment of our remaining $40 million subordinated debt investment in 3SI Acquisition Holdings, Inc. and sold all of our common equity for $53 million in proceeds realizing a total gain of $27 million offset by a reversal of unrealized appreciation of $28 million. The gain that we recognized includes escrowed proceeds of $4 million, which we expect to receive.

 

During 2006, we received full repayment of our $21 million subordinated debt investment in ASC Industries, Inc. and sold all of our equity investments for $35 million in proceeds realizing a total gain of $25 million offset by a reversal of unrealized appreciation of $19 million.

 

During 2006, we received full repayment of our $23 million subordinated debt investment in Jones Stephens Corp. and sold all of our common and preferred equity for $38 million in proceeds realizing a total gain of $25 million offset by a reversal of unrealized appreciation of $31 million. The gain that we recognized includes escrowed proceeds of $5 million, which we expect to receive. We provided $22 million of subordinated debt financing to the purchasers of Jones Stephens.

 

During 2006, we received full repayment of our remaining $47 million senior and subordinated debt investments in Bankruptcy Management Solutions, Inc. and sold all of our common equity for $21 million in proceeds realizing a total gain of $22 million offset by a reversal of unrealized appreciation of $21 million.

 

During 2006, we received full repayment of our remaining $10 million subordinated debt investment in Network for Medical Communication & Research, LLC and sold all of our common equity warrants for $22 million in proceeds realizing a total gain of $22 million offset by a reversal of unrealized appreciation of $23 million. The gain that we recognized includes escrowed proceeds of $1 million, which we expect to receive.

 

During 2006, we surrendered all of our equity securities and a portion of our debt securities in Flexi-Mat Holdings, Inc. that we believe did not have any fair value on the date of transfer. We recorded a realized loss of $31 million offset by a reversal of unrealized depreciation of $20 million. We continue to own a senior debt investment in Flex-Mat.

 

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During 2006, Weber Nickel Technologies, Ltd. filed for bankruptcy protection in Canada under the Companies’ Creditors Arrangement Act. Although we are pursuing our claims, we do not expect to receive any proceeds from our subordinated debt or equity investment in Weber. We deemed our investments to be worthless and recognized a realized loss of $29 million fully offset by a reversal of unrealized depreciation.

 

During 2006, we sold a portion of our equity investment in Stravina Holdings, Inc. for nominal proceeds resulting in a realized loss of $19 million fully offset by a reversal of unrealized depreciation.

 

During 2006, American Decorative Surfaces International, Inc. ceased business operations and a receiver was appointed to liquidate its remaining assets. Although we are pursuing our claims in the receivership, we do not expect to receive any additional proceeds from the liquidation. Our remaining subordinated debt and equity investments were deemed worthless and we recognized a realized loss of $16 million offset by the reversal of unrealized depreciation of $19 million.

 

During 2006, we sold our senior subordinated debt investment in UAV Corporation for nominal proceeds realizing a loss of $15 million offset by a reversal of unrealized depreciation of $12 million.

 

During 2006, we sold a portion of our equity investments in five portfolio companies—nSpired Holdings, Inc., Halex Holdings, Inc., Logex Corporation, KIC Holdings, Inc. and Euro-Caribe Packing Company—in one transaction for nominal proceeds resulting in a total realized loss of $42 million offset by a reversal of unrealized depreciation of $42 million.

 

During 2005, we received full repayment of our $27 million senior and subordinated debt investments in Escort, Inc. and sold all of preferred equity and a portion of common equity for $62 million in proceeds realizing a total gain of $52 million offset by a reversal of unrealized appreciation of $49 million. We retained a 9% fully diluted common equity interest in the newly capitalized Escort, renamed Radar Detection Holdings Corp., and provided $13 million of senior debt financing to the purchasers for the transaction. The gain that we recognized included escrowed proceeds of $1 million.

 

During 2005, we received full repayment of our remaining $5 million subordinated debt investments in Roadrunner Freight Systems, Inc. and sold all of our equity investments in Roadrunner Freight consisting of our common stock and common stock warrants for $42 million in proceeds realizing a total gain of $26 million offset by a reversal of unrealized appreciation of $24 million. We provided $24 million of subordinated bridge debt financing to the purchasers for which we subsequently received full repayment in 2005.

 

During 2005, we received full repayment of our $29 million of subordinated debt investments in CIVCO Holding, Inc. and sold all of our remaining equity investments in CIVCO consisting of our common stock and common stock warrants for $15 million in proceeds realizing a total gain of $13 million offset by a reversal of unrealized appreciation of $7 million. The gain that we recognized included escrowed proceeds of $1 million.

 

During 2005, we received full repayment of our $26 million of remaining senior and subordinated debt investments in Automatic Bar Controls, Inc. and sold all of our equity investments in Automatic Bar consisting of our common stock and common stock warrants for $19 million in proceeds realizing a total gain of $12 million offset by a reversal of unrealized appreciation of $14 million.

 

During 2005, we received full repayment of our $25 million of subordinated debt investments in The Tensar Corporation and sold all of our minority equity investments in Tensar consisting of preferred stock, common stock warrants and common stock for $18 million in proceeds realizing a total gain of $11 million offset by a reversal of unrealized appreciation of $11 million. We provided $104 million in senior and subordinated debt financing to the purchasers in the transaction.

 

 

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During 2005, we sold our common stock investment and a portion of our preferred stock and common stock warrant investments in American Decorative Surfaces International, Inc. for nominal proceeds resulting in a realized loss of $23 million offset by a reversal of unrealized depreciation of $23 million.

 

During 2005, S-Tran Holdings, Inc. filed for Chapter 11 bankruptcy. We do not expect to receive any proceeds from the liquidation of S-Tran for our common stock investment in S-Tran. Our common stock investment was deemed worthless and was written off resulting in a realized loss of $22 million offset by a reversal of unrealized depreciation of $22 million.

 

During 2005, we sold a portion of our preferred stock investments in KIC Holdings, Inc. for nominal proceeds resulting in a realized loss of $15 million offset by a reversal of unrealized depreciation of $15 million.

 

During 2005, we sold our common stock warrant investment and a portion of our preferred stock investments in Optima Bus Corporation for nominal proceeds resulting in a realized loss of $14 million offset by a reversal of unrealized depreciation of $14 million.

 

For our tax year ended September 30, 2006, we had net long-term capital gains of $43 million. We elected to retain such capital gains and pay a federal tax on behalf of our shareholders of $15 million, which is included in our net realized gains. For the tax year ended September 30, 2005, to the extent we had capital gains, they were fully offset by either capital losses or capital loss carry forwards. In addition, for the one-year period ending on October 31, 2006, we did not distribute at least 98% of our taxable net capital gains and recorded an excise tax expense of $2 million, which is also included in our net realized gains.

 

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 recorded a net realized gain of $6 million and a net realized loss of $10 million, during 2006 and 2005, respectively, for the interest rate derivative periodic settlements. The favorable periodic interest settlements in 2006 as compared to the prior year are due primarily to the increase in the average LIBOR in 2006 as compared to 2005. In 2006 and 2005, we also terminated interest rate derivative agreements prior to their maturity resulting in a net cash settlement payment and net realized gain to us of $9 million and $1 million, respectively.

 

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 2006 and 2005 ($ in millions):

 

     Year Ended December 31, 2006

   

Year Ended December 31, 2005


 
     Number of
Companies


  

Amout


    Number of
Companies


  

Amount


 

Gross unrealized appreciation of portfolio company investments

   68    $ 785     43    $ 243  

Gross unrealized depreciation of portfolio company investments

   53      (381 )   34      (222 )

Reversal of prior period net unrealized appreciation upon a realization

          (128 )          (38 )
         


      


Net unrealized appreciation (depreciation) of portfolio company investments

          276            (17 )

Foreign currency translation

          32            —    

Derivative agreements

          (11 )          32  
         


      


Net unrealized appreciation of investments

        $ 297          $ 15  
         


      


 

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The fair value of the 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. The fair value of the derivative agreements appreciate or depreciate based on relative market interest rates and the remaining term to maturity. The net unrealized depreciation of interest rate derivative agreements in 2006 is due primarily to the reversal of unrealized appreciation for interest rate derivative agreements that were terminated in 2006 prior to their maturity that resulted in the recognition of net realized gains of $9 million.

 

We have a limited amount of investments in portfolio companies, including ECAS, for which the investment is denominated in a foreign currency, primarily the Euro. We also have other assets and liabilities denominated in foreign currencies. Fluctuations in exchange rates therefore impact our financial condition and results of operations, as reported in U.S. dollars. During 2006, the foreign currency translation adjustment recorded in our consolidated statements of operations was unrealized appreciation of $32 million primarily as a result of the Euro appreciating against the U.S. dollar for our ECAS investment.

 

Our Board of Directors is responsible for determining the fair value of our portfolio investments on a quarterly basis. In that regard, the board has retained Houlihan Lokey Howard & Zukin Financial Advisors, Inc. (“Houlihan Lokey”) to assist it by having Houlihan Lokey regularly review a designated percentage of our fair value determinations. Houlihan Lokey is a leading valuation firm in the U.S., engaged in approximately 1,000 valuation assignments per year for clients worldwide. Each quarter, Houlihan Lokey reviewed our determination of the fair value of approximately 25% of American Capital’s portfolio company investments that had been portfolio companies for at least one year and that had a fair value in excess of $10 million.

 

In 2006 and 2005, Houlihan Lokey reviewed our valuations of 96 and 99 portfolio company investments, having an aggregate $4,949 million and $3,113 million in fair value, respectively, as reflected in our consolidated financial statements of the respective period ends. In addition, Houlihan Lokey representatives attend our quarterly valuation meetings and provide periodic reports and recommendations to the Audit and Compliance Committee of our Board of Directors. For those portfolio company investments that Houlihan Lokey has reviewed during the applicable period using the scope of review set forth by our board, our board has made a fair value determination that is within the aggregate range of fair value for such investments as determined by Houlihan Lokey. Houlihan Lokey has been engaged, or may in the future be engaged, directly by us or our portfolio companies to provide investment banking services.

 

In February 2006, we entered into a commitment to provide $85 million of mezzanine and equity financing to ASAlliances Biofuels, LLC, through our investment in ACSAB, LLC, to fund its development of three large scale ethanol production facilities. Construction of all facilities has commenced and are projected to be in operation in late 2007. In October 2006, we sold 30% of our equity investment in ACSAB, LLC realizing a gain of $18 million as part of the sale transaction to ACE I. As of December 31, 2006, our cost basis in ACSAB, LLC was $60 million, which represents a 30% diluted ownership interest in ACSAB, LLC. Our investment has appreciated $99 million as of December 31, 2006 to a fair value of $159 million. The increase in the valuation is driven in part by developments in the ethanol and energy markets and market comparables subsequent to our original investment in February 2006. In addition to our standard valuation procedures, we engaged Houlihan Lokey to review the value of ACSAB, LLC as of December 31, 2006 due to the significant increase in fair value in the first year of our investment. The fair value of this investment, as determined by our Board of Directors, is within the range of fair value for the investment as determined by Houlihan Lokey. In addition to the prices of ethanol, the valuation of this investment is highly dependent on the pricing of agricultural commodities, such as corn, which is a raw material used in the production of ethanol, as well as the selling prices of petroleum products, such as the prices of unleaded gasoline and diesel fuel for which ethanol is considered to be a substitute. Therefore, significant fluctuations in the price of ethanol, corn commodities or crude oil could result in a significant effect on the valuation of our investment in ACSAB, LLC. The valuation of this investment is also dependent upon the stock prices of other comparable public companies. Subsequent to December 31, 2006, the prices of corn commodities have increased, the prices of ethanol and crude oil have decreased and the stock prices of comparable public companies have declined, and if such trends continue, this could result in a decrease in the fair value of our investment in ACSAB, LLC in subsequent periods.

 

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As part of our sale transaction of 30% of our equity securities to ACE I on October 1, 2006, our wholly-owned portfolio company, ACEM, will manage ACE I in exchange for a 2% annual management fee on the net cost basis of ACE I and a 10% to 30% carried interest in the net profits of ACE I, subject to certain hurdles. As of December 31, 2006, ACEM’s sole asset consists of this management agreement. As of December 31, 2006, we determined the total fair value of ACEM to be $36 million. In addition to our standard valuation procedures, we engaged Houlihan Lokey to review the value of ACEM as of December 31, 2006. The fair value of this investment, as determined by our Board of Directors, is within the range of fair value for the investment as determined by Houlihan Lokey.

 

Fiscal Year 2005 Compared to Fiscal Year 2004

 

Operating Income

 

Total operating income is comprised of two components: interest and dividend income and asset management and other fee income. For the year ended December 31, 2005, total operating income increased $219 million, or 65%, over the year ended December 31, 2004. Interest and dividend income consisted of the following for the years ended December 31, 2005 and 2004 (in millions):

 

    

Year Ended
December 31,


     2005

   2004

Interest income on debt securities

   $ 383    $ 243

Interest income on bank deposits and employee loans

     4      1

Dividend income on equity securities

     39      27
    

  

Total interest and dividend income

   $  426    $  271
    

  

 

Interest income on debt securities increased by $140 million, or 58%, to $383 million for 2005 from $243 million for 2004, 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. Our daily weighted average debt investments at cost increased from $1,804 million in 2004 to $2,949 million in 2005 resulting from new loan originations net of loan repayments during the year ended December 31, 2005.

 

The daily weighted average effective interest rate on debt investments decreased to 13.0% in 2005 from 13.5% in 2004 due primarily to an increase in the total senior loans as a percentage of our total loan portfolio. Our senior loans as a percentage of our total loans at cost increased to 44% as of December 31, 2005 from 35% as of December 31, 2004. The impact on our daily weighted average effective interest rate of the increase in the percentage of our senior debt investments is partially offset by an increase in interest rates on our variable rate based loans as the weighted average monthly LIBOR rate increased from 1.55% in 2004 to 3.47% in 2005. Our senior loans generally yield lower rates than our subordinated loans, but they are typically variable rate based loans, which do not require the use of interest rate basis swap agreements thereby reducing our overall interest swap costs. 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 swap agreements to match the interest rate basis of our assets and liabilities and to reduce our interest rate risk, 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. Excluding the impact of the interest rate swap agreements, our daily weighted effective interest rate for 2005 decreased 50 basis points to 13.0% as compared to 13.5% for the prior year. However, including the impact of interest rate basis swap agreements, our daily weighted average effective interest rate for 2005 increased 40 basis points to 12.7% as compared to 12.3% for the prior year.

 

However, our derivatives are considered economic hedges that do not qualify for hedge accounting under FASB Statement No. 133. 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

 

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gain (loss) on investments on the interest settlement date. In 2005 and 2004, the total interest rate cost of interest rate derivative agreements included in both net realized gain (loss) on investments and unrealized appreciation (depreciation) of investments was $7 million and $21 million, respectively.

 

Dividend income on equity securities increased by $12 million to $39 million for 2005 from $27 million for 2004 due primarily to an increase in preferred stock investments. We have grown our investments in equity securities to a fair value of $1,722 million as of December 31, 2005, an 89% 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, we received cash dividends from common equity investments, of $2 million from three portfolio companies in 2005 compared to $9 million from six portfolio companies in 2004.

 

Our daily weighted average total debt and equity investments at cost increased from $2,443 million in 2004 to $4,056 million in 2005. The daily weighted average yield on total debt and equity investments decreased from 11.1% in 2004 to 10.4% in 2005 due to the reasons discussed above including an overall increase in equity investments in 2005 that do not produce a current yield. Including the cost of interest rate basis swap agreements that are included net realized gain (loss) on investments and net unrealized appreciation (depreciation) of investments on the consolidated statements of operations, our daily weighted average yield would have been 10.2% in both 2004 and 2005.

 

Asset management and other fee income consisted of the following for the years ended December 31, 2005 and 2004 (in millions):

 

    

Year Ended
December 31,


     2005

   2004

Transaction structuring fees

   $ 28    $ 14

Equity financing fees

     25      10

Portfolio company management and administrative fees

     19      10

Loan financing fees

     18      15

Fund management fees and reimbursements

     14      —  

Prepayment fees

     11      7

Other

     14      9
    

  

Total asset management and other fee income

   $   129    $ 65
    

  

 

Asset management and other fee income increased by $64 million, or 98%, to $129 million in 2005 from $65 million in 2004. In 2005, we recorded $28 million in transaction structuring fees for eighteen buyout investments and two add-on financings for acquisitions totaling $1,662 million of American Capital financing. In 2004, we recorded $14 million in transaction structuring fees for thirteen buyout investments totaling $689 million of American Capital financing. The transaction structuring fees were 1.7% and 2.1% of American Capital financing in 2005 and 2004, respectively.

 

Equity financing fees for the year ended December 31, 2005 increased $15 million over the comparable period in 2004. The increase in equity financing fees was attributable to an increase in new equity investments from $339 million in 2004 to $760 million in 2005. Equity financing fees were 3.3% and 2.9% of equity financing in 2005 and 2004, respectively.

 

Portfolio company management and administrative fees for the year ended December 31, 2005 increased $9 million, or 90%, over the comparable period in 2004. The increase in portfolio company management and administrative fees is attributable primarily to the increase in the number of portfolio companies under management.

 

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Loan financing fees for the year ended December 31, 2005 increased $3 million, or 20%, over the comparable period in 2004. The increase in the loan financing fees was attributable to an increase in new debt investments from $1,679 million in 2004 to $2,257 million in 2005. The loan financing fees were 0.8% and 0.9% of loan originations in 2005 and 2004, respectively. Loan fees that we receive that are representative of additional yield are deferred as a discount and accreted into interest income and are not recorded as fee income.

 

Fund management fees and reimbursements represent fees recognized for providing investment advisory and management services to ECAS pursuant to investment management and services agreements. We recognized $3 million of management fees and $11 million for reimbursements of costs and expenses in 2005.

 

The prepayment fees of $11 million in 2005 are the result of the prepayment by twenty portfolio companies of loans totaling $445 million compared to prepayment fees of $7 million in 2004 as the result of the prepayment by seventeen portfolio companies of loans totaling $267 million. Prepayment fees were 2.5% in both 2005 and 2004, respectively, of loans that contained prepayment fee provisions.

 

Operating Expenses

 

Operating expenses for 2005 increased $114 million, or 100%, over 2004. Our operating leverage was 1.9% for both 2005 and 2004. Operating leverage is our operating expenses, excluding stock-based compensation, interest expense and operating expenses reimbursed under management agreements divided by our total assets at period end.

 

Interest expense increased from $37 million for 2004 to $101 million for 2005. The increase in interest expense is due both to an increase in our weighted average borrowings from $1,000 million for 2004 to $1,892 million for 2005 and to an increase in our weighted average interest rate on outstanding borrowings, including amortization of deferred finance costs, from 3.69% for 2004 to 5.32% for 2005. The increase in the weighted average interest rate is primarily due to an increase in the average monthly LIBOR rate from 1.55% in 2004 to 3.47% in 2005.

 

Salaries, benefits and stock-based compensation expense increased 69% from $51 million for 2004 to $86 million for 2005. Salaries, benefits and stock-based compensation consisted of the following for the years ended December 31, 2005 and 2004 (in millions):

 

    

Year Ended
December 31,


     2005

   2004

Salaries

   $ 64    $ 36

Benefits

     8      5

Stock-based compensation

     14      10
    

  

Total salaries, benefits and stock-based compensation

   $   86    $   51
    

  

 

The total increase is due primarily to an increase in employees from 191 at December 31, 2004 to 308 at December 31, 2005, increases in incentive compensation, and annual salary rate increases. The increase in number of employees is due to our growth as we have added investment professionals and administrative staff in our efforts to build our investment platform, including the opening of two offices in London and Paris. The incentive compensation accrued as a percentage of the maximum amount of incentive compensation available increased in 2005 as compared to the prior year as a result of meeting certain performance criteria in 2005. 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 2005 since it includes the pro-rata vested expense for stock options granted over the past three years compared to the pro-rata vested expense for stock options granted over the past two years in 2004.

 

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General and administrative expenses increased from $26 million for 2004 to $41 million for 2005 primarily due to additional overhead attributable to the increase in the number of employees and the opening of two new offices in London and Paris, including higher employee recruiting costs and rent expense.

 

Provision for Income Taxes

 

We are subject to a nondeductible federal excise tax of 4% on our undistributed investment company taxable income if we do not distribute at least 98% of our investment company ordinary taxable income in any calendar year, 98% of our capital gain net income for each one-year period ending on October 31 and any shortfall in distributing taxable income from the prior calendar year. For 2005, we retained $48 million of our investment company taxable income and accrued a federal excise tax of $2 million, which is included in our provision for income taxes.

 

Our consolidated taxable operating subsidiaries, ACFS and ECFS, are subject to corporate level federal, state and local income tax in their respective jurisdictions. For the years ended December 31, 2005 and 2004, we recorded a tax provision of $11 million and $2 million, respectively, attributable to our taxable operating subsidiaries. The increase in the tax provision in 2005 as compared to 2004 is due primarily to the increase in fee income earned by ACFS in 2005 as result of an increase in American Capital sponsored buyout transactions structured by ACFS. The 2004 income tax provision also benefited from the full utilization of a fully reserved net operating loss carry forward and the reversal of a valuation allowance on deferred tax assets.

 

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Net Realized Gains (Losses)

 

Our net realized gains (losses) for 2005 and 2004 consisted of the following (in millions):

 

       Year Ended
December 31,


 
       2005

     2004

 

Escort, Inc.

     $ 52      $   —    

Roadrunner Freight Systems, Inc.

       26        2  

CIVCO Holding, Inc.

       13        2  

Automatic Bar Controls, Inc.

       12        —    

The Tensar Corporation

       11        4  

Chronic Care Solutions, Inc.

       6        —    

HMS Healthcare, Inc.

       6        —    

Vigo Remittance Corp.

       4        1  

Cycle Gear, Inc.

       4        —    

The Lion Brewery, Inc.

       2        —    

Bumble Bee Seafoods, L.P.

       2        —    

Kelly Aerospace, Inc.

       2        —    

ACS PTI, Inc.

       2        —    

TransCore Holdings, Inc.

       —          20  

Texstars, Inc.

       —          11  

ACAS Acquisitions (PaR Systems), Inc.

       —          10  

Bankruptcy Management Solutions, Inc.

       —          3  

Other

       5        6  
      


  


Total gross realized portfolio gains

     $ 147      $ 59  
      


  


American Decorative Surfaces International, Inc.

       (23 )      —    

S-Tran Holdings, Inc.

       (22 )      —    

KIC Holdings, Inc.

       (15 )      —    

Optima Bus Corporation

       (14 )      —    

Hartstrings LLC

       (8 )      —    

MBT International, Inc.

       (6 )      —    

Aeriform Corporation

       (4 )      —    

Euro-Pro Operating LLC

       (2 )      —    

Chromas Technologies Corp.

       —          (32 )

Fulton Bellows & Components, Inc.

       —          (14 )

Academy Events Services, LLC

       —          (14 )

Sunvest Industries, Inc.

       —          (14 )

Baran Group, Ltd.

       —          (2 )

ThreeSixty Sourcing, Ltd.

       —          (2 )

Other

       (8 )      (1 )
      


  


Total gross realized portfolio losses

     $ (102 )    $ (79 )
      


  


Total net realized portfolio gains (losses)

       45        (20 )
      


  


Interest rate derivative periodic interest payments, net

       (10 )      (18 )

Interest rate derivative termination receipts, net

       1        —    
      


  


Total net realized gains (losses)

     $ 36      $ (38 )
      


  


 

See “Fiscal Year 2006 Compared to Fiscal Year 2005” for discussion on the net realized gains (losses) for the year ended December 31, 2005.

 

During 2004, we received full repayment of our $27 million subordinated debt investments in TransCore Holdings, Inc. and sold all of our equity investments in TransCore consisting of our redeemable preferred stock,

 

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convertible preferred stock and common stock warrants for $26 million in proceeds realizing a total gain of $20 million offset by the reversal of unrealized appreciation of $19 million. The sale proceeds we recognized included proceeds we expect to receive held in escrow of $2 million.

 

During 2004, we received full repayment of our $21 million 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 $13 million in proceeds realizing a total gain of $11 million offset by the reversal of unrealized appreciation of $10 million. The gain that we recognized included escrowed proceeds of $2 million.

 

During 2004, we received full repayment of our $23 million subordinated debt investment in ACAS Acquisitions (PaR Systems), Inc. and received a $11 million 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 $10 million. 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 $5 million in subordinated debt financing to, and retained a 51% diluted ownership in, PaR Systems, Inc.

 

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. 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 million offset by the reversal of unrealized depreciation of $30 million.

 

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

 

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 million offset by the reversal of unrealized depreciation of $8 million.

 

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 million offset by the reversal of unrealized depreciation of $14 million in 2004.

 

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. During 2005 and 2004, we recorded net realized losses of $10 million and $18 million, respectively, for the interest rate derivative periodic settlements. The decrease in cost is due primarily to the increase in average LIBOR in 2005 as compared to 2004.

 

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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 appreciation (depreciation) of investments for 2005 and 2004 ($ in millions):

 

     Year Ended December 31, 2005

    Year Ended December 31, 2004

 
     Number of
Companies


  

Amount


    Number of
Companies


  

Amount


 

Gross unrealized appreciation of portfolio company investments

   43    $ 243     34    $ 192  

Gross unrealized depreciation of portfolio company investments

   34      (222 )   31      (135 )

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

          (38 )          34  
         


      


Net unrealized (depreciation) appreciation of portfolio company investments

          (17 )          91  

Derivative agreements

          32            8  
         


      


Net unrealized appreciation of investments

        $ 15          $ 99  
         


      


 

The increase in the fair value of our interest rate derivative agreements in 2005 is due primarily to the increase in average LIBOR in 2005 and a resulting increase in the forward interest rate yield curve.

 

Financial Condition, Liquidity and Capital Resources

 

As of December 31, 2006, we had $77 million in cash and cash equivalents and $233 million 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 quarter to pay interest and principal on the securitized debt. As of December 31, 2006, we had availability of $588 million under our revolving credit facilities (excluding standby letters of credit of $7 million). We had no forward equity sale agreements outstanding as of December 31, 2006. During 2006, we principally funded investments using draws on the revolving credit facilities, proceeds from asset securitizations, unsecured debt issuances and equity offerings, including forward equity sale agreements, as well as proceeds from syndications of senior loans, repayments of loans and sales of equity investments.

 

We expect to continue to raise new capital in order to fund our investment objectives by issuing both debt and equity securities in the future. In 2006, we achieved an investment grade credit rating. Moody’s Investors Service assigned us a Baa2 long-term issuer rating, Standard & Poor’s Ratings Service assigned us a BBB counterparty credit rating and Fitch Ratings assigned our long-term default rating and senior unsecured debt rating at BBB. As a result of these improved credit ratings, we may be able to obtain more favorable pricing on future debt issuances and we may also look to access the public markets for future debt issuances. However, the terms of any 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.

 

As a regulated investment company, we are required to distribute annually 90% or more of our investment company taxable income. We provide shareholders with the option of reinvesting their dividends in American Capital. In 2006, 2005 and 2004, shareholders reinvested $29 million, $38 million and $7 million, respectively, in dividends. Since our IPO through December 31, 2006, shareholders have reinvested $78 million of dividends in American Capital. In August 2004, we amended our 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.

 

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We are currently in compliance with the requirements to qualify as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986, as amended, and to qualify as a business development company under the Investment Company Act of 1940, as amended. 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 senior securities. As of December 31, 2006 and 2005, our asset coverage was 211% and 217%, respectively.

 

Equity Capital Raising Activities

 

On June 23, 2006, 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 $3 billion. As of December 31, 2006, our remaining capacity under the shelf registration statement was $1.9 billion.

 

Forward Sale Agreements

 

We periodically complete public offerings where shares of our common stock are sold in which a portion of the shares are offered directly by us and a portion of the shares are sold by third parties, or forward purchasers, in connection with agreements to purchase common stock from us for future delivery dates pursuant to forward sale agreements. The shares of common stock sold by the forward purchasers are borrowed from third party market sources. Pursuant to the forward sale agreements, we are required to sell to the forward purchasers shares of our common stock generally at such times as we elect over a one-year period. The forward sale agreements provide for settlement date or dates to be specified at our discretion within a one-year period. On a settlement date, we issue and sell shares of our common stock to the forward purchaser at the then applicable forward sale price. The forward sale price is initially the public offering price of shares of our common stock less the underwriting discount. The forward sale agreements provide that the initial forward sale price per share is subject to daily adjustment based on a floating interest factor equal to the federal funds rate, less a spread, and also is subject to specified decreases on certain dates during the duration of the agreement. 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.

 

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. 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.

 

As of December 31, 2006 all forward sale agreements have been fully settled.

 

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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. For example, as of December 31, 2006, our ratio of debt to equity was 0.90:1.

 

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. For example, the use of the forward sale agreements beginning in 2004 has enabled us to increase our debt to equity ratio from 0.71 as of December 31, 2003 to 0.90 as of December 31, 2006. 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.

 

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Equity Offerings

 

For fiscal years 2006, 2005 and 2004, we completed several public offerings of our common stock and entered into several forward sale agreements. The following table summarizes the total shares sold, including shares sold directly by us, including shares sold pursuant to the underwriters’ over-allotment options and through forward sale agreements, and the proceeds we received, excluding issuance costs, for the public offerings of our common stock for the fiscal years 2006, 2005 and 2004 (in millions, except per share data):

 

     Shares Sold

   Proceeds, Net of
Underwriters’ Discount


   Average Price per Share

Issuances under September 2006 forward sale agreement

   3.0    $ 110    $   36.75

July 2006 public offering

   3.0      100      32.78

Issuances under April 2006 forward sale agreements

   4.0      133      33.38

April 2006 public offering

   9.8      333      33.99

February 2006 public offering

   1.0      36      36.10

Issuances under January 2006 forward sale agreements

   4.0      137      34.31

January 2006 public offering

   0.6      21      34.84

Issuances under November 2005 forward sale agreements

   3.5      125      35.66

Issuances under September 2005 forward sale agreements

   0.8      26      34.82
    
  

  

Total for the year ended December 31, 2006

   29.7    $   1,021    $ 34.38
    
  

  

Issuances under November 2005 forward sale agreements

   1.5    $ 55    $ 36.25

November 2005 public offering

   3.0      113      36.94

Issuances under September 2005 forward sale agreements

   4.8      167      35.23

September 2005 public offering

   2.0      72      35.72

Issuances under March 2005 forward sale agreements

   8.0      235      29.42

March 2005 public offering

   2.0      60      30.11

Issuances under September 2004 forward sale agreements

   6.3      178      28.53
    
  

  

Total for the year ended December 31, 2005

   27.6    $ 880    $ 31.93
    
  

  

 

In January 2007, we completed a public offering in which 6.3 million shares of our common stock, excluding an underwriters’ over-allotment of 0.9 million shares, were sold at a public offering price of $45.83 per share. Of those shares, 4.3 million were offered directly by us and 2.0 million shares 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 “January 2007 Forward Sales Agreements”). Upon completion of the offering, we received proceeds, net of the underwriters’ discount and closing costs, of $231 million in exchange for 5.2 million shares of common stock which includes the underwriter’s over-allotment of 0.9 million shares.

 

The remaining 2.0 million shares of common stock were borrowed from third party market sources by the counterparties, or forward purchasers, of the January 2007 Forward Sale Agreement who then sold the shares to the public. Pursuant to the January 2007 Forward Sale Agreements, we must sell to the forward purchasers 2.0 million shares of our common stock generally at such times as we elect over a one-year period. The January 2007 Forward Sale Agreements provides for settlement date or dates to be specified at our discretion within the duration of the January 2007 Forward Sale Agreements through termination in January 2008. On a settlement date, we will issue shares of our common stock to the applicable forward purchaser at the then applicable forward sale price. The forward sale price was initially $44.11 per share, which was the public offering price of shares of

 

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our common stock less the underwriting discount. The January 2007 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 will be subject to a decrease by $0.89, $0.91, $0.92, and $0.96 on each of March 2, 2007, June 1, 2007, September 7, 2007 and December 7, 2007, respectively. The forward sale price will also be subject to decrease if the cost to the forward purchasers of borrowing our common stock exceeds a specified amount.

 

Debt Capital Raising Activities

 

Our debt obligations consisted of the following as of December 31, 2006 and 2005 (in millions):

 

   

December 31, 


Debt


  2006

  2005

Secured revolving credit facility, $1,250 million commitment

  $ 669   $ 593

Unsecured revolving credit facility, $900 million commitment

    893     163

Unsecured debt due through September 2011

    167     167

Unsecured debt due August 2010

    126     126

Unsecured debt due October 2020

    75     75

Unsecured debt due February 2011

    24     —  

TRS Facility, $350 million commitment

    296     110

ACAS Business Loan Trust 2002-2 asset securitization

    —       6

ACAS Business Loan Trust 2003-1 asset securitization

    —       23

ACAS Business Loan Trust 2003-2 asset securitization

    —       32

ACAS Business Loan Trust 2004-1 asset securitization

    410     410

ACAS Business Loan Trust 2005-1 asset securitization

    830     762

ACAS Business Loan Trust 2006-1 asset securitization

    436     —  
   

 

Total

  $  3,926   $  2,467
   

 

 

The weighted average debt balance for the years ended December 31, 2006 and 2005 was $3,021 million and $1,892 million, respectively. The weighted average interest rate on all of our borrowings, including amortization of deferred financing costs, for the years ended December 31, 2006, 2005 and 2004 was 6.28%, 5.32% and 3.69%, respectively. We believe that we are currently in compliance with all of our debt covenants. As of December 31, 2006 and 2005, the fair value of the above borrowings was $3,928 million and $2,466 million, respectively. The fair value of fixed rate debt instruments is based upon market interest rates. The fair value of variable rate debt instruments is assumed to equal cost as the interest rates are considered to be at market.

 

Revolving Debt-Funding Facilities

 

We, through a consolidated affiliated statutory trust, have a secured revolving credit facility. In October 2006, we amended the secured revolving credit facility to extend the liquidity purchase termination date to October 2007 and increased the commitment to $1,250 million. As amended, our ability to make draws under the facility expires one business day before the liquidity purchase termination date. If the facility is not extended before the liquidity purchase termination date, any principal amounts then outstanding will be amortized over a 24-month period through the commitment termination date in October 2009. As of December 31, 2006, this facility was collateralized by loans and assets from our portfolio companies with a principal balance of $1,008 million. 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 of 0.75%. We are also charged an unused commitment fee of 0.13%. 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.

 

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We also have an unsecured revolving credit facility with a syndication of lenders. In January 2006, we expanded the committed amount of the facility from $255 million to $310 million as a result of new lender commitments. In May 2006, the facility was amended and restated to add additional new lenders and to increase the available commitments to $900 million. The facility may be expanded through new or additional commitments up to $1,150 million in accordance with the terms and conditions set forth in the related agreement. The facility expires in May 2008 unless extended for an additional 364-day period with the consent of the lenders. Interest on borrowings under the facility is charged at either (i) LIBOR plus the applicable percentage at such time or (ii) the greater of the lender prime rate or the federal funds effective rate plus 50 basis points. We are also charged an unused commitment fee of 0.15%. The amended agreement contains various covenants including limits on annual corporate capital expenditures, maintaining certain unsecured debt ratings and a minimum net worth.

 

In October 2006, we terminated the $125 million secured revolving credit facility. There were no amounts outstanding under this facility as of December 31, 2005.

 

Unsecured Debt

 

In February 2006, we entered into a note purchase agreement to issue €14 million and £3 million of senior unsecured five-year notes to institutional investors in a private placement offering ($24 million at December 31, 2006). The €14 million Series 2006-A Notes have a fixed interest rate of 5.177% and the £3 million Series 2006-B Notes have a fixed interest rate of 6.565%. Each series matures in February 2011. The note purchase agreement contains customary default provisions.

 

In September 2005, we entered into a note purchase agreement to issue $75 million of senior unsecured fifteen-year notes to accredited investors in a private placement offering. The unsecured notes have a fixed interest rate of 6.923% through the interest payment date in October 2015 and at the rate of LIBOR plus 2.65% thereafter and mature in October 2020.

 

In August 2005, we entered into a note purchase agreement to issue an aggregate of $126 million of long-term unsecured five-year notes to institutional investors in a private placement offering. The unsecured notes have a fixed interest rate of 6.14% and mature in August 2010.

 

In September 2004, we sold an aggregate $167 million 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 million of senior notes, Series A and $85 million 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.

 

Asset Securitizations

 

In July 2006, we completed a $500 million asset securitization. In connection with the transaction, ACAS Business Loan Trust 2006-1 (“BLT 2006-1”), an indirect consolidated subsidiary, issued $291 million Class A notes, $37 million Class B notes, $73 million Class C notes, $36 million Class D notes and $64 million Class E notes (collectively, the “2006-1 Notes”). The Class A notes, Class B notes, Class C notes and Class D notes were sold to institutional investors and the Class E notes were retained by us. The 2006-1 Notes are secured by loans originated or acquired by us and sold to a wholly-owned consolidated subsidiary, which in turn sold such loans to BLT 2006-1. Through August 2009, BLT 2006-1 may also generally use principal collections from the underlying loan pool to purchase additional loans to secure the 2006-1 Notes. After such time, principal payments on the 2006-1 Notes will generally be applied pro rata to each class of 2006-1 Notes outstanding until the aggregate outstanding principal balance of the loan pool is less than $250 million or the occurrence of certain other events. Payments will then be applied sequentially to the Class A notes, the Class B notes, the Class C notes, the Class D notes and the Class E notes. Subject to continuing compliance with certain conditions, we will remain as servicer of the loans. The Class A notes have an interest rate of three-month LIBOR plus 23 basis points, the Class B notes have an interest rate of three-month LIBOR plus 36 basis points, the Class C notes have

 

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an interest rate of three-month LIBOR plus 65 basis points and the Class D notes have an interest rate of three-month LIBOR plus 125 basis points. The loans are secured by loans and assets from our portfolio companies with a principal balance of $500 million as of December 31, 2006. The 2006-1 Notes contain customary default provisions and mature in November 2019 unless redeemed or repaid prior to such date.

 

In October 2005, we completed a $1,000 million asset securitization. In connection with the transaction, ACAS Business Loan Trust 2005-1 (“BLT 2005-1”), an indirect consolidated subsidiary, issued $435 million Class A-1 notes, $150 million Class A-2A notes, $50 million Class A-2B notes, $50 million Class B notes, $145 million Class C notes, $90 million Class D notes and $80 million Class E notes (collectively, the “2005-1 Notes”). The Class A-1 notes, Class A-2A notes, Class A-2B notes, Class B notes and Class C notes were issued to institutional investors and the Class D notes and Class E notes were retained by us. The 2005-1 Notes are secured by loans originated or acquired by us and sold to a wholly-owned consolidated subsidiary, which in turn sold such loans to BLT 2005-1. Of the $150 million Class A-2A notes, $82 million was drawn upon in 2005 and the balance of $68 million was drawn upon in 2006. Through January 2009, BLT 2005-1 may reinvest any principal collections of its existing loans into purchases of additional loans to secure the 2005-1 Notes. After such time, principal payments on the 2005-1 Notes will be applied first to the Class A-1 notes, Class A-2A notes and Class A-2B notes, next to the Class B notes and then to the Class C notes. Subject to continuing compliance with certain conditions, we will remain as servicer of the loans. The Class A-1 notes have an interest rate of three-month LIBOR plus 25 basis points, the Class A-2A notes have an interest rate of three-month LIBOR plus 20 basis points, the Class A-2B notes have an interest rate of three-month LIBOR plus 35 basis points, the Class B notes have an interest rate of three-month LIBOR plus 40 basis points, and the Class C notes have an interest rate of three-month LIBOR plus 85 basis points. The loans are secured by loans and assets from our portfolio companies with a principal balance of $1,000 million as of December 31, 2006. The 2005-1 Notes contain customary default provisions and mature in July 2019 unless redeemed or repaid prior to such date.

 

In December 2004, we completed a $500 million asset securitization. In connection with the transaction, ACAS Business Loan Trust 2004-1 (“BLT 2004-1”), an indirect consolidated subsidiary, issued $302 million Class A notes, $34 million Class B notes, $74 million Class C notes, $50 million Class D notes, and $40 million Class E notes (collectively, the “2004-1 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 2004-1 Notes are secured by loans originated or acquired by us and sold to a wholly-owned consolidated subsidiary, which in turn sold such loans to BLT 2004-1. Through January 2007, BLT 2004-1 has the option to reinvest any principal collections of its existing loans into purchases of new loans. After such time, payments 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 have an interest rate of three-month LIBOR plus 32 basis points, the Class B notes have an interest rate of three-month LIBOR plus 50 basis points, and the Class C notes have an interest rate three-month LIBOR plus 100 basis points. Subject to continuing compliance with certain conditions, we will remain as servicer of the loans. The loans are secured by loans and assets from our portfolio companies with a principal balance of $500 million as of December 31, 2006. The 2004-1 Notes contain customary default provisions and mature in October 2017 unless redeemed or repaid prior to such date.

 

In December 2003, we completed a $398 million asset securitization. In connection with the transaction, ACAS Business Loan Trust 2003-2 (“BLT 2003-2”), an indirect consolidated subsidiary issued $258 million Class A notes, $40 million Class B notes, $20 million Class C notes, $40 million Class D notes, and $40 million of Class E notes (collectively, the “2003-2 Notes”). The Class A notes, Class B notes and Class C notes were issued to institutional investors and the Class D notes and Class E notes were retained by us. The 2003-2 Notes were secured by loans originated or acquired by us and sold to a wholly-owned consolidated subsidiary, which in turn sold such loans to BLT 2003-2. Early payments were first applied to the Class A notes, then to the Class B notes and then to the Class C notes. The Class A notes carried an interest rate of one-month LIBOR plus 48 basis points, the Class B notes carried an interest rate of one-month LIBOR plus 95 basis points, and the Class C notes carried an interest rate of one-month LIBOR plus 175 basis points. As of December 31, 2006, there are no notes outstanding and BLT 2003-2 was terminated in June 2006.

 

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In May 2003, we completed a $308 million asset securitization. In connection with the transaction, ACAS Business Loan Trust 2003-1 (“BLT 2003-1”), an indirect consolidated subsidiary, issued $185 million Class A notes, $31 million Class B notes, $23 million Class C notes and $69 million Class D notes (collectively, the “2003-1 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 2003-1 Notes were secured by loans originated or acquired by us and sold to a wholly-owned consolidated subsidiary, which in turn sold such loans to BLT 2003-1. Early payments were first applied to the Class A notes, then to the Class B notes and then to the Class C notes. The Class C notes consisted of a $17 million tranche of floating rate notes and a $6 million tranche of fixed rate notes. The Class A notes carried an interest rate of one-month LIBOR plus 55 basis points and the Class B notes carried an interest rate of one-month LIBOR plus 120 basis points. The floating rate tranche of the Class C notes carried an interest rate of one-month LIBOR plus 225 basis points and the fixed rate tranche carried an interest rate of 5.14%. As of December 31, 2006, there were notes outstanding and BLT 2003-1 was terminated in May 2006.

 

Total Return Swap Facility

 

We have a total return swap facility (the “TRS Facility”) with Wachovia Bank, N.A. (“Wachovia”) under which we pledge certain of our investments to Wachovia from time to time in exchange for financing. Subject to the terms and conditions of the TRS Facility, we may generally repay and reborrow proceeds and are required to make payments to Wachovia on outstanding borrowings at a rate equal to one-month LIBOR plus 125 basis points. We must also repay all or a portion of any funded amount upon the occurrence of certain events. The TRS Facility commitment was increased from $250 million to $350 million effective December 2006 and is scheduled to terminate in December 2007. We have accounted for the TRS Facility as a secured financing arrangement under FASB Statement No. 140 with the outstanding borrowed amount included as a debt obligation on the accompanying consolidated balance sheets.

 

A summary of our contractual payment obligations as of December 31, 2006 are as follows (in millions):

 

     Payments Due by Period

Contractual Obligations


   Total

   Less than 1 year

   1-3 years

   4-5 years

   After 5 years

Revolving credit facilities

   $ 1,562    $ 29    $ 1,533    $   —      $ —  

Notes payable

     1,676      28      207      380      1,061

Unsecured debt

     392      —        82      235      75

TRS facility

     296      296      —        —        —  

Interest payments on debt obligations(1)

     823      223      306      172      122

Operating leases

     105      13      28      25      39
    

  

  

  

  

Total

   $ 4,854    $ 589    $ 2,156    $ 812    $ 1,297
    

  

  

  

  


(1) For variable rate debt, future interest payments are based on the interest rate as of December 31, 2006.

 

To the extent that we receive unscheduled prepayments 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 fifteen years and contain provisions for certain annual rental escalations.

 

As of December 31, 2006, we had commitments under loan and financing agreements to fund up to $446 million to 56 portfolio companies. These commitments are primarily composed of working capital credit facilities, acquisition credit facilities and subscription agreements. The commitments are generally subject to the borrowers meeting certain criteria. The terms of the borrowings and financings subject to commitment are comparable to the terms of other debt and equity securities in our portfolio.

 

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A summary of our loan and equity commitments as of December 31, 2006 is as follows:

 

     Amount of Commitment Expiration by Period

     Total

   Less than 1 year

   1-3 years

   4-5 years

   After 5 years

Loan and Equity Commitments

   $ 446    $ 96    $ 79    $ 194    $ 77

 

Portfolio Credit Quality

 

Loan Performance

 

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. As of December 31, 2006, loans on non-accrual status for fourteen portfolio companies were $183 million, calculated as the cost plus unamortized OID, and had a fair value of $54 million. These loans include a total of $169 million with PIK interest features. As of December 31, 2005, loans on non-accrual status for fourteen portfolio companies were $132 million, calculated as the cost plus unamortized OID, and had a fair value of $48 million.

 

At December 31, 2006 and 2005, loans on accrual status past due and loans on non-accrual status were as follows ($ in millions):

 

    December 31, 2006

    December 31, 2005

 

Days Past Due


  Number of
Portfolio Companies


 

Amount


    Number of
Portfolio Companies


 

Amount


 

Current

  118   $ 4,623     111   $ 3,286  
   
 


 
 


One Month Past Due

        —             8  

Two Months Past Due

        —             11  

Three Months Past Due

        —             —    

Greater than Three Months Past Due

        12           35  

Loans on Non-accrual Status

        183           132  
       


     


Subtotal

  14     195     14     186  
   
 


 
 


Total

  132   $ 4,818     125   $ 3,472  
   
 


 
 


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

        4.0 %         5.4 %
       


     


 

The loan balances above reflect our cost basis of the debt, excluding CMBS securities, plus unamortized OID. We believe that debt service collection is probable for our loans that are past due.

 

In the third quarter of 2006, we recapitalized one portfolio company by contributing our subordinated debt with a cost basis and fair value of $22 million into our existing common equity. Prior to the recapitalization, the subordinated notes were accruing loans.

 

In the third quarter of 2006, we recapitalized one portfolio company by exchanging our subordinated debt investment into convertible preferred stock and contributing our remaining subordinated debt investments into our existing common equity that had a total cost basis of $8 million and a fair value of zero. Prior to the recapitalization, the subordinated notes were non-accruing loans.

 

In the third quarter of 2006, we recapitalized one portfolio company by exchanging our subordinated debt with a cost basis of $15 million and a fair value of $2 million into preferred and common equity. Prior to the recapitalization, the subordinated notes were non-accruing loans.

 

In the third quarter of 2006, we recapitalized one portfolio company by contributing our subordinated debt with a cost basis $19 million and a fair value of zero into our existing common equity. Prior to the recapitalization, the subordinated notes were non-accruing loans.

 

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In the second quarter of 2006, we recapitalized one portfolio company by contributing our subordinated debt with a cost basis of $4 million and a fair value of $3 million into our existing common equity. Prior to the recapitalization, the subordinated note was a non-accruing loan.

 

In the second quarter of 2006, we recapitalized one portfolio company by exchanging our junior subordinated debt with a cost basis of $6 million and a fair value of $3 million into redeemable preferred stock. Prior to the recapitalization, the junior subordinated note was an accruing loan.

 

In the second quarter of 2006, we recapitalized one portfolio company by contributing our senior subordinated debt with a cost basis of $9 million and a fair value of $4 million into our existing common equity. Prior to the recapitalization, the senior subordinated note was a non-accruing loan.

 

In the second quarter of 2006, we recapitalized one portfolio company by exchanging our subordinated debt with a cost basis of $7 million and a fair value of zero into redeemable preferred stock. Prior to the recapitalization, the subordinated note was a non-accruing loan.

 

In the fourth quarter of 2005, we recapitalized one portfolio company by exchanging our subordinated debt with a cost basis of $2 million and a fair value of $1 million into convertible preferred stock. Prior to the recapitalization, the subordinated note was a non-accruing loan.

 

In the fourth quarter of 2005, we recapitalized one portfolio company by exchanging subordinated debt notes with a cost basis of $4 million and a fair value of zero into redeemable preferred stock. Prior to the recapitalization, a portion of the subordinated notes were non-accruing loans.

 

In the fourth quarter of 2005, one of our portfolio companies was recapitalized whereby the senior lenders restructured their senior loans in exchange for an 80% equity interest in the portfolio company and we exchanged our subordinated debt investment with a cost basis of $17 million for a 20% equity interest in the portfolio company. Prior to the recapitalization, the subordinated note was a non-accruing loan.

 

In the second quarter of 2005, we recapitalized one portfolio company by exchanging our senior subordinated debt with a cost basis and fair value of $6 million into redeemable preferred stock. Prior to the recapitalization, the senior subordinated note was an accruing loan.

 

In the second quarter of 2005, we recapitalized another portfolio company. As part of the recapitalization, we exchanged junior subordinated debt with a cost basis of $5 million and a fair value of zero into redeemable preferred stock. Prior to the recapitalization, the junior subordinated notes were non-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

 

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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