Item 1. Business
General
GSC Investment Corp. is a Maryland corporation that has elected to be treated as a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”). The Company is the successor by merger to GSC Investment, LLC (the “LLC”), a Maryland limited liability company that had elected to be regulated as a BDC, which was merged into the Company concurrently with the Company’s incorporation on March 21, 2007. As a result of the merger, each outstanding common share of the LLC was converted into an equivalent number of shares of the Company’s common stock. As of February 28, 2007, the Company (including its predecessors) had not commenced operations or investment activities.
Our investment objectives are to generate current income and capital appreciation through debt and equity investments by primarily investing in middle market companies and select high yield bonds. We have elected and qualified to be treated as a regulated investment company (“RIC”) under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). We commenced operations on March 23, 2007 and completed our initial public offering (“IPO”) on March 28, 2007. We are externally managed and advised by our investment adviser, GSCP (NJ), L.P. (together with certain of its affiliates, “GSC Group”).
We used the net proceeds of our IPO to purchase approximately $100.7 million in aggregate principal amount of debt investments from GSC Partners CDO Fund III, Limited (“CDO Fund III”), a collateralized loan obligation (“CLO”) fund managed by our investment adviser. We used borrowings under our Facilities (as defined below) to purchase approximately $115.1 million in aggregate principal amount of debt investments in April and May 2007 from CDO Fund III and GSC Partners CDO Fund Limited (“CDO Fund I”), a collateralized debt obligation fund managed by our investment adviser. As of February 28, 2009, our portfolio consisted of $118.9 million of investments in 35 portfolio companies and one CLO.
Our portfolio is comprised primarily of investments in leveraged loans (comprised of both first and second lien term loans) issued by middle market companies and high yield bonds. We seek to create a diversified portfolio by investing up to 5% of our total assets in each investment, although the investment sizes may be more or less than the targeted range. These investments are sourced in both the primary and secondary markets through a network of relationships with commercial and investment banks, commercial finance companies and financial sponsors. Due to unfavorable conditions in the credit market, the majority of our trading activity over the last year has been in the secondary market. The leveraged loans and high yield bonds that we purchase are generally used to finance buyouts, acquisitions, growth, recapitalizations and other types of transactions. Leveraged loans are generally senior debt instruments that rank ahead of subordinated debt of the portfolio company. Leveraged loans also have the benefit of security interests on the assets of the portfolio company, which may rank ahead of, or be junior to, other security interests. High yield bonds are typically subordinated to leveraged loans and generally unsecured, though a substantial amount of the high yield bonds that we currently own are secured. Substantially all of the debt investments held in our portfolio hold a non-investment grade rating by Moody’s Investors Service (“Moody’s”) and/or Standard & Poor’s or, if not rated, would be rated below investment grade if rated. High yield bonds rated below investment grade are commonly referred to as “junk bonds.” As part of our long-term strategy, we also anticipate purchasing mezzanine debt and making equity investments in middle market companies. Mezzanine debt is typically unsecured and subordinated to senior debt of the portfolio company. For purposes of this Annual Report, we generally use the term “middle market” to refer to companies with annual EBITDA of between $5 million and $50 million. EBITDA represents earnings before net interest expense, income taxes, depreciation and amortization. Investments in middle market companies are generally less liquid than equivalent investments in companies with larger capitalizations.
While our primary focus is to generate current income and capital appreciation through investments in debt and equity securities of middle market companies and high yield bonds, we intend to invest up to 30% of our assets in opportunistic investments. Opportunistic investments may include investments in distressed debt, debt and equity securities of public companies, credit default swaps, emerging market debt, and structured finance vehicles, including CLOs. As part of this 30%, we may also invest in debt of middle market companies located outside the United States. Given our primary investment focus on first and second lien term loans issued by middle market companies and high yield bonds, we believe our opportunistic investments will allow us to supplement our core investments with other investments that are within our investment adviser’s expertise that we believe offer attractive yields and/or the potential for capital appreciation. As of February 28, 2009, our investment in the subordinated notes of GSC Investment Corp. CLO 2007, Ltd. (“GSCIC CLO”), a CLO we manage, constituted 17.1% of our total assets. We do not expect to manage and purchase all of the equity in another CLO transaction in the near future. We may, however, invest in CLO securities issued by other investment managers.
As a BDC, we are required to comply with certain regulatory requirements. For instance, we have to invest at least 70% of our total assets in “qualifying assets,” including securities of U.S. operating companies whose securities are not listed on a national securities
exchange (i.e., New York Stock Exchange, American Stock Exchange and The NASDAQ Global Market), U.S. operating companies with listed securities that have market capitalizations of less than $250 million, cash, cash equivalents, U.S. government securities and high-quality debt investments that mature in one year or less. In addition, we are only allowed to borrow money such that our asset coverage, which, as defined in the 1940 Act, measures the ratio of total assets less total liabilities (excluding borrowings) to total borrowings, equals at least 200% after such borrowing, with certain limited exceptions.
Investments
As of February 28, 2009, our portfolio consisted of $118.9 million in investments. We seek to create a diversified portfolio that includes leveraged loans, mezzanine debt and high yield bonds by investing up to 5% of our total investments in each portfolio company, although the investment sizes may be more or less than the targeted range. As of February 28, 2009, we invested in excess of 5% of our total investments in 4 of the 35 portfolio companies and the GSCIC CLO, but in each case less than 18.8% of our total investments, and our five largest portfolio company exposures represented approximately 43.6% of our total investments. As part of our long-term strategy, we also anticipate purchasing mezzanine debt and making equity investments in middle market companies.
Leveraged loans
Our leveraged loan portfolio is comprised primarily of first lien and second lien term loans. First lien term loans are secured by a first priority perfected security interest on all or substantially all of the assets of the borrower and typically include a first priority pledge of the capital stock of the borrower. First lien term loans hold a first priority with regard to right of payment. Generally, first lien term loans offer floating rate interest payments, have a stated maturity of five to seven years, and have a fixed amortization schedule. First lien term loans generally have restrictive financial and negative covenants. Second lien term loans are secured by a second priority perfected security interest on all or substantially all of the assets of the borrower and typically include a second priority pledge of the capital stock of the borrower. Second lien term loans hold a second priority with regard to right of payment. Second lien term loans offer either floating rate or fixed rate interest payments, generally have a stated maturity of five to eight years, and may or may not have a fixed amortization schedule. Second lien term loans that do not have fixed amortization schedules require payment of the principal amount of the loan upon the maturity date of the loan. Second lien term loans have less restrictive financial and negative covenants than those that govern first lien term loans.
High yield bonds
High yield bonds are generally either senior secured or unsecured. Senior secured bonds are secured by a perfected security interest on all or substantially all of the assets of the borrower (which, however, may be contractually subordinated to liens on certain assets of the borrower). In addition, senior secured bonds may have a pledge of the capital stock of the borrower. Senior secured bonds offer either floating rate or fixed rate interest payments and generally have a stated maturity of five to eight years and do not have fixed amortization schedules. Senior secured bonds generally have less restrictive financial and negative covenants than those that govern first lien and second lien term loans.
Unsecured bonds are not secured by the underlying assets or collateral of the issuer and may be subordinate in priority of payment to senior debt of the issuer. In the event of the borrower’s liquidation, dissolution, reorganization, bankruptcy or other similar proceeding, the bondholders only have the right to share pari passu in the issuer’s unsecured assets with other equally-ranking creditors of the issuer. Unsecured bonds typically have fixed rate interest payments and a stated maturity of five to ten years and do not have fixed amortization schedules.
Mezzanine debt
Mezzanine debt usually ranks subordinate in priority of payment to senior debt and is often unsecured. However, mezzanine debt ranks senior to common and preferred equity in a borrowers’ capital structure. Mezzanine debt typically has fixed rate interest payments and a stated maturity of six to eight years and does not have fixed amortization schedules.
In some cases our debt investments may provide for a portion of the interest payable to be paid-in-kind interest. To the extent interest is paid-in-kind, it will be payable through the increase of the principal amount of the obligation by the amount of interest due on the then-outstanding aggregate principal amount of such obligation.
Equity investments
Equity investments may consist of preferred equity that is expected to pay dividends on a current basis or preferred equity that does not pay current dividends. Preferred equity generally has a preference over common equity as to distributions on liquidation and
dividends. In some cases, we may acquire common equity. In general, our equity investments are not control-oriented investments and we expect that in many cases we will acquire equity securities as part of a group of private equity investors in which we are not the lead investor.
Opportunistic Investments
Opportunistic investments may include investments in distressed debt, debt and equity securities of public companies, credit default swaps, emerging market debt, structured finance vehicles, including CLOs, and debt of middle market companies located outside the United States. In January 2008, we purchased for $30 million all of the outstanding subordinated notes of GSCIC CLO, a $400 million CLO managed by us that invests primarily in leveraged loans. As of February 28, 2009, the GSCIC CLO portfolio consisted of $416.0 million in aggregate principal amount of investments in 152 obligors with an average obligor exposure of $2.7 million and $9.4 million in uninvested cash. The weighted average maturity of the portfolio is 4.7 years. We do not expect to manage and purchase all of the equity in another CLO transaction in the near future. We may, however, invest in CLO securities issued by other investment managers.
Prospective portfolio company characteristics
Our investment adviser, GSC Group, utilizes the investment philosophy of its corporate credit and distressed investment group in identifying and selecting portfolio company investments. Our portfolio companies generally have one or more of the following characteristics:
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a history of generating stable earnings and strong free cash flow;
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well constructed balance sheets, including an established tangible liquidation value;
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reasonable debt-to-cash flow multiples;
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industry leadership with competitive advantages and sustainable market shares in attractive sectors; and
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capital structures that provide appropriate terms and reasonable covenants.
Investment selection
In managing us, GSC Group employs the same investment philosophy and portfolio management methodologies used by its corporate credit and distressed investment group. Through this investment selection process, based on quantitative and qualitative analysis, GSC Group seeks to identify issuers with superior fundamental risk-reward profiles and strong, defensible business franchises with the goal of minimizing principal losses while maximizing risk-adjusted returns. Our adviser’s investment process emphasizes the following:
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bottoms-up, company-specific research and analysis;
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capital preservation, low volatility and minimization of downside risk; and
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investing with experienced management teams that hold meaningful equity ownership in their businesses.
Our adviser’s investment process generally includes the following steps:
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Initial screening. A brief analysis identifies the investment opportunity and reviews the merits of the transaction. The initial screening memorandum provides a brief description of the company, its industry, competitive position, capital structure, financials, equity sponsor and deal economics. If the deal is determined to be attractive by the senior members of the deal team, the opportunity is more fully analyzed.
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Full analysis. A full analysis includes:
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Business and Industry analysis - a review of the company’s business position, competitive dynamics within its industry, cost and growth drivers and technological and geographic factors. Business and industry research often includes meetings with industry experts, consultants, other investors, customers and competitors.
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Company analysis - a review of the company’s historical financial performance, future projections, cash flow characteristics, balance sheet strength, liquidation value, legal, financial and accounting risks, contingent liabilities, market share analysis and growth prospects.
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Structural/security analysis - a thorough legal document analysis including but not limited to an assessment of financial and negative covenants, events of default, enforceability of liens and voting rights.
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Approval of the group head. After an investment has been identified and diligence has been completed, a report is prepared. This report is reviewed by the senior investment professional in charge of the potential investment. If such senior investment professional is in favor of the potential investment, it is presented for the approval of the group head. Additional due diligence with respect to any investment may be conducted by attorneys and independent accountants prior to the closing of the investment, as well as by other outside advisers, as appropriate.
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Approval of the investment committee. After the approval of the group head, the investment is presented to the investment committee for approval. Sale recommendations made by the investment staff must also be approved by the investment committee. Purchase and sale recommendations over $10 million per issuer require unanimous and majority approval of the investment committee, respectively. Each of our Chief Executive Officer, Seth M. Katzenstein, and Chairman, Richard M. Hayden has discretionary authority to make purchases or sales below $10 million per issuer, subject to certain aggregate limits.
Investment structure
In general, our investment adviser intends to select investments with financial covenants and terms that reduce leverage over time, thereby enhancing credit quality. These methods include:
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maintenance leverage covenants requiring a decreasing ratio of debt to cash flow;
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maintenance cash flow covenants requiring an increasing ratio of cash flow to the sum of interest expense and capital expenditures; and
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debt incurrence prohibitions, limiting a company’s ability to re-lever.
In addition, limitations on asset sales and capital expenditures should prevent a company from changing the nature of its business or capitalization without consent.
Our investment adviser seeks, where appropriate, to limit the downside potential of our investments by:
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requiring a total return on our investments (including both interest and potential equity appreciation) that compensates us for credit risk;
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requiring companies to use a portion of their excess cash flow to repay debt;
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selecting investments with covenants that incorporate call protection as part of the investment structure; and
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selecting investments with affirmative and negative covenants, default penalties, lien protection, change of control provisions and board rights, including either observation or participation rights.
There may be certain restrictions on our investment adviser’s ability to negotiate and structure the terms of our investments when we co-invest with other GSC Group-managed investment vehicles. See “- Co-investment” below.
Valuation process
Investments for which market quotations are readily available are recorded in our financial statements at such market quotations subject to any decision by our Board of Directors to make a fair value determination to reflect significant events affecting the value of these investments. We value investments for which market quotations are not readily available quarterly at fair value as determined in good faith by our Board of Directors based on input from our investment adviser, our audit committee and, if our board or audit committee so request, a third party independent valuation firm. Determinations of fair value may involve subjective judgments and estimates. The types of factors that may be considered in a fair value pricing include the nature and realizable value of any collateral, the portfolio company’s ability to make payments, the markets in which the portfolio company does business, market yield trend analysis, comparison to publicly traded companies, discounted cash flow and other relevant factors.
Our investment in the subordinated notes of GSCIC CLO is carried at fair value, which is based on a discounted cash flow model that utilizes prepayment, re-investment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow, and comparable yields for similar CLO subordinated notes or equity, when available.
We undertake a multi-step valuation process each quarter when valuing investments for which market quotations are not readily available, as described below:
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each investment is initially valued by the responsible investment professionals and preliminary valuation conclusions are documented and discussed with our senior management; and
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an independent valuation firm engaged by our Board of Directors independently values at least one quarter of our investments each quarter so that the valuation of each investment for which market quotes are not readily available is independently valued by an independent valuation firm at least annually.
In addition, all our investments are subject to the following valuation process:
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the audit committee of our Board of Directors reviews each preliminary valuation and our investment adviser and independent valuation firm (if applicable) will supplement the preliminary valuation to reflect any comments provided by the audit committee; and
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our Board of Directors discusses the valuations and determines the fair value of each investment in good faith based on the input of our investment adviser, independent valuation firm (if applicable) and audit committee.
Because such valuations, and particularly valuations of private investments and private companies, are inherently uncertain, they may fluctuate over short periods of time and may be based on estimates. The determination of fair value by our Board of Directors may differ materially from the values that would have been used if a ready market for these investments existed. Our net asset value could be materially affected if the determinations regarding the fair value of our investments were materially higher or lower than the values that we ultimately realize upon the disposal of such investments.
Ongoing relationships with and monitoring of portfolio companies
Our investment adviser will closely monitor each investment the Company makes and, when appropriate, will conduct a regular dialogue with both the management team and other debtholders and seek specifically tailored financial reporting. In addition, in certain circumstances, senior investment professionals of GSC Group may take board seats or board observation seats.
Leverage
In addition to funds available from the issuance of our common stock, we use borrowed funds, known as “leverage,” to make investments and to attempt to increase returns to our shareholders by reducing our overall cost of capital. As a BDC, we are only allowed to employ leverage to the extent that our asset coverage, as defined in the 1940 Act, equals at least 200% after giving effect to such leverage. As of February 28, 2009, our asset coverage ratio, as defined in the 1940 Act, was 215%.
On April 11, 2007, we entered into a $100 million revolving securitized credit facility (the “Revolving Facility”). On May 1, 2007, we entered into a $25.7 million term securitized credit facility (the “Term Facility” and, together with the Revolving Facility, the
“Facilities”), which was fully drawn at closing. In December 2007, we consolidated the Facilities by using a draw under the Revolving Facility to repay the Term Facility. Effective January 14, 2009, we terminated the revolving period of the Revolving Facility and commenced a two-year amortization period during which all principal proceeds from the collateral will be used to repay outstanding borrowings. At the end of the two year amortization period, all advances will be due and payable. In March 2009 we amended the Revolving Credit Facility to decrease the minimum required collateralization and increase the portion of the portfolio that can be invested in “CCC” rated investments in return for an increased interest rate and expedited amortization.
As of February 28, 2009, we had borrowed an aggregate of $59.0 million under the Revolving Facility. Interest is payable on funds drawn under the Revolving Facility at the prevailing commercial paper rates or, if the commercial paper market is at any time unavailable, the prevailing LIBOR rates, plus 0.70%, payable monthly. The interest margin will increase from and after the March 2009 amendment to 4.00% until March 2010 (6.00% if the commercial paper market is unavailable) and 5.00% thereafter (6.00% if the commercial paper market is unavailable).
A significant percentage of our total investments have been pledged to secure our obligations under the Revolving Facility.
In the interests of diversifying our sources of debt funding, we may in the future borrow from and issue senior debt securities to banks and other lenders and/or securitize certain of our portfolio investments, subject to our ability to satisfy the 1940 Act restrictions on BDCs.
Dividend
We intend to make quarterly distributions to our stockholders out of assets legally available for distribution. Our quarterly distributions, if any, will be determined by our Board of Directors. Any such distributions will be taxable to our stockholders, including to those stockholders who receive additional shares of our common stock pursuant to a dividend reinvestment plan.
In order to maintain our qualification as a RIC, we must for each fiscal year distribute an amount equal to at least 90% of our ordinary net taxable income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, reduced by deductible expenses. In addition, we will be subject to federal excise taxes to the extent we do not distribute during the calendar year at least (1) 98% of our ordinary income for the calendar year, (2) 98% of our capital gains in excess of capital losses for the one year period ending on October 31 of the calendar year and (3) any ordinary income and net capital gains for preceding years that were not distributed during such years. To provide stability in our dividend distributions (which might otherwise be adversely affected by timing mismatches between the receipt of payments on our investments and the payment of dividends) we did not distribute all of our ordinary income earned during the 2008 calendar year and incurred federal excise taxes as a result. There were no capital gains in excess of capital losses realized during the one year period ended October 31, 2008. We expect to declare dividends payable from 2008 calendar year earnings prior to November 15, 2009 and to distribute such dividends prior to February 28, 2010. We may similarly withhold from distribution a portion of our ordinary income for the 2009 calendar year and/or portion of the capital gains in excess of capital losses realized during the one year period ending October 31, 2009, if any, and, if we do so, we would expect to incur federal excise taxes again as a result.
We maintain an “opt out” dividend reinvestment plan for our common stockholders. As a result, if we declare a dividend, then stockholders’ cash dividends will be automatically reinvested in additional shares of our common stock, unless they specifically “opt out” of the dividend reinvestment plan so as to receive cash dividends.
We have distributed $2.58 per share of dividends to stockholders since we commenced operations in March 2007. Please see Part II, Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for additional details. We are prohibited from making distributions that cause us to fail to maintain the asset coverage ratios stipulated by the 1940 Act or that violate our debt covenants.
Subject to certain conditions, for taxable years ending on or before December 31, 2009, we are permitted to make distributions to our stockholders in the form of shares of our common stock in lieu of cash distributions. The decision to make such distributions will be made by our Board of Directors.
About GSC Group
GSC Group was founded in 1999 by Alfred C. Eckert III, its Chairman and Chief Executive Officer. GSC Group specializes in complex credit-based alternative investment strategies. GSC Group is privately owned, has approximately 85 employees, and has
offices in New Jersey, New York and London. GSC Group conducts its investment advisory business through GSCP (NJ), L.P., an investment adviser registered with the U.S. Securities and Exchange Commission (the “SEC”) with approximately $8.2 billion of assets under management(1) as of December 31, 2008.
GSC Group operates in two main business lines: (i) the corporate credit and distressed investments group, which provides investment advisory and management services to the Company, which is comprised of 19 investment professionals who manage approximately $7.4 billion of assets(1) in various collateralized loan and debt obligation funds, credit funds, control distressed debt funds and sponsors, provides administrative services to, and acts as officers and directors of, a special acquisition company and (ii) the European Mezzanine Lending group, which is comprised of 8 investment professionals who manage approximately $0.8 billion of assets(1) in various mezzanine lending funds.
(1)
The methodology used by GSC Group to calculate its assets under management varies with the nature of the account and represents (i) the sum of cash, uncalled capital commitments, as applicable, and the market value of each investment or (ii) the principal balance of the underlying assets adjusted for defaulted securities plus the market value of equity securities, all as measured under the relevant account documents. In all cases, the fair value (as determined in accordance with U.S. GAAP) of the underlying assets may differ significantly from the assets under management as forth above. Assets under management does not include pooled investment vehicles comprised of asset-backed securities that are co-managed by GSC Group with a sub-advisor
Our investment adviser
Our Chairman, Richard M. Hayden, and Chief Executive Officer, Seth M. Katzenstein, are senior managers of our investment adviser. Mr. Hayden is Vice Chairman of GSC Group, head of GSC Group’s European mezzanine lending group and serves on both the European CDO and European mezzanine lending group credit committees. Mr. Katzenstein is a Senior Managing Director of GSC Group, a member of the European mezzanine lending group and serves on both the GSC Investment Corp. and U.S. CDO credit committees. Mr. Hayden and Mr. Katzenstein have over 35 years and 13 years experience in the financial services industry, respectively. Mr. Hayden and Mr. Katzenstein are supported by the 19 investment professionals within GSC Group’s corporate credit and distressed investments group.
Our investment adviser is responsible for administering our business activities and day-to-day operations. Our investment adviser is able to leverage GSC Group’s current investment platform, resources and existing relationships with financial institutions, financial sponsors and investment firms to provide us with attractive investment opportunities. In addition to deal flow, the GSC Group investment platform assists our investment adviser in analyzing and monitoring investments. In particular, these resources provide us with a wide variety of investment opportunities and information that assists us in making investment decisions across our targeted asset classes, which we believe provide us with a competitive advantage. GSC Group has been investing in corporate debt since its founding in 1999. In addition to having access to GSC Group’s investment professionals, we also have access to GSC Group’s administrative professionals who provide assistance in accounting, legal, compliance and investor relations.
Our relationship with our investment adviser and GSC Group
We currently have no employees, and each of our executive officers is also an employee of GSC Group. As of May 4, 2009, GSC Group and its affiliates owned 995,869 shares (12%) of our common stock and senior employees of GSC Group (managing director and above) owned an additional 382,425 shares (4.6%) of our common stock. Some, but not all, of these persons are required to file statements of beneficial ownership pursuant to Section 16 of the Exchange Act.
Our investment advisory and management agreement with our investment adviser has been renewed through March 21, 2010. Pursuant to the investment advisory and management agreement, our investment adviser implements our business strategy on a day-to-day basis and performs certain services for us, subject to oversight by our Board of Directors. Our investment adviser is responsible for, among other duties, performing all of our day-to-day functions, determining investment criteria, sourcing, analyzing and executing investments, asset sales, financings and performing asset management duties. Under our investment advisory and management agreement, we have agreed to pay our investment adviser an annual base management fee based on our total assets, as defined under the 1940 Act (other than cash and cash equivalents but including assets purchased with borrowed funds), and an incentive fee based on our performance. The investment advisory and management agreement renews automatically for additional one-year terms at the end of each year subject to certain approvals by our Board of Directors and/or our stockholders.
Pursuant to our investment advisory and management agreement, our investment adviser has formed an investment committee to advise and consult with our investment adviser’s senior management team with respect to our investment policies, investment
portfolio holdings, financing and leveraging strategies and investment guidelines. We believe that the cumulative experience of the investment committee members across a variety of fixed income asset classes benefits us. Along with GSC Group’s U.S. corporate credit and distressed investments group’s investment staff, the investment committee monitors investments in our portfolio.
In April 2009, our investment adviser withheld a scheduled principal amortization payment under its credit facility, resulting in a default thereunder. Our investment adviser has initiated discussions with its secured lenders regarding a consensual restructuring of its obligations under such credit facility. While we are not directly affected by our investment adviser’s default, if it is unable to restructure its credit facility, or an acceleration of the outstanding principal balance by the lenders occurs, the ability of the investment adviser to retain key individuals and perform its investment advisory duties for us could be significantly impaired. A material adverse change in the business, condition (financial or otherwise), operations or performance of our investment adviser could constitute a default under our Revolving Facility.
Competitive advantages
We believe that through our relationship with GSC Group we enjoy several competitive advantages over other capital providers to private middle market companies.
GSC Group’s investment platform
GSC Group has a long history of strong performance across a broad range of asset classes and sectors. The senior investment professionals of GSC Group have extensive experience investing in leveraged loans, high-yield bonds, mezzanine debt and private equity. GSC Group’s corporate credit and distressed investments group has drawn from its extensive middle market investment experience to develop a rigorous investment process that emphasizes detailed business and financial analysis to minimize principal loss while maximizing risk adjusted returns.
Experience sourcing and managing middle market loans
GSC Group’s U.S. corporate credit and distressed investments group has historically focused on investments in private middle market companies and we expect to benefit from this experience. Our investment adviser uses GSC Group’s extensive network of relationships with intermediaries focused on private middle market companies to attract well-positioned prospective portfolio company investments. Since 2003, GSC Group’s U.S. corporate credit and distressed investments group has reviewed over 1,200 new middle market loan opportunities, including over 400 second lien loans. Of the loans reviewed, approximately 350 were purchased by the group for the clients it advises, including approximately 60 second lien loans.
Experienced management and investment committee
Seth M. Katzenstein, our Chief Executive Officer and a Senior Managing Director of GSC Group, has over 13 years of financial services experience, having managed leveraged loan, high-yield bond, mezzanine debt, distressed debt and private equity portfolios. In addition to Mr. Katzenstein, our investment committee consists of Robert F. Cummings, Jr., a Director of the Company and a Senior Managing Director of GSC Group, who has over 35 years experience in corporate finance, Michael R. Lynch, a Senior Managing Director, Chief Administrative Officer and Chief Financial Officer of GSC Group, who has over 30 years corporate finance experience and Alexander B. Wright, a Managing Director of GSC Group, who has over 15 years corporate finance experience.
Access to GSC Group’s infrastructure
We have access to GSC Group’s finance and administration infrastructure, which addresses information technology, risk management, legal and compliance, and operational matters, and promulgates and administers comprehensive policies and procedures regarding important investment adviser matters, including portfolio management, trade allocation and execution and securities valuation. We believe that the finance and administrative infrastructure established by GSC Group is an important component of a complex investment vehicle such as a BDC. These systems support, and are integrated with, our portfolio management functions.
We also have the benefit of the experience of GSC Group’s senior professionals, many of whom have served on public and private company boards and/or served in other senior management roles.
Compliance policies
GSC Group has designed a compliance program to monitor its conflict-resolution policies and procedures and regularly evaluates the reasonableness of such policies and procedures. GSC Group’s compliance program monitors the implementation of and tests adherence to compliance-related policies and procedures that address GSC Group’s Code of Ethics and other compliance matters including investment allocation, trade aggregation, best execution, cross trades and proxy voting and related matters. The program is governed in part by the requirements of the 1940 Act and is headed by GSC Group’s Chief Compliance Officer.
Managerial assistance
As a BDC we offer, and must provide upon request, managerial assistance to our portfolio companies. This assistance could involve, among other things, monitoring the operations of our portfolio companies, participating in board and management meetings, consulting with and advising officers of portfolio companies and providing other organizational and financial guidance. Pursuant to a separate administration agreement, our investment adviser (to the extent permitted under the 1940 Act) will provide such managerial assistance on our behalf to portfolio companies that request this assistance, recognizing that our involvement with each investment will vary based on factors including the size of the company, the nature of our investment, the company’s overall stage of development and our relative position in the capital structure. We may receive fees for these services.
Competition
Our primary competitors in providing financing to private middle market companies include public and private investment funds, commercial and investment banks and commercial financing companies. Many of our competitors are substantially larger and have considerably greater financial and marketing resources than us. For example, some competitors may have 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 may allow them to consider a wider variety of investments. Furthermore, many of our competitors are not subject to the regulatory restrictions that the 1940 Act imposes on us as a BDC. We expect to use GSC Group’s knowledge and resources to learn about, and compete effectively for, financing opportunities with attractive private middle market companies in the industries in which we seek to invest. For additional information concerning the competitive risks we face, please see Part I, Item 1A
Item 1A. Risk Factors
Investing in our common stock involves a high degree of risk. The risks set forth below are not the only risks we face. If any of the following risks occur, our business and financial condition could be materially adversely affected. In such case, our net asset value and the trading price of our common stock could decline.
Risks related to current economic and market conditions
Economic recessions, including the current global recession, could impair our portfolio companies and harm our operating results.
The U.S. economy is in the midst of a severe recession that is expected to continue until late 2009 or 2010. Many of the companies in which we have made or will make investments are susceptible to economic slowdowns or recessions. An economic recession, including the current and any future recessions or economic slowdowns, may affect the ability of a company to repay our loans or engage in a liquidity event such as a sale, recapitalization, or initial public offering. Our nonperforming assets are likely to increase and the value of our portfolio is likely to decrease during these periods. Current adverse economic conditions also have decreased the value of any collateral securing our loans, if any, and a prolonged recession or depression may further decrease such value. A portfolio company’s failure to satisfy financial or operating covenants imposed by us or other lenders could lead to defaults and, potentially, acceleration of the time when the loans are due 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 that we hold and the value of any equity securities we own. We may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting portfolio company. These conditions are contributing to, and if prolonged could lead to further, losses of value in our portfolio and a decrease in our revenues, net income, assets and net worth.
Declining asset values and illiquidity in the corporate debt markets have adversely affected, and may continue to adversely affect, the fair value of our portfolio investments, reducing the value of our assets.
As a BDC, we are required to carry our investments at market value or, if no market value is ascertainable, at fair market value as determined in good faith by the Board of Directors. Decreases in the values of our investments are recorded as unrealized depreciation. The continuing unprecedented declines in asset values and liquidity in the corporate debt markets have resulted in significant net unrealized depreciation in our portfolio. As of February 28, 2009, conditions in the debt markets had continued to deteriorate and pricing levels continued to decline. As a result, we have incurred and, depending on market conditions, we may continue to incur, significant unrealized depreciation in our portfolio, which could have a material adverse impact on our business, financial condition and results of operations.
Ratings downgrades in our portfolio could require us to liquidate assets or face a default under the Revolving Facility.
The amount that may be outstanding under our Revolving Facility at any time (our “Borrowing Base”) is based on, among other things, the value of the pledged collateral. (See Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Financial Condition, Liquidity and Capital Resources” in this Annual Report for details). If securities deemed to have a rating of Caa2 or below by Moody’s comprise in excess of 30% of the value of the collateral, such excess Caa2 rated securities are deemed to have a value of zero when calculating the Borrowing Base. The economic recession and resultant stress on our portfolio companies has resulted in a large number of our portfolio companies being downgraded by one or more rating agencies, and continued economic stress may result in additional downgrades in the future. As of February 28, 2009, approximately 23.4% of the collateral was deemed to be rated Caa2 or below by Moody’s and a further 29.5% of the collateral was deemed to be rated Caa1. In some cases, we feel that these ratings do not reflect the underlying strength of the investment; in other cases, we feel that current market conditions preclude obtaining a fair sale price for the investment.
Once the 30% threshold is reached, any additional Caa2 downgrades would cause our Borrowing Base to decrease, and may result in the Borrowing Base being less than our outstanding borrowings. In such circumstances, we would be required to repay the excess borrowing within a prescribed time limit or increase our Borrowing Base by pledging more collateral. Failure to cure a Borrowing Base violation within the prescribed time limit constitutes a default under the Revolving Facility and may result in an acceleration of all outstanding loans. If we are unable to promptly repay the accelerated loans, our lenders could liquidate the collateral.
The current severe capital markets disruption has limited our ability to obtain new equity capital and alternative sources of leverage.
The U.S. capital markets have been experiencing extreme volatility and disruption for more than 12 months, as evidenced by a lack of liquidity in the debt capital markets, significant write-offs in the financial services sector, the re-pricing of risk in the credit markets and the failure of major financial institutions. This prolonged period of financial market illiquidity has had, and will continue to have, an adverse effect on our business, financial condition, and results of operations. We have been unable to find new or alternative sources of leverage to supplement or replace our Revolving Facility, which entered into its amortization period in January 2009. The current bear market in equities has made equity capital difficult or impossible to raise, as our stock has been trading below net asset value, and, under the 1940 Act, we are generally unable to issue and sell our common stock at a price below net asset value per share. If our lender is unable to fund our existing debt in the commercial paper market, the cost of our Revolving Facility may also increase. These events have, and will continue to have, negative repercussions on our operating results and on our ability to grow.
Our common stock could be delisted from the New York Stock Exchange if our average market capitalization over 30 consecutive trading days is below $15 million.
In order to maintain our listing on the New York Stock Exchange (“NYSE”), we must continue to meet the NYSE minimum average market capitalization requirement. At February 28, 2009, our minimum average market capitalization over the preceding 30 consecutive trading days was $19.5 million. If the average market capitalization over 30 consecutive trading days falls below $15.0 million, our common stock may be delisted, which could (i) reduce the liquidity and market price of our common stock; (ii) negatively impact our ability to raise equity financing and access the public capital markets; and (iii) materially adversely impact our results of operations and financial condition.
Risks related to our business
We employ leverage.
We currently use the Revolving Facility to leverage our portfolio and we expect in the future to borrow from and issue senior debt securities to banks and other lenders and may securitize certain of our portfolio investments.
With certain limited exceptions, as a BDC we are only allowed to borrow amounts such that our asset coverage, as defined in the 1940 Act, is at least 200% after such borrowing. The amount of leverage that we employ will depend on our investment adviser’s and our Board of Directors’ assessment of market conditions and other factors at the time of any proposed borrowing. There is no assurance that a leveraging strategy will be successful. Leverage involves risks and special considerations for stockholders, including:
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A likelihood of greater volatility in the net asset value and market price of our common stock.
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Diminished operating flexibility as a result of asset coverage or investment portfolio composition requirements that are more stringent than those imposed by the 1940 Act.
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The possibility that investments will have to be liquidated at less than full value or at inopportune times to comply with debt covenants or to pay interest or dividends on the leverage.
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Increased operating expenses due to the cost of leverage, including issuance and servicing costs.
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Subordination to lenders’ superior claims on our assets as a result of which lenders will be able to receive proceeds available in the case of our liquidation before any proceeds are distributed to our shareholders.
For example, the amount we may borrow under our Revolving Facility is determined, in part, by the fair value of our investments. If the fair value of our investments declines, we may be forced to sell investments at a loss to maintain compliance with our borrowing limits. Other debt facilities we may enter into in the future may contain similar provisions. Any such forced sales would reduce our net asset value and also make it difficult for the net asset value to recover.
Our investment adviser and our Board of Directors in their best judgment nevertheless may determine to use leverage if they expect that the benefits to our stockholders of maintaining the leveraged position will outweigh the risks.
We need to find alternative sources of leverage and/or access the equity markets to maintain and grow our business.
Our Revolving Facility entered its amortization period effective January 14, 2009. During the amortization period, all principal proceeds of our pledged investments are used to reduce the outstanding borrowings under the Revolving Credit Facility. On the second anniversary of the amortization period, all remaining outstanding borrowings under the Revolving Credit Facility will become due and payable. As a result of these mandatory repayments, our investment portfolio will begin to de-leverage commencing with the payment of the first principal proceeds on our portfolio, and must be completely deleveraged in two years, unless we can obtain an alternative source of financing. Given the unfavorable conditions in the credit markets, there is no guarantee we will be able to secure new financing in the immediate future or, if we are able to obtain financing, that the terms of such financing will be commensurate with the terms of the Revolving Credit Facility. Because our ability to generate net investment income is based, in part, on the use of relatively inexpensive financing available under the Revolving Credit Facility to purchase portfolio assets, the amortization of the Revolving Credit Facility will negatively impact our ability to generate investment income (and pay dividends) in the future.
Because the amount of leverage we can employ is limited by the 1940 Act, our ability to grow depends on raising additional equity capital notwithstanding the availability of additional leverage. An inability to successfully access the capital markets will limit our ability to grow our business and fully execute our business strategy.
Many of our portfolio investments are recorded at fair value as determined in good faith by our Board of Directors; such valuations are inherently uncertain and may be materially higher or lower than the values that we ultimately realize upon the disposal of such investments.
A large percentage of our portfolio is, and we expect will continue to be, comprised of investments that are not publicly traded. The value of investments that are not publicly traded may not be readily determinable. We value these investments quarterly at fair value as determined in good faith by our Board of Directors. Where appropriate, our Board of Directors may utilize the services of an independent valuation firm to aid it in determining fair value. The types of factors that may be considered in valuing our investments include the nature and realizable value of any collateral, the portfolio company’s ability to make payments and its earnings, the markets in which the portfolio company does business, market yield trend analysis, comparison to publicly traded companies, discounted cash flow and other relevant factors. Because such valuations, and particularly valuations of private investments and private companies, are inherently uncertain, 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 ready market for these investments existed. Our net asset value could be materially affected if the determinations regarding the fair value of our investments were materially higher or lower than the values that we ultimately realize upon the disposal of such investments.
We may be obligated to pay our investment adviser incentive compensation even if we incur a net loss, regardless of the market value of our common stock.
Our investment adviser is entitled to incentive compensation for each fiscal quarter in an amount equal to a percentage of the excess of our investment income for that quarter (before deducting incentive compensation, net operating losses and certain other items) above a threshold return for that quarter. Our pre-incentive fee net investment income, for incentive compensation purposes, excludes realized and unrealized capital losses that we may incur in the fiscal quarter, even if such capital losses result in a net loss on our statement of operations for that quarter. Thus, we may be required to pay our investment adviser incentive compensation for a fiscal quarter even if there is a decline in the value of our Portfolio or we incur a net loss for that quarter.
Under the investment advisory and management agreement, we will defer cash payment of any incentive fee otherwise earned by our investment adviser if, during the most recent four full quarterly periods ending on or prior to the date such payment is to be made, the sum of (a) our aggregate distributions to our stockholders and (b) our change in net assets (defined as total assets less liabilities) is less than 7.5% of our net assets at the beginning of such period. These calculations will be appropriately pro rated during the first three quarters of this fiscal year and will be adjusted for any share issuances or repurchases. Furthermore, the incentive fee that we pay is not tied to the market value of our common stock.
If a portfolio company defaults on a loan that is structured to provide accrued interest, it is possible that accrued interest previously included in the calculation of the incentive fee will become uncollectible. The investment adviser is not under any obligation to reimburse us for any part of the incentive fee it received that was based on accrued income that we never received as a result of a default by an entity on the obligation that resulted in the accrual of such income.
Our investment adviser’s incentive compensation may cause it to pursue a high risk investment strategy.
The incentive fee payable to the investment adviser may create an incentive for the investment adviser to make investments that are riskier or more speculative than would be the case in the absence of such compensation arrangement. The way in which the incentive fee payable to the investment adviser is determined (20% of the pre-incentive fee net investment income that exceeds a hurdle rate of a 1.875% quarterly return on the value of net assets) may encourage the investment adviser to use leverage to increase the return to the Company’s investments. If the investment adviser acquires poorly-performing assets with such leverage, the loss to holders of the shares could be substantial. Moreover, if our leverage is increased, we will be exposed to increased risk of loss, bear the increased cost of issuing and servicing such senior indebtedness, and will be subject to any additional covenant restrictions imposed on us in an indenture or other instrument or by the applicable lender. Our Board of Directors will monitor the conflicts presented by this compensation structure by approving the amount of leverage that we may incur. In addition, the investment adviser receives the incentive fee based, in part, upon net capital gains realized on our investments. Unlike the portion of the incentive fee based on income, there is no hurdle rate applicable to the portion of the incentive fee based on net capital gains. As a result, the investment adviser may have a tendency to invest more in investments that are likely to result in capital gains as compared to income producing securities. Such a practice could result in our investing in more speculative securities than would otherwise be the case, which could result in higher investment losses, particularly during economic downturns.
Our investment adviser’s base compensation may cause it to increase our leverage contrary to our interest.
We pay the investment adviser a quarterly base management fee based on the value of our total assets (including any assets acquired with leverage). Accordingly, the investment adviser has an economic incentive to increase our leverage. Our Board of Directors monitors the conflicts presented by this compensation structure by approving the amount of leverage that we incur. If our leverage is increased, we will be exposed to increased risk of loss, bear the increase cost of issuing and servicing such senior indebtedness, and will be subject to any additional covenant restrictions imposed on us in an indenture or other instrument or by the applicable lender.
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 plan to make in private middle market companies. We compete with other BDCs, public and private funds, commercial and investment banks, commercial financing companies, insurance companies, high-yield investors, hedge funds, and, to the extent they provide an alternative form of financing, private equity funds. Many of our competitors are substantially larger and have considerably greater financial, technical and marketing resources than us. 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 that 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 that the 1940 Act imposes on us as a BDC. As a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time, and we cannot assure you that we will be able to identify and make investments that meet our investment objectives.
We do not seek to compete primarily based on the interest rates we offer and we believe that some of our competitors may 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. As a result of operating in such a competitive environment, we may make investments that are on better terms to our portfolio companies than we originally anticipated, which may impact our return on these investments.
We are a non-diversified investment company within the meaning of the 1940 Act, and therefore are not limited with respect to the proportion of our assets that may be invested in securities of a single issuer. To the extent that we assume large positions in the securities of a small number of issuers, our net asset value may fluctuate to a greater extent than that of a diversified investment company as a result of changes in the financial condition or the market’s assessment of the issuer. We may also be more susceptible to any single economic or regulatory occurrence than a diversified investment company. However, we intend to comply with the diversification requirements imposed by the Code for qualification as a RIC.
Our financial condition and results of operation depend on our ability to manage future growth effectively.
Our ability to achieve our investment objectives depends on our ability to acquire suitable investments and monitor and administer those investments, which depends, in turn, on our investment adviser’s ability to identify, invest in and monitor companies that meet our investment criteria.
Accomplishing this result on a cost-effective basis is largely a function of our investment adviser’s structuring of the investment process and its ability to provide competent, attentive and efficient service to us. Our executive officers and the employees of our investment adviser have substantial responsibilities in connection with their roles at GSC Group and with the other GSC Group investment vehicles as well as responsibilities under the investment advisory and management agreement. They may also be called upon to provide managerial assistance to our portfolio companies. These demands on their time, which will increase as the number of investments grow, may distract them or slow the rate of investment. In order to grow, our investment adviser may need to hire, train, supervise and manage new employees. However, we cannot assure you that any such employees will contribute to the work of the investment adviser. Any failure to manage our future growth effectively could have a material adverse effect on our business and financial condition.
There are conflicts of interest in our relationship with our investment adviser and/or GSC Group that could cause them to make decisions that are not in the best interests of our stockholders.
Subject to the restrictions of the 1940 Act, we may co-invest in investments of portfolio companies on a concurrent basis with other investment vehicles managed by GSC Group. Similarly a GSC Group-managed investment vehicle may, in certain circumstances, invest in securities issued by a company in which we have made, or are making, an investment. Similarly, in certain circumstances, we may invest in securities issued by a company in which another GSC Group-managed investment vehicle has made an investment. Although certain such investments may present conflicts of interest, we nonetheless may pursue and consummate such transactions. These conflicts may include:
Co-Investment. We are prohibited from co-investing with other investment vehicles managed now or in the future by GSC Group in certain investments of portfolio companies in instances where GSC Group negotiates terms other than price. In instances where we co-invest with a GSC Group-managed investment vehicle, while we will invest on the same terms and neither we nor the GSC Group-managed investment vehicle may negotiate terms of the transaction other than price, conflicts of interest may arise. For example, if an investee company in which both we and a GSC Group-managed investment vehicle have invested becomes distressed, and the size of our relative investments varies significantly, the decisions relating to actions to be taken could raise conflicts of interest.
Conflicts in Different Parts of Capital Structure. If a portfolio company in which we and another GSC Group-managed investment vehicle hold different classes of securities encounters financial problems, decisions over the terms of any workout will raise conflicts of interest. For example, a debt holder may be better served by a liquidation of the issuer in which it will be paid in full, whereas an equity holder might prefer a reorganization that could create value for the equity holder.
Potential Conflicting Positions. Given our investment objectives and the investment objectives of other GSC Group-managed investment vehicles, it is possible that we may hold a position that is contrary to a position held by another GSC Group-managed investment vehicle. For example, we could hold a longer term investment in a certain portfolio company and at the same time another GSC Group-managed investment vehicle could hold a short-term position in the same company. GSC Group makes each investment decision separately based upon the investment objective of each of its clients.
Shared Legal Counsel. We and other GSC Group-managed investment vehicles generally engage common legal counsel in transactions in which both are participating or with respect to matters that may affect both. Although separate counsel may be engaged, the time and cost savings and other efficiencies and advantages of using common counsel will generally outweigh the disadvantages. In the event of a significant dispute or divergence of interests, typically in a work-out or other distressed situation, separate representation may become desirable, and in litigation and other circumstances, separate representation may be necessary.
Allocation of Opportunities. Our investment adviser provides investment management, investment advice or other services in relation to a number of investment vehicles that focus on corporate credit, distressed debt, mezzanine investments and structured finance products and have investment objectives that are similar to or overlap with ours. Investment opportunities that may be of interest to us may also be of interest to GSC Group’s other investment vehicles, and GSC Group may buy or sell securities for us which differ from securities which they may cause to be bought or sold for other investment vehicles. GSC Group has greater
interests in other investment vehicles it manages, including greater capital commitments to, or larger fees earned from, such investment vehicles. These differing interests may create a conflict of interest for GSC Group in determining which investment vehicle should pursue a given investment opportunity.
Material Nonpublic Information. GSC Group or its employees, officers, principals or affiliates may come into possession of material nonpublic information in connection with business activities unrelated to our operations. The possession of such information may limit our ability to buy or sell securities or otherwise participate in an investment opportunity or to take other action it might consider in our best interest.
Cross-Trading. Subject to applicable law, we may engage in transactions directly with other investment vehicles managed by GSC Group, including the purchase or sale of all or a portion of a portfolio investment. Cross-trades can save us brokerage commissions and, in certain cases, related transaction costs. Cross-trades between affiliates may create conflicts of interest with respect to certain terms of the transaction, including price. The 1940 Act imposes substantial restrictions on cross-trades between us and investment vehicles managed by GSC Group. As a result, our Board of Directors has adopted cross-trading procedures designed to ensure compliance with the requirements of the 1940 Act and will regularly review the terms of any cross-trades.
We may compete with investment vehicles of GSC Group for access to GSC Group.
Our investment adviser and its affiliates have sponsored and currently manage other investment vehicles with an investment focus that overlaps with our focus, and may in the future sponsor or manage additional investment vehicles with an overlapping focus to ours, which, in each case, could result in us competing for access to the benefits that we expect our relationship with GSC Group to provide to us.
We are dependent upon our investment adviser and its personnel.
We depend on the diligence, skill and network of business contacts of GSC Group’s investment professionals and the information and deal flow generated by them in the course of their investment and portfolio management activities. The departure of a significant number of the investment professionals of GSC Group could have a material adverse effect on our ability to achieve our investment objectives. In addition, we cannot assure you that our investment adviser will remain our investment adviser or that we will continue to have access to GSC Group’s investment professionals or its information and deal flow. In April 2009, our investment adviser withheld a scheduled principal amortization payment under its credit facility, resulting in a default thereunder. Our investment adviser has initiated discussions with its secured lenders regarding a consensual restructuring of its obligations under such credit facility. While we are not directly affected by our investment adviser’s default, if it is unable to restructure its credit facility, or an acceleration of the outstanding principal balance by the lenders occurs, the ability of the investment adviser to retain key individuals and perform its investment advisory duties for us could be significantly impaired. A material adverse change in the business, condition (financial or otherwise), operations or performance of our investment adviser could constitute a default under our Revolving Facility.
We are exposed to risks associated with changes in interest rates.
General interest rate fluctuations and changes in credit spreads on floating rate loans may have a substantial negative impact on our investments and investment opportunities and, accordingly, may have a material adverse effect on investment objectives and our rate of return on invested capital. In addition, an increase in interest rates would make it more expensive to use debt to finance our investments. Decreases in credit spreads on debt that pays a floating rate of return would have an impact on the income generation of our floating rate assets. Trading prices for debt that pays a fixed rate of return tend to fall as interest rates rise. Trading prices tend to fluctuate more for fixed-rate securities that have longer maturities. Although we have no policy governing the maturities of our investments, under current market conditions we expect that we will invest in a portfolio of debt generally having maturities of up to ten years. This means that we will be subject to greater risk (other things being equal) than an entity investing solely in shorter-term securities. A decline in the prices of the debt we own could adversely affect the trading price of our common stock.
We may experience fluctuations in our quarterly results.
We could experience fluctuations in our quarterly operating results due to a number of factors, including the interest rate payable on the debt investments we make, the default rate on such investments, the level of our expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our markets and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods.
Our investment adviser’s liability is limited under the investment advisory and management agreement and we will indemnify our investment adviser against certain liabilities, which may lead our investment adviser to act in a riskier manner on our behalf than it would when acting for its own account.
Our investment adviser has not assumed any responsibility to us other than to render the services described in the investment advisory and management agreement. Pursuant to the investment advisory and management agreement, our investment adviser and its general partner, officers and employees are not liable to us for their acts, under the investment advisory and management agreement, absent willful misfeasance, bad faith, gross negligence or reckless disregard in the performance of their duties. We have agreed to indemnify, defend and protect our investment adviser and its general partner, officers and employees with respect to all damages, liabilities, costs and expenses resulting from acts of our investment adviser not arising out of willful misfeasance, bad faith, gross negligence or reckless disregard in the performance of their duties under the investment advisory and management agreement. These protections may lead our investment adviser to act in a riskier manner when acting on our behalf than it would when acting for its own account.
Changes in laws or regulations governing our operations, or changes in the interpretation thereof, and any failure by us to comply with laws or regulations governing our operations may adversely affect our business.
We and our portfolio companies are subject to regulation at the local, state and federal levels. These laws and regulations, as well as their interpretation, may be changed from time to time. Any change in these laws or regulations, or their interpretation, or any failure by us to comply with these laws or regulations may adversely affect our business.
As discussed below, there is a risk that certain investments that we intend to treat as qualifying assets will be determined to not be eligible for such treatment. Any such determination would have a material adverse effect on our business.
We have a limited operating history.
We were incorporated in March 2007 and commenced our operations that same month. We are subject to all of the business risks and uncertainties associated with any new business, including the risk that we may not achieve our investment objectives and that the value of your investment could decline substantially.
Risks related to our operation as a BDC
Our common stock may trade at a discount to our net asset value per share.
Common stock of BDCs, as closed-end investment companies, frequently trade at a discount to net asset value. Our common stock has traded at a discount to our net asset value since shortly after our initial public offering. The risk that our common stock may continue to trade at a discount to our net asset value is separate and distinct from the risk that our net asset value per share may decline.
Regulations governing our operation as a BDC will affect our ability to raise additional capital.
We have incurred indebtedness under the Revolving Facility and we may issue debt securities or preferred stock, 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, we are permitted, as a BDC, to incur indebtedness or issue senior securities only in amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after such incurrence or issuance. If the value of our assets declines, we may be unable to satisfy this test, which could prohibit us from paying dividends and prevent us from qualifying as a RIC. If we cannot satisfy this test, we may be required to sell a portion of our investments and, depending on the nature of our leverage, repay a portion of our indebtedness at a time when such sales may be disadvantageous.
We are not generally able to issue and sell our common stock at a price below net asset value 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 net asset value of the common stock if our Board of Directors determines that such sale is in our best interests and the best interests of our stockholders, and our stockholders approve such sale. In any such case, the price at which our securities are 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 commission or discount). If our common stock trades at a discount to net asset value, this restriction could adversely affect our ability to raise capital.
To generate cash for funding new investments, we pledged a substantial portion of our portfolio investments under the Revolving Facility. Such assets are not available to secure other sources of funding or for securitization. Our ability to obtain additional secured or unsecured financing on attractive terms in the future is uncertain. Alternatively, we may in the future seek to securitize a portion of our loan portfolio. The loan and securitization markets are subject to changing market conditions, however, and we may not be able to access this market when we would otherwise deem appropriate. An inability to obtain additional leverage through secured or unsecured financing or securitization of our loan portfolio could limit our ability to grow our business, fully execute our business strategy and decrease our earnings, if any. We may also face a heightened risk of loss to the extent we hold a first loss position in a securitized loan portfolio. The 1940 Act may also impose restrictions on the structure of any securitization.
There is a risk that you may not receive distributions or that our distributions may not grow over time.
As a BDC for 1940 Act purposes and a RIC for U.S. federal income tax purposes, we intend to make distributions out of assets legally available for distribution on a quarterly basis to our stockholders once such distributions are authorized by our Board of Directors and declared by us. We cannot assure you that we will achieve investment results that will allow us to make a specified level of cash distributions or year-to-year increases in cash distributions. In addition, due to the asset coverage test that is applicable to us as a BDC, we may be limited in our ability to make distributions. Further, if we invest a greater amount of assets in equity securities that do not pay current dividends, it could reduce the amount available for distribution.
Our investment adviser has limited experience in managing a BDC.
The 1940 Act imposes numerous constraints on the operations of BDCs. For example, BDCs are required to invest at least 70% of their total assets primarily in securities of private U.S. operating companies or public U.S. companies whose securities are not listed on a national securities exchange registered under the Exchange Act (i.e., NYSE, American Stock Exchange and The NASDAQ Global Market), cash, cash equivalents, U.S. government securities and high quality debt investments that mature in one year or less. Our investment adviser does not manage any BDCs other than the Company, and the Company has been in operation only since March 2007. Our investment adviser’s limited experience in managing a portfolio of assets under such constraints may hinder its ability to take advantage of attractive investment opportunities and, as a result, achieve our investment objectives.
A failure on our part to maintain our qualification as a BDC would significantly reduce our operating flexibility.
If we fail to qualify as a BDC, we might be regulated as a closed-end investment company under the 1940 Act, which would significantly decrease our operating flexibility.
We will be subject to corporate-level income tax if we fail to qualify as a RIC.
We will seek to qualify as a RIC under the Code, which requires us to qualify continuously as a BDC and meet certain source of income, distribution and asset diversification requirements.
The source of income requirement is satisfied if we derive at least 90% of our annual gross income from interest, dividends, payments with respect to certain securities loans, gains from the sale or other disposition of securities or options thereon or foreign currencies, or other income derived with respect to our business of investing in such securities or currencies, and net income from interests in “qualified publicly traded partnerships,” as defined in the Code.
The annual distribution requirement is satisfied if we distribute to our stockholders on an annual basis an amount equal to at least 90% of our ordinary net taxable income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, reduced by deductible expenses. We are subject to certain asset coverage ratio requirements under the 1940 Act and covenants under the Facilities that could, under certain circumstances, restrict us from making distributions necessary to qualify as a RIC. In such case, if we are unable to obtain cash from other sources, we may fail to qualify as a RIC and, thus, may be subject to corporate-level income tax.
To qualify as a RIC, we must also meet certain asset diversification requirements at the end of each calendar quarter. Failure to meet these tests may result in our having to (i) dispose of certain investments quickly or (ii) raise additional capital to prevent the loss of our RIC qualification. Because most of our investments will be in private companies, any such dispositions could be made at disadvantageous prices and may result in substantial losses. If we raise additional capital to satisfy the asset diversification requirements, it could take us time to invest such capital. During this period, we will invest the additional capital in temporary investments, such as cash and cash equivalents, which we expect will earn yields substantially lower than the interest income that we anticipate receiving in respect of investments in first and second lien loans, mezzanine debt and high yield debt.
If we fail to qualify as a RIC for any reason, all of our taxable income will be subject to U.S. federal income tax at regular corporate rates. The resulting corporate 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 us and our stockholders.
As a BDC, we may have difficulty paying our required distributions if we recognize income before or without receiving cash in respect of such income.
For U.S. federal income tax purposes, we include in income certain amounts that we have not yet received in cash, such as original issue discount, which may arise if we receive warrants in connection with the making of a loan or possibly in other circumstances, or contracted paid-in-kind interest, which represents contractual interest added to the loan balance and due at the end of the loan term. Such original issue discount, which could be significant relative to our overall investment activities, or increases in loan balances will be included in income before we receive any corresponding cash payments. We also may be required to include in income certain other amounts that we will not receive in cash, including, for example, non-cash income from paid-in-kind securities and deferred payment securities. In addition, we will consolidate GSCIC CLO for federal income tax purposes, and income earned thereon may differ from the distributions paid in respect of our investment in the GSCIC CLO subordinated notes because of the factors set forth above or because distributions on the subordinated notes are contractually required to be diverted for reinvestment or to pay down outstanding indebtedness.
Since in certain cases we may recognize income before or without receiving cash in respect of such income, we may have difficulty meeting the requirement that we distribute an amount equal to at least 90% of our ordinary net taxable income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, reduced by deductible expenses, to qualify as a RIC. Accordingly, we may have to sell some of our investments (or investments in the GSCIC CLO portfolio) at times we would not consider advantageous, raise additional debt or equity capital or reduce new investments to meet these distribution requirements. If we are not able to obtain cash from other sources, or are restricted from selling investments in the GSCIC CLO portfolio by the terms of the applicable indenture, we may fail to qualify as a RIC and thus be subject to corporate-level income tax.
If our primary investments are deemed not to be qualifying assets, we could fail to qualify as a BDC or be precluded from investing according to our current business plan.
If we are to maintain our qualification as a BDC, we must 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. We believe that the leveraged loans and mezzanine investments that we propose to acquire constitute qualifying assets because, at the time of our investment, the privately held issuers will not have securities listed on a national securities exchange and the publicly traded issuers will have a market capitalization of less than $250 million.
The floating interest rate features of any indebtedness incurred by us could adversely affect us if interest rates rise.
Any indebtedness incurred by us will likely bear interest at a floating rate based on an index. As a result, if that index increases, our costs under any indebtedness incurred would become more expensive, which could have a material adverse effect on our earnings.
Risks related to our investments
Our investments may be risky, and you could lose all or part of your investment.
Substantially all of the debt investments held in the portfolio hold, and will likely continue to hold, a non-investment grade rating by Moody’s and/or Standard & Poor’s or, where not rated by any rating agency, would be below investment grade, if rated. High yield bonds rated below investment grade are commonly referred to as “junk bonds.” A below investment grade rating means that, in the rating agency’s view, there is an increased risk that the obligor on such debt will be unable to pay interest and repay principal on its debt in full. We may also invest in debt that defers or pays paid-in-kind interest. To the extent interest payments associated with such debt are deferred, such debt will be subject to greater fluctuations in value based on changes in interest rates, such debt could produce taxable income without a corresponding cash payment to us, and since we generally do not receive any cash prior to maturity of the debt, the investment will be of greater risk.
In addition, private middle market companies in which we expect to invest are exposed to a number of significant risks, including:
•
limited financial resources and an inability to meet their obligations, which may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of us realizing any guarantees we may have obtained in connection with our investment;
•
shorter operating histories, narrower product lines and smaller market shares than larger businesses, which tend to render them more vulnerable to competitors’ actions and market conditions, as well as general economic downturns;
•
dependence on the management talents and efforts of a small group of persons; the death, disability, resignation or termination of one or more of which could have a material adverse impact on the company and, in turn, on us;
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less predictable operating results and, possibly, substantial additional capital requirements to support their operations, finance expansion or maintain their competitive position.; and
•
difficulty accessing the capital markets to meet future capital needs.
In addition, our executive officers, directors and our investment adviser may, in the ordinary course of business, be named as defendants in litigation arising from our investments in the portfolio companies.
The lack of liquidity in our investments may adversely affect our business.
We expect to make investments in private companies. A portion of these securities may be subject to legal and other restrictions on resale, transfer, pledge or other disposition or will otherwise be less liquid than publicly traded securities. The illiquidity of our investments may make it difficult for us to sell such investments if the need arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded our investments. In addition, we may face other restrictions on our ability to liquidate an investment in a business entity to the extent that we or our investment adviser has or could be deemed to have material non-public information regarding such business entity.
The debt securities in which we invest are subject to credit risk and prepayment risk.
An issuer of debt security may be unable to make interest payments and repay principal. We could lose money if the issuer of a debt obligation is, or is perceived to be, unable or unwilling to make timely principal and/or interest payments, or to otherwise honor its obligations. The downgrade of a security by rating agencies may further decrease its value.
Certain debt instruments may contain call or redemption provisions which would allow the issuer thereof to prepay principal prior to the debt instrument’s stated maturity. This is known as prepayment risk. Prepayment risk is greater during a falling interest rate environment as issuers can reduce their cost of capital by refinancing higher interest debt instruments with lower interest debt instruments. An issuer may also elect to refinance their debt instruments with lower interest debt instruments if the credit standing of the issuer improves. To the extent debt securities in our portfolio are called or redeemed, we may receive less than we paid for such security and we may be forced to reinvest in lower yielding securities or debt securities of issuers of lower credit quality.
Our investment in GSCIC CLO constitutes a leveraged investment in a portfolio of predominantly senior secured first lien term loans and is subject to additional risks and volatility.
At February 28, 2009, our investment in the subordinated notes of GSCIC CLO had a fair value of $22.3 million and constituted 18.8% of our portfolio. This investment constitutes a first loss position in a portfolio that, as of February 28, 2009, was composed of $416.0 million in aggregate principal amount of primarily senior secured first lien term loans and $9.4 million in uninvested cash. Interest payments generated from this portfolio will be used to pay the administrative expenses of GSCIC CLO and interest on the debt issued by GSCIC CLO before paying a return on the subordinated notes. Principal payments will be similarly applied to pay administrative expenses of GSCIC CLO and for reinvestment or repayment of GSCIC CLO debt before paying a return on, or repayment of, the subordinated notes. In addition, 80% of our fixed management fee and 100% our incentive management fee is subordinated to the payment of interest and principal on GSCIC CLO’s debt. Any losses on the portfolio will accordingly reduce the cash flow available to pay these management fees and provide a return on, or repayment of, our investment. Depending on the amount and timing of such losses we may experience smaller than expected returns and, potentially, the loss of our entire investment.
As the manager of the portfolio, we will have some ability to direct the composition of the portfolio, but our discretion is limited by the terms of the debt issued by GSCIC CLO, which may limit our ability to make investments that we feel are in the best interests of the subordinated notes, and the availability of suitable investments. The performance of the portfolio is also subject to many of the same risks sets forth in this Annual Report with respect to portfolio investments in senior secured first lien term loans.
Available information about privately held companies is limited.
We invest primarily in privately-held companies. Generally, little public information exists about these companies, and we are required to rely on the ability of our investment adviser’s investment professionals to obtain adequate information to evaluate the potential returns from investing in these companies. These companies and their financial information are not subject to the Sarbanes-Oxley Act and other rules that govern public companies. If we are unable to uncover all material information about these companies, we may not make a fully informed investment decision, and we may lose money on our investments.
When we are a debt or minority equity investor in a portfolio company, we may not be in a position to control the entity, and its management may make decisions that could decrease the value of our investment.
We anticipate making both debt and minority equity investments; therefore, we will be subject to the risk that a portfolio company may make business decisions with which we disagree, and the stockholders and management of such 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.
Our portfolio companies may incur debt or issue equity securities that rank equally with, or senior to, our investments in such companies.
Our portfolio companies usually will have, or may be permitted to incur, other debt, or issue other equity securities that rank equally with, or senior to, our investments. By their terms, such instruments may provide that the holders are entitled to receive payment of dividends, interest or principal on or before the dates on which we are entitled to receive payments in respect of our investments. These debt instruments will usually prohibit the portfolio companies from paying interest on or repaying our investments in the event and during the continuance of a default under such debt. Also, in the event of insolvency, liquidation, dissolution, reorganization or bankruptcy of a portfolio company, holders of securities ranking senior to our investment in that portfolio company would typically be entitled to receive payment in full before we receive any distribution in respect of our investment. After repaying such holders, the portfolio company may not have any remaining assets to use for repaying its obligation to us. In the case of debtor equity ranking equally with our investments, we would have to share on an equal basis any distributions with other holders in the event of an insolvency, liquidation, dissolution, reorganization or bankruptcy of the relevant 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.
If one of our portfolio companies were to go bankrupt, even though we may have structured our interest as senior debt, depending on the facts and circumstances, including the extent to which we actually provided managerial assistance to that portfolio company, a bankruptcy court might recharacterize our debt holding and subordinate all or a portion of our claim to that of other creditors. In addition, lenders can be subject to lender liability claims for actions taken by them where they become too involved in the borrower’s business or exercise control over the borrower. It is possible that we could become subject to a lender’s liability claim, including as a result of actions taken if we actually render significant managerial assistance.
Investments in equity securities involve a substantial degree of risk.
We may purchase common stock and other equity securities. Although equity securities have historically generated higher average total returns than fixed-income securities over the long-term, equity securities also have experienced significantly more volatility in those returns and in recent years have significantly under performed relative to fixed-income securities. The equity securities we acquire may fail to appreciate and may decline in value or become worthless 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:
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any equity investment we make in a portfolio company could be subject to further dilution as a result of the issuance of additional equity interests and to serious risks as a junior security that will be subordinate to all indebtedness or senior securities in the event that the issuer is unable to meet its obligations or becomes subject to a bankruptcy process;
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to the extent that the portfolio company requires additional capital and is unable to obtain it, we may not recover our investment in equity securities; and
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in some cases, equity securities in which we invest will not pay current dividends, and our ability to realize a return on our investment, as well as to recover our investment, will be dependent on the success of our portfolio companies. Even if the portfolio companies are successful, our ability to realize the value of our investment may be dependent on the occurrence of a liquidity event, such as a public offering or the sale of the portfolio company. It is likely to take a significant amount of time before a liquidity event occurs or we can sell our equity investments. In addition, the equity securities we receive or invest in may be subject to restrictions on resale during periods in which it could be advantageous to sell.
There are special risks associated with investing in preferred securities, including:
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preferred securities may include provisions that permit the issuer, at its discretion, to defer distributions for a stated period without any adverse consequences to the issuer. If we own a preferred security that is deferring its distributions, we may be required to report income for tax purposes even though we have not received any cash payments in respect of such income;
•
preferred securities are subordinated with respect to corporate income and liquidation payments, and are therefore subject to greater risk than debt;
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preferred securities may be substantially less liquid than many other securities, such as common securities or U.S. government securities; and
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preferred security holders generally have no voting rights with respect to the issuing company, subject to limited exceptions.
Our investments in foreign debt, including that of emerging market issuers, may involve significant risks in addition to the risks inherent in U.S. investments.
Although there are limitations on our ability to invest in foreign debt, we may, from time to time, invest in debt of foreign companies, including the debt of emerging market issuers. Investing in foreign companies may expose us to additional risks not typically associated with investing in U.S. companies. These risks include changes in exchange control regulations, political and social instability, expropriation, imposition of foreign taxes, less liquid markets and less available information than is generally the case in the United States, higher transaction costs, less government supervision of exchanges, brokers and issuers, less developed bankruptcy laws, difficulty in enforcing contractual obligations, lack of uniform accounting and auditing standards and greater price volatility. Investments in the debt of emerging market issuers may subject us to additional risks such as inflation, wage and price controls, and the imposition of trade barriers. Furthermore, economic conditions in emerging market countries are, to some extent, influenced by economic and securities market conditions in other emerging market countries. Although economic conditions are different in each country, investors’ reaction to developments in one country can have effects on the debt of issuers in other countries.
Although most of our investments will be U.S. dollar-denominated, our investments that are denominated in a foreign currency will be subject to the risk that the value of a particular currency will change in relation to one or more other currencies. Among the factors that may affect currency values are trade balances, the level of short-term interest rates, differences in relative values of similar assets in different currencies, long-term opportunities for investment and capital appreciation, and political developments. We may employ hedging techniques to minimize these risks, but we cannot assure you that we will fully hedge against these risks or that such strategies will be effective.
We may expose ourselves to risks if we engage in hedging transactions.
We may utilize instruments such as forward contracts, currency options and interest rate swaps, caps, collars and floors to seek to hedge against fluctuations in the relative values of our portfolio positions from changes in currency exchange rates and market interest rates. Use of these hedging instruments may expose us to counter-party credit risk. Hedging against a decline in the values of our portfolio positions does not eliminate the possibility of fluctuations in the values of such positions or prevent losses if the values of such positions decline. However, such hedging can establish other positions designed to gain from those same developments, thereby offsetting the decline in the value of such portfolio positions. Such hedging transactions may also limit the opportunity for gain if the values of the portfolio positions should increase. Moreover, it may not be possible to hedge against an exchange rate or interest rate fluctuation that is generally anticipated at an acceptable price.
Our Board of Directors may change our operating policies and strategies without prior notice or stockholder approval, the effects of which may be adverse.
Our Board of Directors has the authority to modify or waive our current operating policies and our strategies without prior notice and without stockholder approval. We cannot predict the effect any changes to our current operating policies and strategies would have on our business, financial condition, and value of our common stock. However, the effects might be adverse, which could negatively impact our ability to pay dividends and cause you to lose all or part of your investment.
Risks related to an investment in our shares
Investing in our common stock may involve an above average degree of risk.
The investments we make in accordance with our investment objectives may result in a higher amount of risk than alternative investment options and volatility or loss of principal. Our investments in portfolio companies may be highly speculative and aggressive, and therefore, an investment in our common stock may not be suitable for someone with lower risk tolerance.
The market price of our common stock may fluctuate significantly.
The market price and liquidity of the market for our common stock may be significantly affected by numerous factors, some of which are beyond our control and may not be directly related to our operating performance. These factors include:
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significant volatility in the market price and trading volume of securities of BDCs or other companies in our sector, which are not necessarily related to the operating performance of these companies;
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changes in regulatory policies or tax rules, particularly with respect to RICs or BDCs;
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loss of RIC qualification;
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changes in the value of our portfolio of investments;
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any shortfall in revenue or net income or any increase in losses from levels expected by investors or securities analysts;
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departure of our investment adviser’s key personnel;
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operating performance of companies comparable to us;
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general economic trends and other external factors; and
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loss of a major funding source.
Provisions of our governing documents and the Maryland General Corporation Law could deter takeover attempts and have an adverse impact on the price of our common stock.
We are governed by our charter and bylaws, which we refer to as our “governing documents.”
Our governing documents and the Maryland General Corporation Law contain provisions that may have the effect of delaying, deferring or preventing a transaction or a change in control of us that might involve a premium price for our stockholders or otherwise be in their best interest.
Our charter provides for the classification of our Board of Directors into three classes of directors, serving staggered three-year terms, which may render a change of control of us or removal of our incumbent management more difficult. Furthermore, any and all vacancies on our Board of Directors will be filled generally only by the affirmative vote of a majority of the remaining directors in office, even if the remaining directors do not constitute a quorum, and any director elected to fill a vacancy will serve for the remainder of the full term until a successor is elected and qualifies.
Our Board of Directors is authorized to create and issue new series of shares, to classify or reclassify any unissued shares of stock into one or more classes or series, including preferred stock and, without stockholder approval, to amend our charter to increase or decrease the number of shares of stock that we have authority to issue, which could have the effect of diluting a stockholder’s ownership interest. Prior to the issuance of shares of stock of each class or series, including any reclassified series, our Board of Directors is required by our governing documents to set the terms, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends or other distributions, qualifications and terms or conditions of redemption for each class or series of shares of stock.
Our governing documents also provide that our Board of Directors has the exclusive power to adopt, alter or repeal any provision of our bylaws, and to make new bylaws. The Maryland General Corporation Law also contains certain provisions that may limit the ability of a third party to acquire control of us, such as:
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The Maryland Business Combination Act, which, subject to certain limitations, prohibits certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of the common stock or an affiliate thereof) for five years after the most recent date on which the stockholder becomes an interested stockholder and, thereafter, imposes special minimum price provisions and special stockholder voting requirements on these combinations; and
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The Maryland Control Share Acquisition Act, which provides that “control shares” of a Maryland corporation (defined as shares of common stock which, when aggregated with other shares of common stock controlled by the stockholder, entitles the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares of common stock.
The provisions of the Maryland Business Combination Act will not apply, however, if our Board of Directors adopts a resolution that any business combination between us and any other person will be exempt from the provisions of the Maryland Business Combination Act. Although our Board of Directors has adopted such a resolution, there can be no assurance that this resolution will not be altered or repealed in whole or in part at any time. If the resolution is altered or repealed, the provisions of the Maryland Business Combination Act may discourage others from trying to acquire control of us.
As permitted by Maryland law, our bylaws contain a provision exempting from the Maryland Control Share Acquisition Act any and all acquisitions by any person of our common stock. Although our bylaws include such a provision, such a provision may also be amended or eliminated by our Board of Directors at any time in the future.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
We do not own any real estate or physical properties materially important to our business. Our corporate office is located at 888 Seventh Avenue, New York, New York 10019. Our telephone number is (212) 884-6200. We believe that our office facilities are suitable and adequate for our business as currently conducted and as reasonably foreseeable.
Item 3.
Item 3. Legal Proceedings
Neither we nor our investment adviser are currently subject to any material legal proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of stockholders through the solicitation of proxies or otherwise during the fourth quarter of the fiscal year ended February 28, 2009.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Price range of common stock
Our common stock is quoted on the NYSE under the symbol “GNV” and started trading on March 23, 2007 at an initial public offering price of $15.00 per share. Prior to such date there was no public market for our common stock. Set forth below are the high and low sales prices for our common stock for each full quarterly period since our common stock began trading.
(1)
Net asset value per share is determined as of the last day in the relevant quarter and therefore may not reflect the net asset value per share on the date of the high and low closing sales prices. The net asset values shown are based on outstanding shares at the end of each period.
Holders
As of May 4, 2009, there were 16 holders of record and approximately 3400 beneficial holders of our common stock.
Dividend Policy
Set forth below are the cash dividends declared by the Company since March 23, 2007, the date on which we commenced operations:
We intend to make quarterly distributions to our stockholders out of assets legally available for distribution. Our quarterly distributions, if any, will be determined by our Board of Directors. Any such distributions will be taxable to our stockholders, including to those stockholders who receive additional shares of our common stock pursuant to a dividend reinvestment plan. We are prohibited from making distributions that cause us to fail to maintain the asset coverage ratios stipulated by the 1940 Act or that violate our debt covenants.
In order to maintain our qualification as a RIC, we must for each fiscal year distribute an amount equal to at least 90% of our ordinary net taxable income and realized net short-term capital gains in excess of realized net long-term capital losses, if any, reduced by deductible expenses. In addition, we will be subject to federal excise taxes to the extent we do not distribute during the calendar year at least (1) 98% of our ordinary income for the calendar year, (2) 98% of our capital gains in excess of capital losses for the one year period ending on October 31 of the calendar year and (3) any ordinary income and net capital gains for preceding years that were not distributed during such years. To provide stability in our dividend distributions (which might otherwise be adversely affected by timing mismatches between the receipt of payments on our investments and the payment of dividends) we did not distribute all of our ordinary income earned during the 2008 calendar year and incurred federal excise taxes as a result. There were no capital gains in excess of capital losses realized during the one year period ended October 31, 2008. We expect to declare dividends payable from 2008 calendar year earnings prior to November 15, 2009 and to distribute such dividends prior to February 28, 2010. We may similarly withhold from distribution a portion of our ordinary income for the 2009 calendar year and/or portion of the capital gains in excess of capital losses realized during the one year period ending October 31, 2009, if any, and, if we do so, we would expect to incur federal excise taxes again as a result.
We maintain an “opt out” dividend reinvestment plan for our common stockholders. As a result, if we declare a dividend, then stockholders’ cash dividends will be automatically reinvested in additional shares of our common stock, unless they specifically “opt out” of the dividend reinvestment plan so as to receive cash dividends. GSC Group, and the funds managed by it, do not currently participate in the dividend reinvestment plan with respect to their holdings of the company’s common stock.
Subject to certain conditions, for taxable years ending on or before December 31, 2009, we are permitted to make distributions to our stockholders in the form of shares of our common stock in lieu of cash distributions. The decision to make such distributions will be made by our Board of Directors.
Performance Graph
The following graph compares the return on our common stock with that of the Standard & Poor’s 500 Stock Index and the NASDAQ Financial 100 index, for the period from March 23, 2007, the date our common stock began trading, through February 28, 2009. The graph assumes that, on March 23, 2007, a person invested $100 in each of our common stock, the Standard & Poor’s 500 Stock Index and the NASDAQ Financial 100 index. The graph measures total shareholder return, which takes into account both changes in stock price and dividends. It assumes that dividends paid are reinvested in like securities.
Sales of unregistered securities
We did not sell any securities during the period covered by this report that were not registered under the Securities Act.
Issuer purchases of equity securities
In December 2008, as part of our dividend reinvestment plan for our common stockholders, we purchased 126,855 shares of our common stock for $0.3 million in the open market in order to satisfy the reinvestment portion of our dividends. The following chart outlines repurchases of our common stock during the quarter ended February 28, 2009.
(1)
Pursuant to our dividend reinvestment plan, we directed our plan administrator to purchase the indicated quantity of shares in the open market in order to satisfy our obligations to deliver shares of common stock to our stockholders with respect to our dividend for the third quarter of fiscal year 2009.
Item 6.
Item 6. Selected Financial Data
As of February 28, 2007, the Company (including its predecessors) had not yet commenced operations. The following selected financial and other data for the years ended February 28, 2009 and February 29, 2008 are derived from our consolidated financial statements which have been audited by Ernst & Young LLP, an independent registered public accounting firm whose report thereon is included within this Annual Report. The data should be read in conjunction with our consolidated financial statements and notes thereto, which are included elsewhere in this Annual Report, and Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
GSC INVESTMENT CORP.
SELECTED FINANCIAL DATA
For the Years Ended February 28, 2009 and February 29, 2008
Quarterly Data
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with our financial statements and related notes and other financial information appearing elsewhere in this Annual Report. In addition to historical information, the following discussion and other parts of this Annual Report contain forward-looking information that involves risks and uncertainties. Our actual results could differ materially from those anticipated by such forward-looking information due to the factors discussed under Part I, Item 1A “Risk Factors” and “Note about Forward-Looking Statements” appearing elsewhere herein.
Overview
GSC Investment Corp. is a Maryland corporation that has elected to be treated as a BDC. Our investment objectives are to generate current income and capital appreciation through debt and equity investments by primarily investing in middle market companies and select high yield bonds. We have elected and qualified to be treated as a RIC under subchapter M of the Code. We commenced operations on March 23, 2007, and completed our IPO on March 28, 2007. We are externally managed and advised by our investment adviser, GSCP (NJ), L.P.
We used the net proceeds of our IPO to purchase approximately $100.7 million in aggregate principal amount of debt investments from CDO Fund III, a CLO fund managed by our investment adviser. We used borrowings under our credit facilities to purchase approximately $115.1 million in aggregate principal amount of debt investments in April and May 2007 from CDO Fund III and CDO Fund I, a collateralized debt obligation fund managed by our investment adviser. As of February 28, 2009, our portfolio consisted of $118.9 million, principally invested in 35 portfolio companies and one CLO.
Revenues
We generate revenue in the form of interest income and capital gains on the debt investments that we hold and capital gains, if any, on equity interests that we may acquire. We expect our debt investments, whether in the form of first and second lien term loans, mezzanine debt or high yield bonds, to have terms of up to ten years, and to bear interest at either a fixed or floating rate. Interest on debt will be payable generally either quarterly or semi-annually. In some cases our debt investments may provide for a portion of the interest to be paid-in-kind (“PIK”). To the extent interest is paid-in-kind, it will be payable through the increase of the principal amount of the obligation by the amount of interest due on the then-outstanding aggregate principal amount of such obligation. The principal amount of the debt and any accrued but unpaid interest will generally become due at the maturity date. In addition, we may generate revenue in the form of commitment, origination, structuring or diligence fees, fees for providing managerial assistance or investment management services and possibly consulting fees. Any such fees will be generated in connection with our investments and recognized as earned. We may also invest in preferred equity securities that pay dividends on a current basis.
Pursuant to an agreement with our investment adviser entered into on October 17, 2006, prior to becoming a BDC, we acquired the right to act as investment adviser to CDO Fund III and collect the management fees related thereto from March 20, 2007 until the liquidation of the CDO Fund III assets. We paid our investment adviser a fair market price of $0.1 million for the right to act as investment adviser to CDO Fund III.
On January 22, 2008 we entered into a collateral management agreement with GSCIC CLO pursuant to which we will act as its collateral manager and receive a senior collateral management fee of 0.10% and a subordinate collateral management fee of 0.40% of the outstanding principal amount of GSCIC CLO’s assets, paid quarterly to the extent of available proceeds. We are also entitled to an incentive management fee equal to 20% of excess cash flow to the extent the GSCIC CLO subordinated notes receive an internal rate of return equal to or greater than 12%.
We recognize interest income on our investment in the subordinated notes of GSCIC CLO using the effective interest method, based on the anticipated yield and the estimated cash flows over the projected life of the investment. Yields are revised when there are changes in actual or estimated cash flows due to changes in prepayments and/or re-investments, credit losses or asset pricing. Changes in estimated yield are recognized as an adjustment to the estimated yield over the remaining life of the investment from the date the estimated yield was changed.
Expenses
Our primary operating expenses include the payment of investment advisory and management fees, professional fees, directors and officers insurance, fees paid to independent directors and administrator expenses, including our allocable portion of our administrator’s overhead. Our allocable portion is based on the ratio of our total assets to the total assets administered by our administrator. Our investment advisory and management fees compensate our investment adviser for its work in identifying, evaluating, negotiating, closing and monitoring our investments. We bear all other costs and expenses of our operations and transactions, including those relating to:
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calculating our net asset value (including the cost and expenses of any independent valuation firm);
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expenses incurred by our investment adviser payable to third parties, including agents, consultants or other advisers, in monitoring our financial and legal affairs and in monitoring our investments and performing due diligence on our prospective portfolio companies;
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interest payable on debt, if any, incurred to finance our investments;
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offerings of our common stock and other securities;
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investment advisory and management fees;
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administration fees;
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fees payable to third parties, including agents, consultants or other advisers, relating to, or associated with, evaluating and making investments;
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transfer agent and custodial fees;
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registration fees;
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listing fees;
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taxes;
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independent directors’ fees and expenses;
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costs of preparing and filing reports or other documents of the SEC;
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the costs of any reports;
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proxy statements or other notices to stockholders, including printing costs;
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to the extent we are covered by any joint insurance policies, our allocable portion of the insurance premiums for such joint policies;
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direct costs and expenses of administration, including auditor and legal costs; and
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all other expenses incurred by us or our administrator in connection with administering our business.
The amount payable to GSC Group as administrator under the administration agreement is capped to the effect that such amount, together with our other operating expenses, does not exceed an amount equal to 1.5% per annum of our net assets attributable to common stock. In addition, for the current one-year term of the administration agreement (expiring March 21, 2010), GSC Group has waived our reimbursement obligation under the administration agreement until our total assets exceed $500 million.
Pursuant to the investment advisory and management agreement, we pay GSC Group as investment adviser a quarterly base management fee of 1.75% of the average value of our total assets (other than cash or cash equivalents but including assets purchased with borrowed funds) at the end of the two most recently completed fiscal quarters, and appropriately adjusted for any share issuances or repurchases during the applicable fiscal quarter, and an incentive fee.
The incentive fee has two parts:
•
A fee, payable quarterly in arrears, equal to 20% of our pre-incentive fee net investment income, expressed as a rate of return on the value of the net assets at the end of the immediately preceding quarter, that exceeds a 1.875% quarterly (7.5% annualized) hurdle rate measured as of the end of each fiscal quarter. Under this provision, in any fiscal quarter, our investment adviser receives no incentive fee unless our pre-incentive fee net investment income exceeds the hurdle rate of
1.875%. Amounts received as a return of capital are not included in calculating this portion of the incentive fee. Since the hurdle rate is based on net assets, a return of less than the hurdle rate on total assets may still result in an incentive fee.
•
A fee, payable at the end of each fiscal year, equal to 20% of our net realized capital gains, if any, computed net of all realized capital losses and unrealized capital depreciation, in each case on a cumulative basis, less the aggregate amount of capital gains incentive fees paid to the investment adviser through such date.
We will defer cash payment of any incentive fee otherwise earned by our investment adviser if, during the most recent four full fiscal quarter period ending on or prior to the date such payment is to be made, the sum of (a) our aggregate distributions to our stockholders and (b) our change in net assets (defined as total assets less liabilities) (before taking into account any incentive fees payable during that period) is less than 7.5% of our net assets at the beginning of such period. These calculations will be appropriately pro rated for the first three fiscal quarters of operation and adjusted for any share issuances or repurchases during the applicable period. Such incentive fee will become payable on the next date on which such test has been satisfied for the most recent four full fiscal quarters or upon certain terminations of the investment advisory and management agreement. We commenced deferring cash payment of incentive fees during the quarterly period ended August 31, 2007, and have continued to defer such payments through the current quarterly period; we have recorded a payable in respect of such deferred fees in the amount of $2.3 million as of February 28, 2009.
To the extent that any of our leveraged loans are denominated in a currency other than U.S. dollars, we may enter into currency hedging contracts to reduce our exposure to fluctuations in currency exchange rates. We may also enter into interest rate hedging agreements. Such hedging activities, which will be subject to compliance with applicable legal requirements, may include the use of interest rate caps, futures, options and forward contracts. Costs incurred in entering into or settling such contracts will be borne by us.
From the commencement of operations until March 23, 2008, GSC Group reimbursed us for operating expenses to the extent that our total annual operating expenses (other than investment advisory and management fees and interest and credit facility expenses) exceeded an amount equal to 1.55% of our net assets attributable to common stock.
Portfolio and investment activity
Corporate Debt Portfolio Overview(1)
(1)
Excludes our investment in the subordinated notes of GSCIC CLO and GSC Partners CDO GP III, LP.
During the fiscal year ended February 28, 2009, we made 17 investments in an aggregate amount of $23.1 million in new portfolio companies and $5.2 million in investments in existing portfolio companies. Also during the fiscal year ended February 28, 2009, we had $49.2 million in aggregate amount of exits and repayments resulting in net repayments of $20.9 million for the year.
During the fiscal year ended February 29, 2008, we made 144 investments in an aggregate amount of $314.0 million. Also during the fiscal year ended February 29, 2008, we had $141.8 million in aggregate amount of exits and repayments, resulting in net investments of $172.2 million in aggregate amount for the year.
Our portfolio composition at February 28, 2009 and February 29, 2008 was as follows:
Portfolio composition
Our investment in the subordinated notes of GSCIC CLO represents a first loss position in a portfolio that, at February 28, 2009, was composed of $416.0 million in aggregate principal amount of predominantly senior secured first lien term loans. This investment is subject to unique risks. (See Part I, Item 1A “Risk Factors-Risks related to our investments-Our investment in GSCIC CLO constitutes a leveraged investment in a portfolio of predominantly senior secured first lien term loans and is subject to additional risks and volatility”) and we do not consolidate the GSCIC CLO portfolio on our financial statements. Accordingly, the metrics below do not include the underlying GSCIC CLO portfolio investments. However, at February 28, 2009, two GSCIC CLO portfolio investments were in default and over 75.7% of the GSCIC CLO portfolio investments had a CMR (as defined below) numerical debt score of less than 2.99 and a corporate letter rating of A or B.
GSC Group normally grades all of our investments using an internally developed credit and monitoring rating system (“CMR”). The CMR rating consists of two components: (i) a numerical debt score and (ii) a corporate letter rating. The numerical debt score is based on the objective evaluation of six risk categories: (i) leverage, (ii) seniority in the capital structure, (iii) fixed charge coverage ratio, (iv) debt service coverage/liquidity, (v) operating performance, and (vi) business/industry risk. The numerical debt score ranges from 1.00 to 5.00, which can generally be characterized as follows:
•
1.00-2.00 represents investments that hold senior positions in the capital structure and, typically, have low financial leverage and/or strong historical operating performance;
•
2.00-3.00 represents investments that hold relatively senior positions in the capital structure, either senior secured, senior unsecured, or senior subordinate, and have moderate financial leverage and/or are performing at or above expectations;
•
3.00-4.00 represents investments that are junior in the capital structure, have moderate financial leverage and/or are performing at or below expectations; and
•
4.00-5.00 represents investments that are highly leveraged and/or have poor operating performance.
The numerical debt score is designed to produce higher scores for debt positions that are more subordinate in the capital structure. Therefore, second lien term loans, high-yield bonds and mezzanine debt will generally be assigned scores of 2.25 or higher.
The CMR also consists of a corporate letter rating whereby each credit is assigned a letter rating based on several subjective criteria, including perceived financial and operating strength and covenant compliance. The corporate letter ratings range from (A) through (F) and are characterized as follows: (A) equals strong credit, (B) equals satisfactory credit, (C) equals special attention credit, (D) equals payment default risk, (E) equals payment default, (F) equals restructured equity security.
The CMR distribution of our investments at February 28, 2009 and February 29, 2008 was as follows:
Portfolio CMR distribution
(1)
Predominantly comprised of our investment in the subordinated notes of GSCIC CLO.
At February 28, 2009, 36.0% of our investments had a CMR debt score of 2.99 or below, a decline of 21.5% from February 29, 2008. The decline is mainly due to deterioration in leverage ratios and interest coverage ratios in our investments as of their latest quarterly financials and, in some cases, a decline in EBITDA as compared to a prior period. Additionally, at February 28, 2009, 41.3% of our investments were assigned a CMR letter rating of A or B, a decline of 23.5% from February 29, 2008. The migration of our investments from primarily B/C to primarily B/C/D is mainly attributable to deterioration in credit metrics as compared to the covenant tests in the applicable credit agreement or indenture.
The following table shows the portfolio composition by industry grouping at fair value at February 28, 2009 and February 29, 2008.
Portfolio composition by industry grouping at fair value
(1)
Comprised of our investment in the subordinated notes of GSCIC CLO.
The following table shows the portfolio composition by geographic location at fair value at February 28, 2009 and February 29, 2008. The geographic composition is determined by the location of the corporate headquarters of the portfolio company.
Portfolio composition by geographic location at fair value
(1)
Predominantly comprised of our investment in the subordinated notes of GSCIC CLO.
Results of operations
Investment income
Total investment income was $23.4 million for the fiscal year ended February 28, 2009 versus $21.4 million for the fiscal year ended February 29, 2008, an increase of $2.0 million, or 9.3%. The increase is predominantly attributable to the management fee earned from GSCIC CLO during the fiscal year ended February 28, 2009 and the Company’s being operational for only eleven months during the fiscal year ended February 29, 2008.
The composition of our investment income in each period was as follows:
Investment Income
For the fiscal year ended February 28, 2009, total PIK income was $0.8 million. For the fiscal year ended February 29, 2008, total PIK income was $0.4 million.
Operating expenses
Total operating expenses before manager reimbursement were $10.4 million for the fiscal year ended February 28, 2009 versus $12.3 million for the fiscal year ended February 29, 2008, a decrease of $1.9 million, or 15.4%. The composition of our operating expenses in each period was as follows:
Operating Expenses
The decrease in interest and credit facility expense for the fiscal year ended February 28, 2009 versus the fiscal year ended February 29, 2008 was due to decreased borrowing under the Revolving Facility (please see “--Financial Condition, Liquidity and Capital Resources” below for more information). The increase in incentive management fee for the fiscal year ended February 28, 2009 versus the fiscal year ended February 29, 2008 resulted from the combination of higher net investment income and lower operating expenses between the two periods, and was partially offset by a decrease in base management fees resulting from a decrease in the average value of our total net assets, and decreased professional fees.
For the fiscal year ended February 28, 2009, we recorded $1.0 million in expense waiver and reimbursement from the administrator and Manager versus $1.8 million for the fiscal year ended February 29, 2008. The decline was due to the termination of the expense reimbursement agreement as of March 23, 2008, pursuant to which GSC Group had reimbursed the Company for operating expenses (other than investment advisory and management fees and interest and credit facility expenses) in excess of 1.55% of net assets attributable to common stock.
Net realized gains/losses on sales of investments
For the fiscal year ended February 28, 2009, the Company had $7.2 million of net realized losses versus $3.9 million of net realized gains for the fiscal year ended February 29, 2008. The most significant realized gains and losses for each period were the following:
The most significant losses for the period are attributable to the bankruptcy of Atlantis Plastics Films, Inc. and the sale of EuroFresh Inc. Due to deteriorating performance and increased leverage, we liquidated our investment in EuroFresh, Inc. during our third quarter. Atlantis Plastics Films, Inc. filed for bankruptcy during our second quarter and was auctioned in two separate asset sales transactions during our third quarter.
The most significant gains for the period are attributable to the repayment at par of the Sportcraft, Ltd. second lien term loan and the McMillin Companies, LLC senior secured notes and the exchange of SILLC Holdings, LLC senior secured notes for a second lien term loan.
Net unrealized appreciation/depreciation on investments
For the fiscal year ended February 28, 2009, the Company’s investments had an increase in net unrealized depreciation of $28.0 million versus an increase in net unrealized depreciation of $20.1 million for the fiscal year ended February 29, 2008. The most significant cumulative changes in unrealized depreciation for each period were the following:
The $6.5 million net unrealized depreciation in our investment in the GSCIC CLO subordinated notes was due to an increase in the assumed portfolio default rate and present value discount rate in our discounted cash flow model. These changes were made to reflect the current market environment for CLO equity investments and not as a result of any change in the underlying GSCIC CLO portfolio. The reasons for changes in the fair value of other portfolio investments must be considered on a case-by-case basis. However, two factors that we believe have had a significant impact on our portfolio overall are the market wide increase in interest yield as a result of risk re-pricing and the profusion of forced liquidations as loan buyers are forced to raise capital. For example, from the fiscal year ended February 29, 2008 to the fiscal year ended February 28, 2009, the Credit Suisse High Yield Index increased from an average
yield of 10.33% to 17.85% and the Credit Suisse Leveraged Loan Index decreased from an average price of 88.33% to 65.13%. While we believe that these indices effectively illustrate the adverse general market conditions, we believe that market-wide movements are not necessarily indicative of any changes in the condition or prospects of the affected portfolio investments. Nonetheless, our valuation process requires us to take into account such conditions in determining the fair value of our portfolio.
The net unrealized depreciation in Eurofresh, Inc. unsecured notes and Atlantis Plastics Films, Inc. second lien term loan were converted into realized losses upon their sale in the fiscal year ended February 28, 2009. The net unrealized depreciation in SILLC Holdings, LLC second lien term loan was reversed when the loan was repaid at par in the fiscal year ended February 28, 2009.
Net realized gains/losses on derivatives
For the fiscal year ended February 28, 2009, the Company recorded a net realized gain on derivatives of $30,454 relating to our investment in the GSCIC CLO warehouse facility. For the fiscal year ended February 29, 2008, the Company recorded a net realized gain on derivatives of $0.7 million from the same warehouse facility (see “- Off-balance sheet arrangements” below).
Net unrealized appreciation/depreciation on derivatives
For the fiscal year ended February 28, 2009, changes in the value of the interest rate caps purchased pursuant to the credit facilities resulted in an unrealized depreciation of $37,221 versus an unrealized depreciation of $54,266 for the fiscal year ended February 29, 2008.
Changes in net asset value from operations
For the fiscal year ended February 28, 2009, we recorded a net decrease in net assets resulting from operations of $21.3 million versus a net decrease in net assets resulting from operations of $5.5 million for the fiscal year ended February 29, 2008. The difference is attributable to the $7.9 million increase in net unrealized depreciation on investments, the decrease of $0.7 million in net realized gains on derivatives and the increase in net realized losses on investments of $10.3 million from the earlier to the latter period, which offset the $2.0 million gain in investment income and reduction of $1.9 million in operating expenses before manager expense waiver and reimbursement. Based on 8,291,384 weighted average common shares outstanding as of February 28, 2009, our per share net decrease in net assets resulting from operations was $2.57 for the fiscal year ended February 28, 2009 versus a per share net decrease in net assets resulting from operations of $0.70 for the fiscal year ended February 29, 2008 (based on 7,761,965 weighted average common shares outstanding for the fiscal year ended February 29, 2008).
Financial condition, liquidity and capital resources
The Company’s liquidity and capital resources have been generated primarily from the net proceeds of its IPO, advances from the Revolving Facility and the Term Facility, as well as cash flows from operations. On March 28, 2007, we completed our IPO and issued 7,250,000 common shares and received net proceeds of $100.7 million.
On April 11, 2007, we entered into a $100.0 million revolving securitized credit facility (the “Revolving Facility”). On May 1, 2007, we entered into a $25.7 million term securitized credit facility (the “Term Facility” and, together with the Revolving Facility, the “Facilities”), which was fully drawn at closing. In December 2007, we consolidated the Facilities by using a draw under the Revolving Facility to repay the Term Facility. In response to the market wide decline in financial asset prices, which has negatively affect the value of our portfolio, we terminated the revolving period of the Revolving Facility effective January 14, 2009 and commenced a two-year amortization period during which all principal proceeds from the collateral will be used to repay outstanding borrowings. At the end of the two year amortization period, all advances will be due and payable. In March 2009 we amended the
Revolving Credit Facility to decrease the minimum required collateralization and increase the portion of the portfolio that can be invested in “CCC” rated investments in return for an increased interest rate and expedited amortization. As a result of these transactions, we expect to have additional cushion under our Borrowing Base (as defined below). If we are not able to obtain new sources of financing, however, we expect our portfolio will gradually de-lever as principal payments are received, which may negatively impact our net investment income and ability to pay dividends. Please see Part I, Item 1A “Risk Factors-Risks Related to Our Business-We need to find alternative sources of leverage and/or access the equity markets to maintain and grow our business” for more information.
As of February 28, 2009, we had borrowed an aggregate of $59.0 million under the Revolving Facility. Interest is payable on funds drawn under the Revolving Facility at the prevailing commercial paper rates or, if the commercial paper market is at any time unavailable, the prevailing LIBOR rates, plus 0.70%, payable monthly. The interest margin will increase from and after the March 2009 amendment to 4.00% until March 2010 (6.00% if the commercial paper market is unavailable) and 5.00% thereafter (6.00% if the commercial paper market is unavailable).
A significant percentage of our total investments have been pledged to secure our obligations under the Revolving Facility.
The actual amount that may be outstanding on the Revolving Facility at any given time (the “Borrowing Base”) is dependent upon the amount and quality of the collateral securing the Revolving Facility. Our Borrowing Base was $59.9 million at February 28, 2009 versus $83.6 million at February 29, 2008. The decline in our Borrowing Base during this period is mainly attributable to the decline in the value of the pledged collateral and the downgrade of certain public ratings or private credit estimates of the pledged collateral. Pro forma for the March 2009 amendment, our Borrowing Base at February 28, 2009 would have been $72.4 million as a result of the decrease in minimum required collateralization and increase in the permissible amount of “CCC” rated investments in the collateral.
For purposes of determining the Borrowing Base, most assets are assigned the values set forth in our most recent quarterly report filed with the SEC. Accordingly, the February 28, 2009 Borrowing Base relies upon the valuations set forth in the quarterly report for the quarter ended November 30, 2008. The valuations presented in this Annual Report will not be incorporated into the Borrowing Base until after this report is filed with the SEC. Pro forma for the March 2009 amendment and using the February 28, 2009 values, the collateral balance at February 28, 2009 would have been $62.0 million. At February 28, 2009, the Company had $6.4 million of unrestricted cash and cash equivalents that could be pledged under the Revolving Facility to increase the Borrowing Base or to repay outstanding borrowings.
A Borrowing Base violation will occur if our outstanding borrowings exceed the Borrowing Base at any time. We can cure a Borrowing Base violation by reducing our borrowing below the Borrowing Base (by, e.g., selling collateral and repaying borrowings) or pledging additional collateral to increase the Borrowing Base. If we fail to cure a Borrowing Base violation within the specified time, a default under the Revolving Facility shall occur. Please see Part I, Item 1A. “Risk Factors-Risks Related to Current Economic and Market Conditions-Ratings downgrades in our portfolio could require us to liquidate assets or face a default under the Revolving Facility” for more information.
Following the end of the fiscal year ended February 28, 2009, AbitibiBowater Inc. and certain of its subsidiaries, which includes Abitibi-Consolidated Company of Canada (“Abitibi”), filed voluntary petitions on April 16, 2009 in the United States under Chapter 11 of the United States Bankruptcy Code and sought creditor protection under the Companies’ Creditors Arrangement Act in Canada. At April 30, 2009, after giving effect to this filing, our pro forma Borrowing Base (pro forma for our February 28, 2009 asset values) was $57.4 million, our outstanding borrowings were $57.8 million and our pro forma unrestricted cash and cash equivalents (pro forma for payments under our Revolving Facility as of April 30, which were received in May) was $9.9 million. Two other portfolio investments have experienced adverse events that, if not cured, will result in additional decreases in our Borrowing Base of $1.3 million at the end of May and $7.8 million at the end of June. Further decreases in our Borrowing Base could result in a Borrowing Base violation that we may not be able to cure with our remaining unrestricted cash and cash equivalents.
In April 2009, our investment adviser withheld a scheduled principal amortization payment under its credit facility, resulting in a default thereunder. Our investment adviser has initiated discussions with its secured lenders regarding a consensual restructuring of its obligations under such credit facility. While we are not directly affected by our investment adviser’s default, a material adverse change in the business, condition (financial or otherwise), operations or performance of our investment adviser could constitute a default under our Revolving Facility.
Our asset coverage ratio, as defined in the 1940 Act, was 215% at February 28, 2009 versus 225% at February 29, 2008.
At February 28, 2009 and February 29, 2008, the fair value of investments, cash and cash equivalents and cash and cash equivalents, securitization accounts were as follows:
A dividend of $0.25 per share was paid on December 29, 2008, to common stockholders of record on December 18, 2008. In order to better manage the Company’s capital in light of continuing volatility in the credit markets, the Board determined that, beginning with the fourth quarter of fiscal year 2009, it would determine the amount and timing of dividends, if any, upon review of the financial results of the quarter. Accordingly, the Board will consider payment of a dividend for the fourth quarter of fiscal year 2009 at its regularly scheduled May 2009 meeting. The timing and amount of dividends remains within the Board’s discretion. Subject to certain conditions, for taxable years ending on or before December 31, 2009, we are permitted to make distributions to our stockholders in the form of shares of our common stock in lieu of cash distributions. The decision to make such distributions will be made by our Board of Directors.
Contractual obligations
The following table shows our payment obligations for repayment of debt and other contractual obligations at February 28, 2009:
Off-balance sheet arrangements
At February 28, 2009 and February 29, 2008, we did not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.
Recent Developments
In March 2009 we amended the Revolving Credit Facility to decrease the minimum required collateralization and increase the portion of the portfolio that can be invested in “CCC” rated investments in return for an increased interest rate and expedited amortization. As a result of these transactions, we expect to have additional cushion under our Borrowing Base. If we are not able to obtain new sources of financing, however, we expect our portfolio will gradually de-lever as principal payments are received, which may negatively impact our net investment income and ability to pay dividends. Please see Part I, Item 1A “Risk Factors-Risks Related to Our Business-We need to find alternative sources of leverage and/or access the equity markets to maintain and grow our business” for more information. As a result of the amendment, the interest margin on the Revolving Facility will increase from 0.70% over the prevailing commercial paper rate (Or LIBOR, if the commercial paper market is unavailable) to 4.00% until March 2010 (6.00% if the commercial paper market is unavailable) and 5.00% thereafter (6.00% if the commercial paper market is unavailable).
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Our business activities contain elements of market risk. We consider our principal market risks to be fluctuations in interest rates and the inherent difficulty of determining the fair value of our investments that do not have a readily available market value.
Managing these risks is essential to our business. Accordingly, we have systems and procedures designed to identify and analyze our risks, to establish appropriate policies and thresholds and to continually monitor these risks and thresholds by means of administrative and information technology systems and other policies and processes.
Interest Rate Risk
Interest rate risk is defined as the sensitivity of our current and future earnings to interest rate volatility, including relative changes in different interest rates, variability of spread relationships, the difference in re-pricing intervals between our assets and liabilities and the effect that interest rates may have on our cash flows. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on interest earning assets and our interest expense incurred in connection with our interest bearing debt and liabilities. Changes in interest rates can also affect, among other things, our ability to acquire leveraged loans, high yield bonds and other debt investments and the value of our investment portfolio.
Our investment income is affected by fluctuations in various interest rates, including LIBOR and the prime rate. A large portion of our portfolio is, and we expect will continue to be, comprised of floating rate investments that utilize LIBOR. Our interest expense is affected by fluctuations in the commercial paper rate or, if the commercial paper market is unavailable, LIBOR. At February 28, 2009, we had $59.0 million of borrowings outstanding at a floating rate tied to the prevailing commercial paper rate plus a margin of 0.70%.
In April and May 2007, pursuant to the Revolving Facility, the Company entered into two interest rate cap agreements with notional amounts of $34.0 million (increased to $40.0 million in May 2007) and $60.9 million. These agreements provide for a payment to the Company in the event LIBOR exceeds 8%, mitigating our exposure to increases in LIBOR. At February 28, 2009, the aggregate interest rate cap agreement notional amount was $66.4 million.
We have analyzed the potential impact of changes in interest rates on interest income from investments net of interest expense on the Revolving Facility. Assuming that our investments as of February 28, 2009 were to remain constant for a full fiscal year and no actions were taken to alter the existing interest rate terms, a hypothetical change of 1% in interest rates would cause a corresponding change of approximately $0.2 million to our interest income net of interest expense.
Although management believes that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size and composition of the assets on the balance sheet and other business developments that could magnify or diminish our sensitivity to interest rate changes, nor does it account for divergences in LIBOR and the commercial paper rate, which have historically moved in tandem but, in times of unusual credit dislocations, have experienced periods of divergence. Accordingly no assurances can be given that actual results would not materially differ from the potential outcome simulated by this estimate.
Portfolio Valuation
We carry our investments at fair value, as determined in good faith by our Board of Directors. Investments for which market quotations are readily available are fair valued at such market quotations. We value investments for which market quotations are not readily available at fair value as determined in good faith by our Board under our valuation policy and a consistently applied valuation process. For investments that are thinly traded, we review the depth and quality of the available quotations to determine if market quotations are readily available. If the available quotations are indicative only, we may determine that market quotations are not readily available. Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of our investments may differ significantly from the values that would have been used had a ready market existed for such investments, 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 ultimately realized on these investments to be different than the valuations that are assigned.
The types of factors that we may take into account in fair value pricing of our investments include, as relevant, the nature and realizable value of any collateral, third party valuations, the portfolio company’s ability to make payments and its earnings, the markets in which the portfolio company does business, market yield trend analysis, comparison to publicly-traded securities, recent sales of or offers to buy comparable companies, and other relevant factors. The fair value of our investment in the subordinated notes of GSCIC CLO is based on a discounted cash flow model that utilizes prepayment, re-investment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow, and comparable yields for similar CLO subordinated notes or equity, when available.
The table below describes the primary considerations made by our Board of Directors in determining the fair value of our investments at February 28, 2009:
Item 8.
Item 8. Financial Statements and Supplementary Data
Our financial statements are annexed to this Annual Report beginning on page.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A. Controls and Procedures
Evaluation of disclosure controls and procedures
Our CEO and our CFO have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, our CEO and CFO have concluded that our current disclosure controls and procedures are effective as of the end of the period covered by this report.
Management’s annual report on internal control over financial reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) and for the assessment of the effectiveness of internal control over financial reporting. Under the supervision and with the participation of management, including the CEO and CFO, the Company conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on the Company’s evaluation under the framework in Internal Control-Integrated Framework, the Company’s management concluded that the Company’s internal control over financial reporting was effective as of February 28, 2009.
This Annual Report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the company to provide only management’s report in this Annual Report.
Changes in internal controls over financial reporting.
There have been no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this item will be contained in the Company’s definitive Proxy Statement for its 2009 Annual Stockholder Meeting and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The information required by this item will be contained in the Company’s definitive Proxy Statement for its 2009 Annual Stockholder Meeting and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item will be contained in the Company’s definitive Proxy Statement for its 2009 Annual Stockholder Meeting and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this item will be contained in the Company’s definitive Proxy Statement for its 2009 Annual Stockholder Meeting and is incorporated herein by reference.
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by this item will be contained in the Company’s definitive Proxy Statement for its 2009 Annual Stockholder Meeting and is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Consolidated Financial Statement Schedules
Consolidated Financial Statements
The following financial statements of the Company are filed herewith:
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of February 28, 2009 and February 29, 2008
Consolidated Statements of Operations for the years ended February 28, 2009 and February 29, 2008 and for the period from May 12, 2006 (date of inception) to February 28, 2007
Consolidated Schedule of Investments as of February 28, 2009 and February 29, 2008
Consolidated Statements of Changes in Net Assets for the years ended February 28, 2009 and February 29, 2008 and for the period from May 12, 2006 (date of inception) to February 28, 2007
Consolidated Statements of Cash Flows for the years ended February 28, 2009 and February 29, 2008 and for the period from May 12, 2006 (date of inception) to February 28, 2007
Notes to Consolidated Financial Statements
Exhibits
EXHIBIT INDEX
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.
* * * * *
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of GSC Investment Corp.
We have audited the accompanying consolidated balance sheets of GSC Investment Corp. (the “Company”), including the consolidated schedule of investments as of February 28, 2009 and February 29, 2008, and the related consolidated statements of operations, changes in net assets, and cash flows for the period from May 12, 2006 (date of inception) to February 28, 2007 and for each of the two years ended February 28, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of GSC Investment Corp. at February 28, 2009 and February 29, 2008, and the consolidated results of their operations, changes in their net assets and their cash flows for the period from May 12, 2006 to February 28, 2007 and for each of the two years ended February 28, 2009 in conformity with U.S. generally accepted accounting principles.
Ernst & Young LLP
New York, NY
May 15, 2009
GSC Investment Corp.
Consolidated Balance Sheets
See accompanying notes to consolidated financial statements.
GSC Investment Corp.
Consolidated Statement of Operations
See accompanying notes to consolidated financial statements.
GSC Investment Corp.
Consolidated Schedule of Investments
February 28, 2009
See accompanying notes to consolidated financial statements.
GSC Investment Corp.
Consolidated Schedule of Investments
February 28, 2009
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
(a)
All of the Fund’s equity and debt investments are issued by eligible portfolio companies, as defined in the Investment Company Act of 1940, except Abitibi-Consolidated Company of Canada, Grant U.S. Holdings LLP, GSC Investment Corp. CLO 2007, Terphane Holdings Corp., and GSC Partners CDO GP III, LP.
(b)
Percentages are based on net assets of $68,013,777 as of February 28, 2009.
(c)
Fair valued investment (see Note 2 to the consolidated financial statements).
(d)
All or a portion of the securities are pledged as collateral under a revolving securitized credit facility (see Note 7 to the consolidated financial statements).
(e)
Non-U.S. company. The principal place of business for Terphane Holdings Corp is Brazil, and for Abitibi-Consolidated Company of Canada and Grant U.S. Holdings LLP is Canada.
(f)
12.15% represents the modeled effective interest rate that is expected to be earned over the life of the investment.
(g)
As defined in the Investment Company Act, we are an “Affiliate” of this portfolio company because we own 5% or more of the portfolio company’s outstanding voting securities. Transactions during the period in which the issuer was an Affiliate are as follows:
(h)
As defined in the Investment Company Act, we are an “Affiliate” of this portfolio company because we own 5% or more of the portfolio company’s outstanding voting securities. In addition, as defined in the Investment Company Act, we “Control” this portfolio company because we own more than 25% of the portfolio company’s outstanding voting securities. Transactions during the period in which the issuer was both an Affiliate and a portfolio company that we Control are as follows:
See accompanying notes to consolidated financial statements.
GSC Investment Corp.
Consolidated Schedule of Investments
February 29, 2008
See accompanying notes to consolidated financial statements.
GSC Investment Corp.
Consolidated Schedule of Investments
February 29, 2008
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
(a)
All of the Fund’s equity and debt investments are issued by eligible portfolio companies, as defined in the Investment Company Act of 1940, except Atlantis Plastics Films, Inc., Grant U.S. Holdings LLP, GSC Investment Corp. CLO 2007, Terphane Holdings Corp., and GSC Partners CDO GP III, LP.
(b)
Percentages are based on net assets of $97,869,040 as of February 29, 2008.
(c)
Fair valued investment (see Note 2 to the consolidated financial statements).
(d)
All or a portion of the investment is pledged as collateral under a revolving securitized credit facility (see Note 7 to the consolidated financial statements).
(e)
Non-U.S. company. The principal place of business for Terphane Holdings Corp is Brazil, and for Grant U.S. Holdings LLP is Canada.
(f)
As defined in the Investment Company Act, we are an “Affiliate” of this portfolio company because we own 5% or more of the portfolio company’s outstanding voting securities. Transactions during the period in which the issuer was an Affiliate are as follows:
(g)
As defined in the Investment Company Act, we are an “Affiliate” of this portfolio company because we own 5% or more of the portfolio company’s outstanding voting securities. In addition, as defined in the Investment Company Act, we “Control” this portfolio company because we own more than 25% of the portfolio company’s outstanding voting securities. Transactions during the period in which the issuer was both an Affiliate and a portfolio company that we Control are as follows:
See accompanying notes to consolidated financial statements.
GSC Investment Corp.
Consolidated Statements of Changes in Net Assets
See accompanying notes to consolidated financial statements.
GSC Investment Corp.
Consolidated Statements of Cash Flows
See accompanying notes to consolidated financial statements.
GSC INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Organization and Basis of Presentation
GSC Investment Corp. (the “Company”, “we” and “us”) is a non-diversified closed end management investment company incorporated in Maryland that has elected to be treated and is regulated as a business development company (“BDC”) under the Investment Company Act of 1940 (the “1940 Act”). We commenced operations on March 23, 2007 and completed our initial public offering (“IPO”) on March 28, 2007. We have elected to be treated as a regulated investment company (“RIC”) under subchapter M of the Internal Revenue Code. We expect to continue to qualify and to elect to be treated for tax purposes as a RIC. Our investment objectives are to generate both current income and capital appreciation through debt and equity investments by primarily investing in private middle market companies and select high yield bonds.
GSC Investment, LLC (the “LLC”) was organized in May 2006 as a Maryland limited liability company. As of February 28, 2007, the LLC had not yet commenced its operations and investment activities.
On March 21, 2007, the Company was incorporated and concurrently, the LLC was merged with and into the Company in accordance with the procedure for such merger in the LLC’s limited liability company agreement and Maryland law. In connection with such merger, each outstanding common share of the LLC was converted into an equivalent number of shares of common stock of the Company and the Company is the surviving entity.
We are externally managed and advised by our investment adviser, GSCP (NJ), L.P. (individually and collectively with its affiliates, “GSC Group” or the “Manager”), pursuant to an investment advisory and management agreement.
The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in conformity with U. S. generally accepted accounting principles (“GAAP”) and include the accounts of the Company and its special purpose financing subsidiaries, GSC Investment Funding, LLC and GSC Investment Funding II, LLC. The consolidated financial statements reflect all adjustments and reclassifications which, in the opinion of management, are necessary for the fair presentation of the results of the operations and financial condition for the periods presented. All intercompany accounts and transactions have been eliminated in consolidation. All references made to the “Company,” “we,” and “us” in the financial statements encompassing of these consolidated subsidiaries, except as stated otherwise.
Note 2. Summary of Significant Accounting Policies
Use of Estimates in the Preparation of Financial Statements
The preparation of the accompanying consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the period reported. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents include short-term, liquid investments in a money market fund. Cash and cash equivalents are carried at cost which approximates fair value.
Cash and cash equivalents, Securitization Accounts
Cash and cash equivalents, securitization accounts include amounts held in designated bank accounts in the form of cash and short-term liquid investments in money market funds representing payments received on securitized investments or other reserved amounts associated with the Company’s securitization facilities. The Company is 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. Cash held in such accounts may not be available for the general use of the Company.
Risk Management
In the ordinary course of its business, the Company manages a variety of risks, including market risk and credit risk. Market risk is the risk of potential adverse changes to the value of investments because of changes in market conditions such as interest rate movements and volatility in investment prices.
Credit risk is the risk of default or non-performance by portfolio companies equivalent to the investment’s carrying amount.
The Company is also exposed to credit risk related to maintaining all of its cash and cash equivalents including those in securitization accounts at a major financial institution and credit risk related to the derivative counterparty.
The Company has investments in lower rated and comparable quality unrated high yield bonds and bank loans. Investments in high yield investments are accompanied by a greater degree of credit risk. The risk of loss due to default by the issuer is significantly greater for holders of high yield securities, because such investments are generally unsecured and are often subordinated to other creditors of the issuer.
Investment Classification
The Company classifies its investments in accordance with the requirements of the 1940 Act. Under the 1940 Act, “Control Investments” are defined as investments in companies in which we own more than 25% of the voting securities or maintain greater than 50% of the board representation. Under the 1940 Act, “Affiliated Investments” are defined as those non-control investments in companies in which we own between 5% and 25% of the voting securities. Under the 1940 Act, “Non-affiliated Investments” are defined as investments that are neither Control Investments or Affiliated Investments.
Investment Valuation
The fair value of the Company’s assets and liabilities which qualify as financial instruments under Statement of Financial Accounting Standards No. 107, “Disclosure About Fair Value of Financial Instruments,” approximates the carrying amounts presented in the consolidated balance sheet.
Investments for which market quotations are readily available are fair valued at such market quotations obtained from independent third party pricing services and market makers subject to any decision by our board of directors to make a fair value determination to reflect significant events affecting the value of these investments. We value investments for which market quotations are not readily available as stated above at fair value as determined in good faith by our board of directors based on input from our Manager, our audit committee and, if our board or audit committee so request, a third party independent valuation firm. Determinations of fair value may involve subjective judgments and estimates. The types of factors that may be considered in a fair value pricing include the nature and realizable value of any collateral, the portfolio company’s ability to make payments, market yield trend analysis, the markets in which the portfolio company does business, comparison to publicly traded companies, discounted cash flow and other relevant factors.
We undertake a multi-step valuation process each quarter when valuing investments for which market quotations are not readily available, as described below:
•
Each investment is initially valued by the responsible investment professionals and preliminary valuation conclusions are documented and discussed with our senior management; and
•
An independent valuation firm engaged by our board of directors reviews at least one quarter of these preliminary valuations each quarter so that the valuation of each investment for which market quotes are not readily available is reviewed by the independent valuation firm at least annually.
In addition, all our investments are subject to the following valuation process.
•
The audit committee of our board of directors reviews each preliminary valuation and our investment adviser and independent valuation firm (if applicable) will supplement the preliminary valuation to reflect any comments provided by the audit committee; and
•
Our board of directors discuss the valuations and determine the fair value of each investment in good faith based on the input of our investment adviser, independent valuation firm (if applicable) and audit committee.
Our equity investment in GSC Investment Corp. CLO 2007, Ltd. (“GSCIC CLO”) is carried at fair value, which is based on a discounted cash flow model that utilizes prepayment, re-investment and loss assumptions based on historical experience and projected performance, economic factors, the characteristics of the underlying cash flow, and comparable yields for similar CLO equity, when available, as determined by our investment advisor and recommended to our board of directors.
Because such valuations, and particularly valuations of private investments and private companies, are inherently uncertain, they may fluctuate over short periods of time and may be based on estimates. The determination of fair value by our board of directors may differ materially from the values that would have been used if a ready market for these investments existed. Our net asset value could be materially affected if the determinations regarding the fair value of our investments were materially higher or lower than the values that we ultimately realize upon the disposal of such investments.
We account for derivative financial instruments in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities”, (“FAS 133”) as amended. FAS 133 requires recognizing all derivative instruments as either assets or liabilities on the consolidated balance sheet at fair value. The Company values derivative contracts at the closing fair value provided by the counterparty. Changes in the values of derivative contracts are included in the consolidated statement of operations.
Income Recognition
Purchases and sales of investments and the related realized gains or losses are recorded on a trade-date basis. Interest income, adjusted for amortization of premium and accretion of discount, is recorded on an accrual basis to the extent that such amounts are expected to be collected. The Company stops accruing interest on its investments when it is determined that interest is no longer collectible. If any cash is received after it is determined that interest is no longer collectible, we will treat the cash as payment on the principal balance until the entire principal balance has been repaid, before any interest income is recognized. Discounts and premiums on investments purchased are accreted/amortized over the life of the respective investment using the effective yield method. The amortized cost of investments represents the original cost adjusted for the accretion of discounts and amortizations of premium on investments.
Loans are generally placed on non-accrual status when there is reasonable doubt that principal or interest will be collected. Accrued interest is generally reversed when a loan is placed on non-accrual status. Interest payments received on non-accrual loans may be recognized as principal depending upon management’s judgment regarding collectability. Non-accrual loans are restored to accrual status when past due principal and interest is paid and, in management’s judgment, are likely to remain current. The Company may make exceptions to this if the loan has sufficient collateral value and is in the process of collection.
Interest income on our investment in GSCIC CLO is recorded using the effective interest method in accordance with the provision of EITF 99-20, based on the anticipated yield and the estimated cash flows over the projected life of the investment. Yields are revised when there are changes in actual or estimated cash flows due to changes in prepayments and/or re-investments, credit losses or asset pricing. Changes in estimated yield are recognized as an adjustment to the estimated yield over the remaining life of the investment from the date the estimated yield was changed.
Paid-in-Kind Interest
The Company includes in income certain amounts that it has not yet received in cash, such as contractual paid-in-kind interest (“PIK”), which represents contractually deferred interest added to the investment balance that is generally due at maturity. We stop accruing PIK if we do not expect the issuer to be able to pay all principal and interest when due.
Organizational Expenses
Organizational expenses consist principally of professional fees incurred in connection with the organization of the Company and have been expensed as incurred.
Deferred Credit Facility Financing Costs
Financing costs incurred in connection with each respective credit facility have been deferred and are being amortized using the straight line method over the life of each respective facility.
Indemnifications
In the ordinary course of its business, the Company may enter into contracts or agreements that contain indemnifications or warranties. Future events could occur that lead to the execution of these provisions against the Company. Based on its history and experience, management feels that the likelihood of such an event is remote.
Income Taxes
The Company has filed an election to be treated for tax purposes as a RIC under Subchapter M of the Code and, among other things, intends to make the requisite distributions to its stockholders which will relieve the Company from federal income taxes. Therefore, no provision has been recorded for federal income taxes.
In order to qualify as a RIC, among other requirements, the Company is required to timely distribute to its stockholders at least 90% of its investment company taxable income, as defined by the Code, for each fiscal tax year. The Company will be subject to a nondeductible U.S. federal excise tax of 4% on undistributed income if we do not distribute at least 98% of our investment company taxable income in any calendar year and 98% of our capital gain net income for each one-year period ending on October 31.
Depending on the level of taxable income earned in a tax year, we may choose to carry forward taxable income in excess of current year dividend distributions into the next tax year and pay a 4% excise tax on such income, as required. To the extent that the Company determines that its estimated current year annual taxable income will be in excess of estimated current year dividend distributions, the Company accrues excise tax, if any, on estimated excess taxable income as taxable income is earned. For the year ended February 28, 2009 provisions of $140,322 were recorded for Federal excise taxes. As of February 28, 2009, the entire $140,322 was unpaid and included in accounts payable on the accompanying consolidated balance sheet. This amount was paid subsequent to year end.
The Company has adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB No. 109, Accounting for Income Taxes, and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. In May 2007, the FASB issued Staff Position, FIN 48-1, Definition of Settlement in FASB Interpretation No. 48 (“FSP FIN 48-1”), which provides guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1 is effective with the initial adoption of FIN 48. The adoption of FIN 48 and FSP FIN 48-1 did not have a material impact on our consolidated financial statements.
Dividends
Dividends to common stockholders are recorded on the ex-dividend date. The amount to be paid out as a dividend is determined by the board of directors. Net realized capital gains, if any, are generally distributed at least annually, although we may decide to retain such capital gains for reinvestment.
The Company has adopted a dividend reinvestment plan that provides for reinvestment of our dividend distributions on behalf of our stockholders unless a stockholder elects to receive cash. As a result, if our board of directors authorizes, and we declare, a cash dividend, then our stockholders who have not ‘‘opted out’’ of our dividend reinvestment plan will have their cash dividends automatically reinvested in additional shares of our common stock, rather than receiving the cash dividends. If the Company’s common stock is trading below net asset value at the time of valuation, the plan administrator will receive the dividend or distribution in cash and will purchase common stock in the open market, on the New York Stock Exchange or elsewhere, for the account of each Participant.
New Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”), which provides companies with an option to report selected financial assets and liabilities at fair value. The objective of FAS 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. FAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities and to more easily understand the effect of the company’s choice to use fair value on its earnings. FAS 159 also requires entities to display the fair value of the selected assets and liabilities on the face of the balance sheet. FAS 159 does not eliminate disclosure requirements of other accounting standards, including fair value measurement disclosures in FAS 157. This statement is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. The Company did not elect fair value measurement for assets or liabilities other than portfolio investments, which are already measured at fair value, therefore, the adoption of this statement did not have a significant effect on the Company’s financial position or its results of operations.
In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities (“FAS 161”). The objective of FAS 161 is to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. FAS 161 improves transparency about the location and amounts of derivative instruments in an entity’s financial statements; how derivative instruments and related hedged items are accounted for under FAS 133; and how derivative instruments and related hedged items affect its financial position, financial performance, and cash flows. FAS 161 achieves these improvements by requiring disclosure of the fair values of derivative instruments and their gains and losses in a tabular format. It also provides more information about an entity’s liquidity by requiring disclosure of derivative features that are credit risk related. Finally, it requires cross-referencing within footnotes to enable financial statement users to locate important information about derivative instruments. FAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company did not early adopt FAS 161. Management is currently evaluating the enhanced disclosure requirements and the impact on our consolidated financial statements of adopting FAS 161.
In October 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. FSP No. 157-3 clarifies the application of FAS No. 157 in a market that is not active. More specifically, FSP No. 157-3 states that significant judgment should be applied to determine if observable data in a dislocated market represents forced
liquidations or distressed sales and are not representative of fair value in an orderly transaction. FSP No. 157-3 also provides further guidance that the use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available. In addition, FSP No. 157-3 provides guidance on the level of reliance of broker quotes or pricing services when measuring fair value in a non active market stating that less reliance should be placed on a quote that does not reflect actual market transactions and a quote that is not a binding offer. The guidance in FSP No. 157-3 is effective upon issuance for all financial statements that have not been issued and any changes in valuation techniques as a result of applying FSP No. 157-3 are accounted for as a change in accounting estimate.
In April 2009, the FASB issued FASB Staff Position No. FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (FSP 157-4). FSP 157-4 provides additional guidance for estimating fair value under Statement of Financial Accounting Standard No. 157, “Fair Value Measurements” when there is an inactive market or the market is not orderly. This FSP is effective for interim and annual periods ending after June 15, 2009.
In April 2009, the FASB issued FASB Staff Position No. FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP FAS 115-2 and FAS 124-2”), amends current other-than-temporary impairment guidance in GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. This FSP does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. The provisions of FSP FAS 115-2 and FAS 124-2 are effective for interim and annual periods ending after June 15, 2009.
Note 3. Investments
The Company adopted Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“FAS 157”) as of March 1, 2008, which among other matters, requires enhanced disclosures about investments that are measured and reported at fair value. As defined in FAS 157, fair value is 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. FAS 157 establishes a hierarchal disclosure framework which prioritizes and ranks the level of market price observability used in measuring investments at fair value. Market price observability is affected by a number of factors, including the type of investment and the characteristics specific to the investment. Investments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of market price observability and a lesser degree of judgment used in measuring fair value.
Based on the observability of the inputs used in the valuation techniques the Company is required to provide the following information according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Investments carried at fair value will be classified and disclosed in one of the following three categories:
•
Level 1 - Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.
•
Level 2 - Valuations based on inputs other than quoted prices in active markets, which are either directly or indirectly observable.
•
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The inputs into the determination of fair value may require significant management judgment or estimation. Even if observable-market data is available, such information may be the result of consensus pricing information or broker quotes which include a disclaimer that the broker would not be held to such a price in an actual transaction. The non-binding nature of consensus pricing and/or quotes accompanied by disclaimer would result in classification as Level III information, assuming no additional corroborating evidence.
In addition to using the above inputs in investment valuations, we continue to employ the valuation policy approved by our board of directors that is consistent with FAS 157 (see Note 2). Consistent with our valuation policy, we evaluate the source of inputs, including any markets in which our investments are trading, in determining fair value.
The following table presents fair value measurements of investments as of February 28, 2009 (dollars in thousands):
The following table provides a reconciliation of the beginning and ending balances for investments that use Level 3 inputs for the year ended February 28, 2009 (dollars in thousands):
Purchases and other adjustments to cost include new investments at cost, effects of refinancing/restructuring, accretion income from discount on debt securities, and PIK.
Sale and redemptions represent net proceeds received and realized gains and losses from investments sold during the period.
Net transfers in and/or out represent existing investments that were either previously categorized as a higher level and the inputs to the model became unobservable or investments that were previously classified as the lowest significant input became observable during the period. These investments are recorded at their end of period fair values.
The composition of our investments as of February 28, 2009, at amortized cost and fair value were as follows (dollars in thousands):
The composition of our investments as of February 29, 2008, at amortized cost and fair value were as follows (dollars in thousands):
Note 4. Investment in GSC Investment Corp. CLO 2007, Ltd.
On January 22, 2008, we invested $30 million in all of the outstanding subordinated notes of GSC Investment Corp. CLO 2007, Ltd., (the “GSCIC CLO”), a $400 million CLO managed by us that invests primarily in senior secured loans. Additionally, we entered into a collateral management agreement with GSCIC CLO pursuant to which we will act as collateral manager to it. In return for our collateral management services, we are entitled to a senior collateral management fee of 0.10% and a subordinate collateral management fee of 0.40% of the outstanding principal amount of GSCIC CLO’s assets, to be paid quarterly to the extent of available proceeds. We are also entitled to an incentive management fee equal to 20% of excess cash flow to the extent the GSCIC CLO subordinated notes receive an internal rate of return equal to or greater than 12%. For the years ended February 28, 2009 and February 29, 2008, we accrued $2.0 and $0.6 million in management fees and $4.4 and $0.3 million in interest income, respectively. We did not accrue any amounts related to the incentive management fee as the 12% hurdle rate has not yet been achieved.
Note 5. Income Taxes
The Company intends to operate so as to qualify to be taxed as a RIC under Subchapter M of the Code and, as such, will not be subject to federal income tax on the portion of taxable income and gains distributed to stockholders.
The Company owns 100% of GSC Investment Corp. CLO 2007, Ltd. (“CLO”), an Exempted Company incorporated in the Cayman Islands. For financial reporting purposes, the CLO is not included as part of the consolidated financial statements. For federal income tax purposes, the Company has requested and received approval from the Internal Revenue Service to treat the CLO as a disregarded entity. As such, for federal income tax purposes and for purposes of meeting the RIC qualification and diversification tests, the results of operations of the CLO are included with those of the Company.
To qualify as a RIC, the Company is required to meet certain income and asset diversification tests in addition to distributing at least 90% of its investment company taxable income, as defined by the Code. Because federal income tax regulations differ from accounting principles generally accepted in the United States, distributions in accordance with tax regulations may differ from net investment income and realized gains recognized for financial reporting purposes. Differences may be permanent or temporary in nature. Permanent differences are reclassified among capital accounts in the financial statements to reflect their tax character. Differences in classification may also result from the treatment of short-term gains as ordinary income for tax purposes. During the year ended February 28, 2009, the Company reclassified for book purposes amounts arising from permanent book/tax differences primarily related to nondeductible excise tax and meals & entertainment, market discount, interest income with respect to the CLO which is consolidated for tax purposes, and the tax character of distributions as follows (dollars in thousands):
For income tax purposes, distributions paid to shareholders are reported as ordinary income, return of capital, long term capital gains or a combination thereof. The tax character of distributions paid for the year ended February 28, 2009 was as follows (dollars in thousands):
(a) Ordinary income is reported on Form 1099-DIV as non-qualified.
For federal income tax purposes, the cost of investments owned at February 28, 2009 was $526.3 million.
At February 28, 2009, the components of distributable earnings on a tax basis as detailed below differ from the amounts reflected per the Company’s Statement of Assets and Liabilities by temporary book/tax differences primarily arising from the consolidation of the CLO for tax purposes, market discount and original issue discount income and amortization of organizational expenditures (dollars in thousands).
The Company has incurred capital losses of $3.2 million for the year ended February 28, 2009. Such capital losses will be available to offset future capital gains if any and if unused, will expire on February 28, 2017.
Management has analyzed the Company’s tax positions taken on federal income tax returns for all open tax years (fiscal years 2008-2009), and has concluded that no provision for income tax is required in the Company’s financial statements.
Note 6. Agreements
On March 21, 2007, the Company entered into an investment advisory and management agreement (the “Management Agreement”) with GSC Group. The initial term of the Management Agreement is two years, with automatic, one-year renewals at the end of each year subject to certain approvals by our board of directors and/or our stockholders. Pursuant to the Management Agreement, our investment adviser implements our business strategy on a day-to-day basis and performs certain services for us, subject to oversight by our board of directors. Our investment adviser is responsible for, among other duties, determining investment criteria, sourcing, analyzing and executing investments transactions, asset sales, financings and performing asset management duties. Under the Management Agreement, we have agreed to pay our investment adviser a management fee for investment advisory and management services consisting of a base management fee and an incentive fee.
The base management fee of 1.75% is calculated based on the average value of our total assets (other than cash or cash equivalents but including assets purchased with borrowed funds) at the end of the two most recently completed fiscal quarters, and appropriately adjusted for any share issuances or repurchases during the applicable fiscal quarter.
The incentive fee consists of the following two parts:
The first, payable quarterly in arrears, equals 20% of our pre-incentive fee net investment income (not including excise taxes), expressed as a rate of return on the value of the net assets at the end of the immediately preceding quarter, that exceeds a 1.875% quarterly (7.5% annualized) hurdle rate measured as of the end of each fiscal quarter. Under this provision, in any fiscal quarter, our investment adviser receives no incentive fee unless our pre-incentive fee net investment income, as defined above, exceeds the hurdle rate of 1.875%. Amounts received as a return of capital are not included in calculating this portion of the incentive fee. Since the hurdle rate is based on net assets, a return of less than the hurdle rate on total assets may still result in an incentive fee.
The second, payable at the end of each fiscal year equals 20% of our net realized capital gains, if any, computed net of all realized capital losses and unrealized capital depreciation, in each case on a cumulative basis, less the aggregate amount of such incentive fees paid to the investment adviser through such date.
We will defer cash payment of any incentive fee otherwise earned by our investment adviser if, during the most recent four full fiscal quarter period ending on or prior to the date such payment is to be made, the sum of (a) our aggregate distributions to our stockholders and (b) our change in net assets (defined as total assets less liabilities) (before taking into account any incentive fees payable during that period) is less than 7.5% of our net assets at the beginning of such period. These calculations will be appropriately pro rated for the first three fiscal quarters of operation and adjusted for any share issuances or repurchases during the applicable period. Such incentive fee will become payable on the next date on which such test has been satisfied for the most recent four full fiscal quarters or upon certain terminations of the investment advisory and management agreement.
For the years ended February 28, 2009 and February 29, 2008, we incurred $2.7 and $2.9 million in base management fees and $1.8 and $0.7 million in incentive fees related to pre-incentive fee net investment income, respectively. For the years ended February 28, 2009 and February 29, 2008, we incurred no incentive management fees related to net realized capital gains. As of February 28, 2009, $0.6 million of base management fees and $2.3 million of incentive fees were unpaid and included in management and incentive fees payable in the accompanying consolidated balance sheet.
As of February 28, 2009, the end of the fourth quarter of fiscal year 2009, the sum of our aggregate distributions to our stockholders and our change in net assets (defined as total assets less liabilities) (before taking into account any incentive fees payable during that period) was less than 7.5% of our net assets at the beginning of the fourth fiscal quarter of fiscal year 2008. Accordingly, the payment of the incentive fee for the quarter ended February 28, 2009 will be deferred. The total deferred incentive fee payable at February 28, 2009 is $2.3 million.
On March 21, 2007, the Company entered into a separate administration agreement (the “Administration Agreement”) with GSC Group, pursuant to which GSC Group, as our administrator, has agreed to furnish us with the facilities and administrative services necessary to conduct our day-to-day operations and provide managerial assistance on our behalf to those portfolio companies to which we are required to provide such assistance. Our allocable portion is based on the proportion that our total assets bears to the total assets or a subset of total assets administered by our administrator.
For the years ended February 28, 2009 and February 29, 2008, we expensed $1.0 and $0.9 million of administrator expenses, respectively, pertaining to bookkeeping, record keeping and other administrative services provided to the Company in addition to our allocable portion of rent and other overhead related expenses. GSC Group has agreed not to be reimbursed by the Company for any expenses incurred in performing its obligations under the Administration Agreement until the Company’s total assets exceeds $500 million. Additionally, the Company’s requirement to reimburse GSC Group is capped such that the amounts payable, together with the Company’s other operating expenses, will not exceed an amount equal to 1.5% per annum of the Company’s net assets attributable to the Company’s common stock. Accordingly, for the years ended February 28, 2009 and February 29, 2008, we have recorded $1.0 and $1.8 million in expense waiver and reimbursement, respectively, under the Administration Agreement in the accompanying consolidated statement of operations.
On March 23, 2007, the Manager provided the Company with a Notification of Fee Reimbursement (the “Expense Reimbursement Agreement”). The Expense Reimbursement Agreement provides for the Manager to reimburse the Company for operating expenses to the extent that our total annual operating expenses (other than investment advisory and management fees, interest and credit facility expenses, and organizational expense) exceed an amount equal to 1.55% of our net assets attributable to common stock. The Manager is not entitled to recover any reimbursements under this agreement in future periods. The term of the Expense Reimbursement Agreement is for a period of 12 months beginning March 23, 2007 and for each twelve months period thereafter unless otherwise agreed by the Manager and the Company. For the year ended February 28, 2009, we have recorded $49,715 in expense waiver and reimbursement under the Expense Reimbursement Agreement in the accompanying consolidated statement of operations. On April 15, 2008, the Manager and the Company agreed not to extend the agreement for an additional twelve month period and terminated the Expense Reimbursement Agreement as of March 23, 2008.
Note 7. Borrowings
As a BDC, we are only allowed to employ leverage to the extent that our asset coverage, as defined in the 1940 Act, equals at least 200% after giving effect to such leverage. The amount of leverage that we employ at any time depends on our assessment of the market and other factors at the time of any proposed borrowing.
On April 11, 2007, we formed GSC Investment Funding LLC (“GSC Funding”), a wholly owned consolidated subsidiary of the Company, through which we entered into a revolving securitized credit facility (the “Revolving Facility”) with Deutsche Bank AG, as administrative agent, under which we may borrow up to $100 million. A significant percentage of our total assets have been pledged under the Revolving Facility to secure our obligations thereunder. Under the Revolving Facility, funds are borrowed from or through certain lenders at prevailing commercial paper rates or, if the commercial paper market is at any time unavailable, at prevailing LIBOR rates, plus 0.70% payable monthly. As of February 28, 2009, there was $59.0 million outstanding under the Revolving Facility and the Company continues to be in compliance with all of the limitations and requirements of the Revolving Facility. As of February 29, 2008, there was $78.5 million outstanding under the Revolving Facility. For the years ended February 28, 2009 and February 29, 2008, we recorded $2.4 and $4.0 million of interest expense and $193,464 and $155,946 of amortization of deferred financing costs related to the Revolving Facility, respectively, and the interest rates on the outstanding borrowings ranged from 1.51% to 4.99%.
On May 1, 2007, we formed GSC Investment Funding II LLC (“GSC Funding II”), a wholly owned consolidated subsidiary of the Company, through which we entered into a $25.7 million term securitized credit facility (the “Term Facility” and, together with the Revolving Facility, the “Facilities”) with Deutsche Bank AG, as administrative agent, which was fully drawn at closing. A significant percentage of our total assets were pledged under the Term Facility to secure our obligations thereunder. The Term Facility bears interest at prevailing commercial paper rates or, if the commercial paper market is at any time unavailable, at prevailing LIBOR rates, plus 0.70%, payable quarterly. For the year ended February 29, 2008, we recorded $0.6 million of interest expense and $0.3 of amortization of deferred financing costs related to the Term Facility.
Each of the Facilities contain limitations as to how borrowed funds may be used, such as restrictions on industry concentrations, asset size, payment frequency and status, average life, collateral interests and investment ratings. The Facilities also include certain requirements relating to portfolio performance the violation of which could result in the early amortization of the Facilities, limit further advances (in the case of the Revolving Facility) and, in some cases, result in an event of default, allowing the lenders to accelerate repayment of amounts owed thereunder.
On December 12, 2007, the Company consolidated its Facilities by using the proceeds of a draw under the Revolving Facility to repay and terminate the Term Facility and transferring all assets in GSC Funding II to GSC Funding. The Company’s aggregate indebtedness and cost of funding were unchanged as a result of this consolidation.
In March 2009 we amended the Revolving Credit Facility to increases the portion of the portfolio that can be invested in “CCC” rated investments in return for an increased interest rate and expedited amortization. As a result of these transactions, we expect to have additional cushion under our Borrowing Base (as defined below) that will allow us to better manage our capital in times of declining asset prices and market dislocation. If we are not able to obtain new sources of financing, however, we expect our portfolio will gradually de-lever as principal payments are received, which may negatively impact our net investment income and ability to pay dividends.
At February 28, 2009, we had $59.0 million in borrowings under the Revolving Facility. At February 29, 2008, we had $78.5 million in borrowings under the Revolving Facility and $21.5 million of undrawn commitments remaining. The actual amount that may be outstanding at any given time (the “Borrowing Base”) is dependent upon the amount and quality of the collateral securing the Revolving Facility. Our Borrowing Base was $59.9 million at February 28, 2009 versus $83.6 million at February 29, 2008. The decline in our Borrowing Base during this period is mainly attributable to the decline in the value of the pledged collateral and the downgrade of certain public ratings or private credit estimates of the pledged collateral.
For purposes of determining the Borrowing Base, most assets are assigned the values set forth in our most recent quarterly report filed with the SEC. Accordingly, the February 28, 2009 Borrowing Base relies upon the valuations set forth in the quarterly report for the quarter ended November 30, 2008. The valuations presented in this annual report will not be incorporated into the Borrowing Base until after this report is filed with the SEC.
A Borrowing Base violation will occur if our outstanding borrowings exceed the Borrowing Base at any time. We can cure a Borrowing Base violation by reducing our borrowing below the Borrowing Base (by, e.g., selling collateral and repaying borrowings) or pledging additional collateral to increase the Borrowing Base. If we fail to cure a Borrowing Base violation within the specified time, a default under the Revolving Facility shall occur.
Note 8. Interest Rate Cap Agreements
In April and May 2007, pursuant to the requirements of the Facilities, GSC Funding and GSC Funding II entered into interest rate cap agreements with Deutsche Bank AG with notional amounts of $34 million and $60.9 million at costs of $75,000, and $44,000, respectively. In May 2007 GSC Funding increased the notional under its agreement from $34 million to $40 million for an additional cost of $12,000. The agreements expire in February 2014 and November 2013 respectively. These interest rate caps are treated as free-standing derivatives under FAS 133 and are presented at their fair value on the consolidated balance sheet and changes in their fair value are included on the consolidated statement of operations.
The agreements provide for a payment to the Company in the event LIBOR exceeds 8%, mitigating our exposure to increases in LIBOR. With respect to calculating the payments under these agreements, the notional amount is determined based on a pre-determined schedule set forth in the respective agreements which provides for a reduction in the notional at specified dates until the maturity of the agreements. As of February 28, 2009 we did not receive any such payments as the LIBOR has not exceeded 8%. At February 28, 2009, the total notional outstanding for the interest rate caps was $66.4 million with an aggregate fair value of $0.04 million, which is recorded in outstanding interest cap at fair value on the Company’s consolidated balance sheet. For the year ended February, 28, 2009, the Company recorded $0.04 million of unrealized depreciation on derivatives in the consolidated statement of operations related to the change in the fair value of the interest rate cap agreements.
The table below summarizes our interest rate cap agreements as of February 28, 2009 (dollars in thousands):
The table below summarizes our interest rate cap agreements as of February 29, 2008 (dollars in thousands):
Note 9. Directors Fees
The independent directors receive an annual fee of $40,000. They also receive $2,500 plus reimbursement of reasonable out-of-pocket expenses incurred in connection with attending each board meeting and receive $1,000 plus reimbursement of reasonable out-of-pocket expenses incurred in connection with attending each committee meeting. In addition, the chairman of the Audit Committee receives an annual fee of $5,000 and the chairman of each other committee receives an annual fee of $2,000 for their additional services in these capacities. In addition, we have purchased directors’ and officers’ liability insurance on behalf of our directors and officers. Independent directors have the option to receive their directors’ fees in the form of our common stock issued at a price per share equal to the greater of net asset value or the market price at the time of payment. No compensation is paid to directors who are “interested persons.” For the year ended February 28, 2009 we accrued $0.3 million for directors fees expense and $18,017 for reimbursement of out-of-pocket expenses. As of February 28, 2009, $5,250 in directors fees expense was unpaid and included in accounts payable and accrued expenses in the consolidated balance sheet. As of February 28, 2009, we had not issued any common stock to our directors as compensation for their services.
Note 10. Stockholders’ Equity
On May 16, 2006, GSC Group capitalized the LLC, by contributing $1,000 in exchange for 67 shares, constituting all of the issued and outstanding shares of the LLC.
On March 20, 2007, the Company issued 959,955 and 81,362 shares of common stock, priced at $15.00 per share, to GSC Group and certain individual employees of GSC Group, respectively, in exchange for the general partnership interest and a limited partnership interest in GSC Partners CDO III GP, LP, collectively valued at $15.6 million. At this time, the 67 shares owned by GSC Group in the LLC were exchanged for 67 shares of GSC Investment Corp.
On March 28, 2007, the Company completed its IPO of 7,250,000 shares of common stock, priced at $15.00 per share, before underwriting discounts and commissions. Total proceeds received from the IPO, net of $7.1 million in underwriter’s discount and commissions, and $1.0 million in offering costs, were $100.7 million.
Note 11. Earnings Per Share
The following information sets forth the computation of the weighted average basic and diluted net decrease in net assets per share from operations for the years ended February 28, 2009, and February 29, 2008 (dollars in thousands except per share amounts):
Note 12. Dividend
The following table summarizes dividends declared during the years ended February 28, 2009 and February 29, 2008 (dollars in thousands except per share amounts):
*
Amount per share is calculated based on the number of shares outstanding at the date of declaration.
Note 13. Financial Highlights
The following is a schedule of financial highlights for the years ended February 28, 2009 and February 29, 2008:
*
Net unrealized depreciation on investments and derivatives per share amount includes the net loss incurred prior to the IPO.
Note 14. Related Party Transaction
On March 20, 2007, the Company issued 959,955 and 81,362 shares of common stock, priced at $15.00 per share, to GSC Group and certain individual employees of GSC Group, respectively, in exchange for the general partnership interest and a limited partnership interest in GSC Partners CDO III GP, LP, collectively valued at $15.6 million. Additionally, GSC Group assigned its rights to act as collateral manager for GSC Partners CDO Fund III, Limited (“CDO III”) to the Company. The Company paid GSC Group $0.1 million to acquire the rights to act as collateral manager and expected to receive collateral management fees of $0.2 million. For the year ended February 29, 2008 we received $0.4 million of management fee income from CDO III and received distributions of $16.1 million from our partnership interests resulting in a realized gain of $0.5 million. As of February 28, 2009, the fair value of the general partnership interest and limited partnership interest is $108,939.
On January 10, 2008, GSC Group notified our Dividend Reinvestment Plan Administrator that it was electing to receive dividends and other distributions in cash (rather than in additional shares of common stock) with respect to all shares of stock held by it and the investment funds under its control. For the year ended February 29, 2008, GSC Group received 35,911 of additional shares under the dividend reinvestment plan. As of February 28, 2009, GSC Group and its affiliates own approximately 12% of the outstanding common shares of the Company.
On January 22, 2008, we entered into a collateral management agreement with GSCIC CLO pursuant to which we will act as collateral manager to it. In return for our collateral management services, we are entitled to a senior collateral management fee of 0.10% and a subordinate collateral management fee of 0.40% of the outstanding principal amount of GSCIC CLO’s assets, to be paid quarterly to the extent of available proceeds. We are also entitled to an incentive management fee equal to 20% of excess cash flow to the extent the GSCIC CLO subordinated notes receive an internal rate of return equal to or greater than 12%. We do not expect to enter into additional collateral management agreements in the near future.
In April 2009, our investment adviser withheld a scheduled principal amortization payment under its credit facility, resulting in a default thereunder. Our investment adviser has initiated discussions with its secured lenders regarding a consensual restructuring of its obligations under such credit facility. While we are not directly affected by our investment adviser’s default, if it is unable to restructure its credit facility, or an acceleration of the outstanding principal balance by the lenders occurs, the ability of the investment adviser to retain key individuals and perform its investment advisory duties for us could be significantly impaired.
Note 15. Selected Quarterly Data (Unaudited)
Note 16. Subsequent Events
Following the end of the fiscal year ended February 28, 2009, AbitibiBowater Inc. and certain of its subsidiaries, which includes the Company’s $2.1 million investment in Abitibi-Consolidated Company of Canada (“Abitibi”), filed voluntary petitions on April 16, 2009 in the United States under Chapter 11 of the United States Bankruptcy Code and sought creditor protection under the Companies Creditors Arrangement Act in Canada.