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As filed with the Securities and Exchange Commission on March 29, 1999
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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 814-00149
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AMERICAN CAPITAL STRATEGIES, LTD.
Delaware 52-1451377
- - ------------------------------- ----------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
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3 Bethesda Metro Center
Suite 860
Bethesda, Maryland 20814
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(Address of principal executive offices)
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(301) 951-6122
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(Registrant's telephone number, including area code)
Securities to be registered pursuant to Section 12(b) of the Act: Not Applicable
Securities registered pursuant to section 12(g) of the Act:
Name of each exchange
Title of each class on which registered
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Common Stock, $0.01 par value per share NASDAQ Stock Market
Indicate by check mark whether the registrant (1) has filed all reports
to be filed by Section 13 of 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter earlier period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [ X ]. No [ ].
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
On March 16, 1999, the aggregate market value of the Registrant's
common stock held by nonaffiliates of the Registrant was approximately
$177,637,809 based upon a closing price of the Registrant's common stock of
$17.25 per share as reported on the NASDAQ Stock Market on that date. (For this
computation, the registrant has excluded the market value of all shares of its
Common Stock reported as beneficially owned by executive officers and directors
of the registrant and certain other stockholders; such an exclusion shall not be
deemed to constitute an admission that any such person is an "affiliate" of the
registrant.) On March 16, 1999, there were 11,106,105 shares of the Registrant's
common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE. The Company's definitive proxy
statement for the Annual Meeting of Stockholders to be held on May 6, 1999 is
incorporated by reference into certain sections of Part III herein.
Certain exhibits previously filed with the Securities and Exchange
Commission are incorporated by reference into Part IV of this report.
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PART I
Item 1. Business of the Company
Background
American Capital Strategies, Ltd., a Delaware corporation (the
"Company"), was incorporated in 1986 to provide financial advisory services to
and invest in middle market companies. On August 29, 1997, the Company completed
an initial public offering ("IPO") of 10,382,437 shares of its common stock
("Common Stock") and became a non-diversified, closed end investment company
that has elected to be treated as a business development company ("BDC") under
the Investment Company Act of 1940, as amended ("1940 Act"). On October 1, 1997,
the Company began operations so as to qualify to be taxed as a regulated
investment company ("RIC") as defined in Subtitle A, Chapter 1, under Subchapter
M of the Internal Revenue Code of 1986 as amended (the "Code"). As contemplated
by these transactions, the Company materially changed its business plan and
format from structuring and arranging financing for buyout transactions on a fee
for services basis to primarily being a lender to and investor in middle market
companies. The Company continues to provide financial advisory services to
businesses through ACS Capital Investments Corporation ("CIC"), a wholly-owned
subsidiary. The Company had established itself as a leading firm in structuring
and obtaining funding for management and employee buyouts of subsidiaries,
divisions and product lines being divested by larger corporations through the
use of employee stock ownership plans ("ESOPs"). From its formation in 1986
through the IPO, the Company arranged 29 financing transactions aggregating over
$400 million. From the IPO through December 31, 1998, the Company has invested
$150 million in debt and equity securities of middle market companies.
Business
The Company is a buyout and specialty finance company that is
principally engaged in providing senior debt, subordinated debt and equity to
middle market companies in need of capital for management buyouts including ESOP
buyouts, growth, acquisitions, liquidity and restructuring. The Company invests
up to $20 million in each transaction and through its subsidiary, CIC, will
arrange and secure capital for larger transactions. The Company's primary
business objectives are to increase its net operating income and net asset value
by investing its assets in senior debt, subordinated debt with detachable
warrants and equity of middle market companies with attractive current yields
and potential for equity appreciation. The Company's loans typically range from
$3 million to $20 million, mature in five to ten years, and require monthly or
quarterly interest payments at fixed rates or variable rates based on the prime
rate or LIBOR, plus a margin. The Company prices its debt and equity investments
based on its analysis of each transaction. As of December 31, 1998 the weighted
average effective yield on the Company's investments was 13.0%.
In most cases, the Company receives the right to require the business
to purchase the warrants or stock held by the Company ("Put Rights") under
various circumstances including, typically, the repayment of the Company's loans
or debt securities. When no public offering is available, the Company may use
its Put Rights to dispose of its equity interest in a business, although the
Company's ability to exercise Put Rights may be limited or nonexistent if a
business is illiquid. In most cases the Company also receives the right to
representation on the businesses' board of directors. At December 31, 1998, the
Company had board seats on 14 out of 18 businesses and had board observation
rights on 2 of the remaining businesses in which it has made investments.
The Company's equity interests in middle market companies are purchased
with the goal of disposing of such interests and realizing a gain within three
to seven years. The opportunity to realize such gain may occur if the Company
exercises its Put Rights, the business recapitalizes its equity, either through
a sale to new owners or a public offering of its equity. The Company generally
does not have the right to require that a business undergo an initial public
offering by registering securities under the Securities Act of 1933, but the
Company generally does have the right to sell its equity interests in a public
offering by the business to the extent permitted by the underwriters.
The Company makes available significant managerial assistance to its
portfolio companies. Such assistance typically involves closely monitoring the
operations of the company, participating in its board and management meetings,
being available for consultation with its officers and providing organizational
and financial guidance. Providing assistance to its borrowers serves as a means
of influence for the Company as well as an opportunity for the Company to assist
in maximizing the operations of the borrower.
Prior to the IPO, the Company established itself as a leading firm in
structuring and obtaining funding for management and employee buyouts of
subsidiaries, divisions and product lines being divested by larger corporations
through the use of an ESOP. The selling entities have included Sunbeam
Corporation, the U.S. Office of Personnel Management, American Premier
Underwriters, Inc. (formerly Penn Central Corporation), Campbell Soup Company,
Union Carbide Corporation, National Forge Company, Inc., Air Products Company,
Ampco-Pittsburgh Corporation and British Petroleum Company. In most of the ESOP
transactions structured by
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the Company, the employees agree to restructure their wages and benefits so that
overall cash compensation is reduced while contributions of stock are made to an
ESOP. The resulting company is structured so that the fair market value of stock
contributed to the ESOP can be deducted from corporate income before paying
taxes. Restructuring employee compensation together with the ESOP tax advantages
has the effect of improving the cash flow of the ESOP company. The Company
believes that its ESOP knowledge and experience and its ability to fund
transactions positions the Company favorably in the market place.
The Company provides financial advisory services and structuring of
transactions through its wholly-owned subsidiary CIC. The typical advisory
engagement includes a monthly retainer and a performance fee contingent upon
closing of the transaction or event which is the subject of the engagement.
Management believes that future growth of CIC is attainable through adding
additional professionals, by gaining additional market share and by realizing
the benefits of what is expected to be an increasing client base, which should
expand as a result of its relationship with the Company.
The Company believes that, through the structuring and advisory
business, it has established an extensive referral network comprised of venture
capitalists, investment bankers, attorneys, accountants, commercial bankers,
unions, business and financial brokers, and prospective or existing ESOP
companies. The Company has also developed an extensive internet site that
generates financing requests and provides businesses an efficient tool for
learning about the Company and its capabilities. The Company has a vice
president of marketing dedicated to maintaining contact with members of the
referral network and receiving opportunities for the Company to consider. During
1998, the vice president of marketing received in excess of 1,500 transactions
for consideration. Many of those transactions did not meet the Company's
criteria for initial consideration but the opportunities that met those criteria
were sent to the Company's principals for further review and consideration. The
vice president of marketing and CIC are continuing the relationships with the
referral network and the Company utilizes the referral network and CIC's client
base as its primary sources of investment opportunities. The Company also
anticipates hiring an additional marketing person during 1999.
Lending and Investment Decision Criteria
The Company reviews certain criteria in order to make investment
decisions. The criteria listed below provide a general guide for the Company's
lending and investment decisions, although not all criteria are required to be
favorable in order for the Company to make an investment.
Operating History. The Company focuses on target companies that have
stable operating histories and are profitable or near profitable at existing
operating levels. The Company reviews the target companies ability to service
and repay debt based on its historical results of operations. The Company
considers factors such as market shares, customer concentration, recession
history, competitive environment, and ability to sustain margins. The Company
does not expect to lend or invest in start-up or other early stage companies.
Growth. The Company considers a target company's ability to increase
its cash flow. Anticipated growth is a key factor in determining the value
ascribed to any warrants and equity interests acquired by the Company.
Liquidation Value of Assets. Although the Company does not operate as
an asset-based lender, liquidation value of the assets collateralizing the
Company's loans is an important factor in each credit decision. Emphasis is
placed both on tangible assets (accounts receivable, inventory, plant, property
and equipment) as well as intangible assets such as customer lists, networks,
databases and recurring revenue streams.
Experienced Management Team. The Company requires that each borrower
have a management team that is experienced and properly incentivized through a
significant ownership interest in the borrower. The Company requires that a
potential recipient of the Company's financing have a management team who have
demonstrated the ability to execute the company's objectives and implement its
business plan.
Exit Strategy. Prior to making an investment, the Company analyzes the
potential for the target company to experience a liquidity event that will allow
the Company to realize value for its equity position. Liquidity events include,
among other things, a private sale of the Company's financial interest, a sale
of the company, an initial public offering, or a purchase by the company or one
of its stockholders of the Company's equity position.
Operations
Marketing and Origination Process. The Company and CIC have twenty four
professionals responsible for originating loans and investments and providing
financial assistance to middle market companies and intends to hire an
additional three to six professionals by December 31, 1999. To originate
financing opportunities, these professionals use an extensive referral network
3
comprised of venture capitalists, investment bankers, unions, attorneys,
accountants, commercial bankers, business and financial brokers and prospective
or existing ESOP companies. The Company also has an extensive set of internet
sites that it uses to attract financing opportunities.
Approval Process. The Company's financial professionals review
informational packages in search of potential financing opportunities and
conduct a due diligence investigation of each applicant that passes an initial
screening process. This due diligence investigation generally includes one or
more on-site visits, a review of the company's historical and prospective
financial information, interviews with management, employees, customers and
vendors of the applicant, and background checks and research on the applicant's
product, service or particular industry. The Company engages professionals such
as environmental consultants, accountants, lawyers, risk managers, and
management consultants to perform elements of the due diligence review as it
deems appropriate. Upon completion of a due diligence investigation, one of the
Company's principals creates a profile summarizing the target company's
historical and projected financial statements, industry and management team and
analyzing its conformity to the Company's general investment criteria. The
principal then presents this profile to the Company's Investment Committee,
which is comprised of Malon Wilkus, David Gladstone and Adam Blumenthal, the
Chairman, Vice Chairman and Executive Vice President, respectively, of the
Company. The Company's Investment Committee and the Company's Board of Directors
must approve each financing.
Portfolio Management. In addition to the review at the time of original
underwriting, the Company attempts to preserve and enhance the earnings quality
of its portfolio companies through proactive management of its relationships
with its clients. This process includes attendance at portfolio company board
and management meetings, management consultation, and review and management of
covenant compliance. The Company's investment and finance personnel regularly
review portfolio company financial statements to assess cash flow performance
and trends, periodically evaluate the operations of the client, seek to identify
industry or other economic issues that may adversely affect the client, and
prepare periodic summaries of the aggregate portfolio quality for management
review.
Support Services. A commercial bank provides certain administrative
services for the Company's investments and also acts as the custodian of the
Company's portfolio assets pursuant to and in accordance with the 1940 Act.
Loan Grading
The Company has implemented a system to evaluate and classify all loans
based on their current risk profile. The system requires each principal to grade
a loan on a scale of one to four. Loans graded four involve the least amount of
risk of loss, while loans graded one have an unacceptable level of risk and a
high probability of loss. The loan grade is then reviewed and approved by the
senior management of the Company and the board of directors. This system is
intended to reflect the performance of the borrower's business, the collateral
coverage of the loans and other factors considered relevant. For more
information regarding the Company's loan grading practices, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Portfolio Credit Quality."
Competition
The Company's primary competitors include financial institutions,
buyout and venture capital firms and other nontraditional lenders. Many of these
entities have greater financial and managerial resources than the Company.
Nevertheless, the Company believes that it competes effectively with these
entities through, among other means, its responsiveness to the needs of its
customers and its flexibility in structuring transactions.
Employees
As of March 1, 1999, the Company had thirty-one employees, twenty-four
of whom are professionals working on financings for middle market companies. The
Company believes that the relations with its employees are excellent.
4
The Company's Operations as a BDC and RIC
As a BDC, the Company may not acquire any asset other than Qualifying
Assets unless, at the time the acquisition is made, Qualifying Assets represent
at least 70% of the value of the Company's total assets. The principal
categories of Qualifying Assets relevant to the business of the Company are the
following:
(i) securities purchased in transactions not involving any public
offering from the issuer of such securities, which issuer is
an eligible portfolio company. An eligible portfolio company
is defined as any issuer that (a) is organized and has its
principal place of business in the United States, (b) is not
an investment company other than a small business investment
company wholly-owned by the BDC, and (c) does not have any
class of publicly-traded securities with respect to which a
broker may extend credit;
(ii) securities received in exchange for or distributed with
respect to securities described above, or pursuant to the
exercise of options, warrants or rights relating to such
securities; and
(iii) cash, cash items, Government securities, or high quality debt
securities maturing in one year or less from the time of
investment.
The Company may not change the nature of its business so as to cease to
be, or withdraw its election as, a BDC unless authorized by vote of a majority,
as defined in the 1940 Act, of the Company's shares. Since the Company made its
BDC election, it has not made any substantial change in its structure or in the
nature of its business.
The Company operates so as to qualify as a RIC under the Code.
Generally, in order to qualify as a RIC, the Company must distribute to
shareholders in a timely manner, at least 90% of its "investment company taxable
income" as defined by the Code. The Company must derive at least 90% of its
gross income from dividends, interest, payments with respect to securities
loans, gains from the sale of stock or other securities, or other income derived
with respect to its business of investing in such stock or securities as defined
by the Code. Additionally, the Company must diversify its holdings so that (i)
at least 50% of the value of the Company's assets consists of cash, cash items,
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
Company's assets and 10% of the outstanding voting securities of the issuer and
(ii) no more than 25% of the value of the Company's assets are invested in the
securities of one issuer (other than U.S. government securities and securities
of other RICs), or of two or more issuers that are controlled by the Company and
are engaged in the same or similar or related trades or businesses. The Company
must, in order to avoid federal corporate income tax, annually distribute all of
its investment company taxable income and net capital gains. The Company must
distribute each calendar year at least 98% of its "ordinary income" and "capital
gain net income" as defined in the Code to avoid a 4% federal excise tax on
distributed income.
Temporary Investments
Pending investment in other types of Qualifying Assets, the Company has
invested its otherwise uninvested cash primarily in cash, cash items, government
securities, agency paper or high quality debt securities maturing in one year or
less from the time of investment in such high quality debt investments
("Temporary Investments") so that at least seventy percent (70%) of its assets
are Qualifying Assets. Typically, the Company invests in U.S. Treasury bills.
Additionally, the Company may invest in repurchase obligations of a "primary
dealer" in government securities (as designated by the Federal Reserve Bank of
New York) or of any other dealer whose credit has been established to the
satisfaction of the Board of Directors. There is no percentage restriction on
the proportion of the Company's assets that may be invested in such repurchase
agreements. A repurchase agreement involves the purchase by an investor, such as
the Company, of a specified security and the simultaneous agreement by the
seller to repurchase it at an agreed upon future date and at a price which is
greater than the purchase price by an amount that reflects an agreed-upon
interest rate. Such interest rate is effective for the period of time during
which the investor's money is invested in the arrangement and is related to
current market interest rates rather than the coupon rate on the purchased
security. The Company requires the continual maintenance by its custodian or the
correspondent in its account with the Federal Reserve/Treasury Book Entry System
of underlying securities in an amount at least equal to the repurchase price. If
the seller were to default on its repurchase obligation, the Company might
suffer a loss to the extent that the proceeds from the sale of the underlying
securities were less than the repurchase price. A seller's bankruptcy could
delay or prevent a sale of the underlying securities.
Leverage
For the purpose of making investments and to take advantage of
favorable interest rates, the Company has issued, and intends to continue to
issue, senior debt securities, up to the maximum amount permitted by the 1940
Act, which currently permits the Company, as a BDC, to issue senior debt
securities and preferred stock (collectively, "Senior Securities") in amounts
such that the Company's asset coverage, as defined in the 1940 Act, is at least
200% after each issuance of Senior Securities. Such indebtedness may also be
incurred for the purpose of effecting share repurchases. As a result, the
Company is exposed to the risks of leverage.
5
Although the Company has no current intention to do so, it has retained the
right to issue preferred stock. As permitted by the 1940 Act, the Company may,
in addition, borrow amounts up to five percent (5%) of its total assets for
temporary or emergency purposes.
Item 2. Properties
Neither the Company nor any of its subsidiaries owns any real estate or
other physical properties materially important to the operation of the Company
or any of its subsidiaries. The Company leases an aggregate of approximately
9,000 square feet of office space in two locations for terms ranging up to six
years.
Item 3. Legal Proceedings
Although the Company may, from time to time, be involved in litigation
and claims arising out of its operations in the normal course of business, as of
December 31, 1998, the Company was not presently a party to any material pending
legal proceedings.
Item 4. Submission of Matters to a Vote of Security Holders
During the fourth quarter of the fiscal year ended December 31,
1998, there were no matters submitted to a vote of the Company's security
holders through the solicitation of proxies or otherwise.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Since the IPO, the Company has distributed, and currently intends to
continue to distribute in the form of dividends, a minimum of 90% of its net
operating income and 98% of its net realized short-term capital gains, if any,
on a quarterly basis to its stockholders. Net realized long-term capital gains
may be retained to supplement the Company's equity capital and support growth in
its portfolio, unless the Board of Directors determines in certain cases to make
a distribution. There is no assurance that the Company will achieve investment
results or maintain a tax status that will permit any specified level of cash
distributions or year-to-year increases in cash distributions.
The Company's Common Stock is quoted on the Nasdaq Stock Market under
the symbol ACAS. As of March 16, 1999, the Company had 163 stockholders of
record and approximately 4,500 beneficial owners. The following table sets forth
the range of high and low sales prices of the Company's Common Stock as reported
on the Nasdaq Stock Market and the dividends declared by the Company for the
period from August 29, 1997, when public trading of the Common Stock commenced
pursuant to the IPO, through March 16, 1999.
Bid Price
Dividend
High Low Declared
---- --- --------
1997
Third Quarter (beginning August 29, 1997) $ 20.25 $ 18.50 $ 0.00
Fourth Quarter $ 20.75 $ 16.50 $ 0.21
1998
First Quarter $ 22.50 $ 17.25 $ 0.25
Second Quarter $ 24.63 $ 21.25 $ 0.29
Third Quarter $ 24.25 $ 10.13 $ 0.32
Fourth Quarter $ 18.44 $ 9.19 $ 0.48
1999
First Quarter (through March 16, 1999) $ 19.00 $ 14.00 $ 0.41
6
Item 6. Selected Financial Data
AMERICAN CAPITAL STRATEGIES, LTD.
Selected Financial Data
The selected financial data should be read in conjunction with the
Company's financial statements and notes thereto. As discussed in Notes 1 and 2,
the Company completed an initial public offering of its common stock on August
29, 1997 and on October 1, 1997 began to operate so as to qualify to be taxed as
a RIC. As a result of the changes, the financial results of the Company for
periods prior to October 1, 1997 are not comparable to periods commencing
October 1, 1997 and are not expected to be representative of the financial
results of the Company in the future.
(In thousands except per share data)
Three Months | | Nine Months
Year Ended Ended | | Ended Year Ended Year Ended Year Ended
December 31, December 31, | |September 30, December 31, December 31, December 31,
1998 1997 | | 1997 1996 1995 1994
------------ ------------ | |------------- ------------ ------------ ------------
Total operating income $ 16,979 $ 2,797 | | $ 2,901 $2,746 $2,706 $2,498
Total operating expenses 1,709 551 | | 2,651 2,862 2,928 2,606
| |
Operating income (loss) before equity in | |
(loss) earnings of unconsolidated operating | |
subsidiary 15,270 2,246 | | 250 (116) (222) (108)
Equity in (loss) earnings of unconsolidated | |
operating subsidiary (482) 24 | | -- -- -- --
| |
Net operating income (loss) 14,788 2,270 | | 250 (116) (222) (108)
Increase in unrealized appreciation on | |
investments 2,127 167 | | 5,321 484 371 956
Realized gain (loss) on investments -- -- | | -- -- 66 (23)
| |
Income before income taxes 16,915 2,437 | | 5,571 368 215 825
Provision for income taxes -- -- | | 2,128 159 57 422
| |
Net increase in shareholders' equity | |
resulting from operations 16,915 2,437 | | 3,443 209 158 403
| |
Per share data: | |
Net operating income: | |
Basic $ 1.34 $ 0.21 | |
Diluted $ 1.29 $ 0.20 | |
Net increase in shareholders' equity | |
resulting from operations: | |
Basic $ 1.53 $ 0.22 | |
Diluted $ 1.48 $ 0.21 | |
Cash dividends $ 1.34 $ 0.21 | |
| |
Balance Sheet Data: | |
Total assets $270,019 $150,705 | | $154,322 $5,432 $ 4,382 $3,930
Total shareholders' equity 152,723 150,652 | | 150,539 3,372 2,946 2,571
| |
Other Data: | |
Number of portfolio companies at period | |
end 15 3 | |
Principal amount of loan originations $116,864 $ 16,817 | |
Principal amount of loan repayments $ 1,719 $ 93 | |
Return on equity (1) (2) 11.2% 6.5% | |
Weighted average yield on investments | |
to date 13.0% 12.2% | |
(1) Amounts are annualized for the three months ended December 31, 1997.
(2) Return represents net increase in shareholders' equity resulting from
operations.
7
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATION
(In thousands except per share data)
Management's Discussion and Analysis of Financial Condition and Results of
Operations
All statements contained herein that are not historical facts
including, but not limited to, statements regarding anticipated activity are
forward looking in nature and involve a number of risks and uncertainties.
Actual results may differ materially. Among the factors that could cause actual
results to differ materially are the following: changes in the economic
conditions in which the Company operates negatively impacting the financial
resources of the Company; certain of the Company's competitors with
substantially greater financial resources than the Company reducing the number
of suitable investment opportunities offered to the Company or reducing the
yield necessary to consummate the investment; increased costs related to
compliance with laws, including environmental laws; general business and
economic conditions and other risk factors described in the Company's reports
filed from time to time with the Securities and Exchange Commission. The Company
cautions readers not to place undue reliance on any such forward looking
statements, which statements are made pursuant to the Private Securities
Litigation Reform Act of 1995 and, as such, speak only as of the date made.
The following analysis of the financial condition and results of
operations of the Company should be read in conjunction with the Company's
financial statements and the notes thereto. As discussed in Notes 1 and 2, the
Company completed an initial public offering ("IPO") of its common stock on
August 29, 1997 and on October 1, 1997 began to operate so as to qualify to be
taxed as a regulated investment company ("RIC"). After the IPO, the Company
changed its primary business plan and format from structuring and arranging
financing for buyout transactions on a fee for services basis to being a lender
to and investor in middle market companies. As a result of the changes, the
Company's predominant source of operating income has changed from financial
performance and advisory fees to interest and dividends earned from investing
the Company's assets in debt and equity of businesses. Additionally, pursuant to
RIC accounting requirements, effective October 1, 1997, the Company's accounting
for its operating subsidiary, ACS Capital Investments Corporation (CIC), changed
from a consolidated basis to the equity method. The financial results of the
Company for the periods through September 30, 1997 are not comparable to periods
commencing October 1, 1997 and are not expected to be representative of the
financial results of the Company in the future. Accordingly, those periods are
discussed separately.
Portfolio Composition
The Company's primary business is investing in and lending to
privately-owned businesses through investments in senior debt, subordinated debt
with detachable common stock warrants, preferred stock, and common stock. The
total portfolio value of investments in non-publicly traded securities was
$165,035 and $20,645 at December 31, 1998 and December 31, 1997, respectively.
During the year ended December 31, 1998 and the three months ended December 31,
1997, the Company made investments totaling $150,249, including $7,384 in funds
committed but undrawn under credit facilities, and $20,622, respectively. The
weighted average effective interest rate on the investment portfolio was 13.0%
and 12.2%, respectively, at December 31, 1998 and December 31, 1997. A summary
of the composition of the Company's portfolio of non-publicly traded securities
at December 31, 1998 and December 31, 1997 is shown in the following table:
December 31, 1998 December 31, 1997
----------------- -----------------
Senior debt 15.0% 27.7%
Subordinated debt 65.5% 53.5%
Convertible preferred stock 3.3% 11.2%
Common stock warrants 13.5% 7.6%
Common stock 2.7% --
The Company expects its portfolio composition in 1999 to be similar to
its portfolio composition at December 31, 1998. The Company will continue to
heavily weigh its portfolio composition toward investments in subordinated debt
with detachable warrants.
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The following table shows the portfolio composition by industry
grouping:
December 31, 1998 December 31, 1997
----------------- -----------------
Manufacturing 66.1% 52.8%
Media 9.1% --
Construction 10.0% --
Wholesale & Retail 7.4% 30.0%
Transportation 5.4% --
Service 2.0% 17.2%
Management expects that the largest percentage of its investments will
continue to be in manufacturing companies, however, the Company intends to
continue to diversify its portfolio and will explore new investment
opportunities in a variety of industries.
Results of Operations
The Company's financial performance, as reflected in its Statements of
Operations, is composed of four primary elements. The first element is "Net
operating income (loss)," which for periods prior to October 1, 1997 ("Pre-RIC")
is the difference between the Company's revenue earned from arranging financing
for middle market companies and other financial advisory work and its total
operating expenses including ESOP contributions, depreciation and interest
expense. For periods prior to October 1, 1997, ESOP contributions represented a
significant component of total operating expenses. All required contributions to
the Company's ESOP have been made by the Company, and further contributions will
be made at the discretion of the Company's Board of Directors. Net operating
income (loss) for periods commencing October 1, 1997 ("Post-RIC") is primarily
the interest and dividends earned from investing in debt and equity securities
and the equity in earnings of its unconsolidated operating subsidiary less the
operating expenses of the Company. The second element is "Change in unrealized
appreciation of investments," which is the net change in the estimated fair
value of the Company's portfolio assets at the end of the period compared with
their estimated fair values at the beginning of the period or their stated
costs, as appropriate. The third element is "Realized gain on investments,"
which reflects the difference between the proceeds from a sale or maturity of a
portfolio investment and the cost at which the investment was carried on the
Company's balance sheet. The fourth element is "Provision for income taxes,"
which reflects a statutory tax rate applied to the Company's GAAP pretax income
for pre-RIC periods. Actual taxes paid have historically been lower than the
provision primarily due to the temporary difference of the unrealized
appreciation of investments which has resulted in a deferred tax liability on
the pre-RIC balance sheet of CIC. For post-RIC periods, the Company intends to
operate so as to qualify to be taxed as a RIC. As long as the Company qualifies
as a RIC, it will be able to take a deduction against its otherwise taxable
income for certain dividends it pays, allowing it to substantially reduce or
eliminate its corporate-level tax liability. As a result, the provisions for
income taxes for post-RIC periods are expected to be minimal.
As discussed above, as a RIC, the Company is required to account for
investments in operating subsidiaries under the equity method, regardless of
ownership interest. Accordingly, the Company's investment in CIC, which prior to
RIC status was consolidated, is presented on the equity method effective October
1, 1997. Therefore, commencing on October 1, 1997, and consistent with the
equity method of accounting, the portfolio companies owned by CIC are not
reported separately by the Company.
9
The operating results for the year ended December 31, 1998 are as
follows:
Year Ended
December 31, 1998
-----------------
Operating income $16,979
Operating expenses 1,709
Equity in loss of unconsolidated operating subsidiary (482)
-------
Net operating income 14,788
Increase in unrealized appreciation of investments 2,127
-------
Net increase in shareholders' equity resulting from operations $16,915
=======
Total operating income consisted of $2,549 in loan processing fees and
$11,020 in interest and dividends on non-publicly traded securities and $3,410
in interest on government agency securities, bank deposits and repurchase
agreements. The loan fees were earned as result of closing fourteen investments
in private companies totaling $150 million during the year.
Operating expenses for the year consisted of $843 in salaries and
benefits, $809 in general and administrative expenses, and $57 in interest
expense.
Equity in loss of unconsolidated operating subsidiary represents CIC's
results. For the year ended December 31, 1998, CIC's results included $5,227 of
operating income, $6,451 of operating expenses, $481 of unrealized appreciation
of investments, and $202 in other income.
The increase in unrealized appreciation of investments as discussed in
Note 2 to the financial statements is based on portfolio asset valuations
determined by the Company's Board of Directors. The increase in unrealized
appreciation of investments for the year ended December 31, 1998 is $2,127,
which consists of valuation increases of $2,324 at nine portfolio companies and
valuation decreases of $197 at three portfolio companies.
The Post-RIC operating results for the three months ended December 31,
1997 are summarized as follows:
Three Months Ended
December 31, 1997
-----------------
Operating income $2,797
Operating expenses 551
Equity in earnings of unconsolidated operating subsidiary 24
------
Net operating income 2,270
Increase in unrealized appreciation of investments 167
------
Net increase in shareholders' equity resulting from operations $2,437
======
Total operating income consisted of approximately $700 in loan
processing fees and $200 in interest on non-publicly traded securities and
$1,900 in interest on government agency securities and overnight repurchase
agreements. The loan fees were earned as a result of closing three investments
in private companies totaling $21 million during the period.
Operating expenses for the period consisted of $243 in salaries and
benefits and $308 in general and administrative expenses.
Equity in earnings of unconsolidated operating subsidiary represents
CIC's results including the portfolio companies. For the three months ended
December 31, 1997, CIC's results included $414 of operating income, $987 of
operating expenses, $605 of unrealized appreciation of investment and $8 in tax
provisions.
10
The increase in unrealized appreciation of investments as discussed in Note 2 to
the financial statements is determined by the Company's Board of Directors. The
change in unrealized appreciation of investments for the three month period is
$167 which consists of an increase of $52 in the valuation of the government
agency securities and an increase of $115 in the valuation of the investments in
private companies.
The operating results for the nine months ended September 30, 1997
compared to nine months ended September 30, 1996.
Nine Months Ended
September 30,
1997 1996
---- ----
Operating income $2,901 $1,758
Operating expenses 2,651 1,921
------ ------
Net operating income 250 (163)
Increase in unrealized appreciation of investments 5,321 441
Provision for income taxes 2,128 109
------ ------
Net increase in shareholders' equity resulting from
operations $3,443 $ 169
====== ======
Total operating income was $2,901 for the nine months ended September
30, 1997, compared to $1,758 for the nine months ended September 30, 1996, a
65.0% increase. Financial advisory fees were $1,122 and $1,300 for the nine
months ended September 30, 1997 and 1996, respectively. The decline in financial
advisory fees was attributable to a relative increase in management attention to
engagements producing financial performance fees, and to the IPO. Financial
performance fees were $798 and $241 for the nine months ended September 30, 1997
and 1996, respectively. The increase in financial performance fees was
associated with the Company's successful completion of an engagement to advise
the Allied Pilots Association on the structuring of an employee option plan at
American Airlines. Other operating income was $428 and $265 for the nine months
ended September 30, 1997 and 1996, respectively. The increase in other operating
income was attributable to a higher level of expense reimbursement for the
Company. Included in total operating revenue for the nine months ended September
30, 1997 was interest income earned on investment securities and overnight
repurchase agreements of $553.
Total operating expenses for the nine months ended September 30, 1997
and 1996 were $2,651 and $1,921, respectively, an increase of 38.0%. Salaries
and benefits for the nine months ended September 30, 1997 and 1996, were $1,221
and $935, respectively, a 30.6% increase which was predominantly associated with
increased levels of staffing. General and administrative expenses for the nine
months ended September 30, 1997 and 1996, were $1,514 and $772, respectively, a
96.1% increase primarily associated with the increased use of consultants by the
Company. The increase in other expenses is attributable to a variety of expenses
associated with potential transactions. For the nine months ended September 30,
1997 and 1996, interest expense was $60 and $21, respectively. The increase in
interest expense relates to the Company's increased levels of working capital
for the period in 1997 prior to the initial public offering.
During the nine months ended September 30, 1997, the Company changed
its evaluation of collectibility of a receivable from Martino's Bakery, Inc. due
to Martino's improved financial condition, restructuring of repayment terms, and
subsequent payment history. Therefore, the Company recorded a reversal in its
provision for doubtful accounts totaling $177. During the nine months ended
September 30, 1996, the Company had accrued $164 as a provision for doubtful
accounts related to two companies, one of which was Martino's Bakery, Inc.
For the nine months ended September 30, 1997 and 1996, the Company
recorded net increases in unrealized appreciation of investments in its
portfolio companies of $5,321 and $441, respectively. Included in unrealized
appreciation of investments during the first nine months of 1997 was $4,400
associated with the acquisition of Biddeford Textile Company, formerly the
blanket operation of the electric blanket manufacturing division of Sunbeam
Products, Inc. Also included in unrealized appreciation of investments during
the first nine months of 1997 was appreciation of $731 associated with the
Company's investment in Mobile Tool International, Inc., appreciation of $356
associated with Four S Baking Company, Inc., and depreciation of $138 associated
with Martino's Bakery, Inc.
11
The following table sets forth the components of the increase in
unrealized appreciation of investments for the nine months ended September 30,
1997 and 1996:
Nine Months Ended
September 30,
1997 1996
---- ----
Government Securities $ (27) $ --
Erie Forge and Steel, Inc -- 153
Four S Baking Company, Inc 355 (54)
Indiana Steel & Wire Corporation -- 7
Martino's Bakery, Inc. (138) 143
Mobile Tool International, Inc. 731 192
Biddeford Textile Corporation 4,400 --
------ -----
Increase in unrealized appreciation of investments $5,321 $ 441
====== =====
The Company recorded provisions for income taxes for the nine months
ended September 30, 1997 and 1996 of $2,129 and $109, respectively. Unrealized
appreciation (depreciation) of investments does not affect the actual tax paid
by the Company. However, under GAAP, the Company provides for income taxes based
on its GAAP pretax income, which includes unrealized appreciation (depreciation)
of investments. Actual income taxes paid may differ substantially from the
provision for income taxes. The Company accounted for this difference by
recognition of a deferred tax liability in the Pre-RIC balance sheet of CIC.
Year Ended
December 31, 1996
-----------------
Operating income $2,746
Operating expenses excluding ESOP contribution 2,645
ESOP contribution 216
------
Total operating expenses 2,861
------
Net operating loss before investment activity (115)
Increase in unrealized appreciation of investments 483
Provision for income taxes 159
------
Net increase in shareholders' equity resulting from operations $ 209
======
Operating income consists predominantly of financial advisory fees and
financial performance fees. During 1996, financial advisory fees and financial
performance fees constituted 86.9% of total revenue.
Total operating expenses at the Company were $2,861 in 1996. Salaries
and benefits, excluding ESOP contributions, were $1,067 in 1996. General and
administrative and other expenses were $1,282 in 1996.
The Company's interest expense was $33 in 1996. Interest expense is
primarily associated with credit facilities used by the Company to support its
working capital requirements and to finance a portion of its investments in
middle market companies. The Company's total borrowings under these facilities
were approximately $430 at December 31, 1996. In addition, the Company had a
note payable to its President in the amount of $74 at December 31, 1996. During
1996, the Company has paid interest on its debt obligations to unrelated parties
at rates ranging from 1.5% above the lender's base rate of interest to 3% above
such rate. The rate of interest on the Company's note payable to its President
was 4% above the prime rate of interest.
The Company made ESOP contributions of $216 in 1996. These
contributions represent an allocation of the preferred stock held by the ESOP to
the Company's employees which preferred stock was converted into common stock on
a one for one basis on July 28, 1997. As a result, these contributions did not
result in a cash outflow from the Company. These contributions were deductible
for tax purposes and served to reduce the Company's tax obligations. At December
31, 1996, unearned ESOP shares totaled $117, and the Company's obligation to
make further contributions to the ESOP was limited to that amount.
12
For the year ended December 31, 1996, the Company recorded net
increases in unrealized appreciation of investments of $483 as follows:
Year Ended
December 31, 1996
-----------------
Erie Forge and Steel, Inc $204
Four S Baking Company, Inc (81)
Indiana Steel & Wire Corporation 9
Martino's Bakery, Inc. 156
Mobile Tool International, Inc. 195
----
Increase in unrealized appreciation of investments $483
====
During 1996, the Company was taxed as a C Corporation. Unrealized
appreciation (depreciation) of investments does not affect the actual tax paid
by the Company. However, under GAAP, the Company provides for income taxes based
on its GAAP pretax income, which includes unrealized appreciation (depreciation)
of investments. The Company accounted for this difference by recognition of a
deferred tax provision of $159 in 1996.
Financial Condition, Liquidity, and Capital Resources
At December 31, 1998, the Company had $6,149 in cash and cash
equivalents and $89,948 in investments in Federal agency securities. In
addition, the Company had outstanding debt secured by assets of the Company of
$30,000 in borrowings under credit facilities and $85,948 in short-term notes
payable. During 1998, the Company's primary source of funding was the proceeds
received in connection with its IPO. The Company completed investing the
proceeds of its IPO during 1998 and began funding its investments with proceeds
from a line of credit and short term borrowings.
As of March 31, 1999, the Company closed a maximum $100,000 debt
funding facility. In connection with the closing, the Company established ACS
Funding Trust I (the "Trust"), an affiliated business trust, and contributed or
sold to the Trust approximately $157,000 in loans. Subject to certain conditions
precedent, the Company will be required to contribute related equity warrants to
the Trust in the future. The Company will remain the servicer of the loans.
Simultaneously with the initial contribution, the Trust entered into a loan
agreement with First Union Capital Markets Corp., as deal agent, and certain
other parties providing for loans in an amount up to 50% of the eligible loan
balance subject to certain concentration limits. The loans to the Trust are
expected to be funded primarily through a commercial paper conduit. The Company
used initial proceeds under this facility to repay existing debt and expects to
use future proceeds to continue making investments in the debt and equity
securities of middle market companies. In order to manage interest rate risk
associated with the floating rate borrowings, the Trust will enter into hedging
agreements. The Trust intends to use derivative instruments for non-trading and
non-speculative purposes only.
As a RIC, the Company is required to distribute annually 90% or more of
its net operating income and net realized short-term capital gains to
shareholders. While the Company provides shareholders with the option of
reinvesting their distributions in the Company, the Company anticipates having
to issue debt or equity securities in addition to the above borrowings to expand
its investments in middle market companies. The terms of the future debt and
equity issuances can not be determined and there can be no assurances that the
debt or equity markets will be available to the Company on terms it deems
favorable.
Portfolio Credit Quality
At December 31, 1998 and December 31, 1997, the Company's outstanding
loans had estimated fair values of $132,878 and $16,763, respectively. All of
the Company's outstanding loans are performing and paying as agreed.
The Company has implemented a system under which it grades all loans on a scale
of 1 to 4. This system is intended to reflect the performance of the borrower's
business, the collateral coverage of the loans and other factors considered
relevant. Under this system, management believes that loans with a grade of 4
involve the least amount of risk in the Company's portfolio. The borrower is
performing above expectations and the trends and risk factors are generally
favorable. Management believes that loans graded 3 involve an acceptable level
of risk that is similar to the risk at the time of origination. The borrower is
performing as expected and the risk factors are neutral to favorable. All new
loans are initially graded 3.
13
Loans graded 2 involve a borrower performing below expectations and the
loan risk has increased since origination. The borrower may be out of compliance
with debt covenants, however, loan payments are not more than 120 days past due.
For loans graded 2, the Company's management will increase procedures to monitor
the borrower and will write down the fair value of the loan if it is deemed to
be impaired. A loan grade of 1 indicates that the borrower is performing
materially below expectations and the loan risk has substantially increased
since origination. Some or all of the debt covenants are out of compliance and
payments are delinquent. Loans graded 1 are not anticipated to be repaid in full
and the Company will reduce the fair market value of the loan to the amount it
anticipates will be recovered.
To monitor and manage the investment portfolio risk, management tracks
the weighted average portfolio grade. The weighted average portfolio grade was
3.2 and 3.0 at December 31, 1998 and December 31, 1997, respectively. In
addition, at December 31, 1998 and December 31, 1997, all of the Company's loans
were graded 3 or higher.
Impact of the Year 2000
The "Year 2000 Issue" is the result of computer programs being written
using two digits rather than four to define the applicable year. Any of the
Company's computer programs or hardware that have date-sensitive software or
embedded chips may recognize a date using "00" as the year 1900 rather than the
year 2000. This could result in a system failure or miscalculations causing
disruption of operations, including, among other things, a temporary inability
to process transactions, send invoices, or engage in similar normal business
activities. The Company created a Year 2000 Compliance Committee to address the
Year 2000 compliance of the Company's information technology and non-information
technology systems, the systems of third parties, and the systems of the
portfolio companies. The Company has also engaged outside technology consultants
to assist with its Year 2000 project.
All of the software used by the Company in its information technology
systems is provided by outside vendors. The Company has taken an inventory of
all of its information technology systems and is in the process of obtaining
Year 2000 compliance designation from the vendors and internally conducting
compliance testing. Based on its assessment of its information technology
systems, management has identified the general ledger software package as the
significant system that is Year 2000 non-compliant. As such, the Company will
replace its accounting software with a new, Year 2000 compliant software
package. The new accounting software and all necessary modifications to other
information technology systems will be completed by August, 1999.
The Company is also evaluating the Year 2000 compliance of its
non-information technology systems, consisting of office equipment other than
computers and communications equipment. The Company has contacted the office
equipment vendors to obtain Year 2000 compliance designation. The Company
believes it will complete the remediation, testing and implementation of these
non-information technology systems by July, 1999.
The Company has contacted third parties that do not share information
systems with the Company ("external agents"). These third parties include the
Company's banks, landlords, utility companies, telecommunication providers and
other vendors. To date, the Company is not aware of any external agent Year 2000
issue that would materially impact the Company's results of operations,
liquidity, or capital resources. However, the Company has no means of ensuring
that external agents will be Year 2000 ready. The inability of external agents
to complete their Year 2000 resolution process in a timely fashion could
materially impact the Company. The effect of non-compliance by external agents
is not determinable.
The Company is also evaluating the Year 2000 readiness of its portfolio
companies. Beginning in the summer of 1998, the Company has required that each
portfolio company expressly warrant in its loan agreement that it is or will be
Year 2000 compliant prior to December 31, 1999. The Company has also submitted
questionnaires to all of its portfolio companies to determine their exposure to
the Year 2000 problem and the adequacy of their plans to address the issues.
Over 90% of the portfolio companies have responded to the questionnaire. Based
on the correspondence received from the portfolio companies, management believes
that over two-thirds of its portfolio companies have either no material exposure
to the Year 2000 issue or are adequately carrying out their plans to address
their exposure. The Company has either not received complete questionnaires from
the remaining one third of the portfolio companies or has requested that the
portfolio companies improve the scope and detail of their responses. The Company
intends to follow up with the portfolio companies to ensure that they have
executed their compliance plan by June 30, 1999.
Throughout 1999, the Company will continue to address any issues of
Year 2000 non-compliance and further develop its contingency plan to ensure
business operations in the event of systems failure in the Year 2000. The
Company is utilizing both internal and external resources to reprogram or
replace, test, and implement the software and other systems for Year 2000
modifications. The Company estimates that the cost of its Year 2000 project will
be less than $125. This amount includes the cost of additional software,
reviewing the portfolio companies' readiness, and outside systems professionals
working on the Company's Year 2000 compliance.
14
The Company's plans to complete the Year 2000 modifications are based
on management's best estimates, which were derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, estimates on the status of completion and the total expected costs.
However, there can be no guarantee that these estimates will be achieved and
actual results could differ materially from those plans. Specific issues that
might cause such material differences include, but are not limited to, the
availability and cost of personnel trained in this area, the ability to locate
and correct all relevant computer codes, and similar uncertainties. Significant
systems failures at the Company, a third party, or the portfolio companies could
have a materially adverse effect on the Company's business. While the Company
believes that its portfolio companies are adequately addressing the Year 2000
issue, no assurance can be given that some of its portfolio companies will not
suffer material adverse effects from Year 2000 issues. Management believes that
the most likely worst case Year 2000 scenario is a material decrease in interest
income and an impairment in the valuation of the Companies investment portfolio.
The magnitude of these material adverse effects on the portfolio companies and
the operating results and financial of the Company cannot be determined at this
time.
Impact of Inflation
Management believes that inflation can influence the value of the
Company's investments through the impact it may have on the capital markets, the
valuations of business enterprises and the relationship of the valuations to
underlying earnings.
15
Item 8. Financial Statements and Supplementary Data
Report of Independent Auditors
Board of Directors
American Capital Strategies, Ltd.
We have audited the accompanying balance sheets of American Capital Strategies,
Ltd., including the schedules of investments, as of December 31, 1998 and 1997,
the related statements of operations, shareholders' equity and cash flows for
the year ended December 31, 1998, the three months ended December 31, 1997, the
nine months ended September 30, 1997, and the year ended December 31, 1996, and
the financial highlights for the year ended December 31, 1998 and the three
months ended December 31, 1997. These financial statements and the financial
highlights are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material aspects, the financial position of American Capital Strategies,
Ltd. at December 31, 1998 and 1997, and the results of its operations and its
cash flows for the year ended December 31, 1998, the three months ended December
31, 1997, the nine months ended September 30, 1997, and the year ended December
31, 1996, and the financial highlights for the year ended December 31, 1998 and
the three months ended December 31, 1997 in conformity with generally accepted
accounting principles.
/s/ Ernst & Young LLP
Washington, D.C.
February 2, 1999
16
AMERICAN CAPITAL STRATEGIES, LTD.
BALANCE SHEETS
(In thousands except per share data)
December 31, December 31,
1998 1997
---- ----
Assets
Investments at fair value (cost of $252,718 and $133,274, respectively) $254,983 $133,415
Cash and cash equivalents 6,149 8,862
Investment in unconsolidated operating subsidiary 6,386 6,869
Due from unconsolidated operating subsidiary 778 861
Interest receivable 1,561 644
Other 162 54
-------- --------
Total assets $270,019 $150,705
======== ========
Liabilities and Shareholders' Equity
Accounts payable and accrued liabilities $ 126 $ 53
Accrued dividends payable 1,222 --
Notes payable 85,948 --
Revolving credit facility 30,000 --
-------- --------
Total liabilities 117,296 53
Shareholders' equity:
Undesignated preferred stock, $0.01 par value, 5,000 shares authorized,
0 issued and outstanding -- --
Common stock, $.01 par value, 20,000 shares authorized, and 11,081 and
11,069 issued and outstanding, respectively 111 111
Capital in excess of par value 145,245 144,940
Note receivable from sale of common stock (300) --
Distributions in excess of net realized earnings (116) (55)
Unrealized appreciation of investments 7,783 5,656
-------- --------
Total shareholders' equity 152,723 150,652
-------- --------
Total liabilities and shareholders' equity $270,019 $150,705
======== ========
See accompanying notes.
17
AMERICAN CAPITAL STRATEGIES, LTD.
SCHEDULE OF INVESTMENTS
DECEMBER 31, 1998
(In thousands except per share data)
Industry Cost Fair Value
-------- ---- ----------
Senior Debt--9.47%
- - ------------------
Four S Baking Company Baking $ 1,266 $ 1,266
BIW Connector Systems, LLC Manufacturing 3,404 3,404
Chance Coach, Inc. Bus Manufacturer 1,286 1,286
JAG Industries, Inc. Manufacturing 1,200 1,200
Wilderness Systems, Inc. Canoes & Kayaks 9,675 9,675
Cycle Gear, Inc. Motor Cycle Accessories 750 750
Eurocaribe, Inc. Meat Processing 7,181 7,181
-------- --------
Subtotal 24,762 24,762
Subordinated Debt--41.37%
- - -------------------------
Four S Baking Company Baking 1,588 1,588
BIW Connector Systems, LLC. Manufacturing 6,710 6,710
Westwinds Group Holdings, Inc. Restaurant 2,932 2,932
JAG Industries, Inc. Manufacturing 2,335 2,335
Specialty Transportation Services, Inc. Waste Hauler 7,368 7,368
Chance Coach, Inc. Bus Manufacturer 7,060 7,060
The L.A. Studios, Inc. Audio Production 2,393 2,393
Decorative Surfaces International, Inc. Decorative Paper & 10,490 10,490
Vinyl Mfg.
New Piper Aircraft, Inc. Aircraft Manufacturing 17,858 17,858
Electrolux, LLC Vacuum Cleaner 7,264 7,264
Cycle Gear, Inc. Motor Cycle Accessories 633 633
Wilderness System, Inc. Canoes & Kayaks 4,701 4,701
Eurocaribe, Inc. Meat Processing 8,905 8,905
ConStar International, Inc. Electrical 12,839 12,839
Centennial Broadcasting, Inc. Radio Stations 15,040 15,040
-------- --------
Subtotal 108,116 108,116
Convertible Preferred Stock--2.10%
- - ------------------------------------
Four S Baking Company 15% dividend convertible into
51,390 shares of common stock or 10.89% of Co. Baking 2,756 2,756
Chance Coach, Inc. 12% dividend convertible into 20% of Co. Bus Manufacturer 2,000 2,079
Decorative Surfaces International, Inc. prime rate plus
4% dividend convertible into 2.9% of Co. Decorative Paper &
Vinyl Mfg. 646 646
Subtotal -------- --------
5,402 5,481
Common Stock Warrants(1)--8.52%
- - ----------------------------------
Four S Baking Company 3.26% of Co. Baking 462 600
BIW Connector Systems, LLC 8% of LLC Manufacturing 652 540
Westwinds Group Holdings, Inc. 5% of Co. Restaurant 350 421
JAG Industries, Inc. 75% of Co. Manufacturing 505 465
Specialty Transportation Services, Inc. 9.1% of Co. Waste Hauler 694 784
Chance Coach, Inc. 43.7% of Co. Bus Manufacturer 4,041 4,543
The L.A. Studios, Inc. 17% of Co. Audio Production 902 857
Decorative Surfaces International, Inc. 42.3% of Co. Decorative Paper &
Vinyl Mfg. 4,571 5,596
New Piper Aircraft, Inc. 4% of Co. Aircraft Manufacturing 2,231 2,231
Electrolux, LLC 2.5% of Co. Vacuum Cleaner 246 246
Cycle Gear, Inc. 16.5% of Co. Motor Cycle Accessories 374 374
Wilderness System, Inc. 18% of Co. Canoes & Kayaks 1,319 1,319
Eurocaribe, Inc. 37% of Co. Meat Processing 1,110 1,110
ConStar International, Inc. 17.5% of Co. Electrical 3,171 3,171
-------- --------
Subtotal 20,628 22,257
Common Stock (1) - 1.69%
- - ------------------------
Four-S Baking Company 5.5% of Co. Baking 966 1,004
Specialty Transportation Services, Inc. 9.1% of Co. Waste Hauler 500 784
Chance Coach, Inc. 18.3% of Co. Bus Manufacturer 1,896 2,131
ConStar International, Inc. 2.8% Electrical 500 500
-------- --------
Subtotal 3,862 4,419
-------- --------
Subtotal--non-publicly traded securities--63.15% 162,770 165,035
Government Securities--34.41%
- - -----------------------------
FHLB Discount Note due 1/4/98 89,948 89,948
-------- --------
Total Investments 252,718 254,983
Investment in Unconsolidated Operating Subsidiary--2.44%
- - --------------------------------------------------------
ACS Capital Investments Corporation(1)(2)--100% of Co. Investment Banking 403 6,386
-------- --------
Totals $253,121 $261,369
======== ========
(1) Non-income producing
(2) Affiliate
See accompanying notes.
18
AMERICAN CAPITAL STRATEGIES, LTD.
SCHEDULE OF INVESTMENTS
DECEMBER 31, 1997
(In thousands except per share data)
Industry Cost Fair Value
-------- ---- ----------
Senior Debt--4.07%
- - ------------------
Four S Baking Company Baking $ 1,825 $ 1,825
BIW Connector Systems, LLC. Manufacturing 3,890 3,890
-------- --------
Subtotal 5,715 5,715
Subordinated Debt--7.88%
- - ------------------------
Four S Baking Company Baking 1,492 1,492
BIW Connector Systems, LLC. Manufacturing 6,350 6,350
Westwinds Group Holdings, Inc. Restaurant 3,206 3,206
-------- --------
Subtotal 11,048 11,048
Convertible Preferred Stock--1.64%
- - -------------------------------------
Four S Baking Company 15% dividend convertible into
51,390 shares of common stock or 10.89% of Co. Baking 2,303 2,303
Common Stock Warrants(1)--1.13%
- - ----------------------------------
Four S Baking Company 3.26% of Co. Baking 461 577
BIW Connector Systems, LLC 8% of LLC Manufacturing 652 652
Westwinds Group Holdings, Inc. 5% of Co. Restaurant 350 350
-------- --------
Subtotal 1,463 1,579
-------- --------
Subtotal--non-publicly traded securities--14.72% 20,529 20,645
Government Securities--80.38%
- - -----------------------------
FHLB Discount Note due 2/4/98 20,969 20,981
FHLB Discount Note due 3/6/98 10,893 10,898
FHLB Discount Note due 4/1/98 9,865 9,868
FNMA Discount Note due 4/24/98 6,877 6,883
FFCB 5.90% due 6/2/98 20,017 20,016
FHLB Discount Note due 6/8/98 14,646 14,644
FHLB Discount Note due 8/20/98 14,483 14,480
FNMA 5.71% due 9/9/98 14,995 15,000
-------- --------
Subtotal 112,745 112,770
-------- --------
Total Investments 133,274 133,415
Investment in Unconsolidated Operating Subsidiary--4.90%
ACS Capital Investments Corporation(1)(2)--100% of Co Investment Banking 403 6,869
-------- --------
Totals $133,677 $140,284
======== ========
(1) Non-income producing
(2) Affiliate
See accompanying notes.
19
AMERICAN CAPITAL STRATEGIES, LTD.
STATEMENTS OF OPERATIONS
(In thousands except per share data)
Three Months
Year Ended Ended Nine Months Ended Year Ended
December 31, 1998 December 31, 1997 September 30, 1997 December 31, 1996
----------------- ----------------- ------------------ -----------------
Operating income:
Financial advisory fees $ -- $ -- $ 1,122 $ 1,738
Financial performance fees -- -- 798 649
Interest and dividend income 14,430 2,123 553 --
Loan processing fees 2,549 654 -- --
Other -- 20 428 359
-------- ------- -------- --------
Total operating income 16,979 2,797 2,901 2,746
Operating expenses:
Salaries and benefits 843 243 1,221 1,283
General, administrative and other 809 308 1,514 1,282
Provision for (reversal of) doubtful accounts -- -- (177) 224
Interest 57 -- 60 33
Depreciation and amortization -- -- 33 39
-------- ------- -------- ------
Total operating expenses 1,709 551 2,651 2,861
Operating income (loss) before equity in
earnings of unconsolidated operating
subsidiary 15,270 2,246 250 (115)
Equity in (loss) earnings of unconsolidated
operating subsidiary (482) 24 -- --
-------- ------- -------- ------
Net operating income (loss) 14,788 2,270 250 (115)
Increase in unrealized appreciation of
investments 2,127 167 5,321 483
-------- ------- -------- ------
Income before income taxes 16,915 2,437 5,571 368
Provision for income taxes -- -- 2,128 159
-------- ------- -------- ------
Net increase in shareholders' equity resulting
from operations $ 16,915 $ 2,437 $ 3,443 $ 209
======== ======= ======== =======
Net operating income per share Basic $ 1.34 $ 0.21
Diluted $ 1.29 $ 0.20
Net increase in shareholders' equity Basic $ 1.53 $ 0.22
resulting from operations per share Diluted $ 1.48 $ 0.21
Weighted average shares of Basic 11,068 11,069
common stock outstanding Diluted 11,424 11,405
See accompanying notes.
20
AMERICAN CAPITAL STRATEGIES, INC.
STATEMENTS OF SHAREHOLDERS' EQUITY
(In thousands except per share data)
Unearned Capital in
Preferred ESOP Common Stock Excess of Retained
Stock Shares Shares Amount Par Value Earnings
----- ------ ------ ------ --------- --------
Balance at December 31, 1995 $ 1,419 $ (333) 480 $ 5 $ 10 $ 1,845
Net increase in shareholders'
equity resulting from
operations -- -- -- -- -- 209
Options exercised -- -- 1 -- 1 --
ESOP shares earned -- 216 -- -- -- --
-------- ------- ----- ----- ------- --------
Balance at December 31, 1996 $ 1,419 $ (117) 481 $ 5 $ 11 $ 2,054
Net increase in shareholders'
equity resulting from
operations -- -- -- -- -- 3,443
Contribution of common stock
to ESOP -- -- 1 -- 8 (8)
Conversion of preferred stock
to common stock (1,419) -- 205 2 1,417 --
Issuance of common stock -- -- 10,382 104 143,504 --
ESOP shares earned -- 117 -- -- -- --
------- -------- ------- ----- -------- -------
Balance at September 30, 1997 $ -- $ -- $11,069 $ 111 $144,940 $ 5,489
======= ======== ======= ===== ======== =======
- - ---------------------------------------------------------------------------------------------------------------------
- - ---------------------------------------------------------------------------------------------------------------------
Effect of reorganization as a
RIC -- -- -- -- -- (5,489)
Net increase in shareholders'
equity resulting from
operations -- -- -- -- -- --
Distributions -- -- -- -- -- --
-------- -------- ------- ----- -------- ------
Balance at December 31, 1997 $ -- $ -- 11,069 $ 111 $144,940 $ --
======== ======== ======= ===== ======== ======
Issuance of common stock
under the 1997 Stock
Option Plan -- -- 28 -- 396 --
Issue of common stock under
the Dividend Reinvestment
Plan -- -- 7 -- 128 --
Repurchase of outstanding
shares -- -- (23) -- (219) --
Issuance of note receivable
from sale of common stock -- -- -- -- -- --
Net increase in shareholders'
equity resulting from
operations -- -- -- -- -- --
Distributions -- -- -- -- -- --
------- ------- ------ ----- ------- ------
Balance at December 31, 1998 $ -- $ -- 11,081 $ 111 $145,245 $ --
======= ======= ======= ===== ======== ======
AMERICAN CAPITAL STRATEGIES, INC.
STATEMENTS OF SHAREHOLDERS' EQUITY
(In thousands except per share data)
Notes
Receivable Unearned Unrealized Total
From Sale of Net Realized Appreciation Shareholders'
Common Stock Earnings of Investments Equity
------------ -------- -------------- ------
Balance at December 31, 1995 -- -- -- $ 2,946
Net increase in shareholders'
equity resulting from
operations -- -- -- 209
Options exercised -- -- -- 1
ESOP shares earned -- -- -- 216
------- -------- ------ --------
Balance at December 31, 1996 -- -- -- $ 3,372
------- -------- ------ --------
Net increase in shareholders'
equity resulting from
operations -- -- -- 3,443
Contribution of common stock
to ESOP -- -- -- --
Conversion of preferred stock
to common stock -- -- -- --
Issuance of common stock -- -- -- 143,608
ESOP shares earned -- -- 117
------- -------- ------- --------
Balance at September 30, 1997 $ -- $ -- $ -- $150,540
======= ======== ======= ========
- - -----------------------------------------------------------------------------------------------
- - -----------------------------------------------------------------------------------------------
Effect of reorganization as a
RIC -- -- 5,489 --
Net increase in shareholders'
equity resulting from
operations -- 2,269 167 2,436
Distributions -- (2,324) -- (2,324)
------- -------- ------- --------
Balance at December 31, 1997 $ -- $ (55) $ 5,656 $150,652
======= ======== ======= ========
Issuance of common stock
under the 1997 Stock
Option Plan -- -- -- 396
Issue of common stock under
the Dividend Reinvestment
Plan -- -- -- 128
Repurchase of outstanding
shares -- -- -- (219)
Issuance of note receivable
from sale of common stock (300) -- -- (300)
Net increase in shareholders'
equity resulting from
operations -- 14,788 2,127 16,915
Distributions -- (14,849) -- (14,849)
------- -------- -------- --------
Balance at December 31, 1998 $ (300) $ (116) $ 7,783 $152,723
======= ======== ======= ========
See accompanying notes.
21
AMERICAN CAPITAL STRATEGIES, LTD.
STATEMENTS OF CASH FLOWS
(In thousands except per share data)
Three Months Nine Months
Year Ended Ended Ended Year Ended
December 31, December 31, September 30, December 31,
1998 1997 1997 1996
----------- ----------- ------------ ------------
Operating activities
Net increase in shareholders' equity resulting from
operations $ 16,915 $ 2,437 $ 3,443 $ 209
Adjustments to reconcile net increase in shareholders'
equity resulting from operations to net cash provided
by (used in) operating activities:
Depreciation and amortization -- -- 33 38
Uunrealized appreciation of investments (2,127) (167) (5,321) (483)
Net amortization of securities (1,336) (1,234) (337) --
Amortization of loan discounts (913) -- -- --
Amortization of deferred finance costs -- -- 3 11
Provision for deferred income taxes -- -- 2,102 121
Contribution of stock to ESOP -- -- 117 216
Increase in interest receivable (917) (207) (122) --
Provision for doubtful accounts -- -- (177) 224
Increase in accrued payment-in-kind dividend and
interest (478) -- -- --
Decrease (increase) in due from unconsolidated
subsidiary 83 (526) -- --
Decrease (increase) in accounts receivable -- -- 486 (865)
Decrease in income taxes receivable -- -- 24 101
(Increase) decrease in other assets (71) 62 (113) 6
Increase (decrease) in accounts payable and accrued
liabilities 73 (328) 128 228
Loss (earnings) of unconsolidated operating subsidiary 482 (24) -- --
----------- --------- --------- ---------
Net cash provided by (used in) operating activities 11,711 13 266 (194)
Investing activities
Proceeds from sale or maturity of investments 231,580 35,000 60 --
Principal repayments 1,719 93 -- --
Purchase of investments (142,865) (20,622) (483) (75)
Purchase of securities (207,146) (16,593) (129,896) --
Purchases of property and equipment, net of disposals -- -- (29) (39)
----------- --------- --------- ---------
Net cash used in investing activities (116,712) (2,122) (130,348) (114)
Financing activities
Proceeds from short term notes payable, net 85,948 -- (430) 269
Drawings on revolving credit facilities, net 30,000 -- -- --
Increase in deferred financing costs (37) -- -- (4)
(Decrease) increase in due to related parties, net -- -- (78) 6
Repurchase of common stock (219) -- -- --
Issuance of common stock 224 -- 143,608 --
Options exercised -- -- -- 1
Distributions paid (13,628) (2,325) -- --
----------- --------- --------- ---------
Net cash provided by (used in) financing activities 102,288 (2,325) 143,100 272
----------- --------- --------- ---------
Net (decrease) increase in cash and cash equivalents (2,713) (4,434) 13,018 (36)
Cash and cash equivalents at beginning of period 8,862 13,296 323 359
----------- --------- -------- ---------
Cash and cash equivalents at end of period $ 6,149 $ 8,862 $ 13,341 $ 323
=========== ========= ========= =========
Non-cash financing activities:
- - -----------------------------
Note receivable issued in sale of common stock $ 300 $ -- $ -- $ --
See accompanying notes.
22
AMERICAN CAPITAL STRATEGIES, LTD.
FINANCIAL HIGHLIGHTS
(In thousands except per share data)
Year Ended Three Months Ended
December 31, 1998 December 31, 1997
------------------- -------------------
Per Share Data(1)
Net asset value at beginning of the period $ 13.61 $ 13.60
Net operating income 1.34 0.21
Increase in unrealized appreciation on investments 0.19 0.01
---------------- -------------------
Net increase in shareholders' equity from operations $ 1.53 $ 0.22
Distribution of net investment income 1.34 0.21
---------------- -------------------
Net asset value at end of period $ 13.80 $ 13.61
Per share market value at end of period $ 17.25 $ 18.125
Total return (3) 2.57% 22.23%
Shares outstanding at end of period 11,081 11,069
Ratio/Supplemental Data
Net assets at end of period $ 152,723 $ 150,652
Ratio of operating expenses to average net assets(2) 1.13% 1.46%
Ratio of net operating income to average net assets(2) 9.75% 6.03%
- - ------------------
(1) Basic per share data.
(2) Amounts were annualized for the results of the three month period ended
December 31, 1997.
(3) Amounts were not annualized for the results of the three month period
ended December 31, 1997.
See accompanying notes.
23
AMERICAN CAPITAL STRATEGIES, LTD.
NOTES TO FINANCIAL STATEMENTS
(In thousands except per share data)
Note 1. Organization
American Capital Strategies, Ltd., a Delaware corporation (the
"Company"), was incorporated in 1986 to provide financial advisory services to
and invest in middle market companies. On August 29, 1997, the Company completed
an initial public offering ("IPO") of 10,382,437 shares of common stock ("Common
Stock"), and became a non-diversified close end investment company that has
elected to be treated as a business development company ("BDC") under the
Investment Company Act of 1940, as amended ("1940 Act"). On October 1, 1997, the
Company began operations so as to qualify to be taxed as a regulated investment
company ("RIC") as defined in Subtitle A, Chapter 1, under Subchapter M of the
Internal Revenue Code of 1986 as amended (the "Code"). As contemplated by these
transactions, the Company materially changed its business plan and format from
structuring and arranging financing for buyout transactions on a fee for
services basis to primarily being a lender to and investor in middle market
companies. As a result of the changes, the Company is operating as a holding
company whose predominant source of operating income has changed from financial
performance and advisory fees to interest and dividends earned from investing
the Company's assets in debt and equity of businesses. The Company's investment
objectives are to achieve current income from the collection of interest and
dividends, as well as long-term growth in its shareholders' equity through
appreciation in value of the Company's equity interests. The Company continues
to provide financial advisory services to businesses through ACS Capital
Investments Corporation ("CIC"), a wholly-owned subsidiary. The Company is
headquartered in Bethesda, Maryland, and has offices in New York, Boston,
Pittsburgh, San Francisco, Chicago, and Dallas.
Note 2. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying financial statements have been prepared in accordance
with generally accepted accounting principles and for periods commencing with
the Company's election to be treated as a RIC, in accordance with Article 6 of
Regulation S-X of the Code of Federal Regulations. For the nine months ended
September 30, 1997 and the year ended December 31, 1996 the financial statements
are prepared on a consolidated basis with the accounts of CIC, the Company's
wholly owned subsidiary. All intercompany transactions and balances were
eliminated. Effective October 1, 1997, pursuant to RIC accounting requirements,
CIC was deconsolidated, and, as a result, for the year ended December 31, 1998
and the three months ended December 31, 1997 the Company accounted for its
investment in CIC under the equity method. In connection with this change, the
Company contributed the following assets and liabilities to CIC:
Investment in Erie Forge and Steel $2,736
Other assets 791
Other liabilities 69
Deferred tax liability 3,333
As a result of these changes, the Company's financial statements for
periods through September 30, 1997 ("pre-RIC") are not comparable with the
financial statements for periods commencing after October 1, 1997 ("post-RIC").
Valuation of Investments
Investments are carried at fair value, as determined by the Board of
Directors.
Securities which are publicly traded are valued at the closing bid
price on the valuation date.
Debt and equity securities which are not publicly traded are valued at
fair value as determined in good faith by the Board of Directors. In making such
determination, the Board of Directors will value non-convertible debt securities
at cost plus amortized original issue discount, if any, unless adverse factors
lead to a determination of a lesser valuation. In valuing convertible debt,
equity or other securities, the Board of Directors determines the fair value
based on the collateral, the issuer's ability to make payments, the earnings of
the issuer, sales to third parties of similar securities, the comparison to
publicly traded securities and other pertinent factors. Due to the uncertainty
inherent in the valuation process, such estimates of fair value may differ
significantly from the values that would have been used had a ready market for
the securities existed, and the differences could be material.
24
AMERICAN CAPITAL STRATEGIES, LTD.
NOTES TO FINANCIAL STATEMENTS
(In thousands except per share data)
Cash and Cash Equivalents
Cash and cash equivalents consist of demand, deposits and highly liquid
investments with original maturities of three months or less. Cash and cash
equivalents are carried at cost which approximates fair value.
Interest and Dividend Income Recognition
Interest income is recorded on the accrual basis to the extent that
such amounts are expected to be collected. Original issue discount is amortized
into interest income using the effective interest method. Dividend income is
recognized on the ex-dividend date.
Financial Advisory and Performance Fee Recognition
Financial advisory fees represent amounts received for providing advice
and analysis to middle market companies and are recognized as earned based on
hours incurred. Financial performance fees represent amounts received for
structuring, financing, and executing transactions and are generally payable
only if the transaction closes and are recognized as earned when the transaction
is completed. Financial advisory and performance fees are for services provided
by CIC.
Loan Fee and Loan Processing Fee Recognition
The Company records loan fees as income on the closing date of the
related loan. Loan processing fees are recorded by the Company's wholly owned
subsidiary, CIC, as income on the closing date of the related loan.
Realized Gain or Loss and Unrealized Appreciation or Depreciation on Investments
Realized gain or loss is recorded at the disposition of an investment
and is the difference between the net proceeds from the sale and the cost basis
of the investment using the specific identification method. Unrealized
appreciation or depreciation reflects the difference between the Board of
Directors' valuation of the investments and the cost basis of the investments.
Distributions to Shareholders
Distributions to shareholders are recorded on the ex-dividend date.
Federal Income Taxes
The Company operates so as to qualify to be taxed as a RIC under the
Internal Revenue Code. Generally, a RIC is entitled to deduct dividends it pays
to its shareholders from its income to determine "taxable income." The Company
has distributed and currently intends to distribute sufficient dividends to
eliminate taxable income. Therefore, the statement of operations contains no
provision for income taxes for the year ended December 31, 1998 and the three
months ended December 31, 1997.
During the pre-RIC periods, the Company operated under Subchapter C of
the Internal Revenue Code and calculated its tax provision pursuant to Statement
of Financial Accounting Standards No. 109. Deferred income taxes were determined
based on the differences between financial reporting and tax basis of assets and
liabilities.
Use of Estimates in Preparation of Financial Statements
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenues
and expenses and disclosure of contingent assets and liabilities. Actual results
could differ from those estimates.
Property and Equipment
Property and equipment are carried at cost and are depreciated using
the straight-line method over the estimated useful lives of the related assets
ranging from five to seven years.
25
AMERICAN CAPITAL STRATEGIES, LTD.
NOTES TO FINANCIAL STATEMENTS
(In thousands except per share data)
Management Fees
The Company is self-managed and therefore does not incur management
fees payable to third parties.
Reclassifications
Certain previously reported amounts have been reclassified to conform
with the current financial statement presentation.
Recent Accounting Pronouncements
As of January 1, 1998, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income" ("SFAS
130"). SFAS 130 established new rules for the reporting and display of
comprehensive income and its components; however, the adoption of this statement
had no impact on the Company's net increase in shareholders' equity resulting
from operations or shareholders' equity.
As of January 1, 1998, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131
established standards for determining an entity's operating segments and the
type and level of financial information to be disclosed in both annual and
interim financial statements. It also established standards for related
disclosures about products and services, geographic areas and major customers.
Accordingly, the Company's reportable segments are its investing operations as a
business development company and the financial advisory operations of its
wholly-owned subsidiary, CIC (see Note 4).
As of January 1, 1998, the Company adopted SFAS No. 132, "Employers'
Disclosures about Pensions and Other Postretirement Benefits - an amendment of
FASB Statements No. 87, 88, and 106" ("SFAS 132"). SFAS 132 revises employers'
disclosures about pension and other postretirement benefit plans. Adoption of
SFAS 132 does not have a material impact on the financial statements of the
Company.
In June 1998, the Financial Accounting Standards Board (FASB) issued
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities"
("SFAS 133"). SFAS 133 establishes accounting and reporting standards for
derivative instruments. The statement requires an entity to recognize all
derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value. This statement is
effective for all fiscal quarters of fiscal years beginning after June 15, 1999.
Adoption of SFAS 133 is not expected to have a material impact on the Company's
financial statements or disclosures.
Note 3. Investments
Investments consists of securities issued by various agencies of the
Federal government valued at $89,948 with maturities of less than one year from
the date of purchase and securities issued by privately-held companies valued at
$165,035. The securities issued by privately-held companies consist of senior
debt, subordinated debt with equity warrants, convertible preferred stock and
common stock. The debt securities have effective interest rates ranging from
8.8% to 22.4% and are payable in installments with final maturities from 5 to 10
years and are generally collateralized by assets of the borrower. The Company's
investments in equity warrants and common stock are non-income producing. The
net unrealized appreciation in investments for Federal income tax purposes is
the same as for book purposes and none of the Company's investments are on
non-accrual status.
Note 4. Investment in Unconsolidated Operating Subsidiary
As discussed in Note 2, CIC is an operating subsidiary of the Company
and is accounted for under the equity method effective October 1, 1997. The
investment in CIC is carried at fair value as determined by the Board of
Directors.
26
AMERICAN CAPITAL STRATEGIES, LTD.
NOTES TO FINANCIAL STATEMENTS
(In thousands except per share data)
Condensed financial information for CIC is as follows:
December 31, 1998 December 31, 1997
----------------- -----------------
Assets
Investments in portfolio companies, at fair value $ 10,837 $ 10,361
Other assets, net 1,359 991
------------- ------------
Total assets $ 12,196 $ 11,352
============= ============
Liabilities and Shareholder's Equity
Deferred income taxes $ 2,921 $ 3,323
Due to parent 778 861
Other liabilities 2,111 299
Shareholder's equity 6,386 6,869
------------- ------------
Total liabilities and shareholder's equity $ 12,196 $ 11,352
============= ============
Year Ended Three Months Ended
December 31, 1998 December 31, 1997
----------------- -----------------
Operating income $ 5,227 $ 532
Operating expense 6,451 1,084
------------- ------------
Net operating loss (1,224) (552)
Increase in unrealized appreciation of investments 481 605
Other 261 (29)
------------- ------------
Net (loss) income $ (482) $ 24
============= ============
Note 5. Stock Option Plan
The Company applies APB No. 25, "Accounting for Stock Issued to
Employees" (APB 25), and related interpretations in accounting for its
stock-based compensation plan. In accordance with SFAS 123, "Accounting for
Stock-Based Compensation" (SFAS 123), the Company elected to continue to apply
the provisions of APB 25 and provide pro forma disclosure of the Company's net
operating income and net increase in shareholders' equity resulting from
operations calculated as if compensation costs were computed in accordance with
SFAS 123. The Company is providing this information for the post-RIC period as
discussed in Notes 1 and 2 and from the time the 1997 Stock Option Plan (the
1997 Plan) was established by the Company. The 1997 Plan provides for the
granting of options to purchase up to 1,328 shares of common stock at a price of
not less than the fair market value of the common stock on the date of grant to
employees of the Company. On May 14, 1998, the Company authorized 500 additional
shares to be granted under the 1997 Plan. As of December 31, 1998, there are 195
shares available to be granted under the 1997 Plan.
Options granted under the 1997 Plan may be either incentive stock
options within the meaning of Section 422 of the Code or nonstatutory stock
options. Only employees of the Company and its subsidiaries are eligible to
receive incentive stock options under the 1997 Plan; such options generally vest
over a three year period. Incentive stock options must have a per share exercise
price of no less than the fair market value on the date of the grant.
Nonstatutory stock options granted under the 1997 Plan must have a per share
exercise price of no less than the fair market value on the date of the grant.
Options granted under the 1997 Plan may be exercised for a period of no more
than ten years from the date of grant.
Year Ended Three months ended
December 31, 1998 December 31, 1997
----------------- -----------------
Net operating income
as reported $ 14,788 $ 2,270
pro forma $ 13,609 $ 2,030
Net increase in shareholders' equity resulting from operations
as reported $ 16,915 $ 2,437
pro forma $ 15,737 $ 2,197
27
AMERICAN CAPITAL STRATEGIES, LTD.
NOTES TO FINANCIAL STATEMENTS
(In thousands except per share data)
The effects of applying SFAS 123 for providing pro forma disclosures
are not likely to be representative of the effects on reported net operating
income and net increase in shareholders' equity resulting from operations for
future years.
For options granted during the year ended December 31, 1998, the
Company estimated a fair value per option on the date of grant of $4.72 using a
Black-Scholes option pricing model and the following assumptions: dividend yield
7.9%, risk free interest rate 5.1%, expected volatility factor .51, and expected
lives of the options of 7 years.
For options granted during the three months ended December 31, 1997,
the Company estimated a fair value per option on the date of grant of $2.44
using a Black-Scholes option pricing model and the following assumptions;
dividend yield 6.5%, risk free interest rate 6.5%, expected volatility factor
.25, and expected lives of the options of 7 years.
A summary of the status of the Company's stock option plans as of and
for the year ended December 31, 1998 and as of and for the three months ended
December 31, 1997 is as follows:
Year Ended Three Months Ended
December 31, 1998 December 31, 1997
----------------------------- -----------------------------
Weighted-Average Weighted-Average
Exercise Exercise
Shares Price Shares Price
------ ----- ------ -----
Options outstanding, beginning of period 1,297 $ 15.00 -- --
Granted 692 $ 18.42 1,303 $ 15.00
Exercised (28) $ 15.00 -- --
Canceled (328) $ 22.38 (6) $ 15.00
------ --------- ----- ----------
Options outstanding, end of year 1,633 $ 14.96 1,297 $ 15.00
===== ========= ===== ==========
Options exercisable at year end 1,633 1,297
The following table summarizes information about stock options
outstanding at December 31, 1998:
Options Outstanding Options Exercisable
------------------- -------------------
Weighted-
Number Average Weighted Number Weighted
Outstanding at Remaining Average Exercisable at Average
Range of Exercise Prices December 31, 1998 Contractual Life Exercise Price December 31, 1998 Exercisable Price
------------------------ ---------------- ---------------- -------------- ----------------- -----------------
Less than $14.01 62 9.7 years $ 14.00 62 $ 14.00
$14.01 to $15.00 1,571 8.9 years $ 15.00 1,571 $ 15.00
----- --------- --------- ----- -----------
$14.00 to $15.00 1,633 8.9 years $ 14.96 1,633 $ 14.96
===== ========= ========= ===== ===========
In 1998, the Company issued 20 shares of common stock to an officer of
the Company in exchange for a note receivable in the amount of $300. The
transaction was executed pursuant to the 1997 Stock Option Plan, which allows
the Company to lend to its employees funds to pay for the exercise of stock
options. All loans made under this arrangement are fully secured by the value of
the common stock purchased. Interest is charged and paid on such loans at the
Applicable Federal Rate as defined in the Internal Revenue Code.
On November 6, 1997, the Board of Directors authorized the
establishment of a stock option plan for the non-employee directors. The plan
was approved by shareholders at the annual meeting held on May 14, 1998. The
Company is awaiting approval of the plan by the Securities and Exchange
Commission (SEC). Pending SEC approval, the Board of Directors has authorized
the Company to issue 15 options to each of the six non-employee directors.
28
AMERICAN CAPITAL STRATEGIES, LTD.
NOTES TO FINANCIAL STATEMENTS
(In thousands except per share data)
Note 6. Related Parties
Prior to the Company's IPO, ACS Partners I, L.P., a Delaware
Partnership, was formed in 1997 with a wholly owned subsidiary of the Company as
sole general partner and several principals of the Company as limited partners
to allow the principals the opportunity to co-invest in a transaction with the
Company. Pursuant to the terms of the partnership agreement of ACS Partners I,
L.P. the Company through its wholly owned subsidiary, as sole general partner,
has all discretion over the purchase, sale, restructuring and disposition of the
assets of ACS Partners I, L.P. Upon completion of its IPO, the Company became
subject to the 1940 Act. Pursuant to the rules and regulations of the 1940 Act,
the Company is prohibited from allowing employees to co-invest with the Company.
While no investments in ACS Partners I, L.P. were made subsequent to the IPO, as
of December 31, 1998 and December 31, 1997, principals of the Company had
invested $260 in ACS Partners I, L.P. for investment commitments issued prior to
the Company's IPO.
The Company and CIC have entered into an expense sharing agreement
whereby CIC reimburses the Company for expenses paid by the Company on CIC's
behalf.
Note 7. Notes Payable
During December, 1998, the Company borrowed $80,948 secured by
government agency securities with a fair value of $89,948. The interest rate on
the Note was 4.25% and the note was fully repaid on January 4, 1999.
During November, 1998, the Company entered into a credit agreement with
two banks under which the Company has the ability to borrow up to $30 million.
Interest on borrowings is accrued and paid monthly at the prime rate (7.75% at
December 31, 1998). At December 31, 1998, the outstanding balance was $30
million, which is due in October, 2000. The credit facility is secured by the
certain investments of the Company.
During December, 1998, the Company borrowed $5 million from a
corporation. Interest is accrued and paid monthly at 7.75% and the principal of
the note is due on March 31, 1999.
During the year ended December 31, 1998, the nine months ended
September 30, 1997 and the year ended December 31, 1996, the cash paid for
interest was approximately $56, $88, and $43, respectively. The weighted average
interest rates, including amortization of deferred finance costs, for the year
ended December 31, 1998, the nine months ended September 30, 1997 and the year
ended December 31, 1996 and 1995 were 5.9%, 16.9%, and 17.3%, respectively.
Due to the short term of the borrowings, the fair value of the notes
payable approximates cost.
Note 8. Income Taxes
The Company operates so as to qualify to be taxed as a RIC under the
Internal Revenue Code. Generally, a RIC is entitled to deduct dividends it pays
to its shareholders from its income to determine taxable income." The Company
has distributed and currently intends to distribute sufficient dividends to
eliminate taxable income. Therefore, the statement of operations contains no
provision for income taxes for the year ended December 31, 1998 and the three
months ended December 31, 1997.
During the pre-RIC periods, the Company operated under Subchapter C of
the Internal Revenue Code and calculated its tax provision pursuant to Statement
of Financial Accounting Standards No. 109. Deferred income taxes were determined
based on the differences between financial reporting and tax basis of assets and
liabilities.
The components of the income tax provision were as follows:
Nine Months Ended Year Ended
September 30, 1997 December 31, 1996
------------------ -----------------
Current provision $ 2 $ 39
Deferred provision 2,126 120
---------- -----------
$ 2,128 $ 159
---------- -----------
29
AMERICAN CAPITAL STRATEGIES, LTD.
NOTES TO FINANCIAL STATEMENTS
(In thousands except per share data)
The differences between taxes at the Federal statutory tax rate and the
effective tax rate were as follows:
Nine Months Ended Year Ended
September 30, 1997 December 31, 1996
------------------ -----------------
Statutory rate $ 1,803 $ 125
State taxes 342 15
Change in valuation
Allowance -- (26)
Other (17) 45
---------- ---------
Effective rate $ 2,128 $ 159
========== ==========
During the nine months ended September 30, 1997 and the year ended
December 31, 1996, cash paid for income taxes was approximately $2 and $1,
respectively.
The aggregate gross and net unrealized appreciation over the cost for
Federal income tax purposes was $2,265, $7,414, and $3,399 as of December 31,
1998, December 31, 1997 and 1996, respectively. The aggregate cost of securities
for Federal income tax purposes was $252,718, $132,870 and $581, as of December
31, 1998, December 31, 1997 and 1996, respectively.
As discussed in Note 1, the Company had been taxed under subchapter C
prior to October 1, 1997, when the Company converted to a subchapter M
corporation for Federal income tax purposes. As a subchapter M corporation, the
Company is entitled to deduct dividends it pays to shareholders from its income
to determine taxable income. The Company has distributed and intends to
distribute sufficient dividends to eliminate taxable income. As a result, the
Company does not have a provision for income taxes for the year ended December
31, 1998 and the three months ended December 31, 1997.
The Company requested a ruling in June 1997 from the IRS seeking to
clarify the tax consequences of the conversion from taxation under subchapter C
to subchapter M. The Company was seeking to avoid having to incur a tax
liability associated with the unrealized appreciation of assets whose fair
market value exceeded their basis upon the ruling from the IRS in regards to the
treatment of the unrecognized gain. Provided the Company meets all the
requirements to be taxed as a RIC, it will be permitted to elect to be subject
to rules similar to the rules of Section 1374 of the Internal Revenue Code with
respect to any unrealized gain inherent in its assets, upon its conversion to
RIC status ("built-in gain"). Generally, this treatment allows the deferring of
recognition of the built-in gain. If the Company were to divest itself of any
assets in which it had built-in gains prior to the end of a ten year recognition
period, the Company would then be subject to the extent of its built-in gain.
Note 9. Commitments and Contingencies
The Company has non-cancelable operating leases for office space and
office equipment. The leases expire over the next seven years and contain
provisions for certain annual rental escalations. Rent expense for operating
leases for the year ended December 31, 1998, the three months ended December 31,
1997, the nine months ended September 30, 1997 and the year ended December 31,
1996 was approximately $60, $73, $97, and $101, respectively.
Future minimum lease payments under non-cancelable operating leases at
December 31, 1998 were as follows:
1999 $ 240
2000 241
2001 248
2002 236
2003 and thereafter 374
--------
Total $ 1,339
========
In addition, at December 31, 1998, the Company had commitments $7.4
million to three portfolio companies. These commitments are composed of two
working capital credit facilities and one acquisition credit facility. The
commitments are subject to
30
AMERICAN CAPITAL STRATEGIES, LTD.
NOTES TO FINANCIAL STATEMENTS
(In thousands except per share data)
the borrowers meeting certain criteria. The terms of the borrowings subject to
commitment are comparable to the terms of other debt securities in the Company's
portfolio.
Note 10. Employee Stock Ownership Plan
The Company maintains an ESOP, which includes all employees and is
fully funded on a pro rata basis by the Company and its wholly owned subsidiary,
CIC. Contributions are made at the Company's discretion up to the lesser of $30
or 25% of annual compensation expense for each employee. Employees are not fully
vested until completing five years of service. For the year ended December 31,
1998, the Company and CIC contributed $97 to the ESOP, or 3% of total eligible
employee compensation.
The Company sponsors an employee stock ownership trust to act as the
depository of employer contributions to the ESOP as well as to administer and
manage the actual trust assets which are deposited into the ESOP.
Note 11. Capital Stock
In July, 1997, all unearned ESOP shares became earned and were
allocated to the ESOP accounts of the Company's employees. Pursuant to the
Company's Class A preferred stock declaration, the Class A preferred stock held
by the ESOP was converted into common stock on a one share to one share basis.
The Company also contributed an additional 529 shares of common stock to the
ESOP.
In August 1997, the Company increased its authorized shares of
unallocated preferred stock to 5,000,000 and increased its authorized shares of
common stock to 20,000,000.
On August 27, 1997, the Company declared a stock split effective August
29, 1997, effected in the form of a stock dividend pursuant to which each
outstanding share of common stock was effectively converted into 29.859 shares.
Outstanding shares and per share amounts for all periods presented have been
restated to reflect this stock split.
On August 29, 1997, the Company completed its IPO and sold 10,382
shares of its common stock at a price of $15.00 per share. Pursuant to the terms
of the Company's agreement with the underwriter of the offering, the Company
issued 442,751 common stock warrants ("Warrants") to the underwriter. The
Warrants have a term of five years from the date of issuance and may be
exercised at a price of $15.00 per share.
The Company declared dividends of $14,849, or $1.34 per share for the
year ended December 31, 1998; at year end, $1,222 remained accrued and
undistributed to shareholders. For the three months ended December 31, 1997, the
Company distributed $2,324, or $0.21 per share, to its shareholders. For Federal
income tax purposes, the distributions were 100% from ordinary income. In
addition, in accordance with regulations governing RIC's, the Company notified
shareholders of its intention to periodically repurchase its outstanding common
stock. Following release of this notification, the Company repurchased 23 shares
of it common stock at a weighted average price of $10.12 per share.
Note 12. Earnings Per Share
The following table sets forth the computation of basic and diluted
earnings per share for the year ended December 31, 1998 and the three months
ended December 31, 1997. For all other periods, earnings per share is not
presented since it is not considered meaningful due to the IPO and
reorganization of the Company as a RIC.
Year Ended Three Months Ended
December 31, 1998 December 31, 1997
----------------- -----------------
Numerator for basic and diluted net increase in
shareholders' equity resulting from operations $ 16,915 $ 2,437
Denominator for basic-weighted average shares 11,068 11,069
Employee stock options 269 251
Warrants 87 85
----------- ------------
Dilutive potential shares 356 334
Denominator for diluted 11,424 11,405
----------- ------------
Basic earnings per share $ 1.53 $ 0.22
Diluted earnings per share $ 1.48 $ 0.21
Note 13. Subsequent Events
During February 1999, the Company obtained a commitment for a $100,000
credit facility. The credit facility is funded by a commercial paper conduit and
requires the Company to create ACAS Funding, a bankruptcy remote wholly-owned
subsidiary. The Company is required to make a capital contribution of $115,000
consisting of loans and any related equity warrants to ACAS Funding. ACAS
Funding will then acquire loans and related equity warrants originated by the
Company and may borrow up to 50% of the eligible loan balance subject to certain
concentration limits. The term of the facility is two years and interest on
borrowings will be charged at LIBOR plus 2.50%. The full amount of principal is
due at the end of the term and interest is payable monthly.
31
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
NONE
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information in response to this Item is incorporated herein by reference to the
information provided in the Company's Proxy Statement for its Annual Meeting of
Shareholders to be held May 6, 1999 (the "1999 Proxy Statement") under the
headings "ELECTIONS OF DIRECTORS" and "SECTION (16) (a) BENEFICIAL OWNERSHIP
REPORTING COMPLIANCE".
ITEM 11. EXECUTIVE COMPENSATION
Information in response to this Item is incorporated herein by reference to the
information provided in the 1999 Proxy Statement under the heading "COMPENSATION
OF EXECUTIVE OFFICERS" and "DIRECTOR COMPENSATION".
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT
Information in response to this Item is incorporated herein by reference to the
information provided in the 1999 Proxy Statement under the heading "Security
Ownership of Management and Certain Beneficial Owners."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information in response to this Item is incorporated herein by reference to the
information provided in the 1999 Proxy Statement under the heading "Certain
Transactions."
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
FORM 8-K
(a) (1) The following financial statements are filed herewith:
AMERICAN CAPITAL STRATEGIES, LTD.
Report of Independent Public Accountant
Balance Sheets as of December 31, 1998 and 1997
Schedule of Investments as of December 31, 1998 and 1997
Statement of Operations for the Year Ended December 31,
1998, the Three Months Ended December 31, 1997, the Nine
Months September 30, 1997, and the Year Ended December
31, 1996.
Statement of Shareholders' Equity as of December 31,
1998, December 31, 1997, September 30, 1997, and
December 31, 1996.
Statement of Cash Flows for the Year Ended December 31,
1998, the Three Months Ended December 31, 1997, the Nine
Months Ended September 30, 1997 and the Year Ended
December 31, 1996.
Financial Highlights for the Year Ended December 31,
1998 and the Three Months Ended December 31, 1997
Notes to Financial Statements
32
(2) No financial statement schedules of the Company are filed
herewith because (i) such schedules are not required or
(ii) the information required has been presented in the
aforementioned financial statement
(3) The following exhibits are filed herewith or incorporated
herein by reference
Exhibit Description
------ -----------
3.1 American Capital Strategies, Ltd. Second Amended and Restated
Certificate of Incorporation. Incorporated herein by reference
to Exhibit a of the Pre-Effective Amendment Number 1 to the
Registration Statement on Form N-2 (File No. 333-29943) filed
on August 12, 1997.
3.2 American Capital Strategies, Ltd. Second Amended and Restated
Bylaws. Incorporated herein by reference to Exhibit b of the
Pre-Effective Amendment Number 1 to the Registration Statement
on Form N-2 (File No. 333-29943) filed on August 12, 1997.
10.1 Credit Agreement dated October 30, 1998, among the Company,
certain financial institutions named therein and LaSalle
National Bank, filed herewith.
10.2 Promissory Note dated October 30, 1998, made by the Company
in favor of LaSalle National Bank, filed herewith.
10.3 Security and Pledge Agreement dated October 30, 1998, among
the Company, certain other persons or entities named therein
and LaSalle National Bank, filed herewith.
10.4 Custody Control Agreement dated October 30, 1998, between the
Company and LaSalle National Bank, filed herewith.
10.5 Account Control Agreement dated October 30, 1998, between the
Company and LaSalle National Bank, filed herewith.
10.6 First Amendment to the Credit Agreement dated December 30,
1998, among the Company, certain financial institutions named
therein and LaSalle National Bank, filed herewith.
10.7 Promissory Note dated December 30, 1998, made by the Company
in favor of First Tennessee Bank National Association, filed
herewith.
10.8 Promissory Note dated December 30, 1998, made by the Company
in favor of US Investigations Services, Inc., filed herewith.
13 1998 Annual Report to Stockholders, incorporated herein by
reference.
21 Subsidiaries of the Company and jurisdiction of incorporation:
ACS Capital Investments Corporation, a Delaware corporation.
27 Financial Data Schedule.
- - ----------
* Management Contract or Compensatory Plan or Arrangement
(b) Reports on Form 8-K
NONE
(c) Exhibits. See the exhibits filed herewith
(d) Additional financial statement schedules
NONE
33
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.
AMERICAN CAPITAL STRATEGIES, LTD.
By: /s/ John R. Erickson
----------------------------
John R. Erickson
Vice President and
Chief Financial Officer
Date: March 31, 1998
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Name Title Date
- - ---- ----- ----
/s/ Malon Wilkus President, Chief Executive Officer,
Chairman and Director March 31, 1999
- - -------------------
Malon Wilkus
/s/ David J. Gladstone Vice Chairman and Director March 31, 1999
- - -------------------
David J. Gladstone
/s/ Adam Blumenthal Executive Vice President March 31, 1999
- - ------------------- and Director
Adam Blumenthal
/s/ John R. Erickson Vice President and Chief March 31, 1999
- - ------------------- Financial Officer
John R. Erickson (Principal Financial and
Accounting Officer)
/s/ Stephen L. Hester Vice President and General Counsel March 31, 1999
- - ------------------- Director
Stephen L. Hester
/s/ Robert L. Allbritton Director March 31, 1999
- - -------------------
Robert L. Allbritton
/s/ Alvin N. Puryear Director March 31, 1999
- - -------------------
Alvin N. Puryear
/s/ Neil M. Hahl Director March 31, 1999
- - -------------------
Neil M. Hahl
/s/ Philip R. Harper Director March 31, 1999
- - -------------------
Philip R. Harper
/s/ Stan Lundine Director March 31, 1999
- - -------------------
Stan Lundine
/s/ Steven P. Walko Director March 31, 1999
- - -------------------
Steven P. Walko
34