ITEM 1. BUSINESS
General
We are a solutions-focused commercial finance company that provides capital and advisory services to middle-market companies throughout the United States. Our investment objective is to achieve current income and capital gains.
We are an internally managed, non-diversified, closed-end investment company that has elected to be regulated as a business development company, or BDC, under the Investment Company Act of 1940, or the 1940 Act. As a BDC, we are required to meet various regulatory tests, which include investing at least 70% of our total assets in private or thinly traded public U.S.-based companies and meeting a 200% asset coverage ratio of total net assets to total senior securities.
For federal income tax purposes, we have elected to be treated as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code. In order to continue to qualify as a RIC for federal income tax purposes and obtain favorable RIC tax treatment, we must meet certain requirements, including certain minimum distribution requirements.
Corporate Structure
We conduct some of our activities through wholly owned, special-purpose financing subsidiaries. These subsidiaries are bankruptcy remote, special-purpose entities to which we transfer certain loans. Each financing subsidiary, in turn, transfers the loans to a Delaware statutory trust. For accounting purposes, the transfers of the loans to the Delaware statutory trusts are structured as on-balance sheet securitizations. We also use wholly owned subsidiaries, all of which are structured as Delaware corporations and limited liability companies, to hold the assets of one or more of our portfolio companies. Some of these subsidiaries have wholly owned subsidiaries, all of which are Delaware corporations that hold the assets of certain of our portfolio companies.
We also make investments in qualifying small businesses through Solutions Capital I, L.P., or Solutions Capital, our wholly owned subsidiary licensed by the United States Small Business Administration, or the SBA, to operate as a small business investment company, or SBIC, under the Small Business Investment Act of 1958, as amended, or the SBIC Act. As a SBIC, Solutions Capital is subject to a variety of regulations concerning, among other things, the size and nature of the companies in which it may invest and the structure of those investments.
Company Background
We were incorporated in Delaware in 1998. On March 18, 1998, we changed our name from MCG, Inc. to MCG Credit Corporation and, on June 14, 2001, we changed our name from MCG Credit Corporation to MCG Capital Corporation. Our principal executive offices are located at 1100 Wilson Boulevard, Suite 3000, Arlington, VA 22209 and our telephone number is (703) 247-7500.
In this Annual Report on Form 10-K, the terms “Company,” “MCG,” “we,” “us” and “our” refer to MCG Capital Corporation and its wholly owned subsidiaries (including its affiliated securitization trusts) unless the context otherwise requires.
We are subject to the informational requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and, accordingly, file reports, proxy statements and other information with the SEC. Such reports, proxy statements and other information can be read and copied at the public reference facilities maintained by the SEC at the Public Reference Room, 100 F Street, N.E., Washington, D.C. 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a web site (www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC.
Our Internet address is www.mcgcapital.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K. We make available free of charge on our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.
Our logo, trademarks and service marks are the property of MCG. Other trademarks or service marks appearing in this Annual Report on Form 10-K are the property of their respective holders.
Significant Developments in 2010 and
During 2010, the United States economy continued to recover from the effects of the recent recession. Leading economic indicators, coupled with recent tax-related legislation enacted by Congress in late 2010, are indicative that the economic recovery may continue into 2011. Although the economy has not yet recovered to pre-recession levels, we are cautiously optimistic of the potential for future economic growth.
In the event of renewed financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry or significant financial service institution failures, there could be a new or incremental tightening in the credit markets, low liquidity and extreme volatility in fixed-income, credit, currency and equity markets. European credit issues have destabilized the global markets, government-sponsored stimulus measures, such as the tax credit for first-time home buyers, have expired and the fear of increased regulations and municipal fiscal crises have contributed to a high unemployment rate. In addition, the risk remains that there could be a number of follow-on effects from the credit crisis on our business.
During 2009 and continuing into 2010, we began to implement a strategic plan designed to establish a foundation for us to reposition our company in future years to close the gap between share price and net asset value, or NAV, and to enhance stockholder value. Initially, in late 2009 and early 2010, we focused our strategic plan on capital preservation, monetizing lower-yielding investments and deleveraging our balance sheet. As the economy began to stabilize during the second half of 2010 and early 2011, we began making investments in yield-oriented securities.
We believe that we can increase stockholder value by converting lower-yielding equity investments and deploying cash in securitization and restricted accounts into yield-oriented new investment opportunities. As we continue to execute on our strategic plan over the next several years, we also expect to improve the returns on our debt and equity portfolio by improving the operating performance or by multiple expansion of our investments. In addition, we expect to continue to monetize lower-yielding equity investments and redeploy that capital and cash held in securitization and restricted accounts into debt securities with interest yields that are intended to increase our operating income and support the future growth of distributions to our stockholders. As we execute on this monetization strategy, we will continue to focus on preserving our NAV and enhancing the overall return profile on our investment capital. In addition, we expect to reduce our investment in equity securities to no more than 10% to 20% of the fair value of our total portfolio over the next few years.
We generally expect to limit our future investing activities principally to debt investments until such time that we have further narrowed the valuation gap between our stock price and our NAV and can validate the performance returns of our existing equity portfolio. We do not intend to make significant investments in control companies beyond those that are currently in our portfolio for the foreseeable future. When making new investments, we expect to underwrite credit in a manner consistent with our expectation that macro-economic conditions will be under pressure for an extended period of time. Over time, if we meet our goals with respect to leverage levels and unrestricted cash balances, we potentially may, depending on stock price and debt pricing levels, seek to repurchase our equity and additional debt securities, including our collateralized loan obligations, subject to the limitations set forth in our private placement borrowing agreements and regulatory requirements. To help provide sustainable stockholder value, we expect to make future distributions to stockholders based upon a quarterly assessment of the minimum statutorily required level of distributions, gains and losses recognized for tax purposes, portfolio transactional events, our liquidity, cash earnings and our asset coverage ratio at the time of such decision.
MCG’s Investment Portfolio
Our investment portfolio is composed primarily of middle-market companies in which we have made up to $75 million of debt and equity investments. Typically, these middle-market companies have $20 million to $200 million in annual revenue and $3 million to $25 million for earnings before interest, taxes, depreciation and amortization, or EBITDA. Generally, our portfolio companies use our capital investments to finance acquisitions, recapitalizations, buyouts, organic growth and working capital. We identify and source new portfolio companies through multiple channels, including private equity sponsors, investment bankers, brokers, fund-less sponsors, institutional syndication partners, owner operators, and other club lenders (“club lenders” are organizations that facilitate peer-to-peer loans). We generally invest in some combination of senior debt, second lien debt, secured and unsecured subordinated debt and equity. We may also purchase syndicated private debt in larger companies through our on-balance sheet securitization trust. We use our Commercial Loan Trust 2006-1 borrowing facility
primarily to fund these investments in syndicated private debt, while we use borrowings under our SBIC to fund unitranche (unitranche debt combines both senior and subordinated financing, generally in a first-lien position), second lien and subordinated debt investments, and we intend to use our MCG Commercial Loan Funding Trust borrowing facility, or SunTrust Warehouse, to make senior secured loans.
OVERVIEW OF INVESTMENT PORTFOLIO IN 2010
As of December 31, 2010, we had debt and equity investments in 71 portfolio companies with a combined fair value of over $1.0 billion. As shown in the following chart, over three-quarters of the fair value of our portfolio as of December 31, 2010 was invested in senior and subordinated debt, while the remainder of our portfolio was invested in preferred and common equity securities. Our diversified investment portfolio spans 31 industries. The following chart also shows that 14.9% of the fair value of our portfolio is invested in companies in the communications industry and 9.2% is invested in the cable industry. Approximately 41.6% of our portfolio is composed of investments in industries that comprise less than 5% of the fair value of our portfolio. See Portfolio Composition in our Management’s Discussion and Analysis of Financial Condition and Results of Operations for additional detail about our investment portfolio, including a detailed listing of the industries represented in our investment portfolio.
Most of the loans in our portfolio were originated directly with our portfolio companies; however, we have also participated in loan syndications or other transactions. Our debt instruments bear contractual interest rates ranging from 3.0% to 17.6%, a portion of which may be deferred. As of December 31, 2010, approximately 75.5% of the fair value of our loan portfolio was at variable rates, based on a LIBOR benchmark or prime rate, and 24.5% of the fair value of our loan portfolio was at fixed rates. As of December 31, 2010, approximately 61.4% of the fair value of our loan portfolio had LIBOR floors between 1.0% and 3.0% on a LIBOR-based index or prime floors between 2.25% and 6.0%. At origination, our loans generally have four- to eight-year stated maturities. Borrowers typically pay an origination fee based on a percent of the total commitment and a fee on undrawn commitments.
Often, we make equity investments in companies in which we have also made debt investments. Our equity investments include preferred stock, common stock and warrants and, in many cases, include the right to board representation. We may invest across the capital structure of our portfolio companies using a combination of debt and equity investments to meet our portfolio companies’ needs and achieve favorable risk-adjusted returns.
The following table summarizes the fair value and revenue contributions of our ten largest investments. As of December 31, 2010, these ten investments comprised 42.2% of the fair value of our portfolio and contributed 36.1% of our total revenues during 2010.
As of December 31, 2010, our control companies comprised 30.7% of the fair value of our portfolio and contributed 23.5% of our total revenues during 2010.
Competition
Our primary competitors in providing financing to middle-market companies include public and private funds, commercial and investment banks, commercial financing companies, and, to the extent they provide an alternative form of financing, private equity funds. Additionally, because competition for investment opportunities generally has increased among alternative investment vehicles, such as hedge funds, those entities have begun to invest in areas they have not traditionally invested, including investments in middle-market companies. Some of our existing and potential competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, some competitors may have a lower cost of funds and access to funding sources that are not available to us. In addition, some 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.
We do not seek to compete primarily based on the interest rates we offer, and we believe that some of our competitors make loans with interest rates that are comparable to, or lower than, the rates we offer. We generally compete by using our knowledge of our portfolio companies’ business needs, derived from the research, analyses, and interaction by our professional staff with our portfolio companies, to offer the appropriate product-mix coupled with a range of corporate finance services and information that enhances our portfolio companies’ business prospects.
Life Cycle of Debt and Equity Originations
The key aspects of our portfolio origination, servicing and monitoring process are set forth below.
INVESTMENT OBJECTIVE AND STRATEGIES
Our investment objective is to achieve current income and capital gains. The primary goal of our investment process is to increase our earnings and NAV by investing in debt and equity securities of middle-market companies. We earn interest, dividends and fees on our investments, and we may report unrealized gains and losses as the fair value of our investments increases or decreases. We realize these capital gains or losses when the investment is eventually monetized. To meet our investment objective, we selectively invest in companies that present opportunities for favorable risk-adjusted returns.
When we originate debt and equity investments, we strive to achieve favorable risk-adjusted rates of return in the form of current income and capital gains, while maintaining credit and investment quality in our portfolio. Before
making investments, we apply well-established credit processes to assess investment risk and we structure and price our investments accordingly. We have developed proprietary analytics, data and knowledge to support our business activities. We designed our investment process to achieve the following strategic objectives:
•
generate favorable risk-adjusted rates of return by delivering capital and strategic insight to increase our portfolio companies’ enterprise value;
•
maintain sound credit and investment discipline and pricing practices, regardless of market conditions, to avoid adverse investment selection; and
•
manage risk by utilizing an integrated team approach to business development, underwriting and investment servicing.
We maintain a flexible approach to funding that permits us to adjust price, maturity and other transaction terms to accommodate the needs of our portfolio companies.
ORGANIZATION OF MCG’S INVESTMENT PROFESSIONALS
Our organization includes experienced professionals with the ability to originate, underwrite, finance, syndicate, monitor and exit investments that generate attractive returns. The following bullets describe the key functional teams that are responsible for our investment processes:
•
Deal Teams-Our deal teams are responsible for identifying and performing a preliminary assessment of potential investment opportunities. In addition, the deal team provides assistance and support to our underwriting team. After an investment is approved and funded, the deal teams have continuing ongoing responsibility for monitoring the performance of their respective investments. Under the general direction of our Executive Vice President-Business Development, our deal teams are led by one of our Managing Directors or Deal Sponsors and also include one or more financial analysts, a senior credit manager and a member of our in-house legal staff.
•
Underwriting Teams-Our underwriting teams are responsible for performing an in-depth risk analysis of all potential investments identified by the deal teams. Under the general direction of our Executive Vice President-Risk Management and Underwriting, each of our underwriting teams is led by a Senior Vice President in our Underwriting Department and also include one or more financial analysts and a member of our in-house legal staff.
•
Credit Committee-After the underwriting process is complete, the prospective investment is presented to MCG’s Credit Committee for review and approval. The Credit Committee includes our Chief Executive Officer, Executive Vice President-Business Development, Executive Vice President-Risk Management and Underwriting, and one or more Managing Directors.
•
Investment and Valuation Committee of the Board of Directors-The Investment and Valuation Committee is responsible for reviewing all investments over $30 million and has the discretion to review and approve other investments. Subsequent to the review and funding of an investment, the Investment and Valuation Committee makes recommendations that are used by our board of directors for its quarterly determination of the fair value of our investment portfolio.
The following sections provide additional information on how these teams support the investment process. In addition to the teams described above, we also have a strong infrastructure of professionals that provide accounting, finance, human resources, investor relations, legal, and other services that support our investment professionals and provide other corporate, compliance and governance functions.
BUSINESS DEVELOPMENT
MCG and its predecessors have been active investors in middle-market companies since 1990 and have invested $6.2 billion in 618 transactions. We believe our experience in middle-market investing is a meaningful competitive advantage that we use to operate our business.
Our deal teams identify and source new investments through multiple channels, including private equity sponsors, investment bankers, brokers, fund-less sponsors, institutional syndication partners, other club lenders and owner-operators. The deal teams also market to prospective portfolio companies identified through various data services, customized Internet searches and relationships with investment bankers, accountants, lawyers and other professionals. The deal teams also make recommendations for purchasing investments through syndicated or other transactions.
Once we identify a prospective portfolio company, we review the company’s financial reports, business plan, corporate activities and other relevant information that we gather from third-party databases, industry reports and publications. We focus on a company’s fundamental performance against industry conditions and operational benchmarks. We work with our current and prospective portfolio companies to understand their business, as well as the costs and benefits of their corporate development initiatives, opportunities, competition and acceptable risks and returns. This analysis allows us to support our portfolio companies’ corporate development decisions, even in some cases where short-term financial ratios or other metrics may decline temporarily.
RISK ANALYSIS
After we identify a prospective investment, we review the company’s history, organization and product lines. In addition, we analyze the prospective portfolio company’s industry, competition and market share, obsolescence and substitution risk, markets served, legal and regulatory environment and technology. In particular, we analyze:
•
Industry Risks-maturity, cyclicality and seasonality associated with the industries in which we invest, as well as the proportion of our portfolio that is invested in specific industries and individual portfolio companies;
•
Competitive Risks-strengths and weaknesses of prospective portfolio companies relative to their competitors’ pricing, product quality, customer loyalty, substitution and switching costs, brand positioning and capitalization. We also assess the defensibility of a prospect’s market position and its opportunity for increasing market share;
•
Management Risks-track records, industry experience, the prospective portfolio companies respective business plans and management incentives;
•
Regulatory Risks-new and evolving regulations applicable to the BDC industry and industries in which the prospective portfolio companies operate;
•
Customer Concentration and Market Risks-sustainability, stability and opportunities for the growth of the prospective portfolio company’s respective customer bases, including the number and size of its customers, attrition rates and dependence on one or a limited number of customers; and
•
Technology Risks-impact of technological advances in the industries and portfolio companies in which we may invest.
We also assess other attributes that may have a significant impact on the risk of a potential transaction. Quantitative attributes that we evaluate include industry-specific comparisons, such as cash flow margins, product and cash flow diversification, revenue growth rates, cost structure and other operating benchmarks that are derived from historical and projected financial statements. Qualitative attributes we evaluate may include management skill and depth, industry risk, substitution risk, sensitivity to economic cycles, cyclicality, geographic diversification, facilities infrastructure, administration requirements and product quality and ranking.
To assess the risk of a potential investment and to quantify the underlying value of the prospective portfolio company, we employ a series of valuation techniques. We primarily derive enterprise valuations through analyses of comparative public and private market transactions and other data. We also generally prepare discounted cash flow models based on our projections of the future free cash flows of the business and industry derived capital costs. Finally, we look to comparable public companies to benchmark the value of the enterprise using public market data. We generally base enterprise value on current and projected market conditions. Using these methods provides us with multiple views of the value of the enterprise and allows us to calculate certain metrics that we use in both risk assessment and product pricing, such as loan-to-value ratios for our debt investments.
UNDERWRITING AND RISK MANAGEMENT
Our underwriting process, which focuses on investment risk analysis, is initiated during the business development process. Our underwriting process includes standard due diligence on a prospective portfolio company’s financial performance, as well as customized analyses of a prospective portfolio company’s operations, systems, accounting policies, human resources and competitive, legal and regulatory environments. Our underwriting team works to gain an understanding of the relationships among each prospective portfolio company’s business plan, operations and financial performance. We frequently engage external experts to supplement and assist in the underwriting process.
In addition to gaining an in-depth understanding of prospective portfolio companies, our research and due diligence process evaluates industry-wide operational, strategic and valuation issues. In addition, our underwriting and risk management teams support our business development and risk management process by identifying attractive industries, emerging trends and competitive threats. The knowledge and insight we obtain through our research are valuable to our portfolio companies who may draw on our industry expertise to refine their strategic plans, identify acquisition opportunities, and set appropriate financial and operational goals.
As part of our evaluation, the underwriting team prepares an investment memorandum for presentation to our credit committee and the board. When the dollar amount of the proposed investment exceeds certain pre-defined thresholds, the investment memorandum is submitted to our investment and valuation committee of our board of directors for review and approval. The investment memorandum generally consists of:
•
a business description;
•
historical financial analyses, projections and scenario modeling;
•
a risk evaluation specific to the prospective portfolio company’s business and industry, considering the anticipated use of proceeds of our investment;
•
an enterprise valuation to assess the underlying value of the prospective portfolio company, both as an ongoing operation and its value relative to comparable public and private companies; and
•
a description of the capital structure and the investment risk and return characteristics.
INVESTMENT STRUCTURE
We evaluate our portfolio companies’ needs and utilize our product-mix to structure investments that meet their capital requirements and business plans and protect our capital, while generating favorable risk-adjusted returns through current income on our loans and equity investments and capital gains on our equity investments. We structure our debt investments to mitigate risk by requiring appropriate financial and collateral coverage thresholds. When structuring our debt investments, we evaluate key components, including payment priority, collateral or asset value, and financial support from guarantors and other credit enhancements. Since our investments typically include loans and our loans are typically cash-flow loans, rather than asset-backed loans, the enterprise value of assets is a factor in our credit decisions. For the majority of our loans, we receive a security interest in our portfolio companies’ tangible and intangible assets, which entitles us to a preferred position on payments in the event of liquidation. In addition, our loan covenants generally include affirmative covenants that require the portfolio company to provide periodic financial information, notification of material events and compliance with laws, as well as restrictive covenants that prevent the portfolio company from taking a range of significant actions, such as incurring additional indebtedness or making acquisitions without our consent. We also generally include covenants requiring the portfolio company to maintain or achieve specified financial ratios, such as cash flow leverage, interest charge coverage, total charge coverage, and, in certain cases, covenants requiring the portfolio company to maintain certain operational benchmarks.
We generally invest in some combination of the following securities:
•
Senior Debt-We provide cash flow based senior debt in the form of amortizing term loans, bullet maturity term loans, and revolving credit facilities. Senior debt ranks senior in priority of payment to other debt and equity, and benefits from a senior collateral interest in the assets of the borrower. As such, most other creditors rank junior to our investments in these securities in the event of insolvency. Due to its lower risk profile and often more restrictive covenants as compared to other debt, senior secured debt generally earns a lower return.
•
Second Lien Debt-We provide second-lien term loans on a sole-source or participant basis where assets or enterprise-value based borrowing capacity is not readily available within typical senior debt leverage constraints. Second lien debt ranks senior in priority of payment to subordinated debt and equity but subordinated to senior debt. Second lien debt benefits from a collateral interest in the assets of the borrower subordinated to senior debt. As such, other creditors may rank senior to us in the event of insolvency. However, second lien debt ranks senior to subordinated debt and common and preferred equity in a borrower’s capital structure. Due to its higher risk profile and often less restrictive covenants as compared to senior debt, second lien debt generally earns a higher return than senior debt.
•
Secured and Unsecured Subordinated Debt-We invest in secured and unsecured subordinated debt, which may be structured with a combination of current interest, deferred interest or equity-linked components. Subordinated debt ranks subordinate in priority of payment to senior and second lien debt.
Our subordinated debt may not have a collateral interest in the borrower or may have a subordinated collateral interest. As such, other creditors may rank senior to us in the event of insolvency. However, subordinated debt ranks senior to common and preferred equity in a borrower’s capital structure. Due to its higher risk profile and often less restrictive covenants as compared to other loans, subordinated debt generally earns a higher return than other debt.
•
Equity-We invest in minority or control equity positions with private equity partners or on our own. In addition, we may receive warrants to purchase preferred of common stock of a portfolio company related to our debt investments in such portfolio company.
In addition to the investments listed above, we may provide unitranche debt that combines both senior and subordinated financing, generally in a first-lien position.
To protect our investments and maximize our returns, we negotiate the structure of each debt and equity security in our investment portfolio. Our contracts with those portfolio companies generally include many terms governing interest rate, repayment terms, prepayment penalties, financial covenants, operating covenants, ownership and corporate governance parameters, dilution parameters, liquidation preferences, voting rights, and put or call rights. In some cases, our loan agreements also allow for increases in the spread to the base index rate, if the portfolio company’s financial or operational performance deteriorates or shows negative variances from its business plan and, in some cases, allow for decreases in the spread if financial or operational performance improves or exceeds the portfolio company’s plan.
We use the following core products to execute our strategy:
•
One-Stop Solution-Our “one-stop” solution, which refers to our ability to provide all of the debt capital in a transaction in separate and distinct securities, enables our portfolio companies to satisfy multiple financing needs from a single capital provider with an efficient diligence, structuring, negotiating and closing process. In a typical “one-stop” transaction, we provide a combination of senior and subordinated debt to the portfolio company and, in certain cases, also acquire an equity interest in the portfolio company. The overall transaction size and product mix are based upon our portfolio company’s needs. In some cases our “one-stop” solution results in a product mix that meets our portfolio company’s needs, but which, we believe, does not optimize the use of our capital. In these cases, we may sell portions of some of the securities to achieve a more optimal mix. Typically, when we sell portions of one of our investments, we continue to service the investment. Thus, these sales are seamless to our portfolio companies. “One-stop” transactions generally provide current interest income on our loans and the opportunity to achieve capital gains on our equity investment, as well as fee income generated through syndication of portions of the investment.
•
Institutional Subordinated Debt-We provide institutional subordinated debt in the form of junior, yielding capital, as a sole or club investor in the larger end of our target market. Typically, these loans are payable in full at maturity and generally provide attractive yields. Our institutional subordinated debt portfolio companies generally are larger businesses supported by institutional equity capital that reduces the risk profile of these investments.
•
Control Investments-Control investments are investments for which we take a majority ownership position and, in most cases, control the board of directors of a portfolio company. We use our established relationships, market knowledge and one-stop capabilities to secure controlling interests in attractive operating companies. Our control investments typically include investments across the entire capital structure of the portfolio company.
•
Other Investments and Services-To help balance our portfolio, We also make other investments, such as investments in broadly syndicated loans. In addition to capital, we also offer managerial assistance to our portfolio companies. Typically, this assistance involves strategic advice, evaluation of business plans, financial modeling assistance and industry research and insights. We believe that providing assistance to our portfolio companies enables us to maximize our value proposition for our portfolio companies, which, in turn, helps maximize our investment returns.
INVESTMENT APPROVAL PROCESS
The credit process for each investment opportunity begins with our deal sponsors, who are responsible for originating transactions, as well as for investment performance, including credit risk, throughout the life cycle of an investment. Deal sponsors provide an initial credit screen based on our investment policies, described herein, and then bring the best opportunities to our credit committee and our underwriting team in a “pipeline meeting.”
For this meeting, the deal sponsor prepares a report that summarizes the transaction and includes financial statements, credit ratios and pricing, background information on the principals, equity investors and industry dynamics. The credit committee determines whether the investment should be pursued, giving consideration to the risk return profile, industry concentrations and general economic outlook for the sector in which the business operates. In these meetings the credit committee also offers the deal sponsor insight into key underwriting issues that must be resolved in the underwriting process.
Objectives are determined and due diligence is conducted. On-site due diligence, including general ledger reviews, proofs of cash, material contract reviews, background checks, reviews of customer and vendor concentrations, and confirmation of historical results are performed by our personnel and, in special situations, by third-party accounting firms. We believe in using our own in-house expertise when applying our consistent standards for due diligence.
All of our investments are approved by our credit committee. In addition, investments of over $30 million must also be approved by the investment and valuation committee of our board of directors, of which a super majority of the members are independent directors.
INVESTMENT FUNDING
We fund our investments using cash that we receive in exchange for a combination of debt and equity instruments that we issue from time to time. Our debt obligations include both secured and unsecured obligations, which may restrict our investment activity. As a BDC, we are not permitted to incur indebtedness unless immediately after such borrowing we meet a coverage ratio of total assets to total senior securities, which include all of our borrowings (excluding borrowings made by our SBIC) and any preferred stock we may issue in the future, of at least 200%.
INVESTMENT SERVICING
After an investment is approved and funded, we monitor covenant compliance and financial performance in our portfolio investments on an ongoing basis. Our deal teams maintain primary responsibility for monitoring the performance of their respective investments throughout the life of the investment. Our back office operations provide administrative support, including:
•
monitoring the portfolio company’s adherence to relevant covenants and other contract terms;
•
assessing and assisting the portfolio company’s ongoing financial and operating performance;
•
recommending adjustments to the fair value of the investment; and
•
other administrative tasks such as legal support, billing and collections, and other accounting functions.
INVESTMENT MONITORING AND RESTRUCTURING
We monitor the status and financial performance of each company in our portfolio in order to evaluate overall portfolio quality. We closely monitor compliance with all covenants and take appropriate action on all exceptions. We are proactive with companies that are underperforming and, in many instances, have added better covenant protection and rights over time.
When our attempts to collect past due principal and/or interest on a loan are unsuccessful, we will perform an analysis to determine the appropriate course of action. In some cases, we may consider restructuring the investment to better reflect the current financial performance of the portfolio company. Such a restructuring may, among other things, involve deferring payments of principal and interest, adjusting interest rates or warrant positions, imposing additional fees, amending financial or operating covenants or converting debt to equity. In connection with a restructuring, we generally receive appropriate compensation from the portfolio company for any increased risk. During the process of monitoring a loan in default, we generally will send a notice of non-compliance outlining the specific defaults that have occurred and preserving our contractual remedies, and initiate a review of the collateral, if any. When a restructuring is not the most appropriate course of action, we generally pursue remedies available to us that minimize potential losses, including initiating foreclosure and/or liquidation proceedings.
When one of our loans becomes more than 90 days past due, or if we otherwise do not expect the portfolio company to be able to service its debt and other obligations, we will, as a general matter, place the loan on non-accrual status and generally will cease recognizing interest income on that loan until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be
collectible. However, we may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection. If the fair value of a loan is below cost, we may cease recognizing paid-in-kind interest and/or the accretion of a discount on the debt investment until such time that the fair value equals or exceeds cost.
INVESTMENT POLICIES
Our investment policies provide that we will not:
•
act as an underwriter of securities of other issuers, except to the extent that we may be deemed an “underwriter” of securities (i) purchased by us that must be registered under the Securities Act of 1933, as amended, before they may be offered or sold to the public, or (ii) in connection with offerings of securities by our portfolio companies;
•
sell securities short in an uncovered position;
•
write or buy uncovered put or call options, except to the extent of options, warrants or conversion privileges in connection with our loans or other investments, and rights to require the issuers of such investments or their affiliates to repurchase them under certain circumstances;
•
engage in the purchase or sale of commodities or commodity contracts, including futures contracts, except for the purpose of hedging in the ordinary course of business or where necessary in working out distressed loan or investment situations; or
•
acquire more than 3% of the voting stock of, or invest more than 5% of our total assets in any securities issued by, any other investment company, except if we acquire them as part of a merger, consolidation or acquisition of assets or if they result from a sale of a portfolio company, or otherwise as permitted under the 1940 Act.
All of the above policies and the investment and lending guidelines set by our board of directors or any committees, including our investment objective to achieve current income and capital gains, are not “fundamental” as defined under the 1940 Act. Therefore, our board may change them without notice to, or approval by, our stockholders. However, any change may require the consent of our lenders.
Other than the restrictions pertaining to the issuance of senior securities under the 1940 Act, the percentage restrictions on investments generally apply on the effective date of the transaction. 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.
We intend to conduct our business so as to retain our status as a BDC. To retain our status as a BDC, 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” is less than 70% of the value of our total assets.
Investment Adviser
We have no investment adviser and are internally managed by our executive officers under the supervision of the board of directors. Our investment decisions are made by our officers, directors and senior investment professionals who serve on our credit and investment and valuation committees. None of our executive officers or other employees has the unilateral authority to approve any investment.
Regulation
INVESTMENT COMPANY ACT OF 1940
As a BDC, we are regulated under the 1940 Act. The BDC structure provides stockholders the ability to retain the liquidity of a publicly traded stock, while sharing in the possible benefits, if any, of investing in primarily privately owned companies.
In part, the 1940 Act requires us to be organized in the United States for the purpose of investing in, or lending to, primarily private companies and making managerial assistance available to them. As a BDC we may use capital provided by public stockholders and from other sources to invest in long-term, private investments in businesses.
We may not, however, change the nature of our business so as to cease to be, or withdraw our election as, a BDC unless authorized by vote of a majority of our outstanding voting securities. The 1940 Act defines a majority of the outstanding voting securities as the lesser of:
i) 67% or more of such company’s shares present at a meeting if more than 50% of the outstanding shares of such company are present or represented by proxy; or
ii) more than 50% of the outstanding shares of such company.
We currently do not anticipate any substantial change in the nature of our business.
Qualifying Assets
A BDC must have been organized and have its principal place of business in the United States and must be operated for the purpose of making investments in the types of securities described in (1), (2) or (3) below. Thus, under the 1940 Act, a BDC may not acquire any asset other than assets of the type listed in Section 55(a) of the Investment Company Act, which are referred to as qualifying assets, unless, at the time the acquisition is made, qualifying assets represent at least 70% of the company’s total assets. The principal categories of qualifying assets relevant to our business are the following:
1) Securities purchased in transactions not involving any public offering from the issuer of such securities, which issuer (subject to certain limited exceptions):
a) is an eligible portfolio company, or from any person who is, or has been during the preceding 13 months, an affiliated person of an eligible portfolio company, or from any other person, subject to such rules as may be prescribed by the SEC. An eligible portfolio company is defined in the 1940 Act as any issuer that:
i) is organized under the laws of, 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 BDC) or a company that would be an investment company but for certain exclusions under the Investment Company Act; and
iii) does not have any class of securities listed on a national securities exchange;
b) is a company that meets the requirements of (a)(i) and (ii) above, but is not an eligible portfolio company because it has issued a class of securities on a national securities exchange, if:
i) at the time of the purchase, we own at least 50% of the (x) greatest number of equity securities of such issuer and securities convertible into or exchangeable for such securities; and (y) the greatest amount of debt securities of such issuer, held by us at any point in time during the period when such issuer was an eligible portfolio company; and
ii) we are one of the 20 largest holders of record of such issuer’s outstanding voting securities; or
c) is a company that meets the requirements of (a)(i) and (ii) above, but is not an eligible portfolio company because it has issued a class of securities on a national securities exchange, if the aggregate market value of such company’s outstanding voting and non-voting common equity is less than $250.0 million.
2) Securities of any eligible portfolio company that we control.
3) Securities purchased in a private transaction from a U.S. issuer that is not an investment company or from an affiliated person of the issuer, or in transactions incident thereto, if the issuer is in bankruptcy and subject to reorganization or if the issuer, immediately prior to the purchase of its securities was unable to meet its obligations as they came due without material assistance other than conventional lending or financing arrangements.
4) Securities of an eligible portfolio company purchased from any person in a private transaction if there is no ready market for such securities and we already own 60% of the outstanding equity of the eligible portfolio company.
5) Securities received in exchange for or distributed on or with respect to securities described in (1) through (4) above, or pursuant to the exercise of warrants or rights relating to such securities.
6) Cash, cash items, U.S. Government securities or high-quality debt securities maturing in one year or less from the time of investment.
Control, as defined by the 1940 Act, is presumed to exist where a BDC beneficially owns more than 25% of the outstanding voting securities of the portfolio company. For the foreseeable future, we do not expect to add new control positions to our portfolio.
Significant Managerial Assistance
In order to count portfolio securities as qualifying assets for the purpose of the 70% test discussed above, a BDC must either control the issuer of the securities or must offer to make available significant managerial assistance; except that, where the BDC purchases such securities in conjunction with one or more other persons acting together, one of the other persons in the group may make available such managerial assistance. Making available significant managerial assistance means, among other things, any arrangement whereby the BDC, through its directors, officers or employees, offers to provide and, if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of a portfolio company through monitoring of portfolio company operations, selective participation in board and management meetings, consulting with and advising a portfolio company’s officers or other organizational or financial guidance.
Warrants and Options
Under the 1940 Act, a BDC is subject to restrictions on the amount of warrants, options, restricted stock or rights to purchase shares of capital stock that it may have outstanding at any time. In particular, the amount of capital stock that would result from the conversion or exercise of all outstanding warrants, options or rights to purchase capital stock cannot exceed 25% of the BDC’s total outstanding shares of capital stock. This amount is reduced to 20% of the BDC’s total outstanding shares of capital stock if the amount of warrants, options or rights issued pursuant to an executive compensation plan would exceed 15% of the BDC’s total outstanding shares of capital stock. We have received exemptive relief from the SEC permitting us to issue restricted stock to our employees and directors subject to the above conditions, among others.
Indebtedness and Senior Securities
We will be permitted, under specified conditions, to issue multiple classes of indebtedness and one class of stock senior to our common stock if our asset coverage, as defined in the 1940 Act, is at least equal to 200% immediately after each such issuance. In addition, we may not be permitted to declare any cash dividend or other distribution on our outstanding common shares, or purchase any such shares, unless, at the time of such declaration or purchase, we have asset coverage of at least 200% after deducting the amount of such dividend, distribution, or purchase price. We may also borrow amounts up to 5% of the value of our total assets for temporary or emergency purposes.
Capital Structure
As a BDC, we generally cannot issue and sell our common stock at a price below the current NAV per share. We may, however, sell our common stock, or warrants, options or rights to acquire our common stock, at a price below the current NAV of our common stock in a rights offering to our stockholders if: 1) our board of directors determines that such sale is in the best interests of the Company and our stockholders; 2) our stockholders approve the sale of our common stock at a price that is less than the current NAV and 3) the price at which our common stock is to be issued and sold may not be less than a price which, in the determination of our board of directors, closely approximates the market value of such securities (less any sales load).
We may also be prohibited under the 1940 Act from knowingly participating in certain transactions with our affiliates without the prior approval of our directors who are not interested persons and, in some cases, prior approval by the SEC.
We do not intend to acquire securities issued by any investment company that exceed the limits imposed by the 1940 Act. Under these limits, we generally cannot acquire more than 3% of the voting stock of any registered investment company (as defined in the 1940 Act), invest more than 5% of the value of our total assets in the securities of one such investment company or invest more than 10% of the value of our total assets in the securities of such investment companies in the aggregate. With regard to that portion of our portfolio invested in securities issued by investment companies, it should be noted that such investments might subject our stockholders to additional expenses.
1940 Act Code of Ethics
We have adopted and will maintain a code of ethics that establishes procedures for personal investments and restricts certain personal securities transactions. Personnel subject to the code may invest in securities for their personal investment accounts, including securities that may be purchased or held by us, so long as such investments are made in accordance with the code’s requirements. Our Amended and Restated Code of Ethics, or 1940 Act Code of Ethics, will generally not permit investments by our employees in securities that may be purchased or held by us. We may be prohibited under the 1940 Act from conducting certain transactions with our affiliates without the prior approval of our directors who are not interested persons and, in some cases, the prior approval of the SEC.
A copy of our 1940 Act Code of Ethics is available at our website at www.mcgcapital.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Form 10-K. To review the 1940 Act Code of Ethics on our website, click on the Investor Relations page, then select Corporate Information. In addition, you may read and copy the 1940 Act Code of Ethics at the SEC’s Public Reference Room in Washington, D.C. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the 1940 Act Code of Ethics is available on the EDGAR Database on the SEC’s Internet site at http://www.sec.gov. You may obtain copies of the 1940 Act Code of Ethics, after paying a duplicating fee, by electronic request at the following email address: publicinfo@sec.gov, or by writing the SEC’s Public Reference Section, Washington, D.C. 20549.
Privacy Principles
We are committed to maintaining the privacy of our stockholders and safeguarding their non-public personal information. The following information is provided to help you understand what personal information we collect, how we protect that information and why, in certain cases, we may share information with select other parties.
Generally, we do not receive any non-public personal information relating to our stockholders, although certain non-public personal information of our stockholders may become available to us. We do not disclose any non-public personal information about our stockholders or former stockholders, except as permitted by law or as is necessary in order to service stockholder accounts (for example, to a transfer agent).
We restrict access to non-public personal information about our stockholders to our employees with a legitimate business need for the information. We maintain physical, electronic and procedural safeguards designed to protect the non-public personal information of our stockholders.
Proxy Voting Policies and Procedures
We vote proxies relating to our portfolio securities in the best interest of our stockholders. We review on a case-by-case basis each proposal submitted to a stockholder vote to determine its impact on the portfolio securities held by us. Although we generally vote against proposals that may have a negative impact on our portfolio securities, we may vote for such a proposal if there exists compelling long-term reasons to do so.
Our proxy voting decisions are discussed with our committee that is responsible for monitoring each of our investments. To ensure that our vote is not the product of a conflict of interest, we require that: (i) anyone involved in the decision making process disclose to our Chief Compliance Officer any potential conflict that he or she is aware of and any contact that he or she has had with any interested party regarding a proxy vote; and (ii) employees involved in the decision making process or vote administration are prohibited from revealing how we intend to vote on a proposal in order to reduce any attempted influence from interested parties.
Exemptive Relief
We have received an exemptive order of the SEC to permit us to issue restricted shares of our common stock as part of the compensation packages for certain of our employees and directors. We believe that the particular characteristics of our business, the dependence we have on key personnel to conduct our business effectively and the highly competitive environment in which we operate require the use of equity-based compensation for our personnel in the form of restricted stock. The issuance of restricted shares of our common stock requires the approval of our stockholders. In June 2006, our stockholders approved our Amended and Restated 2006 Employee Restricted Stock Plan and our Amended and Restated 2006 Non-Employee Director Restricted Stock Plan.
In October 2008, we received exemptive relief from the SEC, which effectively allows us to exclude debt issued by Solutions Capital I, L.P. from the calculation of our consolidated BDC asset coverage ratio.
Other
We will be examined periodically by the SEC for compliance with the Exchange Act and the 1940 Act.
As with other companies regulated by the 1940 Act, a BDC must adhere to certain substantive regulatory requirements. A majority of our directors must be persons who are not interested persons, as that term is defined in the 1940 Act. We are required to provide and maintain a bond issued by a reputable fidelity insurance company to protect us against larceny and embezzlement. Furthermore, as a BDC, we are prohibited from protecting any director or officer against any liability to our stockholders arising from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office.
We are required to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, review these policies and procedures annually for their adequacy and the effectiveness of their implementation. We have designated Mr. Reichert as our Chief Compliance Officer who is responsible for administering these policies and procedures.
Compliance with the Sarbanes-Oxley Act of 2002 and The NASDAQ Global Select Market Corporate Governance Regulations
The Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley Act, imposes a wide variety of regulatory requirements on publicly-held companies and their insiders. Many of these requirements affect us. The Sarbanes-Oxley Act has required us to review our policies and procedures to determine whether we comply with the Sarbanes-Oxley Act and the regulations promulgated thereunder. We will continue to monitor our compliance with all future regulations that are adopted under the Sarbanes-Oxley Act and will take actions necessary to ensure that we are in compliance therewith.
In addition, The NASDAQ Global Select Market has adopted various corporate governance requirements as part of its listing standards. We believe we are in compliance with such corporate governance listing standards. We will continue to monitor our compliance with all future listing standards and will take actions necessary to ensure that we are in compliance therewith.
Small Business Administration Regulations
In December 2004, we formed Solutions Capital and Solutions Capital G.P., LLC. In September 2007, Solutions Capital received final approval to be licensed as an SBIC. Solutions Capital is able to borrow funds from the SBA against eligible investments and additional deposits to regulatory capital. We have received commitments from the SBA to borrow up to $150.0 million of SBA-guaranteed debentures under the SBIC program, based on our current private capital commitments. SBA-guaranteed debentures are non-recourse, interest only debentures with interest payable semi-annually and have a ten-year maturity. The principal amount of SBA-guaranteed debentures is not required to be paid prior to maturity, but may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed at the time of issuance at a market-driven spread over U.S. Treasury Notes with ten year maturities.
The maximum amount of outstanding leverage available to single-license SBIC companies is $150.0 million. The limit may be increased to $225.0 million with the approval of a second SBIC license and the investment of additional regulatory capital. To access the entire $150.0 million, we would have to fund a total of $25.4 million, in addition to the $49.6 million that we had funded through December 31, 2010. There is no assurance that we could draw up to the maximum limit available under the SBIC program.
SBICs are designed to stimulate the flow of private capital to eligible small businesses. Under SBA regulations, Solutions Capital is subject to regulatory requirements including making investments in SBA eligible businesses, investing at least 25% of regulatory capital in eligible “smaller” businesses, placing certain limitations on the financing terms of investments, prohibiting investing in certain industries, required capitalization thresholds, and is subject to periodic audits and examinations among other regulations. If Solutions Capital fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit its use of debentures, declare outstanding debentures immediately due and payable, and/or limit Solutions Capital from making new investments. In addition, the SBA can revoke or suspend a license for willful or repeated violation of, or willful or repeated failure to observe, any provision of the 1958 Act or any rule or regulation promulgated thereunder. These actions by the SBA would, in turn, negatively affect us because Solutions Capital subsidiary is our wholly owned subsidiary.
Eligible Small and Smaller Businesses
Under present SBA regulations, eligible small businesses include businesses that have a tangible net worth not exceeding $18 million and have average annual net income not exceeding $6 million for the two most recent fiscal years. In addition, an SBIC must devote 25% of its investment activity to “smaller” concerns as defined by the SBA. A smaller concern is one that has a tangible net worth not exceeding $6 million and has average annual net income not exceeding $2 million for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses and invest in the equity securities of such businesses. Once an SBIC has invested in a company, it may continue to make follow-on investments in the company, regardless of the size of the business, up and until the time a business offers its securities in a public market. Through Solutions Capital, we plan to provide long-term loans to and equity investments in qualifying small businesses.
Financing Limitations
SBA regulations also include restrictions on a “change of control” of an SBIC or transfers that would result in any person or group owning 10% or more of a class of capital stock (or its equivalent in the case of a partnership) of a licensed SBIC and require that SBICs invest idle funds in accordance with SBA regulations. In addition, our SBIC subsidiary may also be limited in its ability to make distributions to us if it does not have sufficient earnings and capital, in accordance with SBA regulations. The SBA places certain limits on the financing terms of investments by SBICs in portfolio companies such as limiting the interest rate on debt securities and loans provided to portfolio companies of the SBIC. The SBA also limits fees, prepayment terms and other economic arrangements that are typically charged in lending environments.
SBA Leverage or Debentures
SBA-guaranteed debentures are non-recourse to us, have a 10-year maturity, and may be prepaid at any time without penalty. The interest rate of SBA-guaranteed debentures is fixed at the time of issuance at a market-driven spread over 10-year U.S. Treasury Notes. Leverage through SBA-guaranteed debentures is subject to required capitalization thresholds. SBA current regulations limit the amount that Solutions Capital may borrow to a maximum of $150 million, which is up to twice its regulatory capital. This means that Solutions Capital may access the maximum borrowing if it has $75 million in regulatory capital, which generally equates to the amount of its equity capital paid-in.
Our SBIC subsidiary is subject to regulation and oversight by the SBA. Receipt of an SBIC license does not assure that our SBIC subsidiary will receive SBA guaranteed debenture funding, which is dependent upon our SBIC subsidiary continuing to be in compliance with SBA regulations and policies. Periodically, SBA staff audits Solutions Capital to verify its compliance with SBA regulations.
The SBA, as a creditor, will have a superior claim to our SBIC subsidiary’s assets over our stockholders in the event we liquidate our SBIC subsidiary or the SBA exercises its remedies under the SBA-guaranteed debentures issued by our SBIC subsidiary upon an event of default.
CERTAIN U.S. FEDERAL INCOME TAX CONSIDERATIONS
We elected to be treated as a RIC, under Subchapter M of the Internal Revenue Code with the filing of our federal corporate income tax return for 2002, for which the election was effective as of January 1, 2002. As a RIC, we generally do not have to pay corporate taxes on any income we distribute to our stockholders as dividends, which allows us to reduce or eliminate our corporate-level tax liability. To continue to qualify as a RIC, we must, among other things, meet certain source-of-income and asset diversification requirements (as defined below). In addition, to qualify for RIC tax treatment we must distribute to our stockholders, for each taxable year, at least 90% of our “investment company taxable income,” which is generally our ordinary income plus the excess of our realized net short-term capital gains over our realized net long-term capital losses, which we collectively refer to as the 90% Distribution Requirement.
TAXATION AS A REGULATED INVESTMENT COMPANY
If we:
•
qualify as a RIC, and
•
distribute each year to stockholders at least 90% of our investment company taxable income (which is defined in the Internal Revenue Code generally as ordinary income plus realized net short-term capital gains in excess of realized net long-term capital losses), and 90% of any ordinary pre-RIC built-in gains we recognize between January 1, 2002 and December 31, 2011, less our taxes due on those gains,
we will be entitled to deduct and, therefore, will not be subject to U.S. federal income tax on, the portion of our income we distribute or are deemed to distribute to stockholders (other than any built-in gain recognized between January 1, 2002 and December 31, 2011). We will be subject to U.S. federal income tax at the regular corporate rate on any income not distributed (or deemed distributed) to our stockholders. We will be subject to a 4% nondeductible U.S. federal excise tax, or 4% excise tax, to the extent we do not make specified levels of distributions (actually or on a deemed basis) in a timely manner. For calendar years ended December 31, 2010 and earlier, we would have been subject to the 4% excise tax to the extent that we did not distribute (on either an actual or deemed basis): 98% of our ordinary income for each calendar year; 98% of our capital gain net income for each calendar year; and any income realized, but not distributed, in prior calendar years. Beginning in 2011, we will be subject to the 4% excise tax to the extent that we do not distribute (on either an actual or deemed basis): 98% of our ordinary income for each calendar year; 98.2% of our capital gain net income for each calendar year; and any income realized, but not distributed, in prior calendar years.
To qualify as a RIC for federal income tax purposes, we must, among other things:
•
continue to qualify as a BDC under the 1940 Act at all times during each taxable year;
•
derive in each taxable year at least 90% of our gross income from (1) dividends, interest, payments with respect to certain 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 and (2) net income derived from an interest in a “qualified publicly traded partnership;” and
•
diversify our holdings so that at the end of each quarter of the taxable year:
•
at least 50% of the value of our assets consist of cash, cash items, U.S. government securities, securities of other RICs, and other securities if such other securities of any one issuer do not represent more than 5% of the value of our assets or more than 10% of the outstanding voting securities of the issuer; and
•
no more than 25% of the value of our assets is invested in the securities, other than U.S. government securities or securities of other RICs, of (i) one issuer, (ii) two or more issuers that are controlled, as determined under applicable Internal Revenue Code rules, by us and are engaged in the same or similar or related trades or businesses or (iii) one or more “qualified publicly traded partnerships,” known as the Diversification Tests.
We may be required to recognize taxable income in circumstances in which we do not receive cash. For example, if we hold debt obligations that are treated under applicable tax rules as having original issue discount, we must include in taxable income each year a portion of the original issue discount that accrues over the life of the obligation, regardless of whether cash representing such income is received by us in the same taxable year. We also may have to include in taxable income other amounts that we have not yet received in cash, such as payment-in-kind interest and deferred loan origination fees that are paid after origination of the loan or are paid in non-cash compensation such as warrants or stock. Because any original issue discount or other amounts accrued will be included in our investment company taxable income for the year of accrual, we may be required to make a cash distribution to our stockholders in the amount of that non-cash income in order to satisfy the 90% Distribution Requirement, even though we will not have received any cash representing such income.
If we fail to satisfy the 90% Distribution Requirement or fail to qualify as a RIC in any taxable year, we would be subject to tax in that year on all of our taxable income at regular corporate rates, regardless of whether we make any distributions to our stockholders. Distributions would not be required, and any distributions made in taxable years beginning before January 1, 2013 would be taxable to our stockholders as ordinary dividend income that, subject to certain limitations, may be eligible for the 15% maximum rate to the extent of our current and accumulated earnings and profits. Subject to certain limitations under the Code, corporate distributees would be eligible for the dividends-received deduction. Distributions in excess of our current and accumulated earnings
and profits would be treated first as a return of capital to the extent of the stockholder’s tax basis, and any remaining distributions would be treated as a capital gain.
EMPLOYEES
We believe our success will depend greatly on our ability to identify, attract and retain capable employees. As of December 31, 2010, we employed 63 full-time and 3 part-time individuals, including investment, portfolio and operations professionals, in-house counsel and administrative staff, the majority of whom are located in our corporate headquarters in Arlington, Virginia. Our employees are not represented by any collective bargaining unit and we believe our relations with our employees are good.
ITEM 1A.
ITEM 1A. RISK FACTORS.
Investing in our common stock may be speculative and involves a high degree of risk. You should consider carefully 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 and the schedules and exhibits to this Annual Report on Form 10-K. The risks set forth below are not the only risks we face. If any of the following risks occur, our business, financial condition and results of operations could be materially adversely affected. In such case, our net asset value and the trading price of our common stock could decline, and you may lose all or part of your investment.
Substantially all of our portfolio investments are not publicly traded and, as a result, there is uncertainty as to the value of our portfolio investments. If our determinations regarding the fair value of our investments were materially higher than the values that we ultimately realize upon the disposition of such investments, our NAV could be affected adversely.
In accordance with the 1940 Act and accounting principles generally accepted in the United States, we carry substantially all of our portfolio investments at fair value as determined in good faith by our board of directors. Typically, there is no public market for the securities of the privately held companies in which we have invested and generally will continue to invest. As a result, we value these securities quarterly at fair value as determined in good faith by our board of directors.
Whenever possible, we value securities at market value; however, only a small percentage of our investment portfolio is traded publicly. We value the investments that are not publicly traded based on various factors during our valuation process and our investment and valuation committee reviews and approves these valuations. The types of factors that may be considered in the determination of the fair value of these investments include public and private mergers and acquisitions transactions, comparisons to publicly traded comparable companies, third-party assessments of valuation, discounted cash flow analyses, the nature and realizable value of any collateral, the portfolio company’s earnings and its ability to make payments, the markets in which the portfolio company does business, market-based pricing and other relevant factors. In determining fair value in good faith, we generally obtain financial and other information from portfolio companies, which may include unaudited, projected or pro forma financial information. Our board of directors also uses several independent valuation firms to aid it in determining the fair value of these investments. Because our valuations, and particularly the valuations of private securities and private companies, are inherently uncertain, they may fluctuate over short periods of time and may be based on estimates. Our determinations of fair value may differ materially from the values that would have been used if a readily available market for these investments existed and from the amounts we may realize on any disposition of such investments. If our determinations regarding the fair value of our investments were materially higher than the values that we ultimately realize upon the disposition of such investments, our NAV could be affected adversely.
Economic downturns or lingering effects of a capital market disruption and recession could impair our portfolio companies’ financial positions and operating results, which could, in turn, harm our operating results.
Many of the companies in which we have made, or may make, investments are, and may continue to be, susceptible to economic downturns or recessions. During the recession that occurred from late 2007 through mid-2009, the stock market declined and has not recovered to pre-recession levels. The U.S. government has acted to restore liquidity and stability to business, taxpayers and the financial system, but there can be no assurance these regulatory programs, stimulus initiatives and tax reductions either will continue or will have a
long-term beneficial impact. In addition, equity and credit markets were characterized by increasing asset prices, lower volatility and improved liquidity beginning in mid-2009. In the event of renewed financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry or significant financial service institution failures, there could be a new or incremental tightening in the credit markets, low liquidity and extreme volatility in fixed-income, credit, currency and equity markets. To the extent that recessionary conditions recur, the economy remains stagnate or the economy fails to return to pre-recession levels, the financial results of middle-market companies, like those in which we invest, may experience deterioration, which ultimately could lead to difficulty in meeting debt service requirements and an increase in defaults.
Adverse economic conditions have decreased the value of some of our loans and equity investments and lingering after-effects of these economic conditions, may further decrease such value. These conditions have contributed to, and could continue to contribute to, additional losses of value in our portfolio and decreases in our revenues, net income and net assets. If prolonged, unfavorable or uncertain economic and market conditions could affect the ability of our portfolio companies to repay our loans or engage in a liquidity event, such as a sale, merger, recapitalization or initial public offering. Therefore, the number of non-performing assets may increase and the value of one or more of our portfolio companies may decrease during such periods. Adverse economic conditions also may decrease the value of collateral securing some of our loans and the value of our equity investments.
Economic recessions or downturns could impair the ability of our portfolio companies to repay loans, which, in turn, could increase our non-performing assets, decrease the value of our portfolio, reduce our volume of new loans and have an adverse effect on our operating results.
A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, an acceleration of its loans and foreclosure on its secured assets, which could trigger cross-defaults under other agreements and jeopardize our portfolio company’s ability to meet its obligations under the debt securities that we hold. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting portfolio company.
There may be circumstances where our debt investments could be subordinated to claims of other creditors or we could be subject to lender liability claims.
Even though we have structured some of our investments as senior loans, if one of our portfolio companies were to go bankrupt, depending on the facts and circumstances, including the extent to which we provided managerial assistance to that portfolio company, a bankruptcy court might re-characterize our debt investments and subordinate all, or a portion, of our claims to that of other creditors. Holders of debt instruments ranking senior to our investments typically would be entitled to receive payment in full before we receive any distributions. After repaying such senior creditors, such portfolio company may not have any remaining assets to use to repay its obligation to us. We may also be subject to lender liability claims for actions taken by us with respect to a borrower’s business or in instances in which we exercised control over the borrower. It is possible that we could become subject to a lender’s liability claim, including claims associated with significant managerial assistance that we may have provided to our portfolio companies
Investing in middle-market companies involves a high degree of risk and our financial results may be affected adversely if one or more of our significant portfolio investments defaults on its loans or fails to perform as we expect.
Our portfolio consists primarily of debt and equity investments in privately owned middle-market companies. Investing in middle-market companies involves a number of significant risks. Typically, the debt in which we invest may be rated below investment grade by one or more rating agency. Compared to larger publicly traded companies, these middle-market companies may be in a weaker financial position and experience wider variations in their operating results, which may make them more vulnerable to economic downturns. Typically, these companies need more capital to compete; however, their access to capital is limited and their cost of capital is often higher than that of their competitors. Our portfolio companies face intense competition from larger companies with greater financial, technical and marketing resources and their success typically depends on the managerial talents and efforts of an individual or a small group of persons. Therefore, the loss of any of its key employees could affect a portfolio company’s ability to compete effectively and harm its financial condition. Further, some of these companies conduct business in regulated industries that are susceptible to regulatory changes. These factors could impair the cash flow of our portfolio companies and result in other events, such as bankruptcy. These events could limit a portfolio company’s ability to repay its obligations to us, which may have
an adverse affect on the return on, or the recovery of, our investment in these businesses. Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in the value of the loan’s collateral.
Some of these companies cannot obtain financing from public capital markets or from traditional credit sources, such as commercial banks. Accordingly, loans made to these types of companies pose a higher default risk than loans made to companies that have access to traditional credit sources. Generally, little, if any, public information is available about such companies. Therefore, we must rely on our employees’ diligence to obtain information necessary to make well-informed investment decisions. If we do not uncover material information about these companies, we may not make a fully informed investment decision, which could, in turn, cause us to lose money on our investments.
If we fail to invest a sufficient portion of our assets in qualifying assets, we could lose our BDC status.
As a BDC, we may not acquire any assets other than “qualifying assets” unless, at the time of and after giving effect to such acquisition, at least 70% of our total assets are qualifying assets. Thus, we may be precluded from investing in potentially attractive investments if such investments are not qualifying assets for purposes of the 1940 Act. If we fail to invest a sufficient portion of our assets in qualifying assets, we could lose our status as a BDC, which would have a material adverse effect on our business, financial condition and results of operations. In addition, there is a risk that this restriction could prevent us from making additional investments in our existing portfolio companies, which could cause our position to be diluted. We could also be forced to sell certain of our investments to comply with the 1940 Act, which may result in us receiving significantly less than the current value of such investments.
Portfolio company litigation could result in additional costs and the diversion of management time and resources.
In the course of providing significant managerial assistance to certain of our portfolio companies, we may serve as directors on the boards of such companies. To the extent that litigation arises out of our investments in these companies, we may be named as a defendant in such litigation, which could result in additional costs and the diversion of management time and resources.
Our financial position and results of operations could be affected adversely if a significant portion of our portfolio were invested in industries that experience adverse economic or business conditions.
From time to time, we target specific industries in which to invest on a recurring basis. This practice could concentrate a significant portion of our portfolio in a specific industry. For example, as of December 31, 2010, our investments in communications companies represented 14.9% of the fair value of our portfolio. Of the 14.9% investment, 13.0% represented investments in CLECs and 1.9% represented investments in other communications companies. Typically, companies in the communications industries face a variety of risks that could have an adverse impact on their financial performance and fair value, including, but not limited to: competition with both traditional communications companies and other non-traditional service providers; ability to integrate technological developments; managing the obsolescence of their equipment and facility infrastructure; and exposure to natural or man-made disasters.
If an industry in which we have significant investments or revenue concentrations suffers from adverse business or economic conditions, as these industries have to varying degrees, a material portion of our investment portfolio could be affected adversely, which, in turn, could adversely affect our financial position and results of operations.
Our financial results could be affected adversely if a significant portfolio investment fails to perform as expected.
Our total investment in companies may be significant individually or in the aggregate. As a result, if a significant investment in one or more companies fails to perform as expected, our financial results could be affected adversely and the magnitude of the loss could be more significant than if we had made smaller investments in a greater number of companies.
Broadview Network Holdings, Inc., or Broadview, a CLEC serving primarily business customers, is our largest portfolio investment. As of December 31, 2010, we held preferred stock in Broadview with a $103.0 million fair value. As of December 31, 2010, our investment in Broadview represented 10.2% of the fair value of our investment portfolio. If Broadview’s performance deteriorates or valuation multiples contract further in future periods, we may be required to recognize additional unrealized depreciation on this investment. Our ability to
recognize income from our investment in Broadview in future periods depends on the performance and value of Broadview.
We operate in a highly competitive market for investment opportunities.
A number of entities compete with us to make the types of investments that we make. We compete with public and private funds, commercial and investment banks, commercial financing companies and, to the extent they provide an alternative form of financing, private equity funds. Additionally, because competition for investment opportunities generally has increased in recent years among alternative investment vehicles, such as hedge funds, those entities have begun to invest in areas in which traditionally they have not invested. As a result of these entrants, competition for investment opportunities has intensified in recent years and may intensify further in the future. Some of our existing and potential competitors are substantially larger and have considerably greater financial, technical and marketing resources than we do. For example, some competitors may have a lower cost of funds and access to funding sources that are not available to us. In addition, some 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 than us. Furthermore, many of our competitors are not subject to the regulatory restrictions and valuation requirements that the 1940 Act imposes on us as a BDC. We cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition and results of operations. Also, as a result of this existing and potentially increasing competition, we may not be able to take advantage of attractive investment opportunities from time to time. We can offer no assurance that we will be able to identify and make investments that are consistent with our investment objective.
We do not seek to compete primarily based on the interest rates we offer. We believe that some of our competitors make loans with interest rates that are comparable to, or lower than, the rates we offer.
We may lose investment opportunities if we do not match our competitors’ pricing, terms and structure. If we match our competitors’ pricing, terms and structure, we may experience decreased net interest income and increased risk of credit loss.
We have experienced a period of capital markets disruption. This disruption has contributed to a decrease in our NAV and stock price, and could have an adverse impact on our business and operations.
Through early 2009, the financial services industry and the securities markets generally were materially and adversely affected by significant declines in the values of nearly all asset classes and by a lack of liquidity. Initially, these market conditions were triggered by declines in home prices and the values of subprime mortgages, but spread to all mortgage and real estate asset classes, to leveraged bank loans and to nearly all asset classes, including equities. During this period of disruption, the global markets have been characterized by substantially increased volatility, short-selling and an overall loss of investor confidence. While recent economic indicators have shown modest improvements in the capital markets, these indicators could worsen. In the event of renewed financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry, or significant financial service institution failures, there could be a new or incremental tightening in the credit markets, low liquidity and extreme volatility in fixed-income, credit, currency and equity markets. In addition, the risk remains that there could be a number of follow-on effects from the credit crisis on our business.
We may be unable to monetize assets in a challenging market environment that may preclude buyers from making investments at the fair values established by our board of directors. We are susceptible to the risk of significant loss, if we are forced to discount the value of our investments in order to monetize assets to provide liquidity to fund operations, meet our liability maturities and maintain compliance with our debt covenants. In addition, if the fair value of our assets declines substantially, we may fail to maintain the BDC asset coverage ratios stipulated by the 1940 Act. Any such failure would affect our ability to issue senior securities, including borrowings, pay dividends and could cause us to breach certain covenants in our credit facilities, which could materially impair our business operations. Further asset value degradation may result from circumstances that we may be unable to control, such as a severe decline in the value of the U.S. dollar, a protracted economic downturn or an operational problem that affects third parties or us. Ongoing disruptive conditions could cause our stock price and NAV to decline, restrict our business operations and adversely impact our results of operations and financial condition. As of December 31, 2010, our common stock was trading at $6.97 per share, or at 92.4% of NAV.
Fluctuations in interest rates could affect our income adversely.
Because we sometimes borrow to make investments, our net income depends, in part, on the difference between the rate at which we borrow funds and the rate at which we invest these funds. Because a significant portion of our assets and liabilities are priced using various short-term rate indices, including one-month to three-month LIBOR, commercial paper rates and the prime rate, the timing of changes in market interest rates or in the relationship between interest rate indices could affect the interest rates earned on our interest-earning assets differently than the interest rates we pay on interest-bearing liabilities. As a result, significant changes in market interest rates could have a material adverse effect on our net income.
A significant increase in market interest rates could harm our ability to attract new portfolio companies and originate new loans and investments, our non-performing assets could increase and the value of our portfolio could decrease because our floating-rate loan portfolio companies may be unable to meet higher payment obligations. As of December 31, 2010, approximately 75.5% of the fair value of our loan portfolio was at variable rates based on a LIBOR benchmark or prime rate and approximately 24.5% of the fair value of our loan portfolio was at fixed rates. The weighted-average LIBOR interest rate was 0.29% as of December 31, 2010. As of December 31, 2010, approximately 61.4% of the fair value of our loan portfolio had LIBOR floors between 1.0% and 3.0% on the LIBOR base index and prime floors between 2.25% and 6.0%. These floors minimize our exposure to significant decreases in interest rates.
Our shares of common stock may continue to trade at discounts from NAV, which limits our ability to raise additional equity capital.
Shares of closed-end investment companies frequently trade at a market price that is less than the NAV attributable to those shares. This characteristic of closed-end investment companies is separate and distinct from the risk that our NAV per share may decline. It is not possible to predict whether our common stock will trade at, above, or below NAV. In the recent past, the stocks of BDCs as an industry, including shares of our common stock, have traded below NAV and at near historic lows as a result of concerns over liquidity, leverage restrictions and distribution requirements. When our common stock trades below its NAV per share, we generally are unable to issue additional shares of our common stock at the then-current market price without first obtaining approval for such issuance from our stockholders and our independent directors.
If market constraints further prevent us from obtaining additional debt or equity capital, our liquidity could be affected adversely, our business prospects could be impacted negatively, we could lose key employees and our operating results could be affected negatively.
The economic recession in the U.S. resulted in a reduction in the availability of debt and equity capital for the market as a whole, and financial services firms in particular. The effects of the recession continue to constrain us and other companies in the financial services sector, limiting or completely preventing access to markets for debt and equity capital needed to maintain operations, continue investment originations and to grow. In addition, the available debt capital may be at a higher cost and/or less favorable terms and conditions. Equity capital is, and may continue to be, difficult to raise because we generally are not able to issue and sell our common stock at a price below NAV per share without stockholder approval. These economic and market conditions and inability to raise capital have had a negative effect on our origination process, curtailed our ability to grow and had a negative impact on our liquidity and operating results. The prolonged inability to raise additional capital could further constrain our liquidity, negatively impact our business prospects, cause the departure of key employees and have an adverse impact on our operating results.
Stockholders may incur dilution if we sell shares of our common stock in one or more offerings at prices below the then-current NAV per share of our common stock.
Since mid-2008, our common stock has traded consistently, and at times significantly, below NAV. The 1940 Act prohibits us from selling shares of our common stock at a price below the current NAV per share of our stock, subject to certain exceptions. One of these exceptions allows the sale of common stock at a price below NAV if the sale is approved by the holders of a majority of our outstanding voting securities and by holders of a majority of our outstanding voting securities who are not affiliated persons of us, and our board of directors must make certain determinations prior to any such sale.
If we were to sell shares of our common stock below NAV per share, such sales would result in an immediate dilution to the NAV per share. This dilution would occur as a result of the sale of shares at a price below the then-current NAV per share of our common stock and a proportionately greater decrease in a stockholder’s interest in our
earnings and assets and voting interest in us than the increase in our assets resulting from such issuance. The greater the difference between the sale price and the NAV per share at the time of the offering, the more significant the dilutive impact would be. Because the number of shares of common stock that could be so issued and the timing of any issuance is not currently known, the actual dilutive effect, if any, cannot currently be predicted.
We may in the future decide to issue preferred stock, which would magnify the potential for gain or loss and the risks of investing in us in the same way as our borrowings.
Because preferred stock is another form of leverage and the dividends on any preferred stock we might issue must be cumulative, preferred stock has the same risks to our common stockholders as borrowings. Payment of any such dividends and repayment of the liquidation preference of such preferred stock must take preference over any dividends or other payments to our common stockholders, and preferred stockholders are not subject to any of our expenses or losses and are not entitled to participate in any income or appreciation in excess of their stated preference. In addition, holders of any preferred stock we might issue would have the right to elect members of the board of directors and class voting rights on certain matters, including changes in fundamental investment restrictions and conversion to open-end status and, accordingly, could veto any such changes.
If we fail to qualify as a RIC, we will have to pay corporate-level taxes on our income and our income available for distribution would be reduced significantly or eliminated.
We have elected to be taxed for federal income tax purposes as a RIC, under Subchapter M of the Internal Revenue Code. To qualify as a RIC under the Internal Revenue Code, we must meet certain source-of-income, asset diversification and annual distribution requirements and maintain our status as a BDC, including:
•
The annual distribution requirement for a RIC is satisfied if we distribute to our stockholders at least 90% of our ordinary income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, on an annual basis. Because we may use debt financing, we are subject to an asset coverage ratio requirement under the 1940 Act and we may be subject to certain financial covenants under our debt arrangements that could, under certain circumstances, restrict us from making distributions necessary to satisfy the distribution requirement. If we are unable to obtain cash from other sources, we could fail to qualify for RIC tax treatment and, thus, become subject to corporate-level income tax.
•
The income source requirement will be satisfied if we obtain at least 90% of our income for each year from dividends, interest, gains from the sale of stock or securities or similar sources.
•
The asset diversification requirement will be satisfied if we meet certain asset diversification requirements at the end of each quarter of our taxable year. To satisfy these requirements, at least 50% of the value of our assets must consist of cash, cash equivalents, U.S. government securities, securities of other RICs, and other acceptable securities; and no more than 25% of the value of our assets can be invested in the securities, other than U.S. government securities or securities of other RICs, of one issuer, of two or more issuers that are controlled, as determined under applicable Internal Revenue Code rules, by us and that are engaged in the same or similar or related trades or businesses or of certain “qualified publicly traded partnerships.” Failure to meet these requirements may result in our having to dispose of certain investments quickly in order to prevent the loss of RIC status. Because most of our investments will be in private companies, and, therefore, will be relatively illiquid, any such dispositions could be made at disadvantageous prices and could result in substantial losses.
If we fail to qualify as a RIC for any reason and become subject to corporate-level income tax, the resulting corporate-level taxes could substantially reduce our net assets, the amount of income available for distribution and the amount of our distributions. Such a failure would have a material adverse effect on our stockholders and us.
A failure on our part to maintain our qualification as a BDC would significantly reduce our operating flexibility.
If we were to continuously fail to qualify as a BDC, we might be subject to regulation as a registered closed-end investment company under the 1940 Act, which would significantly decrease our operating flexibility. In addition, failure to comply with the requirements imposed on BDCs by the 1940 Act could cause the SEC to bring an enforcement action against us. For additional information on the qualification requirements of a BDC, see the disclosure under the caption Item 1. Business-Regulation.
We have substantial indebtedness and, if we do not service our debt arrangements adequately, our business could be harmed materially.
As of December 31, 2010, we had $546.9 million of outstanding borrowings under our debt facilities. As of December 31, 2010, the weighted-average annual interest rate on all of our outstanding borrowings was 2.3%, excluding the amortization of deferred debt issuance costs. Our ability to service our debt arrangements depends largely on our financial performance and will be subject to prevailing economic conditions and competitive pressures.
Under our warehouse financing facility, or SunTrust Warehouse, funded through Three Pillars Funding LLC, an asset-backed commercial paper conduit administered by SunTrust Robinson Humphrey, Inc., and our debt securitization through MCG Commercial Loan Trust 2006-1, we are subject to financial and operating covenants that restrict our business activities, including limitations that could hinder our ability to finance additional loans and investments or to make the distributions required to maintain our status as a RIC under Subchapter M of the Internal Revenue Code and impact our liquidity. In addition, these facilities include various affirmative and negative covenants, as well as certain cross-default provisions, whereby a payment default or acceleration under one of our debt facilities could, in certain circumstances, constitute a default under other debt facilities. In the event that there is a breach of one of the covenants contained in one of our debt facilities that has not been cured within any applicable cure period the lenders thereunder would have the ability to, in certain circumstances, accelerate the maturity of the indebtedness outstanding under that facility and exercise certain other remedies. In addition, our subsidiaries have sold some of our loans to trusts that serve as the vehicles for our securitization facilities, and these trusts, which are bankruptcy remote, hold legal title to these assets. However, in the event of a default on these loans held by the trusts, we bear losses to the extent that the fair value of our collateral exceeds our borrowings. The fair value of our excess collateral was $219.5 million as of December 31, 2010.
Each of our SunTrust Warehouse and our debt securitization through MCG Commercial Loan Trust 2006-1 requires us to maintain credit ratings for each loan in the collateral pools of these facilities as determined by specified international independent rating agencies. We are subject to periodic review and updates of these credit estimates by these rating agencies that could cause portions of the collateral to become disqualified as eligible assets if credit estimates deteriorate. In the event that a portion of the eligible assets becomes disqualified, loan payments that inure to our benefit could be otherwise diverted to reduce outstanding debt within these facilities. Such diversions could be material in amount and could hinder our ability to finance additional loans, operate our business or make distributions to our stockholders. In addition, if credit estimates deteriorate significantly, an event of default or a termination event could be triggered under these facilities, which would entitle the trustee or administrative agent to exercise available remedies, including selling the collateral securing these facilities and applying the proceeds to reduce outstanding borrowings under these facilities.
Under the terms of our unsecured notes, or the Private Placement Notes, we are also subject to financial and operating covenants that restrict our business activities, including our ability to incur certain additional indebtedness, effect debt and stock repurchases in specified circumstances or through the use of borrowings or unrestricted cash, or pay dividends above certain levels.
Decreases in the fair values of our portfolio company investments, which we record as unrealized depreciation, could affect certain covenants in our credit facilities. Our SunTrust Warehouse requires that we maintain a consolidated tangible net worth of not less than $500.0 million plus 50% of the proceeds from any equity issuances after February 26, 2009. In the event that our investments experience a significant amount of unrealized depreciation, we could breach one or more of the covenants in our credit facilities, pursuant to which our lenders might, among other things, require full and immediate payment. The Private Placement Notes require that we maintain a consolidated stockholders’ equity of $500.0 million for the periods ending as of and after December 31, 2008. As of December 31, 2010, our stockholders’ equity was $578.0 million.
In addition to the credit facility, Solutions Capital has issued SBA debentures that require our SBIC to generate sufficient cash flow to make required interest payments. Further, Solutions Capital must maintain a minimum capitalization that if impaired could materially and adversely affect our liquidity, financial condition and results of operations. Our borrowings under our SBA debentures are collateralized by the assets of Solutions Capital.
As a BDC, we are not permitted to incur indebtedness or issue senior securities, including preferred stock, unless immediately after such borrowing we have an asset coverage for total borrowings (excluding borrowings by our SBIC facility) of at least 200%. In addition, we may not be permitted to declare any cash dividend or other distribution on our outstanding common stock, or purchase any such shares, unless, at the time of such declaration or purchase, we have an asset coverage of at least 200% after deducting the amount of such
dividend, distribution or purchase price. If we are unable to meet this asset coverage requirement, we may not be able to incur additional debt and may need to sell a portion of our investments to repay some debt when it is disadvantageous to do so, and we may not be able to make distributions until we are in compliance with the 200% threshold requirement. As of December 31, 2010, our asset coverage ratio was 231%.
If we are not able to refinance or renew our debt or are not able to do so on favorable terms, our operations could be affected adversely.
As of December 31, 2010, we had $546.9 million of borrowings. In January 2011, the liquidity facility that supports our SunTrust Warehouse was renewed through January 2013.
Absent any acceleration events, the SunTrust Warehouse matures in January 2014 and the Private Placement Notes mature in October 2011 (with respect to the $17.4 million in notes remaining) and October 2012 (with respect to the $8.7 million in notes remaining). We cannot be certain that we will be able to renew our credit facilities as they mature or to establish new borrowing facilities to provide capital for normal operations, including new originations. Reflecting concern about the stability of the financial markets, many lenders and institutional investors have reduced or ceased providing funding to borrowers. This market turmoil and tightening of credit has led to increased market volatility and widespread reduction of business activity generally. If we are unable to renew or refinance such facilities and establish new facilities, at a reasonable size, our liquidity will be reduced significantly. Even if we are able to renew or refinance these facilities or consummate new borrowing facilities, we may not be able to do so on favorable terms. If we are unable to repay amounts outstanding under such facilities and are declared in default or if we are unable to renew or refinance these facilities, our operations could be affected adversely.
In addition to the SunTrust Warehouse, Solutions Capital has issued SBA debentures that require our SBIC to generate sufficient cash flow to make required interest payments. Further, Solutions Capital must maintain a minimum capitalization that if impaired could materially and adversely affect our liquidity, financial condition and results of operations. Our borrowings under our SBA debentures are collateralized by the assets of Solutions Capital.
Our continued compliance with these requirements depends on many factors, some of which are beyond our control. Material net asset devaluation in connection with additional borrowings could result in an inability to comply with our obligation to restrict the level of indebtedness that we are able to incur in relation to the value of our assets or to maintain a minimum level of shareholders’ equity.
When we are a debt or minority equity investor in a portfolio company, we may not be in a position to have significant influence over the entity. The stockholders and management of the portfolio company may make decisions that could decrease the value of our portfolio holdings.
We make both debt and minority equity investments. For these investments, we are subject to the risk that a portfolio company may make business decisions with which we disagree, and the stockholders and management of that company may take risks or otherwise act in ways that do not serve our interests. As a result, a portfolio company may make decisions that could decrease the value of our portfolio holdings and have an adverse effect on our financial position and results of operations.
Investments in equity securities involve a substantial degree of risk.
We may purchase common stock and other equity securities, including warrants. Although equity securities historically have generated higher average total returns than debt securities over the long term, equity securities may experience more volatility in those returns than debt securities. The equity securities we acquire may fail to appreciate, decline in value or lose all value, and our ability to recover our investment will depend on our portfolio company’s success. Investments in equity securities involve a number of significant risks, including the risk of further dilution in the event of additional issuances. Investments in preferred securities involve special risks, such as the risk of deferred distributions, illiquidity and limited voting rights.
You may not receive future distributions.
In the event that our asset coverage ratio falls below 200%, we will be unable to make distributions until our asset coverage ratio improves. If we do not distribute at least 90% of our investment company taxable income annually, we will suffer adverse tax consequences, including the possible loss of our status as a RIC for the applicable period. We cannot assure you that you will receive any distributions or distributions at a particular level. As of
December 31, 2010, our asset coverage ratio was 231%. From December 2001 through December 31, 2010, we declared distributions totaling $12.15 per common share. Due to the recent market dislocation, we suspended our distributions from the third quarter of 2008 through the first quarter of 2010. We reinstated our distribution on April 29, 2010 and have continued to declare quarterly dividend since that time; however, there can be no assurance that distributions will continue in the future.
Future distributions will take into account the requirements for us to distribute the majority of our taxable income to fulfill our distribution requirements as a RIC, together with an assessment of our current and forecasted gains and losses recognized or to be recognized for tax purposes, portfolio transactional events, liquidity, cash earnings and our asset coverage ratio at the time of such decision. We may not be able to achieve operating results or our business may not perform in a manner that will allow us to make any future distributions. In addition, we may not be able to make distributions at a specific level or to increase the amount of these distributions from time to time. Due to the BDC asset coverage test applicable to us as a BDC, we may be limited in our ability to make distributions.
In the future, we may choose to pay distributions with shares of our own common stock. In that case, you may be required to pay tax in excess of the cash you receive.
While currently it is not our intention to do so, we may in the future elect to distribute taxable dividends that are payable, in part, in shares of our common stock. Under an IRS revenue procedure, we may treat a distribution of our stock payable with respect to our taxable years ending on or before December 31, 2011, as a taxable dividend if, among other things, our stock is publicly traded on an established securities market and each stockholder may elect to receive his or her entire distribution in either cash or our stock subject to a limitation on the aggregate amount of cash to be distributed to all stockholders, which must be at least 10% of the aggregate declared distribution. Taxable stockholders receiving such distributions will be required to include the full amount of the distribution as ordinary income (or as a long-term capital gain to the extent such distribution is properly designated as a capital gain dividend). As a result, a U.S. stockholder may be required to pay tax with respect to such distribution in excess of any cash received. If a U.S. stockholder sells the stock it receives as a distribution in order to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of our stock at the time of the sale. Furthermore, with respect to non-U.S. stockholders, we may be required to withhold U.S. income taxes with respect to such distribution, including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of our stockholders decide to sell shares of our stock in order to pay taxes owed on distributions, it may put downward pressure on the trading price of our stock.
We may have difficulty paying our required distributions if we recognize income before, or without, receiving cash representing such income.
In accordance with applicable tax laws and regulations, we include in taxable income certain amounts that we have not yet received in cash, such as contractual paid-in-kind, or PIK, interest, interest on loans that are on non-accrual status and original issue discount. PIK interest represents contractual interest added to the loan balance and due at the end of the loan term. We include increases in loan balances resulting from contracted PIK arrangements in taxable income, in advance of receiving cash payment. For certain of our loans that are on non-accrual status, we may recognize income for tax purposes for which we are not currently receiving payments. In addition, we hold debt instruments that have original issue discount, which may arise if we receive warrants in connection with the issuance of a debt instrument or in other circumstances. We are required to include in income each year a portion of the original issue discount that accrues over the life of the obligation, regardless of whether cash representing such income is received by us in the same taxable year. Since we may recognize income before, or without, receiving cash representing such income, we may have difficulty meeting the requirement to distribute at least 90% of our investment company taxable income to maintain tax benefits as a RIC. Accordingly, we may have to sell some of our investments at times we would not consider advantageous, raise additional debt or equity capital or reduce new investment originations to meet these distribution requirements. If we are not able to obtain cash from other sources, we may fail to qualify as a RIC and, thus, be subject to corporate-level income tax.
The disposition of our investments may result in contingent liabilities.
Most of our investments will involve private securities. In connection with the disposition of an investment in private securities, we may be required to make representations about the business and financial affairs of the portfolio company typical of those made in connection with the sale of a business. We may also be required to indemnify the purchasers of such investment to the extent that any such representations turn out to be inaccurate or with respect
to certain potential liabilities. These arrangements may result in contingent liabilities that ultimately yield funding obligations that must be satisfied through our return of certain distributions previously made to us.
If we need to sell any of our investments, we may not be able to do so at a favorable price and, as a result, we may suffer losses.
Our investments usually are subject to contractual or legal restrictions on resale or are otherwise illiquid because there is usually no established trading market for such investments. The illiquidity of most of our investments may make it difficult for us to dispose of them at a favorable price. As a result, we may suffer losses. In addition, if we were forced to liquidate some or all of the investments in our portfolio immediately, the proceeds of such liquidation could be significantly less than the current fair value of such investments. We may be required to liquidate some or all of our portfolio to meet our debt service obligations or to maintain our qualification as a BDC and as a RIC if we do not satisfy one or more of the applicable criteria under the respective regulatory frameworks.
Our business depends on our key personnel.
We depend on the continued services of our executive officers and other key management personnel. The loss of any of our executive officers or key management personnel could result in inefficiencies in our operations and lost business opportunities, which could have a negative impact on our business. In addition, under our SunTrust Warehouse, if either Steven F. Tunney, our Chief Executive Officer, or B. Hagen Saville, our Executive Vice President, Business Development, ceases to be involved actively in the management of MCG and is not replaced by a person reasonably acceptable to SunTrust within 90 consecutive calendar days of such occurrence, we would be in default under such facility. If we lose the services of Mr. Tunney or Mr. Saville and are unable to identify and hire suitably qualified replacements, it could trigger a covenant default under our SunTrust Warehouse, which could accelerate the termination date of that facility.
Regulations governing our operation as a BDC will affect our ability to, and the way in which we, raise additional capital.
We have issued debt securities and may issue additional debt securities, preferred stock and/or borrow money from banks or other financial institutions, which we refer to collectively as “senior securities,” up to the maximum amount permitted by the 1940 Act. Under the provisions of the 1940 Act, as a BDC, we are permitted to issue senior securities only in amounts such that our BDC asset coverage, as defined in the 1940 Act, equals at least 200% after each issuance of senior securities. If the value of our assets declines, we may be unable to satisfy this test. If that happens, we would be precluded from issuing senior securities and paying dividends and we may be required to sell a portion of our investments and, depending on the nature of our leverage, may be required to repay a portion of our indebtedness at a time when such sales may be disadvantageous. In addition, the 1940 Act prohibits us from selling shares of our common stock at a price below the current NAV unless our stockholders approve such a sale and our board of directors makes certain determinations.
Any change in the regulation of our business could have a significant adverse effect on the profitability of our operations and our cost of doing business.
Changes in the laws, regulations or interpretations of the laws and regulations that govern BDCs, RICs, SBICs or non-depository commercial lenders could have a significant adverse effect on our operations and our cost of doing business. We are subject to federal, state and local laws and regulations and are subject to judicial and administrative decisions that affect our operations. If these laws, regulations or decisions change, or if we expand our business into jurisdictions that have adopted requirements that are more stringent than those in which we currently conduct business, we may have to incur significant expenses in order to comply or we may have to restrict our operations.
Our wholly owned subsidiary is licensed by the SBA and is subject to SBA regulations.
Our wholly owned subsidiary, Solutions Capital I, L.P., is licensed to operate as an SBIC and is regulated by the SBA. The SBIC license allows our SBIC subsidiary to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and other customary procedures. The SBA regulations require, among other things, that a licensed SBIC be examined periodically, by an SBA examiner, to determine the SBIC’s compliance with the relevant SBA regulations, and be audited by an independent auditor.
Under current SBA regulations, a licensed SBIC can provide capital to those entities that have a tangible net worth not exceeding $18.0 million and an average net income after federal income taxes not exceeding
$6.0 million for the two most recent fiscal years. In addition, a licensed SBIC must devote 25% of its investment activity to those entities that have a tangible net worth not exceeding $6.0 million and an average annual net income after federal income taxes not exceeding $2.0 million for the two most recent fiscal years. The SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on factors such as the number of employees and gross sales. The SBA regulations permit licensed SBICs to make long term loans to small businesses and invest in the equity securities of such businesses. The SBA also places certain limitations on the financing terms of investments by SBICs in portfolio companies and prohibits SBICs from providing funds for certain purposes or to businesses in a few prohibited industries. Compliance with SBA requirements may cause our SBIC subsidiary to forego attractive investment opportunities that are not permitted under SBA regulations.
SBA regulations currently limit the amount that a single-license SBIC subsidiary may borrow up to a maximum of $150.0 million when it has at least $75.0 million in private capital, receives a capital commitment from the SBA and has been through an examination by the SBA subsequent to licensing. As of December 31, 2010, our SBIC subsidiary had investments in 12 portfolio companies with a total fair value of $144.8 million.
The SBA prohibits, without prior SBA approval, a “change of control” of an SBIC or transfers that would result in any person (or a group of persons acting in concert) owning 10% or more of a class of capital stock of a licensed SBIC. If our SBIC subsidiary fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit its use of debentures, declare outstanding debentures immediately due and payable, and/or limit it from making new investments. In addition, the SBA can revoke or suspend a license for willful or repeated violation of, or willful or repeated failure to observe, any provision of the SBIC Act or any rule or regulation promulgated thereunder. These actions by the SBA would, in turn, negatively affect us because our SBIC subsidiary is our wholly owned subsidiary.
Our wholly owned SBIC subsidiary may be unable to make distributions to us that will enable us to meet or maintain RIC status, which could result in the imposition of an entity-level tax.
In order for us to continue to qualify for RIC tax treatment and to minimize corporate-level taxes, we will be required to distribute substantially all of our net ordinary income and net capital gain income, including income from certain of our subsidiaries, which includes the income from our SBIC subsidiary. We will be partially dependent on our SBIC subsidiary for cash distributions to enable us to meet the RIC distribution requirements. Our SBIC subsidiary may be limited by the SBIC Act and SBA regulations governing SBICs from making certain distributions to us that may be necessary to maintain our status as a RIC. If our SBIC is unable to make sufficient distributions to us to allow us to make the required annual distributions to maintain our status as a RIC, and we are not able to obtain cash from other sources, we may fail to qualify as a RIC and, thus, be subject to corporate-level income tax.
The impact of recent financial reform legislation on us is uncertain.
In light of current conditions in the U.S. and global financial markets and the U.S. and global economy, legislators, the presidential administration and regulators have increased their focus on the regulation of the financial services industry. The Dodd-Frank Reform Act became effective on July 21, 2010, although many provisions of the Dodd-Frank Reform Act have delayed effectiveness or will not become effective until the relevant federal agencies issue new rules to implement the Dodd-Frank Reform Act. Nevertheless, the Dodd-Frank Reform Act may have a material adverse impact on the financial services industry as a whole and on our business, results of operations and financial condition. Accordingly, we cannot predict the effect the Dodd-Frank Act or its implementing regulations will have on our business, results of operations or financial condition.
Our stock price has been, and continues to be, volatile and purchasers of our common stock could incur substantial losses.
The stock market in general and the market prices for securities of financial services companies, and BDCs in particular, have experienced extreme volatility that often have been unrelated or disproportionate to the operating performance of these companies. If current levels of market volatility continue or worsen, there can be no assurance that we will not continue to experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.
The trading price of our common stock following an offering may fluctuate substantially. The price of the common stock that will prevail in the market after an offering may be higher or lower than the price you paid and the liquidity of our common stock may be limited, in each case depending on many factors, some of which are beyond
our control and may not be related directly to our operating performance. The market price and the liquidity of the market for our shares may from time to time be affected by a number of factors, which include, but are not limited to, the following:
•
our quarterly results of operations;
•
our origination activity, including the pace of, and competition for, new investment opportunities;
•
price and volume fluctuations in the overall stock market from time to time;
•
investors’ general perception of our company, the economy and general market conditions;
•
actual or anticipated changes in our earnings or fluctuations in our operating results or changes in the expectations of securities analysts;
•
the financial performance of the specific industries in which we invest on a recurring basis, including without limitation, our investments in the communications, cable and healthcare industries;
•
significant transactions or capital commitments by us or our competitors;
•
significant volatility in the market price and trading volume of securities of BDCs or other financial services companies;
•
volatility resulting from trading in derivative securities related to our common stock including puts, calls or short trading positions;
•
changes in laws or regulatory policies or tax guidelines with respect to BDCs or RICs;
•
loss of RIC status;
•
the loss of a major funding source, including one of our lenders;
•
announcements of strategic developments, acquisitions and other material events by us or our competitors; or
•
departures of key personnel.
If any of these factors causes an adverse effect on our business, our results of operations or our financial condition, the price of our common stock could fall and investors may not be able to sell their common stock at or above their respective purchase prices.
Certain provisions of the Delaware General Corporation Law and our certificate of incorporation and bylaws could deter takeover attempts and have an adverse impact on the price of our common stock.
The Delaware General Corporation Law, our certificate of incorporation and our bylaws contain provisions that may have the effect of discouraging a third party from making an acquisition proposal for us. We have also adopted measures that may make it difficult for a third party to obtain control of us, including provisions of our certificate of incorporation dividing our board of directors into three classes with the term of one class expiring at each annual meeting of stockholders. These anti-takeover provisions may inhibit a change in control in circumstances that could give the holders of our common stock the opportunity to realize a premium over the market price of our common stock.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
ITEM 2.
ITEM 2. PROPERTIES.
Neither we nor any of our subsidiaries own any facilities or real estate. However, during 2010 we leased 39,574 square feet of office space in Arlington, Virginia for our corporate headquarters and 6,758 square feet in Richmond, Virginia for certain administrative operations. We also leased office space in California and Georgia that is no longer used by MCG, all of which has been sublet to third-parties.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
In December 2007, we received an examination report from the IRS related to its audit of our tax returns for the 2004 and 2005 tax years. The IRS proposed changes to certain deductions made by us for those years, primarily associated with the timing of certain realized losses in our portfolio. We appealed the proposed changes and reached a settlement with the IRS in the fourth quarter of 2010. As a result of this settlement, we will pay approximately $0.8 million in federal and state tax, interest and penalties. We accrued the settlement expenses prior to 2010. In 2009 and 2007 we accrued $0.2 million and $0.3 million, respectively, of estimated tax expense, and during 2009 and 2008 we recorded $0.1 million and $0.2 million, respectively, of estimated interest and penalties in general and administrative expense. All federal tax years subsequent to 2005 remain open to examination by the IRS.
From time to time, we are a party to certain legal proceedings incidental to the normal course of our business including the enforcement of our rights under contracts with our portfolio companies. While we cannot predict the outcome of these legal proceedings with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations.
ITEM 4.
ITEM 4. RESERVED
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
SECURITIES.
Market Information
Our common stock is traded on the NASDAQ Global Select Market under the symbol “MCGC.” The following table sets forth the high and low last sales prices of our common stock for the periods indicated, as reported on the NASDAQ Global Select Market:
Holders
On February 28, 2011 we had approximately 146 holders of record and approximately 20,307 beneficial holders of our common stock.
Recent Sales of Unregistered Securities and Purchases of Equity Securities
As part of our dividend reinvestment plan for our common stockholders, we may direct the plan administrator to purchase shares of our common stock on the open market to satisfy dividend reinvestment requests related to dividends that we pay on outstanding shares of our common stock. In addition, for certain employees, we may be deemed to have purchased through the net issuance of shares, a portion of the shares of restricted stock previously issued under our Third Amended and Restated 2006 Employee Restricted Stock Plan, or the 2006 Plan, for which the forfeiture provisions have lapsed to satisfy the respective employee’s income tax withholding obligations. We retire immediately all such shares of common stock that we purchase in connection with such net issuance to employees. The following table summarizes the shares of common stock that we have purchased during each of the three months ended December 31, 2010.
(a) Represents stock purchased on the open market to satisfy dividend reinvestment requests related to the dividend we paid on October 4, 2010.
(b) Represents the weighted-average purchase price per share, including commissions, for shares purchased pursuant to the terms of our dividend reinvestment plan.
(c) Represents shares repurchased from our employees in connection with the net issuance of shares to satisfy employee tax withholding obligations in connection with the vesting of restricted stock.
(d) Based on the weighted-average closing share prices of our common stock on the dates that the forfeiture restrictions lapsed.
Distribution Policy
As a BDC that has elected to be treated as a RIC, we generally must distribute at least 90% of our investment company taxable income and 90% of any ordinary pre-RIC built-in gains that we recognize in order to deduct distributions made (or deemed made) to our stockholders. In addition, for calendar years ended December 31, 2010 and earlier, we were subject to a 4% excise tax to the extent that we did not distribute (actually or on a deemed basis): 98% of our ordinary income for each calendar year; 98% of our capital gain net income for each calendar year; and any income realized, but not distributed, in prior calendar years. Beginning in 2011, we will be subject to the 4% excise tax to the extent that we do not distribute (actually or on a deemed basis): 98% of our ordinary income for each calendar year; 98.2% of our capital gain net income for each calendar year; and any income realized, but not distributed, in prior calendar years.
We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the BDC asset coverage test for borrowings applicable to us as a BDC under the 1940 Act and due to provisions in our credit facilities. If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including possible loss of favorable RIC tax treatment. We cannot assure stockholders that they will receive any distributions or distributions at a particular level. We may make distributions to our stockholders of certain net capital gains.
The following table summarizes our distributions declared since January 1, 2009:
We incurred certain losses for tax purposes in 2009 that we recognized for book purposes during 2008, which reduced our statutorily required distribution to zero in 2009. We will make decisions with respect to the actual level of 2011 distributions on a quarter-by-quarter basis during 2011, after taking into account the minimum statutorily required level of distributions, gains and losses recognized for tax purposes, portfolio transactional events, our liquidity, cash earnings and our BDC asset coverage ratio at the time of such decision. For additional information about our distributions, see the Liquidity and Capital Resources section of our Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Equity Compensation Plan Information
Information relating to compensation plans under which our equity securities are authorized for issuance is set forth under Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters in our definitive proxy statement for our 2011 Annual Meeting of Stockholders.
Stock Performance Graph
The following comparative stock performance graph compares the cumulative total stockholder return (assuming reinvestment of dividends, if any) from investing $100 on December 31, 2005 through December 31, 2010, in each of: i) our common stock; ii) the Russell 2000 Index; and iii) the NASDAQ Financial 100 Index (capitalization weighted).
The information included under the heading Stock Performance Graph in Item 5 of this Annual Report on Form 10-K is “furnished” and not “filed,” and shall not be deemed to be “soliciting material” or subject to Regulation 14A, shall not be deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liabilities of that section, nor shall it be deemed incorporated by reference in any filing under the Exchange Act.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data set forth in the following table with respect to our statement of operations data for the years ended December 31, 2010, 2009 and 2008 and the balance sheet data as of December 31, 2010 and 2009 are derived from our audited financial statements included in this Annual Report on Form 10-K. The statement of operations data for the years ended December 31, 2007 and 2006 and the balance sheet data as of December 31, 2008, 2007 and 2006 are derived from our audited financial statements, which are not included herein. Historical results are not necessarily indicative of future results. See the notes below and to the consolidated financial statements for an explanation of the method used to determine the number of shares used in computing DNOI and (loss) earnings per common share basic and diluted. The selected consolidated financial data set forth below should be read in conjunction with, and is qualified in its entirety by, our audited consolidated financial statements and related notes thereto found at Item 8. Financial Statements and Supplementary Data and Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information contained in this section should be read in conjunction with the Selected Financial Data and Other Data, and our Consolidated Financial Statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K.
This Annual Report on Form 10-K, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve substantial risks and uncertainties. These forward-looking statements are not historical facts, but rather are based on current expectations, estimates, forecasts, projections, intentions, goals, strategies, plans, prospects and the beliefs and assumptions of our management including, without limitation: our expectations regarding our results of operations, including revenues, net operating income, distributable net operating income, net investment losses and general and administrative expenses and the factors that may affect such results; the cause of unrealized losses; the performance of our current and former portfolio companies; our decision to make dividend distributions during 2011 based on the minimum statutorily required level of distributions, gains and losses recognized for tax purposes, portfolio transactional events, our liquidity, cash earnings and our BDC asset coverage ratio; the reduction of investments in equity securities to no more than 10% to 20% of the fair value of our portfolio over the next few years; our expectations regarding the origination of new loans, the monetization of lower-yielding investments and controlling corporate overhead and the effect of these initiatives will have on our operating performance, including our distributable net operating income; our belief that our inability to access the equity markets has impacted our debt capital market access; our expectation that we can increase stockholder value by converting lower-yielding equity investments and deploying cash in securitization and restricted accounts into yield-oriented new investment opportunities; our plans to improve the returns on our debt and equity portfolio by improving the operating performance or by multiple expansion of our investments; the limitation of future investing activities principally to debt investments until such time that we have further narrowed the valuation gap between our stock price; our level of investments in control companies beyond those that are currently in our portfolio; our underwriting process relative to macro economic conditions; our intentions to issue equity in the future that is accretive to our business and will contribute to our future growth; the timing of, and our ability to, repurchase equity, additional debt securities and make stockholder distributions; the sufficiency of liquidity to meet 2011 operating requirements, as well as new origination opportunities and potential dividend distributions during the upcoming year; our ability to fund requests to draw on unfunded commitments to our portfolio companies; general market conditions; the state of the economy and other factors. Forward-looking statements can be identified by terminology such as “anticipate,” “believe,” “could,” “could increase the likelihood,” “hope,” “target,” “project,” “goals,” “potential,” “predict,” “might,” “estimate,” “expect,” “intend,” “is planned,” “may,” “should,” “will,” “will enable,” “would be expected,” “look forward,” “may provide,” “would” or similar terms, variations of such terms or the negative of those terms. These statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors, some of which are beyond our control and difficult to predict. Important factors could cause our actual results to differ materially from those indicated or implied by forward-looking statements. Such factors that could cause or contribute to such differences include those risk factors discussed in Item IA of Part I of this Annual Report on Form 10-K.
Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also could be incorrect. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this Annual Report on Form 10-K should not be regarded as a representation by us that our plans and objectives will be achieved. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Annual Report on Form 10-K. We undertake no obligation to update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.
Description of Business
We are a solutions-focused commercial finance company providing capital and advisory services to middle-market companies throughout the United States. We make debt and equity investments primarily in companies with annual revenue of $20 million to $200 million and earnings before interest, taxes, depreciation and amortization, or EBITDA, of $3 million to $25 million, which we refer to as “middle-market” companies. Generally, our portfolio companies use our capital investment to finance acquisitions, recapitalizations, buyouts, organic growth and working capital. We identify and source new portfolio companies through multiple channels, including private equity sponsors, investment bankers, brokers, fund-less sponsors, institutional syndication partners, other
club lenders and owner operators. We may also purchase rated syndicated private debt in larger companies through our on-balance sheet securitization trust. We use our Commercial Loan Trust 2006-1 borrowing facility primarily to fund these investments in syndicated private debt, while we use borrowings under our Small Business Investment Company, or SBIC, to fund unitranche, second lien and subordinated debt investments.
We are an internally managed, non-diversified, closed-end investment company that has elected to be regulated as a business development company, or BDC, under the Investment Company Act of 1940, as amended, or the 1940 Act. As a BDC we must meet various regulatory tests, which include investing at least 70% of our total assets in private or thinly traded public U.S.-based companies and meeting a 200% asset coverage ratio of total net assets to total senior securities, which include most of our borrowings (including accrued interest payable) and any preferred stock we may issue in the future. In addition, we have elected to be treated for federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code. In order to continue to qualify as a RIC for federal income tax purposes and obtain favorable RIC tax treatment, we must meet certain requirements, including certain minimum distribution requirements. If we satisfy these requirements, we generally will not have to pay corporate-level taxes on any income we distribute to our stockholders as dividends, allowing us to substantially reduce or eliminate our corporate-level tax liability. From time to time, our wholly owned subsidiaries may execute transactions that trigger corporate-level tax liabilities. In such cases, we recognize a tax provision in the period when it becomes more likely than not that the taxable event will occur.
Recent Developments
During 2010, the United States economy continued to recover from the effects of the recent recession that ended in mid-2009. Leading economic indicators, coupled with recent tax-related legislation enacted by Congress in late 2010, are indicative that the economic recovery may continue into 2011. Although the economy has not yet recovered to pre-recession levels, we are cautiously optimistic of the potential for future economic growth.
Despite the progress that has been made to-date toward restoring the economy, the effects of the recession continue to linger. European credit issues have destabilized the global markets, government sponsored stimulus measures, such as the tax credit for first time home buyers, have expired and the fear of increased regulations and municipal fiscal crises have contributed to a high unemployment rate. The availability of debt and equity capital continues to be constrained. Generally, the limited amount of available debt financing in the capital markets has shorter maturities, higher interest rates and fees and more restrictive terms than debt facilities available prior to the recession. Equity and credit markets were characterized by increasing asset prices, lower volatility and improved liquidity beginning the second half of 2009 and continuing into 2010. As we enter 2011, we continue to be constrained by the limited availability of debt and equity capital. Further, we did not receive approval from our stockholders to sell equity below our net asset value at our most recent stockholders meeting. We believe that our inability to access the equity capital markets has also impacted our ability to access the debt capital markets, as lenders are reluctant to extend credit without equity capital access.
During 2009 and continuing into 2010, we began to implement a strategic plan designed to establish a foundation for us to reposition our company in future years to close the gap between share price and net asset value, or NAV, and to enhance stockholder value. Initially, in late 2009 and early 2010, we focused our strategic plan on preserving capital, monetizing lower-yielding investments and deleveraging our balance sheet. As we transitioned into the next phase of our strategic plan in mid-2010, we began to redeploy the capital from these monetizations, cash in securitized and restricted accounts and capital available in certain of our borrowing facilities into 25 new investments totaling $254.9 million.
To date, the implementation of this strategic plan has: increased our net operating income during the twelve months ended December 31, 2010 by $2.4 million, or 6.2%, over the same period in 2009; increased the market price of our stock from $4.32 at December 31, 2009 to $6.97 at December 31, 2010; allowed us to reinstate our dividend distributions beginning in the second quarter of 2010; and expanded our portfolio to include higher-yielding investments that are consistent with our risk and underwriting standards.
As we move into 2011, we expect to continue to reduce our equity investments to no more than 10% to 20% of the fair value of our portfolio over the next few years. We also expect to continue to originate higher-yielding investments in portfolio companies that meet our risk and underwriting standards. As of December 31, 2010, we had $116.6 million of cash and cash equivalents and cash in secured and restricted accounts that we could use to fund our new investments, operating requirements and dividend distributions. We had $50.0 million of borrowing capacity available under our Series 2006-1 Class A-2 Notes, and we had $6.0 million of funded capacity to originate new investments in Solutions Capital, subject to approval by the SBA. In January 2011, the SBA increased its total commitment for potential borrowings from $130.0 million to $150.0 million. To access the full $150.0 million SBA commitment, we
would have to fund $25.4 million in addition to the $49.6 million that we had funded through December 31, 2010. In January 2011, we also obtained a liquidity renewal from SunTrust Bank for our SunTrust Warehouse, and amended this facility to provide for a final maturity of January 2014. The following section provides an overview of our results of operations for 2010. A more detailed discussion of our results of operations for 2010 is included in the Comparison of the Years Ended December 31, 2010 and 2009 that begins on page 42.
Overview of Results of Operations
During 2010, we reported a net loss of $13.1 million, or $0.17 per diluted share, compared to a net loss of $51.1 million, or $0.68 per diluted share, during 2009. This decrease in net loss resulted primarily from a $39.5 million decrease in our net investment loss and a $2.4 million increase in net operating income, partially offset by a $2.0 million decrease on the gain on extinguishment of debt and a $1.9 million increase in our income tax provision.
Our net operating income during 2010 was $40.6 million, or $0.54 per diluted share, compared to $38.2 million, or $0.51 per diluted share, during 2009. This $2.4 million, or 6.2%, increase from the comparable period in 2009 reflects a $6.6 million, or 28.0%, decrease in interest expense, primarily resulting from decreases in average LIBOR interest rates and our average borrowing balance. In addition, compensation expense and other general and administrative expense decreased by $6.1 million, or 15.9%, primarily because of our continuing emphasis on controlling corporate overhead and the timing of the recognition of certain stock-based compensation. These expense reductions were offset by a $10.3 million, or 10.3%, reduction in revenue, which primarily reflects a decrease in our average loan balance and the net impact of loans on non-accrual status.
During 2010, we realized $11.9 million of gains on our investments primarily resulting from the monetization and repayment of certain investments during the year. In addition, we recorded $66.7 million of net unrealized depreciation during the year, which primarily resulted from $36.0 million of unrealized depreciation on our investment in Broadview Network Holdings, Inc., or Broadview, as a result of our estimate of the fair value of this investment. In addition, we recorded $28.0 million of unrealized depreciation on our investment in Jet Plastica Investors, LLC, or Jet Plastica, primarily attributable to decreases in the performance and valuation multiples of that company.
A more detailed discussion of our results of operations for 2010 is included in the Comparison of the Years Ended December 31, 2010 and 2009 that begins on page 42. We expect to continue to originate new loans, monetize lower-yielding investments and control corporate overhead. We believe that these efforts will continue to improve our operating performance, including our distributable net operating income.
Portfolio Composition
As of December 31, 2010, the fair value of our investment portfolio was $1,009.7 million, which represents a $23.4 million, or 2.4%, increase from the $986.3 million fair value as of December 31, 2009. The following sections describe the composition of our investment portfolio as of December 31, 2010 and 2009 and describe key changes in our portfolio during 2010 and 2009.
The following table summarizes the composition of our investment portfolio at fair value:
Our debt instruments bear contractual interest rates ranging from 3.0% to 17.6%, a portion of which may be deferred. As of December 31, 2010, approximately 75.5% of the fair value of our loan portfolio was at variable rates, based on a LIBOR benchmark or prime rate, and 24.5% of the fair value of our loan portfolio was at fixed rates. As of December 30, 2010, approximately 61.4% of our loan portfolio, at fair value, had LIBOR floors between 1.0% and 3.0% on the LIBOR base index and prime floors between 2.25% and 6.0%. At origination, our loans generally have four- to eight-year stated maturities. Borrowers typically pay an origination fee based on a percentage of the total commitment and a fee on undrawn commitments.
The following table summarizes our investment portfolio by industry at fair value:
(a) No individual industry within this category exceeds 1%.
As of December 31, 2010, approximately 14.9% of the fair value of our investment portfolio was composed of investments in the communications industry. The 14.9% included 13.0% invested in Competitive Local Exchange Carriers, or CLECs, and 1.9% invested in other communications companies, including an incumbent local exchange carrier, a paging service and a telecommunications tower company. As of December 31, 2009, approximately 19.0% of the fair value of our investment portfolio was composed of investments in the communications industry, including 17.2% invested in CLECs, and 1.8% invested in other communications companies. For the years ended December 31, 2010 and 2009, our portfolio companies in the communications industry contributed $4.0 million, or 4.4%, and $4.4 million, or 4.4%, respectively, of our total revenues.
As of December 31, 2010, our ten largest portfolio companies represented approximately 42.2% of the total fair value of our investments. These ten companies accounted for approximately 36.1% of our total revenue during the year ended December 31, 2010. Our investment in Broadview, a CLEC that we control, represents our single largest investment. As of December 31, 2010 and 2009, the fair value of our investment in Broadview
represented $103.0 million and $138.8 million, or 10.2% and 14.1%, respectively, of the fair value of our investment portfolio. We did not accrete any dividends with respect to our investment in Broadview during the years ended December 31, 2010 or 2009, because we determined that the total value that we had recorded for this investment equaled the total enterprise value for this investment.
In addition to the communications industry, we have concentrations in the cable, healthcare and food service industries. The following table summarizes, by industry, our fair value and revenue concentrations in our investments:
CHANGES IN INVESTMENT PORTFOLIO
During the year ended December 31, 2010, we completed $320.3 million of originations and advances, including originations to 24 new portfolio companies and 12 originations and advances to existing portfolio companies, compared to $82.6 million of originations and advances during the year ended December 31, 2009. The following table summarizes our total portfolio investment activity during the years ended December 31, 2010 and 2009:
Originations and Advances
The following table shows our originations and advances during the years ended December 31, 2010 and 2009 by security type:
Repayments, Sales and Other Reductions of Investment Portfolio
The following table shows our gross payments, sales and other reductions of securities during the years ended December 31, 2010 and 2009 by security type:
During the years ended December 31, 2010 and 2009, our gross payments, sales and other reductions of securities by transaction type included:
As shown in the following table, during the year ended December 31, 2010, we monetized all, or part of, investments in 14 portfolio companies with proceeds totaling $175.0 million:
The proceeds from these monetizations correlated closely with the most recently reported fair value of the associated investments.
Asset Quality
Asset quality is generally a function of portfolio company performance and economic conditions, as well as our underwriting and ongoing management of our investment portfolio. In addition to various risk management and monitoring tools, we use the following investment rating system to characterize and monitor our expected level of returns on each investment in our portfolio:
Investment
Rating
Summary Description
Capital gain expected or realized
Full return of principal and interest or dividend expected with customer performing in accordance with plan
Full return of principal and interest or dividend expected, but customer requires closer monitoring
Some loss of interest or dividend expected, but still expect an overall positive internal rate of return on the investment
Loss of interest or dividend and some loss of principal investment expected, which would result in an overall negative internal rate of return on the investment
The following table shows the distribution of our investments on our 1 to 5 investment rating scale at fair value as of December 31, 2010 and December 31, 2009:
(a) As of December 31, 2010 and 2009, Investment Rating “1” included $112.2 million and $218.6 million, respectively, of loans to companies in which we also hold equity securities.
When one of our loans becomes more than 90 days past due, or if we otherwise do not expect the customer to be able to service its debt and other obligations, we will, as a general matter, place the loan on non-accrual status and generally will cease recognizing interest income on that loan until all principal and interest have been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, we may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection. If the fair value of a loan is below cost, we may cease recognizing paid-in-kind, or PIK, interest and/or the accretion of a discount on the debt investment until such time that the fair value equals or exceeds cost.
The following table summarizes loans on non-accrual status and loans greater than 90 days past due, at cost, as of December 31, 2010 and December 31, 2009:
The following table summarizes loans on non-accrual status and loans greater than 90 days past due, at fair value, as of December 31, 2010 and December 31, 2009:
The following table summarizes the changes in the cost and fair value of the loans on non-accrual status from December 31, 2009 through December 31, 2010:
RESULTS OF OPERATIONS
The following section compares our results of operations for the year ended December 31, 2010 compared to 2009.
COMPARISON OF THE YEARS ENDED DECEMBER 31, 2010 AND 2009
The following table summarizes the components of our net loss for the years ended December 31, 2010 and 2009:
NM=Not Meaningful
TOTAL REVENUE
Total revenue includes interest and dividend income and advisory fees and other income. During 2010, our total revenue was $89.6 million, which represents a $10.3 million, or 10.3%, decrease from 2009. This decline was composed primarily of an $11.7 million, or 13.2%, decrease in interest income and a $0.3 million, or 11.0%, decrease in loan fees. These decreases were partially offset by a $1.2 million, or 19.8%, increase in dividend income; and a $0.5 million, or 20.3%, increase in advisory fees and other income. The following sections describe the reasons for the variances in each major component of our revenue during the year ended December 31, 2010.
INTEREST INCOME
The level of interest income that we earn depends upon the level of interest-bearing investments outstanding during the period, as well as the weighted-average yield on these investments. During 2010, the total yield on our average debt portfolio at fair value was 11.7% compared to 11.9% during 2009. The weighted-average yield varies each period because of changes in the composition of our portfolio of debt investments, changes in stated interest rates, fee accelerations of unearned fees on paid/restructured loans and the balance of loans on non-accrual status for which we are not accruing interest.
The following table shows the various components of the total yield on our average debt portfolio at fair value for the years ended December 31, 2010 and 2009:
During 2010 interest income was $76.6 million, compared to $88.3 million during 2009, which represented an $11.7 million, or 13.2%, decrease. This decrease reflected a $10.3 million decrease resulting from a reduction in our average loan balance, a $2.7 million decrease resulting from a 35 basis point reduction in average LIBOR and a $3.1 million decrease in interest income resulting from the net impact of loans that were on non-accrual status during 2010 that were accruing interest during 2009. These decreases were partially offset by a $3.6 million increase in interest income resulting from a 10 basis point increase in our spread to LIBOR and a $0.8 million increase in interest income resulting from the impact of interest rate floors.
PIK Income
Interest income includes certain amounts that we have not received in cash, such as PIK interest. PIK interest represents contractually deferred interest that is added to the loan balance. PIK may be prepaid by either contract or the portfolio company’s choice, but generally is paid at the end of the loan term. The following table shows the PIK-related activity for 2010 and 2009, at cost:
As of December 31, 2010 and 2009, we were not accruing interest on $7.4 million and $4.3 million, respectively, of the PIK loans, at cost, shown in the preceding table.
On July 30, 2010, JetBroadband Holdings, LLC, or JetBroadband, sold substantially all of its assets to Shentel Cable Company, a wholly owned subsidiary of Shenandoah Telecommunications Company. Our cash proceeds in connection with the exit of this investment included $8.5 million of payments received from PIK loans. In addition, during the year ended December 31, 2010, we received a $3.8 million cash repayment of PIK from NDSSI Holdings, LLC, a $3.7 million cash repayment of PIK related to the payoff of subordinated debt from MCI Holdings LLC, a $1.1 million cash payment of PIK from The Matrixx Group, Incorporated and PIK payments totaling $1.7 million from 15 other portfolio companies.
DIVIDEND INCOME
We accrete dividends on equity investments with stated dividend rates as they are earned, to the extent that we believe the dividends will be paid ultimately and the associated portfolio company has sufficient value to support the accretion. We recognize dividends on our other equity investments when we receive the dividend payment. Our dividend income varies from period to period because of changes in the size and composition of our equity investments, the yield from the investments in our equity portfolio and the ability of the portfolio companies to declare and pay dividends.
The following table summarizes our dividend activity for 2010 and 2009:
During 2010, our dividend income was $7.4 million, which represented a $1.2 million, or 19.8%, increase from 2009. Dividend income increased as a result of Stratford School Holdings, Inc. paying a $1.9 million dividend in December 2010, which resulted in $1.5 million more dividends than we had accreted for this investment. Dividend income also increased $1.9 million primarily because of improvements in the fair values of certain equity investments and because the fair value of four existing portfolio companies improved sufficiently to support the accretion of dividends. These increases were partially offset by a decrease in dividend income of $1.5 million primarily as a result of the sale of three dividend-producing investments-Coastal Sunbelt, LLC, LMS Intellibound Investors, LLC and B&H Education, Inc. In addition, dividend income decreased $0.7 million because we ceased accreting dividends on two investments because the fair value of these investments as of December 31, 2010 did not support the accretion of additional dividends.
LOAN FEES
Loan fees include origination fees on loans that we defer and amortize into interest income over the life of the loan. When repayments or restructurings with major modifications occur, we accelerate the recognition of previously unamortized loan origination fees into loan income. These accelerations have the effect of increasing current period income and may reduce future amortizable income. Because the repayments and restructurings may vary from period to period, the level of loan origination fees included in interest income may also vary. During 2010, our loan fees decreased $0.3 million, or 11.0%.
ADVISORY FEES AND OTHER INCOME
Advisory fees and other income primarily include fees related to advisory and management services, equity structuring fees, syndication fees, prepayment fees, bank interest and other income. Generally, advisory fees and other income relate to specific transactions or services and, therefore, may vary from period to period depending on the level and types of services provided. During 2010, we earned $3.0 million of advisory fees and other income, which represented a $0.5 million, or 20.3%, increase from 2009. This increase was due primarily to a $0.9 million increase in advisory fees earned in conjunction with origination activity and a $0.2 million increase from interest on the average balance of cash that we maintained in our bank accounts. These increases were partially offset by a $0.6 million decrease in management fees generated from our portfolio companies.
TOTAL OPERATING EXPENSES
Total operating expenses include interest, employee compensation and general and administrative expenses. During 2010, we incurred $49.0 million of operating expenses, representing a $12.6 million, or 20.5%, decrease from the prior year. This decrease was composed of: a $6.6 million decrease in interest expense; a $4.1 million decrease in general and administrative expense; and a $1.9 million decrease in employee compensation expenses. The reasons for these variances are discussed in more detail below.
INTEREST EXPENSE
During 2010, we incurred $16.9 million of interest expense, which represented a $6.6 million, or 28.0%, decrease from 2009. The previously described reduction in average LIBOR from 0.7% in 2009 to 0.3% in 2010 resulted in a $2.1 million decrease in interest expense. In addition, a decrease in average borrowing balances resulted in a $1.8 million decrease in interest expense and our amortization of debt costs decreased $1.4 million. Furthermore, a narrowing of the interest rate spread from 2.5% during 2009 to 2.3% 2010, decreased interest expense by $1.3 million.
EMPLOYEE COMPENSATION
Employee compensation expense includes base salaries and benefits, variable annual incentive compensation and amortization of employee stock awards. During 2010, our employee compensation expense was $20.6 million, which represented a $1.9 million, or 8.6%, decrease from 2009. Our salaries and benefits increased by $1.5 million, or 9.8%, primarily due to a $1.4 million increase in incentive compensation, reflecting changes in the fair value of liability awards under the Long-Term Incentive Plan, or LTIP. Our amortization of employee restricted stock decreased $3.4 million, or 43.8%, which represented certain awards being fully expensed in 2009 as well as fewer shares awarded during 2010. Awards under the LTIP are contingent upon the closing price of MCG’s stock meeting certain price thresholds and the approval of the compensation committee of our board of directors. We achieved two of these price thresholds in 2010, resulting in the issuance of 346,000 shares of restricted common stock and the award of $2.0 million to LTIP participants.
The following table summarizes the price thresholds, the cumulative percentage and number of shares eligible to be awarded at each threshold, and the cash bonus eligible to be paid after achievement of each stock price threshold that were set forth in the LTIP. In addition, the following table summarizes the market thresholds that were achieved and the associated stock and cash awards through December 31, 2010.
(a)
As of December 31, 2010, we awarded 778,500 shares under the LTIP program, for which the forfeiture provision have lapsed on 663,170 shares. Assuming that the associated LTIP participants meet the continuing service requirements, the forfeiture provisions for 72,080 shares and 43,250 shares will lapse in April 2011 and November 2011, respectively.
(b)
As of December 31, 2010, we awarded $1,996,000 of cash awards under the plan, of which $1,331,000 was paid out upon achievement of the market threshold. Assuming that the associated LTIP participants meet the continuing service requirements, $333,000 will be paid on April 2011 and $332,000 will be paid in November 2011.
GENERAL AND ADMINISTRATIVE
During 2010, general and administrative expense was $11.5 million, which represented a $4.1 million, or 26.5%, decrease compared to 2009. This decrease was attributable primarily to $1.7 million of expense associated with our settlement of matters pertaining to the contested election of directors to our board of directors at our 2009 Annual Meeting, a $1.1 million decrease in insurance costs, $0.9 million of severance costs related to an executive departure incurred during the second quarter of 2009, a $0.9 million decrease in professional fees and legal expenses and $0.9 million of other smaller cost reductions in other general and administrative categories. These decreases were partially offset by $0.9 million of fees paid in the second quarter of 2010 related to the contested election of directors to our board of directors at our 2010 Annual Meeting and $0.5 million of expenses associated with implementing a new computer system.
NET OPERATING INCOME BEFORE NET INVESTMENT LOSS, GAIN ON EXTINGUISHMENT OF DEBT AND INCOME TAX PROVISION (BENEFIT)
Net operating income before investment loss, gain on extinguishment of debt and income tax provision (benefit) for the year ended December 31, 2010 totaled $40.6 million, compared with $38.2 million for the year ended December 31, 2009. This increase is due to the items discussed above.
DISTRIBUTABLE NET OPERATING INCOME
Distributable net operating income, or DNOI, is net operating income before net investment loss, gain on extinguishment of debt and income tax provision (benefit), as determined in accordance with accounting principles generally accepted in the United States, or GAAP, adjusted for amortization of employee restricted stock awards and goodwill impairment. We view DNOI and the related per share measures as useful and
appropriate supplements to net operating income, net income, earnings per share and cash flows from operating activities. These measures serve as an additional measure of MCG’s operating performance exclusive of employee restricted stock amortization and goodwill impairment, which represent expenses of the company, but do not require settlement in cash. DNOI does include PIK interest and dividend income, which generally are not payable in cash on a regular basis, but rather at investment maturity or when declared. DNOI should not be considered as an alternative to net operating income, net income, earnings per share or cash flows from operating activities (each computed in accordance with GAAP). Instead, DNOI should be reviewed in connection with net operating income, net income, earnings per share and cash flows from operating activities in MCG’s consolidated financial statements, to help analyze how MCG’s business is performing.
During 2010, DNOI was $44.9 million, or $0.60 per share, compared to $45.9 million, or $0.61 per share, for 2009. The following table shows a reconciliation of our reported net operating income before net investment loss, gain on extinguishment of debt and income tax provision (benefit) to DNOI for 2010 and 2009:
NET INVESTMENT LOSS BEFORE INCOME TAX PROVISION (BENEFIT)
During 2010, we incurred $54.8 million of net investment loss before income tax provision (benefit), compared to $94.4 million of losses during 2009. These amounts represent the total of net realized gains and losses, net unrealized (depreciation) appreciation, and reversals of unrealized (depreciation) appreciation. We reverse unrealized (depreciation) appreciation at the time that we realize the gain or loss. The following table summarizes our realized and unrealized (loss) and gain on investments and changes in our unrealized appreciation and depreciation on investments for the year ended December 31, 2010:
During 2010, we sold our investments in MCI Holdings, LLC, JetBroadband; B&H Education, Inc.; Quantum Medical Holdings, LLC; and WebMediaBrands, Inc., as well as warrants to purchase common stock that we held in Metropolitan Telecommunications Holding Company. For each of these sales, we reversed unrealized appreciation (depreciation), that we had previously recognized and recorded a realized gain or (loss).
During 2010, we recorded $36.0 million of unrealized depreciation on our investment in Broadview, which reflects a number of inputs into our estimate of the fair value of this investment, including merger and acquisition comparables, private market transactions, public company comparables, a discounted cash flow analysis and an independent third-party valuation. In addition, we recognized unrealized depreciation on other investments in our portfolio, including Jet Plastica; Active Brands International, Inc.; Total Sleep Holdings, Inc.; and PremierGarage Holdings, LLC, primarily because of a decrease in the performance of these companies and a reduction in valuation multiples. The remaining unrealized (depreciation) appreciation shown in the above table resulted predominantly from changes in the performance of certain of our portfolio companies and the multiples used to value certain of our investments.
The following table summarizes our realized and unrealized (loss) gain on investments and changes in our unrealized appreciation and depreciation on investments during 2009:
During 2009, we wrote-off our investment in Cleartel Communications, Inc., which resulted in the realization of a $150.2 million loss and the reversal of $150.1 million of unrealized depreciation that we had recorded in previous years. In addition, we sold our investments in TNR Holdings, Inc.; CEI Holdings, Inc.; Flexsol Packaging Corp.; XFone, Inc.; and Marietta Intermediate Holding Corporation, as well as our equity investments in CWP/RMK Acquisition Corp., and LMS INTELLIBOUND, INC. For each of these sales, we reversed unrealized appreciation (depreciation), that we had recognized in previous years and we recorded a realized gain or (loss). These changes and the remaining unrealized depreciation shown in the above table resulted predominantly from decreases in the performance of certain of the portfolio companies, and, to a lesser extent, decreases in the comparable multiples that we used to estimate the fair value of the investments.
GAIN ON EXTINGUISHMENT OF DEBT
In 2010, we repurchased $8.0 million of collateralized loan obligations for $4.4 million that previously had been issued by our Commercial Loan Trust 2006-1. We recognized a $3.6 million gain on extinguishment of debt, excluding the effect of the amortization of the acceleration of $0.1 million in deferred debt costs during 2010. In accordance with our agreement with noteholders of our private placement notes, we used certain of the proceeds from the monetization of unencumbered investments to repurchase $25.3 million of our private placement notes. Under the terms of the agreement with the private placement noteholders, we were required to repurchase these notes at a 102% premium over the principal amount of these notes, which resulted in our recognition of a $0.5 million loss on the extinguishment of this debt during 2010.
In January 2009, we repurchased $7.5 million of collateralized loan obligations for $2.1 million that previously had been issued by our wholly owned subsidiary, Commercial Loan Trust 2006-1. As a result of this purchase, we recognized a $5.4 million gain on extinguishment of debt during 2009. Partially offsetting this gain was $0.4 million of premiums we incurred when we repurchased $18.5 million of our Private Placement Notes.
INCOME TAX PROVISION (BENEFIT)
During 2010, we recorded a $1.8 million income tax provision compared to a $0.1 million income tax benefit during 2009. Approximately $1.6 million of the income tax expense accrued for the year ended December 31, 2010 was attributable to the sale of JetBroadband in July 2010. The remaining tax expense for 2010 and the income tax benefit for 2009 were primarily attributable to unrealized depreciation or appreciation and flow-through taxable income on certain investments held by our subsidiaries.
NET LOSS
During 2010, we recorded a net loss of $13.1 million compared to a net loss of $51.1 million during 2009. This improvement is attributable to the items discussed above.
SELECTED QUARTERLY DATA
The following tables summarize key unaudited financial information for the eight quarters ended December 31, 2010. Results for any quarter are not necessarily indicative of results for the full year or for any future quarter.
(a) DNOI is net operating income before net investment gain (loss), gain (loss) on extinguishment of debt, and income tax provision (benefit), as determined in accordance with GAAP adjusted for amortization of employee restricted stock awards and goodwill impairment. We view DNOI and the related per share measures as useful and appropriate supplements to net operating income, net income, earnings per share and cash flows from operating activities. These measures serve as an additional measure of our operating performance exclusive of employee restricted stock amortization and goodwill impairment charges, which represents an expense of the company but does not require settlement in cash. DNOI does include PIK interest and dividend income which are generally not payable in cash on a regular basis but rather at investment maturity or when declared. DNOI should not be considered as an alternative to net operating income, net income, earnings per share and cash flows from operating activities (each computed in accordance with GAAP). Instead, DNOI should be reviewed in connection with net operating income, net income, earnings per share and cash flows from operating activities in our consolidated financial statements, to help analyze how our business is performing.
(b) Based on common shares outstanding at period-end.
The following tables summarize key unaudited information about our investment portfolio for the eight quarters ended December 31, 2010. Results for any quarter are not necessarily indicative of results for the full year or for any future quarter.
(a) Weighted based on the portfolio company’s fair value as of the respective period end.
(b) Excludes portfolio companies with limited or no operations.
(c) Excludes public equity portfolio companies.
(d) Excludes portfolio companies valued on a liquidation basis.
(e) For portfolio companies with a nominal EBITDA amount, the EBITDA multiple is limited to 15x. In addition, the maximum debt to EBITDA ratio is limited to 15x.
COMPARISON OF THE YEARS ENDED DECEMBER 31, 2009 AND 2008
The following table summarizes the components of our net loss for the years ended December 31, 2009 and 2008:
TOTAL REVENUE
During 2009, our total revenue was $99.8 million, which represents a $35.5 million, or 26.2%, decrease from 2008. This decline was composed primarily of: a $20.5 million, or 18.9%, decrease in interest income; a $13.8 million, or 69.2%, decrease in dividend income; a $0.6 million, or 18.7%, decrease in advisory fees and other income; and a $0.6 million, or 16.9%, decrease in loan fees. The following sections describe the reasons for the variances.
INTEREST INCOME
During 2009, the total yield on our average debt portfolio at fair value was 11.9% compared to 11.8% during 2008. The following table shows the various components of the total yield on our average debt portfolio at fair value for the 2009 and 2008:
During 2009, interest income was $88.3 million, compared to $108.8 million during 2008, which represented a $20.5 million, or 18.9%, decrease. This decrease reflected a $21.1 million decrease resulting from a 223 basis point reduction in average LIBOR, a $21.0 million decrease in interest income resulting from a decline in average loan balances, and a $12.9 million decrease in interest income resulting from an increase in the average daily balance of loans that were on non-accrual status. These decreases were partially offset by a $25.5 million
increase in interest income resulting from a 229 basis point increase in our spread to LIBOR and a $9.0 million increase in interest income resulting from the impact of interest rate floors.
PIK Income
The following table shows the PIK-related activity for 2009 and 2008, at cost:
As of December 31, 2009 and 2008, we were not accruing interest on $4.3 million and $5.4 million, respectively, of the PIK loans shown in the preceding table.
DIVIDEND INCOME
The following table summarizes our dividend activity for 2009 and 2008:
During 2009, our dividend income was $6.1 million, which represented a $13.8 million, or 69.2%, decrease from 2008. During the second quarter of 2008, we stopped accreting dividends on our Broadview investment, because our fair value reflected the full value of this investment. As a result, during 2009, we did not accrete any dividends from our Broadview investment, as compared to the $8.0 million of dividends we accreted for this investment during early 2008. In addition, the sales of our investments in Coastal Sunbelt, LLC, JUPR Holdings, Inc. and LMS INTELLIBOUND, INC. resulted in a $3.4 million reduction in dividend income. We also ceased to accrete dividends on seven investments, which resulted in an additional $2.8 million reduction in dividend income because the fair value of the investment did not support further accretion. We resumed accreting dividends on one investment, which partially offset these decreases by $0.4 million.
LOAN FEES
During 2009, our loan fees decreased $0.6 million, or 16.9%, from 2008 primarily because of decreased loan origination activity.
ADVISORY FEES AND OTHER INCOME
During 2009, we earned $2.5 million of advisory fees and other income, which represented a $0.6 million, or 18.7%, decrease from 2008. This decrease was attributable to a decrease in interest earned on our bank accounts.
TOTAL OPERATING EXPENSES
Total operating expenses include interest, employee compensation, general and administrative expenses and goodwill impairment. During 2009, we incurred $61.6 million of operating expenses, representing a $17.6 million, or 22.2%, decrease from the prior year. This decrease was composed of: a $12.0 million decrease in interest expense; a $3.8 million goodwill impairment charge taken in 2008; a $1.0 million decrease in general and administrative expense; and an $0.8 million decrease in employee compensation expenses. The reasons for these variances are discussed in more detail below.
INTEREST EXPENSE
During 2009, we incurred $23.4 million of interest expense, which represented a $12.0 million, or 33.8%, decrease from 2008. The previously described reduction in average LIBOR from 2.9% in 2008 to 0.7% in 2009 resulted in a $15.5 million decrease in interest expense. In addition, a decrease in average borrowing balances caused interest expense to decrease by $3.1 million. These decreases were partially offset by $5.0 million of additional interest, resulting from a widening of the interest rate spread from 1.8% during 2008 to 2.5% during 2009; and $1.6 million of additional interest, resulting from increases in our amortization of debt costs.
EMPLOYEE COMPENSATION
During 2009, our employee compensation expense was $22.6 million, which represented an $0.8 million, or 3.4%, decrease from 2008. Salaries and benefits decreased by $1.7 million, or 10.1%, primarily as a result of a 27% reduction in force in August 2008, eleven subsequent voluntary terminations and base compensation freezes for essentially all personnel in 2009. Partially offsetting this reduction in salaries and benefits was a $1.5 million increase in compensation accrued for our 2008 Retention Program and the LTIP.
During 2009, we recognized $7.7 million of compensation expense related to restricted stock awards, compared to $6.8 million for 2008, which represented a $0.9 million, or 12.7%, increase, primarily attributable to the amortization of restricted stock awarded to employees in September 2008 as part of the 2008 Retention Program and the amortization of stock as part of our LTIP. Awards under the LTIP are contingent upon the closing price of MCG’s stock meeting certain price thresholds and the approval of the compensation committee of our board of directors. We achieved two of these price thresholds in October 2009, resulting in the issuance of 432,500 shares of restricted common stock to LTIP participants.
GENERAL AND ADMINISTRATIVE
During 2009, general and administrative expense was $15.6 million, which represented a $1.0 million, or 6.0%, decrease from 2008. This decrease was attributable primarily to: $1.3 million of corporate restructuring charges recognized during the third and fourth quarters of 2008; $0.7 million of fees paid in 2008 for borrowing facility transactions that were not consummated; $1.0 million for reductions in the costs of professional services and director fees; $0.5 million for reduction in employee recruitment costs; $0.3 million of occupancy costs, reflecting the closure and downsizing of certain facilities in 2008; $0.2 million of reduced travel expenses; $0.8 million of lower other general and administrative costs. These decreases were partially offset by $1.7 million of expense associated with our settlement of matters pertaining to the contested election of directors to our board of directors at our 2009 Annual Meeting, a $1.2 million increase in insurance expense and $0.9 million of severance costs related to an executive’s departure.
GOODWILL IMPAIRMENT
In 2008, we conducted an impairment test for goodwill, because the market capitalization for our stock was significantly below NAV for a significant portion of 2008. Our review included evaluations of discounted cash flows, multiples of EBITDA and revenues, and other analyses. Based on that review, we concluded that goodwill was impaired; therefore, we wrote off our $3.8 million balance of goodwill during the fourth quarter of 2008. This write-off is reflected on our 2008 Consolidated Statements of Operations as “Goodwill impairment.”
NET OPERATING INCOME BEFORE NET INVESTMENT LOSS, GAIN ON EXTINGUISHMENT OF DEBT AND INCOME TAX (BENEFIT) PROVISION
Net operating income before investment loss, gain on extinguishment of debt and income tax (benefit) provision for the year ended December 31, 2009 totaled $38.2 million, compared with $56.1 million for the year ended December 31, 2008. This decrease is due to the items discussed above.
DISTRIBUTABLE NET OPERATING INCOME
During 2009, DNOI was $45.9 million, or $0.61 per share, compared to $66.9 million, or $0.93 per share, for 2008. The following table reconciles our reported net operating income before net investment loss, gain on extinguishment of debt and income tax (benefit) provision to DNOI for 2009 and 2008:
NET INVESTMENT LOSS BEFORE GAIN ON EXTINGUISHMENT OF DEBT AND INCOME TAX (BENEFIT) PROVISION
The following table summarizes our realized and unrealized (loss) and gain on investments and changes in our unrealized appreciation and depreciation on investments for the year ended December 31, 2009:
During 2009, we wrote-off our investment in Cleartel Communications, Inc., which resulted in the realization of a $150.2 million loss and the reversal $150.1 million of unrealized depreciation that we had recorded in previous years. In addition, we sold our investments in TNR Holdings, Inc.; CEI Holdings, Inc.; Flexsol Packaging Corp.; XFone, Inc.; and Marietta Intermediate Holding Corporation, as well as our equity investments in CWP/RMK Acquisition Corp., and LMS INTELLIBOUND, INC. For each of these sales, we reversed unrealized appreciation (depreciation), that we had recognized in previous years and we recorded a realized gain or (loss). These changes and the remaining unrealized depreciation shown in the above table resulted predominantly from decreases in the performance of certain of the portfolio companies, and, to a lesser extent, decreases in the comparable multiples that we used to estimate the fair value of the investments.
The following table summarizes our realized and unrealized (loss) gain on investments and changes in our unrealized appreciation and depreciation on investments during 2008:
As shown in the above table, we recorded $58.2 million of unrealized depreciation on Broadview during 2008, primarily because of a reduction in the multiples used in the estimate of the fair value of Broadview. We also took a $40.4 million unrealized loss on Jet Plastica during 2008. In addition to the reduction in multiples, this loss on Jet Plastica was primarily a result of underperformance related to substantial increases in Jet Plastica’s raw
materials cost, which was caused by significant increases in oil prices early in 2008. We recorded a $34.7 million unrealized loss on Cleartel, which wrote down the fair value of our investment in Cleartel to zero. The remaining net unrealized depreciation changes predominantly resulted from a reduction in the market-based multiples used to estimate the fair value of the investments and market pricing used to estimate the fair value of our investments and the performance of certain portfolio companies which reflected a general decline in the U.S. economy.
In September 2008, we also sold substantially all the assets of Working Mother Media, Inc., for net proceeds of $4.0 million, which resulted in a $5.6 million loss in addition to a reversal of our previously recorded $15.4 million unrealized loss on this investment. We also sold our investments in Wiesner Publishing Company, LLC and JUPR Holdings, Inc. for approximately the recorded fair value of these investments as of June 30, 2008.
GAIN ON EXTINGUISHMENT OF DEBT
In January 2009, we repurchased $7.5 million of collateralized loan obligations for $2.1 million that previously had been issued by our wholly owned subsidiary, Commercial Loan Trust 2006-1. As a result of this purchase, we recognized a $5.4 million gain on extinguishment of debt during 2009. Partially offsetting this gain was $0.4 million of premiums we incurred when we repurchased $18.5 million of our Private Placement Notes.
In December 2008, we repurchased $15.1 million of collateralized loan obligations for $4.0 million that had previously been issued by our wholly owned subsidiary, Commercial Loan Trust 2006-1. As a result of this purchase, we recognized an $11.1 million gain on extinguishment of debt during December 2008.
INCOME TAX (BENEFIT) PROVISION
During 2009, we recorded a $0.1 million income tax benefit compared to a $0.8 million income tax provision during 2008. Our income taxes primarily relate to unrealized gains and losses on our investments and the performance of certain of our investments that are held in taxable subsidiaries.
NET LOSS
During 2009, we incurred a $51.1 million net loss compared to a $191.2 million net loss during 2008. This decrease in net loss is attributable to the items discussed above.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
CASH AND CASH EQUIVALENTS, CASH, SECURITIZATION ACCOUNTS, AND CASH, RESTRICTED
Our Consolidated Balance Sheets and our Consolidated Statements of Cash Flows reflect three categories of cash: cash and cash equivalents; cash, securitization accounts; and cash, restricted. Each of these categories is described more fully below:
•
Cash and cash equivalents represents unrestricted cash, including checking accounts, interest bearing deposits collateralized by marketable debt securities and highly liquid investments with original maturities of 90 days or less. As of December 31, 2010 and 2009, we had $45.0 million and $54.2 million, respectively, in cash and cash equivalents. As of December 31, 2010, $23.2 million of this cash and cash equivalents was held in secure interest-bearing accounts.
•
Cash, securitization accounts include principal and interest payments received on securitized loans, which in certain cases, are held in designated bank accounts until monthly or quarterly disbursements are made from the securitization trusts. In certain cases, we are required to use a portion of these amounts to pay interest expense, reduce borrowings or pay other amounts in accordance with the related securitization agreements. In other cases, we are permitted to use these amounts to acquire new loans into the securitization trusts. Cash in securitization accounts has a negative impact on our earnings since the interest we pay on borrowings typically exceeds the rate of return that we are able to earn on temporary cash investments. Our objective is to maintain sufficient cash-on-hand and availability under our debt facilities to cover current funding requirements and operational needs. As of December 31, 2010 and 2009, we had $42.2 million and $109.1 million, respectively, in cash, securitization accounts. During 2011, we expect any balance in our cash, securitization accounts to decrease as we originate new loans.
•
Cash, restricted includes cash held for regulatory purposes and cash that we have received that was earmarked for transfer into our cash securitization accounts. The largest component of restricted cash was
represented by cash held by Solutions Capital I, L.P., our SBIC, which generally is restricted to the origination of new loans from our SBIC. As of December 31, 2010 and 2009, we had $29.4 million and $21.2 million respectively, of restricted cash.
During the year ended December 31, 2010, our operating activities used $35.8 million of cash and cash equivalents, compared to $179.2 million provided during the year ended December 31, 2009. The $215.0 million decrease in cash provided by operating activities results primarily from the resumption of investment origination activities in 2010. During 2010, our financing activities provided $26.6 million of cash, compared to $171.2 million used during 2009. This $197.7 million decrease in cash used by financing activities was due primarily to a $149.4 million net decrease in cash held in securitization and restricted cash accounts and an $81.0 million increase in proceeds from borrowings partially offset by a $15.2 million increase in payments on our borrowings and an $17.6 million increase in payments of dividends.
Although there can be no assurance, we believe we have sufficient liquidity to meet our operating requirements for 2011, as well as liquidity for new origination opportunities and potential dividend distributions.
LIQUIDITY AND CAPITAL RESOURCES
During 2009 and continuing into 2010, we began to implement a strategic plan designed to establish a foundation for us to reposition our company in future years to close the gap between share price and net asset value, or NAV, and to enhance stockholder value. Initially, in late 2009 and early 2010, we focused our strategic plan on preserving capital, monetizing lower-yielding investments and deleveraging our balance sheet.
As we move into 2011, we expect to continue to monetize our equity investments to no more than 10% to 20% of the fair value of our portfolio over the next few years. We also expect to continue to originate higher-yield investments in portfolio companies that meet our risk and underwriting standards. Future distributions will take into account the minimum statutorily required level of distributions, gains and losses recognized for tax purposes, portfolio transactional events, our liquidity, cash earnings and our asset coverage ratio at the time of such decision.
We believe that we can increase stockholder value by converting lower-yielding equity investments and deploying cash in securitization and restricted accounts into yield-oriented new investment opportunities. As we execute this plan over the next several years, we also plan to improve the returns on our debt and equity portfolio by improving the operating performance or by multiple expansion of our investments. In addition, we expect to continue to monetize lower-yielding equity investments and redeploy that capital and cash held in securitization and restricted accounts into debt securities with interest yields that are expected to increase our operating income and support the future growth of distributions to our stockholders.
We generally expect to limit our future investing activities principally to debt investments until such time that we have further narrowed the valuation gap between our stock price and our NAV and can validate the performance returns of our existing equity portfolio. We do not intend to make significant investments in control companies beyond those that are currently in our portfolio for the foreseeable future. When making new investments, we expect to underwrite credit in a manner consistent with our expectation that macro-economic conditions will be under pressure for an extended period of time. Over time, if we meet our goals with respect to leverage levels and unrestricted cash balances, we potentially may, depending on stock price and debt pricing levels, seek to repurchase our equity and additional debt securities, including our collateralized loan obligations, subject to the limitations set forth in our private placement borrowing agreements. To help provide sustainable stockholder value, we expect to make future distributions to stockholders based upon a quarterly assessment of the minimum statutorily required level of distributions, gains and losses recognized for tax purposes, portfolio transactional events, our liquidity, cash earnings and our asset coverage ratio at the time of such decision.
LIQUIDITY AND CAPITAL RESOURCES-BORROWINGS
As of December 31, 2010, we reported $546.9 million of borrowings on our Consolidated Balance Sheet at cost. We estimate that the fair value of these borrowings as of December 31, 2010 was approximately $516.2 million, based on market data and current interest rates. The following table summarizes our borrowing facilities and the potential borrowing capacity of those facilities and contingent borrowing eligibility of Solutions Capital I, L.P., a wholly owned subsidiary, as an SBIC, under the Small Business Investment Act of 1958, as amended, or SBIC Act.
(a) In January 2011, the lender renewed this facility through January 2013. In conjunction with this renewal, the legal final maturity date became January 2014.
(b) Amount outstanding excludes $5.0 million of notes that we repurchased in December 2008 for $1.6 million and $8.0 million of notes that we repurchased in April 2010 for $4.4 million. The notes that MCG, the parent company, purchased are eliminated from this schedule as part of the consolidation process.
(c) Amount outstanding excludes $10.1 million of notes that we repurchased in December 2008 for $2.4 million and $7.5 million of notes that we repurchased in January 2009 for $2.1 million. The notes that MCG, the parent company, purchased are eliminated from this schedule as part of the consolidation process.
(d)
As of December 31, 2010, we had the potential to borrow up to $130.0 million of SBA-guaranteed debentures under the SBIC program. The SBA has approved and committed up to $130.0 million in borrowings to the SBIC. To realize the full $130.0 million borrowing potential approved and committed by the SBIC under this program, we would have had to fund a total of $65.0 million to the SBIC, of which we had funded $49.6 million as of December 31, 2010. Based on our funded capital as of December 31, 2010, Solutions Capital I, L.P., subject to the SBA’s approval, could have borrowed up to an additional $6.0 million to originate investments. The SBA committed an additional $20.0 million in borrowings in January 2011, which increased the SBA’s total commitment to $150.0 million. To access the entire $150.0 million that has been approved and committed by the SBA, we would have to fund an additional $25.4 million.
(e)
As of December 2010, we could originate new borrowings, under the $130.0 million commitment made by the SBA, through September 2012. We must repay borrowings under the SBIC program within ten years after the borrowing date, which will occur between September 2018 and September 2022. The SBA committed an additional $20.0 million in borrowings in January 2011, which we may use to originate loans. We must repay borrowings we make from this incremental $20.0 million commitment within ten years after the borrowing date, which will occur between January 2021 and September 2025.
Each of our credit facilities has certain collateral requirements and/or financial covenants. The net worth covenant of our SunTrust Warehouse requires that we maintain a consolidated tangible net worth of not less than $500.0 million, plus 50% of any equity raised after February 26, 2009. Under these covenants, we must also maintain an asset coverage ratio of at least 180%.
As of December 31, 2010, our asset coverage ratio was 231% and we had $6.0 million of unused, currently available borrowing capacity remaining in our SBIC subsidiary (subject to the SBA’s approval) that is exempt from the asset coverage ratio requirements.
As of December 31, 2010, we were in compliance with all key financial covenants under each of our borrowing facilities, although there can be no assurance regarding compliance in future periods. On our website, we have provided a list of hyperlinks to each of our borrowing agreements where these covenant requirements can be reviewed. You may view this list at http://www.mcgcapital.com/. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K.
Our access to current and future liquidity from our borrowing facilities depends on several factors, including, but not limited to: the credit quality of our investment portfolio, including those investments used to collateralize borrowing facilities; the magnitude of our investments in individual companies and the industries in which they
operate; our compliance with specific covenants in each borrowing agreement; and the specific provisions of our borrowing facilities.
Certain of our borrowing facilities contain provisions that require that we apply a portion of the proceeds we receive from monetizations to pay down a portion of the outstanding balances. In addition, as each of our borrowing facilities mature, it is important that we have sufficient liquidity available to repay our borrowing obligations. We may obtain the liquidity for repayment of our borrowing facilities from a number of sources, including cash on-hand, the maturity or monetization of our investment portfolio, other borrowing facilities and equity issuances, and from other borrowing arrangements.
We fund all of our current debt facilities, except our Private Placement Notes, through our bankruptcy remote, special-purpose, wholly owned subsidiaries. Therefore, these subsidiaries’ assets may not be available to our creditors. In some cases, advances under our debt facilities are subject to certain collateral levels, collateral quality, leverage and other restrictive covenants. We continue to service those portfolio investments that we use as collateral in our secured borrowing facilities.
PRIVATE PLACEMENT NOTES
As of December 31, 2010, we had two series of fixed-term, unsecuritized notes with a total outstanding balance of $26.2 million. Under the terms of the most recent amended agreements for these notes, we are required to offer to repurchase the Private Placement Notes with a portion of certain monetization proceeds at a purchase price of 102% of the principal amount to be purchased. We are required to offer to repurchase the Private Placement Notes with 45% of the cash net proceeds of any sale of unencumbered assets to reduce amounts outstanding under the Private Placement Notes as, and when, such sales occur in the event of proceeds of $5.0 million or more or otherwise on a semi-annual basis, unless an event of default under one of the financing subsidiary debt facilities has occurred and is continuing, in which case the percentage of net proceeds increases to 60%. As the Private Placement Notes mature, we expect to repay these notes with the proceeds from monetizations of our unencumbered investments and unrestricted cash and cash equivalents.
COMMERCIAL LOAN FUNDING TRUST
As of December 31, 2010, we had a $100.3 million balance outstanding under the MCG Commercial Loan Funding Trust, or SunTrust Warehouse, an asset-backed commercial paper conduit administered by SunTrust Robinson Humphrey, Inc. Structured to operate like a revolving credit facility, the SunTrust Warehouse is secured primarily by MCG Commercial Loan Funding Trust’s assets, including commercial loans that MCG Capital Corporation, the parent, sold to the trust. The SunTrust Warehouse is funded by third parties through the commercial paper market with SunTrust Bank providing a liquidity backstop, subject to SunTrust Bank’s annual liquidity commitment. The pool of commercial loans in the trust must meet certain requirements, such as term, average life, investment rating, agency rating and industry diversity requirements. We must also meet certain requirements related to portfolio performance, including required minimum portfolio yield and limitations on delinquencies and charge-offs.
In January 2011, SunTrust Bank renewed this liquidity facility through January 2013. The legal final maturity date of the SunTrust Warehouse is January 2014 and the scheduled termination date is January 2013. If a new agreement or extension is not executed by January 2013, the SunTrust Warehouse enters a 12-month amortization period during which principal under the facility is paid down through orderly monetizations of portfolio company assets that are financed in the facility. Prior to the commencement of any amortization period, net proceeds from monetizations of collateral financed in the SunTrust Warehouse must be reinvested in additional collateral or used to repay the outstanding borrowings. Under the terms of the renewal, investments in new collateral are limited to senior secured loans.
Under the SunTrust Warehouse, we are required to comply with various covenants, reporting requirements and other customary requirements for similar revolving credit facilities, including, without limitation, covenants related to: (a) limitations on the incurrence of additional indebtedness and liens, (b) limitations on certain investments, (c) limitations on certain restricted payments, (d) maintaining a certain minimum stockholders’ equity, (e) maintaining a ratio of total assets (less total liabilities and indebtedness not represented by senior securities) to total indebtedness represented by senior securities, of the Company and its subsidiaries, of not less than 1.8:1.0, and (f) maintaining minimum liquidity.
In addition to the asset coverage ratio described above, borrowings under the SunTrust Warehouse will be subject to compliance with a borrowing base that will apply different advance rates to different types of assets in MCG Commercial Loan Funding Trust’s portfolio.
The following table sets forth the maturity of the SunTrust Warehouse, as well as the maturity of the securitized assets and the December 31, 2010 balance of securitized cash in this borrowing facility.
COMMERCIAL LOAN TRUST 2006-1
As of December 31, 2010, we had $311.9 million of securitized debt outstanding under the Commercial Loan Trust 2006-1, which matures in April 2018. We retain all of the equity in the securitization. The pool of commercial loans in the trust must meet certain requirements, such as asset mix and concentration, collateral coverage, term, agency rating, minimum coupon, minimum spread and sector diversity requirements. The securitization includes a five-year reinvestment period ending in July 2011, unless we terminate this facility earlier, during which the trust may use principal collections received on the underlying collateral to purchase new collateral from us. We have the ability to borrow up to an additional $50.0 million under our Series 2006-1 Class A-2 Notes.
The following table sets forth the maturity of this facility, as well as the maturity of the securitized assets and the current balance of securitized cash in this borrowing facility.
We may use the $35.7 million balance of cash in the securitized account, as well as proceeds from principal collections of securitized investments, to originate new loans until July 2011. At that time, we must apply the balance of unused cash in the securitized account to the outstanding balance of the Commercial Loan Trust 2006-1. In addition, we must apply principal collections from the securitized investments for this facility to repay the outstanding balance of the facility. Thus, we will likely repay this facility well before its maturity as the investments used to collateralize this facility mature and are monetized.
SBIC DEBENTURES
In December 2004, we formed a wholly owned subsidiary, Solutions Capital I, L.P. Solutions Capital I, L.P. has a license from the SBA to operate as an SBIC under the SBIC Act. As of December 31, 2010, the license gave Solutions Capital I, L.P. the potential to borrow up to $130.0 million. Subsequently, in January 2011, the SBA increased the borrowing potential under the license to $150.0 million, which is the maximum amount of outstanding leverage available to single-license SBIC companies. The maximum amount of outstanding leverage available to SBIC companies with multiple licenses is $225.0 million on an aggregate basis.
In total, the SBA has approved and committed $150.0 million in borrowings to the SBIC, subject to certain capital requirements and customary procedures. We may use these funds to provide debt and equity capital to qualifying small businesses. We may use the borrowings from the SBA to fund new originations; however, we may not use these borrowings to originate debt to certain companies that are currently in our portfolio without SBA approval. In addition, we may not use these funds for MCG’s, the parent company’s, working capital.
To realize the full $150.0 million potential borrowing for which we have received approval under this program, we must fund a total of $75.0 million to the SBIC, of which we have funded $49.6 million as of December 31, 2010. Based on our current funded capital as of December 31, 2010, Solutions Capital I, L.P. may, subject to the SBA’s approval, borrow up to an additional $6.0 million to originate new investments. To access the entire $150.0 million that the SBA has approved and committed, we would have to fund an additional $25.4 million in addition to the $49.6 million that we had funded through December 31, 2010.
The following table sets forth the maturity of the SBIC debentures, as well as the maturity of the assets and the current balance of securitized cash in this borrowing facility as of December 31, 2010.
(a) Equity investments do not have a stated maturity date.
As shown in the above table, the collateral in this facility exceeds the outstanding balance.
WEIGHTED-AVERAGE BORROWINGS AND COST OF FUNDS
The following table shows our weighted-average borrowings, the weighted-average interest rate on all of our borrowings, including amortization of deferred debt issuance costs and commitment fees, the average LIBOR, and the average spread to LIBOR for 2010 and 2009:
The 3.2% weighted-average cost of funds for 2010 was 72 basis points less than the same period in 2009. This decrease resulted from a 34 basis point decrease in average LIBOR, a 21 basis point decrease in the average spread to LIBOR and a 17 basis point decrease in the impact of amortization of deferred debt issuance costs.
LIQUIDITY AND CAPITAL RESOURCES-COMMON STOCK
We are a closed-end investment company that has elected to be regulated as a BDC under the 1940 Act. The 1940 Act prohibits us from selling shares of our common stock at a price below the current NAV of such stock unless our stockholders approve such a sale and our board of directors makes certain determinations.
OFF-BALANCE SHEET ARRANGEMENTS
FINANCIAL INSTRUMENTS
We are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our customers. These instruments include commitments to extend credit and involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. We attempt to limit our credit risk by conducting extensive due diligence and obtaining collateral where appropriate.
Commitments to extend credit include the unused portions of commitments that obligate us to extend credit in the form of loans, participations in loans, guarantees, letters of credit and other financial commitments. Commitments to extend credit would also include loan proceeds we are obligated to advance, such as loan draws, rotating or revolving credit arrangements, or similar transactions. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the counterparty. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
We do not report the unused portions of these commitments on our Consolidated Balance Sheets. As of December 31, 2010, we had $32.3 million of outstanding unused loan commitments, as shown in the table below. We believe that our operations, monetizations and unrestricted cash will provide sufficient liquidity to fund, as necessary, requests to draw on these unfunded commitments. We estimate that the fair value of these commitments was $0.2 million based on the fees that we currently charge to enter into similar arrangements,
taking into account the creditworthiness of the counterparties. From time to time, we provide guarantees or standby letters of credit on behalf of our portfolio companies. As of December 31, 2010, we had no outstanding guarantees or standby letters of credit.
CONTRACTUAL OBLIGATIONS
The following table shows our contractual obligations as of December 31, 2010:
(a) Excludes the unused commitments to extend credit to our customers of $32.3 million as discussed above.
(b) Borrowings under the MCG Commercial Loan Funding Trust Facility are listed based on the contractual maturity due to the revolving nature of the facility.
(c) Interest payments are based on legal maturity and the current outstanding principal balance of our borrowings and assume no changes in interest rate benchmarks.
In addition to our borrowings and lease obligations, we have entered into two interest rate swap agreements to manage our interest rate exposure related to our financing facilities. As of December 31, 2010, the swap agreements had a total notional amount of $21.2 million. Under the interest rate swap agreements, we will pay a fixed interest rate and receive a floating rate based on the prevailing three-month LIBOR. Our obligations under these swap agreements would be limited to the difference between these fixed and floating rates accrued on the notional amount. As of December 31, 2010 the fair value of these interest rate swaps was $0.3 million, and was included in our liabilities on our Consolidated Balance Sheets.
DISTRIBUTIONS
As a BDC that has elected to be treated as a RIC, we generally must distribute at least 90% of our investment company taxable income and 90% of any ordinary pre-RIC built-in gains that we recognize in order to deduct distributions made (or deemed made) to our stockholders. In addition, for calendar years ended December 31, 2010 and earlier, we were subject to a 4% excise tax to the extent that we did not distribute (actually or on a deemed basis): 98% of our ordinary income for each calendar year; 98% of our capital gain net income for each calendar year; and any income realized, but not distributed, in prior calendar years. Beginning in 2011, we will be subject to the 4% excise tax to the extent that we do not distribute (actually or on a deemed basis): 98% of our ordinary income for each calendar year; 98.2% of our capital gain net income for each calendar year; and any income realized but not distributed in prior calendar years.
We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions. In addition, we may be limited in our ability to make distributions due to the BDC asset coverage test for borrowings applicable to us as a BDC under the 1940 Act and due to provisions in our credit facilities. If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including possible loss of favorable RIC tax treatment. We cannot assure stockholders that they will receive any distributions or distributions at a particular level. We may make distributions to our stockholders of certain net capital gains. Since December 2001, we have declared distributions of $12.15 per share.
The following table summarizes the distributions that we declared for 2010:
As of the end of each fiscal year, we make the determinations of the tax attributes of our distributions, including determinations of return of capital, based upon our taxable income and distributions paid for the full year, which we report to each stockholder on a Form 1099. Based on the tax attributes of the distributions that we declared for 2010, 100% of these distributions were made from ordinary income. Future distributions will take into account the requirements for us to distribute the majority of our taxable income to fulfill our distribution requirements as a RIC, together with an assessment of our current and forecasted gains and losses recognized or to be recognized for tax purposes, portfolio transactional events, liquidity, cash earnings and our asset coverage ratio at the time of such decision.
Each year, we mail statements on Form 1099-DIV to our stockholders, which identify the source of the distribution, such as paid from ordinary income, paid from net capital gains on the sale of securities and/or a return of paid-in-capital surplus, which is a nontaxable distribution. To the extent our taxable earnings fall below the total amount of our distributions for that fiscal year, a portion of those distributions may be deemed a return of capital to our stockholders for tax purposes. A portion of the distributions that we paid to stockholders during fiscal years 2008, 2006, 2005, 2004 and 2003 represented a return of capital. During the fiscal year 2009, we did not declare or pay any dividends to stockholders. For the tax year ended December 31, 2008, we elected to distribute such net long-term capital gains to our stockholders by designating a portion of our dividends as distributions of our net long-term capital gains. During 2010, we declared and paid distributions from ordinary income that were sufficient to meet our distribution requirements as a RIC. We will monitor 2011 taxable income in order to ensure compliance with the distribution requirements as a RIC. We determine the tax attributes of our distributions as of the end of our fiscal year based upon our taxable income for the full year and distributions paid during the full year. Therefore, a determination of tax attributes made on a quarterly basis may not be representative of the actual tax attributes of distributions for a full year.
For tax years ended on or before December 31, 2010, we were able to carryforward net capital losses that we may have incurred for a period of eight years. In December 2010, Congress enacted the Regulated Investment Company Modernization Act of 2010, which, in part, will allow us to indefinitely carryover net capital losses that we may incur after 2010. For the tax years ended December 31, 2010 and 2009, we had net capital losses of $4.9 million and $54.2 million, respectively, which we will carry forward to offset future net capital gains to the extent provided by federal tax law. The net capital loss carryforward from 2010 will expire in the tax year ending December 31, 2018 and the net capital loss carryforward from 2009 will expire in the tax year ending December 31, 2017.
The following table reconciles GAAP net income (loss) to taxable net income (loss) for 2010 and 2009:
CRITICAL ACCOUNTING POLICIES
The consolidated financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions. We believe that the following are some of the more critical judgment areas in the application of our accounting policies that currently affect our financial condition and results of operations.
INCOME RECOGNITION
We follow the policies described below to recognize income on our Consolidated Statement of Operations:
•
Interest Income-We accrue interest income if we expect that ultimately we will be able to collect it. Generally, when a loan becomes more than 90 days past due, or if we otherwise believe the customer is unable to service its debt and other obligations, we will as a general matter place the loan on non-accrual status and will cease recognizing interest income on that loan until all principal and interest is current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, we remain contractually entitled to this interest. We may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection.
PIK represents contractually deferred interest that typically is added to the loan balance. Generally, PIK interest is due at the end of the loan term. We generally accrue PIK interest when collection is expected and cease accruing PIK if there is insufficient value to support the accrual or we expect the customer is unable to pay all principal and interest due.
•
Dividend Income-We accrue dividend income on equity investments with stated income, if we expect to collect the dividends. We record dividend income on common equity investments, and gains from realized distributions, when the dividend has been declared and is required to be paid.
•
Loan Origination Fees-We capitalize loan origination fees, then amortize these fees into interest income over the term of the loan using the effective interest rate method. In certain loan arrangements, we receive warrants or other equity interests from the borrower as additional origination fees. Typically, borrowers granting these interests are not traded publicly. We record the financial instruments received at fair value as determined in good faith by our board of directors. In certain cases, when we record a warrant or other equity instrument that results in a loan discount, we accrete the discount into income over the term of the loan.
•
Advisory Fees and Other Income-We charge our portfolio companies fees for services that we provide, including advisory and management services, equity structuring, prepayments, research and other fees. These fees are based on market rates, which are documented in an agreement between MCG and the respective portfolio companies. We recognize advisory and management services fees when earned. We also recognize equity structuring fees as earned, which generally occurs when the investment transaction closes. We recognize prepayment fees upon receipt. Finally, certain of the bank accounts in which we maintain cash balances pay interest, which we recognize when the interest is earned.
VALUATION OF INVESTMENTS
FAIR VALUE MEASUREMENTS AND DISCLOSURES
We account for our investments at fair value in accordance with Accounting Standard Codification Topic 820-Fair Value Measurements and Disclosures, or ASC 820. ASC 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about assets and liabilities measured at fair value. ASC 820 defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This fair value definition focuses on exit price in the principal, or most advantageous, market and prioritizes, within a measurement of fair value, the use of market-based inputs over entity-specific inputs.
ASC 820 establishes the following three-level hierarchy, based upon the transparency of inputs to the fair value measurement of an asset or liability as of the measurement date:
ASC 820
Fair Value
Hierarchy
Inputs to Fair Value Methodology
Level 1
Quoted prices in active markets for identical assets or liabilities
Level 2
Quoted prices for similar assets or liabilities; quoted markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the financial instrument; inputs other than quoted prices that are observable for the asset or liability; or inputs that are derived principally from, or corroborated by, observable market information
Level 3
Pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption is unobservable or when the estimation of fair value requires significant management judgment
We categorize a financial instrument in the fair value hierarchy based on the lowest level of input that is significant to its fair value measurement. In the event that such transfers were to occur in the future, we would recognize those transfers as of the ending balance sheet date, based on changes in the use of observable and unobservable inputs utilized to perform the valuation for the period.
DETERMINATION OF FAIR VALUE IN GOOD FAITH
As a BDC, we invest primarily in illiquid securities, including debt and equity securities of private companies. To protect our investments and maximize our returns, we negotiate the structure of each debt and equity security in our investment portfolio. Our contracts with those portfolio companies generally include many terms governing interest rate, repayment terms, prepayment penalties, financial covenants, operating covenants, ownership and corporate governance parameters, dilution parameters, liquidation preferences, voting rights, and put or call rights. In some cases, our loan agreements also allow for increases in the spread to the base index rate, if the portfolio company’s financial or operational performance deteriorates or shows negative variances from its business plan and, in some cases, allow for decreases in the spread if financial or operational performance improves or exceeds the portfolio company’s plan. Generally, our investments are subject to some restrictions on resale and have no established trading market. Because of the type of investments that we make and the nature of our business, our valuation processes require analyses of numerous market, industry and company-specific factors, including the performance of the underlying investment, the financial condition of the portfolio company, changing market events and other factors relevant to the individual security.
There is no single approach for determining fair value in good faith. Unlike banks, we are not permitted to provide a general reserve for anticipated loan losses. As a result, for portfolio investments that do not have an active market, we must apply judgment to the specific facts and circumstances associated with each security to determine fair value.
We use several valuation methodologies to estimate the fair value of our investment portfolio, which generally results in a range of fair values from which we derive a single estimate of the portfolio company’s fair value. To determine a portfolio company’s fair value, we analyze its historical and projected financial results, as well as key market value factors. In determining a security’s fair value, we assume we would exchange it in an orderly transaction at the measurement date. We use the following methods to determine the fair value of investments in our portfolio that are not traded actively:
•
Majority-Owned Control Investments-Majority-owned control investments comprise 30.4% of our investment portfolio. Market quotations are not readily available for these investments; therefore, we use a combination of market and income approaches to determine their fair value. Typically, private companies are bought and sold based on multiples of EBITDA, cash flows, net income, revenues or, in limited cases, book value. Generally, we apply multiples that we observe for other comparable companies to relevant financial data for the portfolio company. Also, in a limited number of cases, we use income approaches to determine the fair value of these securities, based on our projections of the discounted future free cash flows that the portfolio company will likely generate, as well as industry derived capital costs. Our valuation approaches for majority-owned investments estimate the value were we to sell or exit the investment. These valuation approaches assume the highest and best use of the investment by market participants and consider the value of our ability to control the portfolio company’s capital structure and the timing of a potential exit.
•
Non-Majority-Owned Control Investments-Non-majority owned investments comprise 0.3% of our investment portfolio. For our non-majority owned equity investments, we use the same market and income valuation approaches used to value our majority-owned control investments. For non-majority-owned control debt investments, we estimate fair value using the market yield approach based on the expected future cash flows discounted at the loans’ effective interest rates, based on our estimate of current market rates. We may adjust discounted cash flow calculations to reflect other market conditions or the perceived credit risk of the borrower.
•
Non-Control Investments-Non-control investments comprise 69.3% of our investment portfolio. Quoted prices are not available for 81.1% of our non-control investments. For our non-control equity investments, we use the same market and income approaches used to value our control investments. For non-control debt investments, we estimate fair value using a market-yield approach based on the expected future cash flows discounted at the loans’ effective interest rates, based on our estimate of current market rates. We may adjust discounted cash flow calculations to reflect other market conditions or the perceived credit risk of the borrower.
•
Thinly Traded and Over-the-Counter Securities-Generally, we value securities that are traded in the over-the-counter market or on a stock exchange at the average of the prevailing bid and ask prices on the date of the relevant period end. However, we may apply a discount to the market value of restricted or thinly traded public securities to reflect the impact that these restrictions have on the value of these securities. We review factors including the trading volume, total securities outstanding and our percentage ownership of securities to determine whether the trading levels are active (Level 1) or inactive (Level 2). As of December 31, 2010, these securities represented 13.1% of our investment portfolio.
Our valuation analyses incorporate the impact that key events could have on the securities’ values, including public and private mergers and acquisitions, purchase transactions, public offerings, letters of intent and subsequent debt or equity sales. Our valuation analyses also include key external data, such as market changes and industry valuation benchmarks. We also use independent valuation firms to provide additional data points for our quarterly valuation analyses. Our general practice is to obtain an independent valuation or review of valuation at least once per year for each portfolio investment that had a fair value in excess of $5.0 million, unless the fair value has otherwise been derived through a sale of some or all of our investment in the portfolio company or is a new investment made within the last twelve months. As set forth in more detail in the following table, in total, either we obtained a valuation or review from an independent firm, considered new investments made or used market quotes for 99.4% of the fair value of our investment portfolio as of December 31, 2010.
The majority of the valuations performed by the independent valuation firms utilize proprietary models and inputs. We have used, and intend to continue to use, independent valuation firms to provide additional support for our internal analyses. Our board of directors considers our valuations, as well as the independent valuations and reviews, in its determination of the fair value of our investments. The fair value of our interest rate swaps is based on a binding broker quote, which is based on the estimated net present value of the future cash flows using a forward interest rate yield-curve in effect as of the measurement period.
Due to the uncertainty inherent in the valuation process, such fair value estimates 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. In addition, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses that we ultimately realize on these investments to differ from the valuations currently assigned.
BORROWING FACILITIES
As described more fully in Liquidity and Capital Resources-Borrowings, we borrow funds from various lenders through unsecured credit facilities, private placements, warehouse loan facilities and the SBA. In addition, we have bankruptcy remote, special-purchase entities that issued debt collateralized by pools of loans that we transfer to the entity. To date, we have recorded our obligation to repay all of our borrowings at cost on our Consolidated Balance Sheets. In the future, however, as we enter into new borrowing facilities or make significant modifications to existing facilities, we may consider reporting those facilities using the fair value option as allowed under ASC 825-Financial Instruments. Debt issuance costs represent fees and other direct incremental costs incurred in connection with our borrowings. We amortize these costs ratably over the contractual term of the borrowing using the effective interest method and include this amortization in interest expense on our Consolidated Statements of Operations.
Periodically, we transfer pools of loans to bankruptcy-remote, special-purpose entities for use in securitization transactions. We account for loans transferred to our bankruptcy remote, special-purpose entities for use in securitization transactions in accordance with ASC 860-Transfers and Servicing.
From time to time, we may repurchase certain debt instruments issued by one of our bankruptcy-remote special-purpose entities from third parties at a negotiated price that may be different than the principal amount of the debt. In accordance with ASC 470-Debt, we treat these repurchases as if the debt were extinguished and report the difference between the reacquisition price and the net carrying amount of the extinguished debt as a gain on extinguishment of debt on our Consolidated Statements of Operations.
GOODWILL
We account for goodwill in accordance with ASC 350-Intangibles-Goodwill and Other, or ASC 350. Based on the results of our impairment testing in December 2008, we concluded that our goodwill was fully impaired. In accordance with ASC 350, we wrote off this goodwill and reported the $3.9 million impairment on a separate line item titled “Goodwill impairment” on our Consolidated Statement of Operations for 2008. The balance of our goodwill was zero as of December 31, 2010 and 2009.
SHARE-BASED COMPENSATION
We recognize share based compensation in accordance with ASC Topic 718-Compensation-Stock Compensation, or ASC 718. In accordance with ASC 718, we recognize compensation cost related to share-based awards for which forfeiture provisions are expected to lapse over the requisite service period.
INCOME TAXES
We currently qualify as a RIC for federal income tax purposes, which generally allows us to avoid paying corporate income taxes on any income or gains that we distribute to our stockholders. We have distributed and intend to distribute sufficient dividends to eliminate taxable income. In addition, for calendar years ended December 31, 2010 and earlier, we were subject to a 4% excise tax to the extent that we did not distribute (actually or on a deemed basis): 98% of our ordinary income for each calendar year; 98% of our capital gain net income for each calendar year; and any income realized, but not distributed, in prior calendar years. Beginning in 2011, we will be subject to the 4% excise tax to the extent that we do not distribute (actually or on a deemed basis): 98% of our ordinary income for each calendar year; 98.2% of our capital gain net income for each calendar year; and any income realized but not distributed in prior calendar years.
We have certain wholly owned taxable subsidiaries, each of which holds one or more portfolio investments listed on our Consolidated Schedule of Investments. The purpose of these taxable subsidiaries is to permit us to hold portfolio companies organized as LLCs or other forms of pass-through entities and still satisfy the RIC tax requirement that at least 90% of our gross revenue for income tax purposes must consist of investment income. Absent the taxable subsidiaries, a portion of the gross income of any LLC or other pass-through entity portfolio investment would flow through directly to us for the 90% test. To the extent that such income did not consist of investment income, it could jeopardize our ability to qualify as a RIC and, therefore, cause us to incur significant federal income taxes. The income of the LLCs or other pass-through entities owned by taxable subsidiaries is
taxed to the taxable subsidiaries and does not flow through to us, thereby helping us preserve our RIC status and resultant tax advantages. We do not consolidate the taxable subsidiaries for income tax purposes and they may generate income tax expense because of the taxable subsidiaries’ ownership of the portfolio companies. We reflect any such income tax expense on our Consolidated Statement of Operations.
EARNINGS (LOSS) PER SHARE
We determine basic and diluted earnings (loss) per weighted-average common share in accordance with ASC Topic 260-Earnings per Share, or ASC 260. We compute basic earnings (loss) per share by dividing net income (loss) applicable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. We compute diluted earnings (loss) per share by dividing such net income (loss) by the sum of the weighted-average number of shares outstanding for the period and the dilutive impact of restricted stock for which forfeiture provisions have not lapsed. We include unvested share-based awards that contain non-forfeitable rights in the computation of basic and diluted earnings (loss) per share pursuant to the two-class method.
RECENT DEVELOPMENTS
AMENDED WAREHOUSE SALE AND SERVICING AGREEMENT
On January 25, 2011, SunTrust Bank provided the renewal of its liquidity facility that supports our SunTrust Warehouse through January 25, 2013. The new legal final maturity date of the SunTrust Warehouse is January 25, 2014. The SunTrust Warehouse is non-recourse to us; therefore, in the event of a termination event or upon the legal final maturity date, the lenders under the warehouse facility may only look to the collateral to satisfy the outstanding obligations under this facility.
In connection with the renewal of SunTrust Bank’s liquidity facility, we also agreed to a number of modifications to the SunTrust Warehouse terms, including an extension of the scheduled termination date of this facility to January 25, 2013. If a new agreement or extension is not executed by January 25, 2013, the SunTrust Warehouse enters a 12-month amortization period during which principal under the facility is paid down through orderly monetizations of portfolio company assets that are financed in the facility. Additionally, prior to the commencement of any amortization period, net proceeds from monetizations of collateral financed in the SunTrust Warehouse must be reinvested in additional collateral or used to repay outstanding borrowings.
The new interest rate on the SunTrust Warehouse equals the commercial paper rate plus 3.25%, an increase of 0.75% from the rate as of December 31, 2010. Outstanding borrowings on the SunTrust Warehouse were approximately $98.8 million as of January 24, 2011. We paid to SunTrust a facility renewal fee of $1.5 million, or 1.0%.
INCREASE IN SBIC DEBT COMMITMENT
In January 2011, the SBA approved an additional $20.0 million leverage commitment to the SBIC which increased the maximum amount of outstanding leverage available to us under the SBIC program to $150.0 million from $130.0 million as of December 31, 2010. To realize the full $150.0 million borrowing potential approved and committed under this program, we must fund a total of $75.0 million to the SBIC, which would be a $25.4 million increase from the amount we had funded as of December 31, 2010. The additional $20.0 million commitment may be drawn subject to the SBA’s approval and expires in September 2015. We paid a $0.2 million commitment fee related to this commitment.
SECOND SBIC LICENSE APPLICATION
On March 1, 2011, we made a submission to the SBA commencing our application process for a second SBIC license. If approved, our total borrowing capacity under the SBIC program will increase from $150 million to $225 million, subject to SBA approval of a capital commitment for the second SBIC and our funding of required capital.
PORTFOLIO INVESTMENTS
On February 14, 2011, Avenue Broadband LLC and the other stockholders of Avenue Broadband Holdings, Inc., or Holdings, signed a definitive agreement to sell all of the outstanding capital stock of Holdings. We anticipate that we will receive approximately $50.4 million in cash as a result of this transaction resulting from the repayment of our debt investment and distributions on our equity investment. Final closing of the sale transaction is subject
to satisfaction of customary closing conditions, including regulatory approvals, and is expected to occur in March 2011.
RECENT ACCOUNTING PRONOUNCEMENTS
In January 2010, FASB issued Accounting Standard Update No. 2010-06-Improving Disclosures about Fair Value Measurements, or ASU 2010-06. The January 2010 update amends ASC 820 to add new requirements for disclosures about significant transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances and settlements relating to Level 3 measurements. In addition, the update clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. ASU 2010-06 became effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures became effective for interim and annual reporting periods beginning after December 15, 2010. We adopted this standard beginning with our financial statements ending March 31, 2010. Our adoption of this standard did not affect our financial position or results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
During 2010, the United States economy continued to recover from the effects of the recent recession that ended in mid-2009. Leading economic indicators, coupled with recent tax-related legislation enacted by Congress in late 2010, are indicative that the economic recovery may continue into 2011. Although the economy has not yet recovered to pre-recession levels, we are cautiously optimistic of the potential for future economic growth.
In the event of renewed financial turmoil affecting the banking system and financial markets, the financial position and results of operations of certain of the middle-market companies in our portfolio could be affected adversely, which ultimately could lead to difficulty in meeting debt service requirements and an increase in defaults.
Interest rate sensitivity refers to the change in earnings that may result from changes in the level of interest rates. Our net interest income is affected by changes in various interest rates, including LIBOR, prime rates and commercial paper rates. As of December 31, 2010, approximately 75.5% of our loan portfolio, at fair value, bore interest at a spread to LIBOR or prime rate, and 24.5% at a fixed interest rate. As of December 31, 2010, approximately 61.4% of our loan portfolio, at fair value, had LIBOR floors between 1.0% and 3.0% on the LIBOR base index and prime floors between 2.25% and 6.0%. The three-month weighted-average LIBOR interest rate was 0.29% as of December 31, 2010. Thus, the LIBOR floors in these loan investments lessen the impact of such historically low LIBOR rates.
We regularly measure exposure to interest rate risk. We assess interest rate risk and we manage our interest rate exposure on an ongoing basis by comparing our interest rate sensitive assets to our interest rate sensitive liabilities. Based on this review, we determine whether or not any hedging transactions are necessary to mitigate exposure to changes in interest rates. We also enter into derivative transactions in connection with our financing vehicles. During the quarter ended March 31, 2009, in connection with our financing vehicle requirements, we entered into two interest rate swaps, expiring in August 2011, having notional amounts of $8.7 million and $12.5 million at interest rates of 9.0% and 13.0%, respectively. During 2008, we entered into two interest rate swaps, which expired in November 2010, having notional amounts of $16.0 million and $8.0 million at interest rates of 10.0% and 14.0%, respectively, related to the same financing vehicle.
The following table shows a comparison of the interest rate base for our interest-bearing cash, outstanding commercial loans, at cost, and our outstanding borrowings as of December 31, 2010 and December 31, 2009:
Based on our December 31, 2010 balance sheet, the following table shows the impact to net income of hypothetical base rate increases in interest rates, assuming no changes in our investment and borrowing structure. The impact to net income of hypothetical base rate decreases in interest rates is not shown in the following table because as of December 31, 2010, the quarterly average LIBOR was 0.29% and a 100-basis point decrease could not occur:
From February 2009 through December 2009, we maintained our cash in non-interest-bearing accounts, which were fully insured by the FDIC, under the FDIC’s Temporary Liquidity Guarantee Program. The FDIC’s Temporary Liquidity Guarantee Program was originally scheduled to expire on December 31, 2009, but was subsequently extended through June 30, 2010. Nonetheless, beginning in January 2010, a number of banks opted out of this program. Because of the minimal availability of the Temporary Liquidity Guarantee Program beginning in January 2010, combined with some stabilization of the banking industry during the quarter ended March 31, 2010, we redeployed a portion of our unrestricted cash into secure, interest-bearing accounts. Consequently, we deposited a portion of our excess cash into secure interest-bearing accounts during the quarter ended March 31, 2010. As we redeploy additional cash into interest-bearing accounts and we originate new investments, our sensitivity to interest rate fluctuations and our net loss from a hypothetical increase in interest rates should decrease. As of December 31, 2010, we had a total of $116.6 million of unrestricted cash, restricted cash and cash in securitization accounts of which $93.4 million was in non-interest bearing accounts. For each $10.0 million of cash in these non-interest bearing accounts that we redeploy into variable interest rate investments, the net loss from our sensitivity to interest rate fluctuations will decrease by approximately $100,000 for each 100 basis point increase in interest rates.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
MCG Capital Corporation
We have audited MCG Capital Corporation’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). MCG Capital Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, MCG Capital Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of MCG Capital Corporation (the Company), including the consolidated schedule of investments, as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in net assets, and cash flows for each of the three years in the period ended December 31, 2010, and the consolidated financial highlights for each of the five years in the period ended December 31, 2010. Our report dated March 4, 2011 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
March 4, 2011
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
MCG Capital Corporation
We have audited the accompanying consolidated balance sheets of MCG Capital Corporation (the Company), including the consolidated schedule of investments, as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in net assets, and cash flows for each of the three years in the period ended December 31, 2010, and the consolidated financial highlights for each of the five years in the period ended December 31, 2010. These financial statements and financial highlights are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2010, by correspondence with the custodians, or by other appropriate auditing procedures. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the consolidated financial position of MCG Capital Corporation at December 31, 2010 and 2009, the consolidated results of its operations, changes in its net assets, and its cash flows for each of the three years in the period ended December 31, 2010 and its consolidated financial highlights for each of the five years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), MCG Capital Corporation’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 4, 2011 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
March 4,
MCG Capital Corporation
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2010
(dollars in thousands)
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2010
(dollars in thousands)
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2010
(dollars in thousands)
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2010
(dollars in thousands)
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2010
(dollars in thousands)
(a) We include the fair value of these interest rate swaps in other liabilities on our Consolidated Balance Sheets.
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2009
(dollars in thousands)
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2009
(dollars in thousands)
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2009
(dollars in thousands)
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2009
(dollars in thousands)
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
CONSOLIDATED SCHEDULE OF INVESTMENTS
December 31, 2009
(dollars in thousands)
(a) We include the fair value of these interest rate swaps in other liabilities on our Consolidated Balance Sheets.
(1) Some or all of this security is funded through our SBIC subsidiary or one of our other financing subsidiaries and may have been pledged as collateral in connection therewith. See Note 6-Borrowings to the Consolidated Financial Statements.
(2) Includes securities issued by one or more of the portfolio company’s affiliates.
(3) Affiliate investments represent companies in which we own at least 5%, but not more than 25% of the portfolio company’s voting securities.
(4) Control investments represent companies in which we own more than 25% of the portfolio company’s voting securities.
(5) Represents a non-majority-owned control portfolio company of which we own at least 25%, but not more than 50% of the portfolio company’s voting securities.
(6) Portfolio company is non-income producing at period-end.
(7) Loan or debt security is on non-accrual status.
(8) We did not recognize paid-in-kind interest or accretion income because the fair value of our investment was below its cost basis. However, we continue to accrue interest that is receivable in cash from the portfolio company.
(9) Interest rates represent the weighted-average annual stated interest rate on loans and debt securities, presented by nature of indebtedness for a single issuer. The maturity dates represent the earliest and the latest maturity dates. Rates on preferred stock and preferred LLC interests, where applicable, represent the contractual rate.
(10) On April 29, 2008, Home Interiors & Gifts, Inc., or HIG, filed for Chapter 11 bankruptcy protection. In September 2010, we received a $200,000 distribution of the remaining proceeds resulting from the several sales collectively of substantially all of the assets of HIG and settlement of certain issues amongst the various classes of interest holders in HIG.
(11) On February 22, 2009, Philadelphia Newspapers, LLC filed for Chapter 11 bankruptcy protection. On October 8, 2010, substantially all of the assets of Philadelphia Media Holdings, LLC and affiliates, including the operating subsidiaries of Philadelphia Newspapers, LLC, were sold to Philadelphia Media Network, Inc., or PMN, in a transaction approved by the bankruptcy court, and in connection therewith, we were issued shares of common stock of PMN.
(12) On February 24, 2010, we exercised warrants to purchase 100,000 shares of common stock of Jenzabar, Inc. and we submitted the requisite payments for this stock. Our receipt of the common stock certificates from Jenzabar is pending.
(13) In connection with a recapitalization transaction, on December 20, 2010, Metropolitan Telecommunications Holding Company redeemed our warrants for a purchase price of $12.0 million.
(14) On January 25, 2011, Summit Business Media Intermediate Holding Company, LLC filed for Chapter 11 bankruptcy protection.
(15) On January 24, 2011, Maverick Healthcare Equity, LLC subordinated debt was repaid in full.
(16) On January 27, 2011, MCG sold all of its common stock in Sunshine Media Holdings Corporation in exchange for $0.2 million in cash and a warrant to purchase shares of Common Stock of Sunshine Media Group, Inc. In connection with this transaction, Sunshine Media Delaware, LLC is being dissolved.
(17) On February 11, 2011, Interactive Data Corporation senior debt was repaid in full.
(18) On February 14, 2011, Avenue Broadband LLC and the other stockholders of Avenue Broadband Holdings, Inc., or Holdings, signed a definitive agreement to sell all of the outstanding capital stock of Holdings. MCG anticipates that it will receive approximately $50.4 million in cash as a result of this transaction resulting from the repayment of MCG’s debt investment and distributions on its equity investment. Final closing of the sale transaction is subject to satisfaction of customary closing conditions, including regulatory approvals, and is expected to occur in March 2011.
(19) On February 18, 2011, Knology Inc. senior debt was repaid in full.
(20)
On February 18, 2011, The SI Organization, Inc. senior debt was repaid in full.
(21) On February 24, 2011, we agreed to a discounted payoff of Lambeau Telecom Company, LLC’s senior debt for proceeds of approximately the December 31, 2010 fair value of the senior debt.
(22)
On February 28, 2011, Focus Brands Inc. senior debt was repaid in full.
(23) On March 1, 2011, Visant Corporation senior debt was repaid in full.
The accompanying notes are an integral part of these financial statements
MCG Capital Corporation
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1-DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
These Consolidated Financial Statements present the results of operations, financial position and cash flows of MCG Capital Corporation and its consolidated subsidiaries. The terms “we,” “our,” “us” and “MCG” refer to MCG Capital Corporation and its consolidated subsidiaries.
We are a solutions-focused commercial finance company that provides capital and advisory services to middle-market companies throughout the United States. We are an internally managed, non-diversified, closed-end investment company that elected to be regulated as a business development company, or BDC, under the Investment Company Act of 1940, as amended, or the 1940 Act. Our organization includes the following categories of subsidiaries:
Wholly Owned Special-Purpose Financing Subsidiaries-These subsidiaries are bankruptcy remote, special-purpose entities to which we transfer certain loans. Each financing subsidiary, in turn, transfers the loans to a Delaware statutory trust. For accounting purposes, the transfers of the loans to the Delaware statutory trusts are structured as on-balance sheet securitizations.
Small Business Investment Subsidiaries-We own Solutions Capital I, L.P., a wholly owned subsidiary licensed by the United States Small Business Administration, or SBA, which operates as a small business investment company, or SBIC, under the Small Business Investment Act of 1958, as amended, or SBIC Act. In connection with the formation of Solutions Capital I, L.P., MCG also established another wholly owned subsidiary, Solutions Capital G.P., LLC, to act as the general partner of Solutions Capital I, L.P., while MCG is the sole limited partner.
Taxable Subsidiaries-We currently qualify as a regulated investment company, or RIC, for federal income tax purposes and, therefore, are not required to pay corporate income taxes on any income or gains that we distribute to our stockholders. We have certain wholly owned taxable subsidiaries, or Taxable Subsidiaries, each of which holds one or more portfolio investments listed on our Consolidated Schedules of Investments. The purpose of these Taxable Subsidiaries is to permit us to hold portfolio companies organized as limited liability companies, or LLCs, (or other forms of pass-through entities) and still satisfy the RIC tax requirement that at least 90% of our gross revenue for income tax purposes must consist of investment income. Absent the Taxable Subsidiaries, a portion of the gross income of any LLC (or other pass-through entity) portfolio investment would flow through directly to us for the 90% test. To the extent that such income did not consist of investment income, it could jeopardize our ability to qualify as a RIC and, therefore, cause us to incur significant federal income taxes. The income of the LLCs (or other pass-through entities) owned by Taxable Subsidiaries is taxed to the Taxable Subsidiaries and does not flow through to us, thereby helping us preserve our RIC status and resultant tax advantages. We do not consolidate the Taxable Subsidiaries for income tax purposes and they may generate income tax expense because of the Taxable Subsidiaries’ ownership of the portfolio companies. We reflect any such income tax expense on our Consolidated Statements of Operations.
The accompanying financial statements reflect the consolidated accounts of MCG and the following subsidiaries: Solutions Capital I, L.P.; Solutions Capital G.P., LLC; and MCG’s special-purpose financing subsidiaries: MCG Finance V, LLC and MCG Finance VII, LLC.
Basis of Presentation and Use of Estimates
These consolidated financial statements and the accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America and conform to Regulation S-X under the Securities Exchange Act of 1934, as amended. We believe we have made all necessary adjustments so that the consolidated financial statements are presented fairly and that all such adjustments are of a normal recurring nature. We eliminated all significant intercompany balances. In accordance with Article 6 of Regulation S-X of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, we do not consolidate portfolio company investments, including those in which we have a controlling interest. Certain prior period information has been reclassified to conform to current year presentation. Further, in connection with the preparation of these Consolidated Financial Statements, we have evaluated subsequent events that occurred after the balance sheet date of December 31, 2010 through the date these financial statements were issued.
Preparing financial statements requires us to make estimates and assumptions that affect the amounts reported on our Consolidated Financial Statements and accompanying notes. Although we believe the estimates and
assumptions used in preparing these Consolidated Financial Statements and related notes are reasonable, actual results could differ materially.
NOTE 2-SIGNIFICANT ACCOUNTING POLICIES, CERTAIN RISKS AND UNCERTAINTIES AND NEW ACCOUNTING PRONOUNCEMENTS
Significant Accounting Policies
INCOME RECOGNITION
We follow the policies described below to recognize income on our Consolidated Statements of Operations:
•
Interest Income-We accrue interest income if we expect that ultimately we will be able to collect it. Generally, when a loan becomes more than 90 days past due, or if we otherwise believe the customer is unable to service its debt and other obligations, we will place the loan on non-accrual status and will cease recognizing interest income on that loan until all principal and interest is current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, we remain contractually entitled to this interest. We may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection.
Paid-in-kind interest, or PIK, represents contractually deferred interest that typically is added to the loan balance. Generally, PIK interest is due at the end of the loan term. We generally accrue PIK interest when collection is expected and cease accruing PIK if there is insufficient value to support the accrual or we expect the customer is unable to pay all principal and interest due.
•
Dividend Income-We accrue dividend income on equity investments with stated income, if we expect to collect the dividends. We record dividend income on common equity investments, and gains from realized distributions, when the dividend has been declared and is required to be paid.
•
Loan Origination Fees-We capitalize loan origination fees, then amortize these fees into interest income over the term of the loan using the effective interest rate method. In certain loan arrangements, we receive warrants or other equity interests from the borrower as additional origination fees. Typically, borrowers granting these interests are not traded publicly. We record the financial instruments received at fair value as determined in good faith by our board of directors. In certain cases, when we record a warrant or other equity instrument that results in a loan discount, we accrete the discount into income over the term of the loan.
•
Advisory Fees and Other Income-We charge our portfolio companies fees for services that we provide, including advisory and management services, equity structuring, prepayments, research, bank interest and other fees. These fees are based on market rates, which are documented in an agreement between MCG and the respective portfolio companies. We recognize advisory and management services fees when earned. We also recognize equity structuring fees as earned, which generally occurs when the investment transaction closes. Finally, we recognize prepayment fees upon receipt.
PORTFOLIO INVESTMENTS
In accordance with the 1940 Act, we classify portfolio investments on our Consolidated Balance Sheets and our Consolidated Schedules of Investments into the following categories:
•
Control Investments-Investments in which we control more than 25% of the voting securities or have greater than 50% representation on the board of directors;
•
Affiliate Investments-Investments in which we own between 5% and 25% of the voting securities and have less than 50% representation on the board of directors; and
•
Non-Affiliate Investments-Investments in which we own less than 5% of the voting securities.
We carry our investments at fair value in accordance with the 1940 Act and Accounting Standard Codification Topic 820-Fair Value Measurements and Disclosures, or ASC 820. We base the fair value of portfolio investments on market prices when market quotations are readily available. As required by the 1940 Act, the fair value of all other investments is determined in good faith by our board of directors. Typically, there are no readily available market values for the majority of investments in our portfolio. As a result, the fair value of all of our investment portfolio was determined in good faith by our board of directors as of December 31, 2010. We determine fair values using various valuation models that estimate the underlying value of the associated entity,
taking into consideration our ownership share, as well as any discounts for transfer restrictions or other terms that impact the value. No single standard exists for determining fair value in good faith. Therefore, our board of directors applies judgment to specific facts and circumstances about each investment in our portfolio pursuant to our valuation policy and accounting principles generally accepted in the United States.
ASC 820 defines fair value, establishes a framework for measuring fair value and expands disclosures about assets and liabilities measured at fair value. ASC 820’s definition of fair value focuses on exit price in the principal, or most advantageous, market and prioritizes the use of market-based inputs over entity-specific inputs within a measurement of fair value.
Each quarter, we record the difference between the carrying value of our investments and the fair values determined by the board of directors as unrealized (depreciation) appreciation on investments on our Consolidated Statements of Operations. Upon the ultimate disposition of an asset in our portfolio, we reverse any previously recorded unrealized (depreciation) appreciation and realize a (loss) gain on investment that reflects the difference between the carrying cost of the investment and the net proceeds from the sale. See Note 4-Fair Value Measurement for additional information about the methodologies that the board of directors uses to determine the fair value of our investments, as well as our application of ASC 820.
CASH
Our Consolidated Balance Sheets and our Consolidated Statements of Cash Flows reflect the following categories of cash:
•
Cash and cash equivalents-Represents unrestricted cash, including checking accounts, interest bearing deposits collateralized by marketable debt securities and highly liquid investments with original maturities of 90 days or less;
•
Cash, securitization accounts-Represents principal and interest held in designated bank accounts that we received on securitized loans or other reserved amounts associated with our securitization facilities. We must use the funds deposited in these accounts to pay interest, reduce borrowings or pay other specified obligations in accordance with associated securitization agreements. Interest collections in excess of the interest payments and other specified obligations are distributed back to us; and
•
Cash, restricted-Includes cash held in escrow that we received as part of an asset sale, cash held for regulatory purposes and cash that we have received that is earmarked for transfer into our cash, securitization accounts.
BORROWING FACILITIES
As described more fully in Note 6-Borrowings, we borrow funds from various lenders through unsecured credit facilities, private placements, warehouse loan facilities and the SBA. In addition, we have bankruptcy-remote, special-purpose entities that issued debt collateralized by pools of loans that we transfer to the entity. To date, we have recorded our obligation to repay all our borrowings at cost on our Consolidated Balance Sheets. In the future, however, as we enter into new borrowing facilities or make significant modifications to existing facilities, we may consider reporting those facilities using the fair value option as allowed under ASC Topic 825-Financial Instruments. We account for loans transferred to our bankruptcy remote, special-purpose entities for use in securitization transactions in accordance with ASC Topic 860-Transfers and Servicing, or ASC 860. As of December 31, 2010, we reported $546.9 million of borrowings at cost on our Consolidated Balance Sheet. We estimate that the fair value of these borrowings as of December 31, 2010 was approximately $514.1 million, based on market data and current interest rates.
Debt issuance costs represent fees and other direct incremental costs incurred in connection with our borrowings. We amortize these costs ratably over the contractual term of the borrowing using the effective interest method and include this amortization in interest expense on our Consolidated Statements of Operations.
From time-to-time, we may repurchase certain debt instruments issued by one of our bankruptcy-remote special-purpose entities from third parties at a negotiated price that may be different than the principal amount of the debt. In accordance with ASC 470-Debt, we treat these repurchases as if the debt were extinguished and report the difference between the reacquisition price and the net carrying amount of the extinguished debt as a gain on extinguishment of debt on our Consolidated Statements of Operations.
GOODWILL
We account for goodwill in accordance with ASC 350-Intangibles-Goodwill and Other, or ASC 350. Based on the results of our impairment testing in December 2008, we concluded that our goodwill was fully impaired. In
accordance with ASC 350, we wrote off this goodwill and reported the $3.9 million impairment on a separate line item titled “Goodwill impairment” on our Consolidated Statement of Operations for 2008. The balance of our goodwill was zero as of December 31, 2010 and 2009.
SHARE-BASED COMPENSATION
We recognize share-based compensation in accordance with ASC Topic 718-Compensation-Stock Compensation, or ASC 718. In accordance with ASC 718, we recognize compensation cost related to share-based awards for which forfeiture provisions are expected to lapse over the requisite service period.
INCOME TAXES
We currently qualify as a RIC for federal income tax purposes, which generally allows us to avoid paying corporate income taxes on any income or gains that we distribute to our stockholders. Generally, we distribute and intend to distribute sufficient dividends to eliminate taxable income; however, we did have taxable income in 2010 associated with the sales of one of our portfolio companies. In addition, for calendar years ended December 31, 2010 and earlier, we were subject to a 4% excise tax to the extent that we did not distribute (actually or on a deemed basis): 98% of our ordinary income for each calendar year; 98% of our capital gain net income for each calendar year; and any income realized, but not distributed, in prior calendar years. Beginning in 2011, we will be subject to the 4% excise tax to the extent that we do not distribute (actually or on a deemed basis): 98% of our ordinary income for each calendar year; 98.2% of our capital gain net income for each calendar year; and any income realized but not distributed in prior calendar years.
We have certain wholly owned Taxable Subsidiaries, each of which holds one or more portfolio investments listed on our Consolidated Schedule of Investments. The purpose of these Taxable Subsidiaries is to permit us to hold portfolio companies organized as LLCs or other forms of pass-through entities and still satisfy the RIC tax requirement that at least 90% of our gross revenue for income tax purposes must consist of investment income. Absent the Taxable Subsidiaries, a portion of the gross income of any LLC or other pass-through entity portfolio investment would flow through directly to us for the 90% test. To the extent that such income did not consist of investment income, it could jeopardize our ability to qualify as a RIC and, therefore, cause us to incur significant federal income taxes. The income of the LLCs or other pass-through entities owned by Taxable Subsidiaries is taxed to the Taxable Subsidiaries and does not flow through to us, thereby helping us preserve our RIC status and resultant tax advantages. We do not consolidate the Taxable Subsidiaries for income tax purposes and they may generate income tax expense because of the Taxable Subsidiaries’ ownership of the portfolio companies. We reflect any such income tax expense on our Consolidated Statement of Operations. For additional information about our Taxable Subsidiaries and the determination of our income taxes, see Note 11-Income Taxes and Note 13-Commitments and Contingencies.
EARNINGS (LOSS) PER SHARE
We determine basic and diluted earnings (loss) per weighted-average common share in accordance with ASC Topic 260-Earnings per Share, or ASC 260. We compute basic earnings (loss) per share by dividing net income (loss) applicable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. We compute diluted earnings (loss) per share by dividing such net income (loss) by the sum of the weighted-average number of shares outstanding for the period and the dilutive impact of restricted stock for which forfeiture provisions have not lapsed. We include unvested share-based awards that contain non-forfeitable rights in the computation of basic and diluted earnings (loss) per share pursuant to the two-class method.
Recent Accounting Pronouncements
In January 2010, FASB issued Accounting Standard Update No. 2010-06-Improving Disclosures about Fair Value Measurements, or ASU 2010-06. The January 2010 update amends Accounting Standards Codification Topic 820-Fair Value Measurements and Disclosures, or ASC 820, to add new requirements for disclosures about significant transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances and settlements relating to Level 3 measurements. In addition, the update clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. ASU 2010-06 became effective for interim and annual reporting periods that began after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll-forward of activity in Level 3 fair value measurements. Those disclosures became effective for interim and annual reporting periods beginning after December 15, 2010. We adopted this standard beginning with our financial statements ended March 31, 2010. These disclosures are reflected in Note 4-Fair Value Measurement. Our adoption of this standard did not affect our financial position or results of operations.
NOTE 3-INVESTMENT PORTFOLIO
The following table summarizes the composition of our investment portfolio at cost:
Our debt instruments bear contractual interest rates ranging from 3.0% to 17.6%, a portion of which may be deferred. As of December 31, 2010, approximately 75.5% of the fair value of our loan portfolio was at variable rates, based on a LIBOR benchmark or prime rate, and 24.5% of the fair value of our loan portfolio was at fixed rates. As of December 31, 2010, approximately 61.4% of our loan portfolio, at fair value, had LIBOR floors between 1.0% and 3.0% on the LIBOR base index and prime floors between 2.25% and 6.0%. At origination, our loans generally have four- to eight-year stated maturities. Borrowers typically pay an origination fee based on a percent of the total commitment and a fee on undrawn commitments.
When one of our loans becomes more than 90 days past due, or if we otherwise do not expect the customer to be able to service its debt and other obligations, we will, as a general matter, place the loan on non-accrual status and generally will cease recognizing interest income on that loan until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, we may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection. If the fair value of a loan is below cost, we may cease recognizing paid-in-kind interest and/or the accretion of a discount on the debt investment until such time that the fair value equals or exceeds cost.
The following table summarizes the cost of loans more than 90 days past due and loans on non-accrual status:
The following table summarizes the changes in the cost and fair value of the loans on non-accrual status from December 31, 2009 through December 31, 2010:
The following table summarizes our investment portfolio by industry at cost:
(a) No individual industry within this category exceeds 1%.
The following table summarizes our investment portfolio by industry at fair value:
(a) No individual industry within this category exceeds 1%.
We manage our interest rate exposure and financing facility requirements on an ongoing basis by comparing our interest rate sensitive assets to our interest rate sensitive liabilities, and from time to time, may enter into interest rate swaps. We include the fair value of these interest rate swaps in other liabilities on our Consolidated Balance Sheets. We do not designate any of our interest rate swaps as hedges for accounting purposes. Each quarter, we settle these interest rates swaps for cash. During 2010 and 2009, we reported changes in the fair value of these interest rate swaps in net unrealized appreciation (depreciation) on investments on our Consolidated Statement of Operations.
As of December 31, 2010 and 2009, the notional amount of our interest rate swaps was $21.2 million and $45.2 million, respectively, and the fair value of these interest rate swaps included in our liabilities was $0.3 million and $1.1 million, respectively. The following table summarizes our existing interest rate swaps with SunTrust Bank, as the counterparty, for which we pay fixed interest rates and receive floating interest rates as of December 31, 2010 and 2009:
The following table summarizes the realized and unrealized gains and losses that we recorded on these interest rate swaps for the years ended December 31, 2010 and 2009:
NOTE 4-FAIR VALUE MEASUREMENT
We account for our investments in portfolio companies under ASC 820. ASC 820 defines fair value, establishes a framework for measuring fair value and expands disclosures about assets and liabilities measured at fair value. ASC 820 defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This fair value definition focuses on exit price in the principal, or most advantageous, market and prioritizes, within a measurement of fair value, the use of market-based inputs over entity-specific inputs.
FAIR VALUE HIERARCHY
ASC 820 establishes the following three-level hierarchy, based upon the transparency of inputs to the fair value measurement of an asset or liability as of the measurement date:
ASC 820
Fair Value
Hierarchy
Inputs to Fair Value Methodology
Level 1
Quoted prices in active markets for identical assets or liabilities
Level 2
Quoted prices for similar assets or liabilities; quoted markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the financial instrument; inputs other than quoted prices that are observable for the asset or liability; or inputs that are derived principally from, or corroborated by, observable market information
Level 3
Pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption is unobservable or when the estimation of fair value requires significant management judgment
We categorize a financial instrument in the fair value hierarchy based on the lowest level of input that is significant to its fair value measurement.
Our investment portfolio is not composed of homogeneous debt and equity securities that can be valued with a small number of inputs. Instead, the majority of our investment portfolio is composed of complex debt and equity securities with unique contract terms and conditions. As such, our valuation of each investment in our portfolio is unique and complex, often factoring in hundreds of unique inputs, including the historical and forecasted financial and operational performance of the portfolio company, projected cash flows, market multiples, comparable market transactions, the priority of our securities compared with those of other investors, credit risk, interest rates, independent valuations and reviews and other inputs too numerous to list quantitatively herein.
ASSETS AND LIABILITIES MEASURED AT FAIR VALUE ON A RECURRING BASIS
The following table presents the assets and liabilities that we report at fair value on our Consolidated Balance Sheet by ASC 820 hierarchy:
As of December 31, 2010, we had no investments that had quoted market prices in active markets, which we would categorize as Level 1 investments under ASC 820.
VALUATION METHODOLOGIES
As required by the 1940 Act, we classify our investments by level of control. Control investments include both majority-owned control investments and non-majority owned control investments. A majority-owned control investment represents a security in which we own more than 50% of the voting interest of the portfolio company and generally control its board of directors. A non-majority owned control investment represents a security in which we own 25% to 50% of the portfolio company’s equity. Non-control investments represent both affiliate and non-affiliate securities for which we do not have a controlling interest. Affiliate investments represent securities in which we own 5% to 25% of the portfolio company’s equity. Non-affiliate investments represent securities in which we own less than 5% of the portfolio company’s equity.
•
Majority-Owned Control Investments-Majority-owned control investments comprise 30.4% of our investment portfolio as of December 31, 2010. Market quotations are not readily available for these investments; therefore, we use a combination of market and income approaches to determine their fair value. Typically, private companies are bought and sold based on multiples of EBITDA, cash flows, net income, revenues or, in limited cases, book value. Generally, we apply multiples that we observe for other comparable companies to relevant financial data for the portfolio company. Also, in a limited number of cases, we use income approaches to determine the fair value of these securities, based on our projections of the discounted future free cash flows that the portfolio company will likely generate, as well as industry derived capital costs. Our valuation approaches for majority-owned investments estimate the value were we to sell or exit the investment. These valuation approaches assume the highest and best use of the investment by market participants and consider the value of our ability to control the portfolio company’s capital structure and the timing of a potential exit.
•
Non-Majority-Owned Control Investments-Non-majority owned investments comprise 0.3% of our investment portfolio as of December 31, 2010. For our non-majority owned equity investments, we use the same market and income valuation approaches used to value our majority-owned control investments. For non-majority owned control debt investments, we estimate fair value using the market-yield approach based on the expected future cash flows discounted at the loans’ effective interest rates, based on our estimate of current market rates. We may adjust discounted cash flow calculations to reflect other market conditions or the perceived credit risk of the borrower.
•
Non-Control Investments-Non-control investments comprise 69.3% of our investment portfolio as of December 31, 2010. Quoted prices are not available for 81.1% of our non-control investments as of December 31, 2010. For our non-control equity investments, we use the same market and income approaches used to value our control investments. For non-control debt investments, we estimate fair value using a market-yield approach based on the expected future cash flows discounted at the loans’ effective interest rates, based on our estimate of current market rates. We may adjust discounted cash flow calculations to reflect other market conditions or the perceived credit risk of the borrower.
•
Thinly Traded and Over-the-Counter Securities-Generally, we value securities that are traded in the over-the-counter market or on a stock exchange at the average of the prevailing bid and ask prices on the date of the relevant period end. However, we may apply a discount to the market value of restricted or thinly traded public securities to reflect the impact that these restrictions have on the value of these securities. We review factors including the trading volume, total securities outstanding and our percentage ownership of securities to determine whether the trading levels are active (Level 1) or inactive (Level 2). As of December 31, 2010, these securities represented 13.1% of our investment portfolio.
Our valuation analyses incorporate the impact that key events could have on the securities’ values, including public and private mergers and acquisitions, purchase transactions, public offerings, letters of intent and subsequent debt or equity sales. Our valuation analyses also include key external data, such as market changes and industry valuation benchmarks. We also use independent valuation firms to provide additional data points for our quarterly valuation analyses. Our general practice is to obtain an independent valuation or review of valuation at least once per year for each portfolio investment that had a fair value in excess of $5.0 million, unless the fair value has otherwise been derived through a sale of some or all of our investment in the portfolio company or is a new investment made within the last twelve months. As set forth in more detail in the following table, in total, either we obtained a valuation or review from an independent firm, considered new investments made or used market quotes for 99.4% of the fair value of our investment portfolio as of December 31, 2010.
The majority of the valuations performed by the independent valuation firms utilize proprietary models and inputs. We have used, and intend to continue to use, independent valuation firms to provide additional support for our internal analyses. Our board of directors considers our valuations, as well as the independent valuations and reviews, in its determination of the fair value of our investments. The fair value of our interest rate swaps is based on a binding broker quote, which is based on the estimated net present value of the future cash flows using a forward interest rate yield-curve in effect as of the measurement period.
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 such differences could be material. In addition, 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 differ from the valuations currently assigned.
CHANGES IN LEVEL 3 FAIR VALUE MEASUREMENTS
We classify securities in the Level 3 valuation hierarchy based on the significance of the unobservable factors to the overall fair value measurement. Our fair value approach for Level 3 securities primarily uses unobservable inputs, but may also include observable, actively quoted components derived from external sources. Accordingly, the gains and losses in the table below include fair value changes due, in part, to observable factors. Additionally, we transfer investments in and out of Level 1, 2 and 3 securities as of the ending balance sheet date, based on changes in the use of observable and unobservable inputs utilized to perform the valuation for the period. During 2010, there were no transfers in or out of Level 1, 2 or 3.
The following table provides a reconciliation of fair value changes during the year ended December 31, 2010 for all investments for which we determine fair value using unobservable (Level 3) factors.
The following table provides a reconciliation of fair value changes during the year ended December 31, 2009 for all investments for which we determine fair value using unobservable (Level 3) factors.
We did not purchase any Level 3 investments during 2009.
UNREALIZED (DEPRECIATION) APPRECIATION OF LEVEL 3 INVESTMENTS
The following table summarizes the unrealized (depreciation) appreciation that we recognized on those investments for which we determined fair value using unobservable inputs (Level 3) for the years ended December 31, 2010 and 2009.
NOTE 5-CONCENTRATIONS OF INVESTMENT RISK
As of December 31, 2010, approximately 14.9% of the fair value of our investment portfolio was composed of investments in the communications industry. The 14.9% included 13.0% invested in CLECs and 1.9% invested in other communications companies, including an incumbent local exchange carrier and a telecommunications tower company. As of December 31, 2009, approximately 19.0% of the fair value of our investment portfolio was composed of investments in the communications industry, including 17.2% invested in CLECs and 1.8% invested in other communications companies. For the years ended December 31, 2010 and 2009, our portfolio companies in the communications industry contributed $4.0 million, or 4.4%, and $4.4 million, or 4.4%, respectively, of our total revenues.
Our investment in Broadview Networks Holdings, Inc., or Broadview, a CLEC that we control, represents our single largest investment. As of December 31, 2010 and 2009, the fair value of our investment in Broadview represented $103.0 million and $138.8 million, or 10.2% and 14.1%, respectively, of the fair value of our investment portfolio. We did not accrete any dividends with respect to our investment in Broadview during the year ended December 31, 2010 or 2009, because we determined that the total value that we had recorded for this investment equaled the total enterprise value for our portion of this investment.
In addition to the communications industry, we have concentrations in the cable, healthcare and food service industries. The following table summarizes, by industry, our fair value and revenue concentrations in our investments:
NOTE 6-BORROWINGS
As of December 31, 2010, we reported $546.9 million of borrowings on our Consolidated Balance Sheet at cost. We estimate that the fair value of these borrowings as of December 31, 2010 was approximately $516.2 million, based on market data and current interest rates. The following table summarizes our borrowing facilities and the facility amounts and amounts outstanding and contingent borrowing eligibility of Solutions Capital I, L.P., a wholly owned subsidiary, as an SBIC, under the SBIC Act.
Each of our credit facilities has certain collateral requirements and/or financial covenants. The net worth covenant of our Commercial Loan Funding Trust, or SunTrust Warehouse, requires that we maintain a consolidated tangible net worth of not less than $500.0 million, plus 50% of any equity raised after February 26, 2009. Under these covenants, we must also maintain an asset coverage ratio of at least 180%.
As a BDC, we are not permitted to incur indebtedness or issue senior securities, including preferred stock, unless immediately after such borrowing we have an asset coverage for total borrowings (excluding borrowings by our SBIC facility) of at least 200%. In addition, we may not be permitted to declare any cash dividend or other distribution on our outstanding common shares, or purchase any such shares, unless, at the time of such declaration or purchase, we have an asset coverage of at least 200% after deducting the amount of such dividend, distribution or purchase price. If we are unable to meet this asset coverage requirement, we may not be able to incur additional debt. As of December 31, 2010, our ratio of total assets to total borrowings and other senior securities was 231%.
We fund all of our current debt facilities, except our Series 2005-A and Series 2007-A unsecured notes, through our bankruptcy remote, special-purpose, wholly owned subsidiaries. Therefore, these subsidiaries’ assets may not be available to our creditors. In some cases, advances under our debt facilities are subject to certain collateral levels, collateral quality, leverage and other restrictive covenants. We continue to service the portfolio investments that we use as collateral in our secured borrowing facilities.
The following table summarizes repayments of our borrowings based on the final legal maturity or the contractual principal collections of the outstanding loans that comprise the collateral, where applicable. Certain of our borrowing facilities contain provisions that require that we apply a portion of the proceeds we receive from monetizations to paydown a portion of the outstanding balances. Actual repayments could differ significantly due to future prepayments by our borrowers, modifications of our borrowers’ existing loan agreements, and monetizations.
The following table summarizes our aggregate outstanding borrowings as of December 31, 2010 and December 31, 2009, by interest rate benchmark:
As of December 31, 2010, we were in compliance with all key financial covenants under each of our borrowing facilities, although there can be no assurance regarding compliance in future periods. The following sections provide additional detail about each of our borrowing facilities.
PRIVATE PLACEMENT NOTES
In October 2005, we issued $50.0 million of Series 2005-A unsecured notes, at a fixed-interest rate of 6.73% per annum. In October 2007, we issued an additional $25.0 million of Series 2007-A unsecured notes at a fixed-interest rate of 6.71% per annum. Both of these tranches, or the Private Placement Notes, were issued as five-year notes that require semi-annual interest payments. As of December 31, 2010, the outstanding balances under the Series 2005-A and Series 2007-A Private Placement Notes were $17.4 million and $8.7 million, respectively.
In 2009, the Private Placement Notes were amended. As of December 31, 2010, the interest rates were 9.98% for the Series 2005-A unsecured notes and 8.96% for the Series 2007-A unsecured notes. In addition, the maturity dates of the Series 2005-A and Series 2007-A unsecured notes are October 2011 and October 2012, respectively.
The amendments also require us to offer to repurchase the Private Placement Notes with a portion of certain monetization proceeds at a purchase price of 102% of the principal amount to be purchased. In addition, we agreed to limit the amount of debt from the 2006-1 Trust and our common stock that we may repurchase. For every $5.0 million of Private Placement Notes we offer to purchase after February 26, 2009, we may repurchase $2.5 million of debt from the 2006-1 Trust. We may also repurchase $1.0 million of shares of our common stock for every $5.0 million increment of Private Placement Notes offered to be repurchased after February 26, 2009, provided that the amount of permitted debt repurchases under the 2006-1 Trust shall be reduced by the amount of any of our common stock repurchases made. Since the execution of this amendment in February 2009, we have repurchased a total of $48.8 million of Private Placement Notes as of December 31, 2010.
We are required to offer to repurchase the Private Placement Notes with 45% of the cash net proceeds of any sale of unencumbered assets to reduce amounts outstanding under the Private Placement Notes as, and when, such sales occur in the event of proceeds of $5.0 million or more or otherwise on a semi-annual basis, unless an event of default under one of the financing subsidiary debt facilities had occurred and was continuing, in which case the percentage of net proceeds would increase to 60%.
The following table summarizes the reductions in the borrowing capacity from monetization proceeds:
(a) Private Placement Notes were repurchased at a price of 102% of the principal amount repurchased. In 2010 and 2009, the premiums paid on repurchases of Private Placement Notes were $506 and $371, respectively. These premiums reduce our gain on extinguishment of debt on the Consolidated Statement of Operations.
(b) In 2009, the Private Placement Notes were amended and we made a $5.0 million prepayment at par.
COMMERCIAL LOAN FUNDING TRUST
We established, through MCG Commercial Loan Funding Trust, a $250.0 million warehouse financing facility funded through Three Pillars Funding LLC, an asset-backed commercial paper conduit administered by SunTrust Robinson Humphrey, Inc. The SunTrust Warehouse, which is structured to operate like a revolving credit facility, is secured primarily by MCG Commercial Loan Funding Trust’s assets, including commercial loans that we sold to the trust. The pool of commercial loans in the trust must meet certain requirements, such as term, average life, investment rating, agency rating and industry diversity requirements. We must also meet certain requirements related to portfolio performance, including required minimum portfolio yield and limitations on delinquencies and charge-offs. We funded this facility through two separate Variable Funding Certificates, or VFCs, including a $218.75 million Class A VFC and a $31.25 million Class B VFC. In February 2009, the Class B VFC were redeemed. The facility is funded by third parties through the commercial paper market with SunTrust Bank providing a liquidity backstop, subject to SunTrust Bank’s annual liquidity commitment.
In February 2010, SunTrust Bank provided its 2010 annual renewal of this liquidity facility. In connection with the 2010 renewal, the SunTrust Warehouse was modified in a number of ways, including: the legal final maturity date was extended to August 2012, subject to contractual terms and conditions; the minimum consolidated tangible net worth covenant was reduced from $525.0 million plus 50% of the proceeds from any equity issuances after February 26, 2009 to $500.0 million plus 50% of the proceeds from any equity issuances after February 26, 2009; and the facility borrowing commitment was reduced from $190.0 million to $150.0 million. In addition, the terms of the SunTrust Warehouse limit the total outstanding balance of fixed-rate loans, which was increased through this amendment from 40% to 55%. The interest rate on the SunTrust Warehouse remained unchanged at the commercial paper rate plus 2.50%. The February 2010 amendment provided that if a new agreement or extension had not been executed by February 16, 2011, the SunTrust Warehouse would enter an 18-month amortization period during which principal under the facility would be paid down through orderly monetizations of portfolio company assets that are financed in the facility. We paid a $1.5 million, or 1.0%, facility fee for this renewal. Subsequently, in January 2011, SunTrust Bank provided its renewal of this liquidity facility through January 2013. The new legal final maturity date of the SunTrust Warehouse was extended to January 2014 and the new scheduled termination date was extended to January 2013. See Note 16-Subsequent Events for additional information about the January 2011 amendment to this facility.
Advances under the VFC may be up to 64% of eligible collateral. The SunTrust Warehouse is non-recourse to us; therefore, in the event of a termination event or upon the legal final maturity date, the lenders under the SunTrust Warehouse may only look to the collateral to satisfy the outstanding obligations under this facility. The following table summarizes the collateral under the Commercial Loan Funding Trust as of December 31, 2010 and 2009:
As of December 31, 2010, prior to the commencement of any amortization period, we were required to contribute 80% of net proceeds from monetizations of collateral financed in the SunTrust Warehouse to repay the outstanding borrowings. In connection with the January 2011 renewal of the SunTrust Warehouse, net proceeds from monetizations must be reinvested in additional collateral or used to repay the outstanding borrowings. See Note 16-Subsequent Events for additional information about the January 2011 amendment to this facility.
COMMERCIAL LOAN TRUST 2006-1
In April 2006, we completed a $500.0 million debt securitization through Commercial Loan Trust 2006-1, a wholly owned subsidiary. The 2006-1 Trust issued $106.25 million of Class A-1 Notes, $50.0 million of Class A-2 Notes, $85.0 million of Class A-3 Notes, $58.75 million of Class B Notes, $45.0 million of Class C Notes and $47.5 million of Class D Notes. The respective classes of notes bear interest at LIBOR plus 0.33%, 0.35%, 0.33%, 0.58%, 1.05% and 2.25%.
All the notes are secured by the assets of the 2006-1 Trust. The following table summarizes the assets securitized under this facility as of December 31, 2010 and December 31, 2009:
We retain all of the equity in the securitization. The securitization includes a five-year reinvestment period ending in July 2011, unless we terminate this facility earlier, during which the trust may use principal collections received on the underlying collateral to purchase new collateral from us. Up to 55% of the collateral may be non-senior secured, and, in certain instances, unsecured commercial loans. The remaining 45% must be senior secured commercial loans.
The Class A-1, Class B, Class C and Class D Notes are term notes. The Class A-2 Notes are a revolving class of secured notes and have a five-year revolving period. The Class A-3 Notes are a delayed draw class of secured notes, which were drawn in full between July 2006 and April 2007. From time to time, the trust purchases additional commercial loans from us, primarily using the proceeds from the Class A-2 revolving notes and principal collections. The pool of commercial loans in the trust must meet certain requirements, such as asset mix and concentration, collateral coverage, term, agency rating, minimum coupon, minimum spread and sector diversity requirements.
In 2010, 2009 and 2008, we repurchased collateralized loan obligations that previously had been issued by the 2006-1 Trust. These repurchases resulted in gains on extinguishment of debt as summarized in the following table:
SBIC DEBENTURES
In December 2004, we formed a wholly owned subsidiary, Solutions Capital I, L.P. Solutions Capital I, L.P. has a license from the SBA to operate as an SBIC under the SBIC Act. As of December 31, 2010, the license gave Solutions Capital I, L.P. the potential to borrow up to $130.0 million. The SBA approved and committed $130.0 million in borrowings to the SBIC, subject to certain capital requirements and customary procedures. These funds can be used to provide debt and equity capital to qualifying small businesses. We may use the borrowings from the SBA to fund new originations; however, we may not use these borrowings to originate debt to certain companies that are currently in our portfolio without SBA approval. In addition, we may not use these funds for MCG’s, the parent company’s, working capital.
To realize the full $130.0 million potential borrowing for which we had been approved under this program, we would have had to fund a total of $65.0 million to the SBIC, of which we had funded $49.6 million as of December 31, 2010. Based on our funded capital as of December 31, 2010, Solutions Capital I, L.P. could have, subject to the SBA’s approval, borrowed up to an additional $6.0 million to originate new investments. To access the entire $130.0 million that the SBA had approved and committed as of December 31, 2010, we would have had to fund an additional $15.4 million.
The maximum amount of outstanding leverage available to single-license SBIC companies is $150.0 million. As described more fully in Note 16-Subsequent Events, the SBA approved and committed an additional $20.0 million of borrowing capacity in January 2011, which brings the total borrowing capacity up to the maximum of $150.0 million of outstanding leverage available to single-license companies. To access the entire $150.0 million, we would have to fund a total of $25.4 million, in addition to the $49.6 million that we had funded through December 31, 2010. The maximum amount of outstanding leverage available to SBIC companies with multiple licenses is $225.0 million on an aggregate basis.
As of December 31, 2010 and 2009, we had $144.9 million and $30.8 million, respectively, of investments and we had $29.4 million and $21.2 million, respectively, of restricted cash to be used for investments in our SBIC.
Once drawn, the SBIC debt bears an interim interest rate of LIBOR plus 30 basis points. The rate becomes fixed at the time of SBA pooling, which is within nine months of funding, and is set to the then-current 10-year treasury rate plus a spread and an annual SBA charge. As of December 31, 2010, the SBIC had $108.6 million of borrowings outstanding summarized in the following table:
In October 2008, we received exemptive relief from the SEC, which effectively allows us to exclude debt issued by Solutions Capital I, L.P. from the calculation of our consolidated BDC asset coverage ratio.
NOTE 7-CAPITAL STOCK
We have one class of common stock and one class of preferred stock authorized. Our board of directors is authorized to: provide for the issuance of shares of preferred stock in one or more series; establish the number of shares to be included in each such series; and establish the designations, voting powers, preferences and rights of the shares of each such series, and any qualifications, limitations or restrictions thereof, subject to the 1940 Act.
The following table summarizes our distributions declared since January 1, 2008:
NOTE 8-EMPLOYEE BENEFIT PLANS
All full-time employees, and those part-time employees who work at least 1,000 hours per year, are eligible to participate in a contributory employee savings plan that we sponsor under Section 401(k) of the Internal Revenue Code, or 401(k) Plan. Eligible employees may participate in the 401(k) Plan beginning on the first day of the calendar quarter following their respective date of hire. We match a portion of the contribution made by employees to the 401(k) Plan, based upon a percent of defined compensation. During the years ended December 31, 2010, 2009 and 2008, we incurred $216,000, $228,000 and $304,000, respectively, of expenses related to the 401(k) Plan.
We have also created a deferred compensation plan for certain executives that allows them to defer a portion of their salary and bonuses to an unfunded deferred compensation plan that we manage. Contributions to the deferred compensation plan earn interest at a rate of 2.00% over our internal cost of funds rate, as defined by the plan. During the years ended December 31, 2010, 2009 and 2008, we incurred $65,000, $62,000 and $62,000, respectively, of expenses related to our deferred compensation plan.
NOTE 9-SHARE BASED COMPENSATION
EMPLOYEE SHARE-BASED COMPENSATION
From time to time, we award shares of restricted common stock to employees under our Third Amended and Restated 2006 Employee Restricted Stock Plan, or the 2006 Plan, which our stockholders initially approved in June 2006. In May 2010, our stockholders approved an amendment to the 2006 Plan increasing the number of shares we may award from 3,500,000 to 6,050,000 shares. Shares of restricted common stock awarded under the 2006 Plan may be subject to the employees’ meeting service or performance conditions specified at the time of award. The award date is the date on which the shares are awarded by the Compensation Committee of our board of directors, while the fair value of the respective stock award is based on the closing price of our common stock on the NASDAQ Global Select Market on the award date. We amortize restricted stock awards on a straight-line basis over the requisite service period and report this expense as amortization of employee restricted stock awards on our Consolidated Statements of Operations.
During the year ended December 31, 2010, we issued 424,500 shares of restricted stock under the 2006 Plan with a weighted-average fair value per share of common stock at the award date of $2.86. During the year ended December 31, 2009, we issued 475,000 shares of restricted stock under the 2006 Plan with a weighted-average fair value per share of common stock on the award date of $2.50. Of the shares awarded in 2010 and 2009, 346,000 shares and 432,500 shares, respectively, were awarded under the Long Term Incentive Plan (discussed in more detail below). During the year ended December 31, 2008, we issued 1,335,600 shares of restricted stock under the 2006 Plan, with a weighted-average fair value per share of common stock on the award date of $4.99. These 2008 awards included 647,500 shares of restricted stock awarded under the 2006 Plan as part of the MCG Capital Corporation 2008 Retention Program, or the Retention Program, with a weighted-average fair value per share of common stock of $3.58.
The forfeiture provisions for the shares of restricted common stock issued under the Retention Program will lapse on a cliff basis in March 2011. The forfeiture provisions for the other shares of restricted common stock awarded in 2008 generally lapse ratably, in quarterly installments, over the three- or four-year period set forth in the respective award agreements.
The following table summarizes shares of restricted stock awarded under the 2006 Plan:
(a) Includes 647,500 shares of restricted common stock awarded as part of the Retention Program of which 593,000 shares remain outstanding as of December 31, 2010.
During the years ended December 31, 2010, 2009 and 2008 we recognized $4.3 million, $7.7 million and $6.9 million, respectively, of compensation expense related to share-based compensation awards, including $0.1 million in 2008, of dividends paid on shares securing non-recourse employee loans. In addition, during 2008, we recorded $0.1 million of amortization of restricted stock awards as restructuring expense. As of December 31, 2010, all the restricted share awards for which forfeiture provisions have not lapsed carried non-forfeitable dividend rights to the holder of the restricted shares. We record dividends paid on shares of restricted common stock for which forfeiture provisions are expected to lapse to retained earnings, while we record dividends paid on shares of restricted common stock for which forfeiture provisions are not expected to lapse to compensation expense. During the years ended December 31, 2010 and 2008, all dividends paid on restricted common stock were charged to retained earnings, except for dividends paid on shares securing non-recourse employee loans, because we expected the forfeiture provisions to lapse for all such shares. No dividends were paid during the year ended December 31, 2009. As of December 31, 2010, we had $1.4 million of unrecognized compensation cost related to restricted common stock awarded to employees. We will recognize these costs over the remaining weighted-average requisite service period of 1.7 years.
Long-Term Incentive Plan
On July 23, 2009, our board of directors approved the Long-Term Incentive Plan, or the LTIP, which is effective for the three-year period ending July 22, 2012. LTIP participants, including our executive officers and key, non-executive employees, are eligible, in the sole discretion of the Compensation Committee of our board of directors, to receive their respective portions of up to an aggregate of 865,000 shares of our restricted common stock to be issued under the 2006 Plan and up to $5.2 million of cash bonuses if the closing price of our common stock achieves specific price thresholds for 20 consecutive trading days. We are under no obligation to issue restricted stock or to pay a cash award under the LTIP, until such time as the Compensation Committee of our board of directors makes such determination in its sole discretion, regardless of whether the share price thresholds have been achieved.
Shares of common stock subject to restricted stock awards under the LTIP may not be issued until such time as our share price achieves the price thresholds set forth in the following table and the issuance of such shares is authorized by the Compensation Committee of our board of directors. As such, the participants in the LTIP are not eligible to receive dividends on the shares of common stock subject to their awards of restricted stock until a share price threshold is attained and the common stock is issued. Upon issuance, forfeiture provisions for two-thirds of the applicable stock awards lapse immediately, while the forfeiture provisions for the remaining one-third lapse twelve months later. Cash awards under the LTIP may not be issued until such time that our share price achieves the thresholds set forth in the following table and the payment of such awards is authorized by the Compensation Committee of our board of directors. Upon achievement of a price threshold, two-thirds of the associated cash is expected to be paid out immediately and the remaining one-third will be paid out twelve months later.
The following table summarizes the price thresholds, the cumulative percentage and number of shares eligible to be awarded at each threshold, and the cash bonus eligible to be paid after achievement of each stock price threshold that were set forth in the LTIP. In addition, the following table summarizes the market thresholds that were achieved and the associated stock and cash awards through December 31, 2010.
We account for the restricted stock awards as equity awards. As of the July 23, 2009 grant date for the LTIP, we estimated the fair value of these awards was $1.9 million, and we are amortizing this amount on a straight-line basis over the derived service period. During the years ended December 31, 2010 and 2009, we recognized $0.6 million and $1.3 million, respectively, of compensation expense for these equity awards.
We account for the cash portion of the LTIP as liability awards. As liability awards, we are required to account for the awards based on the fair value of the award at the end of each reporting period and to recognize the expense over the then-current estimated requisite service period. In total, during the years ended December 31, 2010 and 2009, we recognized $2.5 million and $0.8 million, respectively, of compensation expense for the cash awards for all tranches of the LTIP. As of December 31, 2010, the fair value of the $7.00 and $8.00 tranches was $1.7 million. Total fair value of these tranches could, however, vary from zero to $3.2 million over the term of the LTIP because we adjust the fair value of the LTIP awards each quarter.
NON-EMPLOYEE DIRECTOR SHARE BASED COMPENSATION
During June 2006, our stockholders initially approved the 2006 Non-Employee Director Restricted Stock Plan, which was subsequently amended and restated and which we refer to as the 2006 Non-Employee Plan. In May 2010, our
stockholders approved an amendment to the 2006 Non-Employee Plan that increased the number of shares we may award from 100,000 to 150,000 shares. During the years ended December 31, 2010, 2009 and 2008, we awarded 7,500, 22,500 and 15,000 shares of restricted common stock, respectively, to eligible non-employee directors. During the years ended December 31, 2010, 2009 and 2008, we recognized $0.1 million, $0.1 million and $0.3 million, respectively, of compensation costs related to share-based awards to non-employee directors. We include this compensation cost in general and administrative expense on our Consolidated Statements of Operations. As of December 31, 2010, we had $0.1 million of unrecognized compensation cost related to restricted common stock awarded to non-employee directors, which we expect to recognize over the remaining weighted-average requisite service period of 1.4 years.
SUMMARY OF EMPLOYEE AND NON-EMPLOYEE DIRECTOR SHARE-BASED COMPENSATION
The following table summarizes our restricted stock award activity during 2010:
NOTE 10-CORPORATE RESTRUCTURING
In August 2008, we reduced our workforce by 27%, including 18 current employees and 10 vacant positions that we otherwise would have filled. Affected employees received severance packages including severance pay, benefits and vesting of previously issued shares of restricted common stock during their respective three- to nine-month severance periods. In total, 22,100 shares of restricted common stock vested during these employees’ respective severance periods. As of December 31, 2010, 2009 and 2008, our headcount was 66, 64 and 73 employees, respectively.
In 2008, we also closed our facility in Atlanta, Georgia, and sublet this lease in December 2008 for the remainder of the lease, which expires in February 2013. In November 2008 we also terminated, at minimal cost, a lease for part of our facility in Arlington, Virginia.
During 2008, we recognized $1.0 million of severance benefits and $0.3 million of facility closure costs associated with these restructuring initiatives. We did not recognize significant restructuring expenses during 2009 or 2010. We report restructuring in general and administrative expense on our Consolidated Statements of Operations.
We included liabilities associated with our restructuring in other liabilities on our Consolidated Balance Sheets. The following table summarizes changes in the balance of our restructuring liabilities from January 1, 2008 through December 31, 2010:
NOTE 11-INCOME TAXES
As a RIC, we are taxed under Subchapter M of the Internal Revenue Code. As such, our income generally is not taxable to the extent we distribute it to stockholders and we meet certain qualification tests as outlined in the Internal Revenue Code. However, income from certain investments owned by our wholly owned subsidiaries is subject to federal, state and local income taxes. During 2010, we declared and paid distributions from ordinary income that were sufficient to meet our distribution requirements as a RIC. We did not have a distribution requirement as a RIC for 2009 because we incurred certain losses for tax purposes in 2009. On a continuing basis, we monitor distribution requirements in order to comply with Subchapter M of the Internal Revenue Code.
We use the asset and liability method to account for our taxable subsidiaries’ income taxes. Using this method, we recognize deferred tax assets and liabilities for the estimated future tax effects attributable to temporary differences between financial reporting and the tax bases of assets and liabilities. In addition, we recognize deferred tax benefits associated with net operating carryforwards that we may use to offset future tax obligations. We measure deferred tax assets and liabilities using the enacted tax rates expected to apply to taxable income in the years in which we expect to recover or settle those temporary differences. During the years ended December 31, 2010 and 2008, we recorded income tax provisions of $1.8 million and $0.8 million, respectively. During 2009, we recorded an income tax benefit of $0.1 million. Approximately $1.6 million of the income tax expense accrued during 2010 was attributable to the sale of JetBroadband Holdings, LLC in July, 2010. The remaining tax expense for 2010 and 2008 and the income tax benefit for 2009 were primarily attributable to unrealized depreciation or appreciation and flow-through taxable income on certain investments held by our subsidiaries.
Historically, we have declared dividends that were paid the following quarter. From December 2001 through December 31, 2010, we declared distributions per share of $12.15. Each year, we mail statements on Form 1099-DIV to our stockholders that identify whether we made distributions from ordinary income, net capital gains on the sale of securities, which are each taxable distributions, and/or a return of paid-in-capital surplus, which is a nontaxable distribution. A portion of our distributions may represent a return of capital to our stockholders, to the extent that the total distributions paid in a given year exceed current and accumulated taxable earnings and profits. A portion of the distributions that we paid to stockholders during fiscal years 2008, 2006, 2005, 2004 and 2003 represented a return of capital.
The following table summarizes the distributions that we declared and paid during the three years ended December 31, 2010.
We determine the tax attributes of our distributions as of the end of our fiscal year based upon our taxable income for the full year and distributions paid during the full year. During 2010, we declared and paid distributions from ordinary income that were sufficient to meet our distribution requirements as a RIC. During fiscal year 2009, we did not declare or pay any dividends to stockholders. We will monitor 2011 taxable income in order to ensure compliance with the distribution requirements as a RIC.
For tax years ended on or before December 31, 2010, we were able to carryforward net capital losses that we may have incurred for a period of eight years. In December 2010, Congress enacted the Regulated Investment Company Modernization Act of 2010, which, in part, will allow us to indefinitely carryover net capital losses that we may incur after 2010. For the tax years ended December 31, 2010 and 2009, we had net capital losses of $4.9 million and $54.2 million, respectively, which we will carry forward to offset future net capital gains to the extent provided by federal tax law. The net capital loss carryforward from 2010 will expire in the tax year ending December 31, 2018 and the net capital loss carryforward from 2009 will expire in the tax year ending December 31, 2017. For the tax year ended December 31, 2008, we elected to distribute such net long-term capital gains to our stockholders by designating a portion of our dividends as distributions of our net long-term capital gains.
For income tax purposes, we report distributions paid to stockholders as ordinary income, return of capital, capital gains or a combination thereof. For the tax year ended December 31, 2010, 100% of our distributions were from ordinary income. We did not make distributions on our common stock during the year ended December 31, 2009. Distributions per common share for the years ended December 31, 2010 and 2008 were taxable as follows:
(a) For 2010 and 2008, ordinary income was reported on Form 1099-DIV as either qualified or non-qualified and long-term capital gains are reported on Form 1099-DIV in various sub-categories that have differing tax treatments to stockholders. Those sub-categories have not been shown herein.
(b) Return of capital refers to those amounts reported as nontaxable distributions on Form 1099-DIV.
On a tax basis, distributions allocable to 2010 were composed of $20.0 million of ordinary income and distributions in 2008 were composed of a $76.7 million return of capital and $1.4 million of long-term capital gains.
Taxable income differs from net income recognized in accordance with accounting principles generally accepted in the United States, or GAAP, because of temporary and permanent differences in income and expense recognition.
Taxable income generally excludes unrealized gains and losses from appreciation or depreciation of our investments, which are included in GAAP net income. Further, amounts recognized for financial reporting purposes may differ from amounts included in taxable income due to the accrued dividends on preferred stock,
which increases the book basis but not the tax basis of our investments, and non-accrual interest on loans, which increases tax basis but not book basis.
The following table summarizes the cost, as well as the unrealized appreciation and depreciation for federal income tax purposes as of December 31, 2010 and 2009:
The following table reconciles GAAP net income (loss) to taxable net income (loss) for the years ended December 31, 2010 and 2009:
(a) Results for the years ended December 31, 2010 and 2009, reflect the reversal of interest that we previously recognized on non-accrual loans of a portfolio investment that we liquidated. We applied the proceeds from the liquidation to the portfolio company’s outstanding principal balance on the debt obligation to us.
In December 2007, we received an examination report from the IRS related to its audit of our tax returns for the 2004 and 2005 tax years. The IRS proposed changes to certain deductions made by us for those years, primarily associated with the timing of certain realized losses in our portfolio. We appealed the proposed changes and reached a settlement with the IRS in the fourth quarter of 2010. As a result of this settlement, we paid approximately $0.8 million in federal and state tax, interest and penalties. We accrued the settlement expenses prior to 2010. In 2009 and 2007 we accrued $0.2 million and $0.3 million, respectively, of estimated tax expense, and during 2009 and 2008 we recorded $0.1 million and $0.2 million, respectively, of estimated interest and penalties in general and administrative expense. All federal tax years subsequent to 2005 remain open to examination by the IRS.
NOTE 12-LOSS PER SHARE
The following table sets forth the computation of basic and diluted loss per common share for the years ended December 31, 2010, 2009 and 2008:
(b) For the years ended December 31, 2010, 2009 and 2008, we excluded 1,085, 1,287 and 1,273, weighted-average shares of restricted common stock from the calculation of diluted loss per share because the inclusion of these shares would have had an anti-dilutive impact on the calculation of loss per share.
Holders of unvested shares of our issued and outstanding restricted common stock are eligible to receive non-forfeitable dividends. As such, these unvested shares are participating securities requiring the two-class method of computing earnings per share. Pursuant to the two-class method, we report basic and diluted earnings per share both inclusive and exclusive of the participating securities.
NOTE 13-COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
We are a party to certain legal proceedings incidental to the normal course of our business, including the enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot at this time be predicted with certainty, we do not expect that these proceedings will have a material effect on our financial condition or results of operations.
FINANCIAL INSTRUMENTS
During the normal course of business, we are party to certain financial instruments, including loans, participations in loans, guarantees, letters of credit and other financial commitments. We conduct extensive due diligence and, when appropriate, obtain collateral to limit our credit risk. Generally, these commitments have fixed expiration dates or other termination clauses, which may require payment of a fee by the counterparty. We expect many of these commitments will not be fully used before they expire; therefore, the total commitment amounts do not necessarily represent future cash requirements.
We do not report the unused portions of these commitments on our Consolidated Balance Sheets. As of December 31, 2010 and 2009, we had $32.3 million and $36.5 million, respectively, of outstanding unused loan commitments. We estimate that for both December 31, 2010 and 2009 the fair value of these commitments were $0.2 million based on the fees that we currently charge to enter into similar arrangements, taking into account the creditworthiness of the counterparties. As of December 31, 2010 and 2009, we had no outstanding guarantees or standby letters of credit.
LEASE OBLIGATIONS
We lease our headquarters and certain other facilities under non-cancelable operating and capital leases which expire through 2014. We have sublet certain of our facilities to third parties. Future minimum lease payments for non-cancelable leases with terms of one year or more are as follows:
Certain leases contain provisions for rental options and rent escalations based on scheduled increases, as well as increases resulting from a rise in certain costs incurred by the lessor. During the years ended December 31, 2010, 2009 and 2008, our rent expense totaled $1.7 million, $1.8 million and $2.4 million, respectively, which was partially offset by sublease income in 2008 of $0.2 million.
NOTE 14-FINANCIAL HIGHLIGHTS
Following schedule summarizes financial highlights for the five years ended December 31, 2010:
(a) Based on total shares outstanding.
(b) Based on weighted-average shares outstanding.
(c) The effect on distributions of stock offerings after record dates represents the effect on net asset value of issuing additional shares after the record date of a distribution.
(d) Represents the effects of shares issued during the period and the lapsing of forfeiture provisions on restricted stock on earnings per share.
(e) Total return = [(ending market price per share - beginning market price per share + dividends paid per share) / beginning market price].
NOTE 15-SELECTED QUARTERLY DATA (UNAUDITED)
The following tables summarize key unaudited financial information for the eight quarters ended December 31, 2010. Results for any quarter are not necessarily indicative of results for the full year or for any future quarter.
NOTE 16-SUBSEQUENT EVENTS
AMENDED WAREHOUSE SALE AND SERVICING AGREEMENT
On January 25, 2011, SunTrust Bank provided the renewal of its liquidity facility that supports our SunTrust Warehouse through January 25, 2013. The new legal final maturity date of the SunTrust Warehouse is January 25, 2014. The SunTrust Warehouse is non-recourse to us; therefore, in the event of a termination event or upon the legal final maturity date, the lenders under the warehouse facility may only look to the collateral to satisfy the outstanding obligations under this facility.
In connection with the renewal of SunTrust Bank’s liquidity facility, we also agreed to a number of modifications to the SunTrust Warehouse terms, including an extension of the scheduled termination date of this facility to January 25, 2013. If a new agreement or extension is not executed by January 25, 2013, the SunTrust Warehouse enters a 12-month amortization period during which principal under the facility is paid down through orderly monetizations of portfolio company assets that are financed in the facility. Additionally, prior to the commencement of any amortization period, net proceeds from monetizations of collateral financed in the SunTrust Warehouse must be reinvested in additional collateral or used to repay outstanding borrowings.
The new interest rate on the SunTrust Warehouse equals the commercial paper rate plus 3.25%, an increase of 0.75% from the rate as of December 31, 2010. Outstanding borrowings on the SunTrust Warehouse were approximately $98.8 million as of January 24, 2011. We paid to SunTrust a facility renewal fee of $1.5 million, or 1.0%.
INCREASE IN SBIC DEBT COMMITMENT
In January 2011, the SBA approved an additional $20.0 million leverage commitment to the SBIC which increased the maximum amount of outstanding leverage available to us under the SBIC program to $150.0 million from $130.0 million as of December 31, 2010. To realize the full $150.0 million borrowing potential approved and committed under this program, we must fund a total of $75.0 million to the SBIC, which would be a $25.4 million increase from the amount we had funded as of December 31, 2010. The additional $20.0 million commitment may be drawn subject to the SBA’s approval and expires in September 2015. We paid a $0.2 million commitment fee related to this commitment.
SECOND SBIC LICENSE APPLICATION
On March 1, 2011, we made a submission to the SBA commencing our application process for a second SBIC license. If approved, our total borrowing capacity under the SBIC program will increase from $150 million to $225 million, subject to SBA approval of a capital commitment for the second SBIC and our funding of required capital.
PORTFOLIO INVESTMENTS
On February 14, 2011, Avenue Broadband LLC and the other stockholders of Avenue Broadband Holdings, Inc., or Holdings, signed a definitive agreement to sell all of the outstanding capital stock of Holdings. We anticipate that we will receive approximately $50.4 million in cash as a result of this transaction resulting from
the repayment of our debt investment and distributions on our equity investment. Final closing of the sale transaction is subject to satisfaction of customary closing conditions, including regulatory approvals, and is expected to occur in March 2011.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
1. Disclosure Controls and Procedures.
Our management, with the participation of our Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2010. The term “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the foregoing evaluation of our disclosure controls and procedures as of December 31, 2010, our Chief Executive Officer, our Chief Financial Officer and our Chief Accounting Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.
2. Internal Control Over Financial Reporting.
(a) MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Exchange Act as a process designed by, or under the supervision of, the company’s principal executive and principal financial officers and effected by the company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Our management, including the supervision and participation of the Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer, assessed the effectiveness of our internal control over financial reporting as of December 31, 2010. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in “Internal Control-Integrated Framework.”
Based on our assessment, management concluded that, as of December 31, 2010, our internal control over financial reporting is effective based on those criteria.
Our independent registered public accounting has issued an attestation report with regard to our internal control over financial reporting.
(b) ATTESTATION REPORT OF THE REGISTERED PUBLIC ACCOUNTING FIRM
The attestation report of our independent registered public accounting firm regarding our internal control over financial reporting appears on page 74.
(c) CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act), occurred during the fiscal quarter ended December 31, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
On March 3, 2011, the Company accepted William B. Ford’s resignation as a Senior Vice President and Managing Director of the Company, effective immediately, to allow him to pursue other interests. Mr. Ford’s resignation from the Company is not the result of any disagreement with the Company, known to an executive officer of the Company, on any matter relating to the Company’s operations, policies or practices.
On March 3, 2011, or the Separation Date, Mr. Ford executed a letter agreement, or the Letter Agreement, which sets forth the terms of his separation from the Company. Under the Letter Agreement, Mr. Ford will receive: (i) all of his accrued compensation through the Separation Date; and (ii) a payment in the amount of $175,000 (representing six months of Mr. Ford’s current base salary), which amount will be paid in installments over the six months following the Separation Date.
In addition, on the Separation Date, Mr. Ford is entitled to the following cash awards and shares of restricted stock (net of applicable taxes) originally awarded under certain of the Company’s incentive compensation plans:
•
3,333 shares of restricted stock for which forfeiture restrictions were scheduled to lapse on April 19, 2011 under the LTIP;
•
2,000 shares of restricted stock for which forfeiture restrictions were scheduled to lapse on November 1, 2011 under the LTIP;
•
1,333 shares of stock restricted stock for which forfeiture restrictions were scheduled to lapse on February 29, 2012 under the LTIP;
•
Cash in the amount of $15,333.33 for which restrictions were scheduled to lapse on April 19, 2011 under the LTIP;
•
Cash in the amount of $15,333.33 for which forfeiture restrictions were scheduled to lapse on November 1, 2011 under the LTIP;
•
Cash in the amount of $15,667.67 for which restrictions were scheduled to lapse on February 29, 2012 under the LTIP; and
•
50,000 shares of restricted stock for which forfeiture restrictions were scheduled to lapse on March 31, 2011 under the Company’s 2008 Retention Program.
In the event that, within 60 days of the Separation Date, the $8.00 threshold is satisfied under the LTIP, Mr. Ford will receive an additional $102,000 in cash. The 7,807 shares of restricted stock for which the forfeiture restrictions have not yet lapsed under the award made to Mr. Ford on April 30, 2008 pursuant to the Company’s Amended and Restated 2006 Employee Restricted Stock Plan will be forfeited.
Under law, the Letter Agreement may be revoked by Mr. Ford at any time prior to March 10, 2011.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
The information relating to our directors, nominees for election as directors, executive officers and audit committee under the headings Election of Directors, Corporate Governance-Our Executive Officers, Corporate Governance-Section 16(a) Beneficial Ownership Reporting Compliance and Corporate Governance-Board Committees in our definitive proxy statement for the 2011 Annual Meeting of Stockholders is incorporated herein by reference to such proxy statement.
We have adopted a written code of business conduct and ethics that applies to our directors, officers and employees, including our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. We make available our code of business conduct and ethics free of charge through our website which is located at www.mcgcapital.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K. We intend to disclose any amendments to, or waivers from, our code of business conduct and ethics that are required to be publicly disclosed pursuant to rules of the Securities and Exchange Commission and the NASDAQ Global Select Market by filing such amendment or waiver with the Securities and Exchange Commission and by posting it on our website.
We made no material change to the procedures by which stockholders may recommend nominees to our board of directors, as described in our 2010 proxy statement.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The discussion under the headings Executive Compensation, Compensation of Directors, Compensation Committee Report, Compensation Committee Interlocks and Insider Participation, and Narrative Disclosure of Our Compensation Policies and Practices as They Relate to Risk Management in our definitive proxy statement for the 2011 Annual Meeting of Stockholders is incorporated herein by reference to such proxy statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The discussion under the heading Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters in our definitive proxy statement for the 2011 Annual Meeting of Stockholders is incorporated herein by reference to such proxy statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
The discussion under the headings Certain Relationships and Related Transactions; Policies and Procedures for Related Person Transactions and Corporate Governance-Board Determination of Independence in our definitive proxy statement for the 2011 Annual Meeting of Stockholders is incorporated herein by reference to such proxy statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The discussion under the heading Ratification of Selection of Independent Registered Public Accounting Firm-Auditors’ Fees and-Pre-Approval Policies and Procedures in our definitive proxy statement for the 2011 Annual Meeting of Stockholders is incorporated herein by reference to such proxy statement.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
MCG Capital Corporation
We have audited the consolidated balance sheets of MCG Capital Corporation (the Company), including the consolidated schedule of investments, as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in net assets, and cash flows for each of the three years in the period ended December 31, 2010, and the consolidated financial highlights for each of the five years in the period ended December 31, 2010, and have issued our report thereon dated March 4, 2011 (included elsewhere in this Form 10-K). Our audits also included the Schedule 12-14 listed in Item 15 of this Form 10-K. The Schedule 12-14 is the responsibility of the Company’s management. Our responsibility is to express an opinion based on our audits.
In our opinion, the Schedule 12-14 referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP
McLean, Virginia
March 4, 2011
Schedule 12-14
MCG Capital Corporation
SCHEDULE OF INVESTMENTS IN AND ADVANCES TO AFFILIATES
MCG Capital Corporation
SCHEDULE OF INVESTMENTS IN AND ADVANCES TO AFFILIATES
This schedule should be read in conjunction with our Consolidated Financial Statements, including our Consolidated Schedule of Investments and Notes 3 and 4 to the Consolidated Financial Statements.
(a) Common stock, warrants, options and, in some cases, preferred stock generally are non-income producing and restricted. The principal amount of the debt and the number of shares of common stock and preferred stock is shown in the Consolidated Schedule of Investments as of December 31, 2010.
(b) Gross additions include increases in investments resulting from new portfolio company investments, paid-in-kind interest or dividends, amortization of discounts and fees, and exchange of one or more existing securities for one or more new securities. Gross additions also include net increases in unrealized appreciation or net decreases in unrealized depreciation.
(c) Gross reductions include decreases in investments resulting from principal collections related to investment repayments or sales and the exchange of one or more existing securities for one or more new securities. Gross reductions also include net increases in unrealized depreciation or net decreases in unrealized appreciation.
(d) All or part of this debt is on non-accrual status as of December 31, 2010, and, therefore, is considered non-income producing.
(e) We did not recognize paid-in-kind interest or accretion of dividend income during one or more quarters in 2010, including the quarter ended December 31, 2010, because the fair value of our investment was below its cost basis. However, we continue to accrue interest that is receivable in cash from the portfolio company.
(f) Represents the total amount of interest or dividends credited to income for the portion of the year an investment was a control investment (more than 25% owned) or an affiliate investment (5% to 25% owned), respectively. All dividend income is non-cash unless otherwise noted.
(g) Cash dividend.
** Information related to the amount of equity in the net profit and loss for the period for the investments listed has not been included in this schedule. This information is not considered to be meaningful due to the complex capital structures of the portfolio companies, with different classes of equity securities outstanding with different preferences in liquidation. These investments are neither consolidated nor accounted for under the equity method of accounting.
Exhibits
The following table lists exhibits filed as part of this report, according to the number assigned to them in Item 601 of Regulation S-K. All exhibits listed in the following table are incorporated by reference except for those exhibits denoted in the last column. Please note that the agreements included as exhibits to this Form 10-K are included to provide information regarding their terms and are not intended to provide any other factual or disclosure information about us or the other parties to the agreements. The agreements contain representations and warranties by each of the parties to the applicable agreement that have been made solely for the benefit of the other parties to the applicable agreement and may not describe the actual state of affairs as of the date they were made or at any other time.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 4, 2011.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.