Item 1. Business
GENERAL
We are a solutions-focused commercial finance company providing capital and advisory services to middle market companies throughout the United States. We make debt and equity investments primarily in companies with annual revenue of $20 million to $200 million and earnings before interest, taxes, depreciation and amortization, or EBITDA, of $3 million to $25 million, which we refer to as “middle market” companies. Our capital is generally used by our portfolio companies to finance acquisitions, recapitalizations, buyouts, organic growth and working capital. Buyouts generally include transactions that involve the acquisition of a controlling interest in an entity, either by management or other investors. Organic growth refers to growth through the internal operations of the company, through investments in marketing initiatives, capital expenditures or other internal growth initiatives, rather than growth by means of an acquisition. We identify and source new customers through multiple channels, including private equity sponsors, investment bankers, brokers, fund-less sponsors, institutional syndication partners, other club lenders and owner operators. We originate most of our investments directly with our customers, although from time to time we do participate in loan syndications or other deals. We have controlling equity positions in certain of our portfolio companies. We base our investment decisions on extensive analyses of potential customers’ business operations and asset valuations. We utilize specialized risk management methods, pricing tools, due diligence methodologies and data management processes that are designed to help us assess risk, establish appropriate pricing, and maximize our return on investment.
Our primary business objectives are to increase our earnings and net asset value by investing in debt and equity securities of middle market companies. Our investment objective is to achieve current income and capital gains. We earn current income, in the form of interest, dividends, and fees, from our investments in debt and equity securities and achieve capital gains through appreciation in the value of our equity investments. To meet our business and investment objectives, we selectively invest in companies which present opportunities for favorable risk-adjusted returns. In addition, we maintain a flexible approach to funding that permits adjustments to transaction terms, including pricing terms, to accommodate the shifting corporate development needs of our customers.
We have built our portfolio through our disciplined underwriting and investment approval processes and active portfolio management. We believe that our core competencies include risk assessment and risk management, and we have developed expertise which is reflected in our underwriting and compliance processes. We generally make investments of up to $75 million utilizing three core products: our “one-stop” solution, institutional subordinated debt, and control investing. In addition to our core products we also make other investments, such as senior loans and investments in broadly syndicated loans. Our debt investments include senior and subordinated securities, most of which include a security interest. Our loans typically mature in four to eight years, and require monthly or quarterly interest payments at fixed rates or variable rates based on the prime rate or LIBOR, plus a margin. We price our debt securities based upon our credit analysis and risk assessment. Our equity investments are often made in companies in which we have also made debt investments. Our equity investments include preferred stock, common stock, and warrants and, in many cases, will include the right to board representation. We may invest across the capital structure of our portfolio companies using a combination of debt and equity investments to meet our customers’ needs and achieve favorable risk-adjusted returns.
CORPORATE HISTORY AND OFFICES
We are an internally managed, non-diversified, closed-end investment company that has elected to be regulated as a business development company under the Investment Company Act of 1940, or the 1940 Act. As a business development company, we are required to meet various regulatory tests, which include investing at least
70% of our total assets in private or thinly traded public U.S.-based companies and meeting a coverage ratio of total net assets to total senior securities, which include all of our borrowings (including accrued interest payable) and any preferred stock we may issue in the future, of at least 200%. See “Regulation.” In addition, we have elected to be treated for federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code. In order to continue to qualify as a RIC for federal income tax purposes and to obtain favorable RIC tax treatment, we must meet certain requirements, including certain minimum distribution requirements. See “Certain U.S. Federal Income Tax Considerations.”
Our business began in 1990 as a division of Signet Bank known as the media communications group. Signet Banking Corporation, the parent of Signet Bank, was acquired by First Union Corporation (now Wachovia Corporation) on November 27, 1997. We were formed in 1998 by certain members of our management and affiliates of Goldman, Sachs & Co. to purchase a loan portfolio and certain other assets from First Union National Bank (now Wachovia Bank, National Association) in a management buyout. MCG was organized as a Delaware corporation on March 18, 1998 at which time we changed our name from MCG, Inc. to MCG Credit Corporation. On June 14, 2001, we changed our name from MCG Credit Corporation to MCG Capital Corporation. We completed our initial public offering on December 4, 2001.
Our executive offices are located at 1100 Wilson Boulevard, Suite 3000, Arlington, Virginia 22209 and our telephone number is (703) 247-7500. We also have offices in Richmond, Virginia and Atlanta, Georgia. Our Internet site address is www.mcgcapital.com. Information contained on our web site is not incorporated by reference into this Annual Report and you should not consider information contained on our web site to be part of this Annual Report. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and our current reports on Form 8-K, as well as any amendments to those reports, are available free of charge through our website as soon as reasonably practicable after we file them with, or furnish them to, the Securities and Exchange Commission (“SEC”).
MARKET OPPORTUNITY
We believe that the middle market is a significant, growing segment of the U.S. economy that has increasing demand for, and less access to, high-quality differentiated corporate financial services, and that this trend is likely to continue. We also believe that the middle market offers attractive rates of return and that middle market companies have unique capital and servicing requirements. Our focus on the smaller end of the middle market, which we believe is underserved, and our ability to structure transactions to meet these capital and servicing requirements for companies across a diverse industry base enhances our market opportunity.
We have migrated from a sector specialist to a multi-industry capital partner to enhance our risk-adjusted returns. As a cross-industry capital partner, our opportunities for investment are expanded. We remain a selective investor, evaluating potential new investments through objective evaluation criteria. We seek characteristics that indicate predictable, promising long-term performance:
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Clear and understandable businesses;
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Quality management teams;
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Sustainable competitive advantage;
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Stable customer bases;
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Favorable financial characteristics and credit metrics; and
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Barriers to entry and defensible market shares.
In order to enhance our continued service to our middle market customers, we continuously engage with existing and prospective customers and conduct ongoing market research. We believe that our extensive knowledge and research capabilities differentiate us in the marketplace because we are able to demonstrate our expertise and knowledge of the middle market and share it with our customers and prospective customers.
STRATEGY
We seek to achieve favorable risk-adjusted rates of return in the form of current income and capital gains, while maintaining credit and investment quality in our portfolio. We believe our financial performance is a product of our knowledge and insight, effectiveness in targeting potential customers, exceptional customer service, risk-based pricing techniques, and effective risk management. We apply well established credit processes to assess investment risk, and we structure and price our investments accordingly. We have developed proprietary analytics, data and knowledge to support our business activities.
Our investment process is designed to achieve the following strategic objectives:
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generate favorable risk-adjusted rates of return by delivering capital and strategic insight to increase our customers’ enterprise value;
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maintain sound credit and investment discipline and pricing practices, regardless of market conditions, to avoid adverse investment selection;
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manage risk by utilizing an integrated team approach to business development, underwriting, and investment servicing.
INVESTMENTS
We make both debt and equity investments in middle market companies. Our debt investments include senior and subordinated securities, substantially all of which include a security interest. Our loans typically mature in four to eight years, and require monthly or quarterly interest payments at fixed rates or variable rates based on the prime rate or LIBOR, plus a margin. We price our debt securities based upon our credit analysis and risk assessment. Our equity investments are often made in companies in which we have also made debt investments. Our equity investments include preferred stock, common stock, and warrants and, in many cases, will include the right to board representation. We may invest across the capital structure of our portfolio companies using a combination of debt and equity investments to meet our customers’ needs and optimize our returns. In order to execute our strategy we utilize three core products: our “one-stop” solution, institutional subordinated debt, and control investing.
“One-stop” Solution. Our “one-stop” solution, which refers to our ability to provide all of the debt capital in a transaction in separate and distinct securities, enables our customers to satisfy multiple financing needs from a single capital provider with an efficient diligence, structuring, negotiating and closing process. In a typical “one-stop” transaction, we provide a combination of senior and subordinated debt to our customer and, in certain cases, also acquire an equity interest in the customer. The overall transaction size and product mix are based upon our customer’s needs. In some cases our “one-stop” solution results in a product mix that meets our customer’s needs but which we believe is not the most efficient use of our capital. In these cases, we may sell portions of some of the securities in order to achieve a more optimal mix. Typically, when we sell portions of one of our investments, we continue to service the investment and thus these sales are seamless to our customers. “One-stop” transactions generally provide current interest income on our loans and the opportunity to achieve capital gains on our equity investment, as well as fee income generated through syndication of portions of the investment.
Institutional Subordinated Debt. We provide institutional subordinated debt in the form of junior, yielding capital, as a sole or club investor in the larger end of our target market. These loans are typically payable in full at maturity and generally provide attractive yields. Our institutional subordinated debt customers are generally larger businesses supported by institutional equity capital that reduces the risk profile of these investments.
Control Investments. Control investments are investments for which we take a majority ownership position and, in most cases, control the board of directors of a portfolio company. We use our established relationships, market knowledge and one-stop capabilities to secure controlling interests in attractive operating
companies. Control investments are long-term investments in which we expect to achieve the majority of our returns through capital appreciation. Our control investments typically include investments across the entire capital structure of the portfolio company. We believe control investments generally provide a reliable income stream and an opportunity to generate capital gains on our investment.
Other Investments and Services. In addition to our core products we also make other investments, such as senior loans and investments in broadly syndicated loans. These other investments help balance our portfolio. In addition to capital, we also offer managerial assistance to our portfolio companies. This assistance typically involves strategic advice, evaluation of business plans, financial modeling assistance and industry research and insights. We believe that providing assistance to our portfolio companies enables us to maximize our value proposition for our customers which, in turn, helps us maximize our investment returns.
OPERATIONS
We engage our markets with expertise and superior responsiveness, which enables us to originate and manage a diverse portfolio of investments that produce current income and capital gains in order to create consistent, high quality and sustainable dividends for our stockholders. To achieve our goal of being a leading provider of solutions-focused financial services to middle market companies, we have established a credit and business culture that strives to identify and attract new customers and provide excellent customer service, while protecting our capital and generating favorable risk-adjusted returns through current income on our loans and equity investments and capital gains on our equity investments.
Business Development
MCG and its predecessors have been active investors in the middle market since 1990 and have invested over $5.7 billion in approximately 550 transactions. We believe that our experience in middle market investing is a meaningful competitive advantage that we use to develop our business. We identify and source new customers through multiple channels, including private equity sponsors, investment bankers, brokers, fund-less sponsors, institutional syndication partners, other club lenders and owner operators. We also market to prospective customers identified through various data services, customized internet searches, and relationships with investment bankers, accountants, lawyers and other professionals. From time to time we also purchase investments through syndicated or other deals. Members of our professional staff engage in other marketing initiatives on a national scale, including attending and presenting at industry forums, conferences and meetings and participating in industry associations. Of our investments in new customers during 2007, approximately 60% were in deals sponsored by private equity investors, 20% were in syndicated or other deals, and 20% were direct investments in owner operators.
Once we identify a prospective customer, we review its financial reports, business plan, corporate activities, and other relevant information which we gather from third-party databases, industry reports, and publications. We focus on a company’s fundamental performance against industry conditions and operational benchmarks. We work with our current and prospective customers to understand their business, costs and benefits of their corporate development initiatives, opportunities, competition, and acceptable risks and returns. This understanding allows us to support our customers’ corporate development decisions, even in some cases where short-term financial ratios or other metrics may temporarily decline. We believe this approach differentiates us from most other lenders and investors and enables us to make investments and achieve returns based on the value we help create rather than solely on the basis of our cost of capital. This approach has been successful in attracting new customers and in gaining additional business from existing customers as they execute their long term growth strategies.
Underwriting and Risk Management
Our underwriting philosophy places primary emphasis on investment risk analysis. Our underwriting function is initiated during the business development process. Our underwriting team typically consists of investment professionals who perform due diligence and financial analyses, deal teams who are responsible for originating and managing the transaction and a member of our legal team. Our underwriting processes, which have been developed over more than 17 years, include standard due diligence on a prospective customer’s financial performance as well as customized analyses of a prospective customer’s operations, systems, accounting policies, human resources and competitive, legal and regulatory environments. Our underwriting team works to gain an understanding of the relationships among the customer’s business plan, operations and financial performance. We frequently engage external experts to supplement and assist in the underwriting process.
In addition to gaining an in-depth understanding of our customers and prospective customers, our research and due diligence provide expert perspectives on industry wide operational, strategic, and valuation issues and support our business development and risk management processes by identifying attractive industries, emerging trends, and competitive threats. We continually update our investment perspectives and develop investment hypotheses for new industries. The knowledge and insight we obtain through our research are valuable to our customers who may draw on our industry expertise to refine their strategic plans, identify acquisition opportunities, and set appropriate financial and operational goals.
As part of our evaluation of a proposed investment, the underwriting team prepares an investment memorandum for presentation to our credit committee and, in some instances, our investment committee. The investment memorandum generally consists of:
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a business description;
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historical financial analyses, projections and scenario modeling;
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a risk evaluation specific to the prospective portfolio company’s business and industry, considering the anticipated use of proceeds of our investment;
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an enterprise valuation to assess the underlying value of the customer, both as an ongoing operation and its value relative to comparable public and private companies; and
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a description of the capital structure and the investment risk and return characteristics.
Risk Analysis. We review the prospective portfolio company’s history, organization and product lines, and we analyze the prospective portfolio company’s industry, competition and market share, obsolescence and substitution risk, markets served, legal and regulatory environment and technology. In particular, we analyze the following risks:
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Industry Risks. We analyze the specific vulnerability to industry risk, such as maturity, cyclicality, and seasonality.
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Competitive Risks. We analyze the strengths and weaknesses of the prospective portfolio company relative to its competitors in terms of its pricing, product quality, customer loyalty, substitution and switching costs, brand positioning and capitalization. We also assess the defensibility of a prospect’s market position and its opportunity for increasing market share.
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Regulatory Risks. We follow regulatory developments in the industries in which we invest and assess the risks that are presented by existing and proposed regulations.
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Customer Concentration and Market Risks. We evaluate the stability of the prospective portfolio company’s customer base by analyzing the number and size of its customers and their attrition rates, the potential impact of above average customer attrition and low renewals, and the risk due to loss of its significant customers.
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Technology Risks. We follow technological advances in the industries in which we invest and analyze the positive or negative impacts these advances may have on the prospective portfolio company.
We also assess other attributes of a potential transaction. We evaluate management’s track record, their business plan, their judgments about their products and other characteristics that may significantly affect the risk of a transaction. Quantitative attributes that we evaluate include industry-specific comparisons such as cash flow margins, product and cash flow diversification, revenue growth rates, cost structure and other operating benchmarks that are derived from historical financial statements. Qualitative attributes we evaluate may include management skill and depth, industry risk, substitution risk, cyclicality, geographic diversification, facilities infrastructure, administration requirements and product quality and ranking.
Enterprise Valuation. To assess the risk of a potential investment and to quantify the underlying value of the enterprise in which we are investing, we employ a series of valuation techniques. We primarily derive enterprise valuations through analyses of comparative public and private market transactions using our database of transactions. We also generally prepare discounted cash flow models based on our projections of the future free cash flows of the business and industry derived capital costs. Finally, we look to comparable public companies to benchmark the value of the enterprise using public market data. We generally base enterprise value on current and projected market conditions. Using these methods provides us with multiple views of the value of the enterprise and allows us to calculate certain metrics that we use in both risk assessment and product pricing, such as loan-to-value ratios for our debt investments.
Investment Structure. We evaluate our customers’ needs and utilize our product mix to structure investments that meet their capital requirements and business plans and protect our capital while generating favorable risk-adjusted returns through current income on our loans and equity investments and capital gains on our equity investments. We structure our debt investments to mitigate risk by requiring appropriate financial and collateral coverage thresholds. When structuring our debt investments, we evaluate key components, including payment priority, collateral or asset value, and financial support from guarantors and other credit enhancements. Since our investments typically include loans and our loans are typically cash flow loans, rather than asset backed loans, liquidation value of assets is a factor in our credit decisions. In the majority of our loans, we receive a security interest in our customers’ tangible and intangible assets, which entitles us to a preferred position on payments in the event of liquidation. In addition, our loan covenants generally include affirmative covenants that require the customer to provide periodic financial information, notification of material events and compliance with laws, as well as restrictive covenants that prevent customers from taking a range of significant actions, such as incurring additional indebtedness or making acquisitions without our consent. We also generally include covenants requiring the customer to maintain or achieve specified financial ratios, such as cash flow leverage, interest charge coverage and total charge coverage, and, in certain cases, operating covenants requiring them to maintain certain operational benchmarks.
Investment Approval Process
The credit process for each investment opportunity begins with our deal sponsors. Our deal sponsors are responsible for investment performance, including credit risk, throughout the life cycle of an investment. Deal sponsors provide an initial credit screen based on our investment guidelines, and then bring the best opportunities to our credit committee and senior underwriting professionals in a “pipeline meeting.” For this meeting, the deal sponsor prepares a pipeline report that provides a summary of the transaction, financial statements, credit ratios and pricing, and background information on the principals, equity investors and industry dynamics. Additionally, financial statements and company offering materials are distributed. This group determines whether the investment should be pursued, giving consideration to the risk return profile, industry concentrations and general economic outlook for the sector in which the business operates. In these meetings the committee also offers the deal sponsor insight into key underwriting issues that must be resolved in the underwriting process.
As part of our underwriting process, a transaction team is formed typically consisting of the deal sponsor, a member of our in-house legal team, two to three corporate financial analysts and a senior credit manager. Objectives are determined and due diligence is conducted. On site due diligence, including general ledger reviews, proofs of cash, material contract reviews, background checks, review of customer and vendor
concentrations, and confirmation of historical results are performed by our personnel and, in special situations, by third party accounting firms. We believe strongly in using our own in-house experts applying our consistent standards for due diligence.
All of our investments are approved by our credit committee, whose members include Steven F. Tunney, our President and Chief Executive Officer; Robert J. Merrick, our Chief Investment Officer; B. Hagen Saville, our Executive Vice President of Business Development; William B. Ford, a Senior Vice President and Managing Director; and Robert L. Marcotte, a Senior Vice President and Managing Director. In addition, certain investments based on asset type and investment size must also be approved by the investment committee of our board of directors, whose members include Messrs. Tunney, Saville and Merrick and independent directors Jeffrey M. Bucher, A. Hugh Ewing, Wallace B. Millner, Kim D. Kelly, and Edward S. Civera.
Investment Servicing
After an investment is approved and funded, the deal sponsor and underwriting team, along with the investment administration group and the compliance and valuation group, monitor covenant compliance and financial performance on an ongoing basis. Our deal teams maintain primary responsibility for the performance of their investments throughout the life of the investment.
Investment Administration Group. This group maintains our investment transaction records and is responsible for:
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funding the investments in accordance with credit committee and, if applicable, investment committee approval;
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recording the investments into our accounting system;
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billing and collecting;
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reporting and collecting on past due accounts; and
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maintaining the collateral that is in our possession.
Compliance and Valuation Group. This group monitors investment compliance and ensures that all investments adhere to our internal policies and procedures. This group is responsible for:
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reviewing the investment agreement to ensure that the final documents reflect the terms approved by the credit committee and, if applicable, the investment committee and advising of any deviations;
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ensuring that the portfolio company compliance package is prepared in accordance with the loan covenant requirements;
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entering the portfolio company’s financial statements into our tracking system and entering the loan covenants into our covenant tracking system;
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ensuring the mathematical accuracy of applicable covenant requirements;
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reviewing the portfolio company’s financial statements to ensure that the portfolio company performs in accordance with our expectations and to identify any changes in risk;
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reporting all covenant violations, loan amendments and covenant waivers to the credit committee; and
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preparing quarterly portfolio valuations for review by the valuation committee of our Board of Directors.
Investment Monitoring and Restructuring Procedures. We continually monitor the status and financial performance for each individual customer in order to evaluate overall portfolio quality. We closely monitor compliance with all covenants and take appropriate action on all exceptions. We do not believe that all contract exceptions, such as breaches of contractual covenants or late delivery of financial statements, are necessarily an indication of deterioration in the credit quality or the need to pursue remedies or an active workout of a portfolio investment. We are proactive with companies that are underperforming and have continually added better covenant protection and rights over time. This approach enables us to more quickly and effectively take action to mitigate potential losses.
When our attempts to collect past due principal and interest on a loan are unsuccessful, we will perform an analysis to determine the appropriate course of action. In some cases, we may consider restructuring the
investment to better reflect the current financial performance of the customer. Such a restructuring may, among other items, involve deferring payments of principal and interest, adjusting interest rates or warrant positions, imposing additional fees, amending financial or operating covenants or converting debt to equity. In connection with a restructuring, we generally receive appropriate compensation from the customer for any increased risk. During the process of monitoring a loan in default, we will generally send a notice of non-compliance outlining the specific defaults that have occurred and preserving our remedies, and initiate a review of the collateral, if any. When a restructuring is not the most appropriate course of action, we generally pursue remedies available to us that minimize any potential losses, including initiating foreclosure and/or liquidation proceedings.
When one of our loans becomes more than 90 days past due, or if we otherwise do not expect the customer to be able to service its debt and other obligations, we will, as a general matter, place the loan on non-accrual status and will generally cease recognizing interest income on that loan until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, we may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection.
Investment Funding
We fund our investments using cash that we receive in exchange for a combination of debt and equity instruments that we issue from time to time. Our debt obligations include both secured and unsecured obligations. As a business development company we are required to meet a coverage ratio of total assets to total senior securities, which include all of our borrowings and any preferred stock we may issue in the future, of at least 200%. Our equity is publicly traded on the NASDAQ Global Select Market under the symbol “MCGC”.
Portfolio Valuation
We determine the value of each investment in our portfolio on a quarterly basis, and record changes in value as unrealized appreciation or depreciation in our statement of operations. Value, as defined in Section 2(a)(41) of 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by the board of directors. Since there is typically no readily ascertainable market value for the investments in our portfolio, we value substantially all of our investments at fair value as determined in good faith by the board of directors pursuant to a valuation policy and a consistent valuation process. We also retain independent valuation firms to perform independent valuations of certain of our portfolio companies and perform reviews for our fair value determinations. The independent valuations and reviews are considered by our board of directors in its determination of the fair value of our portfolio investments. At December 31, 2007 and 2006, approximately 95% of our total assets represented investments of which approximately 97% are valued at fair value and approximately 3% valued at market value based on readily ascertainable public market quotes, respectively. Because of 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 determined in good faith by the board of directors may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material. See further discussion in “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies.”
Portfolio Overview
As of December 31, 2007, our investment portfolio consisted of approximately 67% of debt investments and 33% of equity investments. Approximately 97% of our debt investments as of that date had security interests.
Our debt instruments provide for a contractual interest rate generally ranging from 10% to 16%, a portion of which may be payment-in-kind (“PIK”) which we typically do not collect until maturity. At December 31, 2007, approximately 63% of the debt investments in our portfolio, based on amounts outstanding at fair value, were at variable rates determined on the basis of LIBOR or prime rate, and approximately 37% were at fixed rates. In addition, approximately 28% of our debt investment portfolio has floors of between 1.50% and 3.00% on the LIBOR base index. Our loans have stated maturities at origination that generally range from four to eight years. Our customers typically pay an origination fee based on a percentage of the commitment amount and also often pay a fee on any undrawn commitments.
The following table shows statistics of our portfolio as of December 31, 2007 and 2006, and activity for the years then ended:
The following table shows our portfolio of investments by industry at fair value, as of December 31, 2007 and 2006:
(a)
No individual industry within this category exceeds 1%.
Our ten largest portfolio companies represented approximately 39.9% of the total fair value of our investments at December 31, 2007 and accounted for approximately 38.0% of our total revenue during the year ended December 31, 2007. At December 31, 2007, approximately 19.1% of our portfolio at fair value was invested in companies in the communications industry. The communications industry is a regulated industry. Of the 19.1% in the communications industry, 16.5% represents our investments in CLECs. Our remaining investments in the communications industry include telecommunications tower companies, rural local exchange carriers, Internet service providers, wireless companies and security alarm companies. Two of our portfolio companies, which we control, Broadview Networks Holdings, Inc. (“Broadview”) and Cleartel Communications, Inc. (“Cleartel”) are CLECs. Broadview is our largest investment. See additional discussion of Broadview and Cleartel in “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Portfolio Composition and Investment Activity.”
Investment Rating System
We use an investment rating system to characterize and monitor our expected level of return on each investment in our portfolio. We use the following 1 to 5 investment rating scale:
Investment
Rating
Summary Description
Capital gain expected or realized
Full return of principal and interest or dividend expected with customer performing in accordance with plan
Full return of principal and interest or dividend expected but customer requires closer monitoring
Some loss of interest or dividend expected but still expecting an overall positive internal rate of return on the investment
Loss of interest or dividend and some loss of principal investment expected which would result in an overall negative internal rate of return on the investment
We monitor and, when appropriate, recommend changes to investment ratings. The valuation committee of our board of directors reviews management’s recommendations and affirms or changes the investment ratings quarterly. In most cases, where we hold multiple securities in a portfolio company, the investment rating is the same for each security in that portfolio company.
The following table shows the distribution of our investments on the 1 to 5 investment rating scale at fair value as of December 31, 2007 and 2006:
(a)
At December 31, 2007 and 2006, approximately $627.4 million and $447.4 million, respectively, of our investments with an investment rating of “1” were loans to companies in which we also hold equity securities or for which we have already realized a gain on our equity investment.
(b)
The increase in the amount of investments with an investment rating of “5” from December 31, 2006 to December 31, 2007 is primarily due to our investment in Cleartel. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Results of Operations” for additional information regarding our investment in Cleartel.
COMPETITION
In general, we compete for investments with a large number of financial services companies, including commercial finance companies, commercial banks, private mezzanine and equity funds, investment banks and other investment funds such as hedge funds. These include lending subsidiaries of investment banks, other business development companies, and finance subsidiaries of large industrial corporations.
We do not seek to compete primarily based on the interest rates we offer, and we believe that some of our competitors make loans with interest rates that are comparable to or lower than the rates we offer. We generally compete by using our insight and knowledge of our customers’ business needs, derived from our research, analysis, and interaction of our professional staff with our customers, to offer the appropriate product mix coupled with a range of corporate finance services and information that enhances our customers’ business prospects.
OUR SUBSIDIARIES
We conduct some of our activities through wholly owned special purpose financing subsidiaries. These subsidiaries are bankruptcy remote, special purpose entities to which we transfer certain loans. Each financing subsidiary in turn transfers the loans to a Delaware statutory trust. The transfers of the loans to the Delaware statutory trusts are structured as on-balance sheet securitizations for accounting purposes.
In December 2004, we formed a subsidiary, Solutions Capital I, LP, which is licensed by the United States Small Business Administration, or SBA, to operate as a small business investment company, or SBIC, under the Small Business Investment Act of 1958, as amended. At the same time we organized another wholly owned subsidiary, Solutions Capital GP, LLC, as a Delaware limited liability company. Solutions Capital GP, LLC will act as the general partner of Solutions Capital I, LP, while we will be the sole limited partner. We have applied for exemptive relief from the SEC to permit us to exclude senior securities issued by the SBA to Solutions Capital I, LP from our consolidated asset coverage ratio, which will enable us to fund more investments with debt capital. There can be no assurance that we will receive the requested exemptive relief from the SEC.
On March 31, 2007, we formed a special situations fund, MCG Opportunity Investment Fund I, LLC. This Special Situations Fund will allow us to pursue distressed debt opportunities, as well as undervalued equity opportunities.
We also use wholly owned subsidiaries, all of which are structured as Delaware corporations and limited liability companies, to hold the assets of one or more of our portfolio companies. Some of these subsidiaries have wholly owned subsidiaries, all of which are Delaware corporations, that hold the assets of certain of our portfolio companies.
INVESTMENT POLICIES
Our investment policies provide that we will not:
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act as an underwriter of securities of other issuers, except to the extent that we may be deemed an “underwriter” of securities (i) purchased by us that must be registered under the Securities Act of 1933 before they may be offered or sold to the public, or (ii) in connection with offerings of securities by our portfolio companies;
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sell securities short in an uncovered position;
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write or buy uncovered put or call options, except to the extent of options, warrants or conversion privileges in connection with our loans or other investments, and rights to require the issuers of such investments or their affiliates to repurchase them under certain circumstances;
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engage in the purchase or sale of commodities or commodity contracts, including futures contracts, except for purposes of hedging in the ordinary course of business or where necessary in working out distressed loan or investment situations; or
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acquire more than 3% of the voting stock of, or invest more than 5% of our total assets in any securities issued by, any other investment company, except if we acquire them as part of a merger, consolidation or acquisition of assets or if they result from a sale of a portfolio company, or otherwise as permitted under the 1940 Act.
All of the above policies and the investment and lending guidelines set by our board of directors or any committees, including our investment objective to achieve current income and capital gains, are not “fundamental” as defined under the 1940 Act. Therefore, our board may change them without notice to or approval by our stockholders, but any change may require the consent of our lenders.
Other than the restrictions pertaining to the issuance of senior securities under the 1940 Act, the percentage restrictions on investments generally apply at the time a transaction is effected. A subsequent change in a percentage resulting from market fluctuations or any cause other than an action by us will not require us to dispose of portfolio securities or to take other action to satisfy the percentage restriction.
We intend to conduct our business so as to retain our status as a business development company. In order to retain our status as a business development company, we may not acquire any assets, other than non-investment assets necessary and appropriate to our operations as a business development company, if after giving effect to such acquisition the value of our “qualifying assets” is less than 70% of the value of our total assets.
EMPLOYEES
As of December 31, 2007, we employed 95 employees, including 55 investment and portfolio management professionals. We also employ operations professionals, in-house legal counsel, and administrative staff. We believe that our relations with our employees are good.
INVESTMENT ADVISER
We have no investment adviser and are internally managed by our executive officers under the supervision of the board of directors. Our investment decisions are made by our officers, directors and senior investment professionals who serve on our credit and investment committees, as discussed under “-Operations-Investment Approval Process” above. None of our executive officers or other employees has the authority to individually approve any investment.
CERTAIN U.S. FEDERAL INCOME TAX CONSIDERATIONS
We elected to be treated as a “regulated investment company” or “RIC” under Subchapter M of the Internal Revenue Code with the filing of our federal corporate income tax return for 2002, which election was effective as of January 1, 2002. As a RIC, we generally do not have to pay corporate taxes on any income we distribute to our stockholders as dividends, which allows us to reduce or eliminate our corporate-level tax liability.
Taxation as a Regulated Investment Company
If we:
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qualify as a RIC, and
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distribute each year to stockholders at least 90% of our “investment company taxable income” (which is defined in the Internal Revenue Code generally as ordinary income plus realized net short-term capital gains in excess of realized net long-term capital losses), and 90% of any ordinary pre-RIC built-in gains we recognize between January 1, 2002 and December 31, 2011, less our taxes due on those gains (collectively, the “90% Distribution Requirement”),
we will be entitled to deduct, and therefore will not be subject to U.S. federal income tax on, the portion of our income we distribute or are deemed to distribute to stockholders (other than any built-in gain recognized between January 1, 2002 and December 31, 2011). We will be subject to U.S. federal income tax at the regular corporate
rate on any income not distributed (or deemed distributed) to our stockholders. We will be subject to a 4% nondeductible U.S. federal excise tax to the extent we do not distribute (actually or on a deemed basis) in a timely manner 98% of our ordinary income for each calendar year, 98% of our capital gain net income for each calendar year, and any income realized but not distributed in prior calendar years.
In order to qualify as a RIC for federal income tax purposes, we must, among other things:
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continue to qualify as a business development company under the 1940 Act at all times during each taxable year;
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derive in each taxable year at least 90% of our gross income from (1) dividends, interest, payments with respect to certain securities, loans, gains from the sale of stock or other securities, or other income derived with respect to our business of investing in such stock or securities and (2) net income derived from an interest in a “qualified publicly traded partnership” (known as the “90% Income Test”); and
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diversify our holdings so that at the end of each quarter of the taxable year:
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at least 50% of the value of our assets consists of cash, cash items, U.S. government securities, securities of other RICs, and other securities if such other securities of any one issuer do not represent more than 5% of the value of our assets or more than 10% of the outstanding voting securities of the issuer, and
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no more than 25% of the value of our assets is invested in the securities, other than U.S. government securities or securities of other RICs, of (i) one issuer, (ii) two or more issuers that are controlled, as determined under applicable Internal Revenue Code rules, by us and are engaged in the same or similar or related trades or businesses or (iii) one or more “qualified publicly traded partnerships” (known as the “Diversification Tests”).
We may be required to recognize taxable income in circumstances in which we do not receive cash. For example, if we hold debt obligations that are treated under applicable tax rules as having original issue discount, we must include in taxable income each year a portion of the original issue discount that accrues over the life of the obligation, regardless of whether cash representing such income is received by us in the same taxable year. We also may have to include in taxable income other amounts that we have not yet received in cash, such as payment-in-kind interest and deferred loan origination fees that are paid after origination of the loan or are paid in non-cash compensation such as warrants or stock. Because any original issue discount or other amounts accrued will be included in our investment company taxable income for the year of accrual, we may be required to make a cash distribution to our stockholders in the amount of that non-cash income in order to satisfy the 90% Distribution Requirement, even though we will not have received any cash representing such income.
If we fail to satisfy the 90% Distribution Requirement or fail to qualify as a RIC in any taxable year, we will be subject to tax in that year on all of our taxable income, regardless of whether we make any distributions to our stockholders. In that case, all of our income will be subject to corporate-level tax, reducing the amount available to be distributed to our stockholders, and all of our distributions to our stockholders will be characterized as ordinary dividends (to the extent of our current and accumulated earnings and profits). Such dividends generally would be subject to tax to non-corporate U.S. Stockholders at a maximum rate of 15 percent.
Treatment of Pre-Conversion Built-in Gain
Through December 31, 2001, we were subject to tax as an ordinary corporation under Subchapter C of the Internal Revenue Code. As of January 1, 2002, we held substantial assets (including intangible assets not reflected on the balance sheet, such as goodwill) with built-in gain (i.e., with a fair market value in excess of tax basis). Under a special tax rule that applies to corporations that convert from taxation under Subchapter C of the Internal Revenue Code to taxation as a RIC, we are required to pay corporate level tax on the amount of any net built-in gains we recognize within ten years after the effective date of our election to be treated as a RIC. Any such corporate level tax will be payable at the time those gains are recognized (which, generally, will be the years in which we sell or dispose of the built-in gain assets in a taxable transaction). Based on the assets that we
hold as of December 31, 2007 that we currently anticipate selling within the ten-year period beginning January 1, 2002 and ending December 31, 2011, we expect we may have to pay a built-in gain tax of up to $0.2 million at current corporate tax rates. The amount of this tax will vary depending on the assets that are actually sold by us in this ten-year period and applicable tax rates. Under Treasury Regulations, recognized built-in gains (or losses) will generally retain their character as capital gain or ordinary income (or capital or ordinary losses). Recognized built-in gains that are ordinary in character will be included in our investment company taxable income, and we must distribute to our stockholders at least 90% of any such built-in gains recognized within the ten-year period, net of the corporate taxes paid by us on the built-in gains. Any such amount distributed will be taxable to stockholders as ordinary income. Recognized built-in gains within the ten-year period, net of taxes, that are capital gains will be distributed or deemed distributed to our stockholders. Any such amount distributed or deemed distributed will be taxable to stockholders as a capital gain.
REGULATION
Business Development Company Regulations
A business development company is regulated by the 1940 Act. A business development company must be organized in the United States for the purpose of investing in or lending to primarily private companies and making managerial assistance available to them. A business development company may use capital provided by public shareholders and from other sources to invest in long-term, private investments in businesses. A business development company provides stockholders the ability to retain the liquidity of a publicly traded stock, while sharing in the possible benefits, if any, of investing in primarily privately owned companies.
As a business development company, we may not acquire any asset other than “qualifying assets” unless, at the time we make the acquisition, the value of our qualifying assets represents at least 70% of the value of our total assets. The principal categories of qualifying assets relevant to our business are:
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Securities of an eligible portfolio company that are purchased in transactions not involving any public offering. An eligible portfolio company is defined under the 1940 Act to include any issuer that:
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is organized and has its principal place of business in the U.S.;
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is not an investment company or a company operating pursuant to certain exemptions under the 1940 Act, other than a small business investment company wholly owned by a business development company; and
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does not have any class of publicly traded securities with respect to which a broker may extend margin credit;
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does not have a class of securities listed on a national securities exchange;
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Securities received in exchange for or distributed with respect to securities described in the bullet above or pursuant to the exercise of options, warrants, or rights relating to those securities; and
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Cash, cash items, government securities, or high quality debt securities (as defined in the 1940 Act), maturing in one year or less from the time of investment.
To include certain securities described above as qualifying assets for the purpose of the 70% test, a business development company must offer to make available to the issuer of those securities significant managerial assistance such as providing guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company. We offer to provide managerial assistance to each portfolio company.
As a business development company, we are required to meet a coverage ratio of the value of total assets to total senior securities, which include all of our borrowings and any preferred stock we may issue in the future, of
at least 200%. We may also be prohibited under the 1940 Act from knowingly participating in certain transactions with our affiliates without the prior approval of our directors who are not interested persons and, in some cases, prior approval by the SEC.
As a business development company regulated under provisions of the 1940 Act, we are not generally able to issue and sell our common stock at a price below the current 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 our common stock in a rights offering to our stockholders or; if (1) our board of directors determines that such sale is in the best interests of the Company and our stockholders, (2) our stockholders approve the sale of our common stock at a price that is less than the current net asset value, and (3) the price at which our common stock is to be issued and sold may not be less than a price which, in the determination of our board of directors, closely approximates the market value of such securities (less any sales load).
Our board of directors has appointed a chief compliance officer pursuant to the requirements of the 1940 Act. We are subject to periodic examination by the SEC for compliance with the 1940 Act.
As with other companies regulated by the 1940 Act, a business development company must adhere to certain substantive regulatory requirements. A majority of our directors must be persons who are not interested persons, as that term is defined in the 1940 Act. Additionally, we are required to provide and maintain a bond issued by a reputable fidelity insurance company to protect the business development company. Furthermore, as a business development company, we are prohibited from protecting any director or officer against any liability to us or our stockholders arising from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office.
As a business development company under the 1940 Act, we are entitled to provide and have previously provided loans to our employees in connection with the purchase of shares of our common stock. However, as a result of certain provisions of the Sarbanes-Oxley Act of 2002, we are prohibited from making new loans to, or materially modifying existing loans with, our executive officers for that purpose.
We have received an exemptive order of the SEC to permit us to issue restricted shares of our common stock as part of the compensation packages for certain of our employees and directors. We believe that the particular characteristics of our business, the dependence we have on key personnel to conduct our business effectively and the highly competitive environment in which we operate require the use of equity-based compensation for our personnel in the form of restricted stock. The issuance of restricted shares of our common stock requires the approval of our stockholders. Our stockholders approved our 2006 Employee Restricted Stock Plan and our 2006 Non-employee Restricted Stock Plan in June 2006.
As required by the 1940 Act, we maintain a code of ethics that establishes procedures for personal investments and restricts certain transactions by our personnel. Our code of ethics generally does not permit investments by our employees in securities that may be purchased or held by us. You may read and copy the code of ethics at the Securities and Exchange Commission’s Public Reference Room in Washington, D.C. You may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission at 1-800-SEC-0330. In addition, the code of ethics is available on the EDGAR Database on the Securities and Exchange Commission’s Internet site at http://www.sec.gov. You may obtain copies of the code of ethics, after paying a duplicating fee, by electronic request at the following Email address: publicinfo@sec.gov, or by writing the Securities and Exchange Commission’s Public Reference Room, 100 F Street NE, Washington, D.C. 20549.
We may not change the nature of our business so as to cease to be, or withdraw our election as, a business development company unless authorized by vote of a majority of the outstanding voting securities, as required by the 1940 Act. A majority of the outstanding voting securities of a company is defined under the 1940 Act as the lesser of: (i) 67% or more of such company’s shares present at a meeting if more than 50% of the outstanding shares of such company are present or represented by proxy, or (ii) more than 50% of the outstanding shares of such company. We do not anticipate any substantial change in the nature of our business.
In addition, as a publicly held company we are subject to compliance with the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002, as well as the rules and regulations promulgated thereunder, imposed a wide variety of regulatory requirements on publicly held companies and their insiders, which affect us. For example:
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Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended (the “1934 Act”), our chief executive officer and chief financial officer must certify the accuracy of the financial statements contained in our periodic reports;
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Pursuant to Item 307 of Regulation S-K, our periodic reports must disclose our conclusions about the effectiveness of our disclosure controls and procedures;
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Pursuant to Rule 13a-15 of the 1934 Act, our management must prepare a report regarding its assessment of our internal control over financial reporting; and
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Pursuant to Item 308 of Regulation S-K, our periodic reports must disclose whether there were significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
The Sarbanes-Oxley Act requires us to review our current policies and procedures to determine whether we comply with the Sarbanes-Oxley Act and the regulations promulgated thereunder. We will continue to monitor our compliance with all regulations that are adopted under the Sarbanes-Oxley Act and will take actions necessary to ensure that we are in compliance therewith.
During 2006, a special committee of the independent members of our board of directors (the “Independent Committee”) was formed after the timeliness of reimbursements of certain tax withholding payments was brought to the attention of the Audit Committee by our executive officers. The Independent Committee conducted a review of the timeliness of certain loan payments and tax withholding reimbursements involving six of our current and former executive officers and has reported these matters to the staff of the Securities and Exchange Commission (the “SEC Staff”). On September 21, 2006, we reported that the review by the Independent Committee had been substantially completed, although the SEC Staff has requested that we furnish additional information. The Independent Committee believes it has fully cooperated with the SEC Staff and it will continue to do so. The SEC Staff may also require additional information in the future, the nature and scope of which cannot be determined at this time. As part of its review, the Independent Committee considered whether there were any violations of the Company’s code of business conduct and ethics and the federal securities laws, including but not limited to, Section 402 of the Sarbanes-Oxley Act of 2002 (Section 13(k) of the Securities Exchange Act of 1934). Based upon its review, the Independent Committee concluded that certain violations of our code of business conduct and ethics did occur and reached no conclusion regarding Section 402 of the Sarbanes-Oxley Act of 2002. We continue to believe that there will be no impact on previously reported earnings as a result of these matters. We have instituted procedures to ensure concurrent payment to the Company of all future obligations of executive officers resulting from tax withholding paid by the Company on behalf of its executive officers, and we have taken certain other actions as previously disclosed.
In addition, we have adopted certain policies and procedures intended to comply with the NASDAQ Global Select Market’s corporate governance rules. We will continue to monitor our compliance with all future listing standards that are approved by the SEC and will take actions necessary to ensure that we are in compliance therewith.
Small Business Administration Regulations
In December 2004, we formed Solutions Capital I, L.P. and Solutions Capital GP, LLC. In September 2007, Solutions Capital I, L.P. received final approval to be licensed as a small business investment company (“SBIC”). Solutions Capital I, L.P. is able to borrow funds from the Small Business Administration (“SBA”) against eligible pre-approved investments and additional deposits to regulatory capital. The SBIC regulations
currently limit the amount that is available to borrow by any SBIC to $130.6 million, subject to periodic adjustments by the SBA. There is no assurance that we will draw up to the maximum limit available under the SBIC program.
SBICs are designed to stimulate the flow of private equity capital to eligible small businesses. Under present SBA regulations, eligible small businesses include businesses that have a tangible net worth not exceeding $18 million and have average annual fully taxed net income not exceeding $6 million for the two most recent fiscal years. In addition, an SBIC must devote 20% of its investment activity to “smaller” concerns as defined by the SBA. A smaller concern is one that has a tangible net worth not exceeding $6 million and has average annual fully taxed net income not exceeding $2 million for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services. Through our wholly-owned subsidiary Solutions Capital I, L.P., we plan to provide long-term loans to qualifying small businesses, and in connection therewith, make equity investments and provide them with consulting and advisory services.
Solutions Capital I, L.P. will be periodically examined and audited by the SBA’s staff to determine its compliance with SBIC regulations.
QUARTERLY DETERMINATION OF NET ASSET VALUE
We determine the net asset value per share of our common stock quarterly. The net asset value per share is equal to the value of our total assets minus liabilities and any preferred stock outstanding divided by the total number of shares of common stock outstanding. At the time of this filing, we do not have any preferred stock outstanding.
DETERMINATIONS OF NET ASSET VALUE IN CONNECTION WITH OFFERINGS
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, at a price below the current net asset value of the common stock, or sell warrants, options or rights to acquire such 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 the best interests of the Company and our stockholders, and our stockholders approve our policy and practice of making such sales. 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 distributing commission or discount).
In connection with each offering of shares of our common stock, our board of directors or a committee thereof is required to make the determination that we are not selling shares of our common stock at a price below the then current net asset value of our common stock at the time at which the sale is made. Our board of directors considers the following factors, among others, in making such determination:
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the net asset value of our common stock disclosed in the most recent periodic report we filed with the SEC;
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our management’s assessment of whether any material change in the net asset value of our common stock has occurred (including through the realization of gains on the sale of our portfolio securities) from the period beginning on the date of the most recently disclosed net asset value of our common stock to the period ending two days prior to the date of the sale of our common stock; and
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the magnitude of the difference between the net asset value of our common stock disclosed in the most recent periodic report we filed with the SEC and our management’s assessment of any material change in the net asset value of our common stock since the date of the most recently disclosed net asset value of our common stock, and the offering price of the shares of our common stock in the proposed offering.
Importantly, this determination does not require that we calculate the net asset value of our common stock in connection with each offering of shares of our common stock, but instead it involves the determination by our board of directors or a committee thereof that we are not selling shares of our common stock at a price below the then current net asset value of our common stock at the time at which the sale is made, subject to certain exceptions discussed above.
To the extent that there is even a remote possibility that we may issue shares of our common stock at a price below the then current net asset value of our common stock at the time at which the sale is made, then the board of directors will elect either to postpone the offering until such time that there is no longer the possibility of the occurrence of such event or to undertake to determine the net asset value of our common stock within two days prior to any such sale to ensure that such sale will not be below our then current net asset value. Moreover, to the extent that there is even a remote possibility that we may trigger the undertaking (which we provided to the SEC in our registration statements) to suspend the offering of shares of our common stock if the net asset value of our common stock fluctuates by certain amounts in certain circumstances until the prospectus is amended, then the board of directors will elect to comply with such undertaking or to undertake to determine the net asset value of our common stock to ensure that such undertaking has not been triggered.
Item 1A.
Item 1A. Risk Factors
Investing in our common stock involves a high degree of risk. You should consider carefully the risks described below and all other information contained in this Annual Report, including our financial statements and the related notes and the schedules and exhibits to this Annual Report.
Because there is generally no established market from which to value most of our investments, our board of directors’ determination of the value of our investments may differ materially from the values that a ready market or third party would attribute to these investments.
Under the 1940 Act, we are required to carry our portfolio investments at market value or, if there is no readily available market value, at fair value as determined by our board. We are not permitted to maintain a general reserve for anticipated loan losses. Instead, we are required by the 1940 Act to specifically value each individual investment and to record any unrealized depreciation for any asset that we believe has decreased in value. Because there is typically no public market for the securities of the companies in which we invest, our board will determine the fair value of these securities on a quarterly basis pursuant to our valuation policy. Because of 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 determined in good faith by the board of directors may differ significantly from the values that would have been used had a ready market existed for the investments and the differences could be material.
In addition, we are currently analyzing the effect of the adoption of SFAS No. 157 (“SFAS No. 157”), “Fair Value Measurements” on our consolidated financial position, including our net asset value, and results of operations. We will adopt this statement on a prospective basis effective January 1, 2008. Adoption of this statement could have a material effect on our consolidated financial statements, including our net asset value. However, the actual impact on our consolidated financial statements in the period of adoption and subsequent to the period of adoption cannot be determined at this time as it will be influenced by the estimates of fair value for that period and the number and amount of investments we originate, acquire or exit. See Note 1, “Description of Business, Basis of Presentation, and Summary of Significant Accounting Policies” from our Notes to the Consolidated Financial Statements included in Item 8.
We primarily make investments in privately owned middle market companies, which may default on their loans or fail to perform as we expect, thereby reducing or eliminating the return on our investments.
Our portfolio primarily consists of debt and equity investments in privately owned middle market businesses. Compared to larger publicly owned companies, these middle market companies may be more vulnerable to economic downturns, may have more limited access to capital and higher funding costs, may have a weaker financial position, and may need more capital to expand or compete. These businesses also may experience substantial variations in operating results. They may face intense competition, including from companies with greater financial, technical and marketing resources. Typically, their success depends on the management talents and efforts of an individual or a small group of persons. The death, disability or resignation of any of their key employees could harm their financial condition. Furthermore, some of these companies do business in regulated industries and could be affected by changes in government regulation. Accordingly, these factors could impair their cash flow or result in other events, such as bankruptcy, which could limit their ability to repay their obligations to us, and may adversely affect the return on, or the recovery of, our investment in these businesses. Deterioration in a borrower’s financial condition and prospects may be accompanied by deterioration in any collateral for the loan.
Some of these companies may be unable to obtain financing from public capital markets or from traditional credit sources, such as commercial banks. Accordingly, advances made to these types of customers may entail a higher risk of loss than advances made to customers who are able to utilize traditional credit sources, including the risk that our loans may not be repaid.
Furthermore, there is generally no publicly available information about such companies and we must rely on the diligence of our employees to obtain information in connection with our investment decisions. 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.
If the industries in which we invest on a recurring basis, including the communications industry, experience adverse economic or business conditions, our operating results may be negatively impacted.
From time to time we target specific industries in which to invest on a recurring basis, which could cause a high concentration of our portfolio in a specific industry. At December 31, 2007, approximately 19.1% of our portfolio at fair value was invested in companies in the communications industry. Of the 19.1% in the communications industry, 16.5% represents our investments in CLECs, and 2.6% represents our investments in other communications companies. If our customers in the communications industry, or any other industry in which our portfolio is or may become concentrated, suffer due to adverse business conditions or due to economic slowdowns or downturns, we will be more vulnerable to losses in our portfolio and our operating results may be negatively impacted.
Our financial results could be negatively affected if Broadview Networks Holdings, Inc. fails to perform as expected.
At December 31, 2007, our largest portfolio investment was Broadview Networks Holdings, Inc. (“Broadview”), which totaled $189.5 million at fair value, or 12.2% of the fair value of our investments, and accounted for approximately $29.8 million, or 15.9% of our total revenue during 2007. We own preferred securities of Broadview, which entitle us to a preferred claim of approximately $266.9 million, plus dividends, which accumulate at an annual rate of 12%, compounded quarterly, on our preferred claim. We currently recognize these dividends as income on a quarterly basis; however, our ability to record income related to these accumulating dividends will be dependent upon the performance and value of Broadview. Our financial results could be negatively affected if this portfolio company fails to perform as expected or if we are unable to recognize these dividends as income on a quarterly basis.
Our ability to recognize income from our investment in Cleartel Communications, Inc. in future periods and the fair value of our investment in Cleartel is dependent on Cleartel’s performance and value.
Cleartel Communications, Inc. (“Cleartel”), one of our control investments, is a competitive local exchange carrier (“CLEC”) serving primarily residential customers. During the year ended December 31, 2007, we invested an additional $20.0 million into Cleartel in order to support their operations, of which $4.7 million was invested during the fourth quarter of 2007. In December 2007, we converted a portion of our subordinated debt investment in Cleartel into common stock. This debt to equity conversion did not result in any additional cash investments or repayments. We may elect to make additional investments in Cleartel in future periods to support its business initiatives. As of December 31, 2007, our investment in Cleartel is comprised of subordinated debt with a fair value of $26.2 million, preferred stock with a fair value of zero and 100% of the common stock of Cleartel with a fair value of zero. These fair values reflect unrealized depreciation recorded during 2007 of approximately $63.5 million, including $38.9 million recorded during the fourth quarter. At December 31, 2007, Cleartel represented approximately 1.7% of the fair value of our investments compared to 5.8% of the fair value of our investments at December 31, 2006.
Cleartel has made several acquisitions in recent years, including the acquisition of Supra Telecom (“Supra”), a Florida-based CLEC, during the fourth quarter of 2006. Cleartel achieved operating results during 2007 that were materially below expectations and has not met our expectations and projections with respect to the realization of synergies from its acquisition, reductions in customer attrition and bad debts and the initiation and effective implementation of new marketing programs. During the third quarter of 2007, in connection with the completion of a re-evaluation of Cleartel’s multi-year business plan, it became evident that revenue levels in future periods will run at lower levels than previously anticipated and it will take longer than expected for Cleartel to achieve meaningful profitability. This was due in part to the fact that Cleartel has reduced some of its less profitable initiatives and in part to the impact of the customer attrition that occurred. Because we view revenue as a key component of value, we recorded an unrealized loss of $24.6 million on our Cleartel investment in the third quarter of 2007. During the fourth quarter of 2007, Cleartel continued to significantly underperform on these expectations, which resulted in a further reduction of forecasted revenue. As a result of Cleartel’s underperformance, we recorded an additional $38.9 million unrealized loss during the fourth quarter of 2007.
Since our Cleartel investment is a control investment and because Cleartel is not currently generating sufficient earnings to service its capital structure, all of our Cleartel debt investments were placed on non-accrual status during the first quarter of 2007 and remained on non-accrual status throughout 2007. This investment will remain on non-accrual status until the underlying financial results and cash flows of Cleartel improve. We cannot predict with certainty when any of our Cleartel investments will return to accrual status. At a minimum, we do not expect our Cleartel debt investment to return to accrual status in 2008. Our ability to recognize income from our investment in Cleartel in future periods and the fair value of our investment in Cleartel will be dependent on the financial and operational performance of Cleartel.
Economic downturns or recessions could impair our customers’ financial position and operating results, which could, in turn, harm our operating results and reduce our volume of new investments.
Many of the companies in which we have made or will make investments may be susceptible to economic downturns or recessions. An economic downturn or recession 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. Therefore, our non-performing assets are likely to increase and the value of our portfolio is likely to decrease during these periods. Adverse economic conditions also may decrease the value of collateral securing some of our loans and the value of our equity investments. Economic downturns or recessions could lead to financial losses in our portfolio and decreases in revenue, net income and assets.
An economic downturn could disproportionately impact the industries in which we invest, causing us to be more vulnerable to losses in our portfolio, which could negatively impact our financial results.
Unfavorable economic conditions also could increase our funding costs, limit our access to the capital markets or result in a decision by lenders not to extend credit to us. These events could prevent us from increasing our investment originations and negatively impact our financial results.
If we fail to qualify as a regulated investment company, we will have to pay corporate-level taxes on our income and our income available for distribution would be reduced.
We have elected to be taxed for federal income tax purposes as a regulated investment company, or RIC, under Subchapter M of the Internal Revenue Code. If we can meet certain requirements, including source of income, asset diversification and distribution requirements, as well as if we continue to qualify as a business development company, we will qualify to be a RIC and will not have to pay corporate-level taxes on any income we distribute to our stockholders as dividends, allowing us to substantially reduce or eliminate our corporate-level tax liability. Covenants and provisions in our credit facilities limit the ability of our subsidiaries and our securitization trusts to make distributions to us, which could affect our ability to make distributions to our stockholders and to maintain our status as a RIC. In addition, we may have difficulty meeting the requirement to make distributions to our stockholders because in certain cases we may recognize income before or without receiving cash representing such income. If we fail to qualify as a RIC, or to satisfy applicable distribution requirements, we will have to pay corporate-level taxes on all of our income whether or not we distribute it, which would substantially reduce the amount of income available for distribution to our stockholders. Even if we qualify as a RIC, we generally will be subject to a corporate-level income tax on the income we do not distribute. Moreover, if we do not distribute at least 98% of our income, we generally will be subject to a 4% excise tax. See “Regulation” and “Certain U.S. Federal Income Tax Considerations-Taxation as a Regulated Investment Company.”
Because we will distribute substantially all of our income to our stockholders, we will continue to need additional capital to finance our growth. If additional capital is unavailable or not available on favorable terms, our ability to grow will be impaired.
In order to satisfy the distribution requirements applicable to a RIC, we intend to distribute to our stockholders substantially all of our income. In addition, as a business development company, we generally will be required to meet a coverage ratio of total assets to total senior securities, which includes all of our borrowings and any preferred stock we may issue in the future, of at least 200%. This requirement limits the amount that we may borrow. Because we will continue to need capital to grow our loan and investment portfolio, this limitation may prevent us from incurring debt. Further additional debt financing may not be available on favorable terms, if at all, or may be restricted by the terms of our debt facilities. If we are unable to incur additional debt, we may be required to raise additional equity at a time when it may be disadvantageous to do so. In addition, shares of closed-end investment companies have in the past frequently traded at discounts to their net asset values and our stock may also be discounted in the market. This characteristic of closed-end investment companies is separate and distinct from the risk that our net asset value per share may decline. We cannot predict whether shares of our common stock will trade above, at or below our net asset value. If our common stock trades below its net asset value, we will generally not be able to issue additional shares of our common stock at its market price without first obtaining the approval for such issuance from our stockholders and our independent directors. If additional funds are not available to us, we could be forced to curtail or cease our new lending and investment activities, and our net asset value could decrease and our level of distributions could be impacted.
We have substantial indebtedness and servicing our indebtedness could reduce funds available to grow our business or make new investments.
As of December 31, 2007, we had $751.0 million of outstanding borrowings under our debt facilities. As of December 31, 2007, the weighted average annual interest rate on all of our outstanding borrowings was 6.02%, excluding the amortization of deferred debt issuance costs. In order for us to make our annual interest payments on indebtedness, we must achieve annual returns on our December 31, 2007 total assets of at least 2.86%. Our ability to service our debt depends largely on our financial performance and will be subject to prevailing economic conditions and competitive pressures.
In addition, our subsidiaries have sold some of our loans to trusts that serve as the vehicles for our securitization facilities, and these trusts, which are bankruptcy remote, hold legal title to these assets. However, we bear losses of principal and interest from defaults on these loans held by the trusts up to the amount of our retained interest in the trusts, which was approximately $206.6 million as of December 31, 2007.
Our securitization facilities impose financial and operating covenants that restrict our business activities, including limitations that could hinder our ability to finance additional loans and investments or to make the distributions required to maintain our status as a RIC under Subchapter M of the Internal Revenue Code. In addition, some of our debt facilities, including our unsecured notes, contain cross-default provisions, whereby a default under one of our debt facilities could constitute a default under other debt facilities.
Borrowings, also known as leverage, magnify the potential for gain or loss on amounts invested and, therefore, increase the risks associated with investing in our securities. Leverage is generally considered a speculative investment technique. If the value of our consolidated assets increases, then leveraging would cause the net asset value attributable to our common stock to increase more than it otherwise would have had we not utilized leverage. Conversely, if the value of our consolidated assets decreases, leveraging would cause net asset value attributable to our common stock to decline more than it otherwise would have had we not utilized leverage. Similarly, any increase in our consolidated revenue in excess of consolidated interest expense on our borrowed funds would cause our net income to increase more than it would without the use of leverage. Any decrease in our consolidated revenue would cause net income to decline more than it would have had we not borrowed funds and could negatively affect our ability to make distributions on our common stock.
As a business development company, we generally are required to meet a coverage ratio of total assets to total borrowings and other senior securities, which include all of our borrowings and any preferred stock we may issue in the future, of at least 200%. If this ratio declines below 200%, we may not be able to incur additional debt and may need to sell a portion of our investments to repay some debt when it is disadvantageous to do so, and we may not be able to make distributions. At December 31, 2007, this ratio was approximately 208%.
In addition, because substantially all of our assets and liabilities are priced using various short-term rate indices, including one-month to six-month LIBOR, commercial paper rates and the prime rate, the timing of changes in market interest rates or in the relationship between interest rate indices could affect the interest rates earned on interest-earning assets differently than the interest rates paid on interest-bearing liabilities, which could result in a decrease in net income.
If we are not able to refinance our debt or able to do so on favorable terms, we would not be able to operate our business in the ordinary course.
Our Revolving Unsecured Credit Facility is scheduled to expire on June 4, 2008. Our Commercial Loan Funding Trust Facility $250.0 million warehouse financing facility through Three Pillars Funding, LLC is scheduled to terminate on November 4, 2010, but is subject to annual renewal by the lender and may be extended under certain circumstances. The next renewal date for this facility is July 25, 2008. In addition, our $200.0 million warehouse credit facility with Merrill Lynch Capital Corp. is scheduled to expire on August 31, 2008, and is subject to required reductions of the amount outstanding under the facility throughout the remaining term. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Recent Developments.”
We cannot assure you that we will be able to extend the terms of these facilities or obtain sufficient funds to repay any amounts outstanding under these facilities before they expire or terminate either from a replacement facility or alternative debt or equity financing. If we are unable to repay amounts outstanding under these facilities and are declared in default or are unable to refinance these facilities, we would not be able to operate our business in the regular course. Even if we are able to refinance our debt, we may not be able to do so on favorable terms.
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 management of the company may make decisions that could decrease the value of our portfolio holdings.
We make both debt and minority equity investments. For these investments we are subject to the risk that a portfolio company may make business decisions with which we disagree, and the stockholders and management
of that company may take risks or otherwise act in ways that do not serve our interests. As a result, a portfolio company may make decisions that could decrease the value of our portfolio holdings.
Investments in equity securities involve a substantial degree of risk.
We may purchase common stock and other equity securities, including warrants. Although equity securities have historically generated higher average total returns than debt securities over the long term, equity securities may experience more volatility in those returns than debt securities. The equity securities we acquire may fail to appreciate and may decline in value or lose all value, and our ability to recover our investment will depend on our portfolio company’s success. Investments in equity securities involve a number of significant risks, including the risk of further dilution as a result of additional issuances. Investments in preferred securities involve special risks, such as the risk of deferred distributions, illiquidity and limited voting rights.
You may not receive distributions.
We intend to make distributions on a quarterly basis to our stockholders. We may not be able to achieve operating results or our business may not perform in a manner that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, due to the asset coverage test applicable to us as a business development company, we may be limited in our ability to make distributions. See “Regulation.” If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including possible loss of our status as a regulated investment company. See “Certain U.S. Federal Income Tax Considerations-Taxation as a Regulated Investment Company.” We cannot assure you that you will receive any distributions or distributions at a particular level.
We may have difficulty paying our required distributions if we recognize income before or without receiving cash representing such income.
In accordance with generally accepted accounting principles and tax regulations, we include in taxable income certain amounts that we have not yet received in cash, such as contractual payment-in-kind interest, which represents contractual interest added to the loan balance and due at the end of the loan term. The increases in loan balances as a result of contracted payment-in-kind arrangements are included in taxable income in advance of receiving cash payment. Since we may recognize income before or without receiving cash representing such income, we may have difficulty meeting the requirement to distribute at least 90% of our investment company taxable income to maintain RIC tax treatment. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies” and “Certain U.S. Federal Income Tax Considerations-Taxation as a Regulated Investment Company.”
If we fail to manage our growth, our financial results could be adversely affected.
We have expanded our operations significantly since purchasing our business from First Union National Bank in 1998. Our growth has placed and could continue to place significant strain on our management systems and resources. We must continue to refine and expand our marketing capabilities, our management of the investment process, our access to financing resources and our technology. As we grow, we must continue to hire, train, supervise and manage new employees. We may not develop sufficient lending and administrative personnel and management and operating systems to manage our expansion effectively. If we are unable to manage our growth, our operations could be adversely affected and our financial results could be adversely affected.
If we need to sell any of our investments, we may not be able to do so at a favorable price and, as a result, we may suffer losses.
Our investments are usually subject to contractual or legal restrictions on resale or are otherwise illiquid because there is usually no established trading market for such investments. The illiquidity of most of our
investments may make it difficult for us to dispose of them at a favorable price, and, as a result, we may suffer losses. In addition, if we were forced to immediately liquidate some or all of the investments in our portfolio, the proceeds of such liquidation could be significantly less than the current value of such investments. We may be required to liquidate some or all of our portfolio to meet our debt service obligations or to maintain our qualification as a business development company and as a regulated investment company if we do not satisfy one or more of the applicable criteria under the respective regulatory frameworks.
Our business depends on our key personnel.
We depend on the continued services of our executive officers and other key management personnel. The loss of any of our executive officers or key management personnel could result in inefficiencies in our operations and lost business opportunities, which could have a negative impact on our business.
Fluctuations in interest rates could adversely affect our income.
Because we sometimes borrow to make investments, our net income is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest these funds. A significant increase in market interest rates could harm our ability to attract new customers and originate new loans and investments, our non-performing assets could increase and the value of our portfolio could decrease because our floating-rate loan customers may be unable to meet higher payment obligations. Due to the nature of the portfolio companies to which we provide fixed rate financing, fluctuations in market rates have a limited impact on rates charged. As a result, an increase in market interest rates would generally have no effect on the existing fixed rate loans in our portfolio. In addition, a significant decrease in interest rates could reduce our net income, all other things being equal. A decrease in interest rates may reduce net income despite the increased demand for our capital that the decrease in interest rates may produce. Approximately 63% of the loans in our portfolio, based on amounts outstanding at fair value as of December 31, 2007, were at variable rates determined on the basis of a benchmark LIBOR or prime rate and approximately 37% were at fixed rates.
Regulations governing our operation as a business development company will affect our ability to, and the way in which we, raise additional capital.
We have issued debt securities and may issue debt securities and/or borrow money from banks or other financial institutions, which we refer to collectively as “senior securities,” up to the maximum amount permitted by the 1940 Act. Under the provisions of the 1940 Act, we are permitted, as a business development company, to issue senior securities only in amounts such that our asset coverage, as defined in the 1940 Act, equals at least 200% after each issuance of senior securities. If the value of our assets declines, we may be unable to satisfy this test. If that happens, we 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 the best interests of MCG and its 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 distributing commission or discount). We may also make rights offerings to our stockholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act. If we raise additional funds by issuing more common stock or senior securities convertible into, or exchangeable for, our common stock, the percentage ownership of our stockholders at that time would decrease and they may experience dilution. Moreover, we can offer no assurance that we will be able to issue and sell additional equity securities in the future, on favorable terms or at all.
Any change in regulation of our business could negatively affect the profitability of our operations.
Changes in the laws, regulations or interpretations of the laws and regulations that govern business development companies, regulated investment companies or non-depository commercial lenders could significantly affect our operations and our cost of doing business. We are subject to federal, state and local laws and regulations and are subject to judicial and administrative decisions that affect our operations. If these laws, regulations or decisions change, or if we expand our business into jurisdictions that have adopted more stringent requirements than those in which we currently conduct business, we may have to incur significant expenses in order to comply or we might have to restrict our operations.
One of our wholly-owned subsidiaries is licensed by the SBA, and as a result, we will be subject to SBA regulations.
Our wholly-owned subsidiary Solutions Capital I, LP, is licensed to operate as a SBIC and is regulated by the SBA. The SBA regulations require that a licensed SBIC be periodically examined and audited by the SBA to determine its compliance with the relevant SBA regulations. If Solutions Capital I, LP fails to comply with applicable SBA regulations, the SBA could, depending on the severity of the violation, limit or prohibit the Solutions Capital I, LP’s use of debentures, declare outstanding debentures immediately due and payable, and/or limit Solutions Capital I, LP from making new investments. The SBA also imposes a limit on the maximum amount that may be borrowed by any single SBIC. The SBA prohibits, without prior SBA approval, a “change of control” of a SBIC or transfers that would result in any person (or a group of persons acting in concert) owning 10% or more of a class of capital stock of a licensed SBIC.
The SBA also places certain limitations on the financing terms of investments by SBICs in portfolio companies and prohibits SBICs from providing funds for certain purposes or to businesses in a few prohibited industries. Compliance with SBA requirements may cause the SBIC to forego attractive investment opportunities that are not permitted under SBA regulations.
The SBA can revoke or suspend a license for willful or repeated violation of, or willful or repeated failure to observe, any provision of the Small Business Investment Act of 1958 or any rule or regulation promulgated thereunder.
Certain loan payments and tax withholding reimbursements involving six of our current and former executive officers may have violated Section 402 of the Sarbanes-Oxley Act of 2002.
As previously reported, the independent members of our Board of Directors (the “Independent Committee”) have reviewed the timeliness of certain loan payments and tax withholding reimbursements involving six of our current and former executive officers and have reported these matters to the SEC Staff.
Section 402 of the Sarbanes-Oxley Act of 2002, which became effective on June 30, 2002, prohibits us from directly or indirectly extending or maintaining credit, arranging for the extension of credit, or renewing an extension of credit, in the form of a personal loan to or for any of our directors or executive officers. An extension of credit maintained by us on June 30, 2002 is not subject to these prohibitions so long as there is no renewal or material modification to any such loan after that date.
The Independent Committee has reported these matters to the SEC Staff and has also reported the results of the review to date to the SEC Staff. The review by the Independent Committee has now been substantially completed. Based upon the facts known to the Independent Committee as of the present date, the Independent Committee has concluded that certain violations of our code of business conduct and ethics did occur and reached no conclusion regarding Section 402 of Sarbanes-Oxley. The Independent Committee believes that it has fully cooperated with the SEC Staff, including any additional requests of information by the SEC Staff and will continue to do so. The SEC Staff may also require further information in the future, the nature and scope of which cannot be determined at this time.
As a result of our internal review, we may become subject to SEC investigations and/or litigation, which may not be resolved favorably and will require significant management time and attention, and we could incur costs, which could negatively affect our business, results of operations and cash flows. There are no assurances that an investigation or litigation will not commence, and if commenced, that it will result in the same conclusions as those reached in the Independent Committee’s review.
Item 1B.
Item 1B. Unresolved SEC Staff Comments
None.
Item 2.
Item 2. Properties
Neither we nor any of our subsidiaries own any real estate or other physical properties materially important to our operation or any of our subsidiaries. Currently, we lease approximately 44,800 square feet of office space in Arlington, Virginia for our corporate headquarters. We also lease office space in Richmond, Virginia and Atlanta, Georgia.
Item 3.
Item 3. Legal Proceedings
In December 2007, we received an examination report from the Internal Revenue Service, or IRS, related to their audit of our tax returns for the 2004 and 2005 tax years. The IRS has proposed changes to certain deductions made by us for those years, most of which are related to the timing of certain realized losses in the portfolio. We are in the process of appealing the proposed changes, and we currently believe that it is more likely than not that our appeal will be successful. There can be no assurance that our appeal will be successful with respect to any or all of the changes proposed by the IRS. If we are not successful appealing the adjustments proposed by the IRS, we could be subject to penalties and interest of up to approximately $12 million. If our belief that we are more likely than not to be successful with our appeal changes, we will accrue an estimate of the amounts due.
From time to time, we are a party to certain legal proceedings incidental to the normal course of our business including the enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot at this time be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations.
Item 4.
Item 4. Submissions of Matters to a Vote of Security Holders
None.
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 traded on the NASDAQ Global Select Market under the symbol “MCGC.” The following table sets forth the range of high and low closing prices of our common stock as reported on the NASDAQ Global Select Market for each of the quarterly periods during 2007 and 2006.
As of February 26, 2008, we had approximately 168 shareholders of record. Such number of shareholders of record does not reflect shareholders who beneficially own common stock in nominee or street name.
SALES OF UNREGISTERED SECURITIES
During the year ended December 31, 2007, we issued a total of 58,105 shares of common stock under our dividend reinvestment plan pursuant to an exemption from the registration requirements of the Securities Act of 1933. The aggregate offering price for the shares of common stock sold under the dividend reinvestment plan was approximately $847 thousand.
ISSUER PURCHASES OF EQUITY SECURITIES
We did not repurchase any shares of our common stock during the three months ended December 31, 2007.
DISTRIBUTION POLICY
We intend to make distributions on a quarterly basis to our stockholders of substantially all of our income. We may elect to make deemed distributions to our stockholders of certain net capital gains. If this happens, you will be treated as if you received an actual distribution of the capital gains we retain and reinvested the net after-tax proceeds in us. You may also be eligible to claim a tax credit (or, in certain circumstances, a tax refund) equal to your allocable share of the tax we paid on the capital gains deemed distributed to you.
As a business development company that has elected to be treated as a regulated investment company, we generally are required annually to (1) distribute at least 90% of our investment company taxable income and 90% of any ordinary pre-RIC built in gains that we recognize in order to deduct any distributions made (or deemed made) to our shareholders and (2) distribute (actually or on a deemed basis) at least 98% of our income (both ordinary income and net capital gains) in order to avoid an excise tax.
Through December 31, 2007, we have made distributions in excess of our earnings of approximately $79.4 million, which excludes our net unrealized depreciation on our investments of $19.3 million. We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage requirements applicable to us as a business development company under the 1940 Act. If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including possible loss of favorable regulated investment company tax treatment. We cannot assure shareholders that they will receive any distributions.
The following table summarizes our distributions declared since January 1, 2006:
Since December 2001, we have declared distributions totaling $11.51 per share. For 2008, we currently estimate that our dividends will be at least $1.76 per share. This estimate takes into consideration our expectations for the performance of our business and estimates of distributable net operating income (which is equal to net operating income excluding amortization of employee restricted stock awards), net income, capital gains, and taxable income for 2008.
Each year a statement on Form 1099-DIV identifying the source of the distribution (i.e., paid from ordinary income, paid from net capital gains on the sale of securities, and/or a return of paid-in-capital surplus which is a nontaxable distribution) is mailed to our stockholders. To the extent our taxable earnings fall below the total amount of our distributions for that fiscal year, a portion of those distributions may be deemed a tax return of capital to our stockholders. Thus, the source of a distribution to our stockholders may be the original capital invested by the stockholder rather than our taxable ordinary income or capital gains. Stockholders should read any written disclosure accompanying a dividend payment carefully and should not assume that the source of any distribution is our taxable ordinary income or capital gains.
The table below shows the detail of our taxable distributions for the years ended December 31, 2007 and 2006:
(a)
Ordinary income is reported on Form 1099-DIV as either qualified or non-qualified and long term capital gains are reported on Form 1099-DIV in various sub-categories which have differing tax treatments for shareholders. Those subcategories have not been shown here.
(b)
Return of capital refers to those amounts reported as nontaxable distributions on Form 1099-DIV.
On a tax basis, distributions to stockholders in 2007 were approximately $92.5 million of ordinary income and $13.3 million of long term capital gains, and in 2006 were approximately $53.0 million of ordinary income and $35.2 million of return of capital.
There are certain differences between the net income reported in our consolidated financial statements and our taxable income. The following table is a reconciliation of GAAP net income to taxable net income for the years ended December 31, 2007 and 2006:
STOCK PERFORMANCE GRAPH
This graph compares the return on our common stock with that of the Russell 2000 Index and the NASDAQ Financial 100 Index, for the period December 31, 2002 through December 31, 2007. The graph assumes that, on December 31, 2002, a person invested $100 in each of our common stock, the Russell 2000 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.
Item 6.
Item 6. Selected Financial Data
The following selected financial data, excluding the “Other data (at period end)”, is derived from our audited consolidated financial statements. This selected financial data should be read in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and notes thereto.
(a)
Distributable net operating income is net operating income before investment gains and losses and income tax provision (benefit), as determined in accordance with U.S. generally accepted accounting principles (“GAAP”), adjusted for amortization of employee restricted stock awards. We view DNOI and the related per share measures as useful and appropriate supplements to net operating income, net income, earnings per share and cash flows from operating activities. These measures serve as an additional measure of our operating performance exclusive of employee restricted stock amortization, which represents an expense of the company but does not require settlement in cash. DNOI should not be considered as an alternative to net operating income, net income, earnings per share and cash flows from operating activities (each computed in accordance with GAAP). Instead, DNOI should be reviewed in connection with net operating income, net income, earnings per share and cash flows from operating activities in our consolidated financial statements, to help analyze how our business is performing.
(b)
See Note 10 to our Consolidated Financial Statements under Item 8.
(c)
Based on common shares outstanding at period-end.
(d)
The number of employees at December 31, 2005 and December 31, 2004 include 51 and 47 employees, respectively, of our former subsidiary Kagan Research, LLC.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The information contained in this section should be read in conjunction with the Selected Financial Data and Other Data, and our Consolidated Financial Statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K.
This Annual Report on Form 10-K, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve substantial risks and uncertainties. These forward-looking statements are not historical facts, but rather are based on current expectations, estimates and projections about our industry, our beliefs, and our assumptions. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” and “estimates” and variations of these words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements, including without limitation:
•
economic downturns or recessions may impair our customers’ ability to repay our loans and increase our non-performing assets;
•
economic downturns or recessions may disproportionately impact the industries in which we invest, and such conditions may cause us to suffer losses in our portfolio and experience diminished demand for capital in these industries;
•
a contraction of available credit and/or an inability to access the equity markets could impair our lending and investment activities and adversely impact our financial results;
•
interest rate volatility could adversely affect our results;
•
the risks associated with the possible disruption in our operations due to terrorism; and
•
the risks, uncertainties and other factors we identify from time to time in our filings with the Securities and Exchange Commission, including our Form 10-Ks, Form 10-Qs and Form 8-Ks.
Although we believe that the assumptions on which these forward-looking statements are based are reasonable, any of those assumptions could prove to be inaccurate, and as a result, the forward-looking statements based on those assumptions also could be incorrect. In light of these and other uncertainties, the inclusion of a projection or forward-looking statement in this Annual Report on Form 10-K should not be regarded as a representation by us that our plans and objectives will be achieved. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Annual Report on Form 10-K. We undertake no obligation to update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.
Overview
MCG Capital Corporation is a solutions-focused commercial finance company providing capital and advisory services to middle market companies throughout the United States. We make debt and equity investments primarily in companies with annual revenue of $20 million to $200 million and earnings before interest, taxes, depreciation and amortization, or EBITDA, of $3 million to $25 million, which we refer to as “middle market” companies. Our capital is generally used by our portfolio companies to finance acquisitions, recapitalizations, buyouts, organic growth and working capital. We identify and source new customers through multiple channels, including private equity sponsors, investment bankers, brokers, fund-less sponsors, institutional syndication partners, other club lenders and owner operators.
We are an internally managed, non-diversified, closed-end investment company that has elected to be regulated as a business development company under the Investment Company Act of 1940, or the 1940 Act. As a business development company, we are required to meet various regulatory tests which include investing at least 70% of our total assets in private or thinly traded public U.S.-based companies and meeting a coverage ratio of
total net assets to total senior securities, which include all of our borrowings (including accrued interest payable) and any preferred stock we may issue in the future, of at least 200%. In addition, we have elected to be treated for federal income tax purposes as a regulated investment company, or “RIC,” under Subchapter M of the Internal Revenue Code. In order to continue to qualify as a RIC for federal income tax purposes, we must meet certain requirements, including certain minimum distribution requirements. Pursuant to this election, if we satisfy those requirements, we generally will not have to pay corporate-level taxes on any income we distribute to our stockholders as dividends, allowing us to substantially reduce or eliminate our corporate-level tax liability. From time to time our wholly owned subsidiaries may execute transactions that trigger corporate level tax liabilities. In such cases, we recognize a tax provision in the period that the taxable event becomes probable.
Portfolio Composition and Investment Activity
The total value of our investment portfolio, exclusive of unearned income, was $1,555.9 million and $1,257.6 million at December 31, 2007 and December 31, 2006, respectively. During the year ended December 31, 2007, we originated investments in 31 portfolio companies (some of which were new customers and some of which were existing customers) and made advances to existing customers pursuant to contractual terms. Our gross originations and advances totaled $675.5 million, at cost and $544.7 million, at cost, during the years ended December 31, 2007 and 2006, respectively. During the year ended December 31, 2007, the total value of newly originated investments, additional investments in existing portfolio companies, accrual of payment-in-kind interest and dividends, and net unrealized appreciation on investments, net of sales and repayments of securities, resulted in a $298.3 million increase in the total portfolio value of our investments, exclusive of unearned income.
Total portfolio investment activity (exclusive of unearned income) for the years ended December 31, 2007 and 2006 was as follows:
During the year ended December 31, 2007, our increase in equity investments was primarily due to the increase in our control investments to approximately $764.6 million at December 31, 2007 from approximately $526.1 million at December 31, 2006.
The following table shows our portfolio of investments by security type at December 31, 2007 and 2006:
The following table shows our gross originations and advances during 2007 and 2006 by security type:
The following table shows our gross payments, reductions, and sales of securities during 2007 and 2006 by security type:
During the years ended December 31, 2007 and 2006, our gross payments, reductions and sales of securities by transaction type included:
The following table shows our portfolio of investments by industry at fair value, as of December 31, 2007 and 2006 (excluding unearned income):
(a)
No individual industry within this category exceeds 1%.
At December 31, 2007, our ten largest portfolio companies represented approximately 39.9% of the total fair value of our investments. These ten customers accounted for approximately 38.0% of our total revenue during the year ended December 31, 2007. At December 31, 2007, approximately 19.1% of our portfolio at fair value was invested in companies in the communications industry, of which 16.5% were in CLECs. Our remaining investments in the communications industry include telecommunications tower companies, rural local exchange carriers, Internet service providers, wireless companies and security alarm companies. Two of our portfolio companies, which we control, Broadview Networks Holdings, Inc. (“Broadview”) and Cleartel Communications, Inc. (“Cleartel”) are CLECs. Broadview is our largest investment. See “-Results of Operations” for additional information regarding our investments in Broadview and Cleartel.
ASSET QUALITY
Asset quality is generally a function of portfolio company performance, economic conditions, and our underwriting and ongoing management of our investment portfolio. In addition to various risk management and monitoring tools, we also use an investment rating system to characterize and monitor our expected level of returns on each investment in our portfolio. We use the following 1 to 5 investment rating scale:
Investment
Rating
Summary Description
Capital gain expected or realized
Full return of principal and interest or dividend expected with customer performing in accordance with plan
Full return of principal and interest or dividend expected but customer requires closer monitoring
Some loss of interest or dividend expected but still expecting an overall positive internal rate of return on the investment
Loss of interest or dividend and some loss of principal investment expected which would result in an overall negative internal rate of return on the investment
The following table shows the distribution of our investments on the 1 to 5 investment rating scale at fair value as of December 31, 2007 and 2006:
(a)
At December 31, 2007 and 2006, approximately $627.4 million and $447.4 million, respectively, of our investments with an investment rating of “1” were loans to companies in which we also hold equity securities or for which we have already realized a gain on our equity investment.
(b)
The increase in the amount of investments with an investment rating of “5” from December 31, 2006 to December 31, 2007 is primarily due to our investment in Cleartel. See “-Results of Operations” for additional information regarding our investment in Cleartel.
When one of our loans becomes more than 90 days past due, or if we otherwise do not expect the customer to be able to service its debt and other obligations, we will, as a general matter, place the loan on non-accrual status and will generally cease recognizing interest income on that loan until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, we may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection. The following table summarizes loans on non-accrual status and loans greater than 90 days past due, at fair value, at December 31, 2007 and 2006:
The increase in loans on non-accrual status from $35.4 million at December 31, 2006 to $68.8 million at December 31, 2007 is primarily due to the placement of three portfolio companies on non-accrual status during 2007 with an aggregate fair value of approximately $56.2 million at December 31, 2007. This increase was partially offset by the placement of two portfolio companies back on accrual status during 2007 with an aggregate fair value of approximately $22.1 million at December 31, 2007. One of the three loans placed on non-accrual status in 2007 was our control investment in Cleartel Communications, Inc. (“Cleartel”), a competitive local exchange carrier (“CLEC”) serving primarily residential customers. During the year ended December 31, 2007, we invested an additional $20.0 million into Cleartel in order to support their operations, of which $4.7 million was invested during the fourth quarter of 2007. In December 2007, we converted a portion of our subordinated debt investment in Cleartel into common stock. This debt to equity conversion did not result in any additional cash investments or repayments. We may elect to make additional investments in Cleartel in future periods to support its business initiatives. As of December 31, 2007, our investment in Cleartel is comprised of subordinated debt with a fair value of $26.2 million, preferred stock with a fair value of zero and 100% of the common stock of Cleartel with a fair value of zero. These fair values reflect unrealized depreciation recorded during 2007 of approximately $63.5 million, including $38.9 million recorded during the fourth quarter. At December 31, 2007, Cleartel represented approximately 1.7% of the fair value of our investments compared to 5.8% of the fair value of our investments at December 31, 2006.
Cleartel has made several acquisitions in recent years, including the acquisition of Supra Telecom (“Supra”), a Florida-based CLEC, during the fourth quarter of 2006. Cleartel achieved operating results during 2007 that were materially below expectations and has not met our expectations and projections with respect to the realization of synergies from its acquisitions, reductions in customer attrition and bad debts and the initiation and effective implementation of new marketing programs. During the third quarter of 2007, in connection with the completion of a re-evaluation of Cleartel’s multi-year business plan, it became evident that revenue levels in future periods will run at lower levels than previously anticipated and it will take longer than expected for Cleartel to achieve meaningful profitability. This was due in part to the fact that Cleartel has reduced some of its less profitable initiatives and in part to the impact of the customer attrition that occurred. Because we view revenue as a key
component of value, we recorded an unrealized loss of $24.6 million on our Cleartel investment in the third quarter of 2007. During the fourth quarter of 2007, Cleartel continued to significantly underperform on these expectations, which resulted in a further reduction of forecasted revenue. As a result of Cleartel’s underperformance, we recorded an additional $38.9 million unrealized loss during the fourth quarter of 2007.
Since our Cleartel investment is not currently generating sufficient earnings to service its capital structure, all of our Cleartel debt investments were placed on non-accrual status during the first quarter of 2007 and remained on non-accrual status throughout 2007. This investment will remain on non-accrual status until the underlying financial results and cash flows of Cleartel improve. We cannot predict with certainty when any of our Cleartel investments will return to accrual status. At a minimum, we do not expect our Cleartel debt investment to return to accrual status in 2008.
Our ability to recognize income from our investment in Cleartel in future periods and the fair value of our investment in Cleartel will be dependent on the financial and operational performance of Cleartel.
Comparison of the Years Ended December 31, 2007 and 2006
The following table shows the components of our net income for the years ended December 31, 2007 and 2006:
Total Revenue
Total revenue includes interest and dividend income and advisory fees and other income. The level of interest income is directly related to the balance of the interest-bearing investment portfolio outstanding during the period multiplied by the weighted average yield. The weighted average yield varies from period to period based on the current stated interest rate on interest-bearing investments and the amounts of loans for which interest is not accruing. Dividend income results from dividends earned on our equity investments or from dividends declared and paid by our portfolio companies. Dividend income will vary from period to period depending upon the level of yield on our equity investments and the amount of equities outstanding, as well as the value of the underlying securities.
Total interest and dividend income, which includes loan fees, increased $38.0 million for the year ended December 31, 2007 compared to the year ended December 31, 2006. Interest income, exclusive of loan fees, increased approximately $12.9 million during the year ended December 31, 2007 compared to the year ended December 31, 2006. This increase was due to the increase in our average loan portfolio, which had an impact of approximately $16.4 million, increases in LIBOR, which had an impact of approximately $0.9 million, an increase in the impact of previously unaccrued interest of $0.5 million and an increase in spread to LIBOR on yielding loans, which had an impact of approximately $5.6 million. These increases were partially offset by the impact of non-accrual loans of approximately $(10.5) million. We include in interest income certain amounts that we have not received in cash, such as contractual paid-in-kind (PIK) interest. PIK interest represents contractually deferred interest that is added to the loan balance and which may be prepaid either by contract or the portfolio company’s choice, but is generally paid at the end of the loan term. During the year ended December 31, 2007 and 2006, we recognized approximately $2.9 million and $2.4 million, respectively, of previously unaccrued PIK interest that was paid in cash. The following table shows the PIK related activity for the years ended December 31, 2007 and 2006:
Dividend income increased approximately $25.5 million for the year ended December 31, 2007 compared to the year ended December 31, 2006. Certain of our equity investments have stated accruing dividend rates, for which we accrue dividends as they are earned to the extent we believe they will ultimately be paid. The increase in accrued preferred dividends for the year ended December 31, 2007 as compared to the year ended December 31, 2006 was primarily due to an increase of approximately $12.2 million in accrued preferred dividends from our investment in Broadview, the receipt and recognition of approximately $1.6 million of previously unaccrued dividends from one of our portfolio companies, Stratford School Holdings, Inc., approximately $1.5 million of previously unaccrued dividends on one of our portfolio companies, JUPR Holdings, Inc. and approximately $3.4 million of previously unaccrued dividends we received when we sold our investment in Superior Publishing Corporation. We recognized dividend income equal to the contractual accruing dividend on our preferred equity investment in Broadview of approximately $29.8 million and $17.6 million for the years ended December 31, 2007 and 2006, respectively. The remainder of the increase in dividend income is primarily due to growth in our equity portfolio. Our dividend activity for the years ended December 31, 2007 and 2006 was as follows:
Loan fees include origination fees on loans that are deferred and amortized into interest income over the life of the loan. When repayments or restructurings with other than minor modifications occur, we accelerate the recognition of previously unamortized loan origination fees into loan fee income. These accelerations have the effect of increasing current period income and may reduce future amortizable income. Because these repayments and restructurings may vary from period to period, the amount of loan origination fees that are recognized as interest income may also vary from period to period. Loan fees decreased approximately $(0.4) million for the year ended December 31, 2007 compared to the year ended December 31, 2006.
The following table shows our loan fee activity during the years ended December 31, 2007 and 2006:
The total yield on our average debt portfolio at fair value for the years ended December 31, 2007 and 2006 was 12.5% and 12.9%, respectively. The average LIBOR for the year ended December 31, 2007 was 5.3%, an increase of 0.1% from 5.2% for the year ended December 31, 2006. The decrease in total yield is primarily attributable to the increase in non-accrual loans. For the year ended December 31, 2007, the impact of non-accrual loans on total yield was (1.6%) as compared to (0.4%) for the year ended December 31, 2006. This impact was partially offset by an increase in the spread to average LIBOR on our average yielding loan portfolio of 8.3% for the year ended December 31, 2007, as compared to 7.5% for the year ended December 31, 2006.
Advisory fees and other income primarily include fees related to advisory and management services, equity structuring fees, syndication fees, prepayment fees, bank interest and other income. Advisory fees and other income are generally related to specific transactions or services and therefore may vary from period to period depending on the level and types of services provided. The decrease in advisory fees and other income of $(5.3) million for the year ended December 31, 2007 as compared to the year ended December 31, 2006 was primarily due to decreases in prepayment fees of $(2.7) million, advisory and management fees of $(1.3) million and bank interest and other fees of approximately $(1.3) million.
Broadview Networks Holdings, Inc. (“Broadview”), a CLEC serving primarily business customers, is our largest portfolio investment, in which we hold preferred stock with an aggregate fair value of $189.5 million at December 31, 2007. Our Broadview investment represented approximately 12.2% of the fair value of our total investments at December 31, 2007 compared to 12.7% of the fair value of our total investments at December 31, 2006. Additionally, our investment in Broadview accounted for $29.8 million, or 15.9%, of our total revenue for the year ended December 31, 2007 compared to $22.3 million, or 14.5%, of our total revenue for the year ended December 31, 2006.
Our investment in Broadview entitles us to total preferred claims of approximately $266.9 million, prior to any claims by common shareholders. We are also entitled to accumulating dividends on our preferred stock investment, which accumulate and compound quarterly at an annual rate of 12% on $266.9 million but are not payable in cash on a current basis. Because accumulating dividends are typically not considered as part of taxable income until they are received in cash, it is possible that our GAAP earnings may exceed our taxable earnings by a significant amount until such time as this investment is liquidated.
In December 2007, Broadview filed a registration statement on Form S-1 to register shares for an initial public offering (“IPO”) of equity securities. In the event Broadview is successful with their IPO, we will be required to convert our yielding preferred stock, which represents an ownership interest of approximately 46% on an as-if-converted basis, into non-yielding common stock. This would materially reduce our dividend income from historical levels. In connection with an IPO by Broadview, we may sell a portion of our investment in Broadview, which could result in a significant liquidity event for us.
Our ability to recognize income from our preferred stock investment in Broadview in future periods and the fair value of our preferred stock investment in Broadview will be dependent on the financial and operational performance of Broadview. In the event that the financial and operational performance of Broadview does not support the full recognition of income on our preferred stock investment, our dividend income could be materially reduced from historical levels.
During the first quarter of 2007, we placed our investment in Cleartel, our second largest portfolio company at the time, on non-accrual status. We did not recognize any revenue from this investment during the year ended December 31, 2007, compared to $7.5 million, or 4.8%, of our total revenue for the year ended December 31, 2006. As of December 31, 2007, we held Cleartel subordinated debt with a fair value of $26.2 million, Cleartel preferred stock with a fair value of zero, and Cleartel common stock with a fair value of zero. Our ability to recognize income from our investment in Cleartel in future periods and the fair value of our investment in Cleartel will be dependent on the financial and operational performance and value of Cleartel. See “-Asset Quality” for additional discussion regarding our investment in Cleartel.
Total Operating Expenses
Operating expenses include interest, employee compensation and general and administrative expenses. The increase in interest expense of approximately $6.8 million during the year ended December 31, 2007 as compared to the year ended December 31, 2006, is attributable to higher average borrowings which caused interest expense to increase by approximately $9.1 million and increases in LIBOR which caused interest expense to increase by approximately $0.5 million, partially offset by a decrease of approximately ($2.7) million in amortization of deferred debt issuance costs and a decrease of approximately ($0.1) million in the spread to LIBOR.
Employee compensation includes base salaries and benefits, variable annual incentive compensation, and amortization of employee restricted stock awards. Total salaries and benefits was approximately $21.8 million and $21.3 million during the years ended December 31, 2007 and December 31, 2006, respectively. The increase of $0.5 million in salaries and benefits was primarily due to approximately $2.0 million for increased staffing and variable annual incentive compensation, which was partially offset by approximately $1.5 million of severance costs in 2006 related to our former CEO and a decrease in dividends on restricted shares with performance based forfeiture provisions and shares securing employee loans. Amortization of employee restricted stock awards is
non-cash compensation related to restricted stock awards granted in 2001, 2006, and 2007. During the year ended December 31, 2007, we recognized compensation expense related to restricted stock awards of approximately $9.0 million, compared to approximately $3.5 million for the year ended December 31, 2006. This increase in restricted stock amortization expense is primarily due to the timing of restricted stock grants in the third quarter of 2006 and the first quarter of 2007. We granted approximately 936,000 shares of restricted stock during 2007 pursuant to our 2006 Employee Restricted Stock Plan. The forfeiture provisions lapse quarterly with respect to 836,000 of these restricted shares through September 30, 2011 and with respect to 100,000 of these shares annually through February 28, 2008.
General and administrative expenses include legal and accounting fees, insurance premiums, rent and various other expenses. General and administrative expenses increased approximately $1.6 million during the year ended December 31, 2007 compared to the year ended December 31, 2006, due to costs resulting from the growth of our business partially offset by a decrease in professional fees of approximately $1.4 million. Professional fees in 2006 included fees incurred in conjunction with the independent review of certain tax withholding reimbursements and loan repayments by our current and former executive officers, as previously disclosed.
Net Operating Income Before Investment Gains and Losses and Income Tax Provision
Net operating income before investment gains and losses and income tax provision for the year ended December 31, 2007 totaled $101.9 million, an increase of approximately $18.3 million compared with $83.6 million for the year ended December 31, 2006. This increase is due to the items discussed above.
Distributable Net Operating Income (“DNOI”)
DNOI is net operating income before investment gains and losses and income tax provision, as determined in accordance with GAAP, adjusted for amortization of employee restricted stock awards. We view DNOI and the related per share measures as useful and appropriate supplements to net operating income, net income, earnings per share and cash flows from operating activities. These measures serve as an additional measure of our operating performance exclusive of employee restricted stock amortization, which represents an expense of MCG but does not require settlement in cash. DNOI should not be considered as an alternative to net operating income, net income, earnings per share or cash flows from operating activities (each computed in accordance with GAAP). Instead, DNOI should be reviewed in connection with net operating income, net income, earnings per share and cash flows from operating activities in our consolidated financial statements, to help analyze how our business is performing.
DNOI for the year ended December 31, 2007 was $110.9 million, or $1.81 per share, compared to $87.1 million, or $1.61 per share, for the year ended December 31, 2006. The following table shows a reconciliation of our reported net operating income before investment gains and losses and income tax provision to DNOI for the years ended December 31, 2007 and 2006:
Net Investment Gains and Losses Before Income Tax Provision
Net investment losses before income tax provision totaled approximately ($12.9) million for the year ended December 31, 2007, compared to net investment gains before income tax provision of approximately $20.0 million for the year ended December 31, 2006. These amounts represent the total of net realized gains and losses, net unrealized appreciation and depreciation and reversals of unrealized appreciation and depreciation. Reversals of unrealized appreciation and depreciation occur when a gain or loss becomes realized.
The following table summarizes our gains and (losses) on investments and the change in our unrealized appreciation and depreciation on investments for the year ended December 31, 2007:
The following table summarizes our gains and (losses) on investments and the change in our unrealized appreciation and depreciation on investments for the year ended December 31, 2006:
Income Tax Provision
During the year ended December 31, 2007, we recorded an income tax provision of $2.4 million primarily related to unrealized gains on our investments and the performance of certain of our investments that are held in taxable subsidiaries. During the year ended December 31, 2006, we recorded a $2.7 million income tax provision primarily related to unrealized gains on one of our investments held in a taxable subsidiary.
In December 2007, we received an examination report from the Internal Revenue Service, or IRS, related to their audit of our tax returns for the 2004 and 2005 tax years. The IRS has proposed changes to certain deductions made by us for those years, most of which are related to the timing of certain realized losses in the portfolio. We are in the process of appealing the proposed changes, and we currently believe that it is more likely than not that our appeal will be successful. There can be no assurance that our appeal will be successful with respect to any or all of the changes proposed by the IRS. If we are not successful appealing the adjustments proposed by the IRS, we could be subject to penalties and interest of up to approximately $12 million. If our belief that we are more likely than not to be successful with our appeal changes, we will accrue an estimate of the amounts due.
Net Income
Net income totaled approximately $86.6 million for the year ended December 31, 2007, compared to $100.9 million for the year ended December 31, 2006. The decrease in net income is due to the items discussed above.
Valuation
Our board of directors is responsible for determining the fair value of our portfolio investments on a quarterly basis. As part of our process for determining the fair value of our portfolio of investments, we retain independent valuation firms to perform independent valuations on certain of our portfolio companies and review certain of our fair value determinations. The independent valuations and the reviews are considered by our board of directors in its determination of the fair value of our portfolio companies. We intend to continue to obtain independent valuations or reviews of our fair value determinations and to periodically update those valuations and reviews. The following table summarizes the independent valuations and reviews that have been performed from December 31, 2006 through December 31, 2007:
Comparison of the Years Ended December 31, 2006 and 2005
The following table shows the components of our net income for the years ended December 31, 2006 and 2005:
Total Revenue
Total revenue includes interest and dividend income, loan fees and advisory fees and other income. The level of interest income is directly related to the balance of the interest-bearing investment portfolio outstanding during the period multiplied by the weighted average yield. The weighted average yield varies from period to period based on the current stated interest rate on interest-bearing investments and the amounts of loans for which interest is not accruing. Dividend income results from dividends earned on our equity investments or from dividends declared and paid by our portfolio companies. Dividend income will vary from period to period depending upon the level of yield on our equity investments and the amount of equities outstanding, as well as the value of the underlying securities.
Total interest and dividend income, which includes loan fees, increased $32.6 million for the year ended December 31, 2006 compared to the year ended December 31, 2005. Interest income, exclusive of loan fees increased approximately $24.8 million during the year ended December 31, 2006 compared to the year ended December 31, 2005, due to the increase in LIBOR, which had an impact of approximately $13.9 million, the growth in the size of our loan portfolio, which had an impact of approximately $11.0 million, and the decrease in the spread to LIBOR in our loan portfolio, which had an impact of approximately $(0.1) million. We include in interest income certain amounts that we have not received in cash, such as contractual paid-in-kind (PIK) interest. PIK interest represents contractually deferred interest that is added to the loan balance and which may be prepaid either by contract or the portfolio company’s choice, but is generally paid at the end of the loan term. For the year ended December 31, 2006, PIK interest income totaled $14.7 million, compared to $12.7 million for the year ended December 31, 2005. At December 31, 2006 our total PIK loan balance represented $11.1 million, or
0.9% of our portfolio of investments, compared to $13.5 million, or 1.2%, of our portfolio of investments as of December 31, 2005. The following table shows the PIK related activity for the years ended December 31, 2006 and 2005:
Dividend income increased approximately $11.4 million for the year ended December 31, 2006 compared to the year ended December 31, 2005, due to an increase in dividends declared by our portfolio companies and an increase in accruing preferred dividends. Certain of our equity investments have stated accruing dividend rates, for which we accrue dividends as they are earned to the extent we believe they will ultimately be paid. The accrued dividend balance at December 31, 2006 was approximately $33.6 million, or 2.7% of our portfolio of investments, compared to $12.4 million, or 1.1%, of our portfolio of investments at December 31, 2005. Our dividend activity for the years ended December 31, 2006 and 2005 was as follows:
Loan fees include origination fees on loans that are deferred and amortized into interest income over the life of the loan. When repayments or restructurings with other than minor modifications occur, we accelerate the recognition of previously unamortized loan origination fees into loan fee income. These accelerations have the effect of increasing current period income and may reduce future amortizable income. Because these repayments and restructurings may vary from period to period, the amount of loan origination fees that are recognized as interest income may also vary from period to period. Loan fees for the years ended December 31, 2006 and 2005, were approximately $6.0 million and $9.6 million, respectively.
The following table shows our loan fee activity during the years ended December 31, 2006 and 2005:
The total yield on our debt portfolio at fair value for the years ended December 31, 2006 and 2005 was 12.9% and 11.9%, respectively. The average LIBOR for the year ended December 31, 2006 was 5.2%, an increase of 1.6% from 3.6% for the year ended December 31, 2005. The average spread to LIBOR for the year ended December 31, 2006 was 7.7%, a decrease of approximately 0.6% from 8.3% for the year ended December 31, 2005, primarily due to an increase in the level of fixed rate loans as well as a decrease in amortizing fee income and fee accelerations.
Advisory fees and other income primarily include fees related to advisory and management services, equity structuring fees, syndication fees, prepayment fees, bank interest and other income. Advisory fees and other income are generally related to specific transactions or services and therefore may vary from period to period depending on the level and types of services provided. The increase in fees and other income of $2.3 million for the year ended December 31, 2006 as compared to the year ended December 31, 2005 was primarily due to increases in equity structuring fees of $3.5 million, advisory and management fees of $0.8 million, prepayment fees of $3.0 million, and bank interest and other fees of approximately $0.2 million, partially offset by a decrease in research fees of ($5.3) million due to the deconsolidation of Kagan Research, LLC effective January 1, 2006.
For the year ended December 31, 2006, our largest portfolio company, Broadview, accounted for approximately $22.3 million, or 14.5%, of our total revenue compared to approximately $17.5 million, or 14.6%, of our total revenue for the year ended December 31, 2005. During the year ended December 31, 2006, our revenue from our Broadview investment was comprised of interest and dividend income. During the third quarter of 2006, we converted all our debt investments in Broadview to preferred equity. As of December 31, 2006, our preferred equity investments in Broadview entitle us to a preferred claim of approximately $237.7 million, prior to claims by Broadview common shareholders. We are also entitled to accumulating dividends on our preferred stock investment, which accumulate and compound quarterly at an annual rate of 12% on $237.7 million but are not payable in cash on a current basis. Based on our current investment in Broadview our future earnings will all be in the form of accumulating dividend income. Further, because accumulating dividends are typically not considered part of taxable income until they are received in cash, it is possible that our GAAP earnings may exceed our taxable earnings by a significant amount until such time as this investment is liquidated.
For the year ended December 31, 2006, our second largest portfolio company, Cleartel, accounted for $7.5 million, or 4.8% of our total revenue, compared to $3.7 million, or 3.1%, of our total revenue for the year ended December 31, 2005. During the year ended December 31, 2006, our revenue from our Cleartel investment was comprised of interest and fee income. A portion of the interest income for the year ended December 31, 2006 was in the form of payment-in-kind interest; however, the debt was restructured during the year and is currently current pay interest.
Our ability to recognize income from our investments in Broadview and Cleartel in future periods will be dependent upon the performance and value of each company.
Total Operating Expenses
Operating expenses include interest, employee compensation and general and administrative expenses. The increase in interest expense of approximately $13.2 million during the year ended December 31, 2006 as compared to the year ended December 31, 2005, is primarily attributable to an increase of $8.1 million due to increases in LIBOR, an increase of $1.7 million due to increases in the spread to LIBOR, and an increase of $3.4 million due to higher average borrowings. Of the $1.7 million increase due to increases in the spread to LIBOR, $0.5 million is attributable to the amortization of deferred debt issuance costs. The increase in deferred debt issuance cost amortization is primarily attributable to the expenses associated with the redemption of our Series 2004-1 Notes during the third quarter of 2006.
Employee compensation includes base salaries and benefits, variable annual incentive compensation, and long-term incentive compensation. The decrease in salaries and benefits expense of $0.1 million during the year ended December 31, 2006 as compared to the year ended December 31, 2005 is primarily due to an increase of approximately $2.6 million in salaries and benefits and $1.5 million of severance costs related to our former CEO, more than offset by a decrease of approximately $4.2 million due to the deconsolidation of Kagan Research, LLC. Long-term incentive compensation expense is made up of non-cash amortization of restricted stock awards granted in 2001 and 2006. Long-term incentive compensation decreased $0.9 million for the year ended December 31, 2006 as compared to the year ended December 31, 2005 due to a decrease in the lapsing of
forfeiture provisions on shares of restricted stock during the year ended December 31, 2006 compared to the year ended December 31, 2005, partially offset by a charge of $0.7 million related to the accelerated vesting of certain restricted shares held by our former CEO.
General and administrative expenses include legal and accounting fees, insurance premiums, rent and various other expenses. General and administrative expenses decreased approximately $0.4 million during the year ended December 31, 2006 compared to the year ended December 31, 2005, due to a decrease of approximately $2.8 million due to the deconsolidation of Kagan Research LLC, partially offset by professional fees of approximately $1.4 million incurred in conjunction with the independent review of certain tax withholding reimbursements and loan repayments by our current and former executive officers, as previously disclosed, an increase in directors fees of approximately $0.3 million and an increase in recruiting and other general and administrative costs of approximately $0.7 million.
Net Operating Income Before Investment Gains and Losses and Income Tax Provision
Net operating income before investment gains and losses and income tax provision for the year ended December 31, 2006 totaled $83.6 million, an increase of approximately $23.1 million compared with $60.5 million for the year ended December 31, 2005. This increase is due to the items discussed above. During the year ended December 31, 2005, our wholly owned subsidiary, Kagan Research, LLC, accounted for losses of approximately ($1.7) million. Effective January 1, 2006, Kagan Research, LLC no longer qualified as a consolidated subsidiary of the Company.
Net Investment Gains Before Income Tax Provision
Net investment gains before income tax provision totaled approximately $20.0 million for the year ended December 31, 2006, compared to $7.7 million for the year ended December 31, 2005. These amounts represent the total of net realized gains and losses, net unrealized appreciation and depreciation and reversals of unrealized appreciation and depreciation. Reversals of unrealized appreciation and depreciation occur when a gain or loss becomes realized.
The following table summarizes our gains and (losses) on investments and the change in our unrealized appreciation and depreciation on investments for the year ended December 31, 2006:
Our board of directors is responsible for determining the fair value of our portfolio investments on a quarterly basis. In connection with our process for determining fair value as of December 31, 2006, we retained two independent valuation firms to perform independent valuations of certain of our portfolio companies. Independent valuations were obtained for eleven portfolio companies including all companies in which we hold equity positions with fair value greater than $10.0 million as of December 31, 2006. These valuations were considered by our board of directors in their determination of fair value. The following table summarizes the independent valuations performed:
Broadview, our largest portfolio company, serves primarily business customers. At December 31, 2006, our investment in Broadview had a fair value of approximately $159.8 million, or 12.7% of the value of our total portfolio, compared to $95.1 million, or 8.7% at December 31, 2005. During the year ended December 31, 2006, there was an unrealized gain on our Broadview investment of approximately $38.1 million. This increase in fair value is primarily due to an increase in valuations in comparable industry transactions during the fourth quarter of 2006 and enhanced value associated with Broadview’s acquisition of ATX Communications, Inc. (“ATX”). On September 29, 2006, Broadview completed the acquisition of ATX, an integrated communications provider serving business customers in the Mid-Atlantic region. Broadview financed the ATX acquisition using a portion of the proceeds from a $210.0 million offering of 11 3/8% Senior Secured Notes due 2012, which were offered through Rule 144A under the Securities Act of 1933, as amended (the “Bond Offering”). The Bond Offering closed on August 23, 2006. At the time of the Bond Offering, we invested an additional $5.5 million into Broadview and converted all of our subordinated debt investments, which at that time had a fair value of approximately $51.1 million, to preferred equity. Broadview was one of the portfolio companies for which an independent valuation was obtained as of December 31, 2006.
Cleartel, our second largest portfolio company at December 31, 2006, is a Florida-based CLEC that serves primarily residential customers. At December 31, 2006, Cleartel represented approximately 5.8% of the fair value of our investments compared to 7.2% of the fair value of our investments at December 31, 2005. At December 31, 2006, we held subordinated debt with a fair value of $72.0 million and preferred equity with a fair value of $0.6 million, which included unrealized depreciation of approximately $40.1 million. This decrease in fair value is largely due to a decrease in valuations in comparable residential CLEC industry transactions that occurred during the fourth quarter of 2006. During October 2006, Cleartel acquired Supra Telecom, a Florida-based CLEC. In conjunction with this acquisition, we invested an additional $19.8 million in Cleartel in the form of subordinated debt and restructured our existing debt investments in Cleartel by extending the maturity dates and modifying the interest rates. Cleartel was one of the portfolio companies for which an independent valuation was obtained as of December 31, 2006.
The following table summarizes our gains and (losses) on investments and the change in our unrealized appreciation and depreciation on investments for the year ended December 31, 2005:
Income Tax Provision
During the year ended December 31, 2006, we recorded a $2.7 million income tax provision. This income tax provision is primarily related to unrealized gains on one of our investments.
Net Income
Net income totaled approximately $100.9 million for the year ended December 31, 2006, compared to $68.2 million for the year ended December 31, 2005. The increase in net income is due to the items discussed above.
Financial Condition, Liquidity and Capital Resources
Cash and Cash Equivalents, Cash, Securitization Accounts, and Cash, Restricted
At December 31, 2007 and December 31, 2006, we had $23.3 million and $21.7 million, respectively, in cash and cash equivalents. In addition, at December 31, 2007 and December 31, 2006, we had $37.0 million and $15.9 million, respectively, in cash, securitization accounts. We also had $4.0 million and $2.6 million of restricted cash as of December 31, 2007 and December 31, 2006, respectively. We primarily invest cash on hand in interest bearing deposit accounts. Cash, securitization accounts include principal and interest payments received on securitized loans, which in certain cases are held in designated bank accounts until monthly or quarterly disbursements are made from the securitization trusts. In certain cases, we are required to use a portion of these amounts to pay interest expense, reduce borrowings, or pay other amounts in accordance with the related securitization agreements, while in other cases we are permitted to use these amounts to acquire new loans into the securitization trusts. Cash in securitization accounts negatively impacts our earnings since the interest we pay on borrowings typically exceeds the rate of return that we are able to earn on temporary cash investments. Our objective is to maintain sufficient cash on hand and availability under our debt facilities to cover current funding requirements and operational needs.
For the year ended December 31, 2007, net cash provided by operating activities totaled $54.9 million, a decrease of approximately $15.1 million from $69.9 million for the year ended December 31, 2006. This decrease was due primarily to an increase in the amount of paid-in-kind interest and dividends and an increase in the amount of interest collections that were held in cash, securitization accounts. Cash used in investing activities increased approximately $149.2 million to $265.1 million for the year ended December 31, 2007 from $115.9 million for the year ended December 31, 2006. This change is primarily the result of an increase in originations, draws and advances and a decrease in proceeds from sales and exits of investments. Cash provided by financing activities increased approximately $189.7 million to $211.8 million for the year ended December 31, 2007, from $22.1 million for the year ended December 31, 2006. This change is mainly due to higher proceeds raised through the issuance of common stock and the net proceeds from borrowings during 2007 compared to 2006 partially offset by higher dividends paid during 2007 compared to 2006.
Liquidity and Capital Resources
We expect our cash on hand and cash generated from operations, including the portion of the cash in securitization accounts that will be released to us or used to purchase additional loans, will be adequate to meet our cash needs at our current level of operations. In order to fund new originations, we intend to use cash on hand, advances under our borrowing facilities and equity issuances. Our secured borrowing facilities generally contain collateral requirements, including, but not limited to, asset mix, minimum diversity and rating and limitations on loan size. These limitations limit our ability to fund certain new originations with advances under such facilities, in which case we fund originations using unsecured debt or equity financings.
During the year ended December 31, 2007 we raised approximately $95.1 million of net proceeds by selling 6,000,000 shares of newly issued common stock. During the year ended December 31, 2006 we raised $69.1 million of net proceeds by selling 4,600,000 shares of newly issued common stock.
In order to satisfy the requirements applicable to a regulated investment company, we intend to distribute to our stockholders substantially all of our income. In addition, as a business development company, we generally will be required to meet a coverage ratio of total assets to total senior securities, which include all of our borrowings and any preferred stock we may issue in the future, of at least 200%. As of December 31, 2007, this ratio was 208%. This requirement limits the amount that we may borrow.
To fund growth in our investment portfolio in the future, we anticipate needing to raise additional capital from various sources, including the equity markets and various debt markets. We intend to maintain a current shelf registration statement pursuant to which we may issue common stock from time to time.
As of December 31, 2007, our cash and cash equivalents totaled $23.3 million and our borrowings totaled $751.0 million. Of the $751.0 million in borrowings, approximately $136.4 million was outstanding under our 2006-2 warehouse facility with Merrill Lynch Capital Corporation, which was scheduled to expire on February 29, 2008. On February 12, 2008, this facility was amended to extend the maturity until August 31, 2008. As of the date of the amendment, approximately, $111.3 million was outstanding under this facility. Under the terms of the amendment, we are required to reduce the amount outstanding under this facility to not more than $82.5 million at April 21, 2008, not more than $55.0 million at May 31, 2008, and not more than $27.5 million outstanding at July 21, 2008, with the balance due on August 31, 2008. This warehouse was originally intended to be repaid with proceeds from a placement of debt in the CLO market. However, due to the severe dislocation which has occurred in the CLO market, we have determined that a CLO transaction is not possible at this time.
Our existing debt facilities provide sufficient borrowing capacity to meet our current operational needs, including the required reduction in borrowings under our 2006-2 warehouse facility; however, our outstanding balances under our other debt facilities will increase to higher levels than they otherwise would have absent these required borrowing reductions. As a result, we will have less remaining capacity under these facilities. We are currently working on a variety of initiatives to increase our overall borrowing capacity. While market conditions are challenging and pricing for debt capital is increasing, we remain confident that we will be successful in this regard; however, there can be no assurance that any of these initiatives will be successful.
In addition to our initiatives with respect to our borrowing facilities, we are working on a variety of initiatives to enhance our overall liquidity position, including the sale of certain debt and equity investments and an equity offering. Such an offering could serve to increase the equity capital available for making additional investments. As a business development company, we are prohibited, absent approval from our stockholders, from issuing equity securities at a price below our net asset value per share, or NAV. However, under the 1940 Act, we are permitted to conduct a rights offering of equity securities at a time when our stock is trading below NAV. As a result of our stock trading below NAV, we have not been able to access the equity markets, which has reduced our liquidity and ability to grow. On January 23, 2008, we filed a Registration Statement on Form N-2 with the Securities and Exchange Commission for a rights offering of equity securities. There can be no assurance that we will be able to complete a rights offering.
In addition, the company is in the process of enhancing its liquidity through the sale of debt securities and equity positions in certain portfolio companies, including potentially a portion of our investment in Broadview Networks Holdings, Inc. (“Broadview”), our largest investment, in connection with Broadview’s planned initial public offering in 2008. During the fourth quarter approximately $28.5 million of senior debt securities were sold to third parties. No gains or losses were realized on these sales.
The completion of some or all of these initiatives is expected to provide us with liquidity which will be utilized throughout 2008 and potentially beyond. While we believe that some or all of these initiatives can be completed during the first half of 2008, there can be no assurance that we will be successful with any of these initiatives. In addition, we expect our origination activity to be slower during early 2008, until we are able to complete some or all of these initiatives. In the event that we are unsuccessful with these initiatives, our ability to originate new investments and continue quarterly distributions at current levels could be impacted.
Current Market Conditions
The debt and equity capital markets in the United States have been severely impacted by significant write-offs in the financial services sector relating to subprime mortgages and the re-pricing of credit risk in the broadly syndicated market, among other things. These events, along with the deterioration of the housing market, have led to worsening general economic conditions, which have impacted the broader financial and credit markets and have reduced the availability of debt and equity capital for the market as a whole and financial firms in particular. The Company and other commercial finance companies have historically utilized the collateralized loan obligation (“CLO”) market to finance some of their investment activities. Due to the current dislocation of the
CLO market, which we believe may continue for an extended period of time, we and other companies in the commercial finance sector will have to access alternative debt markets in order to grow. The debt capital that will be available will most likely be at a higher cost, and terms and conditions may be less favorable. This may result in slowing our origination activity during the early part of 2008.
In the event that the United States economy enters into a recession, it is possible that the results of some of the middle market companies similar to those in which we invest could experience deterioration, which could ultimately lead to difficulty in meeting debt service requirements and an increase in defaults. While we are not seeing signs of an overall, broad deterioration in our portfolio company results at this time, there can be no assurance that the performance of certain of our portfolio companies will not be negatively impacted by economic conditions which could have a negative impact on our future results.
Off-Balance Sheet Arrangements
We are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of our customers. These instruments include commitments to extend credit and involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. We attempt to limit our credit risk by conducting extensive due diligence and obtaining collateral where appropriate.
Commitments to extend credit include the unused portions of commitments that obligate us to extend credit in the form of loans, participations in loans or similar transactions. Commitments to extend credit would also include loan proceeds we are obligated to advance, such as loan draws, rotating or revolving credit arrangements, or similar transactions. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the counterparty. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
As of December 31, 2007, we had unused commitments to extend credit to our customers of $85.4 million, which are not reflected on our balance sheet. From time to time, we provide guarantees or standby letters of credit on behalf of our portfolio companies. As of December 31, 2007, we had guarantees and standby letters of credit of approximately $7.5 million.
Contractual Obligations
The following table shows our contractual obligations as of December 31, 2007:
(a)
This excludes the unused commitments to extend credit to our customers of $85.4 million as well as guarantees and standby letters of credit of approximately $7.5 million as discussed above.
(b)
Borrowings under the MCG Commercial Loan Funding Trust Facility, the Commercial Loan Trust 2006-1, the Commercial Loan Trust 2006-2 and the Revolving Unsecured Credit Facility are listed based on the contractual maturity of the respective facility due to the revolving nature of the facilities.
Borrowings
The following table shows the facility amounts and outstanding borrowings at December 31, 2007 and 2006:
(a)
Amended in February 2008 to extend the maturity date to August 31, 2008. See “Recent Developments” for further discussion of this facility.
(b)
Renewable at lender’s discretion each July.
For the above borrowings, the fair value of the borrowings approximates cost. The following table shows our weighted average borrowings, the weighted average interest rate on all of our borrowings, including amortization of deferred debt issuance costs and commitment fees, the average LIBOR, and the average spread to LIBOR for the year ended December 31, 2007 and 2006:
The decrease of approximately 0.5% in the weighted average interest rate for the year ended December 31, 2007 compared to the year ended December 31, 2006 was primarily attributable to a decrease in the amortization of deferred debt issuance costs of 0.6% partially off set by an increase in average LIBOR of 0.1%. The higher deferred debt issuance costs in 2006 were primarily due to the accelerated payoff of our 2004-1 term securitization.
All of our debt facilities, except the Revolving Unsecured Credit Facility and the Unsecured Notes, are funded through our bankruptcy remote, special purpose, wholly owned subsidiaries and, therefore, their assets may not be available to our creditors. In some cases, advances under our debt facilities are subject to certain other covenants, including having sufficient levels of collateral and various restrictions on which loans we may leverage as collateral. We borrow directly, as well as indirectly, through credit facilities maintained by our subsidiaries. Some of our debt facilities contain cross-default provisions, whereby a default under one of our debt facilities could constitute a default under other debt facilities.
Unsecured Notes. On October 11, 2005, we issued $50.0 million of investment grade five-year unsecured notes in a private placement. The notes were rated “BBB-” by Fitch Ratings, Inc. and have a fixed interest rate of 6.73% per year payable semi-annually. Bayerische Hypo-Und Vereinsbank, AG, New York Branch (“HVB”) acted as the placement agent for the issuance.
On October 3, 2007, we issued $25.0 million of long-term unsecured notes in a private placement. The notes have a five-year term and a fixed interest rate of 6.71% per annum paid semi-annually. The interest rate is subject to possible adjustment in the future. The purchasers of the new notes are also holders of our notes issued in the $50.0 million private placement which was completed in 2005.
Commercial Loan Trust 2006-2. On May 2, 2006 we established, through MCG Commercial Loan Trust 2006-2, a $200.0 million warehouse credit facility with Merrill Lynch Capital Corp. The warehouse credit facility allows MCG Commercial Loan Trust 2006-2 to acquire up to $250.0 million of commercial loans with borrowings of up to $200.0 million subject to certain covenants, concentration limitations and other restrictions. The warehouse credit facility is primarily secured by the assets of MCG Commercial Loan Trust 2006-2, including the commercial loans purchased by the trust from us. Under the terms of the credit and warehouse agreement, the loans may be senior secured loans, second lien loans or unsecured loans, as defined in the agreement, subject to certain limitations. Up to 60% of the collateral in this warehouse facility may be non-senior secured loans, and the remaining 40% must be senior secured loans.
We use this warehouse credit facility to fund the origination of loans that will collateralize a future term securitization. On October 23, 2007, we entered into the first amendment to our Commercial Loan Trust 2006-2 warehouse credit facility with Merrill Lynch Capital Corp. Pursuant to this amendment, the maturity date for the facility was extended from November 30, 2007 through February 29, 2008. In addition, the advance rate was reduced from 80% to 75% of the value of the commercial loans purchased by the trust. As of December 31, 2007 we had $136.4 million outstanding under this facility. See “Recent Developments” for further discussion of this facility including amendments made subsequent to December 31, 2007.
MCG Commercial Loan Funding Trust. We have, through MCG Commercial Loan Funding Trust, a $250.0 million warehouse financing facility funded through Three Pillars Funding LLC, an asset-backed commercial paper conduit administered by SunTrust Capital Markets, Inc. The warehouse financing facility operates like a revolving credit facility that is primarily secured by the assets of MCG Commercial Loan Funding Trust, including commercial loans sold by us to the trust. The pool of commercial loans in the trust must meet certain requirements, including, but not limited to, term, average life, investment rating, agency rating and industry diversity requirements. There are also certain requirements relating to portfolio performance, including required minimum portfolio yield and limitations on delinquencies and charge-offs. Such limitations, requirements, and associated defined terms are as provided for in the documents governing the facility. This facility is funded through two separate Variable Funding Certificates, or VFCs, a $218.8 million Class A VFC and a $31.2 million Class B VFC. Advances under the Class A VFC may be up to 70% of eligible collateral. Advances under the Class B VFC may be up to 10% of eligible collateral. The facility is scheduled to terminate on November 4, 2010, but is subject to annual renewal and may be extended under certain circumstances.
In July 2007, we amended the Commercial Loan Funding Trust Facility. Pursuant to this amendment, the interest rates for Class A advances and Class B advances were reduced to the commercial paper rate plus 0.75% and 1.50%, respectively, per annum from the commercial paper rate plus 0.95% and 1.75%, respectively, per annum. The Class A advances and Class B advances previously bore interest at the commercial paper rate plus 0.95% and 1.75%, respectively, per annum. As of December 31, 2007, we had $113.2 million Class A VFC and $8.3 million Class B VFC outstanding under this credit facility.
Commercial Loan Trust 2006-1. On April 18, 2006, we completed a $500.0 million debt securitization through MCG Commercial Loan Trust 2006-1, our wholly owned subsidiary. The 2006-1 Trust issued $106.2 million of Class A-1 Notes rated AAA / Aaa, $50.0 million of Class A-2 Notes rated AAA / Aaa, $85.0 million of Class A-3 Notes rated AAA / Aaa, $58.8 million of Class B Notes rated AA / Aa2, $45.0 million of Class C
Notes rated A / A2 and $47.5 million of Class D Notes rated BBB / Baa2 as rated by Moody’s and S&P, respectively. The Series 2006-1 Class A-1 Notes, Class A-2 Notes, Class A-3 Notes, Class B Notes, Class C Notes and Class D Notes bear interest of LIBOR plus 0.33%, 0.35%, 0.33%, 0.58%, 1.05% and 2.25%, respectively.
We retained all of the equity in the securitization. The securitization includes a reinvestment period of five years, during which principal collections received on the underlying collateral may be used to purchase new collateral from us. Under the terms of the securitization, up to 55% of the collateral may be non-senior secured commercial loans and the remaining 45% must be senior secured commercial loans.
The Class A-1, Class B, Class C and Class D Notes are term notes. The Class A-2 Notes are a revolving class of secured notes and have a revolving period of five years. The Class A-3 Notes are a delayed draw class of secured, which were drawn in full during April 2007. All of the notes are secured by the assets of MCG Commercial Loan Trust 2006-1, including commercial loans totaling $482.5 million as of December 31, 2007, which were purchased by the trust from us. Additional commercial loans will be purchased by the trust from us primarily using the proceeds from Class A-2 revolving notes. The pool of commercial loans in the trust must meet certain requirements, including, but not limited to, asset mix and concentration, collateral coverage, term, agency rating, minimum coupon, minimum spread and sector diversity requirements. As of December 31, 2007, we had $418.1 million of these notes outstanding.
Revolving Unsecured Credit Facility. This facility is a $100.0 million unsecured revolving credit facility established with HVB. The facility allows for additional lenders with HVB acting as the agent. The $100.0 million commitment is maintained by four lenders. HVB, Chevy Chase Bank, Sovereign Bank and Royal Bank of Canada maintain $50.0 million, $10.0 million, $15.0 million, and $25.0 million commitments, respectively. Advances under this credit facility bear interest at LIBOR plus 2.00%, the prime rate plus 0.50% or the Federal Funds rate plus 2.25%, and there is a commitment fee of 0.25% per annum on undrawn amounts. The credit facility contains customary terms and conditions, including, without limitation, affirmative and negative covenants such as information reporting, minimum stockholders’ equity, minimum asset coverage ratio, minimum cash net operating income and a minimum ratio of earnings before interest and taxes to interest expense. The credit facility also contains customary events of default with customary cure and notice, including, without limitation, nonpayment, misrepresentation in a material respect, breach of covenant, cross-default to other indebtedness, bankruptcy, change of control, change of management, and material adverse change. The maturity date of this facility is June 4, 2008. As of December 31, 2007, we had $30.5 million outstanding under this credit facility. See “-Recent Developments” for further discussion of this facility.
SBIC Leverage. On December 13, 2004, we formed a wholly owned subsidiary, Solutions Capital I, LP. Solutions Capita I, LP has received a license from the United States Small Business Administration (“SBA”) to operate as a small business investment company (“SBIC”) under the Small Business Investment Act of 1958, as amended. The license allows Solutions Capital I to borrow up to $100 million in funds which can be used to provide debt and equity capital to qualifying small businesses. Additionally, we have applied for exemptive relief from the SEC similar to relief that has been granted to other business development companies, to permit us to exclude debt issued by the SBA to Solutions Capital I, LP from our consolidated asset coverage ratio, which will enable us to fund more investments with debt capital. There can be no assurance that we will receive the exemptive relief from the SEC. We intend to seek up to $130.6 million in leverage from the SBA, which is subject to SBA approval. The SBIC debt, once drawn, has an interim rate of LIBOR plus 30 basis points. The rate becomes fixed at the time of SBA pooling, which is within six months of funding, and is set to the 10 year treasury rate at the time plus a spread and an annual SBA charge, which taken together currently approximate 175 basis points.
Distributions
We intend to make distributions on a quarterly basis to our stockholders of substantially all of our income. We may make deemed distributions to our stockholders of certain net capital gains.
As a business development company that has elected to be treated as a RIC, we generally are required annually to (1) distribute at least 90% of our investment company taxable income and 90% of any ordinary pre-RIC built in gains that we recognize in order to deduct any distributions made (or deemed made) to our shareholders and (2) distribute (actually or on a deemed basis) at least 98% of our income (both ordinary income and net capital gains) in order to avoid an excise tax.
We may not be able to achieve operating results that will allow us to make distributions at a specific level or to increase the amount of these distributions from time to time. In addition, we may be limited in our ability to make distributions due to the asset coverage test for borrowings applicable to us as a business development company under the Investment Company Act of 1940 and due to provisions in our credit facilities. If we do not distribute a certain percentage of our income annually, we will suffer adverse tax consequences, including possible loss of favorable regulated investment company tax treatment. We cannot assure shareholders that they will receive any distributions.
The following table summarizes our distributions declared since January 1, 2006:
Since December 2001, we have declared distributions totaling $11.51 per share. For 2008, we currently estimate that our dividends will be at least $1.76 per share. This estimate takes into consideration our expectations for the performance of our business and estimates of distributable net operating income, net income, capital gains and taxable income for 2008.
Each year a statement on Form 1099-DIV identifying the source of the distribution (i.e., paid from ordinary income, paid from net capital gains on the sale of securities, and/or a return of paid-in-capital surplus which is a nontaxable distribution) is mailed to our stockholders. To the extent our taxable earnings fall below the total amount of our distributions for that fiscal year, a portion of those distributions may be deemed a tax return of capital to our stockholders.
The table below shows the detail of our taxable distributions for the years ended December 31, 2007 and 2006:
(a)
Ordinary income is reported on Form 1099-DIV as either qualified or non-qualified and long term capital gains are reported on Form 1099-DIV in various sub-categories which have differing tax treatments to shareholders. Those subcategories have not been shown here.
(b)
Return of capital refers to those amounts reported as nontaxable distributions on Form 1099-DIV.
On a tax basis, distributions to stockholders in 2007 were approximately $92.5 million of ordinary income and $13.3 million of long term capital gains, and in 2006 were approximately $53.0 million of ordinary income and $35.2 million of return of capital.
There are certain differences between the net income reported in our consolidated financial statements and our taxable income. The following table is a reconciliation of GAAP net income to taxable net income for the years ended December 31, 2007 and 2006:
Critical Accounting Policies
The consolidated financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions. We believe that the following are some of the more critical judgment areas in the application of our accounting policies that currently affect our financial condition and results of operations.
Income Recognition
Interest and Dividend Income
Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. When a loan becomes more than 90 days past due, or if we otherwise do not expect the customer to be able to service its debt and other obligations, we will, as a general matter, place the loan on non-accrual status and will generally cease recognizing interest income on that loan until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, we may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection.
Dividend income on equity investments that have stated accruing dividend rates is recorded on the accrual basis to the extent that such amounts are expected to be collected. Dividend income on common equity investments is recorded when declared and required to be paid.
Contractual paid-in-kind (PIK) interest, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term, is generally recorded on the accrual basis to the extent such amounts are expected to be collected. We will generally cease accruing PIK if there is insufficient value to support the accrual or we do not expect the customer to be able to pay all principal and interest due.
Loan origination fees are capitalized and then amortized into interest income using the effective interest rate method. In certain loan arrangements, warrants or other equity interests are received from the borrower as additional origination fees. The borrowers granting these interests are typically non-publicly traded companies. We record the financial instruments received at fair value as determined by our board of directors. Fair values are determined using various valuation models which estimate the underlying value of the associated entity. These models are then applied to our ownership share considering any discounts for transfer restrictions or other terms which impact the value. Changes in these values are recorded through our statement of operations. Any resulting discount on the loan from recordation of warrant and other equity instruments are accreted into income over the term of the loan.
Other Fee Income
Other fee income is related to advisory and management services, equity structuring fees, prepayment fees, research revenues, bank interest, and other fees. Advisory and management services fees are recognized when earned. Equity structuring fees are recognized as earned, which is generally when the investment transaction closes. Prepayment fees are recognized upon receipt.
Valuation of Investments
We determine the value of each investment in our portfolio on a quarterly basis. Value, as defined in Section 2(a)(41) of the Investment Company Act of 1940, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by the board of directors. Since there is typically no readily available market value for the investments in our portfolio, we value substantially all of our investments at fair value as determined in good faith by the board of directors pursuant to a valuation policy and a consistent valuation process. At December 31, 2007, approximately 95% of our total assets represented investments of which approximately 97% are valued at fair value and approximately 3% are valued at market value based on readily ascertainable public market quotes at December 31, 2007. Because of 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 determined in good faith by the board of directors may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.
There is no single standard for determining fair value in good faith. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment. Unlike banks, we are not permitted to provide a general reserve for anticipated loan losses. Instead, we determine the fair value of each individual investment on a quarterly basis and record changes in fair value as unrealized appreciation or depreciation on investments in our statement of operations.
As a business development company, we invest primarily in illiquid securities including debt and equity securities of private companies. The structure of each debt and equity security is specifically negotiated to enable us to protect our investment and maximize our returns. We generally include many terms governing interest rate, repayment terms, prepayment penalties, financial covenants, operating covenants, ownership and corporate governance parameters, dilution parameters, liquidation preferences, voting rights, and put or call rights. In some cases, our loan agreements also allow for increases in the spread to the base index rate if the financial or operational performance of the customer deteriorates or shows negative variances from the customer’s business plan and, in some cases, allow for decreases in the spread if financial or operational performance improves or exceeds the customer’s plan. Our investments are generally subject to some restrictions on resale and generally have no established trading market. Because of the type of investments that we make and the nature of our business, our valuation process requires an analysis of various factors. Our fair value methodology includes the examination of, among other things, the underlying investment performance, financial condition and market changing events that impact valuation.
We base the fair value of our investments on the enterprise value of the portfolio companies in which we invest. The enterprise value is the value at which an enterprise could be sold in a transaction between two willing parties other than through a forced or liquidation sale. Typically, private companies are bought and sold based on multiples of EBITDA, cash flows, net income, revenues, or in limited cases, book value. There is no single methodology for determining enterprise value and for any one portfolio company enterprise value is generally described as a range of values from which we derive a single estimate of enterprise value. In determining the enterprise value of a portfolio company, we analyze its historical and projected financial results. We generally prepare discounted cash flow models based on our projections of the future free cash flows of the business and industry derived capital costs. We review external events, including private mergers and acquisitions, and include these events in our enterprise valuation process. We also use industry valuation benchmarks and review public market comparables. In certain cases, we retain independent valuation firms to perform valuations or reviews of
valuations that are considered as part of the determination of portfolio company value. When an external event such as a purchase transaction, public offering, or subsequent debt or equity sale occurs, the pricing indicated by the external event may be used to corroborate our estimate of enterprise value.
Using the estimated enterprise value of the portfolio company, we estimate the value of each investment we own in the portfolio company. For our loans and debt securities, if there is adequate enterprise value to support the repayment of our debt then the fair value of our loan or debt security typically corresponds to cost unless the borrower’s condition or other factors lead to a determination of fair value at a different amount. The fair value of our equity investments is determined based on various factors including the enterprise value remaining for equity holders after the repayment of the portfolio company’s debt and other preference capital, as well as other pertinent factors such as recent offers to purchase a portfolio company, recent sales of the portfolio company’s equity securities, recent liquidation events or other events. The investment value is discounted if it is illiquid in nature and/or a minority, non-control position.
We also retain independent valuation firms to perform independent valuations of certain of our portfolio companies and perform reviews of our fair value determinations. The independent valuations and reviews are considered by our Board of Directors in its determination of the fair value of our portfolio companies. We intend to continue to utilize independent valuations firms to obtain additional support in the valuation process each quarter.
Securities that are traded in the over-the-counter market or on a stock exchange generally will be valued at the average of the prevailing bid and ask price on the date of the relevant period end. However, restricted or thinly traded public securities may be valued at discounts from the public market value due to the restrictions on sale.
Share-based Compensation
Prior to January 1, 2006, we accounted for share based compensation in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Effective January 1, 2006, we adopted the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123R”) using the modified prospective method. The adoption of SFAS No. 123R did not impact our net operating income before investment gains and losses, net income, cash flows from operations, cash flows from financing activities, or basic and diluted earnings per share during that period. See Note 9 to the Consolidated Financial Statements for further discussion of our share-based compensation.
Securitization Transactions
Periodically, we transfer pools of loans to bankruptcy remote, special purpose entities for use in securitization transactions. These transfers of loans are treated as secured borrowing financing arrangements in accordance with FASB SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”. These on-balance sheet securitization transactions comprise a significant source of our overall funding, with the total face amount of the assets assumed by our consolidated bankruptcy remote special purpose entities equaling $827.5 million at December 31, 2007 and $677.4 million at December 31, 2006.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157 (“SFAS No. 157”), “Fair Value Measurements.” Among other requirements, SFAS No. 157 defines fair value and establishes a framework for measuring fair value and also expands disclosure about the use of fair value to measure assets and liabilities. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently analyzing the effect of adoption of this statement on our consolidated
financial position, including our net asset value, and results of operations. We will adopt this statement on a prospective basis effective January 1, 2008. Adoption of this statement could have a material effect on our consolidated financial statements, including our net asset value. However, the actual impact on our consolidated financial statements in the period of adoption and subsequent to the period of adoption cannot be determined at this time as it will be influenced by the estimates of fair value for that period and the number and amount of investments we originate, acquire or exit.
In February 2007, the FASB issued SFAS No. 159 (“SFAS No. 159”), “The Fair Value Option for Financial Assets and Financial Liabilities.” Among other requirements, SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for the first fiscal year that begins after November 15, 2007. We are currently evaluating the impact of FAS No. 159 on our financial position and results of operations.
Recent Developments
On January 8, 2008, we amended our Revolving Credit Facility with Bayerische Hypo-Und Vereinsbank, AG, New York Branch (“HVB”). Pursuant to this amendment, the aggregate revolving commitment amount under this credit facility was increased from $100.0 million to $130.0 million, and an additional lender was added to this facility. Chevy Chase Bank increased its commitment from $10.0 million to $15.0 million. HVB, Sovereign Bank and Royal Bank of Canada maintained their $50.0 million, $15.0 million and $25.0 million commitments, respectively. The additional $25.0 million was committed by SunTrust Bank.
On February 12, 2008, we entered into the second amendment to our Commercial Loan Trust 2006-2 warehouse credit facility with Merrill Lynch Capital Corp. Pursuant to the amendment, the maturity date for the facility was extended from February 29, 2008 through August 31, 2008. In addition, the amendment provides for the reduction of the outstanding amount under the facility, with not more than $82.5 million outstanding on April 21, 2008, not more than $55 million outstanding on May 31, 2008, and not more than $27.5 million outstanding on July 21, 2008, with the balance due on August 31, 2008. After February 29, 2008, the advance rate under the facility is reduced from 75% to 70% for non-senior loans but remains at 75% for senior loans, and the interest rate for advances increases from LIBOR plus 0.75% to LIBOR plus 1.5%. Additionally, we paid a modification fee of $250,000 to Merrill Lynch Capital Corp.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The debt and equity capital markets in the United States have been severely impacted by significant write-offs in the financial services sector relating to subprime mortgages and the re-pricing of credit risk in the broadly syndicated market, among other things. These events, along with the deterioration of the housing market, have led to worsening general economic conditions, which have impacted the broader financial and credit markets and have reduced the availability of debt and equity capital for the market as a whole and financial firms in particular. The Company and other commercial finance companies have historically utilized the collateralized loan obligation (“CLO”) market to finance some of their investment activities. Due to the current dislocation of the CLO market, which we believe may continue for an extended period of time, we and other companies in the commercial finance sector will have to access alternative debt markets in order to grow. The debt capital that will be available will most likely be at a higher cost, and terms and conditions may be less favorable. This may result in slowing our origination activity during the early part of 2008.
In the event that the United States economy enters into an extended downturn or a recession, it is possible that the results of some of the middle market companies similar to those in which we invest could experience deterioration which could ultimately lead to difficulty in meeting debt service requirements and an increase in defaults. While we are not seeing signs of an overall broad deterioration in our portfolio at this time, there can be no assurance that the performance of certain of our portfolio companies will not be negatively impacted by economic conditions, which could have a negative impact on our future results.
Interest rate sensitivity refers to the change in earnings that may result from changes in the level of interest rates. Our net interest income is affected by changes in various interest rates, including LIBOR, prime rates and commercial paper rates. As of December 31, 2007, approximately 63% of our loan portfolio, at fair value, bears interest at a spread to LIBOR or prime rate, and 37% at a fixed rate. As of December 31, 2007, approximately 28% of our loan portfolio, at fair value, has LIBOR floors between 1.50% and 3.00% on the LIBOR base index.
We regularly measure exposure to interest rate risk. We assess interest rate risk and we manage our interest rate exposure on an ongoing basis by comparing our interest rate sensitive assets to our interest rate sensitive liabilities. Based on this review, we determine whether or not any hedging transactions are necessary to mitigate exposure to changes in interest rates. At December 31, 2007, we were not a party to any hedging arrangements. Certain of our interest bearing investments contain LIBOR floors between 1.50% and 3.00% on the LIBOR base index to minimize our exposure to significant decreases in interest rates.
The following table shows a comparison of the interest rate base for our interest bearing cash, outstanding commercial loans and our outstanding borrowings at December 31, 2007 and 2006:
Based on our December 31, 2007 balance sheet, the following table shows the impact to net income of base rate changes in interest rates assuming no changes in our investment and borrowing structure:
Item 8.
Item 8. Financial Statements and Supplementary Data
Management’s Report on Internal Control Over Financial Reporting
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2007 and 2006
Consolidated Statements of Operations for the years ended December 31, 2007, 2006, and 2005
Consolidated Statements of Changes in Net Assets for the years ended December 31, 2007, 2006, and 2005
Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006, and 2005
Consolidated Schedule of Investments as of December 31, 2007
Consolidated Schedule of Investments as of December 31, 2006
Notes to Consolidated Financial Statements
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of MCG Capital Corporation (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting and for the assessment of the effectiveness of internal control over financial reporting. As defined by the SEC, internal control over financial reporting is a process designed under the supervision of the Company’s principal executive, principal financial and principal accounting officers, and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles.
The Company’s internal control over financial reporting is supported by written policies and procedures, that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of the Company’s management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management of the Company conducted an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“the COSO Framework”). Based on this assessment, management has concluded that the Company’s internal control over financial reporting was effective as of December 31, 2007.
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
MCG Capital Corporation
We have audited MCG Capital Corporation’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). MCG Capital Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, MCG Capital Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of MCG Capital Corporation (the Company), including the consolidated schedule of investments, as of December 31, 2007 and 2006, and the related consolidated statements of operations, changes in net assets, and cash flows for each of the three years in the period then ended, and the financial highlights for each of the five years in the period then ended. Our report dated February 27, 2008 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
February 27, 2008
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
MCG Capital Corporation
We have audited the accompanying consolidated balance sheets of MCG Capital Corporation (the Company), including the consolidated schedule of investments, as of December 31, 2007 and 2006, and the related consolidated statements of operations, changes in net assets, and cash flows for each of the three years in the period then ended and the financial highlights for each of the five years in the period then ended. These financial statements and financial highlights are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial highlights based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial highlights are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and financial highlights, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our procedures included confirmation of securities owned as of December 31, 2007, by correspondence with the custodians. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to above present fairly, in all material respects, the consolidated financial position of MCG Capital Corporation at December 31, 2007, the consolidated results of its operations, its cash flows, and changes in its net assets for each of the three years in the period then ended and the financial highlights for each of the five years in the period then ended in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), MCG Capital Corporation’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2008 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
February 27, 2008
MCG Capital Corporation
Consolidated Balance Sheets
(in thousands, except per share amounts)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Statements of Operations
(in thousands, except per share amounts)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Statements of Changes in Net Assets
(in thousands, except per share amounts)
See notes to consolidated financial statements.
MCG Capital Corporation
Consolidated Statements of Cash Flows
(in thousands)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments
December 31, 2007
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2007
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2007
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2007
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2007
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2006
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2006
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2006
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2006
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2006
(in thousands, except share data)
See notes to consolidated financial statements
MCG Capital Corporation
Consolidated Schedule of Investments-(Continued)
December 31, 2007 and 2006
(in thousands, except share data)
(1) Some or all of this security has been pledged as collateral in one or more of MCG’s credit facilities. See Note 3 to the Consolidated Financial Statements.
(2) Some of the securities listed are issued by one or more affiliates of the listed portfolio company.
(3) Affiliate investments are generally defined under the Investment Company Act of 1940 as companies in which MCG owns at least 5% but not more than 25% of the voting securities of the company.
(4) Control investments are generally defined under the Investment Company Act of 1940 as companies in which MCG owns more than 25% of the voting securities of the company. MCG defines non-majority owned control investments as companies in which MCG owns more than 25% but not more than 50% of the voting securities of the company.
(5) MCG defines majority owned control investments as companies in which MCG owns more than 50% of the voting securities of the company.
(6) Non-income producing at the relevant period end.
(7) In August 2006, MCG sold 50.1% of its equity in Crystal Media Network, LLC (“Crystal Media”). As part of the transaction, MCG also issued a written call option to the buyer on up to an additional 10% ownership interest in Crystal Media for $110. The option expires January 31, 2008. This call option is included in other liabilities at fair value on MCG’s consolidated balance sheets.
(8) Interest rates represent the weighted average annual stated interest rate on loans and debt securities, which are presented by nature of indebtedness for a single issuer. The maturity dates represent the earliest and the latest maturity dates. Rates on preferred stock and preferred LLC interests, where applicable, represent the contractual rate.
(9) During the first quarter of 2007, NYL Brands Holdings, Inc. changed its name to Active Brands International, Inc. During the second quarter of 2007, MCG converted its 1,500 Class A shares to non-voting Class A-1 shares. As a result, Active Brands has been classified as a non-affiliate investment since June 30, 2007.
(10) During the second quarter of 2007, JupiterKagan, Inc. changed its name to JUPR Holdings, Inc.
(11) MCG acquired 61% of Total Sleep Holdings, Inc. common stock during the second quarter of 2007 which resulted in it being classified as a majority owned control investment since June 30, 2007. In connection with this transaction, MCG granted a put option to a private equity firm to put an additional 34% of the common stock of Total Sleep Holdings, Inc. to MCG for a price of $1,000. This put option expires April 30, 2009 if not exercised prior to that date. This put option is outstanding at December 31, 2007 and is included in other liabilities at fair value on MCG’s consolidated balance sheets.
(12) Helicon Cable Holdings, LLC refinanced and paid off its senior and subordinated secured debt during the third quarter of 2007, at which time a new unsecured facility to the operating company and a new unsecured facility to the holding company were funded. JetBroadband Holdings, LLC replaced Helicon Cable Holdings, LLC as the parent entity of the portfolio company in connection with a concurrent restructuring of the equity.
(13) MCG’s investment in MTP Holdings, LLC was previously listed as an investment in Midwest Tower Partners, LLC. Midwest Tower Partners, LLC is a subsidiary of MTP Holdings, LLC.
(14) During the third quarter of 2007, all of the existing preferred stock and preferred stock warrants of TNR Entertainment Corp. (“TNR”) were converted to common stock and common stock warrants. In addition, MCG purchased shares of TNR’s voting preferred stock constituting a majority of the outstanding voting securities of TNR. As a result, TNR has been classified as a majority control investment since September 30, 2007.
(15) During the third quarter of 2007, National Display Holdings, LLC changed its name to NDSSI Holdings, LLC.
(16) On December 31, 2007, MCG received 744,777 shares of common stock of Cleartel Communications, Inc.(“Cleartel”) in exchange for, and in cancellation of, $74,478 of debt owed by Cleartel to MCG under its existing credit facilities.
(17)
During the fourth quarter of 2007, Wire Rope Corporation of America, Inc. changed its name to WireCo WorldGroup Inc.
See notes to consolidated financial statements
MCG Capital Corporation
Notes to Consolidated Financial Statements
(in thousands, except per share data)
Note 1-Description of Business, Basis of Presentation, and Summary of Significant Accounting Policies
Description of Business and Basis of Presentation
MCG Capital Corporation (“MCG” or the “Company”) is a solutions-focused commercial finance company providing capital and advisory services to middle market companies throughout the United States. The Company is a non-diversified internally managed, closed-end investment company that elected to be treated as a business development company under the Investment Company Act of 1940, as amended (“1940 Act”).
The Company conducts some of its activities through wholly owned special purpose financing subsidiaries. These subsidiaries are bankruptcy remote, special purpose entities to which the Company transfers certain loans. Each financing subsidiary in turn transfers the loans to a Delaware statutory trust. The transfers of the loans to the Delaware statutory trusts are structured as on-balance sheet securitizations for accounting purposes.
The Company formed a subsidiary, Solutions Capital I, LP, which received a license in 2007 from the United States Small Business Administration (“SBA”) to operate as a small business investment company (“SBIC”) under the Small Business Investment Act of 1958, as amended. In connection with the formation of Solutions Capital I, LP, the Company organized another wholly owned subsidiary, Solutions Capital GP, LLC, as a Delaware limited liability company. Solutions Capital GP, LLC will act as the general partner of Solutions Capital I, LP, while the Company will be the sole limited partner.
The Company also uses wholly owned subsidiaries, all of which are structured as Delaware corporations and limited liability companies, to hold the assets of one or more of its portfolio companies. Some of these subsidiaries have wholly owned subsidiaries, all of which are Delaware corporations, that hold the assets of certain of the Company’s portfolio companies.
The accompanying financial statements reflect the consolidated accounts of MCG, including Solutions Capital I, LP, Solutions Capital GP, LLC, and MCG’s special purpose financing subsidiaries, MCG Finance I, LLC, MCG Finance II, LLC, MCG Finance III, LLC, MCG Finance IV, LLC, MCG Finance V, LLC, MCG Finance VI, LLC, MCG Finance VII, LLC, and MCG Finance VIII, LLC, with all significant intercompany balances eliminated. In accordance with Article 6 of Regulation S-X under the Securities Act of 1933 and Securities Exchange Act of 1934, the Company does not consolidate portfolio company investments, including those in which it has a controlling interest. Prior to January 1, 2006, Kagan Research, LLC was one of the Company’s consolidated subsidiaries. During the first quarter of 2006, Kagan Research, LLC and Jupiter Research, LLC merged to create JupiterKagan, Inc., which is reflected on the Company’s schedule of investments.
Use of estimates
The accompanying financial statements are prepared in conformity with accounting principles generally accepted in the United States. This requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Summary of Significant Accounting Policies
Income Recognition
Interest and dividend income
Interest income is recorded on the accrual basis to the extent that such amounts are expected to be collected. When a loan becomes more than 90 days past due, or if MCG otherwise does not expect the customer to be able to service its debt and other obligations, MCG will, as a general matter, place the loan on non-accrual status and
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
will generally cease recognizing interest income on that loan until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, MCG may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection.
Dividend income on equity investments that have stated accruing dividend rates is recorded on the accrual basis to the extent that such amounts are expected to be collected. Dividend income on common equity investments is recorded when declared and required to be paid.
Contractual paid-in-kind (PIK) interest, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term, is generally recorded on the accrual basis to the extent such amounts are expected to be collected. MCG will generally cease accruing PIK if there is insufficient value to support the accrual or it does not expect the customer to be able to pay all principal and interest due.
Loan origination fees are capitalized and then amortized into interest income using the effective interest rate method. In certain loan arrangements, warrants or other equity interests are received from the borrower as additional origination fees. The borrowers granting these interests are typically non-publicly traded companies. MCG records the financial instruments received at fair value as determined by MCG’s board of directors. Fair values are determined using various valuation models which estimate the underlying value of the associated entity. These models are then applied to MCG’s ownership share considering any discounts for transfer restrictions or other terms which impact the value. Changes in these values are recorded through MCG’s statement of operations. Any resulting discount on the loan from recordation of warrant and other equity instruments are accreted into income over the term of the loan.
Other income
Advisory fees and other income is related to advisory and management services, equity structuring fees, prepayment fees, research revenues, bank interest, and other fees. The Company charges fees for advisory or management services that it provides to its portfolio companies. These fees are charged at market rates as documented in an agreement between the Company and the portfolio company that outlines the services and the fees to which both parties have agreed. Advisory and management services fees are recognized when earned. Equity structuring fees are recognized as earned, which is generally when the investment transaction closes. Prepayment fees are recognized upon receipt.
Securitization Transactions
Periodically, MCG transfers pools of loans to bankruptcy remote, special purpose entities for use in securitization transactions. These transfers of loans are treated as secured borrowing financing arrangements in accordance with FASB SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”.
Cash and Cash Equivalents
Cash and cash equivalents as presented in the balance sheet and the statement of cash flows includes bank checking accounts, highly liquid investments with original maturities of 90 days or less, and interest bearing deposits collateralized by marketable debt securities.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Cash, Securitization Accounts
Cash, securitization accounts includes amounts held in designated bank accounts representing principal and interest payments received on securitized loans or other reserved amounts associated with the Company’s securitization facilities. The Company is required to use these amounts to pay interest expense, reduce borrowings, or pay other amounts in accordance with the related securitization agreements.
Cash, Restricted
Cash, restricted includes cash that was received in exchange for the sale of an asset that is currently held in escrow and cash that is restricted for regulatory purposes.
Investments
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 MCG owns more than 25% of the voting securities or maintains greater than 50% of the board representation. Under the 1940 Act, “Affiliate Investments” are defined as those non-control investments in companies in which MCG owns between 5% and 25% of the voting securities. Under the 1940 Act, “Non-affiliate Investments” are defined as investments that are neither Control Investments nor Affiliate Investments.
All investments are carried at fair value with any adjustments recorded in the statement of operations as investment gains (losses)-unrealized. The Company determines the value of each investment in its portfolio on a quarterly basis. Value, as defined in Section 2(a)(41) of the Investment Company Act of 1940, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by the board of directors. Since there is typically no readily available market value for the investments in the Company’s portfolio, the Company values substantially all of its investments at fair value as determined in good faith by the board of directors pursuant to a valuation policy and a consistent valuation process. At December 31, 2007, approximately 95% of the Company’s total assets represented investments of which approximately 97% are valued at fair value and approximately 3% are valued at market value based on readily ascertainable public market quotes at December 31, 2007. Because of the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of the Company’s investments determined in good faith by the board of directors may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.
There is no single standard for determining fair value in good faith. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment. Unlike banks, the Company is not permitted to provide a general reserve for anticipated loan losses. Instead, the Company must determine the fair value of each individual investment on a quarterly basis and record changes in fair value as unrealized appreciation or depreciation on investments in its statement of operations.
As a business development company, the Company invests primarily in illiquid securities including debt and equity securities of private companies. The structure of each debt and equity security is specifically negotiated to enable us to protect our investment and maximize our returns. The Company generally includes many terms governing interest rate, repayment terms, prepayment penalties, financial covenants, operating covenants, ownership and corporate governance parameters, dilution parameters, liquidation preferences, voting rights, and put or call rights. In some cases, the Company’s loan agreements also allow for increases in the spread
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
to the base index rate if the financial or operational performance of the customer deteriorates or shows negative variances from the customer’s business plan and, in some cases, allow for decreases in the spread if financial or operational performance improves or exceeds the customer’s plan. The Company’s investments are generally subject to some restrictions on resale and generally have no established trading market. Because of the type of investments that the Company makes and the nature of its business, the Company’s valuation process requires an analysis of various factors. The Company’s fair value methodology includes the examination of, among other things, the underlying investment performance, financial condition and market changing events that impact valuation.
The Company bases the fair value of its investments on the enterprise value of the portfolio companies in which it invests. The enterprise value is the value at which an enterprise could be sold in a transaction between two willing parties other than through a forced or liquidation sale. Typically, private companies are bought and sold based on multiples of EBITDA, cash flows, net income, revenues, or in limited cases, book value. There is no single methodology for determining enterprise value and for any one portfolio company enterprise value is generally described as a range of values from which a single estimate of enterprise value is derived. In determining the enterprise value of a portfolio company, the Company analyzes the portfolio company’s historical and projected financial results. The Company generally prepares discounted cash flow models based on its projections of the future free cash flows of the business and industry derived capital costs. The Company reviews external events, including private mergers and acquisitions, and includes these events in the enterprise valuation process. The Company also uses industry valuation benchmarks and reviews public market comparables. In certain cases, the Company retains independent valuation firms to perform valuations or reviews of valuations that are considered as part of the determination of portfolio company value. When an external event such as a purchase transaction, public offering, or subsequent debt or equity sale occurs, the pricing indicated by the external event may be used to corroborate the Company’s estimate of enterprise value.
For loans and debt securities, if there is adequate enterprise value to support the repayment of the Company’s debt then the fair value of its loan or debt security typically corresponds to cost unless the borrower’s condition or other factors lead to a determination of fair value at a different amount. The fair value of the Company’s equity investments is determined based on various factors including the enterprise value remaining for equity holders after the repayment of the portfolio company’s debt and other preference capital, as well as other pertinent factors such as recent offers to purchase a portfolio company, recent sales of the portfolio company’s equity securities, recent liquidation events or other events. The investment value is discounted if it is illiquid in nature and/or a minority, non-control position.
In connection with its process for determining the fair value of its portfolio investments, the Company retains valuation firms to perform independent valuations of certain of its portfolio companies and review certain of its fair value determinations. The independent valuations and reviews are considered by the board of directors in their determination of fair value. The Company intends to continue to utilize independent valuation consultants to obtain additional support in the valuation process each quarter.
Securities that are traded in the over-the-counter market or on a stock exchange generally will be valued at the average of the prevailing bid and ask price on the date of the relevant period end. However, restricted or thinly traded public securities may be valued at discounts from the public market value due to the restrictions on sale.
Debt Issuance Costs
Debt issuance costs represent fees and other direct incremental costs incurred in connection with the Company’s borrowings. These costs are amortized into the consolidated statement of operations as interest expense ratably over the contractual term of the borrowing using the effective interest method.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Share-based Compensation
The Company recognizes share based compensation in accordance with FASB Statement No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123R”), which it adopted effective January 1, 2006 using the modified prospective method. Effective January 1, 2006, unearned compensation amounts previously recorded as a separate component of equity on the Company’s balance sheet are included in paid-in capital. In accordance with FAS 123R, the Company recognizes compensation cost related to share based awards for which forfeiture provisions are expected to lapse over the requisite service period.
Prior to January 1, 2006, the Company accounted for share based compensation in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” The adoption of SFAS No. 123R did not impact the Company’s net operating income before investment gains and losses, net income, cash flows from operations, cash flows from financing activities, or basic and diluted earnings per share. See Note 9 for further discussion of the Company’s share based compensation.
Income Taxes
The Company currently qualifies as a regulated investment company (a “RIC”) for federal income tax purposes, which generally allows it to avoid paying corporate income taxes on any income or gains that it distributes to its shareholders. The Company has distributed and intends to distribute sufficient dividends to eliminate taxable income. The Company may also be subject to federal excise tax if it does not distribute at least 98% of its investment company taxable income in any calendar year and 98% of its capital gain net income in any calendar year.
The Company has certain wholly owned taxable subsidiaries (the “Taxable Subsidiaries”), each of which holds one or more of the Company’s portfolio investments that are listed on the Consolidated Schedule of Investments. The Taxable Subsidiaries are consolidated with the Company for GAAP purposes, such that the Company’s consolidated financial statements reflect its investments in the portfolio companies owned by the Taxable Subsidiaries. The purpose of the Taxable Subsidiaries is to permit the Company to hold portfolio companies that are organized as limited liability companies (“LLCs”) (or other forms of pass-through entities) and still satisfy the RIC tax requirement that at least 90% of the Company’s gross revenue for income tax purposes must consist of investment income. Absent the Taxable Subsidiaries, a proportionate amount of any gross income of an LLC (or other pass-through entity) portfolio investment would flow through directly to the Company. To the extent that such income did not consist of investment income, it could jeopardize the ability of the Company to qualify as a RIC and therefore cause the Company to incur significant amounts of federal income taxes. Where the LLCs (or other pass-through entities) are owned by the Taxable Subsidiaries, however, their income is taxed to the Taxable Subsidiaries and does not flow through to the Company, thereby helping the Company preserve its RIC status and resultant tax advantages. The Taxable Subsidiaries are not consolidated with the Company for income tax purposes and may generate income tax expense as a result of their ownership of the portfolio companies. This income tax expense, if any, is reflected in the Company’s Consolidated Statement of Operations.
Earnings Per Share
Basic earnings per share is computed by dividing net income applicable to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per share is computed by dividing such net income by the sum of the weighted average number of shares outstanding for the period and the dilutive impact of restricted stock for which forfeiture provisions have not lapsed.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Goodwill
The Company records goodwill in accordance with FASB Statement No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). As of December 31, 2007 and December 31, 2006, the balance of goodwill was $3,851 and is included in other assets on the Consolidated Balance Sheets. In accordance with SFAS No. 142, the Company has tested its intangible assets with indefinite lives for impairment and determined that there were no impairments as of those dates.
Reclassifications
Certain prior period information has been reclassified to conform to current year presentation.
Recent Accounting Pronouncements
In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN No. 48”), “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109”, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN No. 48 prescribes a recognition threshold and measurement methodology for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 was effective as of the last day of the first reporting period beginning after December 15, 2006, which was March 31, 2007.
The Company has conducted a review of all open tax year’s income recognition and expense deduction filing positions and income tax returns filed (federal and state) for determination of any uncertain tax positions that may require recognition of a tax liability. This review encompassed an analysis of all book/tax difference adjustments as well as the timing of income and expense recognition for all tax years still open under the statute of limitations. As a result, the Company has determined that it is more likely than not that each tax position taken on a previously filed return or to be taken on current tax returns will be sustained on examination based on the technical merits of the positions and therefore, no recognition of a tax liability on an uncertain income tax position for FIN No. 48 purposes is anticipated.
In September 2006, the FASB issued SFAS No. 157 (“SFAS No. 157”), “Fair Value Measurements.” Among other requirements, SFAS No. 157 defines fair value and establishes a framework for measuring fair value and also expands disclosure about the use of fair value to measure assets and liabilities. SFAS No. 157 is effective for financial statements issued for first fiscal year that begins after November 15, 2007, and interim periods within those fiscal years. The Company is currently analyzing the effect of adoption of this statement on its consolidated financial position, including its net asset value, and results of operations. The Company will adopt this statement on a prospective basis, effective January 1 , 2008. Adoption of this statement could have a material effect on MCG’s consolidated financial statements, including its net asset value. However, the actual impact on MCG’s consolidated financial statements in the period of adoption and subsequent to the period of adoption cannot be determined at this time as it will be influenced by the estimates of fair value for that period and the number and amount of investments MCG originates, acquires or exits.
In February 2007, the FASB issued SFAS No. 159 (“SFAS No. 159”), “The Fair Value Option for Financial Assets and Financial Liabilities.” Among other requirements, SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS No. 159 is effective for the first fiscal year that begins after November 15, 2007. The Company is currently evaluating the impact of SFAS No. 157 and SFAS No. 159 on its financial position and results of operations.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Note 2-Investments
The composition of MCG’s investments as of December 31, 2007 and 2006, at cost, was as follows, excluding unearned income:
The composition of MCG’s investments as of December 31, 2007 and 2006, at fair value, was as follows, excluding unearned income:
The Company’s debt instruments generally provide for a contractual variable interest rate generally ranging from approximately 10% to 16%, a portion of which may be deferred. At December 31, 2007, approximately 63% of loans in the portfolio, based on amounts outstanding at fair value, were at variable rates determined on the basis of a benchmark LIBOR or prime rate and approximately 37% were at fixed rates. In addition, at December 31, 2007, approximately 28% of the loan portfolio has floors of between 1.50% and 3.0% on the LIBOR base index. The Company’s loans generally have stated maturities at origination that range from four to eight years. Customers typically pay an origination fee based on a percentage of the commitment amount. They also often pay a fee based on any undrawn commitments.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
When one of the Company’s loans becomes more than 90 days past due, or if the Company otherwise does not expect the customer to be able to service its debt and other obligations, the Company will, as a general matter, place the loan on non-accrual status and will generally cease recognizing interest income on that loan until all principal and interest has been brought current through payment or due to a restructuring such that the interest income is deemed to be collectible. However, the Company may make exceptions to this policy if the loan has sufficient collateral value and is in the process of collection. The following table summarizes our loans greater than 90 days past due and loans on non-accrual status, at fair value, at December 31, 2007 and 2006:
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Set forth below are tables showing the composition of MCG’s portfolio by industry (excluding unearned income) at cost and fair value as of December 31, 2007 and 2006:
(a)
No individual industry within this category exceeds 1%.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
(a)
No individual industry within this category exceeds 1%.
The Company has issued two call options on its investments. On June 30, 2005, the Company issued a call to Metropolitan Telecommunications Holding Company (“MetTel”) for $575 giving MetTel the right to acquire the remaining warrants to acquire MetTel stock held by the Company for $5,750. The call option issued to MetTel expired unexercised on March 31, 2006. On July 31, 2006, in connection with the sale of 50.1% of the ownership of Crystal Media Network, LLC (“CMN”) to a private investor, the Company issued an option to the private investor to acquire an additional 10% of the ownership of CMN from the Company for $110. The option to acquire 10% of CMN expires January 31, 2008 if not exercised prior to that date and is outstanding as of December 31, 2007. These call options are included in other liabilities at fair value on the Company’s consolidated balance sheets. The following table summarizes the call options issued for the years ended December 31, 2007 and 2006:
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
In addition, one put option granted by the Company was outstanding at December 31, 2007. During 2007, the Company granted a put option to a private equity firm to put an additional 34% of the common stock of Total Sleep Holdings, Inc. to the Company for a price of $1,000. This put option expires April 30, 2009 if not exercised prior to that date. This put option is included in other liabilities at fair value on the company’s consolidated balance sheets. The following table summarizes put options granted for the year ended December 31, 2007:
Note 3-Borrowings
The following is a summary of the borrowings for the years ended December 31, 2007, and 2006:
(a)
Amended in February 2008 to extend the maturity date to August 31, 2008. See Note 13, Subsequent Events, for further discussion of this facility.
(b)
Renewable at lender’s discretion each July.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
All of the Company’s debt facilities, except the Revolving Unsecured Credit Facility and the Unsecured Notes, are funded through the Company’s bankruptcy remote, special purpose, wholly owned subsidiaries and, therefore, the assets of these subsidiaries may not be available to the Company’s creditors. In some cases, advances under the Company’s debt facilities are subject to certain other covenants, including having sufficient levels of collateral and various restrictions on which loans the Company may leverage as collateral. The Company borrows directly, as well as indirectly, through credit facilities maintained by its subsidiaries. Some of the Company’s debt facilities contain cross-default provisions, whereby a default under one of the Company’s debt facilities could constitute a default under other debt facilities.
Unsecured Notes. On October 11, 2005, the Company issued $50,000 of investment grade five-year unsecured notes in a private placement. The notes were rated “BBB-” by Fitch Ratings, Inc. and have a fixed interest rate of 6.73% per year payable semi-annually. Bayerische Hypo-Und Vereinsbank, AG, New York Branch (“HVB”) acted as the placement agent for the issuance.
On October 3, 2007, the Company issued $25,000 of long-term unsecured notes in a private placement. The notes have a five-year term and a fixed interest rate of 6.71% per annum paid semi-annually. The interest rate is subject to possible adjustment in the future. The purchasers of the new notes are also holders of the Company’s notes issued in the $50,000 private placement which was completed in 2005.
Commercial Loan Trust 2006-2. On May 2, 2006 the Company established, through MCG Commercial Loan Trust 2006-2, a $200,000 warehouse credit facility with Merrill Lynch Capital Corp. The warehouse credit facility allows MCG Commercial Loan Trust 2006-2 to acquire up to $250,000 of commercial loans with borrowings of up to $200,000 subject to certain covenants, concentration limitations and other restrictions. The warehouse credit facility is primarily secured by the assets of MCG Commercial Loan Trust 2006-2, including the commercial loans purchased by the trust from the Company. Under the terms of the credit and warehouse agreement, the loans may be senior secured loans, second lien loans or unsecured loans, as defined in the agreement, subject to certain limitations. Up to 60% of the collateral in this warehouse facility may be non-senior secured loans, and the remaining 40% must be senior secured loans.
The Company uses this facility to fund the origination of loans that will collateralize a future term securitization. On October 23, 2007, the Company entered into the first amendment to its Commercial Loan Trust 2006-2 warehouse credit facility with Merrill Lynch Capital Corp. Pursuant to this amendment, the maturity date for the facility was extended from November 30, 2007 through February 29, 2008. In addition, the advance rate was reduced from 80% to 75% of the value of the commercial loans purchased by the trust. As of December 31, 2007 the Company had $136,422 outstanding under this facility. See Note 13, Subsequent Events, for further discussion of this facility including amendments made subsequent to December 31, 2007.
MCG Commercial Loan Funding Trust. The Company has, through MCG Commercial Loan Funding Trust, a $250,000 warehouse financing facility funded through Three Pillars Funding LLC, an asset-backed commercial paper conduit administered by SunTrust Capital Markets, Inc. The warehouse financing facility operates like a revolving credit facility that is primarily secured by the assets of MCG Commercial Loan Funding Trust, including commercial loans sold by the Company to the trust. The pool of commercial loans in the trust must meet certain requirements, including, but not limited to, term, average life, investment rating, agency rating and industry diversity requirements. There are also certain requirements relating to portfolio performance, including required minimum portfolio yield and limitations on delinquencies and charge-offs. Such limitations, requirements, and associated defined terms are as provided for in the documents governing the facility. This facility is funded through two separate Variable Funding Certificates, or VFCs, a $218,750 Class A VFC and a
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
$31,250 Class B VFC. Advances under the Class A VFC may be up to 70% of eligible collateral. Advances under the Class B VFC may be up to 10% of eligible collateral. The facility is scheduled to terminate on November 4, 2010, but is subject to annual renewal and may be extended under certain circumstances.
In July 2007, the Company amended the Commercial Loan Funding Trust Facility. Pursuant to this amendment, the interest rates for Class A advances and Class B advances were reduced to the commercial paper rate plus 0.75% and 1.50%, respectively, per annum from the commercial paper rate plus 0.95% and 1.75%, respectively, per annum. The Class A advances and Class B advances previously bore interest at the commercial paper rate plus 0.95% and 1.75%, respectively, per annum. As of December 31, 2007, the Company had $113,213 Class A VFC and $8,300 Class B VFC outstanding under this credit facility.
Commercial Loan Trust 2006-1. On April 18, 2006, the Company completed a $500,000 debt securitization through MCG Commercial Loan Trust 2006-1, its wholly owned subsidiary. The 2006-1 Trust issued $106,250 of Class A-1 Notes rated AAA / Aaa, $50,000 of Class A-2 Notes rated AAA / Aaa, $85,000 of Class A-3 Notes rated AAA / Aaa, $58,750 of Class B Notes rated AA / Aa2, $45,000 of Class C Notes rated A / A2 and $47,500 of Class D Notes rated BBB / Baa2 as rated by Moody’s and S&P, respectively. The Series 2006-1 Class A-1 Notes, Class A-2 Notes, Class A-3 Notes, Class B Notes, Class C Notes and Class D Notes bear interest of LIBOR plus 0.33%, 0.35%, 0.33%, 0.58%, 1.05% and 2.25%, respectively.
The Company retains all of the equity in the securitization. The securitization includes a reinvestment period of five years, during which principal collections received on the underlying collateral may be used to purchase new collateral from the Company. Under the terms of the securitization, up to 55% of the collateral may be non-senior secured commercial loans and the remaining 45% must be senior secured commercial loans.
The Class A-1, Class B, Class C and Class D Notes are term notes. The Class A-2 Notes are a revolving class of secured notes and have a revolving period of five years. The Class A-3 Notes are a delayed draw class of secured notes, which were drawn in full during April 2007. All of the notes are secured by the assets of MCG Commercial Loan Trust 2006-1, including commercial loans totaling $482,452 as of December 31, 2007, which were purchased by the trust from the Company. Additional commercial loans will be purchased by the trust from the Company primarily using the proceeds from the Class A-2 revolving notes. The pool of commercial loans in the trust must meet certain requirements, including, but not limited to, asset mix and concentration, collateral coverage, term, agency rating, minimum coupon, minimum spread and sector diversity requirements. As of December 31, 2007, a total of $387,600 of these notes were outstanding.
Revolving Unsecured Credit Facility. This facility is a $100,000 unsecured revolving credit facility established with HVB. The facility allows for additional lenders with HVB acting as the agent. The $100,000 commitment is maintained by four lenders. HVB, Chevy Chase Bank, Sovereign Bank, and Royal Bank of Canada maintain commitments of $50,000, $10,000, $15,000, and $25,000, respectively. Advances under this credit facility bear interest at LIBOR plus 2.00%, the prime rate plus 0.50%, or the Federal Funds rate plus 2.25%, and there is a commitment fee of 0.25% per annum on undrawn amounts. The credit facility contains customary terms and conditions, including, without limitation, affirmative and negative covenants such as information reporting, minimum stockholders’ equity, minimum asset coverage ratio, minimum cash net operating income, and a minimum ratio of earnings before interest and taxes to interest expense. The credit facility also contains customary events of default with customary cure and notice, including, without limitation, nonpayment, misrepresentation in a material respect, breach of covenant, cross-default to other indebtedness, bankruptcy, change of control, change of management, and material adverse change. The maturity date of this facility is June 4, 2008. As of December 31, 2007 the Company had $30,500 outstanding under this credit facility. See Note 13, Subsequent Events, for further discussion of this facility including amendments made subsequent to December 31, 2007.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
SBIC Leverage. On December 13, 2004, the Company formed a wholly owned subsidiary, Solutions Capital I, LP. Solutions Capital I, LP has received a license from the United States Small Business Administration (“SBA”) to operate as a small business investment company (“SBIC”) under the Small Business Investment Act of 1958, as amended. The license allows Solutions Capital I to borrow up to $100,000 in funds which can be used to provide debt and equity capital to qualifying small businesses. Additionally, the Company has applied for exemptive relief from the SEC similar to relief that has been granted to other business development companies, to permit us to exclude debt issued by the SBA to Solutions Capital I, LP from our consolidated asset coverage ratio, which will enable us to fund more investments with debt capital. There can be no assurance that we will receive the exemptive relief from the SEC. The Company intends to seek up to $130,600 in leverage from the SBA, which is subject to SBA approval. The SBIC debt, once drawn, has an interim rate of LIBOR plus 30 basis points. The rate becomes fixed at the time of SBA pooling, which is within six months of funding, and is set to the 10 year treasury rate at the time plus a spread and an annual SBA charge, which taken together currently approximate 175 basis points.
Repayments based on the contractual principal collections of the loans which comprise the collateral are as follows:
Actual repayments could differ significantly due to prepayments by our borrowers and modifications of our borrowers’ existing loan agreements.
Borrowings outstanding, by interest rate benchmark, as of December 31, 2007 and December 31, 2006 were as follows:
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Note 4-Capital Stock
MCG has one class of common stock and one class of preferred stock authorized. The Company’s board of directors is authorized to provide for the issuance of shares of preferred stock in one or more series, to establish the number of shares to be included in each such series, and to fix the designations, voting powers, preferences, and rights of the shares of each such series, and any qualifications, limitations or restrictions thereof subject to the 1940 Act.
In 2007, MCG raised $94,504 of net proceeds by selling 6,000 shares of newly issued common stock. In 2006, MCG raised $68,642 of net proceeds by selling 4,600 shares of newly issued common stock.
The following table summarizes MCG’s distributions declared since January 1, 2006:
A return of capital for federal income tax purposes, which MCG calls a tax return of capital, of $0.00 per share, $0.67 per share and $0.22 per share occurred with respect to the fiscal years ended December 31, 2007, 2006 and 2005, respectively. Each year a statement on Form 1099-DIV identifying the source of the dividend (i.e., paid from ordinary income, paid from net capital gains on the sale of securities, and/or a return of paid-in-capital surplus which is a nontaxable distribution) is mailed to MCG’s stockholders. To the extent MCG’s taxable earnings fall below the total amount of MCG’s distributions for that fiscal year, a portion of those distributions may be deemed a tax return of capital to MCG’s stockholders. See “Note 6 - Income Taxes” for further discussion.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Note 5-Employee Benefit Plans
MCG sponsors a contributory savings plan (“The Plan”). The Plan allows all full-time and part-time employees who work at least one thousand hours per year to participate beginning on the first day of the calendar quarter following an employee’s date of hire. MCG matches a portion of the contribution made by employees, which is based upon a percent of defined compensation, to the savings plan. Expenses related to the Plan were $268, $236, and $265 for the years ended December 31, 2007, 2006, and 2005, respectively.
MCG has created a deferred compensation plan for certain executives that allows them to defer a portion of their salary and bonuses to an unfunded deferred compensation plan managed by MCG. Contributions to the plan earn interest at a rate of 2.00% over MCG’s internal cost of funds rate, as defined by the plan. Expenses related to the Plan were $51, $46, and $56 for the years ended December 31, 2007, 2006, and 2005, respectively.
Note 6-Income Taxes
Through December 31, 2001 the Company was taxed under Subchapter C of the Internal Revenue Code. Effective January 1, 2002 the Company elected to be treated as a regulated investment company under Subchapter M of the Internal Revenue Code. The Company’s taxable income therefore generally will not be subject to Federal taxation to the extent such taxable income is distributed to stockholders and the Company annually meets certain qualification and minimum distribution requirements. During the years ended December 31, 2007 and 2006, the Company recorded a tax provision of approximately $2,395 and $2,712, respectively. This tax provision is primarily related to unrealized gains on the Company’s investments.
Deferred income taxes subsequent to conversion to a business development company reflect taxes on built-in gains on equity investments, which amounted to $185, $377, and $377 at December 31, 2007, 2006, and 2005, respectively.
Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation, as gains or losses are not included in taxable income until they are realized. In addition, gains and losses realized for financial reporting purposes may differ from gains and losses included in taxable income due to the accrued dividends on preferred stock which increases the book basis but not tax basis of the Company’s investments.
In December 2007, the Company received an examination report from the Internal Revenue Service, or IRS, related to their audit of the Company’s tax returns for the 2004 and 2005 tax years. The IRS has proposed changes to certain deductions made by the Company for those years, most of which are related to the timing of certain realized losses in the portfolio. The Company is in the process of appealing the proposed changes, and the Company currently believes that it is more likely than not that the Company’s appeal will be successful. There can be no assurance that the Company’s appeal will be successful with respect to any or all of the changes proposed by the IRS. If the Company is not successful appealing the adjustments proposed by the IRS, the Company could be subject to penalties and interest of up to approximately $12,000.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
For income tax purposes, distributions paid to shareholders are reported as ordinary income, return of capital, capital gains, or a combination thereof. Distributions paid per common share for the years ended December 31, 2007, 2006, and 2005 were taxable as follows:
(a)
For 2007, 2006 and 2005, ordinary income is reported on Form 1099-DIV as either qualified or non-qualified and long term capital gains are reported on Form 1099-DIV in various sub-categories which have differing tax treatments to shareholders. Those subcategories have not been shown here.
(b)
Return of capital refers to those amounts reported as nontaxable distributions on Form 1099-DIV.
On a tax basis, distributions to stockholders in 2007 were $92,476 of ordinary income and $13,362 of long term capital gains, and in 2006 were $53,020 of ordinary income and $35,204 of return of capital.
The following table is a reconciliation of GAAP net income to taxable net income for the years ended December 31, 2007 and 2006:
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Note 7-Commitments and Contingencies
MCG is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of customers. These instruments include commitments to extend credit and involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. MCG attempts to limit its credit risk by conducting extensive due diligence and obtaining collateral where appropriate.
Commitments to extend credit include the unused portions of commitments that obligate the Company to extend credit in the form of loans, participations in loans or similar transactions. Commitments to extend credit would also include loan proceeds the Company is obligated to advance, such as loan draws, rotating or revolving credit arrangements, or similar transactions. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the counterparty. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
The balance of unused commitments to extend credit was $85,381 and $71,581 at December 31, 2007 and 2006, respectively. The estimated fair value of these commitments reflects the amount MCG would have to pay a counterparty to assume these obligations and was $427 and $358 at December 31, 2007 and 2006, respectively. These amounts were estimated as the amount of fees currently charged to enter into similar agreements, taking into account the present creditworthiness of the counterparties.
From time to time, the Company provides guarantees or standby letters of credit on behalf of its portfolio companies. As of December 31, 2007 and 2006, the Company had guarantees and standby letters of credit of approximately $7,530 and $9,480, respectively.
Certain premises are leased under agreements which expire at various dates through 2013. Total rent expense amounted to $1,685, $1,541, and $1,758 during the years ended December 31, 2007, 2006, and 2005, respectively.
Future minimum rental commitments as of December 31, 2007 for all non-cancelable operating leases with initial or remaining terms of one year or more were as follows:
The Company is also a party to certain legal proceedings incidental to the normal course of its business including the enforcement of its rights under contracts with its portfolio companies. While the outcome of these legal proceedings cannot at this time be predicted with certainty, the Company does not expect that these proceedings will have a material effect upon the Company’s financial condition or results of operations.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Note 8-Concentrations of Investment Risk
At December 31, 2007, the Company’s ten largest customers represented approximately 39.9% of the total fair value of the Company’s investments and accounted for approximately 38.0% of the Company’s total revenue during the year ended December 31, 2007. At December 31, 2007, approximately 19.1% of the Company’s portfolio at fair value was invested in companies in the communications industry, of which 16.5% were in competitive local exchange carriers, or CLECs. The Company’s remaining investments in the communications industry include telecommunications tower companies, rural local exchange carriers, Internet service providers, wireless companies and security alarm companies. Two of the Company’s customers, which the Company controls, Broadview Networks Holdings, Inc. (“Broadview”) and Cleartel Communications, Inc. (“Cleartel”) are CLEC’s.
Broadview, a CLEC serving primarily business customers, is the Company’s largest portfolio investment, in which the Company holds preferred stock with an aggregate fair value of $189,537 at December 31, 2007. The Company’s Broadview investment represented approximately 12.2% of the fair value of the Company’s total investments at December 31, 2007 compared to 12.7% of the fair value of the Company’s total investments at December 31, 2006. Additionally, the Company’s investment in Broadview accounted for $29.8 million, or 15.9%, of the Company’s total revenue for the year ended December 31, 2007 compared to $22.3 million, or 14.5%, of the Company’s total revenue for the year ended December 31, 2006.
The Company’s investment in Broadview entitles MCG to total preferred claims of approximately $266.9 million, prior to any claims by common shareholders. The Company is also entitled to accumulating dividends on the Company’s preferred stock investment, which accumulate and compound quarterly at an annual rate of 12% on $266.9 million but are not payable in cash on a current basis. Because accumulating dividends are typically not considered as part of taxable income until they are received in cash, it is possible that the Company’s GAAP earnings may exceed the Company’s taxable earnings by a significant amount until such time as this investment is liquidated.
In December 2007, Broadview filed a registration statement on Form S-1 to register shares for an initial public offering (“IPO”) of equity securities. In the event Broadview is successful with their IPO, MCG will be required to convert its yielding preferred stock, which represents an ownership interest of approximately 46% on an as-if-converted basis, into non-yielding common stock. This would materially reduce the Company’s dividend income from historical levels. In connection with an IPO by Broadview, MCG may sell a portion of its investment in Broadview, which could result in significant liquidity for MCG.
The Company’s ability to recognize income from the Company’s preferred stock investment in Broadview in future periods and the fair value of the Company’s preferred stock investment in Broadview will be dependent on the financial and operational performance of Broadview. In the event that the financial and operational performance of Broadview does not support the full recognition of income on the Company’s preferred stock investment, the Company’s dividend income could be materially reduced from historical levels.
At December 31, 2007, the Company’s Cleartel investment represented approximately 1.7% of the fair value of its total investments compared to 5.8% of the fair value of its total investments at December 31, 2006. The Company’s Cleartel investment represented a smaller portion of its total investments as a result of unrealized depreciation of $63,500 recorded on the Cleartel investment during 2007. Additionally, the Company’s investment in Cleartel accounted for zero of its total revenue for the year ended December 31, 2007, compared to $7,473, or 4.8%, of its total revenue for the year ended December 31, 2006. Cleartel was on non-accrual status during 2007.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Note 9-Share Based Compensation
Prior to January 1, 2006, the Company accounted for share based compensation in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Effective January 1, 2006, the Company adopted the FASB Statement No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123R”) using the modified prospective method. The adoption of SFAS No. 123R did not impact the Company’s net operating income before investment gains and losses, net income, cash flows from operations, cash flows from financing activities, or basic and diluted earnings per share. Effective January 1, 2006, unearned compensation amounts previously recorded as a separate component of equity on the Company’s balance sheet are included in paid-in capital.
In accordance with FAS 123R, the Company recognizes compensation cost related to share based awards for which forfeiture provisions are expected to lapse. The Company uses its historical forfeiture rate as a basis for its estimate of awards for which forfeiture provisions will lapse. The grant date is generally the date on which MCG and the employee reach a mutual understanding of the key terms and conditions of a share based award. The grant date fair value of the restricted share awards is based on the closing price of the Company’s common stock as reported on the NASDAQ Global Select Market on that date. For those awards subject to service conditions, the Company uses the straight line method over the entire service period. During June 2006, the 2006 Employee Restricted Stock Plan (“2006 Plan”) was approved by the Company’s shareholders. The Company may issue up to 3,500 shares under the 2006 Plan. Awards granted under the 2006 Plan may be subject to service, performance, or market conditions as specified in the award agreements.
In 2001, MCG terminated its stock option plan and the option grants made thereunder. In connection with the termination of its stock option plan, MCG issued approximately 1,540 shares of restricted stock, for which forfeiture provisions have not lapsed with respect to approximately 9 as of December 31, 2007. During 2006, the Company granted 483 restricted shares under the 2006 Plan. Of these 483 restricted shares, forfeiture provisions lapsed with respect to 83 immediately upon issuance, and forfeiture provisions will lapse with respect to 300 on a quarterly basis from December 31, 2006 through December 31, 2009, subject to service conditions of continued employment with the Company, while forfeiture provisions will lapse with respect to the other 100 annually on September 1, 2007 and September 1, 2008, subject to service conditions of continued employment with the Company. Of the 483 restricted shares granted in 2006, forfeiture provisions have not lapsed on approximately 385 at December 31, 2007.
During the year ended December 31, 2007 the Company granted approximately 936 restricted shares under the 2006 Employee Restricted Stock Plan. The forfeiture provisions will lapse quarterly with respect to 836 of these restricted shares though September 30, 2011. The remaining 100 of these restricted shares are subject to both time-and performance-based forfeiture provisions that lapse annually through February 28, 2008. During the year ended December 31, 2007, approximately 12 restricted shares were forfeited.
During the years ended December 31, 2007 and 2006, the Company recognized compensation expense related to share-based awards in the amount of $9,277 and $4,514, respectively. Included in this amount are dividends of approximately $253 and $1,045 that were paid on shares securing non-recourse employee loans. At December 31, 2007, all the restricted share awards for which forfeiture provisions have not lapsed carried non-forfeitable dividend rights to the holder of the restricted shares. Dividends paid on restricted shares for which forfeiture provisions are expected to lapse are charged to retained earnings while dividends paid on restricted shares for which forfeiture provisions are not expected to lapse are charged to compensation expense. During the year ended December 31, 2007, no dividends paid on restricted stock for which forfeiture provisions
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
have not lapsed were charged to compensation expense as forfeiture provisions are expected to lapse with respect to all such shares. At December 31, 2007, total unrecognized compensation cost related to restricted stock granted to employees was approximately $15,493 and is expected to be recognized over a weighted average remaining requisite service period of approximately 2.4 years.
Non-Employee Director Share Based Compensation
During June 2006, the 2006 Non-Employee Director Restricted Stock Plan (“2006 Non-Employee Plan”) was approved by the Company’s shareholders. The Company may issue up to 100 shares under the 2006 Non-Employee Plan. During the years ended December 31, 2007 and 2006, the Company granted 20 and 25, respectively, restricted shares under the 2006 Non-Employee Plan to certain non-employee directors. Forfeiture provisions will lapse with respect to these restricted shares annually each March 31 from 2007 to 2009. This compensation cost is considered part of the general compensation to these non-employee directors and, therefore, is included as a component of general and administrative expenses on the Company’s Consolidated Statement of Operations for the years ended December 31, 2007 and 2006. At December 31, 2007, total unrecognized compensation cost related to restricted stock granted to non-employee directors was approximately $371 and is expected to be recognized over a weighted average remaining requisite service period of approximately 2.3 years.
The following table summarizes the Company’s restricted stock award activity during the year ended December 31, 2007:
Note 10-Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per common share for the years ended December 31, 2007, 2006, and 2005:
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
For purposes of calculating earnings per common share, shares of restricted common stock for which forfeiture provisions have not lapsed and are solely based on passage of time are included in diluted earnings per common share based on the treasury stock method. Shares of restricted common stock for which forfeiture provisions have not lapsed and are based on performance criteria are included in diluted earnings per common share when it becomes probable such criteria will be met and is calculated using the treasury stock method.
Note 11-Selected Quarterly Data (Unaudited)
The following tables set forth certain quarterly financial information for each of the eight quarters ended with the quarter ended December 31, 2007. This information was derived from our unaudited consolidated financial statements. Results for any quarter are not necessarily indicative of results for the full year or for any future quarter.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
Note 12-Financial Highlights
Following is a schedule of financial highlights for the years ended December 31, 2007, 2006, 2005, 2004 and 2003:
(a)
Based on total shares outstanding.
(b)
Based on average shares outstanding.
(c)
The effect on distributions of stock offerings after record dates represents the effect on net asset value of issuing additional shares after the record date of a distribution.
MCG Capital Corporation
Notes to Consolidated Financial Statements-(Continued)
(in thousands, except per share data)
(d)
The Dilutive effect of share issuances, issuance of restricted stock and restricted stock subject to forfeiture provision represents the effects of shares issued during the period and the lapsing of forfeiture provisions on restricted stock on earnings per share.
(e)
Total return equals the change in the ending market value over the beginning of period price per share plus dividends paid per share during the period, divided by the beginning price.
Note 13-Subsequent Events
On January 8, 2008, the Company amended its Revolving Credit Facility with Bayerische Hypo-Und Vereinsbank, AG, New York Branch (“HVB”). Pursuant to this amendment, the aggregate revolving commitment amount under this credit facility was increased from $100,000 to $130,000, and an additional lender was added to this facility. Chevy Chase Bank increased its commitment from $10,000 to $15,000. HVB, Sovereign Bank and Royal Bank of Canada maintained their $50,000, $15,000 and $25,000 commitments, respectively. The additional $25,000 was committed by SunTrust Bank.
On February 12, 2008, the Company entered into the second amendment to its Commercial Loan Trust 2006-2 warehouse credit facility with Merrill Lynch Capital Corp. Pursuant to the amendment, the maturity date for the facility was extended from February 29, 2008 through August 31, 2008. In addition, the amendment provides for the reduction of the outstanding amount under the facility, with not more than $82,500 outstanding on April 21, 2008, not more than $55,000 outstanding on May 31, 2008, and not more than $27,500 outstanding on July 21, 2008, with the balance due on August 31, 2008. After February 29, 2008, the advance rate under the facility is reduced from 75% to 70% for non-senior loans but remains at 75% for senior loans, and the interest rate for advances increases from LIBOR plus 0.75% to LIBOR plus 1.5%. Additionally, MCG has paid a modification fee of $250 to Merrill Lynch Capital Corp.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
1.
Disclosure Controls and Procedures
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934). Based on that evaluation, our Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer have concluded that our disclosure controls and procedures are effective in timely alerting them of material information relating to us that is required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934.
2.
Internal Control Over Financial Reporting
a.
Management’s Annual Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934 and for the assessment of the effectiveness of internal control over financial reporting.
Management’s report on internal control over financial reporting is set forth under the heading “Management’s Report on Internal Control over Financial Reporting” in this Annual Report.
b.
Attestation Report of the Registered Public Accounting Firm
Our independent registered public accounting firm, Ernst & Young LLP has issued an attestation report on our internal control over financial reporting, which is included at the beginning of Part II, Item 8 of this Annual Report on Form 10-K.
c.
Changes in Internal Control Over Financial Reporting
There have been no changes in MCG’s internal control over financial reporting that occurred during the quarter ended December 31, 2007 that have materially affected, or are reasonably likely to materially affect, MCG’s internal control over financial reporting.
Item 9 B.
Item 9 B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers, and Corporate Governance
The information with respect to our directors, executive officers and corporate governance matters is contained under the captions “Proposal I : Election of Directors,” “Information about Executive Officers who are not Directors,” “Compensation of Executive Officers and Directors” and “Certain Relationships and Transactions,” in our definitive Proxy Statement for the 2008 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 and is incorporated in this Annual Report by reference in response to this item.
We have adopted a code of business conduct and ethics that applies to directors, officers and employees. The code of business conduct and ethics is available on our website at http://www.mcgcapital.com. We will report any amendments to or waivers of a required provision of the code of business conduct and ethics on our website or in a Form 8-K.
Item 11.
Item 11. Executive Compensation
The information with respect to compensation of executives and directors is contained under the caption “Compensation of Executive Officers and Directors” in our definitive Proxy Statement for the 2008 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 and is incorporated in this Annual Report by reference in response to this item.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information with respect to security ownership of certain beneficial owners and management is contained under the captions “Compensation of Executive Officers and Directors” and “Security Ownership of Certain Beneficial Owners and Management” in our definitive Proxy Statement for the 2008 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 and is incorporated in this Annual Report by reference in response to this item.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information with respect to certain relationships and related transactions is contained under the captions “Proposal I: Election of Directors” and “Certain Relationships and Transactions” in our definitive Proxy Statement for the 2008 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act and is incorporated in this Annual Report by reference in response to this item.
Item 14.
Item 14. Principal Accountant Fees and Services
The information with respect to principal accountant fees and services is contained under the captions “Proposal II: Ratification of Selection of Independent Auditors” and “Principal Accountant Fees and Services” in our definitive Proxy Statement for the 2008 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 and is incorporated in this Annual Report by reference to this item.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
1.
The following financial statements are filed herewith
Management’s Report on Internal Control over Financial Reporting
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2007 and 2006
Consolidated Statements of Operations for the years ended December 31, 2007, 2006 and 2005
Consolidated Statements of Changes in Net Assets for the years ended December 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005
Consolidated Schedule of Investments as of December 31, 2007
Consolidated Schedule of Investments as of December 31, 2006
Notes to Consolidated Financial Statements
2.
The following financial statement schedules are filed herewith
Schedule 12-14 Investments in and Advances to Affiliates.
3.
Exhibits required to be filed by Item 601 of Regulation S-K.
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
MCG Capital Corporation
We have audited the consolidated financial statements of MCG Capital Corporation, including the consolidated schedule of investments, as of December 31, 2007 and 2006, and for each of the three years in the period ended December 31, 2007, and have issued our report thereon dated February 27, 2008 (included elsewhere in the Form 10-K). Our audits also included the financial statement schedule listed in Item 15 of this Form 10-K. This schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion based on our audits.
In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP
McLean, Virginia
February 27, 2008
Schedule 12-14
MCG Capital Corporation
Schedule of Investments in and Advances to Affiliates
This schedule should be read in conjunction with the Company’s Consolidated Financial Statements, including the Consolidated Schedule of Investments and Note 2 to the Consolidated Financial Statements.
(1) Common stock, warrants, options, and equity interests are generally non-income producing and restricted. In some cases, preferred stock may also be non-income producing. The principal amount for debt and the number of shares of common stock and preferred stock is shown in the Consolidated Schedule of Investments as of December 31, 2007.
(2) Gross additions include increases in investments resulting from new portfolio company investments, paid-in-kind interest or dividends, the amortization of discounts and fees, and the exchange of one or more existing securities for one or more new securities. Gross additions also include net increases in unrealized appreciation or net decreases in unrealized depreciation.
(3) Gross reductions include decreases in investments resulting from principal collections related to investment repayments or sales and the exchange of one or more existing securities for one or more new securities. Gross reductions also include net increases in unrealized depreciation or net decreases in unrealized appreciation.
(4) Debt is on non-accrual status at December 31, 2007, and is therefore considered non-income producing.
(5) Represents the total amount of interest or dividends credited to income for the portion of the year an investment was a control investment (more than 25% owned) or an affiliate investment (5% to 25% owned), respectively.
** Information related to the amount of equity in the net profit and loss for the period for the investments listed has not been included in this schedule. This information is not considered to be meaningful due to the complex capital structures of the portfolio companies, with different classes of equity securities outstanding with different preferences in liquidation. These investments are not consolidated, nor are they accounted for under the equity method of accounting.
Listed below are the exhibits which are filed as part of this report (according to the number assigned to them in Item 601 of Regulation S-K):
++
Filed Herewith
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on February 28, 2008.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report on Form 10-K has been signed below by the following persons on behalf of the Registrant in the capacities, and on the dates indicated.